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** **

 

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      Quarterly report under Section 13 or15(d) of the Securities Exchange Act of 1934.**

 

**For the fiscal quarter ended July 31, 2010**

 

**OR**

** **

**o****         Transition report under Section 13 or15(d) of the Exchange Act.**

 

**For the transition periodfrom                    to                  .**

 

**COMMISSION FILE NUMBER 000-51825**

 

**HERON LAKE BIOENERGY, LLC**

(Exactname of Registrant as specified in its charter)

 

| **Minnesota**                                  | ** ** | **41-2002393**                        |
|------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of organization) |       | (I.R.S.  Employer Identification No.) |

 

**91246 390th****Avenue, Heron Lake, MN 56137-1375**

(Addressof principal executive offices)

 

**(507) 793-0077**

(Issuer’stelephone number)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  x  Yes  o  No

 

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

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer,” and “smaller reporting company” inRule 12b-2 of the Exchange Act.

 

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

 

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

 

As of August 25, 2010,there were 30,208,074 Class A units outstanding.

 

 

 

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**INDEX**

 
| ** **                                                                                               | **Page No.** |
|----------------------------------------------------------------------------------------------------------|-------------------|
| PART I. FINANCIAL INFORMATION                                                                       |              |
| Item 1. Financial Statements                                                                        | 1                 |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 16                |
| Item 4. Controls and Procedures                                                                     | 22                |
| PART II.  OTHER INFORMATION                                                                         |              |
| Item  1. Legal Proceedings                                                                               | 23                |
| Item  1A. Risk Factors                                                                                   | 23                |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                     | 35                |
| Item 3. Defaults Upon Senior Securities                                                             | 35                |
| Item 4. [Removed and Reserved]                                                                           | 35                |
| Item  5. Other Information                                                                               | 35                |
| Item 6.  Exhibits                                                                                   | 36                |
| SIGNATURES                                                                                               | 37                |

 

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. FinancialStatements**

 

**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

CondensedConsolidated Balance Sheets

 
| ** **                       | ** ** | **July 31,** | ** **        | **October 31,** | ** ** |
|----------------------------------|------------|-------------------|-------------------|----------------------|------------|
| ** **                       | ** ** | **2010**          | ** **        | **2009***            | ** ** |
| ** **                       | ** ** | **(Unaudited)**   | ** **        | ** **           | ** ** |
| **ASSETS**                       |       |              |              |                 |       |
| **Current Assets**               |       |              |              |                 |       |
| Cash  and equivalents            |       | $                 |  216,186     |                 | $          |  3,184,074 |   |
| Restricted  cash                 |       | 1,223,071         |              | 340,644              |       |
| Accounts  receivable             |       | 3,555,643         |              | 4,439,701            |       |
| Inventory                        |       | 6,829,440         |              | 4,752,117            |       |
| Prepaid  expenses                |       | 220,703           |              | 210,136              |       |
| Total  current assets            |       | 12,045,043        |              | 12,926,672           |       |
|                             |       |              |              |                 |       |
| Property  and equipment          |       |              |              |                 |       |
| Land  and improvements           |       | 12,208,498        |              | 12,574,760           |       |
| Plant  buildings and equipment   |       | 94,472,336        |              | 97,332,591           |       |
| Vehicles  and other equipment    |       | 620,788           |              | 604,783              |       |
| Office  buildings and equipment  |       | 605,431           |              | 618,437              |       |
|                             |       | 107,907,053       |              | 111,130,571          |       |
| Less  accumulated depreciation   |       | (16,749,456       | )                 | (12,569,966          | )          |
|                             |       | 91,157,597        |              | 98,560,605           |       |
|                             |       |              |              |                 |       |
| **Other Assets**                 |       |              |              |                 |       |
| Restricted  cash                 |       | 477,878           |              | 718,790              |       |
| Other  intangibles, net          |       | 460,735           |              | 488,010              |       |
| Debt  service deposits and other |       | 559,952           |              | 395,200              |       |
| Total  other assets              |       | 1,498,565         |              | 1,602,000            |       |
|                             |       |              |              |                 |       |
| **Total Assets**                 |       | $                 |  104,701,205 |                 | $          |  113,089,277 |   |

 

See Notes to CondensedConsolidated Financial Statements

 

----

* Derived from auditedfinancial statements

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

CondensedConsolidated Balance Sheets

 
| ** **                                                                                                                                          | ** ** | **July 31,**    | ** **  | **October 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|-------------|----------------------|------------|
| ** **                                                                                                                                          | ** ** | **2010**        | ** **  | **2009***            | ** ** |
| ** **                                                                                                                                          | ** ** | **(Unaudited)** | ** **  | ** **           | ** ** |
| **LIABILITIES AND MEMBERS’ EQUITY**                                                                                             |       |            |        |                 |       |
| **Current Liabilities**                                                                                                                             |       |            |        |                 |       |
| Line  of credit                                                                                                                                     |       | $               | —      |                 | $          | 5,000,000 |   |
| Current  maturities of long-term debt                                                                                                               |       | 51,964,589      |        | 55,224,183           |       |
| Accounts  payable:                                                                                                                                  |       |            |        |                 |       |
| Trade  accounts payable                                                                                                                             |       | 1,937,381       |        | 2,466,040            |       |
| Trade  accounts payable — related party                                                                                                        |       | 537,455         |        | 714,115              |       |
| Construction  payable — related party                                                                                                          |       | —          |        | 3,839,413            |       |
| Accrued  expenses                                                                                                                                   |       | 882,871         |        | 566,481              |       |
| Accrued  losses on forward contracts                                                                                                                |       | 82,306          |        | 1,249,495            |       |
| Derivative  instruments                                                                                                                             |       | 267,388         |        | —               |       |
| Total  current liabilities                                                                                                                          |       | 55,671,990      |        | 69,059,727           |       |
|                                                                                                                                                |       |            |        |                 |       |
| **Long-Term Debt,** net of current maturities                                                                                                       |       | 4,322,940       |        | 4,775,804            |       |
|                                                                                                                                                |       |            |        |                 |       |
| **Commitments and Contingencies**                                                                                                                   |       |            |        |                 |       |
|                                                                                                                                                |       |            |        |                 |       |
| **Members’ Equity, 30,208,074 and 27,104,625 Class A  units issued and outstanding at July 31, 2010 and October 31, 2009,  respectively** |       | 44,706,275      |        | 39,253,746           |       |
|                                                                                                                                                |       |            |        |                 |       |
| **Total Liabilities and Members’ Equity**                                                                                                      |       | $               | 104,701,205 |                 | $          | 113,089,277 |   |

 

See Notes to CondensedConsolidated Financial Statements

 

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*     Derivedfrom audited financial statements

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

CondensedConsolidated Statements of Operations

 
| ** **                                                 | ** ** | **Three Months  Ended July 31,** | ** ** | **Three Months  Ended July 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                              | ** ** | **2009**                                   | ** ** |
| ** **                                                 | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                            | ** ** |
|                                                       |       |                                  |       |                                       |       |
| **Revenues**                                               |       | $                                     | 23,621,607 |                                       | $          | 22,196,118 |   |
|                                                       |       |                                  |       |                                       |       |
| **Cost of Goods Sold**                                     |       |                                  |       |                                       |       |
| Cost  of goods sold                                        |       | 24,329,885                            |       | 21,420,797                                 |       |
| Lower  of cost or market adjustment`                       |       | 113,791                               |       | 1,863,605                                  |       |
| **Total Cost of Goods Sold**                               |       | 24,443,676                            |       | 23,284,402                                 |       |
|                                                       |       |                                  |       |                                       |       |
| **Gross Loss**                                             |       | (822,069                              | )          | (1,088,284                                 | )          |
|                                                       |       |                                  |       |                                       |       |
| **Selling, General, and Administrative Expenses**          |       | (842,953                              | )          | (1,632,166                                 | )          |
|                                                       |       |                                  |       |                                       |       |
| **Settlement Income**                                      |       | 2,600,000                             |       | —                                     |       |
|                                                       |       |                                  |       |                                       |       |
| **Operating Income (Loss)**                                |       | 934,978                               |       | (2,720,450                                 | )          |
|                                                       |       |                                  |       |                                       |       |
| **Other Income (Expense)**                                 |       |                                  |       |                                       |       |
| Interest  income                                           |       | 9,805                                 |       | 13,606                                     |       |
| Interest  expense                                          |       | (1,117,395                            | )          | (1,081,480                                 | )          |
| Other  income, net                                         |       | (414                                  | )          | 3,177                                      |       |
| Total  other income (expense)                              |       | (1,108,004                            | )          | (1,064,697                                 | )          |
|                                                       |       |                                  |       |                                       |       |
| **Net Loss**                                               |       | $                                     | (173,026   | )                                          | $          | (3,785,147 | ) |
|                                                       |       |                                  |       |                                       |       |
| **Net Loss Per Unit - Basic and Diluted**                  |       | $                                     | (0.01      | )                                          | $          | (0.14 | ) |
|                                                       |       |                                  |       |                                       |       |
| **Weighted Average Units Outstanding - Basic and Diluted** |       | 28,116,619                            |       | 27,104,625                                 |       |

 

See Notes to CondensedConsolidated Financial Statements

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

CondensedConsolidated Statements of Operations

 
| ** **                                                 | ** ** | **Nine Months  Ended July 31,** | ** ** | **Nine Months  Ended July 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2010**                             | ** ** | **2009**                             | ** ** |
| ** **                                                 | ** ** | **(Unaudited)**                      | ** ** | **(Unaudited)**                      | ** ** |
|                                                       |       |                                 |       |                                 |       |
| **Revenues**                                               |       | $                                    | 78,809,958 |                                 | $          | 61,784,588 |   |
|                                                       |       |                                 |       |                                 |       |
| **Cost of Goods Sold**                                     |       |                                 |       |                                 |       |
| Cost  of goods sold                                        |       | 73,675,212                           |       | 62,540,473                           |       |
| Lower  of cost or market adjustment                        |       | 902,990                              |       | 5,321,835                            |       |
| **Total Cost of Goods Sold**                               |       | 74,578,202                           |       | 67,862,308                           |       |
|                                                       |       |                                 |       |                                 |       |
| **Gross Margin (Loss)**                                    |       | 4,231,756                            |       | (6,077,720                           | )          |
|                                                       |       |                                 |       |                                 |       |
| **Selling, General, and Administrative Expenses**          |       | (2,896,640                           | )          | (3,368,503                           | )          |
|                                                       |       |                                 |       |                                 |       |
| **Settlement Income**                                      |       | 2,600,000                            |       | —                               |       |
|                                                       |       |                                 |       |                                 |       |
| **Operating Income (Loss)**                                |       | 3,935,116                            |       | (9,446,223                           | )          |
|                                                       |       |                                 |       |                                 |       |
| **Other Income (Expense)**                                 |       |                                 |       |                                 |       |
| Interest  income                                           |       | 34,101                               |       | 65,478                               |       |
| Interest  expense                                          |       | (3,224,161                           | )          | (3,005,009                           | )          |
| Write-off  of loan costs                                   |       | —                               |       | (444,985                             | )          |
| Other  income, net                                         |       | 207,467                              |       | 20,854                               |       |
| Total  other expense, net                                  |       | (2,982,593                           | )          | (3,363,662                           | )          |
|                                                       |       |                                 |       |                                 |       |
| **Net Income (Loss)**                                      |       | $                                    | 952,523    |                                 | $          | (12,809,885 | ) |
|                                                       |       |                                 |       |                                 |       |
| **Net Income (Loss) Per Unit - Basic and Diluted**         |       | $                                    | 0.03       |                                 | $          | (0.47 | ) |
|                                                       |       |                                 |       |                                 |       |
| **Weighted Average Units Outstanding - Basic and Diluted** |       | 27,455,663                           |       | 27,104,625                           |       |

 

See Notes to Condensed ConsolidatedFinancial Statements

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

CondensedConsolidated Statements of Cash Flows

 
| ** **                                                                                | ** ** | **Nine Months  Ended July 31,** | ** ** | **Nine Months  Ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                | ** ** | **2010**                             | ** ** | **2009**                             | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)**                      | ** ** | **(Unaudited)**                      | ** ** |
| **Operating  Activities**                                                                 | ** ** | ** **                           | ** ** | ** **                           | ** ** |
| Net  income (loss)                                                                        |       | $                                    | 952,523    |                                 | $          | (12,809,885 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                                 |       |                                 |       |
| Depreciation  and amortization                                                            |       | 4,206,765                            |       | 4,209,107                            |       |
| Amortization  of loan costs included with interest expense                                |       | —                               |       | 22,143                               |       |
| Write-off  of loan costs                                                                  |       | —                               |       | 444,985                              |       |
| Lower  of cost or market adjustments                                                      |       | 902,990                              |       | 5,321,835                            |       |
| Change  in fair value of derivative instruments                                           |       | 216,291                              |       | —                               |       |
| Non-cash  settlement income                                                               |       | (500,000                             | )          | —                               |       |
| Change  in operating assets and liabilities:                                              |       |                                 |       |                                 |       |
| Restricted  cash                                                                          |       | (882,427                             | )          | 1,023,888                            |       |
| Accounts  receivable                                                                      |       | 884,058                              |       | 630,742                              |       |
| Inventory                                                                                 |       | (2,174,144                           | )          | 1,840,272                            |       |
| Derivative  instruments                                                                   |       | 51,097                               |       | 750,172                              |       |
| Prepaid  expenses and other                                                               |       | (175,319                             | )          | 277,579                              |       |
| Accounts  payable                                                                         |       | (710,409                             | )          | (3,881,175                           | )          |
| Accrued  expenses                                                                         |       | 316,391                              |       | (14,901                              | )          |
| Accrued  loss on forward contracts                                                        |       | (1,973,358                           | )          | (9,544,935                           | )          |
| Net  cash provided (used in) operating activities                                         |       | 1,114,458                            |       | (11,730,173                          | )          |
|                                                                                      |       |                                 |       |                                 |       |
| **Investing Activities**                                                                  |       |                                 |       |                                 |       |
| Payments  for intangibles                                                                 |       | —                               |       | (59,835                              | )          |
| Capital  expenditures                                                                     |       | (110,801                             | )          | (265,821                             | )          |
| Net  cash used in investing activities                                                    |       | (110,801                             | )          | (325,656                             | )          |
|                                                                                      |       |                                 |       |                                 |       |
| **Financing Activities**                                                                  |       |                                 |       |                                 |       |
| Proceeds  (payments) from line of credit, net                                             |       | (5,000,000                           | )          | 5,000,000                            |       |
| Payments  of long-term debt                                                               |       | (3,712,458                           | )          | (3,528,019                           | )          |
| Proceeds  from issuance of long-term debt                                                 |       | —                               |       | 11,486                               |       |
| Debt  service deposits included with other assets                                         |       | —                               |       | (30,350                              | )          |
| Release  of restricted cash                                                               |       | 240,912                              |       | 305,118                              |       |
| Member  contributions                                                                     |       | 4,500,001                            |       | —                               |       |
| Net  cash provided by (used in) financing activities                                      |       | (3,971,545                           | )          | 1,758,235                            |       |
|                                                                                      |       |                                 |       |                                 |       |
| **Net decrease in cash and equivalents**                                                  |       | (2,967,888                           | )          | (10,297,594                          | )          |
|                                                                                      |       |                                 |       |                                 |       |
| **Cash and Equivalents****— Beginning of Period**                                    |       | 3,184,074                            |       | 11,355,075                           |       |
|                                                                                      |       |                                 |       |                                 |       |
| **Cash and Equivalents — End of Period**                                             |       | $                                    | 216,186    |                                 | $          | 1,057,481 |   |
| **Supplemental Cash Flow Information**                                                    |       |                                 |       |                                 |       |
| Total  interest paid                                                                      |       | $                                    | 2,800,734  |                                 | $          | 2,989,903 |   |
| **Supplemental Disclosure of Noncash Investing and Financing  Activities**                |       |                                 |       |                                 |       |
| Fagen  Settlement — Release of retainage                                             |       | $                                    | 3,834,319  |                                 | $          | — |   |
| Fair  value of equipment received as part of settlement income                            |       | $                                    | 500,000    |                                 | $          | — |   |

 

Notes to CondensedConsolidated Financial Statements are an integral part of these Statements.

 

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** **

**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

**1.**             **SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The accompanying unauditedcondensed consolidated interim financial statements have been prepared pursuantto the rules and regulations of the Securities and Exchange Commission.Certain information and disclosures normally included in annual financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted as permitted bysuch rules and regulations. These financial statements and related notesshould be read in conjunction with the financial statements and notes theretoincluded in the Company’s audited financial statements for the year endedOctober 31, 2009, contained in the Company’s annual report onForm 10-K.

 

In the opinion ofmanagement, the condensed consolidated interim financial statements reflect alladjustments (consisting of normal recurring accruals, with the exception of theadjustments to write-off deferred loan costs, reduce inventory and forwardcontacts to net realizable value and to reclassify certain debt as current)that we consider necessary to present fairly the Company’s results ofoperations, financial position and cash flows. The results reported in thesecondensed consolidated interim financial statements should not be regarded asnecessarily indicative of results that may be expected for any other quarter orfor the fiscal year.

