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


**Washington,
      D.C. 20549**





**FORM
      10-KSB**




xANNUAL
      REPORT UNDER SECTION 13 OR 15(d) OF
      THE SECURITIES EXCHANGE ACT OF 1934


For
      the
      Fiscal Year Ended December 31, 2006





o  TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
      the
      transition period from _________________ to ___________________





Commission
      file number 000-28947





**SPACEDEV,
      INC.**


(Name
      of
      small business issuer in its charter)




Colorado        84-1374613


(State
      or
      other jurisdiction      (I.R.S.
      Employer


of
      incorporation or organization)       Identification number)





13855
      Stowe Drive, Poway, California       92064


(Address
      of principal
      executive offices)     (Zip Code)





Issuer's
      telephone number, including area code:  (858)
      375-2030





Securities
      registered under Section 12(b) of the Exchange Act:





Title
                of each class
            Name
                of each exchange on which registeredNone.
            None.





Securities
      registered under Section 12(g) of the Exchange Act:





Common
      Stock, $.0001 par value


(Title
      of
      Class)





Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act.


Yes o   No x





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





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of registrant's knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes o   No x





State
      issuer's revenues for its most recent fiscal year: $32,555,570





The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates, computed by reference to the price at which the stock was sold,
      (the closing price of such stock, as reported by the NASD Over-the-Counter
      Bulletin Board) as of March 5, 2007 was $19,670,605.





As
      of
      March 5, 2007, Registrant had outstanding 29,560,342 shares of common stock,
      its
      only class of common equity outstanding.





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






Table
          of Contents


**TABLE
      OF CONTENTS**


TABLE
                  OF CONTENTS
              IIPART
                  I
              1Forward
                  Looking Statements
              1ITEM
                  1. DESCRIPTION OF BUSINESS
              1Available
                  Information
              1General
              1Business
                  Strategy
              7Products
                  and
                  Services; Market
              8Components
                  and
                  Raw Materials
              12Competition
              13Regulation
              14Employees
              16Intellectual
                  Property
              16Quality
                  Assurance and Testing
              16Research
                  andDevelopment
              17United
                  States Government Contracts
              17RISK
                  FACTORS
              18Risks
                  Related to our Company
              18ITEM
                  2. DESCRIPTION
                  OF PROPERTY
              32ITEM
                  3. LEGAL PROCEEDINGS
              33ITEM
                  4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
                  HOLDERS
              33PART
                  II
              34ITEM
                  5. MARKET FOR COMMON EQUITY, RELATED
                  STOCKHOLDER MATTERS, ANDSMALL BUSINESS ISSUER
                  PURCHASES OF EQUITY
                  SECURITIES
              34Market
                  Information
              34Holders
                  of Record
              34Dividends
              34ITEM
                  6. MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
              35Overview
              35Financing
              36Selection
                  of
                  Significant Contracts
              37Results
                  of Operations
              40Liquidity
                  and
                  Capital Resources
              46Critical
                  Accounting Standards
              48Recent
                  Accounting Pronouncements
              49ITEM
                  7. FINANCIAL
                  STATEMENTS
              50ITEM
                  8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ONAND
                  FINANCIAL DISCLOSURE
              50ITEM
                  8A. CONTROLS AND PROCEDURES
              50ITEM
                  8B. OTHER INFORMATION
              50PART
                  III
              51ITEM
                  9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROLAND
                  CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(a) OFEXCHANGE
                  ACT
              51Committees
                  Of
                  The Board Of Directors
              53Section
                  16 Beneficial Ownership Reporting Compliance
              55ITEM
                  10. EXECUTIVE
                  COMPENSATION
              55Executive
                  Officer Compensation
              55Director
                  Compensation
              57Employment
                  Agreements, Termination of Employment Arrangements and Change
                  of
                Control
                  Agreements
              58ITEM
                  11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERSMANAGEMENTAND
                  RELATED STOCKHOLDER MATTERS
              60Equity
                  Compensation Plan Information
              62ITEM
                  12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
                  ANDINDEPENDENCE
              63Director
                  Independence
              63ITEM
                  13.EXHIBITS
              64ITEM
                  14. PRINCIPAL ACCOUNTANT FEES AND
                  SERVICES
              68CONSOLIDATED
                  FINANCIAL STATEMENTS
              F-1




Table
          of Contents


**PART
      I**





**Forward
      Looking Statements** ****





The
      text
      of this Annual Report should be read in conjunction with our consolidated
      financial statements and the notes thereto and the other financial information
      appearing elsewhere in this document. Readers are also urged to carefully review
      and consider the various disclosures made by us which attempt to advise
      interested parties of the factors which affect our business, including without
      limitation the disclosures made under the caption "Management's Discussion
      and
      Analysis or Plan of Operation," in this Form 10-KSB and in our other SEC
      reports.





