United
States Securities and Exchange Commission
 Washington,
D.C. 20549
 
 Form 10-Q
 
 x  Quarterly Report
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
 For the
quarterly period ended June 30, 2010
 
 or
 
  ̈  Transition Report
Pursuant to Section 13 or 15(d) of the Securities Exchange Act
 For the
transition period from ______ to _______
 
 Commission
file number 333-145183
 
 KL ENERGY
CORPORATION
 (Name of
registrant as specified in its charter )
  Nevada
                  
                  39-2052941(State
      or other jurisdiction of incorporationor
                    organization)
                  
                  (IRS
      Employer Identification
No.)
 
 306
East Saint Joseph Street, Suite 200
 Rapid City, South Dakota
57701
 (Address
of principal executive offices)
 
 (605)
718-0372
 (Registrant’s
telephone number)
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 x Yes   
 ̈ No
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).  Yes    ̈
     No  ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.
  Large
      accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈ (Do
      not check if a smaller reporting company)
              Smaller
      reporting company x
 
 Indicate
by check mark whether the registrant is a shell company  ̈
Yes      x No
 
 Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date: We had 48,378,378 shares of common
stock, $0.001 par value per share, outstanding on August 2,
2010.
  
  KL
Energy Corporation
 Form
10-Q
 For
the Period Ended June 30, 2010
 
 Table
of Contents
 
 PagePart
      I - Financial Information
                    
                    3Item
      1. Financial Statements
                    
                    3-
      Notes to Consolidated Financial Statements
                    
                    7Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of Operations
                    
                    20Item
      3. Quantitative
      and Qualitative Disclosures About Market Risk
                    
                    29Item
      4T. Controls and Procedures
                    
                    29Part
      II - Other Information
                    
                    30Item
      1. Legal Proceedings
                    
                    30Item
      1A.  Risk Factors
                    
                    31Item
      2.  Unregistered Sales of Equity Securities
                    
                    31Item
      3.  Defaults Upon Senior
      Securities
                    
                    31Item
      5. Other Information
                    
                    32Item 6. Exhibits
                    
                    33
 
 CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING INFORMATION
 
 The
report includes certain forward-looking statements.  Forward-looking
statements are statements that estimate the happening of future events and are
not based on historical fact.  Forward-looking statements may be
identified by the use of forward-looking terminology such as, “may,” “shall,”
“could,” “expect,” “estimate,” “anticipate,” “predict,” “probable,” “possible,”
“should,” “continue,” or similar terms, variations of those terms or the
negative of those terms.  The forward-looking statements specified in
the following information have been compiled by us and are considered by us to
be reasonable.  Our future operating results, however, are impossible
to predict; the reader should infer no representation, guaranty or warranty from
those forward-looking statements.
 
 The
assumptions we used for purposes of the forward-looking statements specified in
the following information represent estimates of future events and are subject
to uncertainty as to possible changes in economic, legislative, industry and
other circumstances.  As a result, our identification and
interpretation of data and other information and their use in developing and
selecting assumptions from and among reasonable alternatives require us to
exercise judgment.  To the extent that the assumed events do not
occur, the outcome may vary substantially from anticipated or projected
results.  We cannot assure that any of the assumptions relating to the
forward-looking statements specified in the following information are accurate,
and we assume no obligation to update any such forward-looking
statements.  You should read the following discussion and analysis in
conjunction with our financial statements and the related notes included
elsewhere in this report.  The following discussion and analysis is
qualified in its entirety by reference to such financial statements and related
notes.
 
 When used
in this report, the terms the "Company," "KL Energy", "we," "us," "ours," and
similar terms refer to KL Energy Corporation, a Nevada corporation, and its
subsidiaries.
  -
2 -
  PART
I:  FINANCIAL INFORMATION
 
 Item 1. Financial
Statements
 
 KL
Energy Corporation
 Consolidated
Balance Sheets
 (unaudited)
  June 30,
                          
                          
                          December
                            31,2010
                          
                          
                          2009(unaudited)ASSETSCurrent
      AssetsCash
      and cash equivalents
                          
                          
                          280,951
                          
                          
                          
                          65,049Trade
      receivables, net of allowance for doubtful accounts of $393,840 and
      $393,840, respectively
                          
                          
                          39,180
                          
                          
                          
                          35,000Accounts
      receivable - related parties
                          
                          
                          61,034
                          
                          
                          
                          1,034Inventories
                          
                          
                          14,975
                          
                          
                          
                          14,975Prepaid
      expenses and other assets
                          
                          
                          266,763
                          
                          
                          
                          138,765Deferred
      issuance costs
                          
                          
                          45,000
                          
                          
                          
                          135,000Total
      Current Assets
                          
                          
                          707,903
                          
                          
                          
                          389,823Non-Current
      AssetsProperty,
      Plant and Equipment, Net
                          
                          
                          2,643,848
                          
                          
                          
                          3,501,197Total
      Assets
                          
                          $
                          3,351,751
                          
                          
                          $
                          3,891,020LIABILITIES AND STOCKHOLDERS'
      DEFICITCurrent
      LiabilitiesCurrent
      maturities of long-term debt
                          
                          $
                          1,712,566
                          
                          
                          $
                          1,851,389Current
      maturities of subordinated debt-related party
                          
                          
                          436,461
                          
                          
                          
                          262,500Accounts
      payable
                          
                          
                          1,647,404
                          
                          
                          
                          1,672,156Accounts
      payable-related parties
                          
                          
                          38,533
                          
                          
                          
                          48,234Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
                          
                          
                          1,640,588
                          
                          
                          
                          1,640,588Accrued
      payroll
                          
                          
                          127,729
                          
                          
                          
                          203,161Other
      liabilities
                          
                          
                          843,120
                          
                          
                          
                          770,052Current
      liabilities of discontinued operations
                          
                          
                          316,431
                          
                          
                          
                          356,970Total
      Current Liabilities
                          
                          
                          6,762,832
                          
                          
                          
                          6,805,050Long-term
      debt, less current maturities
                          
                          
                          1,847
                          
                          
                          
                          9,121Subordinated
      debt-related party
                          
                          
                          70,000
                          
                          
                          
                          297,500Total
      Long-Term Debt
                          
                          
                          71,847
                          
                          
                          
                          306,621Stockholders'
      DeficitCommon
      stock, $0.001 par value; 150,000,000 shares authorized; 48,378,378 and
      45,029,894 shares issued and outstanding as of June 30, 2010 and December
      31, 2009, respectively
                          
                          
                          48,378
                          
                          
                          
                          45,029Additional
      paid-in capital
                          
                          
                          10,069,312
                          
                          
                          
                          7,060,161Accumulated
      deficit
                          
                          
                          (11,987,243
                          )
                          
                          
                          (9,267,385
                          )Deficit
      attributable to KL Energy Corporation
                          
                          
                          (1,869,553
                          )
                          
                          
                          (2,162,195
                          )Noncontrolling
      interest
                          
                          
                          (1,613,375
                          )
                          
                          
                          (1,058,456
                          )Total
      Stockholders' Deficit
                          
                          
                          (3,482,928
                          )
                          
                          
                          (3,220,651
                          )Total
      Liabilities and Stockholders' Deficit
                          
                          $
                          3,351,751
                          
                          
                          $
                          3,891,020
 
 See
accompanying notes to consolidated financial statements.
  -
3 -
  KL
Energy Corporation
 Consolidated
Statements of Operations
  ThreeMonthsEnded
                      June 30,
                    
                    
                    SixMonthsEnded
                      June 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009(Restated)RevenueBiofuel
      income
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    120,000
                    
                    
                    $
                    -Total
      Revenue
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    120,000
                    
                    
                    
                    -Operating
      ExpensesBiofuel
      costs
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    60,000
                    
                    
                    
                    -General
      and administrative
                    
                    
                    722,058
                    
                    
                    
                    560,980
                    
                    
                    
                    1,636,894
                    
                    
                    
                    2,635,746Research
      and development
                    
                    
                    784,266
                    
                    
                    
                    993,819
                    
                    
                    
                    1,665,362
                    
                    
                    
                    1,895,085Total
      Operating Expenses
                    
                    
                    1,506,324
                    
                    
                    
                    1,554,799
                    
                    
                    
                    3,362,256
                    
                    
                    
                    4,530,831Loss
      from Operations
                    
                    
                    (1,506,324
                    )
                    
                    
                    (1,554,799
                    )
                    
                    
                    (3,242,256
                    )
                    
                    
                    (4,530,831
                    )Other
      Income (Expense):Other
      income
                    
                    
                    39,018
                    
                    
                    
                    28,931
                    
                    
                    
                    17,034
                    
                    
                    
                    11,409Interest
      income
                    
                    
                    29
                    
                    
                    
                    1,743
                    
                    
                    
                    747
                    
                    
                    
                    44,330Interest
      expense
                    
                    
                    (40,526
                    )
                    
                    
                    (26,813
                    )
                    
                    
                    (80,839
                    )
                    
                    
                    (101,743
                    )Total
      Other Expense, Net
                    
                    
                    (1,479
                    )
                    
                    
                    3,861
                    
                    
                    
                    (63,058
                    )
                    
                    
                    (46,004
                    )Loss
      From Continuing Operations
                    
                    
                    (1,507,803
                    )
                    
                    
                    (1,550,938
                    )
                    
                    
                    (3,305,314
                    )
                    
                    
                    (4,576,835
                    )Income
      (loss) from discontinued operations
                    
                    
                    4,705
                    
                    
                    
                    (20
                    )
                    
                    
                    30,537
                    
                    
                    
                    (12,000
                    )Loss
      From Operations and Before NetLoss Attributable to
      NoncontrollingInterest
                    
                    
                    (1,503,098
                    )
                    
                    
                    (1,550,958
                    )
                    
                    
                    (3,274,777
                    )
                    
                    
                    (4,588,835
                    )Net
      loss attributable to noncontrolling interests
                    
                    
                    260,770
                    
                    
                    
                    379,795
                    
                    
                    
                    554,919
                    
                    
                    
                    670,297Net
      Loss
                    
                    $
                    (1,242,328
                    )
                    
                    $
                    (1,171,163
                    )
                    
                    $
                    (2,719,858
                    )
                    
                    $
                    (3,918,538
                    )Net (Loss) Income Per Share,
      basicand diluted:Continuing
      operations
                    
                    $
                    (0.03
                    )
                    
                    $
                    (0.04
                    )
                    
                    $
                    (0.07
                    )
                    
                    $
                    (0.15
                    )Discontinued
      operations
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    (0.03
                    )
                    
                    $
                    (0.04
                    )
                    
                    $
                    (0.07
                    )
                    
                    $
                    (0.15
                    )Weighted Average Common SharesOutstanding
                    
                    
                    47,686,964
                    
                    
                    
                    36,436,158
                    
                    
                    
                    46,879,634
                    
                    
                    
                    30,306,036
 
 See
accompanying notes to consolidated financial statements.
  -
4 -
  KL Energy Corporation
 Consolidated Statement of Stockholders' Deficit
  CommonStock
                        
                        
                        Stockholders'
                        