 

*Nature ofBusiness*

 

The Company owns andoperates a 50 million gallon ethanol plant near Heron Lake, Minnesota.  In addition, the Company produces and sellsdistillers grains with solubles as co-products of ethanol production.

 

*Principlesof Consolidation*

 

The financial statementsinclude the accounts of Heron Lake BioEnergy, LLC and its wholly ownedsubsidiary, Lakefield Farmers Elevator, LLC, collectively, the “Company.” All significant intercompany balances and transactions are eliminated inconsolidation.

 

*AccountingEstimates*

 

Management uses estimatesand assumptions in preparing these financial statements in accordance withgenerally accepted accounting principles. Those estimates and assumptionsaffect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities, and the reported revenues andexpenses.  The Company uses estimates and assumptions in accounting forsignificant matters including, among others, the analysis of impairment oflong-lived assets, and valuation of forward purchase contract commitments andinventory.  The Company periodically reviews estimates and assumptions,and the effects of revisions are reflected in the period in which the revisionis made. Actual results could differ from those estimates.

 

*Long-LivedAssets*

 

The Company reviews propertyand equipment and other long-lived assets for impairment whenever events orchanges in circumstances indicate that the carrying amount may not berecoverable.  Circumstances which could trigger a review include, but arenot limited to: significant decreases in the market price of the asset;significant adverse changes in the business climate or legal factors;accumulation of costs significantly in excess of the amount originally expectedfor the acquisition or construction of the asset; current period cash flow oroperating losses combined with a history of losses or a forecast of continuinglosses associated with the use of the assets; and current expectation that theasset will more likely than not be sold or disposed significantly before theend of its estimated useful life.  If circumstances require a long-livedasset be tested for possible impairment, the Company first comparesundiscounted cash flows expected to be generated by an asset to the carryingvalue of the asset. If the carrying value of the long-lived asset is notrecoverable on an undiscounted cash flow basis, an impairment is recognized tothe extent that the carrying value exceeds its fair value. Fair value isdetermined through various valuation techniques including discounted cash flowmodels, quoted market values and third-party independent appraisals, asconsidered necessary.

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

The Company’s ethanolproduction plant has a stated capacity of 50 million gallons peryear.  The carrying value of the Company’s facilities at July 31,2010 and October 31, 2009 was approximately $91.2 million and$98.5 million, respectively. In accordance with the Company’s policy forevaluating impairment of long-lived assets described above, management hasevaluated the recoverability of the facilities based on projected future cashflows from operations over the facilities’ estimated useful lives. Managementhas determined that the projected future undiscounted cash flows fromoperations of these facilities exceed their carrying value at July 31,2010 and October 31, 2009; therefore, no impairment loss was indicated orrecognized. In determining the projected future undiscounted cash flows, theCompany has made significant assumptions concerning the future viability of theethanol industry, the future price of corn in relation to the future price ofethanol and the overall demand in relation to production and supplycapacity.  Given the uncertainties in the ethanol industry, shouldmanagement be required to adjust the carrying value of the facilities at somefuture point in time, the adjustment could be significant and could significantlyimpact the Company’s financial position and results of operations.  Noadjustment has been made to these financial statements for this uncertainty.

 

*FinancialInstruments*

 

The Company believes thecarrying value of cash and equivalents and restricted cash approximate fairvalue.

 

The Company believes thecarrying amount of derivative instruments approximates fair value based onquoted prices in active exchange-traded or over-the-counter markets.

 

The Company believes thecarrying amount of the line of credit and the variable rate portion of the notepayable approximates the fair value.

 

The Company estimates thefair value of debt based on the difference between the market interest rate andthe stated interest rate of the debt.   The carrying amount and thefair value of long-term debt are as follows:

 
| ** **                               | ** ** | **Carrying Amount** | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|--------------------------|------------|---------------------|------------|
|                                     |       |                     |       |                |       |
| Long-term  debt at July 31, 2010    |       | $                        | 56,287,529 |                | $          | 54,180,590 |   |
| Long-term  debt at October 31, 2009 |       | $                        | 59,999,987 |                | $          | 60,228,760 |   |

 

*EnvironmentalLiabilities*

 

The Company’s operations aresubject to environmental laws and regulations adopted by various governmentalentities in the jurisdiction in which it operates.  These laws require theCompany to investigate and remediate the effects of the release or disposal ofmaterials at its location.  Accordingly, the Company has adopted policies,practices, and procedures in the areas of pollution control, occupationalhealth, and the production, handling, storage and use of hazardous materials toprevent material environmental or other damage, and to limit the financialliability that could result from such events.  Environmental liabilitiesare recorded when the liability is probable and the costs can be reasonablyestimated.

 

**2.**           **GOING CONCERN**

 

The financial statementshave been prepared on a going-concern basis, which contemplates therecoverability of assets and the satisfaction of liabilities in the normalcourse of business. As a result of our financial performance, the Companyviolated certain financial covenants under its master loan agreement withAgStar Financial Services, PCA (“AgStar”) at the end of each quarter from January 31,2009 to April 30, 2010.  However,the Company was in compliance with covenants of its master loan agreement withAgStar at July 31, 2010.  Additionally,the Company and AgStar entered into a forbearance agreement dated July 2,2010 by which AgStar agreed it would not declare a default under the masterloan agreement or enforce any of the remedies available to it for the period ofJuly 2, 2010 to the earlier of an event of default (as defined under theforbearance agreement) or December 31, 2010.

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

While the Company was incompliance with the covenants of the master loan agreement at July 31,2010, the Company anticipates that one or more of the covenants will not be metat October 31, 2010 and July 31, 2011, without an amendment to thecovenants, improved financial performance, or the addition of significantworking capital to the Company.

 

The Company previouslyreclassified the long-term debt related to the master loan agreement to currentliabilities because of the non-compliance with covenants during prior quartersas explained above. That reclassification remains as of July 31, 2010because of the anticipated covenant defaults stated above.

 

In addition to uncertaintiesresulting to the Company’s ability to comply with the covenants of the Company’smaster loan agreement in the future and the maturity of the Company’s revolvingline of credit note on December 31, 2010, there are material uncertaintiesrelating to the Company’s business and operations.  Among these uncertainties are the volatilityin the ethanol and corn markets, the scheduled expiration of the VolumetricEthanol Excise Tax Credit (commonly called the “blender’s credit”) on December 31,2010 or other changes in government policies or programs that support theethanol industry, the Company’s history of negative margins and the substantialchallenge of maintaining positive margins in the future, the Company’s need foradditional capital to meet financial covenants and the difficulty in raisingany additional capital given our industry and the current economy, and ongoingexpenses relating to the Company’s efforts to address issues relating to theCompany’s air emissions, including anticipated reductions in production andplant shut downs during the remediation process.

 

The challenges of ourbusiness and operations that include financial risk management and realizingpositive margins, our non-compliance with covenants in the prior quarters andanticipated non-compliance in future quarters, and our need for additionalcapital to avoid covenant defaults and to fund our ongoing operations, arefactors that raise substantial doubt about the Company’s ability to continue asa going concern.

 

TheCompany believes it has sufficient capital resources through July 31, 2011based upon its current cash reserves, inventory sales, projected commoditymarkets and the available borrowing under the master loan agreement.  However, the Company will pursue additionalcapital to help fund ongoing operations and to meet its financial covenants,and will seek additional capital from selling additional equity to existing ornew investors, or incurring additional debt. There can be no assurance that the Company will be able to raise thiscapital on favorable terms, if at all. The financial statements do not include any adjustments relating to therecoverability and classification of recorded assets and liabilities that mightbe necessary should the Company not receive the additional capital and beforced to significantly curtail operations, file for bankruptcy orreorganization, or cease operations.

 

**3.**             **UNCERTAINTIES**

 

The Company has certainrisks and uncertainties that it experienced during volatile market conditionssuch as what the Company experienced during fiscal 2009. These volatilities canhave a severe impact on operations. The Company’s revenues are derived from thesale and distribution of ethanol and distillers grains to customers primarilylocated in the U.S. Corn for the production process is supplied to the plantprimarily from local agricultural producers.  Ethanol sales average 75% -85% of total revenues and corn costs average 65% - 75% of cost of goods sold.

 

The Company’s operating andfinancial performance is largely driven by the prices at which it sells ethanoland the net expense of corn. The price of ethanol is influenced by factors suchas supply and demand, the weather, government policies and programs, unleaded gasolineprices and the petroleum markets as a whole. Excess ethanol supply in themarket, in particular, puts downward pressure on the price of ethanol. Thelargest cost of production is corn. The cost of corn is generally impacted byfactors such as supply and demand, the weather, government policies andprograms, and a risk management program used to protect against the pricevolatility of these commodities. Market fluctuations in the price of and demandfor these products may have a significant adverse effect on the Company’soperations, profitability and the availability and adequacy of cash flow tomeet the Company’s working capital requirements.

 

8

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

**4.**             **FAIR VALUE MEASUREMENTS**

 

The Company measures certainfinancial instruments at fair value in its balance sheets.  The fair valueof these instruments is based on valuations that include inputs that can beclassified within one of the three levels of a hierarchy.  Level 1 inputsinclude quoted market prices in an active market for identical assets orliabilities.  Level 2 inputs are market data, other than Level 1, that areobservable either directly or indirectly.  Level 2 inputs include quotedmarket prices for similar assets or liabilities, quoted market prices in aninactive market, and other observable information that can be corroborated bymarket data.  Level 3 inputs are unobservable and corroborated by littleor no market data.   The fair value of certain long-lived assets isbased on recoverability through utilization in operations.  Except forthose assets and liabilities which are required by authoritative accountingguidance to be recorded at fair value in the balance sheets, the Company haselected not to record any other assets or liabilities at fair value.

 

The following table providesinformation on those assets measured at fair value on a recurring basis.

 
| ** **                        | ** ** | **Fair Value as of  July 31, 2010** | ** **      | **Fair Value Measurement Using** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------|-----------------|-------------------------------------------------|------------|
| ** **                        | ** ** | **Level 1**                                             | ** **      | **Level 2**                                | ** ** | **Level 3** | ** ** |
| Restricted  cash – current   |       | $                                                            |  1,223,071 |                                            | $          |  1,223,071 |   | $ |  — |   | $ |  — |   |
|                              |       |                                                         |            |                                            |       |   |   |   |   |
| Restricted  cash – long-term |       | $                                                            |  477,878   |                                            | $          |  477,878 |   | $ |  — |   | $ |  — |   |
|                              |       |                                                         |            |                                            |       |   |   |   |   |
| Commodity  derivative instruments |       | $                                                            |  (267,388  | )                                               | $          |  (267,388 | ) | $ |  — |   | $ |  — |   |

 

The fair value of the moneymarket funds included in restricted cash and derivative instruments are basedon quoted market prices in active markets.

 

**5.**             **INVENTORY**

 

Inventoryconsisted of the following at July 31, 2010 and October 31, 2009:

 
| ** **       | ** ** | **July 31,** | ** ** | **October 31,** | ** ** |
|------------------|------------|-------------------|------------|----------------------|------------|
| ** **       | ** ** | **2010**          | ** ** | **2009 ***      | ** ** |
| Raw  materials   |       | $                 | 3,942,558  |                 | $          | 1,551,255 |   |
| Work  in process |       | 736,315           |       | 776,801              |       |
| Finished  goods  |       | 1,082,529         |       | 800,915              |       |
| Supplies         |       | 834,149           |       | 847,289              |       |
| Other  grains    |       | 233,889           |       | 775,857              |       |
| Total            |       | $                 | 6,829,440  |                 | $          | 4,752,117 |   |

 

----

*    Derived fromaudited financial statements

 

The Company recorded lossesof approximately $30,000 and $97,000 for the three and nine months ended July 31,2010, respectively, related to inventory, in addition to losses recorded onforward purchase contracts as noted in Note 11, where the market value was lessthan the cost basis, attributable primarily to decreases in market prices ofcorn and ethanol. The loss was recorded with the lower of cost or marketadjustment in the statement of operations. In addition, the Company storedgrain inventory for farmers.  The value of these inventories owned byothers is approximately $165,000 and $283,000 based on market prices at July 31,2010 and October 31, 2009, respectively, and is not included in theamounts above.

 

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** **

**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

**6.**             **DERIVATIVE INSTRUMENTS**

 

As of July 31, 2010,the Company has ethanol derivative instruments, which are required to berecorded as either assets or liabilities at fair value in the Condensed BalanceSheet. Derivatives qualify for treatment as hedges when there is a highcorrelation between the change in fair value of the derivative instrument andthe related change in value of the underlying hedged item and when the Companyformally documents, designates, and assesses the effectiveness of transactionsthat receive hedge accounting initially and on an on-going basis. The Companymust designate the hedging instruments based upon the exposure being hedged asa fair value hedge or a cash flow hedge. The Company does not enter intoderivative transactions for trading purposes.

 

The Company enters into cornand ethanol derivatives in order to protect cash flows from fluctuations causedby volatility in commodity prices for periods up to 24 months. Thesederivatives are put in place to protect gross profit margins from potentiallyadverse effects of market and price volatility on ethanol sales and cornpurchase commitments where the prices are set at a future date. Although thesederivative instruments serve the Company’s purpose as an economic hedge, theyare not designated as effective hedges for accounting purposes. For derivativeinstruments that are not accounted for as hedges, or for the ineffectiveportions of qualifying hedges, the change in fair value is recorded throughearnings in the period of change. As of July 31, 2010, the notional amountof the Company’s outstanding derivative instruments was approximately 2,650,000bushels that were entered into to hedge forecasted corn purchases through December 2010.

 

The following tables providedetails regarding the Company’s fair value of the derivative instruments at July 31,2010, none of which are designated as hedging instruments:

 
| ** **      | ** ** | **Balance Sheet location** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
|-----------------|------------|----------------------------|------------|------------|------------|-----------------|------------|
| Corn  contracts |       | Derivative instruments     |       | $          | —     |            | $          | 267,388 |   |
|                 |            |                            |            |            |            |                 |            |  |  |

 

In addition, as of July 31,2010 the Company had approximately $479,000 of restricted cash related tomargin requirements for the Company’s derivative instrument positions.

 

The following tables providedetails regarding the gains and (losses) from the Company’s derivativeinstruments included in the consolidated statements of operations, none ofwhich are designated as hedging instruments:

 
| ** **         | ** ** | **Statement of**        | ** ** | **Three-Months Ended July 31,** | ** ** |
|--------------------|------------|-------------------------|------------|--------------------------------------|------------|
| ** **         | ** ** | **Operations location** | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Corn  contracts    |       | Cost of goods sold      |       | $                                    | 50,000     |   | $ | 122,000 |   |
|               |       |                    |       |                                 |       |   |   |
| Ethanol  contracts |       | Revenues                |       | 11,000                               |       | — |   |
| Totals             |       |                    |       | $                                    | 61,000     |   | $ | 122,000 |   |

 
| ** **         | ** ** | **Statement of**        | ** ** | **Nine-Months Ended July 31,** | ** ** |
|--------------------|------------|-------------------------|------------|-------------------------------------|------------|
| ** **         | ** ** | **Operations location** | ** ** | **2010**                            | ** ** | **2009** | ** ** |
| Corn  contracts    |       | Cost of goods sold      |       | $                                   | 59,000     |   | $ | 1,208,000 |   |
|               |       |                    |       |                                |       |   |   |
| Ethanol  contracts |       | Revenues                |       | (127,000                            | )          | 373,000 |   |
| Totals             |       |                    |       | $                                   | (68,000    | ) | $ | 1,581,000 |   |

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

**7.**             **LINE OF CREDIT**

 

The Company has a line ofcredit with AgStar subject to certain borrowing base requirements.  TheCompany’s revolving line of credit loan is for a maximum commitment of$6,750,000 and had a maturity date of November 1, 2009.  EffectiveDecember 8, 2009, the Company and AgStar agreed upon an amendment thatfurther extended the maturity date of the revolving line of credit toFebruary 1, 2010.  Effective March 25, 2010, the Companyand AgStar agreed upon an amendment that further extended the maturity date ofthe revolving line of credit to April 30, 2010.  EffectiveMay 27, 2010, the Company and AgStar agreed upon an amendment that furtherextended the maturity date of the revolving line of credit to June 30,2010.  On July 2, 2010, the Companyand AgStar agreed upon the terms of the renewal of the Company’s line ofcredit.  Therefore, effective July 2,2010, the Company entered into an Amended and Restated Fifth Supplement to itsmaster loan agreement with AgStar.  Theeffect of this amendment was to renew the Company’s revolving line of creditloan with a maturity date of December 31, 2010.  As of April 30, 2010 and January 31,2010, the Company was not in compliance with the minimum working capitalrequirement of the master loan agreement.  As of October 31, 2009,the Company was not in compliance with the minimum working capital, minimumtangible net worth and minimum fixed charge ratio provisions of the master loanagreement.  However, the Company was in compliance with covenants ofits master loan agreement with AgStar at July 31, 2010.  Additionally, the Company and AgStar enteredinto a forbearance agreement dated July 2, 2010 by which AgStar agreed itwould not declare a default under the master loan agreement or enforce any ofthe remedies available to it for the period of July 2, 2010 to the earlierof an event of default (as defined under the forbearance agreement) orDecember 31, 2010.  Interest accrueson borrowings at the greater of 6.0% or the one-month LIBOR plus 3.25%, whichtotaled 3.58% at July 31, 2010 and 3.49% at October 31, 2009. From February 1, 2010 through July 2, 2010, AgStar charged defaultinterest at a 2.00% default rate on all of the Company’s loans withAgStar.  The Company has a 0.25% commitment fee on the unused portion ofthe line of credit.  There was no balance outstanding on the line ofcredit at July 31, 2010.  As ofOctober 31, 2009, the Company had drawn $5,000,000 on the line of credit.