In
      addition to historical information, the following discussion and other parts
      of
      this document may contain forward-looking statements. These statements relate
      to
      future events or our future financial performance. In some cases, you can
      identify forward-looking statements by terminology such as "may," "will,"
      "should," "expect," "plan," "anticipate," "believe," "estimate," "predict,"
      "potential," or "continue," the negative of such terms or other comparable
      terminology. These statements are only predictions.





Actual
      results could differ materially from those anticipated by such forward-looking
      statements. Although we believe that the expectations reflected in the
      forward-looking statements are reasonable, we cannot guarantee future results,
      levels of activity, performance or achievements. Moreover, neither we nor any
      other person assumes responsibility for the accuracy and completeness of the
      forward-looking statements. We undertake no obligation to publicly update any
      of
      the forward-looking statements after the date of this report to conform such
      statements to actual results or to changes in our expectations.







***ITEM
      1.*** ***DESCRIPTIONOF
      BUSINESS***







**Available
      Information**





We
      maintain internet websites at www.spacedev.com and www.starsys.com ,
      which
      are being upgraded and integrated this year. In addition to news and other
      information about us, we make available on or through the *Investor
      Relations* section
      of our website our annual report on Form 10-KSB, our quarterly reports on Form
      10-QSB, our current reports on Form 8-K, and all amendments to these reports
      via
      a link to the Securities and Exchange Commission website at www.sec.gov as soon
      as reasonably practical after we electronically file this information with
      the
      Securities and Exchange Commission. Copies of information on us may be requested
      by contacting our Investor Relations Department either by e-mail at investor.relations@spacedev.com or by
      telephone at (858) 375-2026. All materials are available free of charge. The
      materials are also available at the SEC's Public Reference Room, located at
      100
      F Street, Washington, D.C. 20549. The public may obtain information through
      the
      public reference room by calling the SEC at (800) SEC-0330.





**General**





SpaceDev,
      Inc., including our wholly-owned active subsidiary, Starsys, Inc., which was
      acquired by us on January 31, 2006, (the "Company," "SpaceDev," "we," "us"
      or
      "our") is engaged in the conception, design, development, manufacture,
      integration, sale and operation of space technology systems, subsystems,
      products and services, as well as the design, manufacture, and sale of
      mechanical and electromechanical subsystems and components for spacecraft.
      We
      are currently focused on the commercial and military development of low-cost
      small satellites and related subsystems, hybrid rocket propulsion for space
      and
      launch vehicles, subsystems that enable critical spacecraft functions such
      as
      pointing solar arrays and communication antennas and restraining, deploying
      and
      actuating moving spacecraft components.





Table
          of Contents
 1


Our
      primary products, mission solutions and services include the
      following:





·
            Small
                Spacecraft.
                Sophisticated small, micro- and nano- satellites for remote sensing,
                military, scientific and commercial missions, and space-related technical
                support services.





·
            Propulsion
                Products and Services.
                We are in the process of developing hybrid rocket-based launch vehicles,
                orbital maneuvering and orbital transfer vehicles as well as safe
                sub-orbital and orbital hybrid rocket-based propulsion systems. We
                are
                also developing commercial hybrid rocket motors for possible use
                in small
                launch vehicles, targets and sounding rockets, and small high performance
                space vehicles and subsystems. Our non-explosive hybrid rocket motors
                use
                synthetic rubber as the fuel, and nitrous oxide for the oxidizer
                to make
                the rubber burn. Traditional rocket motors use two liquids, or a
                solid
                propellant that combines the fuel and oxidizer, but both types of
                rocket
                motors are explosive, and all solid motors produce copious quantities
                of
                toxic exhaust. Our hybrid rocket motors are non-toxic and do not
                detonate
                like solid or liquid rocket motors.





·
            Space
                Components and Mechanisms.
                We manufacture a wide range of products that include high output
                paraffin
                actuators, hinges, battery bypass switches, bi-axis gimbals, flat
                plate
                gimbals, solar array pointing mechanisms, restraint devices, thermal
                switches, thermal louvers, and cover systems. These products are
                sold both
                as "off-the-shelf" catalog products, which represent previously qualified
                devices with spaceflight history, and as custom systems that are
                developed
                for specific applications. Our products are typically sold directly
                to
                spacecraft manufacturers.





·
            Structures.We
                design and manufacture deployable space structures and other structural
                subsystems for spacecraft, which may or may not incorporate our cover
                systems or other components and
                mechanisms.





Our customer
      base is segregated into three major segments: (1) domestic and
      international commercial spacecraft companies; (2) civil spacecraft (i.e.,
      NASA) that are primarily scientific in nature; and, (3) defense spacecraft
      that support the United States' military capability. We also offer products
      to
      non-space customers, including aerospace, maritime, educational institutions,
      and industrial customers.




Our
      engineering and manufacturing capabilities position us to provide spacecraft
      buses, mechanical and electromechanical subsystems for spacecraft, deployable
      booms for spacecraft, and other spacecraft products and subsystems. Our strategy
      is to identify opportunities to develop products from our various technologies
      and product expertise areas. The product life cycle for our products within
      the
      space industry can range from less than three years to more than fifteen
      years.