                        
                        Additional
                          Paid-In
                        
                        
                        Accumulated
                        
                        
                        Noncontrolling
                        
                        
                        Total
                          Stockholders'Shares
                        
                        
                        Amount
                        
                        
                        Contributions
                        
                        
                        Capital
                        
                        
                        Deficit
                        
                        
                        Interest
                        
                        
                        DeficitBalance
      -December
      31,2009
                        
                        
                        45,029,894
                        
                        
                        
                        45,029
                        
                        
                        
                        -
                        
                        
                        
                        7,060,161
                        
                        
                        
                        (9,267,385
                        )
                        
                        
                        (1,058,456
                        )
                        
                        
                        (3,220,651
                        )Issuance
      of shares in private placements at $1.10 per share
                        
                        
                        3,045,454
                        
                        
                        
                        3,046
                        
                        
                        
                        -
                        
                        
                        
                        3,346,954
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        3,350,000Additional
      shares issued at $1.10 per share
                        
                        
                        303,030
                        
                        
                        
                        303
                        
                        
                        
                        -
                        
                        
                        
                        (303
                        )
                        
                        
                        -
                        
                        
                        
                        -Legal,
      professional and placement fees
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (425,000
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (425,000
                        )Stock
      based compensation
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        87,500
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        87,500Net
      loss attributed to noncontrolling interests
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (554,919
                        )
                        
                        
                        (554,919
                        )Net
      loss
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (2,719,858
                        )
                        
                        
                        -
                        
                        
                        
                        (2,719,858
                        )Balance
      - June 30, 2010
                        
                        
                        48,378,378
                        
                        
                        
                        48,378
                        
                        
                        $
                        -
                        
                        
                        $
                        10,069,312
                        
                        
                        $
                        (11,987,243
                        )
                        
                        $
                        (1,613,375
                        )
                        
                        $
                        (3,482,928
                        )
 
 See
accompanying notes to consolidated financial statements.
  -
5 -
  KL Energy Corporation
 Consolidated
Statements of Cash Flows
 
 Six Months EndedJune 30,2010
                    
                    
                    2009Cash
      Flows From Operating ActivitiesNet
      loss
                    
                    
                    (3,274,778
                    )
                    
                    
                    (4,588,835
                    )Adjustments
      to reconcile net loss by cash used in operating
activities:Depreciation
                    
                    
                    969,890
                    
                    
                    
                    967,118Allowance
      for doubtful accounts
                    
                    
                    -
                    
                    
                    
                    450,215Gain
      on sale of property, plant and equipment
                    
                    
                    (535
                    )
                    
                    
                    -Stock based
      compensation expense
                    
                    
                    87,500
                    
                    
                    
                    -Changes
      in current assets and liabilities:(Increase)
      decrease in:Trade
      receivables
                    
                    
                    (64,180
                    )
                    
                    
                    (16,602
                    )Inventories
                    
                    
                    -
                    
                    
                    
                    42,663Prepaid
      expenses and other assets
                    
                    
                    (47,998
                    )
                    
                    
                    384,667Current
      assets of discontinued operations
                    
                    
                    -
                    
                    
                    
                    427Increase
      (decrease) in:Accounts
      payable
                    
                    
                    (34,453
                    )
                    
                    
                    (239,437
                    )Accrued
      payroll and other current liabilities
                    
                    
                    (2,365
                    )
                    
                    
                    980,717Current
      liabilities of discontinued operations
                    
                    
                    (40,539
                    )
                    
                    
                    (160,993
                    )Net
      Cash Used In Operating Activities
                    
                    
                    (2,407,458
                    )
                    
                    
                    (2,180,060
                    )Cash
      Flows From Investing ActivitiesPurchases
      of property, plant and equipment
                    
                    
                    (112,303
                    )
                    
                    
                    (182,436
                    )Proceeds
      from the sale of property, plant and equipment
                    
                    
                    300
                    
                    
                    
                    31,291Net
      Cash Used in Investing Activities
                    
                    
                    (112,003
                    )
                    
                    
                    (151,145
                    )Cash
      Flows From Financing ActivitiesPayments
      from lines of credit and short-term borrowings
                    
                    
                    -
                    
                    
                    
                    (250,000
                    )Proceeds
      from subordinated debt – related parties, net
                    
                    
                    -
                    
                    
                    
                    -Payments
      on subordinated debt - related parties, net
                    
                    
                    (53,539
                    )
                    
                    
                    -Payments
      on long-term debt principal
                    
                    
                    (226,098
                    )
                    
                    
                    (620,725
                    )Issuance
      costs
                    
                    
                    (335,000
                    )
                    
                    
                    (750,000
                    )Proceeds
      from issuance of common stock
                    
                    
                    3,350,000
                    
                    
                    
                    4,000,000Net
      Cash Provided by Financing Activities
                    
                    
                    2,735,363
                    
                    
                    
                    2,379,275Net
      Increase in Cash and Cash Equivalents
                    
                    
                    215,902
                    
                    
                    
                    48,070Cash
      and cash equivalents at beginning of period
                    
                    
                    65,049
                    
                    
                    
                    698,101Cash
      and cash equivalents at end of period
                    
                    $
                    280,951
                    
                    
                    $
                    746,171Supplemental
      Disclosures of Cash Flow InformationInterest
      paid
                    
                    $
                    56,610
                    
                    
                    $
                    69,571Prepaid
      issuance costs netted in equity
                    
                    
                    90,000
                    
                    
                    
                    -Insurance
      premium financed with debt
                    
                    
                    80,000
                    
                    
                    
                    -Conversion
      of accounts payable and accrued liabilities to common
stock
                    
                    
                    -
                    
                    
                    
                    860,225Conversion
      of debt issuance costs payable to common stock
                    
                    
                    -
                    
                    
                    
                    285,000Settlement
      of accounts payable with debt
                    
                    
                    -
                    
                    
                    
                    335,000
 
 See
accompanying notes to consolidated financial statements.
  -
6 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 1 – Nature of Business and Significant
Accounting Policies
 
 Nature of
Business
 
 KL Energy
Corporation (“KL”, formerly known as Revive-it Corp.) was incorporated on
February 26, 2007, in the State of Nevada, to engage in the development of skin
care and cosmetic products. On September 30, 2008, we entered into an Agreement
and Plan of Merger with KL Process Design Group, LLC (“KLPDG”), which provided
for the merger of KLPDG with and into our Company (the “Merger”).  As
a result of the Merger, our Company acquired all of the assets and liabilities
of KLPDG.
 
 For
accounting purposes, the Merger was treated as a reverse acquisition with KLPDG
as the acquirer and the Company as the acquired party. As a result, the business
and financial information included in this report is the business and financial
information of KLPDG. KLPDG was a South Dakota limited liability company that
was organized in April 2003, and commenced business operations in January
2006.
 
 While we
have historically provided engineering, construction, operating and ethanol
marketing services, our focus is now on owning and operating cellulose based
ethanol ("CBE") facilities that utilize our proprietary technology, and
designing CBE facilities for, and licensing our proprietary CBE technology to,
third-party participants in the CBE industry.  We began our cellulose
based ethanol research and development efforts in 2004 and we commissioned our
WBE cellulosic ethanol plant in late 2008.  The Company, through its
majority-owned subsidiary Western Biomass Energy, LLC (“WBE”), has designed,
built, and operates a cellulose-based ethanol (“CBE”) plant based on KL’s
proprietary technology.    The plant is located in Upton,
Wyoming and is designed to convert biomass into ethanol.  The WBE
plant serves as a demonstration and research and development facility and could
operate as a commercial plant pending added investment.   This
plant will be run as an industrial validation facility for approximately the
next 18 months.  Thereafter, and following a full feasibility study,
we will determine the amount of additional investment required.
 
 The
Company also distributed ethanol blended fuel, through its majority-owned
Patriot Motor Fuels, LLC.  As a result of pricing and competitive
factors, the Patriot business was discontinued in January 2009.  In
June 2009, the Company also discontinued two additional businesses in which it
held a majority interest:  KL Management LLC, which managed ethanol
facilities for third parties, and KLHC LLC (formerly known as KL Energy LLC)
which sold wholesale ethanol.  Both businesses were discontinued as a
result of the severe change in the economics of the first generation ethanol
industry but especially due to the Company’s re-focus on cellulosic second
generation ethanol commercialization.
 
 A key
part of our business model is the design of scalable, custom-designed fully
integrated CBE plants, preferably with integrated Combined Heat and Power
(CHP) and Bio-Lignin production, tailored to a project’s geographic area
and locally available feedstock. Through WBE, we have designed, constructed and
operated what we believe to be one of the first second generation CBE
demonstration plants in the United States. This plantwas constructed to both
facilitate research and validate our technology at a demonstration scale.
This allows us to continue to research, and refine our cellulose conversion
technology, while also demonstrating the commercial viability for this type
of technology.
  -
7 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 1 – Nature of Business and Significant
Accounting Policies (continued)
 
 Nature of Business
(continued)
 
 The
amounts reported in this Form 10-Q related to the quarter ended June 30, 2009
have been restated to correct a previous error and to be consistent with the
Company’s presentation in its Annual Report on Form 10-K for the year ended
December 31, 2009.  The previously filed Form 10-Q, for the quarter ended
June 30, 2009, reflected the entire net loss attributable to noncontrolling
interests for the period from January 1, 2009 through June 30, 2009 in the
quarter ended June 30, 2009.  This restatement adjusts the statement
of operations for the quarter ended June 30, 2009 to reflect the net loss
attributable to noncontrolling interests for the period from April 1, 2009
through June 30, 2009.  This error did not have an effect on any
balance sheet period presented in this Form 10-Q or the statement of operations
for the six months ended June 30, 2009.  The following table presents the
effects of correctly recording the net loss attributable to noncontrolling
interests for the quarter ended June 30, 2009:
  As
                      PreviouslyReported
                    
                    
                    Adjustment
                    
                    
                    AsRestatedNet
      loss attributable to noncontrollinginterests
                    
                    $
                    670,297
                    
                    
                    $
                    (290,502
                    )
                    
                    $
                    379,795Loss
      from continuing operations
                    
                    $
                    (1,550,958
                    )
                    
                    $
                    -
                    
                    
                    $
                    (1,550,958
                    )Net
      loss
                    
                    $
                    (880,661
                    )
                    
                    $
                    (290,502
                    )
                    
                    $
                    (1,171,163
                    )Net
      loss per share, basic and diluted
                    
                    $
                    (0.02
                    )
                    
                    $
                    (0.01
                    )
                    
                    $
                    (0.03
                    )
 
 Significant Accounting
Policies
 
 Use
of Estimates
 
 The
preparation of financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from those
estimates.  The following estimates are significant to the Company’s
consolidated financial statements: costs to complete long-term contracts, useful
lives of property, plant and equipment, impairment of long-lived
assets, valuation of share based compensation, going concern analysis,
valuation allowance on deferred tax assets and the allowance for doubtful
accounts.
 