 

**8.**             **DEBT FINANCING**

 

Debt financing consists ofthe following:

 
| ** **                                                   | ** ** | **July 31,** | ** ** | **October 31,** | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2010**          | ** ** | **2009***            | ** ** |
| Term  note payable to lending institution, see terms below   |       | $                 | 50,108,818 |                 | $          | 53,381,697 |   |
|                                                         |       |              |       |                 |       |
| Revolving  term note to lending institution, see terms below |       | 1,155,872         |       | 1,155,872            |       |
|                                                         |       |              |       |                 |       |
| Assessments  payable                                         |       | 3,567,413         |       | 3,677,128            |       |
|                                                         |       |              |       |                 |       |
| Notes  payable to electrical company                         |       | 1,408,519         |       | 1,719,773            |       |
|                                                         |       |              |       |                 |       |
| Equipment  note                                              |       | 46,907            |       | 65,517               |       |
|                                                         |       |              |       |                 |       |
| Total                                                        |       | 56,287,529        |       | 59,999,987           |       |
|                                                         |       |              |       |                 |       |
| Less  amounts due on demand or within one year               |       | 51,964,589        |       | 55,224,183           |       |
|                                                         |       |              |       |                 |       |
| Net  long term debt                                          |       | $                 | 4,322,940  |                 | $          | 4,775,804 |   |

 

----

*    Derived from audited financial statements

 

As described in Note 2, theCompany anticipates it will not be in compliance with certain covenants of themaster loan agreement as of October 31, 2010 and July 31, 2011 withAgStar and has reclassified the long-term portion of the debt with them tocurrent.

 

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Table of Contents

 

**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

*Term Note*

 

The Company is required tomake equal monthly payments of principal and interest of approximately $652,000to amortize the note over a period not to exceed ten years, with a finalballoon payment due in October 2012. In addition, the Company is requiredto make additional payments on the term note of excess cash flow, as defined inthe agreement, up to $2,000,000 per year to AgStar until the Company meets aspecified financial ratio. Interest accrues at the one-month LIBOR plus 3.25%,which totaled 3.58% and 3.49% at July 31, 2010 and October 31, 2009,respectively. In May 2008, the Company locked in an interest rate of 6.58%on $45,000,000 of the note for three years ending July 31, 2011.  As part of the debt financing, the premiumabove LIBOR may be reduced based on the ratio of members’ equity to assets.

 

As described in Notes 2 and7, at October 31, 2009, the Company was not in compliance with certaincovenants of the master loan agreement and the Company does not expect tobe in compliance with one or more covenants of the master loan agreement as ofOctober 31, 2010 and July 31, 2011.  Therefore, the term noteand the revolving term note described below remain classified as currentliabilities. The Company and AgStar entered into a forbearance agreement dated July 2,2010 by which AgStar agreed it would not declare a default under the masterloan agreement or enforce any of the remedies available to it for the period ofJuly 2, 2010 to the earlier of an event of default (as defined under theforbearance agreement) or December 31, 2010.  From February 1, 2010 through July 2,2010, AgStar charged default interest at a 2.00% default rate on all ofthe Company’s loans with AgStar.  As partof the forbearance agreement, AgStar approved the deferral of the defaultinterest accrued prior to July 2, 2010 to the end of the forbearanceperiod, and reduction of the accumulated deferred default interest by 50% ifthe Company complies with all loan covenants and payment obligations under theloan documents with AgStar.

 

*RevolvingTerm Note*

 

The Company has a revolvingterm note with AgStar for up to $4,000,000 for cash and inventory managementpurposes. The maximum amount available under the revolving term note decreases$500,000 each year.  Under the forbearance agreement the Company may onlymake advances for a certain project up to approximately $2.0 million.  The Company pays interest on principaladvances monthly at the one-month LIBOR rate plus 3.25%, which totaled 3.58%and 3.49% at July 31, 2010 and October 31, 2009, respectively. TheCompany pays a commitment fee of 0.35% per annum on the unused portion of therevolving term note.  The maturity dateof this note is October 2012.  Asdescribed above and in Notes 2 and 7, at October 31, 2009, the Company wasout of compliance with the working capital covenant of the master loanagreement and does not anticipate being in compliance as of and for the periodsending October 31, 2010 and July 31, 2011.  As such, amounts dueunder the revolving term note have been classified as current liabilities.  From February 1, 2010 through July 2,2010, AgStar charged default interest at a 2.00% default rate on all ofthe Company’s loans with AgStar.  As partof the forbearance agreement, AgStar approved the deferral of the defaultinterest accrued prior to July 2, 2010 to the end of the forbearanceperiod, and reduction of the accumulated deferred default interest by 50% ifthe Company complies with all loan covenants and payment obligations under theloan documents with AgStar.

 

Estimated maturities oflong-term debt after reclassification to current at July 31, 2010 are asfollows:

 
| 2010                  |   | $         | 51,964,589 |   |
|-----------------------|--------|-----------|------------|--------|
| 2011                  |   | 713,818   |       |
| 2012                  |   | 535,492   |       |
| 2013                  |   | 374,958   |       |
| 2014                  |   | 392,357   |       |
| After  2014           |   | 2,306,315 |       |
|                  |   |      |       |
| Total  long-term debt |   | $         | 56,287,529 |   |

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

**9.             MEMBERS’ EQUITY**

 

The Company is authorized toissue 50,000,000 capital units, of which 35,000,000 have been designatedClass A units and 15,000,000 have been designated as Class Bunits.  As of July 31, 2010 and October 31, 2009, the Companyhad outstanding 30,208,074 and 27,104,625 Class A units, respectively andno Class B units.  Members ofthe Company are holders of units who have been admitted as members and whohold at least 2,500 units.  Any holder of units who is not a member willnot have voting rights.  Transferees of units must be approved by ourboard of governors to become members.  Members are entitled to one votefor each unit held. Subject to the Member Control Agreement, all units shareequally in the profits and losses and distributions of assets on a per unitbasis.

 

In July 2010, theCompany sold to Project Viking, L.L.C. (“Project Viking”), a related party,3,103,449 of its Class A units at a price per unit of $1.45 for totalgross proceeds to the Company of approximately $4.5 million as described inNotes 11 and 12.

 

In August 2010, thecompany approved an offering of up to 4,700,000 of its Class A units (the “Units”)at a price of $1.45 per Unit to existing eligible unit holders and additionaleligible accredited investors for a maximum offering of approximately $6.8million.  Existing eligible HLBE unitholders will have the first right to purchase Units before any new eligibleinvestors may purchase Units in the offering, subject to the terms andconditions of the offering and the subscription procedures establishedtherefore.  The offering will be limitedto Minnesota residents only.

 

**10.            LEASES**

 

The Company leasesequipment, primarily rail cars, under operating leases through2017.   Rent expense for the nine months ended July 31, 2010 and2009 was approximately $1.4 million and $718,000, respectively.

 

At July 31, 2010 theCompany had the following minimum future lease payments, which at inception hadnon-cancelable terms of more than one year:

 
| 2011                     |   | $         | 1,665,960 |   |
|--------------------------|--------|-----------|-----------|--------|
| 2012                     |   | 1,655,970 |      |
| 2013                     |   | 1,569,850 |      |
| 2014                     |   | 1,392,850 |      |
| 2015                     |   | 831,600   |      |
| Thereafter               |   | 1,732,500 |      |
|                     |   |      |      |
| Total  lease commitments |   | $         | 8,848,730 |   |

 

**11.**             **COMMITMENTS AND CONTINGENCIES**

 

*LegalProceedings*

 

Permit Matters

 

The Company’s businesssubjects it to various federal, state and local environmental laws andregulations, including those relating to discharges into the air, water andground; the generation, storage, handling, use, transportation and disposal ofhazardous materials; and the health and safety of its employees.

 

The costs associated withobtaining required permits and meeting the demands of regulators reflected inthe permits have increased the costs of construction and production. Inparticular, the Company has incurred additional costs relating to anair-emission permit from the Minnesota Pollution Control Agency (“MPCA”). TheCompany applied for a synthetic minor air-emissions source permit inJuly 2004 that was granted by the MPCA in May 2005. InJune 2005, a coalition of two environmental groups and one energy groupchallenged the grant of this air emissions permit by an appeal to the MinnesotaCourt of Appeals. In July 2006, the Minnesota Court of Appeals affirmedthe MPCA’s

 

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

issuance of the permit. Inconjunction with the permit and the permit dispute and to prevent furtherappeals by the coalition, the Company entered into a compliance agreement withthe MPCA on January 23, 2007 that currently governs the air emissions fromthe plant. Under the compliance agreement, the Company agreed to submit anamendment to its air permit to qualify its facility as a “major emissionssource”. The compliance agreement also allowed the Company to continue theconstruction of the facility. Under the compliance agreement, the Companyagreed to operate its facility in a manner such that the emissions of each ofthe criteria pollutants generated by the ethanol plant, as determined on a 12month rolling sum, do not exceed 95 tons per year and agreed to comply in allother respects with the air emissions permit previously issued by the MPCA.Accordingly, the Company submitted a major amendment to its existingair-emissions permit in December 2008, and, following air pollutioncontrol device testing, the Company submitted a second major amendment inSeptember 2009, both seeking amendments to the air permit, includingamendments to permit conditions and adjustments to other components of plantoperations and production.   However, the Company is continuingdiscussions with the MPCA regarding the necessity for qualifying the facilityas a major emissions source, particularly in light of changes in federal lawthat increased the limit of certain emissions allowed as a synthetic minorsource. On March 13, 2008, MPCA issued a notice of violation to theCompany for violations of certain rules, statutes, and permit conditions (asmodified by the compliance agreement), including emission violations andreporting violations.  As part of the Company’s continuing discussionswith MPCA, it is seeking to resolve these violations by agreement withMPCA.  A violation of environmental laws, regulations or permit conditionscan result in substantial civil fines or criminal sanctions, or permitrevocations or plant shutdown.  Pending the resolution of this air permitissue, the Company continues to operate subject to the compliance agreement.

 

Fagen Design-Build Disputeand Settlement

 

On September 28, 2005,the Company executed a Design-Build Agreement with Fagen, Inc. (“Fagen”)by which Fagen agreed to design and build a 50 million gallon per yearcoal-fired ethanol plant in Heron Lake, Minnesota, for a contract price ofapproximately $76,000,000.  On September 18, 2009, the Company servedand filed on Fagen a demand for arbitration and request for mediation relatingto the Design-Build Agreement and the air emissions warranties under the Design-BuildAgreement.  In the demand for arbitration, the Company alleged variousbreaches of the Design-Build Agreement, negligence and negligentmisrepresentation by Fagen. On January 4, 2010, Fagen requested to joinICM, Inc. (“ICM”) as a party to the arbitration action and onJanuary 27, 2010, ICM, Inc. agreed to be joined.

 

OnJuly 2, 2010, the Company, Fagen and ICM entered into a Mutual Release andSettlement Agreement (“Settlement Agreement”) relating to the arbitrationcommenced by the Company in September 2009.  Although ICM joined inthe arbitration action, no claims against ICM, or answers, defenses,counterclaims or cross-claims by ICM, had been filed as of the date theSettlement Agreement was entered into.  Under the terms of the SettlementAgreement, Fagen made a one-time cash payment to the Company, and released itsclaims to other amounts it claimed were owed by the Company under theDesign-Build Agreement.  In the Settlement Agreement, each party providedthe other with full releases of all claims in the arbitration, relating to theCompany’s ethanol plant, or relating to the Design-Build Agreement, except forcertain claims arising under the ICM license agreement, which license agreementcontinues in full force and effect following the Settlement Agreement. The effective date of the Settlement Agreement was July 2, 2010.

 

Infurtherance of the Settlement Agreement, the Company, Fagen and ICM stipulatedto the dismissal of the arbitration, along with their respective asserted andunasserted claims, with prejudice. The American Arbitration Associationacknowledged the stipulation of dismissal with prejudice on July 27, 2010.

 

From the settlement, theCompany recorded $2.6 million of settlement income from cash and noncashproceeds.  Also, the construction payableof approximately $3.8 million was extinguished, reducing current liabilitiesand fixed assets.  In connection with the settlement and with the Company’sforbearance agreement with AgStar, the Company sold Class A units asdescribed in Notes 9 and 12.

 

14

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**HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

July 31,2010 (Unaudited)

 

*ContractualObligations*

 

The following table providesinformation regarding the consolidated contractual obligations of the Companyas of July 31, 2010:

 
| ** **                      | ** ** | **Total**  | ** ** | **Less than  One Year** | ** ** | **One to Three  Years** | ** ** | **Three to  Five Years** | ** ** | **Greater  Than Five  Years** | ** ** |
|---------------------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| Long-term  debt obligations (1) |       | $          | 63,810,815 |                              | $          | 55,055,969                        |       | $                                  | 4,811,792  |                               | $          | 1,102,095 |   | $ | 2,840,959 |   |
| Operating  lease obligations    |       | 8,848,730  |       | 1,665,960                         |       | 3,225,820                         |       | 2,224,450                          |       | 1,732,500                          |       |
| Purchase  obligations (2)       |       | 18,818,042 |       | 14,418,662                        |       | 4,399,380                         |       | —                             |       | —                             |       |
| Total  contractual obligations  |       | $          | 91,477,587 |                              | $          | 71,140,591                        |       | $                                  | 12,436,992 |                               | $          | 3,326,545 |   | $ | 4,573,459 |   |

 

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(1)   Long-termdebt obligations include estimated interest and interest on unused debt.

(2)   Purchaseobligations primarily include forward contracts for corn and coal.

 

*ForwardContracts*

 

The Company has forwardcontracts in place for corn purchases of approximately $8.9 million throughOctober 2010, which represents approximately 51% of the Company’santicipated corn purchases for the remainder of fiscal 2010.

 

Currently, some of thesecorn contract prices are above market prices for corn. Given the recentchanging price of corn upon taking delivery under these contracts, the Companywould incur a loss. Accordingly, the Company recorded a loss on purchasecommitments of approximately $84,000 and $806,000 for the three and nine monthsended July 31, 2010, respectively.  The loss was recorded as a lowerof cost or market adjustment on the statement of operations. The amount of theloss was determined by applying a methodology similar to that used in the lowerof cost or market evaluation with respect to inventory. Given the uncertaintyof future ethanol prices, this loss may or may not be recovered, and furtherlosses on the outstanding purchase commitments could be recorded in futureperiods.

 

**12.**          **RELATED PARTY TRANSACTIONS**

 

During the three monthsending July 31, 2010 and July 31, 2009, the Company purchased cornfrom members for approximately $8.6 million and $12.2 million,respectively.  The Company purchased corn from members of approximately$29.6 million and $37.0 million during the nine months ended July 31, 2010and July 31, 2009, respectively.

 

Further, effectiveJuly 2, 2010, the Company sold to Project Viking, L.L.C. (“Project Viking”)3,103,449 of its units at a price per unit of $1.45 for total gross proceeds tothe Company of approximately $4.5 million. All proceeds from the sale of theunits to Project Viking were used to reduce the principal balance of theCompany’s revolving line of credit note with AgStar Financial Services, PCA (“AgStar”).  Following the purchase of units, ProjectViking is a holder of 29.8% of the 30,208,074 units issued and outstanding at July 31,2010.

 

Please refer to the sectiontitled “Legal Proceedings” in Note 11 for information on the settlement of thearbitration proceedings between the Company and Fagen, Inc., a relatedparty. In addition, one of the conditions to the effectiveness of theSettlement Agreement described in Note 11 was the release of Roland J. Fagen byAgStar from his obligations under his personal guaranty of $3.74million of the Company’s indebtedness to AgStar under the Company’s masterloan agreement.  The effective date of the release of Mr. Fagen’spersonal guaranty was July 2, 2010.

** **

**13.**                 **SUBSEQUENT EVENTS**

 

The Company has evaluatedsubsequent events through August 25, 2010 the date which the financialstatements were available to be issued.

 

On August 11, 2010, theCompany borrowed $1 million from its line of credit with AgStar.  The Company has repaid a portion of thisamount as of the date of the filing of this Quarterly Report on Form 10-Q.