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





Table
          of Contents
 2


The
      acquisition of Starsys on January 31, 2006 fundamentally changed our profile.
      SpaceDev's historic business had 2005 revenues of approximately $9.0 million
      and
      a 2005 profit of approximately $0.5 million.  Starsys is a mature operating
      company with 2005 revenues of approximately $18 million and 2005 losses of
      approximately $3.4 million.  In 2006, SpaceDev and Starsys merged and had
      combined revenues of approximately $32 million and losses of less than $1.0
      million. We believe there are numerous potential synergies between the historic
      SpaceDev business and the newly acquired Starsys business.  We have been
      integrating functions of SpaceDev and Starsys this year as we deemed
      appropriate.  We anticipate further functional integrations in 2007 and
      expect the merger integration to be essentially complete by the end of 2007
      or
      early 2008.





We
      have
      been awarded, have concluded, or are concluding contracts from such esteemed
      government, university, and commercial customers as the Air Force Research
      Laboratory, Boeing, the California Space Authority, the Defense Advanced
      Research Projects Agency, NASA's Jet Propulsion Laboratory, Lockheed Martin,
      Northrop Grumman, ITT Industries, Swales Aerospace, the Missile Defense Agency
      (formerly the "Ballistic Missile Defense Organization"), the National
      Reconnaissance Office, Scaled Composites, the University of California at
      Berkeley and many more. With the Starsys merger, our business became more
      heavily focused on mechanical and electro-mechanical systems, subsystems, and
      components that support assembly of spacecraft. We went from being a prime
      contractor on small contracts to being primarily a subcontractor to the prime
      contractors in the aerospace market. The end users of our products generally
      remain the government and commercial enterprises; however, we now find
      ourselves, for the most part, integrating our products into higher level
      assemblies and spacecraft. Several of our customers, in a given year, could
      constitute 10% or more of our consolidated revenues.





Our
      historic SpaceDev business has been conducted predominantly on cost plus fixed
      fee contracts. Starsys' business has been weighed more heavily toward
      fixed-price contracts. To succeed in such a business, we must properly price
      such contracts and then execute efficiently so as to avoid cost overruns.
      Starsys has had problems in this area. For example, under a fixed price
      development contract with Northrop Grumman, we were unable to profitably execute
      the required scope of work and therefore incurred significant losses on the
      program.  Our ability to properly bid fixed price development contracts,
      combined with improving our execution in this area, is a key priority for our
      merged company.





*SpaceDev
      Incorporation and Recent Acquisition*





In
      January 2006, we acquired Starsys Research Corporation and
      maintained our headquarters in
      California, and operating centers in California, Colorado and North Carolina.
      As
      a result of the merger, we grew from just over 50 employees to almost 200
      employees dedicated to the design and manufacture of affordable and innovative
      space products for commercial, military and civilian government use. By
      combining a broad range of high tech space product development and production
      capabilities of Starsys with SpaceDev's capabilities for designing and building
      high performance, low cost satellites, spacecraft and propulsion systems, we
      believe that we can create a dynamic mid-sized aerospace company focused on
      filling the expanding need for affordable and rapid access to
      space.





*Recent
      SpaceDev Contracts and Technology Development*




In
        June
        2002, Starsys was awarded a contract from Northrop Grumman Space Technology
        for
        the design, development, assembly, and test of two configurations of flat
        plate
        gimbal drive assemblies.  These gimbals are used to position six dish
        antennas and two nulling antenna systems for each of two spacecraft. 
Subsequent to this award, Northrop Grumman Space Technology modified this
        contract to include a third shipset bringing the total contract value to
        approximately $7.1 million.  In addition to eight flight unit deliveries
        per spacecraft, the program includes development and qualification
        hardware.  This contract was awarded as a firm fixed price contract with
        the final delivery scheduled for March 2007.  We acquired Starsys on
        January 31, 2006. Revenues generated form this contract from February 1,
        2006
        through December 31, 2006 totaled approximately $2.9 million. We experienced
        significant cost overruns on this contract.  Prior to our merger with
        Starsys, the contract was modified to add an additional $1.7 million. 
After our merger with Starsys, we negotiated contract modifications in both
        the
        timing of payments and in the amount of additional contract consideration
        of up
        to $1.0 million based on the achievement of specific milestones. Of the
        additional possible $1.0 million, we achieved milestones entitling us to
        the
        majority, and possibly all, of the incentive payments, which will partially
        mitigate the impact of significant cost, scope and requirements changes and
        overruns.
  Table
            of Contents
 3
 SpaceShipOne
        into space flight history as the craft garnered the $10 Million Ansari X
        Prize, a
        contest created to stimulate the development of the private sector human
        space
        flight industry. We provided several critical components and the hybrid rocket
        technology for the craft's motor, including igniter, injector and main operating
        valve, which successfully performed as expected and powered SpaceShipOne
        on its
        historic manned flight. SpaceShipOne exceeded the altitude requirement on
        both
        scheduled flights as required by the Ansari X Prize competition. The hybrid
        propulsion system burned full duration and pilot Brian Binnie steered
        SpaceShipOne high above the Mojave, California desert to a height of 367,442
        feet altitude (69.5 miles), which far exceeded the required 328,000 feet
        altitude - a sky-high goal required by the X Prize Foundation of St. Louis,
        Missouri.