 Principles
of Consolidation
 
 The
accompanying consolidated financial statements include the results of operations
and financial position of the Company, KL Energy Services LLC (“KLES”, a
wholly-owned subsidiary, as well as its wholly-owned KLHC LLC (formerly known as
KL Energy LLC, “KLHC”) and majority-owned KL Management, LLC (“KLM”), Patriot
Motor Fuels LLC (“Patriot”) and Western Biomass Energy LLC
(“WBE”).  Until September 30, 2008, KLHC and KLM were 53% owned by
KLPDG and the remaining 47% was owned by three other individuals; Patriot was
50% owned by KLPDG and two other owners held the remaining 50% interest.   At September 30,
2008, the Company ownership interest increased to 75% for KLHC, KLM and Patriot.
WBE is 64% owned by the Company and 36% owned by various unrelated
investors.  All significant intercompany accounts and transactions
have been eliminated in consolidation.
  -
8 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 1 – Nature of Business and Significant
Accounting Policies (continued)
 
 Significant Accounting
Policies (continued)
 
 Basis
of Presentation
 
 The
accompanying unaudited consolidated financial statements and related notes have
been prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and the instructions
to Form 10-Q and Rule 10-01 of Regulation S-X. Results for interim
periods should not be considered indicative of results for a full year. These
interim consolidated financial statements should be read in conjunction with the
consolidated financial statements and related notes contained in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2009. In the
opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair statement of the results for
interim periods have been included.
 
 We have
reclassified certain data in the financial statements of the prior period to
conform to the current period presentation.  Specifically, in the
statement of operations, we reclassified approximately $251,000 and $432,000 of
expenses in the three and six months ended June 30, 2009, respectively, that
were previously included in general and administrative expenses but that were
more appropriately includable in research and development expenses.
 
 Recently
Issued Accounting Pronouncements
 
 In
January 2010, the Financial Accounting Standards Board, or FASB, issued guidance
requiring additional fair value disclosures for significant transfers between
levels of the fair value hierarchy and gross presentation of items within the
Level 3 reconciliation. This guidance also clarifies that entities need to
disclose fair value information for each class of asset and liability measured
at fair value and that valuation techniques need to be provided for all
non-market observable measurements. Our adoption of this guidance on
January 1, 2010, did not impact our consolidated financial statements as we
have no items classified as Level 3.
 
 In August
2009, the FASB issued new accounting guidance to provide clarification on
measuring liabilities at fair value when a quoted price in an active market is
not available. This guidance became effective for us on October 1, 2009. The
Company adopted this guidance on October 1, 2009, and it had no material impact
on our consolidated financial statements.
 
 In April
2009, the FASB issued additional guidance regarding fair value measurements and
impairments of securities which makes fair value measurements more consistent
with fair value principles, enhances consistency in financial reporting by
increasing the frequency of fair value disclosures, and provides greater clarity
and consistency in accounting for and presenting impairment losses on
securities.  The additional guidance is effective for interim and
annual periods ending after June 15, 2009, with early adoption permitted for
periods ending after March 15, 2009.  The Company adopted the
provisions for the period ending March 31, 2009.  The adoption did not
have a material impact on our financial position or results of
operations.
 
 In April
2009, the FASB issued new accounting guidance related to interim disclosures
about the fair values of financial instruments. This guidance requires
disclosures about the fair value of financial instruments whenever a public
company issues financial information for interim reporting periods. This
guidance is effective for interim reporting periods ending after June 15, 2009.
The Company adopted this guidance upon its issuance, and it had no material
impact on our consolidated financial statements.
  -
9 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Long-Lived
Assets
 
 The
Company assesses the realizable value of long-lived assets for potential
impairment at least annually or when events and circumstances warrant such a
review.  The net carrying value of a long-lived asset is considered
impaired when the anticipated fair value is less than its carrying value. 
Approximately 96% of the Company’s property, plant and equipment is attributable
to the WBE facility in Upton, Wyoming.
 
 In
assessing the recoverability of our long-lived assets, we must make assumptions
regarding estimated future cash flows, useful lives and other factors to
determine the fair value of the respective assets.   This facility is
currently used for developing new, or refining existing, cellulosic ethanol
technology.  It is the Company’s intent that this facility’s
alternative future use will involve the production and sale of small but
commercial quality volumes of ethanol and lignin and currently there are no
indications that the Company will be unable to execute its business
plan.  This alternative use is expected to generate positive cash flow
in future years.
 
 As of
December 31, 2009, we evaluated our long-lived assets for potential
impairment.  Based on our evaluation, no impairment charge was
recognized.
 
 Note
2 - Property, Plant, and Equipment
 
 Property,
plant, and equipment consist of the following as of:
  June 30,
                      
                      
                      December
                        31,2010
                      
                      
                      2009Plant
      and Plant Equipment
                      
                      $
                      7,410,262
                      
                      
                      $
                      7,402,413Office
      Furnishings and Equipment
                      
                      
                      373,156
                      
                      
                      
                      274,103Vehicles
                      
                      
                      51,698
                      
                      
                      
                      51,6987,835,116
                      
                      
                      
                      7,728,214Less
      Accumulated Depreciation
                      
                      
                      (5,191,268
                      )
                      
                      
                      (4,227,017
                      )Total
      Property, Plant, and Equipment, Net
                      
                      $
                      2,643,848
                      
                      
                      $
                      3,501,197
 
 Construction
costs associated with the WBE demonstration plant are stated at cost (including
direct construction costs, and capitalized interest).  The Company has
also capitalized approximately $471,000 of professional engineering and
construction services provided by the Company through June 30,
2010.
 
 Note
3 - Financing
 
 On June
4, 2010, the Company received the final installment of an equity financing
pursuant to Securities Purchase Agreement with a certain investor listed on the
signature page of such purchase agreement.  Pursuant to the terms
of the purchase agreement, the Company issued to the Investor 681,818 shares of
the Company’s common stock, at $1.10 per share, for net proceeds to
the Company of $675,000.  The shares were issued in reliance on the
exemption provided by Regulation S of the Securities Act of 1933, as
amended.
  -
10 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note
3 – Financing (continued)
 
 On May 3,
2010, the Company received the final installment of a Securities Purchase
Agreement with a certain investor.  Pursuant to the terms of the
Purchase Agreement, the Company issued to the investor 545,455 shares of the
Company’s common stock, at $1.10 per share, for net proceeds to the
Company of $540,000.  The shares will be issued in reliance on the
exemption provided by Regulation S of the Securities Act of 1933, as
amended.
 
 Effective
April 6, 2010, pursuant to the terms of a Securities Purchase Agreement executed
on January 6, 2010 and which agreement required pricing of these shares to be
reduced to $1.10 per share based on the absence of an investment by an
additional institutional investor within 90 days after the date of the
agreement, the Company issued to this investor an additional 363,636 shares of
the Company’s common stock at $1.10 per share.  The shares were
issued in reliance on the exemption provided by Regulation S of the Securities
Act of 1933, as amended.
 
 On March
30, 2010, the Company received the final installment of the December 2009
Securities Purchase Agreement with a certain investor listed on the signature
page of such Purchase Agreement.  Pursuant to the terms of the
Purchase Agreement, the Company issued to the investor 454,545 shares of the
Company’s common stock, at $1.10 per share, for net proceeds to the
Company of $450,000.  The shares will be issued in reliance on the
exemption provided by Regulation S of the Securities Act of 1933, as
amended.
 
 On
January 6, 2010, the Company entered into a Securities Purchase Agreement
with a certain investor.  Pursuant to the terms of the Purchase
Agreement, the Company received $1.5 million before expenses on that date,
representing 50% of the investor’s commitment to purchase 2,000,000 shares of
the Company’s common stock, and will pay the remaining $1.5 million within 14
days of receiving a written demand from the Company.  The pricing of
these shares may be reduced based on certain subsequent events.  (See
Note 13 for additional details.)  This Purchase Agreement provides
for: (i) piggyback registration rights allowing the Investor to participate in
registration statements filed by the Company and (ii) participation rights
allowing the Investor to purchase its pro rata share of equity securities issued
by the Company for cash, with certain exceptions including, without limitation,
issuances relating to compensation, commercial credit arrangements, and
strategic transactions involving ongoing business relationships. The shares will
be issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.
 
 Note
4 – Net Loss Per Common Share
 
 Basic EPS
includes no dilution and is computed by dividing income or
(loss) applicable to common stock by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
of securities that could share in the earnings of an entity, similar to fully
diluted EPS.   For the three and six months ended June 30, 2010 and
2009, stock warrants for 3,125 shares were not included in the computation of
diluted loss per share because their effect was anti-dilutive.  For the
three and six months ended June 30, 2010, stock options for 83,333 shares of
common stock were not included in the computation of diluted loss per share
because their effect was anti-dilutive.  There were no other stock
warrants or options issued or outstanding as of June 30, 2010.
 
 Note 5 - Operations
 
 Continuing
Operations
 
 During
the period from its inception to June 30, 2010, the Company has incurred
significant annual net losses and at June 30, 2010 and December 31, 2009, the
Company had negative working capital (i.e. current assets less current
liabilities) of approximately $6.1 million and $6.4 million,
respectively.  At June 30, 2010, total liabilities exceeded total
assets by approximately $3.5 million.  The first generation ethanol
industry, in which the Company has historically operated, continues to face
significant challenges including increased construction costs, limited
availability of debt and equity financing and a reduction in public and
governmental support.
 
 These
factors, among others, indicate the Company may be unable to meet its current
obligations and may be unable to continue as a going concern unless it raises
additional capital.  Management is continuing its efforts to raise
additional capital through various methods and has refocused its business to
cellulosic ethanol.
  -
11 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 5 – Operations
(continued)
 
 Discontinued
Operations
 
 In
January 2009, the Company determined that its majority-owned subsidiary, Patriot
Motor Fuels LLC (“Patriot”), should be discontinued as a result of pricing and
other competitive factors.  Patriot distributed ethanol blended
fuel.  In June 2009, the Company also discontinued two additional
businesses in which it held a majority interest:  KL Management LLC
(“KLM”), which managed ethanol facilities for third parties, and KLHC LLC
(formerly known as KL Energy LLC, “KLHC”), which sold wholesale
ethanol. Both businesses were discontinued as a result of the severe change
in the economics of the first generation ethanol industry but especially due to
the Company’s re-focus on cellulosic second generation ethanol
commercialization.
 
 Operating
results from discontinued operations were income (loss) of approximately
$5,000 and ($20) during the three months ended June 30, 2010 and 2009,
respectively, and income (loss) of approximately $31,000 and ($12,000) during
the six months ended June 30, 2010 and 2009, respectively.   At
June 30, 2010 and 2009, these businesses had no assets and the only liabilities
were accounts payable of $316,431 and $356,970, respectively.
 
 Note
6 –Debt
 
 Short-Term
Borrowing Arrangements
 
 The
Company had available a $250,000 revolving line of credit with Wells Fargo Bank,
N.A. that was personally guaranteed by certain Company shareholders, and
collateralized by their personal property, with accrued interest payable monthly
at the prime rate plus 0.5% (3.75% at December 31, 2008). This line of credit
matured and was paid off in June 2009.
 
 In
addition, the Company had approximately $39,000 and $44,000 in credit card
liability at June 30, 2010 and December 31, 2009, respectively, which are also
guaranteed by certain shareholders. These credit card liability balances are
included in accounts payable in the accompanying consolidated balance
sheets.  These liabilities are being reduced monthly.
 