 

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

 

*ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, contains, in addition to historical information, forward-lookingstatements that are based on our expectations, beliefs, intentions or futurestrategies. These statements are subject to risks and uncertainties that couldcause actual results to**differmaterially from the statements because of certain factors, including those setforth under Part I, Item 1A. “Risk Factors” in our Annual Report onForm 10-K for the year ended October 31, 2009, as well as in otherfilings we make with the Securities and Exchange Commission. Allforward-looking statements included herein are based on information availableto us as of the date hereof, and we undertake no obligation to update any suchforward-looking statements.*

 

The following is a discussionand analysis of Heron Lake BioEnergy’s financial condition and results ofoperations as of and for the three month and nine month periods ended July 31,2010 and 2009. This section should be read in conjunction with the condensedconsolidated financial statements and related notes in Item 1 of this reportand the Company’s Annual Report on Form 10-K for the year endedOctober 31, 2009.

 

We prepared the followingdiscussion and analysis to help readers better understand our financialcondition, changes in our financial condition, and results of operations forthe three and nine months ended July 31, 2010.

 

**Overview**

 

Heron Lake BioEnergy, LLC isa Minnesota limited liability company that was formed for the purpose ofconstructing and operating a dry mill corn-based ethanol plant near Heron Lake,Minnesota. The plant has a stated capacity to produce 50 million gallonsof denatured fuel grade ethanol and 160,000 tons of dried distillers’ grainsper year. Production of ethanol and distillers’ grains at the plant began inSeptember 2007. We began recording revenue from plant production inOctober 2007, the last month of our fiscal year. Our revenues are derivedfrom the sale and distribution of our ethanol and in the sale and distributionof our distillers’ grains.

 

Our operating results arelargely driven by the prices at which we sell ethanol and distillers grains andthe costs related to their production, particularly the cost of corn.Historically, the price of ethanol tended to fluctuate in the same direction asthe price of unleaded gasoline and other petroleum products. However, duringfiscal 2009 and continuing into fiscal 2010, ethanol prices tended to move upand down proportionately with changes in corn prices. The price of ethanol canalso be influenced by factors such as general economic conditions, concernsover blending capacities, and government policies and programs. The price ofdistillers grains is generally influenced by supply and demand, the price ofsubstitute livestock feed, such as corn and soybean meal, and other animal feedproteins. Our largest component of and cost of production is corn. The cost ofcorn is affected primarily by factors over which we lack any control such ascrop production, carryout, exports, government policies and programs, andweather. The growth of the ethanol industry has increased the demand for corn.We believe that continuing increase in global demand will result in corn pricesabove historic averages.   During the third quarter of fiscal year2010 ended July 31, 2010, the price of ethanol on the Chicago Board of Tradefluctuated from $1.47 to $1.65 per gallon; our average sales price was $1.50per gallon, with basis.  During the same period, the price of corn on theChicago Board of Trade fluctuated from a low of $3.25 to a high of $3.97 perbushel; our average purchase price was $3.37 per bushel, with basis.

 

**Trends andUncertainties Impacting Our Operations**

 

Our current and futureresults of operation are affected and will continue to be affected by factorssuch as (a) volatile and uncertain pricing of ethanol and corn;(b) availability of corn that is, in turn, affected by trends such as cornacreage, weather conditions, and yields on existing and new acreage divertedfrom other crops; and (c) the supply and demand for ethanol, which isaffected by acceptance of ethanol as a substitute for fuel, public perceptionof the ethanol industry, government incentives and regulation, and competitionfrom new and existing construction, among other things. Other factors that mayaffect our future results of operation include those factors discussed in “Item1. Business” of our Annual Report on Form 10-K for the year endedOctober 31, 2009 and “Part II, Item 1A Risk Factors” of this Form 10-Q.

 

**CriticalAccounting Estimates**

 

A description of ourcritical accounting estimates was provided in the *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations* section of our Annual Report on Form 10-K for theyear ended October 31, 2009. At July 31, 2010, our critical accountingestimates continue to include those described in our Annual Report onForm 10-K. In addition, our analysis of future projections, resolution ofdebt terms and other assumptions in consideration of continuing as a goingconcern include critical accounting estimates.

 

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**Results ofOperations for the Three Months Ended July 31, 2010 and 2009**

 

The following table showssummary information from our Statement of Operations for the three months endedJuly 31, 2010 and July 31, 2009.

 
| ** **                          | ** ** | **Three Months Ended********July 31, 2010** | ** ** | **Three Months Ended********July 31, 2009** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| **Income Statement Data** | ** ** | **Amount**                                  | ** ** | **%**                                       | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                            |       | $                                           | 23,621,607 |                                        | 100.0      |   | $ | 21,196,118 |   | 100.0 |   |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Cost  of Goods Sold                 |       |                                        |       |                                        |       |   |   |   |   |
| Cost  of goods sold                 |       | 24,329,885                                  |       | 103.0                                       |       | 21,420,797 |   | 96.5 |   |
| Lower  of cost or market adjustment |       | 113,791                                     |       | 0.5                                         |       | 1,863,605 |   | 8.4 |   |
| Total  Cost of Goods Sold           |       | 24,443,676                                  |       | 103.5                                       |       | 23,284,402 |   | 104.9 |   |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Gross  Loss                         |       | (822,069                                    | )          | (3.5                                        | )          | (1,088,284 | ) | (4.9 | ) |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Operating  Expenses                 |       | (842,953                                    | )          | (3.5                                        | )          | (1,632,166 | ) | (7.3 | ) |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Settlement  Income                  |       | 2,600,000                                   |       | 11.0                                        |       | — |   | 0.0 |   |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Operating  Income (Loss)            |       | 934,978                                     |       | 4.0                                         |       | (2,720,450 | ) | (12.2 | ) |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Other  Income (Expense), net        |       | (1,108,004                                  | )          | (4.7                                        | )          | (1,064,697 | ) | (4.8 | ) |
|                                |       |                                        |       |                                        |       |   |   |   |   |
| Net  Loss                           |       | $                                           | (173,026   | )                                           | (0.7       | ) | $ | (3,785,147 | ) | (17.0 | ) |

 

*Revenues*

 

Revenues, derived from thesale of fuel ethanol and distillers’ grains with solubles (“DGS”) produced atthe plant, increased 11% for the quarter ended July 31, 2010 as compared to thequarter ended July 31, 2009. Net ethanol revenues during the quarter ended July31, 2010, were approximately $19.8 million, representing 84% of our sales,compared to approximately $17.9 million during the quarter ended July 31, 2009,representing 85% of our sales. The increase in ethanol revenue was a result ofa 16% increase in the gallons of ethanol sold partially offset by a 4% decreasein the average price per gallon of ethanol in the quarter ended July 31, 2010as compared to the quarter ended July 31, 2009. The main contributing factor tothe increase in gallons of ethanol sold is the correction in the first quarterof fiscal 2010 of production difficulties experienced during the third quarterof fiscal 2009.  We had revenue gains ofapproximately $11,000 related to ethanol derivatives for the quarter ended July31, 2010. There were no ethanol derivative gains or losses during the quarterended July 31, 2009.

 

Total sales of DGS duringthe quarter ended July 31, 2010 were approximately $2.9 million comprising12% of our revenues. DGS sales during the quarter ended July 31, 2009 were$3.3 million or 15% of revenues. The average DGS price decreased 49% for thequarter ended July 31, 2010 as compared to the quarter ended July 31, 2009. DGStonnage sales increased by 35% for the quarter ended July 31, 2010 as comparedto the quarter ended July 31, 2009.  Theincreased weight and decreased price is due to an increase in modified DGSsold.  For the three months ended June30, 2009, approximately 1% of our DGS sales were from modified DGS.  For the three months ended June 30, 2010, 12%of our DGS sales were attributable to modified DGS.  The decrease in DGS as a percentage ofrevenues for the quarter ended July 31, 2010 as compared to July 31, 2009 isdue to both lower revenue from DGS sales and higher revenue from ethanol salesfor the quarter ended July 31, 2010.  Theremaining percent of revenues is made up of incidental other sales.

 

*Cost ofGoods Sold*

 

Our costs of sales include,among other things, the cost of corn used in ethanol and DGS production (whichis the largest component of costs of sales); coal, processing ingredients,electricity, and wages, salaries and benefits of production personnel. We useapproximately 1.5 million bushels of corn per month at the plant. Wecontract with local farmers and elevators for our corn supply.

 

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Our cost of goods sold(including lower of cost or market adjustments) as a percentage of revenueswere 103.5% and 104.9% for the three months ended July 31, 2010 and July 31,2009, respectively. The per bushel cost of corn, including lower of cost ormarket adjustments,  decreasedapproximately 12% in the quarter ended July 31, 2010 as compared to the quarterended July 31, 2009. This decrease combined with the 4% decrease in the pergallon sales price of ethanol caused the decrease in the cost of goods sold asa percent of revenues. Cost of goods sold includes lower of cost or marketadjustments of approximately $114,000 and $1,864,000 for the three months endedJuly 31, 2010 and 2009, respectively, which related to forward purchasecontracts and inventory where the fixed price was more than the estimatedrealizable value.  We had gains related to corn derivative instruments ofapproximately $50,000 and $122,000 for the quarters ended July 31, 2010, and2009, which reduced cost of sales. Our gross profit margin for the three monthsended July 31, 2010 improved to a loss of 3.5% from a loss of 4.9% for thethree months ended July 31, 2009. We had an increased gross margin in the thirdquarter of fiscal 2010 as compared to third quarter of fiscal 2009 due to the4% decrease in ethanol prices while the cost of corn, including lower of costor market adjustments,  decreased6%.  For the same period, production increased 12% due to productionproblems in third quarter of fiscal 2009 that we did not experience in thethird quarter of fiscal 2010.

 

The cost of corn fluctuatesbased on supply and demand, which, in turn, is affected by a number of factorswhich are beyond our control. We expect our gross margin to fluctuate in thefuture based on the relative prices of corn and fuel ethanol. We use futuresand option contracts to minimize our exposure to movements in corn prices, butthere is no assurance that these hedging strategies will be effective. At July31, 2010, none of our contracts were designated as hedges and, as a result,changes to the market value of these contracts were recognized as a gain orloss. As a result, gains or losses on derivative instruments do not necessarilycoincide with the related corn purchases. This may cause fluctuations in ourstatement of operations. While we do not use hedge accounting to match gains orlosses on derivative instruments, we believe the derivative instruments providean economic hedge.

 

*OperatingExpenses*

 

Operating expenses consistof selling, general and administrative expense and include wages, salaries andbenefits of administrative employees at the plant, insurance, professional feesand similar costs. These expenses represented 3.5% of total revenues for thethree months ended July 31, 2010 and 7.3% of total revenues for the threemonths ended July 31, 2009.   These expenses generally do not vary withthe level of production at the plant and were relatively constant from period toperiod other than costs of approximately $800,000 incurred for environmentalemissions testing done and unusual boiler repairs during the quarter ended July31, 2009.

 

From the settlement on July2, 2010 of its arbitration proceeding involving Fagen, Inc., the Companyrecorded $2.6 million of settlement income from cash and noncash proceeds,which was recorded separately as Settlement Income.

 

*OtherExpense, Net*

 

Other expenses consistedprimarily of interest expense. Interest expense consists primarily of interestpayments on our credit facilities described below. Interest expense, which wasup for the three months ended July 31, 2010 approximately 3% as compared to thethree months ended July 31, 2009, is dependent on the balances outstanding andon interest rate fluctuations. For the three months ended July 31, 2010, debtbalances were down approximately 9% as compared to the three months ended July31, 2009.  Balances on our line of creditdecreased from $5,000,000 at July 31, 2009 to no balance outstanding at July31, 2010.  However, balances on our lineof credit had a minimum interest rate of 6% during the three months ended July31, 2010.  There was no minimum interestduring the three months ended July 31, 2009. Additionally, we accrued a 2% default interest on all AgStar debtbeginning February 1, 2010 through July 2, 2010 which added additional expensefor the three months ended July 31, 2010 that was not incurred for the threemonths ended July 31, 2009.

 

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**Results ofOperations for the Nine Months Ended July 31, 2010 and 2009**

 

The following table showssummary information from our Statement of Operations for the nine months endedJuly 31, 2010 and July 31, 2009.

 
| ** **                          | ** ** | **Nine Months Ended********July 31, 2010** | ** ** | **Nine Months Ended********July 31, 2009** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| **Income Statement Data** | ** ** | **Amount**                                 | ** ** | **%**                                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                            |       | $                                          | 78,809,958 |                                       | 100.0      |   | $ | 61,784,588 |   | 100.0 |   |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Cost  of Goods Sold                 |       |                                       |       |                                       |       |   |   |   |   |
| Cost  of goods sold                 |       | 73,675,212                                 |       | 93.5                                       |       | 62,540,473 |   | 101.2 |   |
| Lower  of cost or market adjustment |       | 902,990                                    |       | 1.1                                        |       | 5,321,835 |   | 8.6 |   |
| Total  Cost of Goods Sold           |       | 74,578,202                                 |       | 94.6                                       |       | 67,862,308 |   | 109.8 |   |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Gross  Profit (Loss)                |       | 4,231,756                                  |       | 5.4                                        |       | (6,077,720 | ) | (9.8 | ) |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Operating  Expenses                 |       | (2,896,640                                 | )          | (3.7                                       | )          | (3,368,503 | ) | (5.5 | ) |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Settlement  Income                  |       | 2,600,000                                  |       | 3.3                                        |       | — |   | 0.0 |   |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Operating  Income (Loss)            |       | 3,935,116                                  |       | 5.0                                        |       | (9,446,223 | ) | (15.3 | ) |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Other  Expense, net                 |       | (2,982,593                                 | )          | (3.8                                       | )          | (3,363,662 | ) | (5.4 | ) |
|                                |       |                                       |       |                                       |       |   |   |   |   |
| Net  Income (Loss)                  |       | $                                          | 952,523    |                                       | 1.2        |   | $ | (12,809,885 | ) | (20.7 | ) |

 

*Revenues*

 

Revenues are derived fromthe sale of fuel ethanol and distillers’ grains with solubles (“DGS”) producedat the plant and increased 28% for the nine months ended July 31, 2010 ascompared to the nine months ended July 31, 2009. Net ethanol revenues duringthe nine months ended July 31, 2010, were approximately $64.9 million,representing 82% of our revenues, compared to approximately $48.3 millionduring the nine months ended July 31, 2009, representing 78% of our revenues.The increase in ethanol revenue was a result of a 9% increase in the averageprice per gallon of ethanol period to period, in conjunction with a 23%increase in the gallons of ethanol sold. The main contributing factor to theincrease in gallons of ethanol sold is the correction in the first quarter offiscal 2010 of production difficulties experienced during the first nine monthsof fiscal 2009.  We had losses ofapproximately $127,000 and a gain of $373,000 related to ethanol derivativesfor the nine months ended July 31, 2010 and 2009, respectively.

 

Total sales of DGS duringthe nine months ended July 31, 2010 were approximately $9.1 millioncomprising 12% of our revenues. DGS sales during the nine months endedJuly 31, 2009 were $9.7 million or 16% of revenues. The average DGS pricedecreased 56% for the nine months ended July 31, 2010 as compared to the ninemonths ended July 31, 2009. DGS tonnage sales increased by 46% for the ninemonths ended July 31, 2010 as compared to the nine months ended July 31,2009.  The increase in tonnage anddecrease in price are due to an increase in modified DGS sold.  For the nine months ended June 30, 2009,sales related to modified DGS were approximately 2% of total DGS sales comparedto approximately 13% for the nine months ended June 30, 2010.  The remaining percent of revenues is made upof incidental other sales.

 

*Cost ofGoods Sold*

 

Our costs of goods soldincludes, among other things, the cost of corn used in ethanol and DGSproduction (which is the largest component of costs of sales); coal, processingingredients, electricity, and wages, salaries and benefits of productionpersonnel. We use approximately 1.5 million bushels of corn per month atthe plant. We contract with local farmers and elevators for our corn supply.

 

Our cost of goods sold(including lower of cost or market adjustments) as a percentage of revenueswere 94.6% and 109.8% for the nine months ended July 31, 2010 and July 31,2009, respectively. The per bushel cost of corn, including lower of cost ormarket adjustments,  decreasedapproximately 18% in the nine months ended July 31, 2010 as compared to thenine months ended July 31, 2009. This decrease, combined with the 9% increasein the per gallon sales price of ethanol, caused the decrease in the cost ofgoods sold as a percent of revenues. Cost of goods sold also includes lower ofcost or market adjustments of approximately $903,000 and $5,322,000 for thenine months ended July 31, 2010 and 2009, respectively, which related toforward purchase contracts and inventory where the fixed price was more thanthe

 

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estimated realizablevalue.  We had gains related to corn derivative instruments ofapproximately $59,000 and $1,208,000 for the nine months ended July 31, 2010,and 2009, which reduced cost of goods sold. Our gross profit margin for thenine months ended July 31, 2010 increased to 5.4% from a loss of 9.8% for thenine months ended July 31, 2009.  Thisimprovement is primarily due to our positive gross margin in the first twoquarters of fiscal 2010 as compared to a negative gross margin in the first twoquarters of fiscal 2009 due to the 9% increase in ethanol prices while the costof corn, including lower of cost or market adjustments decreased 15%.  Forthe same period, production also increased 23% due to fewer plant shutdownsrelated to production problems.