The
      Ansari X Prize was a contest designed to jumpstart the space tourism industry
      through competition among the most talented entrepreneurs and rocket experts
      in
      the world. SpaceShipOne
      was built and launched with private funds from Paul Allen. The craft was able
      to
      carry equivalent weight of three people to 100 kilometers (62.5 miles) and
      return safely to earth. The competition followed in the footsteps of more than
      100 aviation incentive prizes offered between 1905 and 1935 credited with
      spawning today's multibillion-dollar air transport industry. Although we were
      not the recipient of the Ansari X Prize, by helping SpaceShipOne succeed, we
      were instrumental in moving
      the private space community closer to realizing its vision of creating safe,
      affordable, commercial human space flight.





On
      July
      9, 2003, we were awarded a contract by the Missile Defense Agency to explore
      the
      use of microsatellites in national missile defense. It was a precursor contract
      to the $43 million contract mentioned below. Our microsatellites are operated
      over the Internet and are capable of pointing and tracking targets in space
      or
      on the ground. This study explored fast response microsatellite launch and
      commissioning; small, low-power passive sensors; target acquisition and
      tracking; formation flying and local area networking within a cluster of
      microsatellites; and an extension of our proven use of the Internet for on-orbit
      command, control and data handling. The contract was successfully concluded
      on
      February 27, 2004. The total contract value was $800,000. This contract was
      considered an investigatory phase by MDA.





Also,
      on
      July 9, 2003, we were awarded a Phase I Small Business Innovation Research
      contract by Air Force Research Lab to design and effectively begin the
      development of our small launch vehicle with a classical hybrid upper stage
      rocket. The SpaceDev Small Launch Vehicle is planned to responsively and
      affordably lift up to 1,000 pounds to Low Earth Orbit. The SpaceDev Small Launch
      Vehicle concept is based on a proprietary combination of technologies to
      increase the performance of hybrid rocket motor technology. Hybrid rocket motors
      are a combination of solid fuel and liquid oxidizer, and can be relatively
      safe,
      clean, non-explosive, and storable, and can be throttled, shut down and
      restarted. The original contract was valued at approximately $100,000, and
      was a
      fixed price, milestone-based agreement, which was completed in about one year.
      The Phase II of this SBIR contract was awarded on September 29, 2004 and was
      worth approximately $1.6 million. The contract originally outlined the
      development and test firing of our large Common Core Booster for the SpaceDev
      Small Launch Vehicle but was subsequently changed to expand our hybrid upper
      stage technology and explore aft stage injection technology. Congress awarded
      us
      approximately $3.0 million in additional funding for this project, which became
      available in late 2005, and which we anticipate to expend in 2007. We believe
      that there is additional interest by Congress to provide further funding to
      expand and accelerate the scope of the work; however, there can be no assurance
      that such work will be awarded to us.





Table
          of Contents
 4


On
      December 18, 2003, we were awarded a contract by the Defense Advanced Research
      Projects Agency for the study of Novel Satcom Microsat Constellation Deployment.
      The contract was a milestone-based, fixed price contract with total
      consideration of approximately $200,000. On August 6, 2004, an additional
      $39,849 was added to the contract for increased scope, bringing the total
      contract value on this fixed price effort to approximately $240,000. The
      contract was completed in December 2004.





In
      March
      2004, we were awarded a five-year, cost-plus-fixed fee indefinite
      delivery/indefinite quantity contract for up to $43,362,271 to conduct a
      microsatellite distributed sensing experiment (intended to design and build
      up
      to six responsive, affordable, high performance microsatellites to support
      national missile defense), an option for a laser communications experiment,
      and
      other microsatellite studies and experiments as required in support of the
      Advanced Systems Deputate of the Missile Defense Agency.  The overall
      contract initially called for us to analyze, design, develop, fabricate,
      integrate, test, operate and support a networked cluster of three
      formation-flying boost phase and midcourse tracking microsatellites, with an
      option to design, develop, fabricate, integrate, test, operate and support
      a
      second cluster of three formation-flying microsatellites to be networked
      on-orbit with high speed laser communications technology.  This overall
      contract is proceeding under a phased approach.  The first phase, executed
      under Task Order I for approximately $1.1 million, was awarded in April 2004,
      completed in September 2004, and resulted in a general mission and
      microsatellite design. The second phase, executed under Task Order II for
      approximately $8.3 million, was awarded in October 2004 and was originally
      expected to be completed by January 2006 but was extended at the request of
      the
      Missile Defense Agency with an increased funding of $1.5 million, and
      subsequently completed in March 2006.  Task Order II resulted in a detailed
      mission and microsatellite design, which underwent a successful Critical Design
      Review in March 2006.  Task Order III, the first of several task orders
      expected during the third phase was awarded to us in April 2006 for a total
      of
      approximately $1.5 million, which was later amended to approximately $2.5
      million and ran through June 2006. Task Order IV was awarded by the Missile
      Defense Agency in July 2006, with initial funding of approximately $4.0 million
      through November 2006.  Task Order IV was subsequently amended to
      approximately $4.5 million and extended through June 15, 2007.  We are
      currently negotiating with the Missile Defense Agency for additional funding
      under Task Order IV.  We expect continued modifications to the current
      phase with additional task orders for additional funding throughout GFY
      2007.  Government contract funds will expire at the end of the current
      government fiscal year.  It is uncertain whether additional funding by the
      Missile Defense Agency will be available.  It is possible that another
      government agency may fund the program; however, there can be no assurance
      that
      funding will be available.