 Subordinated
Debt – Related Parties
 
 The
Company has a subordinated secured note payable to a Company shareholder
totaling $506,461and $560,000 at June 30, 2010 and December 31, 2009,
respectively.  This note includes interest at a variable rate, which
was 5.0% at June 30, 2010 and December 31, 2009, respectively, with interest
paid quarterly.  Prior to February 2009, this note was unsecured and
did not have a specified due date. In February 2009, the note was modified to
include principal payments of $10,000 per month, beginning in September 2009,
over a 60-month term. The principal payments are scheduled to be $120,000 in
2010, 2011, 2012, 2013, respectively, and $56,461 in 2014.  Payments
of $120,000 are due on this note in the next twelve months and therefore have
been classified as current at June 30, 2010.  As security for our
obligations under this note, we granted to the lender a security interest in our
current and future accounts receivable.  In addition, if the Company
receives additional equity financing, the Company is obligated to pay 5% of the
proceeds towards principal payments on this note.  Based on equity
financing since February 2009, an additional $310,000 has been classified as
currently payable. Total current maturities and the balance on this note as of
June 30, 2010 were $436,461 and $506,461, respectively
  -
12 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 Note 6 –Debt
(continued)
 
 Long-Term
Debt
 
 Long-term
debt consists of the following as of:
  June 30,
                            2010
                          
                          
                          December
                            31,
                            2010Note
      payable to bank with interest at 6.5%. The note is payable in twelvemonthly
      installments of $17,560 of principal and interest beginning March2010
      with any remaining unpaid principal and interest due March 2011, withadditional
      maturity extensions available. This note is secured by substantiallyall
      assets of WBE and guaranteed by the Company and certain WBEmembers.
                          
                          $
                          1,332,028
                          
                          
                          $
                          1,394,043Payable
      to Hermanson Egge to replace overdue payables for construction services
      with unsecured agreement, interest at 0% with payments of $70,000 in July
      2009, $15,000 monthly from July 2009 to April 2010, $10,000 monthly from
      May 2010 to August 2010, $20,000 monthly for September 2010 to November
      2010 and $15,000 in December 2010.
                          
                          
                          85,000
                          
                          
                          
                          160,000Note
      payable to Lansing Securities Corp., interest at 10% and the maturity date
      has passed and has been temporarily waived by the note holder until
      further notice.
                          
                          
                          250,000
                          
                          
                          
                          250,000Note
      payable to Universal Premium Acceptance Corp. for payment of insurance
      premiums, interest at 9.24%, payable in monthly principal and interest
      installments of $5,239.
                          
                          
                          –
                          
                          
                          
                          30,605Note
      payable to Avid Solutions for centrifuge equipment of $195,000, payable in
      monthly principal and interest installments of $10,000, including interest
      at 10% secured by equipment.
                          
                          
                          –
                          
                          
                          
                          6,767Note
      payable to Shimadzu for lab equipment of $32,114, payable in monthly
      principal and interest installments of $1,072, including interest at 13.6%
      secured by equipment.
                          
                          
                          14,71
      4
                          
                          
                          
                          19,095Note
      payable to First Insurance Funding Corporation for payment of direct or
      and officer insurance premiums, payable in monthly installments of $3,692,
      including interest at 8.4%.
                          
                          
                          32,671
                          
                          
                          
                          –Subordinated
      note payable to Randy Kramer and assigned to First National Bank, interest
      at 5.0%, secured by accounts receivable of the Company, payable in monthly
      installments of $10,000 per month plus interest beginning September 2009
      and 5% of equity financings after February 2009.
                          
                          
                          506,461
                          
                          
                          
                          560,000Subtotal
                          
                          $
                          2,220,874
                          
                          
                          $
                          2,420,510Less
      current maturities of long-term debt
                          
                          
                          (2,149,027
                          )
                          
                          
                          (2,113,889
                          )Total
      Long-Term Debt
                          
                          $
                          71,847
                          
                          
                          $
                          306,621
  -
13 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note
7 – Common Stock Activity
 
 Pursuant
to the terms of a Securities Purchase Agreement executed in January 2010, which
agreement required pricing of these shares to be reduced to $1.10 per share
based on the absence of an investment by an additional institutional investor
within 90 days after the date of the agreement, the Company issued to this
investor 363,636 shares of the Company’s common stock at $1.10 per share. The
shares were issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.
 
 Note 8 - Segment
Information
 
 As of
June 30, 2010, the Company manages its business and aggregates its operational
and financial information in accordance with two reportable segments. Its engineering and management
contracts segment provides contracted engineering and project development
to third party customers. Despite the lack of activity in this segment during
the first three months of 2010, during which time the Company focused its
resources on biofuel research and development, management believes this will be
a viable business segment in the near future. The biofuel segment is
focused on developing unique technical and operational capabilities designed to
enable the production and commercialization of biofuel, in particular ethanol
from cellulosic biomass, and is expected to begin operations starting in
2010.
 
 Management
assesses performance and allocates resources based on specific financial
information for the business segments. For the biofuel segment, performance is
assessed based on total operating expenses and capital expenditures. Operating
expenses for each segment include direct costs of that segment. Expenses and
assets shared by the segments require the use of judgments and estimates in
determining the allocation of expenses to the segments. Different assumptions or
allocation methods could result in materially different results by
segment.
  -
14 -
  KL Energy
Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 8 - Segment Information
(continued)
 
 Financial
information for the Company’s business segments was as follows (in
thousands):
 
 As of
                    
                    
                    As ofJune
      30,
                    
                    
                    December 31,2010
                    
                    
                    2009Identifiable
      Fixed Assets:Engineering
      and management contracts
                    
                    $
                    425
                    
                    
                    $
                    326Biofuel
      research and development
                    
                    
                    7,410
                    
                    
                    
                    7,402Total
                    
                    
                    7,835
                    
                    
                    
                    7,728Accumulated
      depreciation
                    
                    
                    (5,191
                    )
                    
                    
                    ( 4,227
                    )Total
      Identifiable Fixed Assets
                    
                    $
                    2,644
                    
                    
                    $
                    3,501
 
 For the Three Months Ended
                                    
                                    
                                    For the Six Months EndedJune 30,
                                    
                                    
                                    June 30,2010
                                    
                                    
                                    2009
                                    
                                    
                                    2010
                                    
                                    
                                    2009Revenues:Engineering
      and management contracts
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -Biofuel
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    120
                                    
                                    
                                    
                                    -Total
      Revenues
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    120
                                    
                                    
                                    $
                                    -Depreciation:Engineering
      and management contracts
                                    
                                    $
                                    14
                                    
                                    
                                    $
                                    14
                                    
                                    
                                    $
                                    29
                                    
                                    
                                    $
                                    30Biofuel
                                    
                                    
                                    473
                                    
                                    
                                    
                                    467
                                    
                                    
                                    
                                    941
                                    
                                    
                                    
                                    937Total
      Depreciation
                                    
                                    $
                                    487
                                    
                                    
                                    $
                                    481
                                    
                                    
                                    $
                                    970
                                    
                                    
                                    $
                                    967Interest
      Expense:Engineering
      and management contracts
                                    
                                    $
                                    26
                                    
                                    
                                    $
                                    20
                                    
                                    
                                    $
                                    44
                                    
                                    
                                    $
                                    61Biofuel
                                    
                                    
                                    15
                                    
                                    
                                    
                                    6
                                    
                                    
                                    
                                    37
                                    
                                    
                                    
                                    40Total
      Interest Expense
                                    
                                    $
                                    41
                                    
                                    
                                    $
                                    26
                                    
                                    
                                    $
                                    81
                                    
                                    
                                    $
                                    101Net
      Loss:Engineering
      and management contracts
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -Biofuel
                                    
                                    
                                    (1,242
                                    )
                                    
                                    
                                    (1,171
                                    )
                                    
                                    
                                    (2,720
                                    )
                                    
                                    
                                    (3,919
                                    )Net
      Loss
                                    
                                    $
                                    (1,242
                                    )
                                    
                                    $
                                    (1,171
                                    )
                                    
                                    $
                                    (2,720
                                    )
                                    
                                    $
                                    (3,919
                                    )Reconciliations to Reported
      AmountsRevenue
      - Reportable Segments
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    120
                                    
                                    
                                    $
                                    -Eliminations/Other
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
      Consolidated Revenue
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    120
                                    
                                    
                                    $
                                    -Net
      Loss - Reportable Segments
                                    
                                    $
                                    (1,242
                                    )
                                    
                                    $
                                    (1,171
                                    )
                                    
                                    $
                                    (2,720
                                    )
                                    
                                    $
                                    (3,919
                                    )Eliminations/Other
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
      Consolidated Net Loss
                                    
                                    $
                                    (1,242
                                    )
                                    
                                    $
                                    (1,171
                                    )
                                    
                                    $
                                    (2,720
                                    )
                                    
                                    $
                                    (3,919
                                    )
 
 Note 9
– Noncontrolling Interests
 
 On
January 1, 2009, the Company adopted changes issued by the FASB to
consolidation accounting and reporting. These changes establish accounting and
reporting for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. This guidance defines a noncontrolling
interest, previously called a minority interest, as the portion of equity in a
subsidiary not attributable, directly or indirectly, to a parent. These changes
require, among other items, that (a) noncontrolling interests to be included in
the consolidated statement of financial position within equity separate from the
parent’s equity, (b) consolidated net income to be reported at amounts inclusive
of both the parent’s and noncontrolling interest’s shares and, separately, the
amounts of consolidated net income attributable to the parent and noncontrolling
interest all on the consolidated statement of operations, and (c) if a
subsidiary is deconsolidated, any retained noncontrolling equity investment in
the former subsidiary should be measured at fair value and a gain or loss be
recognized in net income based on such fair value. Other than the change in
presentation of noncontrolling interests, the adoption of these changes had no
impact on the consolidated financial statements. The presentation and disclosure
requirements of these changes were applied retrospectively.
  -
15 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note 9
– Noncontrolling Interests (continued)
 
 Components
of noncontrolling interests are as follows:
  June 30,
                      
                      
                      December
                        31,2010
                      
                      
                      2009(unaudited)Beginning
      of period
                      
                      $
                      (1,058,456
                      )
                      
                      $
                      193,399Net
      loss attributable to noncontrolling interests
                      
                      
                      (554,919
                      )
                      
                      
                      (1,251,855
                      )End
      of period
                      
                      $
                      (1,613,375
                      )
                      
                      $
                      (1,058,456
                      )
 
 Note
10 - Contingencies
 
 Litigation
  The
Company is named in a personal injury lawsuit, filed in the District Court of
Lincoln County, Nebraska, relating to an employee of a subcontractor performing
acid cleaning services of a grain based ethanol plant boiler.  The Company
was also performing services at the grain based ethanol plant in 2006. The
plaintiff is seeking general damages, including pain and suffering and loss of
earnings capacity, in an unspecified amount.  The amount of liability,
if any, is not determinable but the Company plans to vigorously defend its
position. The insurance company for the grain based ethanol plant is defending
the Company employee.  The jury trial is expected to take place in the
fourth quarter of 2010.  At this time, the Company is unable to
predict the outcome of the case, and accordingly has not recorded an accrual for
such potential loss, but plans to vigorously defend its position.
 