 

The cost of corn fluctuatesbased on supply and demand, which, in turn, is affected by a number of factorswhich are beyond our control. We expect our gross margin to fluctuate in thefuture based on the relative prices of corn and fuel ethanol. We use futuresand option contracts to minimize our exposure to movements in corn and ethanolprices, but there is no assurance that these hedging strategies will beeffective. At July 31, 2010, none of our contracts were designated as hedgesand, as a result, changes to the market value of these contracts wererecognized as an increase or decrease to our revenue and costs of goods sold.As a result, gains or losses on derivative instruments do not necessarilycoincide with the related corn purchases. This may cause fluctuations in ourstatement of operations. While we do not use hedge accounting to match gains orlosses on derivative instruments, we believe the derivative instruments providean economic hedge.

 

*OperatingExpenses*

 

Operating expenses includewages, salaries and benefits of administrative employees at the plant,insurance, professional fees and similar costs. These expenses represented 3.7%of total revenues for the nine months ended July 31, 2010 and 5.5% of total revenuesfor the nine months ended July 31, 2009.   These expenses generally do notvary with the level of production at the plant and were relatively constantfrom period to period other than costs of approximately $800,000 incurred forenvironmental emissions testing done and unusual boiler repairs during the ninemonths ended July 31, 2009.

 

From the settlement onJuly 2, 2010 of its arbitration proceeding involving Fagen, Inc., theCompany recorded $2.6 million of settlement income from cash and noncashproceeds, which was recorded separately as Settlement Income.

 

*OtherExpense, Net*

 

Other expenses consistedprimarily of interest expense. Interest expense consists primarily of interestpayments on our credit facilities described below. Interest expense, which wasup for the nine months ended July 31, 2010 approximately 7% as compared to thenine months ended July 31, 2009, is dependent on the balances outstanding andon interest rate fluctuations. For the nine months ended July 31, 2010, debtbalances were down approximately 8%. Balances on our line of credit decreased from $5,000,000 at July 31,2009 to no balance outstanding at July 31, 2010.  However, balances on our line of credit had aminimum interest rate of 6% during the nine months ended July 31, 2010.  There was no minimum interest rate during thenine months ended July 31, 2009. Additionally, we accrued a 2% default interest on all AgStar debtbeginning February 1, 2010 through July 2, 2010 which added additional expensefor the nine months ended July 31, 2010 that was not incurred for the ninemonths ended July 31, 2009.

 

**Liquidityand Capital Resources**

 

As of July 31, 2010, we hadcash and cash equivalents (other than restricted cash) of approximately$216,000, current assets of approximately $12.0 million and total assetsof approximately $104.7 million.

 

Our principal sources ofliquidity consist of cash provided by operations, cash and cash equivalents onhand and historically we have also obtained liquidity through borrowing fromAgStar Financials Services, PCA under a master loan agreement.  Under the master loan agreement with AgStar,we have three forms of debt: a term note, a revolving term note and a line ofcredit.  The total indebtedness to AgStar at July 31, 2010 consists of$50.1 million under the term note and $1.1 million under the revolving termnote.  No amounts were outstanding on theline of credit at July 31, 2010.  Among other provisions, our master loanagreement contains covenants requiring us to maintain various financial ratiosand tangible net worth. It also limits our annual capital expenditures andmember distributions. All of our assets and real property are subject tosecurity interests and mortgages in favor of AgStar as security for theobligations of the master loan agreement.

 

As a result of our financialperformance, we violated certain financial covenants under our master loanagreement with AgStar at the end of each quarter from January 31, 2009 to April30, 2010.  However, we were in compliancewith covenants of our master loan agreement with AgStar at July 31, 2010.  Additionally, we and AgStar entered into aforbearance agreement dated July 2, 2010 by which AgStar agreed it would notdeclare a default under the master loan agreement or enforce any of the remediesavailable to it for the period of July 2, 2010 to the earlier of an eventof default (as defined under the forbearance agreement) or December 31,2010.  Furthermore, AgStar renewed ourrevolving line of credit loan effective July 2, 2010 with a maturity date ofDecember 31, 2010 in an aggregate principal amount outstanding at any one timenot to exceed $6,750,000.  Interestaccrues on borrowings at the greater of 6.0% or the one-month LIBOR plus 3.25%.

 

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We do not expect to be incompliance with one or more covenants of the master loan agreement as ofOctober 31, 2010 and July 31, 2011, without an amendment to the covenants,improved financial performance, or the addition of significant working capitalto the Company. Therefore, we have classified $45.7 million of the AgStar debtas a current liability that would otherwise be classified as long term. As aresult, current liabilities as of July 31, 2010 totaled approximately $55.3million, including $45.7 million of long-term debt reclassified as currentliabilities.

 

In May 2008, we lockedin an interest rate of 3.58% plus 3.00%, which totals 6.58%, on $45.0 millionof the term note, for three years ending April 30, 2011. The remainder ofthe amounts outstanding on the term note is subject to the variable rate basedon the one-month LIBOR plus 3.25%.  We are required to make equal monthlypayments of principal and interest of approximately $652,000 to amortize thenote over a period not to exceed ten years, with a final balloon payment due inOctober 2012. In addition, we are required to make additional payments onthe term note of excess cash flow, as defined in the agreement, up to $2.0million per year to AgStar until we meet certain minimum tangible owner’sequity, as defined in the agreement. As part of the debt financing, the premiumabove LIBOR may be reduced based on the ratio of members’ equity to assets. FromFebruary 1, 2010 through July 2, 2010, AgStar accrued default interest ata 2.00% default rate on all of the Company’s loans with AgStar, which was$51.3 million at July 31, 2010.  As part of the forbearance agreement,AgStar approved the deferral of the default interest accrued prior toJuly 2, 2010 to the end of the forbearance period, and reduction of theaccumulated deferred default interest by 50% if the Company complies with allloan covenants and payment obligations under the loan documents with AgStar.

 

Our principal uses of cashare to pay operating expenses of the plant and to make debt service payments onour long-term debt. During the nine months ended July 31, 2010 the Company paid$5.0 million on the line of credit described below.

 

The following tablesummarizes our sources and uses of cash and equivalents from our condensedconsolidated statements of cash flows for the periods presented (in thousands):

 
| ** **                             | ** ** | **Nine Months Ended  July 31** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **2010**                       | ** ** | **2009** | ** ** |
| Net  cash used in operating activities |       | $                              | 1,114,458  |   | $ | (11,730,173 | ) |
| Net  cash used in investing activities |       | (110,801                       | )          | (325,656 | ) |
| Net  cash used in financing activities |       | (3,971,545                     | )          | 1,758,235 |   |
| Net  decrease in cash and equivalents  |       | $                              | (2,967,888 | ) | $ | (10,297,594 | ) |

 

During the nine months endedJuly 31, 2010, we provided $1.1 million in cash from operating activities. Thisconsists primarily of generating net income of $953,000 plus non-cash expensesincluding depreciation and amortization of $4.2 million and lower of cost ormarket adjustments of $0.9 million offset by increasing inventory on hand by$2.2 million and decreasing accrued loss on forward contracts by $2.0 million.

 

During the nine months endedJuly 31, 2009, we used $11.7 million in cash for operating activities. This useconsists primarily of a net loss of $12.8 million, payments for corn inaccounts payable and payments under forward purchase contracts, which hadlosses that were accrued on October 31, 2008.

 

During the nine months endedJuly 31, 2010, we used approximately $111,000 for investing activities to payfor capital expenditures. During the nine months ended July 31, 2010, we used$4.0 million for financing activities consisting primarily of payments onlong-term debt of $3.7 million, payments on the line of credit of $5.0 millionand proceeds from the sale of the Company’s units of $4.5 million.

 

During the nine months endedJuly 31, 2009, we used $0.3 million for investing activities to pay for capitalexpenditures and intangibles. During the nine months ended July 31, 2009, wehad $1.8 million provided by financing activities consisting primarily ofpayment on long term debt of $3.2 million, net of release of restricted cashand a draw on the line of credit of $5.0 million.

 

TheCompany believes it has sufficient capital resources through July 31, 2011based upon its current cash reserves, inventory sales, projected commoditymarkets and the available borrowing under the master loan agreement.  However, the Company will pursue additionalcapital to help fund ongoing operations and to meet its financial covenants,and will seek additional capital from selling additional equity to existing ornew investors, or incurring additional debt. There can be no assurance that the Company will be able to raise thiscapital on favorable terms, if at all. The financial statements do not include any adjustments relating to therecoverability and classification of recorded assets and liabilities that mightbe necessary should the Company not receive the additional capital.  If we are unable to obtain sufficientcapital, we may further curtail our capital expenditures, further reduce ourexpenses, or suspend or discontinue our operations, or sell our assets.  Our ability to comply with the covenants ofour master loan agreement or make required payments on our debt to AgStar mayalso be impaired if we do not obtain sufficient additional capital, resultingin covenant or payment defaults, acceleration of our indebtedness, seizure byAgStar of assets that secure our indebtedness, loss of control of our businessor bankruptcy.

 

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**Outlook**

 

We anticipate that ethanolprices will recover somewhat during the remainder of fiscal year 2010 from thelower prices received during the nine months ended July 31, 2010, based onrecent prices quoted for ethanol futures on the Chicago Board of Trade, and asenergy prices historically increase during the summer driving season.Nevertheless, we expect to see continuing volatility in ethanol prices. Future prices for fuel ethanol will be affected by a variety of factors beyondour control including the amount and timing of additional domestic ethanolproduction and ethanol imports; petroleum and gasoline prices; and thedevelopment of other alternative fuels.

 

Prices for DGS are alsoaffected by a number of factors beyond our control such as the supply of anddemand for DGS as an animal feed, prices of competing feeds, and perceptions ofnutritional value of DGS as compared to those of competing feeds. We believethat current market prices for DGS can be sustained long-term as long as theprices of competing animal feeds remain steady or increase, livestock feederscontinue to create demand for alternative feed sources such as distillers’grains and the supply of distillers’ grains remains relatively stable. On theother hand, if competing commodity price values retreat and DGS suppliesincrease due to growth in the ethanol industry, DGS prices may decline.

 

Corn prices have beenvolatile for the past year due in part to higher demand from the renewablefuels industry. The expansion of ethanol productive capacity has brought abouta substantial increase in demand for corn and thus in corn prices.  However this has been mitigated by a largeincrease in crop size.  We expect theprice of corn to remain at current price levels well into 2011.   Due to increasedexposure of ethanol, corn is now being viewed as an “energy commodity” as opposedto strictly a “grain commodity”, contributing to the upward pressure on cornprices.  The USDA’s August 16, 2010 Feed Outlook Report, projects U.S.corn prices for the 2010 and 2011 season average to be at $3.50 to $4.10 perbushel.

 

**Off-BalanceSheet Arrangements**

 

We do not have anyoff-balance sheet arrangements.

 

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

 

We are subject to marketrisks concerning our long-term debt and future prices of corn, coal, ethanoland distillers grains.  We consider market risk to be the impact ofadverse changes in market prices on our results of operations.  Ingeneral, ethanol prices are affected by the supply and demand for ethanol, thecost of ethanol production, the availability of other fuel oxygenates, theregulatory climate and the cost of alternative fuels such as gasoline. Theprice of corn is affected by weather conditions and other factors affectingcrop yields, farmer planting decisions and general economic, market andregulatory factors.   From time to time, we may purchase corn futuresand options to hedge a portion of the corn we anticipate we will need. Inaddition, we have contracted for future physical delivery of corn. We areexposed to the full impact of market fluctuations associated with interestrates and commodity prices.

 

We are also subject tomarket risk on the selling prices of our distiller grains. These pricesfluctuate seasonally when the price of corn or other cattle feed alternativesfluctuate in price.

 

As an example of ourpotential sensitivity to price changes, if the price of ethanol rises or falls$0.10 per gallon, our annual revenues may increase or decrease accordingly byapproximately $5.0 million, assuming no other changes in our business.Additionally, if the price of corn rises or falls $0.25 per bushel, our annualcost of goods sold may increase or decrease by $5.0 million, againassuming no other changes in our business.  During the third quarter offiscal year 2010 ended July 31, 2010, the price of ethanol on the Chicago Boardof Trade fluctuated from $1.47 to $1.65 per gallon; our average sales price was$1.50 per gallon, with basis.  During the same period, the price of cornon the Chicago Board of Trade fluctuated from a low of $3.25 to a high of $3.97per bushel; our average purchase price was $3.37 per bushel, with basis.  Our future earnings may be affected bychanges in interest rates due to the impact those changes have on our interestexpense on borrowings under our credit facilities. As of July 31, 2010, we had$13.0 million of outstanding borrowings with variable interest rates. With each1% change in interest rates our annual interest expense would change by$130,000.

 

**Item 4.Controls and Procedures**

 

**Effectivenessof Disclosure Controls and Procedures**

 

Our management, with theparticipation of our Chief Executive Officer and Interim Chief FinancialOfficer, has evaluated the effectiveness of our “disclosure controls andprocedures” (as defined in Rules 13a-15(e) under the Exchange Act) asof the end of the period covered by this report. Based on that evaluation, ourChief Executive Officer and Interim Chief Financial Officer have concludedthat, as of the end of such period, our disclosure controls and procedures wereeffective.

 

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**Changes inInternal Control over Financial Reporting**

 

There has been no change inour internal control over financial reporting (as defined inRule 13a-15(f) under the Exchange Act) that occurred in the fiscalquarter ended July 31, 2010 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II. OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

On September 28, 2005,the Company executed a Design-Build Agreement with Fagen, Inc. (“Fagen”)by which Fagen agreed to design and build a 50 million gallon per yearcoal-fired ethanol plant in Heron Lake, Minnesota.  On September 18,2009, the Company served and filed on Fagen a demand for arbitration andrequest for mediation relating to the Design-Build Agreement and the airemissions warranties under the Design-Build Agreement.  In the demand forarbitration, the Company alleged various breaches of the Design-BuildAgreement, negligence and negligent misrepresentation by Fagen. OnJanuary 4, 2010, Fagen requested to join ICM, Inc. (“ICM”) as a partyto the arbitration action and on January 27, 2010, ICM, Inc. agreedto be joined.

 

OnJuly 2, 2010, the Company, Fagen and ICM entered into a Mutual Release andSettlement Agreement (“Settlement Agreement”) relating to the arbitrationcommenced by the Company in September 2009.  Although ICM joined in thearbitration action, no claims against ICM, or answers, defenses, counterclaimsor cross-claims by ICM, had been filed as of the date the Settlement Agreementwas entered into.  Under the terms of the Settlement Agreement, Fagen madea one-time cash payment to the Company, and released its claims to otheramounts it claimed were owed by the Company under the Design-BuildAgreement.  In the Settlement Agreement, each party provided the otherwith full releases of all claims in the arbitration, relating to the Company’sethanol plant, or relating to the Design-Build Agreement, except for certainclaims arising under the ICM license agreement, which license agreementcontinues in full force and effect following the Settlement Agreement. The effective date of the Settlement Agreement was July 2, 2010.

 

Infurtherance of the Settlement Agreement, the Company, Fagen and ICM stipulatedto the dismissal of the arbitration, along with their respective asserted andunasserted claims, with prejudice. The American Arbitration Association acknowledgedthe stipulation of dismissal with prejudice on July 27, 2010.

 

**Item 1A.Risk Factors**

 

The most significant riskfactors applicable to the Company are set forth below and supersede the riskfactors set forth in Part I, Item 1A “Risk Factors” of our Annual Reporton Form 10-K for the year ended October 31, 2009.

 

**Risks Related to Our Financial Condition**

 

***We anticipate that one or more of our covenants under the master loanagreement with AgStar will not be met at October 31, 2010 and July 31, 2011, withoutan amendment to the covenants, improved financial performance, or the additionof significant working capital.***

 

 Asa result of our financial performance, we violated certain financial covenantsunder our master loan agreement with AgStar Financial Services, PCA (“AgStar”)at the end of each quarter from January 31, 2009 to April 30, 2010. On July 2,2010, we entered into a forbearance agreement with AgStar by which AgStaragreed it would not declare a default under the master loan agreement or enforceany of the remedies available to it for the period of July 2, 2010 to theearlier of an event of default (as defined under the forbearance agreement) orDecember 31, 2010. At July 31, 2010, our total indebtedness to AgStar wasapproximately $51.3 million. All of our assets and real property are subject tosecurity interests and mortgages in favor of AgStar as security for theobligations of the master loan agreement.

 

Whilewe were in compliance with covenants of our master loan agreement with AgStarat July 31, 2010, we anticipate that we will not comply with one or more of thecovenants at October 31, 2010 and July 31, 2011 without an amendment to thecovenants, improved financial performance or the addition of significantworking capital. We are attempting to improve various aspects of our businessand to raise significant additional capital in order to avoid any futurecovenant violations. There can be no assurance that our business and financialperformance will improve, that any improvements will be sustained or that anyimprovements will result in our compliance with covenants. Further, there is noassurance that we will be able to obtain any additional working capital onterms favorable to us, if at all. Even if we obtain additional capital, the amountswe raise may not be sufficient to avoid future covenant violations.

 

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Ourfailure to comply with covenants of the master loan agreement or our failure torepay the revolving line of credit loan when due would result event of defaultunder the master loan agreement, entitling AgStar to accelerate and declare dueall amounts outstanding under the master loan agreement.