In
      January 2005, Starsys was awarded a firm fixed price contract from Raytheon
      in
      Goleta, California for the design, development, manufacture, assembly and test
      of the Aerosol Polarimetry Sensor (APS), Scan Mirror Motor/Encoder Assembly
      (SMMA). The APS instrument is slated to fly on the NASA Glory mission. The
      APS
      is also a prime candidate for a secondary payload on NPOESS. The SMMA consists
      of Starsys designed low ripple, precision brushless DC motor and optical encoder
      assembly. The program consists of a development unit, engineering unit,
      qualification/life test unit, and flight units. This contract was awarded as
      a
      cost plus fixed fee contract at a value of $2.5 million. In July 2006, the
      contract was modified to add approximately $2.5 million with incremental funding
      and extend to March 2009. Since our acquisition of Starsys, revenues from
      February 1, 2006 through December 31, 2006 totaled approximately $2.0
      million.





Table
          of Contents
 5


On
      July
      18, 2005, we were awarded a subcontract to provide scientific, engineering,
      development and programmatic support to the development and demonstration of
      an
      innovative space situational awareness (SSA) nanosatellite (<15kg)
      spacecraft. SSA is the ability to search, identify and monitor spacecrafts
      for
      the purpose of obtaining space superiority. The subcontract covered the
      conceptual/preliminary phase of development and included all aspects of
      potential systems from the platforms and associated payloads to the links,
      nodes
      and ground support. The cost plus fixed fee subcontract resulted in revenues
      of
      approximately $120,000. We completed this subcontract in December 2005. We
      submitted a proposal and were awarded the next-phase subcontract in the amount
      of $1.2 million. We began work on this phase in March 2006; however, we were
      informed by the government that due to funding constraints and other matters,
      our participation in the program would end by mid-year 2006. We brought the
      program through preliminary design review and ceased work in August 2006.





In
      October 2005, Starsys was awarded a contract from General Dynamics C4 Systems
      to
      design and deliver an antenna pointing gimbal and control electronics for the
      GeoEye-1 program. The contract, valued at $2.0 million, was awarded and work
      has
      already begun on the antenna in anticipation of an on-time delivery to General
      Dynamics. The GeoEye-1 program is a next-generation, high-resolution commercial
      remote-sensing satellite scheduled for launch in 2007. The Starsys antenna
      control system is uniquely designed to operate by greatly reducing motion,
      to
      the GeoEye-1 spacecraft while pictures are being taken and data is
      simultaneously transmitted to earth ground stations, through incorporation
      of a
      low disturbance designed micro-stepping actuator and actuator drive electronics
      (Quiet Array Drive). Since our acquisition of Starsys, revenues from February
      1,
      2006 through December 31, 2006 totaled approximately $1.26 million.





In
      February 2006, we were awarded two deployable boom technology contracts for
      advance research and development of a self-deployed articulated boom for
      approximately $950,000 and a jack screw deployed boom for approximately $1.5
      million by the Air Force Research Laboratory (AFRL). We recognized
      approximately $833,000 in revenue under this contract from inception through
      December 31, 2006.





In
      June
      2006, we were awarded a firm fixed price contract from Lockheed Martin
      Commercial Space Systems for the design, and fabrication of the antenna pointing
      gimbals onboard the US Navy’s Mobile User Objective System.  The initial
      award is for two flight shipsets and includes two standard A2100 5-meter antenna
      gimbal assemblies, four Ka-Band antenna gimbal assemblies and two 14-meter
      gimbal assemblies.  Options are included for additional gimbals supporting
      three additional spacecraft.  The contract will include the development and
      qualification of the Ka-Band and 14-meter gimbal designs in addition to delivery
      of standard gimbals and solar array deployment hinges Starsys has previously
      provided for the A-2100 bus.  The contract value for the initial award was
      $1.8 million; however, if all options are exercised, the total contract value
      would exceed $6.0 million. We recognized approximately $625,000 in revenue
      under
      this contract from inception through December 31, 2006.