 The
Company is named in a pending action, filed in the Minnehaha County Court in
Sioux Falls, South Dakota, which is captioned Dakota Supply Group, Inc. (“DSG”)
v. KL Process Design Group, LLC (“KL”), and Midwest Renewable Energy, LLC,
(“MRE”).  The action was commenced in 2008 for the collection of a debt of
approximately $524,000 plus interest for electrical supplies and materials
furnished by DSG to MRE.  DSG alleges that KL and MRE are responsible for
the debt because KL executed the purchase order without clarifying that the debt
was the responsibility of MRE and that credit was extended directly to KL rather
than MRE.  Depositions have taken place between all parties. At this time,
the Company is unable to predict the outcome of the case, and accordingly has
not recorded an accrual for such potential loss, but plans to vigorously defend
its position.
  -
16 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note
10 - Contingencies (continued)
 
 Litigation
(continued)
 
 On June
30, 2009, a lawsuit was brought against the Company, certain subsidiaries, and
certain current and past officers in the District Court of Lincoln County,
Nebraska.  The plaintiff is Midwest Renewable Energy, LLC, a Nebraska
limited liability company ("MRE").  MRE previously engaged the Company to
manage its existing ethanol facility, oversee its expansion construction and
market the ethanol produced at its facilities.  The plaintiff alleges,
among other things, that the named individuals and entities engaged in
breaches of fiduciary duties owed to MRE, breaches of contract, fraud,
interference with contract, conversion and negligence relating to the management
and expansion of its corn-based ethanol facilities in
Nebraska.  In August 2009, Company filed a motion to compel MRE to
arbitrate its claims, and also separately filed three arbitration demands for
claims relating to the three agreements between the Company and its affiliates
and MRE that were at issue in the lawsuit.  In November 2009, the
Court ruled for the Company and issued an order to compel arbitration. The
arbitration proceedings for two of the three arbitrations have begun and are
expected to conclude in the fourth quarter of 2010. The Company and MRE are
currently waiting for the third arbitration claim and demand to begin.  At
this time, the Company is unable to predict the outcome of the case, and
accordingly has not recorded an accrual for such potential loss, but plans to
vigorously defend its position.
 
 The
Company may be subject to various claims and legal actions arising in the
ordinary course of business from time to time. The Company maintains insurance
to cover certain such actions.
 
 Note 11
– Related Parties
 
 Pursuant
to its agreement with the Company, Pelly Management, Inc. (“Pelly”) received
fees of $135,000 and $335,000 for the three and six months ended June 30, 2010,
respectively and $0 and $400,000 for the three and six months ended June 30,
2009, respectively.  These amounts represent fees for financial
advisor services.
 
 In March
2010, the Company entered into a consulting agreement with add blue Consultoria
Ltda., a Brazilian consulting company, for the provision of services by Peter
Gross as CEO and President of the Company and its
subsidiaries.  During the three and six months ended June 30, 2010,
fees paid to add blue Consultoria Ltda.  were approximately $48,000
and $72,000, respectively.
 
 In February
2009 and April 2009, the Company entered into a consulting contract with Thomas
Schueller, for the position of Executive Chairman of the Board, and Thomas
Bolan, for the position of Chief Financial Officer,
respectively.  In July 2009, the Company also entered into
a consulting services contract with Alan Rae, a
Director.  During the three months ended June 30, 2010 and 2009, fees
paid to Messrs. Schueller, Bolan and Rae were approximately $37,000 and $36,000,
$ 35,000 and $38,000, and $42,000 and $0, respectively.  During the
six months ended June 30, 2010 and 2009, fees paid to Messrs. Schueller, Bolan
and Rae were approximately $73,000 and $56,000, $73,000 and $38,000, and $77,000
and $0, respectively.
 
 As
approved by the Board of Directors on March 2, 2010, a Director’s fee of $18,000
per annum will be awarded to all serving non-executive and non-consulting
directors.  However, payment of such fees will be deferred until
approved by the Board. As of the date of this report, Alain Vignon was the only
Non-Executive, Non-Consulting director and $31,500 has been accrued for his
services from his appointment in October 2008 through June
2010.
  -
17 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note
12 – Share Based Compensation
 
 On March
2, 2010, the Company issued to a former executive an option to purchase 83,333
shares of the Company’s common stock at an exercise price of $1.10 which became
fully vested on April 2, 2010 and is exercisable for three years.  The
options were issued to Mr. Corcoran pursuant to Regulation D of the Securities
Act of 1933, as amended.  The fair value of this option, based on
volatility of 232%, and dividend and risk-free interest rates of 0% and 1.51%,
respectively, was $87,500 and this amount is included in general and
administrative expense in the consolidated statements of
operations.
 
 The
Company adopted accounting guidance that sets accounting requirements for
share-based compensation to employees and non-employee directors and
consultants, and requires companies to recognize in the statement of operations
the grant-date fair value of stock options and other equity based compensation
expensed over the requisite service and vesting period. For the purpose of
determining the fair value of stock option awards, the Company uses the
Black-Scholes option-pricing model. The estimation of forfeitures is required
when recognizing compensation expense which is then adjusted over the requisite
service period should actual forfeitures differ from such estimates. Changes in
estimated forfeitures are recognized through a cumulative adjustment to
compensation in the period of change.   As of June 30, 2010, the
Company has not experienced any forfeitures.
 
 The
prescribed accounting guidance also requires tax benefits relating to excess
stock-based compensation deductions to be prospectively presented in the
statement of cash flows as financing cash inflows. As of June 30, 2010, the
Company does not have any tax expense (benefits) resulting from stock-based
compensation deductions in excess of amounts reported for financial reporting
purposes.
  -
18 -
  KL
Energy Corporation
 Notes
to Consolidated Financial Statements
 (unaudited)
 
 Note
13 – Subsequent Events
 
 On July
2, 2010, a lawsuit was brought against the Company and certain current directors
and a Company investor in the Seventh Judicial District Court of Pennington
County, South Dakota.  The plaintiff is Randy Kramer, a former CEO of the
Company. The plaintiff alleges, among other things, that the Company
violated the severance agreement signed by the Company and Kramer.  The
plaintiff also alleges that the named defendants engaged in conspiracy to have
him removed as CEO and oppressed him to sign the Severance Agreement. At this
time, the Company is unable to predict the outcome of the case but plans to
vigorously defend its position.
 
 On July
1, 2010, the Company received the final installment of the January 2010
Securities Purchase Agreement with a certain Investor listed on the signature
page of such Purchase Agreement.  In lieu of issuing stock
pursuant to that Purchase Agreement, the Company agreed to issue a $1.5 million
Convertible Promissory Note for such investment which resulted in net
proceeds to the Company of $1.35 million.    This Note
is non-interest bearing and is payable in full on February 11,
2020.  Pursuant to that Note, if the Company raises at least $15.0
million in equity financing prior to February 11, 2020, the outstanding Note
principal will automatically convert into the Company’s common stock at a
conversion rate of $1.10 per share (or 1,363,636 shares).
 
 On June
30, 2010, the Board of Directors approved the issuance of awards, effective July
1, 2010, of incentive stock options on 119,518 shares of common stock to
employees and 44,794 shares of restricted common stock to
consultants.  These awards were made pursuant to the Company’s 2009
Equity Incentive Plan and are one-third vested on July 1, 2010, July 1, 2011 and
July 1, 2012.  The exercise price per share was set at $1.10 per share
on the date of grant.  This grant date and exercise price represents
the effective price at which all recent private placement sales have been
transacted since October 2009.
  -
19 -
  Item
2.  Management's Discussion and Analysis of Financial Condition and
Results of Operations
 
 Business
 
 While we
have historically provided engineering, construction, operating and ethanol
marketing services, for first generation grain based ethanol (“1st Gen” or
“GBE”) our focus is now on owning and operating second generation cellulose
based ethanol (“2nd Gen” or "CBE") integrated facilities that utilize our
proprietary technology, and designing these facilities for, and licensing our
proprietary process technology to, third-parties seeking to participate in the
renewable energy and advanced biofuel markets.
 
 Initially,
we created expansion and optimization programs for 1st Gen facilities. The
experience in the design and operation of these GBE’s has given our company a
significant advantage in the development and future operations of 2nd Gen
facilities. While we are able to offer design and engineering services to
optimize existing GBE facilities, our emphasis in the future will be on
integrated CBE facilities.
 
 The
majority of first generation ethanol is currently produced from sugar cane or
grain-based feedstocks, predominantly corn in the United States, however it can
also be produced from cellulose. The growth of first generation ethanol is
limited due the widespread opposition to using land and crops that can be used
for food or feed, for the production of fuels. This is especially relevant now
that technology has provided a solution that uses widely available cellulose as
a feedstock for ethanol production.  Cellulose is the primary
component of plant cell walls and is one of the most abundant organic compounds
available. Advanced biofuels produced from cellulosic materials draws on
non-food related and waste feedstock sources and has been proven to
substantially reduce carbon dioxide emissions and improve engine
efficiency.
 
 Our
scientists and engineers continue to optimize our technology both independently
and in cooperation with the South Dakota School of Mines and Technology in Rapid
City, South Dakota. Based on laboratory data, we have shown our process is
capable of producing up to 90 gallons of ethanol form every dry metric ton of
certain biomass feedstock. We expect that sugarcane bagasse and eucalyptus
represent two typical and outstanding feedstocks for CBE
production.  Laboratory yields will differ depending on the
feedstock.  For example, Ponderosa pine typically provides lower
ethanol yields.  We have recently achieved a laboratory yield of
slightly over 80 gallons per dry metric ton using sugarcane bagasse, one of the
feedstocks we plan to use in our pilot plant.  The Company expects to
confirm these yields, in validation tests during 2011, at our WBE
facility.
 
 We began
our cellulose based ethanol research and development efforts began in 2004 and
we commissioned our WBE cellulosic ethanol plant in late 2008.  A key
part of our business model is the design of scalable, custom-designed fully
integrated CBE plants, preferably with integrated Combined Heat and Power
(“CHP”) and Bio-Lignin production, tailored to a project’s geographic area and
locally available feedstock.  Through Western Biomass Energy, LLC
(“WBE”), a majority-owned subsidiary of ours, we have designed, constructed
and operated what we believe to be one of the first CBE demonstration
plants in the United States.  This allows us to continue to research, and
refine our cellulose conversion technology, while also demonstrating the
commercial viability for this type of technology
 
 Biomass,
unlike corn, includes all plants and plant-derived materials and is more evenly
distributed among regions of the world.  The quantity of biomass
available for a CBE plant can come from many different sources, including fuel
wood harvesting, wood processing residue, urban wood residue, fuel treatment
operations, municipal solid waste, crop residue, and perennial crops. The
extensive biomass distribution facilitates co-locating CBE plants closer to
plant feedstock, reducing transportation costs relating to feedstock. Locating
CBE facilities near blending facilities and retail fuel outlets will reduce
transportation costs related to the sale of ethanol. This has the potential to
create a truly local and commercially viable energy source.  We
believe that our CBE facilities provide a commercially viable alternative that
may contribute to solving local communities’ energy and economic
needs.
  -
20 -
  Future
Synergistic Projects
 
 Our
design also offers us better access to synergistic opportunities, such as
co-locating  CBE
facilities with combined heat and power plants, pulp & paper industries and
first generation ethanol production plants.
 