 

***While we have relied upon on our masterloan agreement to fund our past operations and past losses, we must generate asufficient level of net income and obtain additional working capital to fundour ongoing operations.***

 

Wehad net losses from operations of approximately $173,000 in the quarter endedJuly 31, 2010 and approximately $11.3 million for the fiscal year ended October31, 2009. Our net losses have primarily been driven by our negative margins.For example, our cost of goods sold (including lower of cost or marketadjustments) as a percentage of revenues was 103.5% and 104.9% for the threemonths ended July 31, 2010 and July 31, 2009, respectively. Whether we achievea sufficient level of net income to fund our operations will depend on a numberof factors, including:

 

·                  our revenue inany given period, which depends both on the volume of our products produced andthe price we receive for these products;

·                  our expenselevels, particularly our operating expenses relating to corn; and

·                  the efficiencyof our plant, particularly managing costs and expenses associated with repairsand air emissions compliance and remediation plans and avoiding plant shutdowns and slow downs.

 

Wehave historically financed our operations primarily through borrowing under ourmaster loan agreement with AgStar, and, to a lesser extent, cash from operatingactivities. As of July 31, 2010, we had cash and cash equivalents (other thanrestricted cash) of approximately $216,000. As of July 31, 2010, ourindebtedness under the master loan agreement with AgStar was approximately$51.3 million.

 

Further, as of July 31,2010, our availability under the master loan agreement with AgStar was limited.We have no available borrowing under the term note and advances from the termrevolving note in the maximum principal amount of $5.0 million may only be usedfor an engineering and emissions remediation project and may not exceed $1.96million. As of July 31, 2010, there was $6.75 million of available borrowingunder our line of credit loan, subject to a defined borrowing base that mayalso significantly limit our borrowing. Additionally, if we are not incompliance with the covenants of our master loan agreement, we are notpermitted to draw on the unused portion of our loans.

 

Theamount currently available under our master loan agreement is insufficient tofund our ongoing operations. To fund our ongoing cash needs and to service ourindebtedness, we must increase the income and cash generated from ouroperations and we must also obtain additional working capital. We cannot assureyou that we will improve our liquidity to the extent required to enable us toservice or reduce our indebtedness or to fund our other capital needs, if atall.

 

***We need additional capital to continue andgrow our business, which may not be available.***

 

 Ourability to execute our long-term strategy depends on our ability to obtainadditional working capital. While we are attempting to generate capital throughincreasing income and cash flow from our operations, we have an immediate needfor additional debt or equity capital to fund our existing operations and togrow our business. We may also need to identify and secure capital to refinanceour existing indebtedness at the maturity of October 1, 2012 or earlier, ifrequired repayment of our debt is accelerated because of a covenant or paymentdefault.

 

Wemay seek additional capital by incurring additional indebtedness or from anoffering of our equity securities or both. No assurance can be given thatadditional working capital will be obtained in an amount that is sufficient forour needs, in a timely manner, or on terms and conditions acceptable to usor our members. Our financing needs are based upon managementestimates as to future revenue and expense. Our business plan and financingneeds are subject to change based upon, among other factors, market andindustry conditions, our ability to increase cash flow from operations andour ability to control costs and expenses. If our estimates of our financing needs change, any capital that we doobtain may not be sufficient for our needs and we may need more capital in thefuture.

 

Ourefforts to raise additional funds from the sale of equity may be hamperedby the significant volatility of ethanol businesses such as ours, depression ofthe ethanol industry, and bankruptcy or reorganization of other ethanolproduction companies. Our efforts to raise funds by incurring additionalindebtedness may be hampered by the fact that we have significantoutstanding indebtedness and the challenges we face in servicing our currentindebtedness with cash flow from operations, as well as the fact that ourassets are pledged to AgStar to secure existing debt. In addition, thecovenants of our master loan agreement restrict our ability to make distributions,create liens, incur indebtedness, and sell our assets and properties.

 

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Thefollowing factors may also affect our ability to obtain additional financing onfavorable terms, or at all:

 

·                  our results ofoperations, financial condition and business prospects;

·                  conditions inthe ethanol industry as well as other renewable energy industries; and

·                  generaleconomic conditions, including the availability of credit and lending standardsof banks and other financial institutions.

 

Ifwe are unable to obtain sufficient capital, we may further curtail our capitalexpenditures, further reduce our expenses, or suspend or discontinue ouroperations. Or sell our assets. Our ability to comply with the covenants of ourmaster loan agreement or make required payments on our debt to AgStar may alsobe impaired if we do not obtain sufficient additional capital, which may resultin covenant or payment defaults, acceleration of our indebtedness, seizure byAgStar of assets that secure our indebtedness, loss of control of our businessor bankruptcy.

 

***Certain provisions of our master loanagreement with AgStar present special risks to our business.***

 

Asof July 31, 2010, our debt with AgStar consists of approximately $38.3 millionin fixed rate obligations and $13.0 million in variable rate obligations aftergiving effect to our election under our master loan agreement with AgStar tofix an interest rate of 6.58% on $45.0 million of our debt effectiveMay 1, 2008 through April 30, 2011. The variable rate on a portion ofour debt may make us vulnerable to increases in prevailing interest rates. Ifthe interest rate on our variable rate debt were to increase, our aggregateannualized interest and principal payments would also increase and couldincrease significantly.

 

Theprincipal and interest payments on our $50.1 million term loan are calculatedusing an amortization period of ten years even though the note will mature onOctober 1, 2012, five years from the date of its issuance. As a result, atmaturity of the term loan, there would be approximately $38.9 million inprincipal remaining under the term loan, without any additional payments thatmay be required under the master loan agreement. In order to finance this largepayment of principal that would be due at maturity, we may attempt to extendthe term of the loan under the master loan agreement, refinance theindebtedness under the master loan agreement, in full or in part, or obtain anew loan to repay the term loan. We cannot assure you that will be successfulin obtaining an extension of or refinancing our indebtedness. We also cannotassure you that we will be able to obtain a new loan in an amount that issufficient for our needs, in a timely manner or on terms and conditionsacceptable to us or our members.

 

Wealso have a revolving term loan with AgStar that will mature on October 1,2012. As of July 31, 2010, we have used approximately $1.1 million of AgStar’scommitment under this loan. We also have a revolving line of credit loan withAgStar. While no amounts were outstanding at July 31, 2010 under the revolvingline of credit, it matures on December 30, 2010. As with the term loan, atmaturity we may attempt to extend, refinance, or obtain a new loan to repay anyoutstanding balance. We cannot assure you that any alternative will besufficient for our needs, available in a timely manner or on terms andconditions acceptable to us or our members.

 

Ifwe are unable to service our debt, AgStar may accelerate all of ourindebtedness and may seize the assets that secure our indebtedness, causing usto lose control of our business.  We mayalso be forced to sell our assets, restructure our indebtedness, submit toforeclosure proceedings, cease operations or seek bankruptcy or reorganizationprotection.

 

**RisksRelating to Our Operations**

 

***If the VEETC, or “blender’s credit,” is not extended beyond December31, 2010 or is extended but is reduced, our business and the ethanol industrywill be materially harmed.***

 

Tax incentives have played acritical role in the development of the ethanol industry in the United States.The volumetric ethanol excise tax credit (VEETC) was established in 2004 in theAmerican Jobs Creation Act as a $0.51 per gallon payment to gasoline refinersand marketers for blending ethanol into the gasoline supply.  For this reason, it is sometimes referred toas the “blenders’ credit.”  The 2008 FarmBill reduced the credit to $0.45 per gallon, which is the current amount of thecredit.  A tariff is imposed on importedethanol to offset the tax benefit of the VEETC. The VEETC is scheduled to expire on December 31, 2010.  If the VEETC is eliminated, we also expectthe import tariff would be eliminated.

 

The failure to extend theVEETC beyond December 31, 2010 will have a material adverse impact on ourbusiness and the ethanol industry.  Ifthe VEETC expires on December 31, 2010 and the import tariff is eliminated, refinersand marketers may replace domestic ethanol with cheaper imported ethanol inorder to meet the requirements of the renewable fuels standard and other stateand federal programs requiring or encouraging ethanol use.  Refiners and marketers may also replaceethanol with another oxygenate without an economic incentive to purchaseethanol and a price differential between ethanol and other oxygenatealternatives.  If the VEETC expires onDecember 31, 2010 and the import tariff is eliminated, we would expect thatdemand for U.S. produced ethanol and ethanol prices will decline.  Reduction in domestic ethanol prices willdeteriorate industry profitability and result in significantly reduced domesticethanol production.  The reduction indemand and in prices may be substantial and depending upon the severity in thereduction, may cause U.S. ethanol producers to reduce production or ceaseproduction entirely.

 

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It is uncertain what action,if any, Congress may take with respect to the VEETC prior to its scheduledexpiration or when such action may be effective.  If Congress determines to extend the VEETC,there can be no assurance that Congress will maintain other features of theVEETC, including the amount of the credit at $0.45 per gallon.  If the VEETC is reduced, the reduction mayalso lead to increased imports of ethanol, decreased prices to U.S. ethanolproducers, and reduction in ethanol production as U.S. ethanol plants as plantscurtail or cease production in response to demand and pricing pressures.

 

If the VEETC and thecorresponding tariff are not extended beyond December 31, 2010 or if theVEETC provides a reduced tax credit, we may be unable to produce and sellethanol profitably.

 

***Because we are primarily dependent upon oneproduct, our business is not diversified, and we may not be able to adapt tochanging market conditions or endure any decline in the ethanol industry.***

 

Oursuccess depends on our ability to efficiently produce and sell ethanol, and, toa lesser extent, distillers’ grains. We do not have any other lines of businessor other significant sources of revenue to rely upon if we are unable toproduce and sell ethanol and distillers’ grains, or if the market for thoseproducts decline. Our lack of diversification means that we may not be able toadapt to changing market conditions, changes in regulation, increasedcompetition or any significant decline in the ethanol industry.

 

***Our profitability depends upon purchasingcorn at lower prices and selling ethanol at higher prices and because thedifference between ethanol and corn prices can vary significantly, ourfinancial results may also fluctuate significantly.***

 

Thesubstantial majority of our revenues are derived from the sale of ethanol. Ourgross profit relating to the sale of ethanol is principally dependent on thedifference between the price we receive for the ethanol we produce and theprice we pay for the corn we used to produce our ethanol. Because we do havecontracts establishing the price we receive for the ethanol we produce or forthe corn we purchase, the price for both ethanol and corn will be determined insignificant part by prevailing market conditions affecting these commodities.

 

Theprice we receive for our ethanol is dependent upon a number of factors.Increasing domestic ethanol capacity may boost demand for corn, resulting in increasedcorn prices and corresponding decrease in the selling price of ethanol asproduction increases. Further, the price of corn is influenced by weatherconditions (including droughts or over abundant rainfall) and other factorsaffecting crop yields, farmers’ planting decisions and general economic, marketand regulatory factors, including government policies and subsidies withrespect to agriculture and international trade, and global and local supply anddemand. Declines in the corn harvest, caused by farmers’ planting decisions orotherwise, could cause corn prices to increase and negatively impact our grossmargins.

 

Wehave experienced negative margins in the past, reflecting a higher expenses forthe corn we purchase and lower revenues from ethanol we produce. For example,our cost of goods sold (including lower of cost or market adjustments) as apercentage of revenues was 103.5% and 104.9% for the three months ended July 31,2010 and July 31, 2009, respectively. Reduction in ethanol prices withoutcorresponding decreases in corn costs or increases in corn prices withoutcorresponding increases in ethanol prices has adversely affected our financialperformance in the past and may adversely affect our financial performance inthe future.

 

***If the supply of ethanol exceeds the demandfor ethanol, the price we receive for our ethanol and distillers’ grains maydecrease.***

 

Accordingto the RFA, domestic ethanol production capacity has increased steadily eachyear from 1999 to 2009 and is projected to further increase in 2010. However,demand for ethanol may not increase as quickly as expected or to a level thatexceeds supply, or at all.

 

Excessethanol production capacity may result from decreases in the demand for ethanolor increased domestic production or imported supply. There are many factorsaffecting demand for ethanol, including regulatory developments and reducedgasoline consumption as a result of increased prices for gasoline or crude oil.Higher gasoline prices could cause businesses and consumers to reduce drivingor acquire vehicles with more favorable gasoline mileage, or higher pricescould spur technological advances, such as the commercialization of enginesutilizing hydrogen fuel-cells, which could supplant gasoline-powered engines.There are a number of governmental initiatives designed to reduce gasolineconsumption, including tax credits for hybrid vehicles and consumer educationprograms.

 

Ifethanol prices decline for any reason, including excess production capacity inthe ethanol industry or decreased demand for ethanol, our business, results ofoperations and financial condition may be materially and adversely affected.

 

Inaddition, because ethanol production produces distillers’ grains as aco-product, increased ethanol production will also lead to increased productionof distillers’ grains. An increase in the supply of distillers’ grains, withoutcorresponding increases in demand, could lead to lower prices or an inabilityto sell our distillers’ grains production. A decline in the price of distillers’grains or the distillers’ grains market generally could have a material adverseeffect on our business, results of operations and financial condition.

 

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***The price of distillers’ grains is affectedby the price of other commodity products, such as soybeans, and decreases inthe price of these commodities could decrease the price of distillers’ grains.***

 

Distillers’grains compete with other protein-based animal feed products. The price ofdistillers’ grains may decrease when the price of competing feed productsdecrease. The prices of competing animal feed products are based in part on theprices of the commodities from which they are derived. Downward pressure oncommodity prices, such as soybeans, will generally cause the price of competinganimal feed products to decline, resulting in downward pressure on the price ofdistillers’ grains. The price of distillers’ grains is not tied to productioncosts. However, decreases in the price of distillers’ grains would result inless revenue from the sale of distillers’ grains and could result in lowerprofit margins.

 

***We face intense competition that******may result in reductions in the price we receive for our ethanol,increases in the prices we pay for our corn, or lower gross profits******.***

 

Competitionin the ethanol industry is intense. We face formidable competition in everyaspect of our business from both larger and smaller producers of ethanol anddistillers’ grains. Some larger producers of ethanol, such as Archer DanielsMidland Company, Cargill, Inc., Valero Energy Corporation, havesubstantially greater financial, operational, procurement, marketing,distribution and technical resources than we have. Additionally, smallercompetitors, such as farmer-owned cooperatives and independent companies ownedby farmers and investors, have business advantages, such as the ability to morefavorably procure corn by operating smaller plants that may not affect thelocal price of corn as much as a larger-scale plant like ours or requiringtheir farmer-owners to sell them corn as a requirement of ownership.

 

BecauseMinnesota is one of the top producers of ethanol in the U.S., we face increasedcompetition because of the location of our ethanol plant in Minnesota. Forexample, according to the Minnesota Department of Agriculture, for 2010, thecapacity for ethanol production in Minnesota exceeds by approximately five timesthe projected ethanol consumption in Minnesota. Therefore, we compete withother Minnesota ethanol producers both for markets in Minnesota and markets inother states.

 

Wealso face increasing competition from international ethanol suppliers. Most internationalethanol producers have cost structures that can be substantially lower thanours and therefore can sell their ethanol for substantially less than we can.While ethanol imported to the U.S. is subjected to an ad valorem tax and a pergallon surcharge that helps mitigate the effects of international competitionfor U.S. ethanol producers, the tax and per gallon surcharge are set to expireon December 31, 2010. If the tax and surcharge on imported ethanol is notextended beyond December 31, 2010, we will face increased competition fromimported ethanol and foreign producers of ethanol. In addition, ethanol importsfrom certain countries are exempted from these tariffs under the CaribbeanBasin Initiative to spur economic development in Central America and theCaribbean. Imports of ethanol from Central American and Caribbean countriesrepresents a significant portion of the gallons imported into the U.S. eachyear and a source of intense competition for us due to the lower productioncosts these ethanol producers enjoy.

 

Competingethanol producers may introduce competitive pricing pressures that mayadversely affect our sales levels and margins or our ability to procure corn atfavorable prices. As a result, we cannot assure you that we will be able tocompete successfully with existing or new competitors.

 

***We engage in hedging transactions whichinvolve risks that can harm our business.***

 

Inan attempt to offset some of the effects of pricing and margin volatility, wemay hedge anticipated corn purchases and ethanol and distillers’ grain salesthrough a variety of mechanisms. Because of our hedging strategies, we areexposed to a variety of market risks, including the effects of changes incommodities prices of ethanol and corn.

 

Hedgingarrangements also expose us to the risk of financial loss in situations wherethe other party to the hedging contract defaults on its contract or, in thecase of exchange-traded contracts, where there is a change in the expecteddifferential between the underlying price in the hedging agreement and theactual prices paid or received by us. Hedging activities can themselves resultin losses when a position is purchased in a declining market or a position issold in a rising market. Our losses or gains from hedging activities may varywidely. For example, for the nine months ended July 31, 2010, we hadlosses of approximately $68,000 on our corn and ethanol hedge contracts, butfor the nine months ended July 31, 2009, we had gains of approximately$1.6 million on our corn and ethanol hedge contracts.