In
      August
      2006, we were awarded a government firm fixed price contract to provide the
      solar array drive, antenna pointing actuators, and gimbal control electronic
      assemblies for the Lunar Reconnaissance Orbiter (LRO) program from NASA Goddard
      Space Flight Center and Swales Aerospace. The total contract value is in excess
      of $6.3 million. The LRO mission is scheduled to launch in the fall of 2008
      as
      part of NASA's Lunar Precursor and Robotic Program. The spacecraft requires
      two
      drive actuators to align the solar panels with the sun, and a two axis pointing
      mechanism to align the downlink antenna for communication with earth. We are
      to
      provide these actuators for the spacecraft along with the electronics to control
      them. A total of seven actuators and five control electronics assemblies will
      be
      delivered under the contract. We recognized approximately $1.8 million in
      revenue under this contract from inception through December 31,
      2006.





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In
      October 2006, we were awarded
      a $330,000 Phase I study contract from Benson Space Company to further the
      SpaceDev Dream Chaser TM spaceship program. The study will contribute to the on-going development of
      the
      spaceship and will result in space vehicle and rocket motor designs ready for
      Phase II vehicle fabrication and testing. The SpaceDev Dream ChaserTM spaceship
      is based on NASA’s design of the ten passenger orbital HL-20 Personnel Launch
      System, and will launch vertically and land horizontally. We recognized
      approximately $76,000 in revenue under this contract from inception through
      December 31, 2006.





In
      January 2007, in
      partnership with the University of Colorado Laboratory for Space Physics, we
      were awarded a $750,000 contract from the Missile Defense Agency to design
      and
      develop a non-sticking cover seal system for the Exo-atmospheric Kill Vehicle
      program, which is the kill vehicle component of the Ground Based Interceptor
      (the weapon element of the Ground-based Midcourse Defense System program).
      The
      contract was awarded under the Small Business Technology Transfer Program that
      provides research funding for partnerships between industry and non-profit
      research institutions. The program is scheduled to complete in 2008 and is
      an
      extension of a Phase 1 program completed in 2006.





In
      February 2007, we were awarded a $1.4 million cost reimbursable design and
      development subcontract with NASA’s Jet Propulsion Laboratory in support of the
      Mars Science Laboratory mission. We will develop and deliver electromechanical
      Descent Brake dampers. The contract period of performance is approximately
      18
      months. NASA’s Mars Science Laboratory mission will deliver an 1800 pound rover
      to the surface of Mars in 2010. Rather than the airbag landing system used
      by
      the Mars Exploration Rover mission, a “Skycrane” landing system will use a
      rocket-decelerated Descent Stage that will hover and gently lower the rover
      on a
      25 feet long bridle cord. A critical component of the “Skycrane” landing system
      is the Descent Brake that will lower the rover in less than seven seconds with
      a
      controlled speed profile that will provide a gentle touch-down on the Martian
      surface.





**Business
      Strategy**





Our
      strategy is based on the belief that innovative advancements in technology
      and
      the application of standard business processes and practices will make access
      to
      space much more practical and affordable. We believe these factors will cause
      growth in certain areas of space commerce and will create new space markets
      and
      increased demand for our proprietary products.





Our
      business strategy and approach for our historical SpaceDev operations is
      to:





·
            Introduce
                commercial business practices into the space arena, use off-the-shelf
                technology in innovative ways and standardize hardware and software
                to
                reduce costs and to increase reliability and
                profits;





·
            Start
                with small, practical and profitable projects, and leverage credibility
                and profits into larger and ever more bold initiatives - utilizing
                partnerships where appropriate;





·
            Bid,
                win, and leverage government programs to fund our Research and Development
                and product development efforts;





·
            Integrate
                our smaller, low cost commercial spacecraft and hybrid space
                transportation systems to provide one-stop turnkey payload and/or
                data
                delivery services to target customers;





·
            Apply
                our low cost space products to new applications and to create new
                users,
                new markets and new revenue
                streams;





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·
            Join
                or establish a team to build a safe, affordable sub-orbital, passenger
                space plane to help initiate the space tourism business;
                and,





·
            Establish
                a team to build a safe, affordable orbital passenger vehicle as a
                potential shuttle replacement.





The
      acquisition of Starsys on January 31, 2006 fundamentally affected our business
      strategy and approach by adding new product offering and revenue generating
      opportunities to our portfolio. The addition of motors, actuators,
      electromechanical subsystems, components, mechanisms and structures has
      broadened our offering and expanded our business strategy. We still believe
      that
      our business model, emphasizing smaller satellites, commercial approaches,
      technological simplicity, architectural and interface standardization and
      horizontal integration (i.e., "whole product"), is sound and provides the
      following advantages:





·
            Enables
                small-space customers to contract for end-to-end mission solutions,
                reducing the need for, and complexity of finding, other contractors
                for
                different project tasks;





·
            Decreases
                schedule time and lowers total project costs, thereby providing greater
                value and increases return on investment for us and our customers;
                and,





·
            Tends
                to create barriers to entry by, and competition from,
                competitors.