 As a
natural consequence of converting the fermentable portion of the biomass
feedstock to ethanol, the solid co-product left behind is rich in lignin, a high
energy solid fuel component which is sulfate-free and can be used as a compound
material in the chemicals industry.  Using a conventional wood pellet
mill, this co-product can be formed into pellets that are more dense and durable
than the typical wood pellet marketed today.  Our process minimizes
chemical biomass pretreatment because the bio-lignin co-product chemistry is
unaltered. This results in a clean-burning, high-energy premium bio-lignin
pellet product.
 
 We have
identified several potential projects and locations for plants using our
technology and are currently conducting multiple pre-feasibility
studies.
 
 Production
Processes
 
 Several
technologies have been developed to produce ethanol from
biomass.  Generally speaking, efforts to convert cellulose into
ethanol follow one of two main processes:
 
 •
              Thermochemical conversion of
      biomass into synthesis gas or “syngas” (a process often referred to as
      “gasification”), followed by catalytic conversion of the syngas into mixed
      alcohols that include ethanol and/or alkaline via modified chemistry;
      or
  •
              Biomechanical conversion, which
      is the enzymatic or chemical breakdown of biomass into component sugars,
      followed by biological fermentation of the sugars into
      ethanol.
 
 We have
selected the enzymatic breakdown of biomass for producing ethanol from cellulose
alternative because we believe it has distinct advantages over the
thermochemical/gasification methods. Gasification methods present a number of
challenges, including the capital intensity of the process, selectivity of the
syngas conversion to ethanol, and alcohol tolerance of the organisms capable of
converting syngas to ethanol. Furthermore, unlike other cellulosic ethanol
technology, we use insignificant amounts of acid (up to .3%) in our process,
eliminating the environmental hazards that result with acid, and producing
valuable by-products from the resulting lignin. Our process has significantly
reduced process water discharge. Other technologies discharge waste water back
into local streams or municipal waste water systems.
 
 In terms
of reduction of greenhouse gases, cellulosic ethanol represents a significant
advance over grain-based ethanol.  According to a report by Argonne
National Laboratory, grain ethanol reduces greenhouse gas by 18% to 29% per
vehicle mile traveled as compared to gasoline, while cellulosic ethanol reduces
greenhouse gas emissions by approximately 85% per vehicle mile traveled. Other
advantages may include additional revenues through the sale of carbon credits,
federal and state tax incentives and other measures that result from
governmental support of cellulosic ethanol.
 
 Business
Strategies
 During
the current year, we plan to continue to optimize our technology and to design
our first commercial (and possibly second) CBE facility. In addition, we intend
to license our technology and contract our design engineering to third
parties.  We will focus on developing cellulosic ethanol projects
integrated into existing industries like CHP plants, together with partners that
will help us accelerate the commercialization of our cellulosic technology and
expand our global market presence.  These strategic partners and
alliances provide an important advantage in realizing success in commercializing
our process technologies.  Key elements of our business strategy
are:
  -
21 -
  · Developing and supplying the
technologies for commercial production of cellulosic ethanol from certain
biomass feedstocks like sugarcane bagasse, eucalyptus and other hard woods, soft
woods and agricultural waste.  The design and production
strategy involves developing scalable facilities preferably with integrated
Combined Heat and Power (CHP) and Bio-Lignin production, based on available
feedstock supplies and providing a commercially viable alternative for local
energy and economic needs.
 
 · Owning and operating our own CBE
facilities.  We intend to own, or co-own, and operate fully
industrially integrated CBE and CBE/CHP facilities that utilize our proprietary
technology.   We intend to co-locate our plants with other industrial
operations such as pulp and paper industries, wood processors, first generation
ethanol and sugar plants that provide synergistic opportunities.
 
 · Developing
national and international strategic partnerships and strategic
alliances.  We intend to develop our projects together with
partners that will help accelerate the commercialization of our cellulosic
technology and expand our global market presence.  These strategic
partners and alliances will be important in accelerating the commercialization
of our process technologies.
 
 · Improving existing ethanol production
through KL CapacitySM.  KL CapacitySM is a service that
provides existing grain-based ethanol plants with specialized engineering
enhancements that improve the efficiency of ethanol production and potential for
increased profitability. KL CapacitySM was developed to respond to rapidly
changing market conditions in grain-based ethanol plants in the US and
sugar-based ethanol plants in Brazil.
 
 We
currently do not sell a material amount of ethanol and/or
bio-lignin.  Our WBE facility is currently designed to gather
data for process enhancements, provide input to the design of commercial-scale
projects and validate our technology as part of the feasibility
studies.
 
 Challenges
 
 KL
Energy’s success depends on the ability to develop multiple projects while also
enhancing our process technology. This strategy places increased demand on our
limited human resources and requires us to substantially expand the capabilities
of our operational staff. The ability to attract, train, manage and retain
qualified management, technical, and engineering personnel presents our greatest
challenge.  Other significant challenges are:
  ●
              A significant portion of our
      business is in the process of scaling-up to commercial operations, causing
      us to rely on outside sources of funding, rather than supporting ourselves
      from our own operations.
 
 ●
              We may be unable to raise debt or
      equity funding, upon which we will be highly dependent, in the near
      term.
 
 ●
              Our poor liquidity may deter
      existing or potential vendors, suppliers or customers from engaging in
      transactions with us.
 
 ●
              We depend on enzymes, some of
      which are in the research and development phase, which currently represent
      a significant and volatile expense in the CBE production process. Recent
      developments have demonstrated that these costs should continue to drop
      rapidly over the next two
years.
 
 ●
              Our industry continues to develop
      both existing and emerging competitors and competitive
      technologies.
 
 Significant
Developments
 
 Recent
Financing
 
 Our
recent financings are described in Note 3 and Note 13 of the Notes to
Consolidated Financial Statements included in this Report and incorporated by
reference herein.
  -
22 -
  Subsequent
Events
 
 Information
regarding subsequent events may be found in Note 13 of the Notes to Consolidated
Financial Statements included in this Report and incorporated by reference
herein.
 
 Critical
Accounting Policies and Estimates:
 
 Trade
Receivables
 
 Trade
receivables are carried at original invoice less an estimate made for doubtful
receivables based on a periodic review of all outstanding
amounts.  Management of the Company has established an allowance for
doubtful accounts based on their estimate of uncollectible accounts and is
established based on historical performance that is tracked by the Company on an
ongoing basis.  Trade receivables are written off when deemed
uncollectible. Recoveries of trade receivables previously written off are
recorded when received.
 
 Long-Lived Assets
 
 The
Company assesses the realizable value of long-lived assets for potential
impairment at least annually or when events and circumstances warrant such a
review. The net carrying value of a long-lived asset is considered impaired when
the anticipated fair value is less than its carrying value. Approximately 96% of
the Company’s property, plant and equipment is attributable to the WBE facility
in Upton, Wyoming.
 
 In
assessing the recoverability of our long-lived assets, we must make assumptions
regarding estimated future cash flows, useful lives and other factors to
determine the fair value of the respective assets.   This facility is
used for developing new, or refining existing, cellulosic ethanol
technology.  It is the Company’s intent that this facility’s future
use will involve the production and sale of small but commercial quality volumes
of ethanol and lignin and currently there are no indicators that the Company
will be unable to execute its business plan.  This future use is
expected to generate positive cash flow in subsequent years.
 
 As of
December 31, 2009, we evaluated our long-lived assets for potential
impairment.  Management used the following tools in order to assess
the fair value of these assets:  internal cash flow budgets and
projections, outside financing activity, historical financial information,
current market conditions and forecasted future market
conditions.  Based on our evaluation, no impairment charge was
recognized.
 
 Revenue
and Cost Recognition
 
 Biofuel
revenue represents income from feedstock testing.  Our standard
feedstock testing agreement requires the customer to pay 50% of the testing fee
upon signing the agreement and the other 50% when the final report is
delivered.  When the final report is delivered, the Company recognizes
100% of the revenue associated with that agreement.
 
 Pre-contract
costs are deferred in anticipation of a specific contract that will result in
little or no value unless the contract is obtained.  Such costs
include consultant expenses for project development, technology improvements,
facility engineering and feedstock evaluation expenses.
 
 Revenue
from fixed price contracts is recognized on the percentage-of-completion method,
measured by the percentage of costs incurred to date to estimated total costs
for each contract. This method is used because management considers expended
costs to be the best available measure of progress on these contracts. Due to
uncertainties inherent in the estimation process, it is at least reasonably
possible that the completion costs for contracts in progress at June 30, 2010
and December 31, 2009 will be revised significantly in the near
term.
 
 Contract
costs include all direct material, subcontract and labor costs, and those
indirect costs related to contract performance, such as labor, supply, tool, and
depreciation costs. Operating costs, including claims and change orders, are
charged to expense as incurred. Revenue is reported net of sales tax collected.
Provisions for estimated losses on uncompleted contracts are made in the period
in which such losses are determined. Changes in job performance, job conditions,
and estimated profitability, including those arising from contract penalty
provisions and final contract settlements, may result in revisions to costs and
income and are recognized in the period in which the revisions are
determined.
 
 The
asset, "Costs and estimated earnings in excess of billings on uncompleted
contracts," represents revenue recognized in excess of amounts
billed.  The liability, "Billings in excess of costs and estimated
earnings on uncompleted contracts," represents billings in excess of revenue
recognized.
  -
23 -
  Patriot
provided blended fuel on consignment to service stations.  Revenue
related to the sale of blended fuel by Patriot was recorded when the ethanol was
sold by the service station to the end customer.  This operation was
discontinued in January 2009.
 
 Income
Taxes
 
 The
Company uses the asset and liability method to account for income
taxes.  Under the asset and liability method, deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax basis.  Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled.  The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date.  The measurement of deferred tax assets
is reduced, if necessary, by a valuation allowance for future tax benefits for
which realization is not considered more likely than not.
 
 Share
Based Compensation
 
 We follow
the guidance in FASB Topic 718 related to share-based payments to recognize all
grants of stock options in our financial statements based upon their respective
grant date fair values.  Under this standard, the fair value of each
employee stock option is estimated on the date of grant using an option pricing
model that meets certain requirements.  We currently use the Black-Scholes
option pricing model to estimate the fair value of our stock options.  The
Black-Scholes model meets the requirements of FASB Topic 718 but the fair values
generated by the model may not be indicative of the actual fair values of our
equity awards as it does not consider certain factors important to those awards
to employees, such as continued employment and periodic vesting
requirements.  The determination of the fair value of share-based payment
awards utilizing the Black-Scholes model is affected by our stock price and a
number of assumptions, including expected volatility, expected life and
risk-free interest rate.  We use a historical volatility rate on our stock
options.  The fair value of our common stock is based on recent private
placement transactions by the Company, as of the date of the grant, which have
been at $1.10 per share.  Because its stock is thinly traded, the
Company does not believe that quotations for our common stock, as reported on
the OTC Bulletin Board, particularly at December 31, 2009, are indicative of the
market value of the business.  If there are any modifications or
cancellations of the underlying securities, we may be required to accelerate,
increase or cancel any remaining unearned stock-based compensation
expense.  To the extent that we grant additional equity securities to
employees, our stock-based compensation expense will be increased by the
additional unearned compensation resulting from those additional
grants.
 