 

Therecan be no assurance that our hedging strategies will be effective and we mayexperience hedging losses in the future. We also vary the amount of hedging orother price mitigation strategies we undertake, and we may choose not to engagein hedging transactions at all. As a result, whether or not we engage inhedging transactions, our business, results of operations and financialcondition may be materially adversely affected by increases in the price ofcorn or decreases in the price of ethanol.

 

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***Operational difficulties at our plant couldnegatively impact our sales volumes and could cause us to incur substantiallosses.***

 

Wehave experienced operational difficulties at our plant that have resulted inscheduled and unscheduled downtime or reductions in the number of gallons ofethanol we produce. Some of the difficulties we have experienced relate toproduction problems, repairs required to our plant equipment and equipmentmaintenance, the installation of new equipment and related testing, and ourefforts to improve and test our air emissions. Our revenues are driven in largepart by the number of gallons of ethanol we produce and the number of tons ofdistillers’ grains we produce. If our ethanol plant does not efficientlyproduce our products in high volumes, our business, results of operations, andfinancial condition may be materially adversely affected.

 

Ouroperations are also subject to operational hazards inherent in our industry andto manufacturing in general, such as equipment failures, fires, explosions,abnormal pressures, blowouts, pipeline ruptures, transportation accidents andnatural disasters. Some of these operational hazards may cause personal injuryor loss of life, severe damage to or destruction of property and equipment orenvironmental damage, and may result in suspension of operations and theimposition of civil or criminal penalties. The occurrence of any of theseoperational hazards may materially adversely affect our business, results ofoperations and financial condition. Further, our insurance may not be adequateto fully cover the potential operational hazards described above or we may notbe able to renew this insurance on commercially reasonable terms or at all.

 

***Our operations and financial performancecould be adversely affected by infrastructure disruptions and lack of adequatetransportation and storage infrastructure in certain areas.***

 

Weship our ethanol to our customers primarily by the railroad adjacent to oursite. We also have the potential to receive inbound corn via the railroad,although we currently receive corn by truck from our facilities in Lakefield,Minnesota and Wilder, Minnesota, each of which is less than 15 miles away fromour plant. Our customers require appropriate transportation and storagecapacity to take delivery of the products we produce. Therefore, our businessis dependent on the continuing availability of rail, highway and relatedinfrastructure. Any disruptions in this infrastructure network, whether causedby labor difficulties, earthquakes, storms, other natural disasters, humanerror or malfeasance or other reasons, could have a material adverse effect onour business. We rely upon third-parties to maintain the rail lines from ourplant to the national rail network, and any failure on their part to maintainthe lines could impede our delivery of products, impose additional costs on usand could have a material adverse effect on our business, results of operationsand financial condition.

 

Inaddition, lack of this infrastructure prevents the use of ethanol in certainareas where there might otherwise be demand and results in excess ethanolsupply in areas with more established ethanol infrastructure, depressingethanol prices in those areas. In order for the ethanol industry to grow andexpand into additional markets and for our ethanol to be sold in these newmarkets, there must be substantial development of infrastructure including:

 

·                  additional rail capacity;

 

·                  additional storage facilities for ethanol;

 

·                  increases in truck fleets capable oftransporting ethanol within localized markets;

 

·                  expansion of refining and blending facilitiesto handle ethanol; and

 

·                  growth in service stations equipped to handleethanol fuels.

 

Thesubstantial investments that will be required for these infrastructure changesand expansions may not be made on a timely basis, if at all, and decisionsregarding these infrastructure improvements are outside of our control.Significant delay or failure to improve the infrastructure that facilitates thedistribution could curtail more widespread ethanol demand or reduce prices forour products in certain areas, which would have a material adverse effect onour business, results of operations or financial condition.

 

***Competition for qualified personnel in theethanol industry is intense and we may not be able to hire and retain qualifiedpersonnel to operate our ethanol plant.***

 

Oursuccess depends in part on our ability to attract and retain competentpersonnel. For our ethanol plant, we must hire qualified managers, operationspersonnel, accounting staff and others, which can be challenging in a ruralcommunity. Competition for employees in the ethanol industry is intense, and wemay not be able to attract and retain qualified personnel. If we are unable tohire productive and competent personnel and retain our existing personnel, ourbusiness may be adversely affected and we may not be able to efficientlyoperate our ethanol business and comply with our other obligations.

 

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***Technology in our industry evolves rapidly,potentially causing our plant to become obsolete, and we must continue toenhance the technology of our plant or our business may suffer.***

 

Weexpect that technological advances in the processes and procedures forprocessing ethanol will continue to occur. It is possible that those advancescould make the processes and procedures that we utilize at our ethanol plantless efficient or obsolete. These advances could also allow our competitors toproduce ethanol at a lower cost than we are able. If we are unable to adopt orincorporate technological advances, our ethanol production methods andprocesses could be less efficient than those of our competitors, which couldcause our ethanol plant to become uncompetitive.

 

Ethanolproduction methods are constantly advancing. The current trend in ethanolproduction research is to develop an efficient method of producing ethanol fromcellulose-based biomass such as agricultural waste, forest residue andmunicipal solid waste. This trend is driven by the fact that cellulose-basedbiomass is generally cheaper than corn and producing ethanol fromcellulose-based biomass would create opportunities to produce ethanol in areasthat are unable to grow corn. Another trend in ethanol production research isto produce ethanol through a chemical or thermal process, rather than afermentation process, thereby significantly increasing the ethanol yield perpound of feedstock. Although current technology does not allow these productionmethods to be financially competitive, new technologies may develop that wouldallow these methods to become viable means of ethanol production in the future.If we are unable to adopt or incorporate these advances into our operations,our cost of producing ethanol could be significantly higher than those of ourcompetitors, which could make our ethanol plant obsolete. Modifying our plantto use the new inputs and technologies would likely require materialinvestment.

 

***If ethanol fails to compete successfullywith other existing or newly-developed oxygenates or renewable fuels, ourbusiness will suffer.***

 

Alternativefuels, additives and oxygenates are continually under development. Alternativefuels and fuel additives that can replace ethanol are currently underdevelopment, which may decrease the demand for ethanol. Technological advancesin engine and exhaust system design and performance could reduce the use ofoxygenates, which would lower the demand for ethanol, and our business, resultsof operations and financial condition may be materially adversely affected.

 

***Our sales will decline, and our businesswill be materially harmed if our third party marketers do not effectivelymarket or sell the ethanol and distillers grains we produce or if there is asignificant reduction or delay in orders from our marketers.***

 

Wehave entered into an agreement with a third party to market our supply ofethanol. We have also entered into an agreement with another third party tomarket our supply of distillers grains. Our marketers are independentbusinesses that we do not control. We cannot be certain that these marketerswill market or sell our ethanol and distillers’ grains effectively. Ouragreements with these marketers do not contain requirements that a certainpercentage of such parties’ sales are of our products, nor do the agreementsrestrict their ability to choose alternative sources for ethanol or distillersgrains.

 

Oursuccess in achieving revenue from the sale of ethanol and distillers grainswill depend upon the continued viability and financial stability of ourmarketers. These marketers may choose to devote their efforts to other ethanolproducers or reduce or fail to devote the necessary resources to provideeffective sales and marketing support of our products. We believe that ourfinancial success will continue to depend in large part upon the success of ourmarketers in operating their businesses. If these marketers do not effectivelymarket and sell our ethanol and distillers grains, our revenues may decreaseand our business will be harmed.

 

**Risks Related to Government Programs and Regulation**

 

***We have experienced and will likelycontinue to experience significant costs in obtaining and complying withpermits and environmental laws, particularly our air emissions permit.***

 

Thecosts associated with obtaining and complying with permits and complying withenvironmental laws have increased our costs of construction and production. Inparticular, we have incurred additional costs relating to an air-emissionpermit from the Minnesota Pollution Control Agency (“MPCA”). We have incurredsignificant legal and other professional costs relating to our application in July 2004for a synthetic minor air-emissions source permit that was granted by the MPCAin May 2005 and relating to a subsequent lawsuit challenging the MPCA’sissuance of the air permit.

 

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Followingthe lawsuit, we entered into a compliance agreement with the MPCA onJanuary 23, 2007 that currently governs the air emissions from our plant.Since entering into the compliance agreement, we have also incurred significantexpense. We have since submitted two amendments to our existing air-emissionspermit under the compliance agreement, one of which was required to qualify ourplant as a “major emissions source.” We have also conducted air pollutioncontrol device testing, adjusted our production and operations that resulted inplant downtime and decreased production, and expended significant managementtime and professional expense performing our other obligations under thecompliance agreement. Additionally, we are continuing discussions with the MPCAregarding the necessity for qualifying our facility as a major emissionssource, which will likely result in additional management time and professionalexpense. Further, on March 13, 2008, the MPCA issued a notice of violationto us for violations of certain rules, statutes, and permit conditions (asmodified by the compliance agreement), including emission violations andreporting violations. As part of our continuing discussions with MPCA, we areseeking to resolve these violations by agreement with MPCA. Such resolution mayresult in the payment of a civil penalty or other sanctions and remediesavailable to MPCA.

 

InSeptember 2009, we commenced an arbitration action againstFagen, Inc. relating to its design-build agreement with us and inparticular, the failure of our ethanol plant to comply with air emissionsguarantees and warranties. On July 2, 2010, we resolved our dispute withFagen, Inc. through settlement and in connection with the settlement, wereleased all of our asserted and unasserted claims under the design-buildagreement. As a result of the settlement, we must bear any future costs orexpenses associated with the resolution of our air permit issue.  Following the settlement, we begannegotiating an agreement for an engineering and emissions remediation projectrelating to our air emissions. Under our forbearance agreement with AgStar,advances from our term revolving note may only be used for this engineering andemissions remediation project and may not exceed $1.96 million.

 

Accordingly,we anticipate the additional future expense associated with our air permitissues, including the engineering and remediation project and our ongoingdiscussions with the MPCA. The resolution of our air emissions permit issuewill likely involve significant management time and expense and may involveongoing operational expense or further modifications to the design or equipmentin our plant. There can be no assurance that we will succeed in our discussionswith the MPCA to qualify our ethanol plant as a minor emissions source or toenter into an agreement relating to our March 2008 notice of violation.

 

Pendingthe resolution of our air permit issues, we continue to operate subject to thecompliance agreement. There can be no assurance that we will be able to complywith any of the conditions of the compliance agreement, any of our otherpermits, or with environmental laws applicable to us.  A violation of environmental laws,regulations or permit conditions can result in substantial fines, naturalresource damage, criminal sanctions, permit revocations or plant shutdown, anyof which could have a material adverse effect on our operations.

 

***Our failure to comply with existing or future regulatory requirementscould have a material adverse effect on our business, financial condition andresults of operations.***

 

Weare subject to various federal, state and local environmental laws andregulations, including those relating to the discharge of materials into theair, water and ground. Certain aspects of our operations require environmentalpermits and controls to prevent and reduce air and water pollution, and thesepermits are subject to modification, renewal and revocation by issuingauthorities including the Minnesota Pollution Control Agency. We could incursubstantial costs, including cleanup costs, fines and civil or criminalsanctions and third-party claims for property damage and personal injury as aresult of violations of or liabilities under environmental laws ornon-compliance with environmental permits. We could also incur substantialcosts and experience increased operating expenses as a result of operationalchanges to comply with environmental laws, regulations and permits. Asdiscussed above, we have incurred substantial costs relating to our airemissions permit and expect additional costs relating to this permit in thefuture.

 

Further,environmental laws and regulations are subject to substantial change. We cannotpredict what material impact, if any, these changes in laws or regulationsmight have on our business. Future changes in regulations or enforcementpolicies could impose more stringent requirements on us, compliance with whichcould require additional capital expenditures, increase our operating costs orotherwise adversely affect our business. These changes may also relaxrequirements that could prove beneficial to our competitors and thus adverselyaffect our business. In addition, regulations of the Environmental ProtectionAgency and the Minnesota Pollution Control Agency depend heavily on administrativeinterpretations. We cannot assure you that future interpretations made byregulatory authorities, with possible retroactive effect, will not adverselyaffect our business, financial condition and results of operations.

 

Failureto comply with existing or future regulatory requirements could have a materialadverse effect on our business, financial condition and results of operations.

 

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***Because federal and state regulationheavily influence the supply of and demand for ethanol, changes in governmentregulation that adversely affect demand or supply will have a material adverseeffect on our business.***

 

Variousfederal and state laws, regulations and programs impact the supply of anddemand for ethanol. Some government regulation, for example those that provideeconomic incentives to ethanol producers, stimulate supply of ethanol byencouraging production and the increased capacity of ethanol plants. Others,such as a federal excise tax incentive program that provides gasolinedistributors who blended ethanol with gasoline to receive a federal excise taxrate reduction for each blended gallon they sell, stimulate demand for ethanolby making it price competitive with other oxygenates. Further, tariffsgenerally apply to the import of ethanol from certain other countries, wherethe cost of production can be significantly less than in the U.S. These tariffsare designed to increase the cost of imported ethanol to a level morecomparable to the cost of domestic ethanol by offsetting the benefit of thefederal excise tax program. Tariffs have the effect of maintaining demand fordomestic ethanol.

 

Additionally,the Environmental Protection Agency has established a revised annual renewablefuel standard (RFS2) that sets minimum national volume standards for use ofrenewable fuels. The RFS2 also sets volume standards for specific categories ofrenewable fuels: cellulosic, biomass-based diesel and total advanced renewablefuels. While our ethanol does not qualify one of the new volume categories ofrenewable fuels, we believe that the overall renewable fuels requirement ofRFS2 creates an incentive for the use of ethanol. Other federal and stateprograms that require or provide incentives for the use of ethanol createdemand for ethanol. Government regulation and government programs that createdemand for ethanol may also indirectly create supply for ethanol as additional producersexpand or new companies enter the ethanol industry to capitalize ondemand.  In the case of the RFS2, whileit creates a demand for ethanol, the existence of specific categories ofrenewable fuels also creates a demand for these types of renewable fuels andwill likely provide an incentive for companies to further develop theseproducts to capitalize on that demand. In these circumstances, the RFS2 may also reduce demand for ethanol infavor of the renewable fuels for which specific categories exist.

 

Federaland state laws, regulations and programs are constantly changing. We cannotpredict what material impact, if any, these changes might have on our business.Future changes in regulations and programs could impose more stringentoperational requirements or could reduce or eliminate the benefits we receive,directly and indirectly, under current regulations and programs. Future changesin regulations and programs may increase or add benefits to ethanol producersother than us or eliminate or reduce tariffs or other barriers to entry intothe U.S. ethanol market, any of which could prove beneficial to ourcompetitors, both domestic and international. Future changes in regulation mayalso hurt our business by providing economic incentives to producers of otherrenewable fuels or oxygenates or encouraging use of fuels or oxygenates thatcompete with ethanol. In addition, both national and state regulation isinfluenced by public opinion and changes in public opinion. For example,certain states oppose the use of ethanol because, as net importers of ethanolfrom other states, the use of ethanol could increase gasoline prices in thatstate and because that state does not receive significant economic benefitsfrom the ethanol industry, which are primarily experienced by corn and ethanolproducing states. Further, some argue that the use of ethanol will have anegative impact on gasoline prices to consumers, result in rising food prices,add to air pollution, harm car and truck engines, and actually use more fossilenergy, such as oil and natural gas, than the amount of ethanol that isproduced. We cannot predict the impact that opinions of consumers, legislators,industry participants, or competitors may have on the regulations and programscurrently benefiting ethanol producers.

 

***The EPA imposed E10 “blend wall” if notovercome will have an adverse effect on demand for ethanol.***

 

Webelieve that the E10 “blend wall” is one of the most critical governmentalpolicies currently facing the ethanol industry. The “blend wall” issue arisesbecause of several conflicting requirements. First, the renewable fuelsstandards dictate a continuing increase in the amount of ethanol blended intothe national gasoline supply. Second, the Environmental Protection Agency (EPA)mandates a limit of 10% ethanol inclusion in non-flex fuel vehicles, and theE85 vehicle marketplace is struggling to grow due to lacking infrastructure.Total gasoline usage by the U.S. is currently around 138 billion gallons, andis expected to decrease to less than 130 billion gallons over the next 5 yearsas fuel mileage standards are changed. The RFS2 dictates an increasing amountof ethanol blending, from 12.95 billion gallons in 2010 to 36 billion gallonsby 2022. To reach the standard as dictated by the RFS2 in 2011, assuming 135billion gallons of total gasoline usage nationally, each gallon of gasolinesold would have to be blended with greater than 10% ethanol. The EPA policy of10% and the RFS increasing blend rate are at odds, which is sometimes referredto as the “blend wall.” While the issue is being considered by the EPA, therehave been no regulatory changes that would reconcile the conflictingrequirements.

 

***Approval of a Low Carbon Fuel Standard (“LCFS”)by the California Air Resources Board (“CARB”) may have a negative impact onour ability to market our ethanol in California.***

 

TheCARB recently proposed rules to implement a LCFS, which would setstandards for the carbon intensity of fuels used in the State of Californiastarting in 2011. While the proposed rules are still subject to rulemakingprocess in California, certain provisions of the proposed LCFS rules havethe potential to ban ethanol produced at our plant from being sold inCalifornia. While we believe there may be some negative impact to our salesfrom the approval of the LCFS in California, we believe we will still be ableto market all the ethanol produced by our plant to markets outside ofCalifornia. However, if additional states where our ethanol is marketed, or thefederal government, adopt similar provisions it could have a severe negativeimpact on our ability to sell all of the ethanol produced at our plant.