That
      being said, a majority of our present-day business, especially at Starsys,
      involves us serving as a subcontractor to a prime contractor who integrates
      our
      contributions into a larger product.





Our
      business development process is generally competitively bid in response to
      a
      request for proposal (RFP) that is generated by our potential customers. 
These proposals have various bases, including firm fixed price, cost plus fixed
      fee (CPFF), and time and materials.  Our revenues in 2006 were derived
      primarily from fixed price contracts and commercial sales of component and
      subsystem products that we acquired in our 2006 acquisition of Starsys along
      with some United States government cost plus fixed fee contracts, which are
      compared to primarily CPFF contracts for the same period in 2005.  We
      typically prepare between ten and twenty proposals in a given month and we
      usually have one to three weeks to respond to an RFP.  These proposals are
      managed by product area.  We also execute on long term build to requirement
      contracts with some of the prime contractors.




We
      see a
      potential for increasing synergies between our historical SpaceDev business
      and
      our new Starsys business. Utilization of Starsys structures such as solar arrays
      and deployable booms as well as antenna on small spacecraft could make a
      powerful combination. Propulsion solutions on small spacecraft from low cost
      and
      powerful hybrid rocket motors could also become an interesting differentiator
      for our products and technology mission solutions.





**Products
      and Services; Market**





With
      the
      merger with Starsys, we now have four primary lines of space products and
      services on which we believe a sound foundation and profitable, cash generating
      business can be built:





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·
            Small
                Spacecraft-
                Small Satellites, Microsatellites & Nanosatellites, Spacecraft Buses,
                and Maneuvering and Orbital Transfer Vehicles.





Ø
            Microsatellites
                and Nanosatellites - The primary benefit of small, micro, and nano
                satellites is lower cost and weight. Since we can dramatically reduce
                manufacturing costs and the costs to launch the satellites to earth-orbit
                and deep space, we can pass those cost savings on to our customers.
                Small,
                inexpensive satellites were once the exclusive domain of scientific
                and
                amateur groups; however, smaller satellites are now a viable alternative
                to larger, more expensive ones, as they provide cost-effective solutions
                to traditional problems. We design and build low cost, high-performance
                space-mission solutions involving microsatellites (generally less
                than 100
                kg) and even smaller satellites (less than 50 kg). Our approach is
                to seek
                to participate in a growth market by providing smaller spacecraft
                and
                compatible low cost, safe hybrid propulsion space systems to commercial,
                government, and potentially international customers.





Ø
            Spacecraft
                buses -We
                have a qualified microsatellite bus available to sell as a standard,
                fixed-price product to government and commercial customers needing
                an
                affordable satellite for small payloads. We began developing this
                product
                in 1999 when we were selected as the mission designer, spacecraft
                bus
                provider, integrator and mission operator of the University of California
                at Berkeley Space Sciences Laboratory's Cosmic Hot Interstellar Plasma
                Spectrometer ("CHIPS") mission. CHIPSat was launched on January 12,
                2003. The satellite achieved 3-axis stabilization with all individual
                components and systems successfully operating and continues to work
                well
                in orbit.





Ø
            Maneuvering
                and Orbital Transfer Vehicle - Our Maneuvering and Orbital Transfer
                Vehicle system is a family of small, throttleable, and restartable
                propulsion and integrated satellite products. The Maneuvering and
                Orbital
                Transfer Vehicle provides the change in velocity and maneuvering
                capabilities to support a wide variety of applications for on-orbit
                maneuvering, proximity operations, rendezvous, inspection, docking,
                surveillance, protection, inclination changes, and orbital transfers.
                In
                addition, our Maneuvering and Orbital Transfer Vehicle can be used
                as a
                standard propulsion module to transport a customer's payload to different
                orbits.





Ø
            Spacecraft
                and Subsystem Design - We also provide access to space through innovative
                solutions currently lacking in the marketplace. Our approach is to
                provide
                smaller spacecraft - generally 250 kg mass and less - and compatible
                hybrid propulsion space systems to commercial, university and government
                customers. The small spacecraft market is supported by the evolution
                and
                enabling of microelectronics, common hardware and software interface
                standards, and smaller launch vehicles. Reduction of the size and
                mass of
                traditional spacecraft electronics has reduced the overall spacecraft
                size, mass, and volume over the past 10 to 15 years. For example,
                our
                miniature flight computer is only 24 cubic inches and provides 300
                million
                instructions per second of processing power versus a competitor's
                more
                "traditional" solution that requires about 63 cubic inches and only
                provides 10 MIPS.