 Liquidity
and Capital Resources
 
 At June
30, 2010, the Company had approximately $708,000 of total current assets which
primarily consisted of $281,000 in cash and cash equivalents, approximately
$267,000 of prepaid insurance, legal and project expenses and $45,000 of
deferred issuance costs.  In addition, we had approximately $2.6
million of net property, plant and equipment.  Our total assets as of
June 30, 2010 were approximately $3.4 million.   With $6.8
million of total current liabilities, the Company had negative working capital
of approximately $6.1 million at June 30, 2010.
 
 We
received additional gross proceeds from private placements of approximately $1.5
million in January 2010, $500,000 in March 2010, $600,000 in May 2010 and
$750,000 in June 2010 fund operating activities and allow long-term borrowing
commitments to remain current. In early July 2010, the Company received
additional capital of approximately $1.5 million in gross
proceeds.  These transactions are described in Note 3 and Note 13 of
the Notes to Consolidated Financial Statements. We expect to rely on funds
raised from these recent private placements, as well as future equity and debt
offerings, to implement our growth plan and meet our liquidity needs going
forward. We continue to seek additional financing but are not certain whether
any such financing would be available on terms acceptable to us, if at
all.
  -
24 -
  In their
report dated March 9, 2010, the Company’s auditors indicated there was
substantial doubt about the Company’s ability to continue as a going
concern.   This financial challenge is the result of the absence
of revenue, attributable to our focus on cellulosic technology, and continuing
research, development and administrative costs.  Based on the
continued support of several current investors, as well as interest expressed by
other investors, we are confident that we will be able to raise additional
funding to provide sufficient working capital for the next twelve months.
Accordingly, unless we raise additional working capital, obtain project
financing and/or revenues grow to support our business plan, we may be unable to
remain in business.
 
 Line
of Credit; Loans
 
 The
Company and certain WBE members are guarantors for, and the Company is
funding payments with respect to, a note payable by WBE to Security
National Bank of $1,332,028 at June 30, 2010.  A principal payment of
$500,000 was made in February 2009.  Pursuant to amendments executed
during the first quarter of 2009 and 2010, principal and interest payments of
$17,560 were required to be made from March 2009 until the current maturity date
of March 2011.  This loan’s maturity may be extended on an annual
basis if the Company is in compliance with the note terms. As of the date of
this report, the Company is in compliance with these terms.  This note
bears interest at 6.5% and is secured by substantially all of the assets of
WBE.
 
 We had a
line of credit with Wells Fargo for borrowings up to $250,000 and at December
31, 2008 we had borrowed the full amount available.  The interest rate
with respect to borrowed amounts was the prime rate used by Wells Fargo plus
0.5%. This line of credit was personally guaranteed by certain persons who
were officers of the Company during 2008. This line of credit has matured and
was paid off in 2009 by a Company payment of $175,000 (plus interest) and by the
proceeds from a line of credit of $75,000 extended to us by a current
shareholder and officer of the Company.  This latter amount (plus
interest) was paid off in June 2009.
 
 We had a
subordinated secured note payable to a current shareholder and former officer of
the Company totaling $600,000 at December 31, 2008.  This note had a
variable interest rate, which was 5.0% at June 30, 2010 and December 31, 2009,
with interest paid quarterly.  Prior to February 2009, this note was
unsecured and did not have a specified due date. In February 2009, the note was
modified to require principal payments of $10,000 per month beginning September
2009 over a 60 month term. The principal payments are scheduled to be $120,000
in each of 2010, 2011, 2012, 2013, and $26,461 in 2014.  As security
for our obligations under this note, we granted to the lender a security
interest in our current and future accounts receivable. In addition, if the
Company receives additional equity financing, the Company is obligated to pay 5%
of the proceeds towards principal payments on this note.  Based on
equity financing since February 2009, an additional $310,000 has been classified
as currently payable. Total current maturities and the balance on this note as
of June 30, 2010 were $436,461 and $506,461, respectively.
 
 The
Company also has a secured promissory note payable to Lansing Securities Corp.
in the amount of $250,000 at 10% interest. The maturity date of this loan has
passed and has been temporarily waived by Lansing Securities until further
notice.
 
 In June
2009, the Company negotiated a repayment of its overdue payables to
Hermanson Egge, a vendor that supplied construction services to
WBE.   The repayment arrangement is unsecured, requires no
interest payments and includes the following schedule of payments:  $70,000
in July 2009, $15,000 monthly from July 2009 to April 2010, $10,000 monthly from
May 2010 to August 2010, $20,000 monthly for September 2010 to November 2010 and
$15,000 in December 2010.  Up to $75,000 of this payable may be
reduced in exchange for the Company engaging Hermanson Egge to provide
future engineering services with scheduled completion and payment dates not
later than December 1, 2010.  The balance of this obligation at June
30, 2010 was $85,000.
  -
25 -
  Additional current liabilities of approximately $4.6 million
consist of accounts payable of approximately $1.7 million (of which
approximately $39,000 was to related parties), billings in excess of costs and
estimated earnings on uncompleted contracts of approximately $1.6 million, , and
accrued liabilities of $971,000 (primarily consisting
of  approximately $128,000 of  payroll related expenses, an
estimated $420,000 for consulting and engineering services provided by Niton
Capital, an estimated $115,000 for accrued legal and audit fees and
approximately $308,000 for other accrued liabilities) and approximately
$316,000 representing liabilities of the discontinued operations of KLM, KLHC
and Patriot.
 
 Long-term
liabilities of approximately $72,000 at June 30, 2010 represent long-term
subordinated indebtedness to a related party ($70,000) and the non-current
portion of the note payable to Shimadzu Financial for financed lab equipment
($1,847).  Our total liabilities were approximately $6.8 million as of
June 30, 2010.
 
 On
October 9, 2008, we entered into a term loan agreement (“O2D Loan”) with
O2Diesel Corporation (“O2D”), formerly a publically traded company, pursuant to
which we agreed to provide O2D with up to $1,000,000 for O2D’s working capital
purposes.  O2D is a commercial developer of cleaner-burning diesel
fuel alternatives, including O2DieselTM, an ethanol-diesel additive.  We
previously licensed certain technology to O2D under a Technology License
and Services Agreement, dated March 6, 2008 (the "License
Agreement"). The O2D Loan provided an initial loan of $250,000 in the form
of a secured promissory note (the “Note”) with an annual interest rate of
10%.   As of March 31, 2009, O2D defaulted on this Note and, due to
O2Diesel’s financial condition, the Company determined it would not make any
additional loans to O2D and reserved for the entire amount of
the Note.   The Company sold this Note at face value to a third
party (the "Note Purchaser") in April 2009.  Subsequently, O2D
declared bankruptcy and the Note Purchaser acquired O2D out of
bankruptcy.  The Company acquired the License Agreement from the Note
Purchaser in exchange for a payment of $150,000 in October 2009 and the
Company's agreement to negotiate a new license for limited territories with the
Note Purchaser.
 
 We have
provided substantial funding for WBE, a 64% owned subsidiary of ours, relating
to the development of our cellulosic technology.  As of June 30, 2010
and December 31, 2009, WBE owed us approximately $9.0 million and $8.8 million,
respectively.  There is currently no specific repayment schedule for
these debts owed to the Company by WBE.
 
 Net
Cash Flow – Operating Activities
 
 As a
result of the Company’s history of losses, our cash flow from operations has
been negative since the inception of the company. We do not anticipate that we
will have a positive cash flow from operations in 2010. Whether we have positive
cash flow in 2010 depends on whether we are able to realize engineering design
and licensing revenue from new CBE projects (expected to start as early as the
last quarter of 2010) and any facility improvement contracts for GBE plants and
other operational revenue.  A significant piece of our business is
still in the research and development phase and we expect to continue to incur
losses until we are able to license our technology for third party projects or
raise financing for our own projects.
 
 We are in
the process of implementing cost control measures that should help us reach our
technology and business goals more efficiently. We have implemented a strict
budgetary and financial control process.  We have also re-focused our
human and financial resources towards the goal of being a technology provider
and eliminated positions that are not critical to this business
mission.
 
 During
the six months ended June 30, 2010, our operating activities used a net of
approximately $2.4 million of cash. This reflected a loss of approximately $2.7
million from continuing and discontinued operations, a net loss attributable to
noncontrolling interests of approximately $555,000, increases in trade
receivables ($64,000), prepaid expenses and other current assets ($48,000)
and decreases in accounts payable ($34,000), accrued liabilities ($2,000) and
current liabilities of discontinued operations ($41,000) which were largely
offset by approximately $1.1 million in cash flows provided by depreciation
($970,000) and stock compensation ($88,000).
  -
26 -
  During
the six months ended June 30, 2009, our operating activities used a net of
approximately $2.2 million of cash. This primarily reflected a net loss of
approximately $3.9 million from continuing and discontinued operations, a net
loss attributable to noncontrolling interests of approximately $670,000, an
increase in trade receivables ($17,000) and a decrease in accounts payable
($239,000) which were largely offset by cash flows provided by depreciation
($967,000), increases in the allowance for doubtful accounts ($450,000), accrued
payroll and other liabilities ($981,000 – primarily an estimated $510,000 for
consulting and engineering services provided by Niton Capital, current
liabilities of discontinued operations $161,000, and decreases in prepaid
expenses and other current assets ($385,000 – primarily the reductions in
deferred issuance costs and prepaid insurance) and a decrease in inventories of
approximately $43,000.
 
 Net
Cash Flow - Investing Activities
 
 Net cash
used in investing activities during the six months ended June 30, 2010 of
approximately $112,000 decreased by approximately $39,000 over investing
activities in the six months ended June 30, 2009.  This decrease was
the primarily a result of lower purchases of property, plant, and
equipment.
 
 Net
Cash Flow – Financing Activities
 
 Net cash
provided by our financing activities was approximately $2.7 million for the six
months ended June 30, 2010. During this period, we received $3.35 million in
gross proceeds from the private placement of common stock offset by $335,000 in
legal, professional and placement fees and approximately $280,000 of net
reductions in short-term borrowings and long-term debt.  Net cash
provided by our financing activities for the six months ended June 30, 2009 was
approximately $2.4 million. During this period, we received $4.0 million in
gross proceeds from the private placement of common stock offset by $750,000 in
legal, professional and placement fees and approximately $871,000 of net
reductions in short-term borrowings and long-term debt.
 
 Results
of Operations for the Three Months Ended June 30, 2010 and 2009
 
 Revenue
 
 In the
three months ended June 30, 2010, the Company did not recognize any biofuel
income due to the timing of several feedstock testing programs.  The
Company did not record any revenue for the three months ended June 30, 2009
which was primarily due to the discontinuance and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008 and it also reflects our focus on research and the enhancement of our CBE
technology.
 