 

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**Risks Related to the Units**

 

***Project Viking owns a large percentage ofour units, which may allow it to control or heavily influence matters requiringmember approval, and Project Viking has been granted additional board rights underour member control agreement.***

 

Asof July 31, 2010, Project Viking, L.L.C. beneficially owned 29.8% of ouroutstanding units. Project Viking is owned by Roland J. (Ron) Fagen and DianeFagen, the principal shareholders of Fagen, Inc., the design-build firmfor our ethanol plant. Project Viking, together with our executive officers andgovernors, together control approximately 33.5% of our outstanding units as of July 31,2010. As a result, these unit holders, acting individually or together, couldsignificantly influence our management and affairs and all matters requiringmember approval, including the election of governors and approval ofsignificant corporate transactions. This concentration of ownership may alsohave the effect of delaying or preventing a change in control of our companyand might affect the price of our units.

 

Additionally,our member control agreement gives members who hold significant amounts ofequity in us the right to designate governors to serve on our board ofgovernors. For every 9% of our units held, the member has the right to appointone person to our board. Project Viking, L.L.C. has the right to appoint threepersons to our board pursuant to this provision and has appointed two personsas of July 31, 2010. Although the designated governors do not represent amajority of our board, their presence on the board may allow Project Viking,L.L.C. to have greater influence over the decisions of our board and ourbusiness than other members.

 

Further,the interests of Project Viking, L.L.C. may not coincide with our interests orthe interests of our other members. For example, Fagen, Inc. has investedand may continue to invest in a number of other ethanol producers, some of whommay compete with us. As a result of these and other potential conflictinginterests, these existing members may make decisions with respect to us withwhich we or our members may disagree.

 

***There is no public market for our units andno public market is expected to develop.***

 

Thereis no established public trading market for our units, and we do not expect oneto develop in the foreseeable future. To maintain our partnership tax status,we do not intend to list the units on any stock exchange or automatic quotationsystem such as OTC Bulletin Board. As a result, units held by our members maynot be easily resold and members may be required to hold their unitsindefinitely. Even if members are able to resell our units, the price may beless than the members’ investment in the units or may otherwise be unattractiveto the member.

 

***There are significant restrictions on thetransfer of our units.***

 

Toprotect our status as a partnership for tax purposes and to assure that nopublic trading market in our units develops, our units are subject tosignificant restrictions on transfer and transfers are subject to approval byour board of governors. All transfers of units must comply with the transferprovisions of our member control agreement and the unit transfer policy adoptedby our board of governors. Our board of governors will not approve transferswhich could cause us to lose our tax status or violate federal or statesecurities laws. On November 5, 2008, our board of governors adopted arevised unit transfer policy. While the revised policy permits transfers of ourunits under certain circumstances, including certain transfers of units forvalue, there continue to be significant restrictions on transfer of our units.Among other things, the revised unit transfer policy places limits on thenumber of units that may be transferred during any fiscal year and requires thetransferor and transferee to complete a unit transfer agreement and applicationform and submit these to us along with the required documents and anapplication fee.

 

EffectiveJuly 2, 2010, the board of governors determined to suspend approvals ofany transfers of units, provided that related-party transfers withoutconsideration will still be considered. This suspension was approved by theboard pursuant to its authority under our member control agreement. On July 9,2010, we notified our members of the suspension of approvals by a letter. Wealso removed all postings on the unit bulletin board. The board will considerlifting the suspension on sales of units when it has determined a course ofaction on the strategies under consideration and information regarding thecourse of action has been communicated to members as required by law, and whenotherwise reasonably believed to be in our best interests.

 

Asa result of the provisions of our member control agreement, members may not beable to transfer their units and may be required to assume the risks of theinvestment for an indefinite period of time.

 

Atransferee may be admitted as a member only upon approval by the board ofgovernors and upon satisfaction of certain other requirements, including thetransferee meeting the minimum unit ownership requirements to become a member(which for our present units requires holding a minimum of 2,500 units). Anytransferee that is not admitted as a member will be deemed an unadmittedassignee. An unadmitted assignee will be a non-member unit holder and will havethe same financial rights as other unit holders, such as the right to receivedistributions that we declare or that are available upon our dissolution orliquidation. As a non-member unit holder, an unadmitted assignee will not havethe voting or other governance rights of members and will not be entitled toany information or accountings regarding our business or to inspect our booksand records.

 

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***There is no assurance that we will be ableto make distributions to our unit holders, which means that holders couldreceive little or no return on their investment.***

 

Distributionsof our net cash flow may be made at the sole discretion of our board ofgovernors, subject to the provisions of the Minnesota Limited Liability CompanyAct, our member control agreement and restrictions imposed by AgStar under ourmaster loan agreement. Our master loan agreements with AgStar currentlymaterially limit our ability to make distributions to our members and arelikely to limit materially the future payment of distributions.  If ourfinancial performance and loan covenants permit, we expect to make future cashdistributions at times and in amounts that will permit our members to makeincome tax payments.  If our financial performance and loan covenantsfurther permit, we intend to make distributions in excess of thoseamounts.  However, our board may elect to retain cash for operatingpurposes, debt retirement, plant improvements or expansion. We may also neverbe in a position to pay distributions because of our financial performance orthe terms of our master loan agreement. Consequently, members may receive little or no return on theirinvestment in the units.

 

***We may authorize and issue units of newclasses which could be superior to or adversely affect holders of ouroutstanding units.***

 

Ourboard of governors, upon the approval of a majority in interest of our members,has the power to authorize and issue units of classes which have voting powers,designations, preferences, limitations and special rights, including preferreddistribution rights, conversion rights, redemption rights and liquidationrights, different from or superior to those of our present units. New units maybe issued at a price and on terms determined by our board of governors. Theterms of the units and the terms of issuance of the units could have an adverseimpact on your voting rights and could dilute your financial interest in us.

 

***Our use of a staggered board of governorsand allocation of governor appointment rights may reduce the ability of membersto affect the composition of the board.***

 

Weare managed by a board of governors, currently consisting of eight electedgovernors and two appointed governors. The seats on the board that are notsubject to a right of appointment will be elected by the members withoutappointment rights. An appointed governor serves indefinitely at the pleasureof the member appointing him or her (so long as such member and its affiliatescontinue to hold a sufficient number of units to maintain the applicableappointment right) until a successor is appointed, or until the earlier death,resignation or removal of the appointed governor.

 

Underour member control agreement, non-appointed governors are divided into threeclasses, with the term of one class expiring each year. As the term of eachclass expires, the successors to the governors in that class will be electedfor a term of three years.  As a result,members elect only approximately one-third of the non-appointed governors eachyear.

 

Theeffect of these provisions may make it more difficult for a third party toacquire, or may discourage a third party from acquiring, control of us and maydiscourage attempts to change our management, even if an acquisition or thesechanges would be beneficial to our members.

 

***Our units represent both financial andgovernance rights, and loss of status as a member would result in the loss ofthe holder’s voting and other rights and would allow us to redeem such holder’sunits.***

 

Holdersof units are entitled to certain financial rights, such as the right to anydistributions, and to governance rights, such as the right to vote as a member.If a unit holder does not continue to qualify as a member or such holder’smember status is terminated, the holder would lose certain rights, such asvoting rights, and we could redeem such holder’s units. The minimum number ofunits presently required for membership is 2,500 units. In addition, holders ofunits may be terminated as a member if the holder dies or ceases to exist,violates our member control agreement or takes actions contrary to ourinterests, and for other reasons. Although our member control agreement doesnot define what actions might be contrary to our interests, and our board ofgovernors has not adopted a policy on the subject, such actions might includeproviding confidential information about us to a competitor, taking a board ormanagement position with a competitor or taking action which results insignificant financial harm to us in the marketplace. If a holder of units isterminated as a member, our board of governors will have no obligation toredeem such holder’s units.

 

***Voting rights of members are notnecessarily equal and are subject to certain limitations.***

 

Membersof our company are holders of units who have been admitted as members upontheir investment in our units and who are admitted as members by our board ofgovernors. The minimum number of units required to retain membership is 2,500units. Any holder of units who is not a member will not have voting rights.Transferees of units must be approved by our board of governors to becomemembers. Members who are holders of our present units are entitled to one votefor each unit held. The provisions of our member control agreement relating tovoting rights applicable to any class of units will apply equally to all unitsof that class.

 

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However,our member control agreement gives members who hold significant amounts ofequity in us the right to designate governors to serve on our board ofgovernors. For every 9% of our units held, the member has the right to appointone person to our board. Project Viking, L.L.C. has the right to appoint threepersons to our board pursuant to this provision and has appointed two personsas of July 31, 2010. If units of any other class are issued in the future,holders of units of that other class will have the voting rights that areestablished for that class by our board of governors with the approval of ourmembers. Consequently, the voting rights of members may not be necessarilyproportional to the number of units held.

 

Further,cumulative voting for governors is not allowed, which makes it substantially lesslikely that a minority of members could elect a member to the board ofgovernors. Members do not have dissenter’s rights. This means that they willnot have the right to dissent and seek payment for their units in the event wemerge, consolidate, exchange or otherwise dispose of all or substantially allof our property. Holders of units who are not members have no voting rights.These provisions may limit the ability of members to change the governance andpolicies of our company.

 

***All members will be bound by actions takenby members holding a majority of our units, and because of the restrictions ontransfer and lack of dissenters’ rights, members could be forced to hold asubstantially changed investment.***

 

Wecannot engage in certain transactions, such as a merger, consolidation,dissolution or sale of all or substantially all of our assets, without theapproval of our members. However, if holders of a majority of our units approvea transaction, then all members will also be bound to that transactionregardless of whether that member agrees with or voted in favor of thetransaction. Under our member control agreement, members will not have anydissenters’ rights to seek appraisal or payment of the fair value of theirunits. Consequently, because there is no public market for the units, membersmay be forced to hold a substantially changed investment.

 

**Risks Related to Tax Issues in a Limited Liability Company**

 

**EACH UNIT HOLDER SHOULD CONSULT THE INVESTOR’S OWN TAXADVISOR WITH RESPECT TO THE FEDERAL AND STATE TAX CONSEQUENCES OF AN INVESTMENTIN HERON LAKE BIOENERGY, LLC AND ITS IMPACT ON THE INVESTOR’S TAX REPORTINGOBLIGATIONS AND LIABILITY.**

 

***If we are not taxed as a partnership, wewill pay taxes on all of our net income and you will be taxed on any earningswe distribute, and this will reduce the amount of cash available fordistributions to holders of our units.***

 

Weconsider Heron Lake BioEnergy, LLC to be a partnership for federal income taxpurposes. This means that we will not pay any federal income tax, and ourmembers will pay tax on their share of our net income. If we are unable tomaintain our partnership tax treatment or qualify for partnership taxation forwhatever reason, then we may be taxed as a corporation. We cannot assure youthat we will be able to maintain our partnership tax classification. Forexample, there might be changes in the law or our company that would cause usto be reclassified as a corporation. As a corporation, we would be taxed on ourtaxable income at rates of up to 35% for federal income tax purposes. Further,distributions would be treated as ordinary dividend income to our unit holdersto the extent of our earnings and profits. These distributions would not bedeductible by us, thus resulting in double taxation of our earnings andprofits. This would also reduce the amount of cash we may have available fordistributions.

 

***Your tax liability from your allocatedshare of our taxable income may exceed any cash distributions you receive,which means that you may have to satisfy this tax liability with your personalfunds.***

 

Asa partnership for federal income tax purposes, all of our profits and losses “pass-through”to our unit holders. You must pay tax on your allocated share of our taxableincome every year. You may incur tax liabilities from allocations of taxableincome for a particular year or in the aggregate that exceed any cashdistributions you receive in that year or in the aggregate. This may occurbecause of various factors, including but not limited to, accountingmethodology, the specific tax rates you face, and payment obligations and otherdebt covenants that restrict our ability to pay cash distributions. If thisoccurs, you may have to pay income tax on your allocated share of our taxableincome with your own personal funds.

 

***You may not be able to fully deduct yourshare of our losses or your interest expense.***

 

Itis likely that your interest in us will be treated as a “passive activity” forfederal income tax purposes. In the case of unit holders who are individuals orpersonal services corporations, this means that a unit holder’s share of anyloss incurred by us will be deductible only against the holder’s income orgains from other passive activities, e.g., S corporations and partnerships thatconduct a business in which the holder is not a material participant. Someclosely held C corporations have more favorable passive loss limitations.Passive activity losses that are disallowed in any taxable year are suspendedand may be carried forward and used as an offset against passive activityincome in future years. Upon disposition of a taxpayer’s entire interest in apassive activity to an unrelated person in a taxable transaction, suspendedlosses with respect to that activity may then be deducted.

 

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Interestpaid on any borrowings incurred to purchase units may not be deductible inwhole or in part because the interest must be aggregated with other items ofincome and loss that the unit holder has independently experienced from passiveactivities and subjected to limitations on passive activity losses.

 

Deductibilityof capital losses that we incur and pass through to you or that you incur upondisposition of units may be limited. Capital losses are deductible only to the extent of capital gains plus,in the case of noncorporate taxpayers, the excess may be used to offset up to$3,000 of ordinary income.  If a noncorporatetaxpayer cannot fully utilize a capital loss because of this limitation, theunused loss may be carried forward and used in future years subject to the samelimitations in the future years.

 

***You may be subject to federal alternativeminimum tax***

 

Individualtaxpayers are subject to an “alternative minimum tax” if that tax exceeds theindividual’s regular income tax. For alternative minimum tax purposes, anindividual’s adjusted gross income is increased by items of tax preference. Wemay generate such preference items. Accordingly, preference items from ouroperations together with other preference items you may have may cause orincrease an alternative minimum tax to a unit holder. You are encouraged andexpected to consult with your individual tax advisor to analyze and determinethe effect on your individual tax situation of the alternative minimum taxableincome you may be allocated, particularly in the early years of our operations.

 

***Preparation of your tax returns may becomplicated and expensive.***

 

Thetax treatment of limited liability companies and the rules regardingpartnership allocations are complex. We will file a partnership income taxreturn and will furnish each unit holder with a Schedule K-1 that sets forthour determination of that unit holder’s allocable share of income, gains,losses and deductions. In addition to United States federal income taxes, unitholders will likely be subject to other taxes, such as state and local taxes,that are imposed by various jurisdictions. It is the responsibility of eachunit holder to file all applicable federal, state and local tax returns and payall applicable taxes. You may wish to engage a tax professional to assist youin preparing your tax returns and this could be costly to you.

 

***Any audit of our tax returns resulting inadjustments could result in additional tax liability to you.***

 

TheIRS may audit our tax returns and may disagree with the positions that we takeon our returns or any Schedule K-1. If any of the information on our partnershiptax return or a Schedule K-1 is successfully challenged by the IRS, thecharacter and amount of items of income, gains, losses, deductions or creditsin a manner allocable to some or all our unit holders may change in a mannerthat adversely affects those unit holders. This could result in adjustments onunit holders’ tax returns and in additional tax liabilities, penalties andinterest to you. An audit of our tax returns could lead to separate audits ofyour personal tax returns, especially if adjustments are required.

 

***The small ethanol producer credit is due toexpire on December 31, 2010***

 

Sinceour production capacity is less than 60 million gallons per year, our unitholders are entitled to share in up to $1.5 million of small ethanol producercredits each year, subject to being limited by the passive loss and creditrestrictions.  This credit is due toexpire at the end of 2010.  While taxincentives such as this credit often have been routinely extended in the past,there is no assurance that the credit will be extended again, and at least oneof the extension proposals would reduce the credit by 20%.

 

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

 

None.

 

**Item 3.Defaults upon Senior Securities**

 

None.

 

**Item 4.[Removed and Reserved]**

 

**Item5.  Other Information**

 

None.

 

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**Item 6.Exhibits**

 

The following exhibits areincluded in this report:

 
| **Exhibit  No.** | ** ** | **Exhibit**                                                                                                          |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                 |
| 31.1             |       | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a) of the  Exchange Act.         |
|             |       |                                                                                                                 |
| 31.2             |       | Certification of Interim  Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d-14(a) of the  Exchange Act. |
|             |       |                                                                                                                 |
| 32               |       | Certification pursuant to  18 U.S.C. § 1350.                                                                    |

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                       | HERON LAKE BIOENERGY, LLC                                                       |
|----------------------------|---------------------------------------------------------------------------------|
|                       |                                                                            |
| Date: August 25, 2010 | /s/  Robert J.  Ferguson                                                   |
|                       | Robert J. Ferguson                                                              |
|                       | President and Chief  Executive Officer   (Principal Executive Officer)          |
|                       |                                                                            |
|                       |                                                                            |
| Date: August 25, 2010 | /s/  Brett L. Frevert                                                      |
|                       | Brett L. Frevert                                                                |
|                       | Interim Chief Financial  Officer   (Principal Accounting and Financial Officer) |

 

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