 Operating
Expenses
 
 Operating
expenses of approximately $1.5 million, in the three months ended June 30, 2010,
were approximately $49,000 lower than the comparable period in the prior
year.  The primary reason for this decrease was an approximately
$161,000 increase in general and administrative expenses offset by a $210,000
decrease in research and development costs.  These decreases were
primarily a result of  the reclassification of expenses to conform to
the current period presentation.
 
 Biofuel costs were $0
for the three months ended June 30, 2010 due to the timing of several
feedstock testing programs.  These costs were also $0 in the
comparable period in the prior year as there were no feedstock testing programs
completed in 2009.
  -
27 -
  General and Administrative
expense of approximately $722,000 for the three months ended June 30,
2010 was approximately $161,000 higher than the comparable 2009
period.  This increase was primarily attributable to $166,000 of
higher administrative expenses (due to higher staffing, advertising, travel and
insurance costs), $31,000 of higher business development expenses (due to an
increase in consulting fees and travel expenses) and $79,000 of higher
legal costs related legacy litigation issues offset by
$115,000 of lower audit and legal fees related to being a public
company.
 
 Research and Development
expense of approximately $784,000 for the three months ended June 30,
2010 was approximately $210,000 lower than the comparable 2009 period primarily
due to reduced operations in 2010 and higher WBE plant maintenance costs in
2009.
 
 Other
Income (Expense)
 
 Other income was
approximately $39,000 and $29,000 for the three months ended June 30, 2010 and
2009, respectively.  The 2010 amount primarily includes payables
write-offs ($26k), scrap iron sales and utility credits ($4k) and a favorable
property tax accrual adjustment ($7k).  The 2009 amount primarily
includes grant income ($35k) and losses on the disposal of assets
($6k).
 
 Interest income of
approximately $29 for the three months ended June 30, 2010 was approximately
$2,000 lower than the comparable 2009 period primarily as a result of lower
invested cash balances.
 
 Interest expense of
approximately $41,000 for the three months ended June 30, 2010 was approximately
$14,000 higher than the comparable 2009 period primarily as a result of higher
interest on the subordinated debt-related party Note and financed lab equipment
and insurance policies in 2010.
 
 Results
of Operations for the Six Months Ended June 30, 2010 and 2009
 
 Revenue
 
 In the
six months ended June 30, 2010, the Company recognized $120,000 in biofuel
income from several feedstock testing programs.  The Company did not
record any revenue for the six months ended June 30, 2009 which was
primarily due to the absence of feedstock testing programs as wells the
discontinuance and/or work stoppage on existing contracts in the grain based
ethanol business in the latter half of 2008.  These results also
reflect our focus on research and the enhancement of our CBE
technology.
 
 Operating
Expenses
 
 Operating
expenses of approximately $3.4 million in the six months ended June 30, 2010
were approximately $1.3 million lower than the comparable period in the prior
year. This 28% improvement was attributable to the $1.0 million decrease in
general and administrative expenses and the $230,000 decrease in research and
development costs offset by $60,000 of higher biofuel costs.  This
significant decrease in operating expenses was primarily a result of lower
personnel costs due to net staff reductions, lower project costs, a reduction in
WBE research and development activities since January 2010 and reduced public
company related legal and accounting fees offset by higher business development
costs and legal costs related legacy litigation issues.
 
 Biofuel costs of
$60,000 in the six months ended June 30, 2010 compared to $0 costs in the
comparable period in the prior year.  This increase is attributable to
several 2010 feedstock testing programs; there were no feedstock testing
programs in the first half of 2009.
  -
28 -
  General and Administrative
expense of $1.6 million for the six months ended June 30, 2010 was $1.0
million, or 38%, lower than the $2.6 million for the comparable period in the
prior year.  This significant improvement was primarily attributable
to $0.9 million of lower administrative expenses (due to lower staffing,
advertising, travel and insurance costs), $0.2 million of lower audit and
legal fees related to being a public company and $64,000 in lower project costs
offset by a $96,000 increase in business development costs (due to an increase
in consulting fees and travel expenses) and $109,000 of higher legal costs
related legacy litigation issues.
 
 Research and Development
expense of $1.7 million for the six months ended June 30, 2010 was $0.2
million, or 12%, lower than the $1.9 million for the comparable period in the
prior year.  This improvement was largely due to reduced operations in
2010 including a significant reduction in personnel and maintenance costs.
Depreciation expense of approximately $938,000 and $926,000 for the six months
ended June 30, 2010 and 2009, respectively, represents approximately 56% and
46%, respectively, of research and development expenses in these
periods.
 
 Other
Income (Expense)
 
 Other income was
approximately $17,000 and $11,000 for the six months ended June 30, 2010 and
2009, respectively.  The 2010 amount primarily includes payables
write-offs ($26k), scrap iron sales and utility credits ($4k) and consulting and
sub-lease income ($6k) offset by property tax accruals ($7k).  The
2009 amount primarily includes grant income ($35k) offset by grant expenses
($5k) and losses on the disposal of assets ($3k).
 
 Interest income of
approximately $700 for the six months ended June 30, 2010 was approximately
$44,000 lower than the comparable 2009 period primarily as a result of higher
interest earned on overdue customer balances and higher invested cash balances
in the first half of 2009.
 
 Interest expense of
approximately $81,000 for the six months ended June 30, 2010 was approximately
$21,000 lower than the comparable 2009 period primarily due to the absence of
interest charges from vendors on overdue balances.
 
 Item
3.  Quantitative and Qualitative Disclosures About Market
Risk
 
 As a
“smaller reporting company” defined in Item 10(f)(1) of Regulation S-K, we are
electing scaled disclosure reporting obligations and therefore are not required
to provide the information requested by this item.
 
 Item 4T.  Changes
in Internal Control Over Financial Reporting
 
 (a) Disclosure Controls and
Procedures. We maintain disclosure controls and procedures designed
to provide reasonable assurance that information required to be disclosed in our
reports under the United States Securities and Exchange Act of 1934, as amended,
is recorded, processed, summarized and reported within the time periods
specified in the SEC’s rules and forms, and that such information is accumulated
and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, to allow timely decisions regarding required
disclosure.
 
 Internal
control over financial reporting may not prevent or detect misstatements.
Therefore, even those systems determined to be effective can provide only
reasonable assurance with respect to financial statement preparation and
presentation.
 
 Our
management, with the participation and oversight of our Chief Executive Officer
and our Chief Financial Officer, has reviewed and evaluated the design and
effectiveness of our disclosure controls and procedures as of the end of the
period covered by this quarterly report on Form 10-Q. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer have concluded that, as
of June 30, 2010, our disclosure controls and procedures were not effective
as a result of the continued existence of material weaknesses in internal
controls including inadequate delegation of responsibilities, appropriate
oversight and review, internal technical expertise, preparation, review and
verification of internally developed documentation, controls ensuring that all
material developments impacting the financial statements are reflected, and
executed agreements for significant contracts.  Listed below are
actions the Company has taken to remediate these weaknesses.
  -
29 -
  Because
of these material weaknesses, we have added additional controls and performed
procedures and analyses designed to ensure that our unaudited consolidated
financial statements are presented fairly in all material respects in accordance
with accounting principles generally accepted in the United States. We relied on
increased monitoring and review to compensate for the material weaknesses in our
internal controls. Accordingly, management believes that the unaudited
consolidated financial statements included in this quarterly report fairly
present, in all material respects, our financial position, results of operations
and cash flows for the periods presented.
 
 (b) Internal Controls . In order
to remediate the weaknesses in our disclosure controls and procedures and
internal control over financial reporting identified in our Annual Report on
Form 10-K for the period ended December 31, 2009 we have taken and continue to
take the following actions during the period covered by this
report:
  ·
              mandated the segregation of
      duties regarding cash
transactions;
 
 ·
              increased the oversight and
      review functions over internally developed
      documentation;
 
 ·
              maintained a Disclosure
      Committee to review material developments at the Company, as well as the
      effectiveness of the Company’s disclosure controls and
      procedures;
 
 ·
              engaged a Chief Financial
      Officer and outside securities counsel, both with SEC reporting
      experience, and
 
 ·
              utilized, as needed, a
      third-party financial consulting firm to assist management in evaluating
      complex accounting issues and implement a system to improve control and
      review procedures over all financial statement and account
      balances.
 
 There were no changes in our internal controls over financial
reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the first
quarter of 2010 that materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.
 
 Management
does not expect that our disclosure controls or our internal control over
financial reporting will prevent or detect all errors and fraud. A control
system cannot provide absolute assurance due to its inherent limitations as it
is a process that involves human diligence and is subject to lapses in judgment
and breakdowns resulting from human failures. However, these inherent
limitations are known features of the financial reporting process; therefore, it
is possible to design into the process safeguards to reduce, though not
eliminate, this risk.
 
 PART
II – OTHER INFORMATION
 
 Item 1.  Legal
Proceedings
 
 On July
2, 2010, a lawsuit was brought against the Company and certain current directors
and a Company investor in the Seventh Judicial District Court of Pennington
County, South Dakota.  The plaintiff is Randy Kramer, a former CEO of the
Company. The plaintiff alleges, among other things, that the Company
violated the severance agreement signed by the Company and Kramer.  The
plaintiff also alleges that the named individuals engaged in conspiracy to have
him removed as CEO and oppressed him to sign the severance agreement. At this
time, the Company is unable to predict the outcome of the case but plans to
vigorously defend its position.
  -
30 -
  The Company may be subject to various claims and legal actions
arising in the ordinary course of business from time to time. The Company
maintains insurance to cover certain such actions.
 
 Item 1A.  Risk
Factors
 
 We are
affected by risks specific to us as well as factors that affect all businesses
operating in a global market.  Certain of the significant factors
known to us that could materially adversely affect our business, financial
condition or operating results are described in our Form 10-K filed with the SEC
on March 9, 2010.  You should consider such risk factors in addition
to the other information set forth below and elsewhere in this
report.  The risks described in our Form 10-K are not the only risks
facing our Company.  Additional risks and uncertainties also may
materially adversely affect our business, financial condition, and/or reporting
results.
 
 Item
2.  Unregistered Sales of Equity Securities And Use of
Proceeds
 
 Descriptions
of unregistered sales of equity securities are contained in Note 3, Note 7 and
Note 13 in the Notes to Consolidated Financial Statements, which are
incorporated herein by reference.
 
 Item 3.  Defaults
Upon Senior Securities
 
 Not
applicable.
  -
31 -
  Item 5. Other
Information
 
 ·
              None.
  -
32 -
  Item 6.
Exhibits
 
 (a)
Exhibits
 
 Exhibit
                Number
              
              Description3.1*
              
              Amended
      and Restated Articles of Incorporation10.1*
              
              Convertible
      Promissory Note with John Buckens, dated March 9, 2010,31.1*
              
              Certification
      of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200231.2*
              
              Certification
      of Acting Chief Financial Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1*
              
              Certification
      of Chief Executive Officer Pursuant to Section 18 U.S.C. Section
      135032.2*
              
              Certification
      of Acting Chief Financial Officer Pursuant to Section 18 U.S.C. Section
      1350
 
 *
Filed herewith.
 
 Signature
 
 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.
  August
      10, 2010
                By:
                /s/ THOMAS J. BOLANThomas
      J. Bolan, Chief Financial Officer(Principal
      Financial Officer and duly authorized
signatory)
  -
33 -