Ø
            Mission
                Control and Operations - Ourmission control and operations center, located in our headquarters
                building near San Diego, coupled with our mission control and operations
                package, is Internet-based and allows for the operation and control
                of
                missions from anywhere in the world that has access to the Internet.
                CHIPSat was the first U.S. mission to use end-to-end satellite operations
                with TCP/IP and FTP. This concept can provide significant advantages.
                For
                example, a formation-flying cluster or constellation of TCP/IP-based
                microsatellites, similar to the cluster of microsats we are developing
                for
                the Missile Defense Agency, can be designed to communicate directly
                with
                each other, as in a wide area network in space. Provided any one
                satellite/node in this network is in line-of-sight with any ground
                station
                at any given time, the entire constellation could always maintain
                ground
                station connectivity, thus creating a network on-orbit and on the
                web, a
                direct extension of CHIPSat's elegantly simple TCP/IP mission operations
                architecture.





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Ø
            Mission
                Analysis and Design - We can provide end-to-end mission design and
                analysis, including the design of the mission and its science, commerce
                or
                technology demonstration goals, the design of an appropriate space
                vehicle
                (satellite or spacecraft), prototype development, construction and
                testing
                of the spacecraft, integration of one or more payloads (instruments,
                experiments or technologies) into the spacecraft, integration of
                the
                spacecraft onto the launch vehicle (rocket), the launch and the mission
                control, and operations during the life of the mission.





·
            Propulsion
                Products and Services-
                Hybrid Propulsion and Launch Vehicle
                Systems.





Ø
            Microsatellite
                & Nanosatellite Launches -Teaming
                with launch providers, we propose to identify and market affordable
                launch
                opportunities for the small satellite market and provide customers
                with a
                complete on-orbit data delivery service that can also involve our
                spacecraft and hybrid propulsion products. These innovative, low-cost,
                turnkey launch solutions will allow us to provide one-stop shopping
                for
                launch services, spacecraft, payload accommodation, total flight
                system
                integration and test, and mission operations. The customer only needs
                to
                provide the payload, and we have the capacity to perform all the
                tasks
                required for the customer to get to orbit and to begin collecting
                their
                data.





Ø
            Hybrid
                Rocket Propulsion and Launch Vehicle Systems - We provide a wide
                variety
                of hybrid propulsion systems to safely and inexpensively enable satellites
                and on-orbit delivery systems to rendezvous and maneuver on-orbit
                and
                deliver payloads to sub-orbital altitudes.Hybrid
                rocket propulsion is a safe and low-cost technology that has tremendous
                benefits for current and future space missions. Our hybrid rocket
                propulsion technology features a simple design, is restartable, is
                throttleable and is easy to transport, handle, and store.





Ø
            Hybrid
                Orbital Vehicle (under development) - We have begun designing a reuseable,
                piloted, sub-orbital space ship that could be scaled to transport
                passengers to and from Low Earth Orbit, including the International
                Space
                Station. The name of the vehicle is the SpaceDev Dream ChaserTM. We signed
                a non-binding Space Act Memorandum of Understanding with NASA Ames
                Research Center, which confirms our intention to explore novel, hybrid
                propulsion based hypersonic test beds for routine human space access.
                We
                will explore with NASA collaborative partnerships to investigate
                the
                potential of using our proven hybrid propulsion and other technologies,
                and a low cost, private space program development approach to establish
                and design new piloted small launch vehicles and flight test platforms
                to
                enable near-term, low-cost routine space access for NASA and the
                United
                States. Unlike the more complex SpaceShipOne, for which SpaceDev
                provided
                critical proprietary hybrid rocket motor propulsion technologies
                and
                components, the SpaceDev Dream ChaserTM would be crewed and launch
                vertically, like most launch vehicles, and would glide back for a
                normal
                horizontal runway landing. The sub-orbital SpaceDev Dream ChaserTM would
                have an altitude goal of approximately 160 km (about 100 miles) and
                would
                be powered by a single, high performance hybrid rocket motor, under
                parallel development by us for the SpaceDev StreakerTM, a family of small,
                expendable launch vehicles, designed to affordably deliver small
                satellites to Low Earth Orbit. The SpaceDev Dream ChaserTM motor would
                produce approximately 100,000 pounds of thrust, about six times the
                thrust
                of the SpaceShipOne motor, but less than one-half the thrust of the
                250,000 pounds of thrust produced by hybrid rocket motors developed
                several years ago by the American Rocket Company.





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·
            Space
                Components and Mechanisms





Ø
            Electromechanical
                Components - We design and manufacture electromechanical components
                (EMC)
                for spacecraft applications. The EMCs are electromagnetic motors
                coupled
                to transmissions and sensors so as to provide the motive force to
                mechanical devices or systems for spacecraft applications. Applications
                include pointing systems for antennas and solar arrays, pump and
                fan
                motors for life support and thermal control systems, drives for planetary
                rovers, robotic systems, deployment, and stowage of mechanical structures
                and general drive applications.





Ø
            Catalog
                products - Motors and actuators are required on spacecraft to move
                instruments, point antennas and solar arrays, and deploy structural
                elements. A significant cost of spacecraft actuators and motors is
                the
                non-recurring engineering required to design these devices for a
                particular application. By providing these devices as an off-the-shelf
                catalog product, these non-recurring costs can be reduced or eliminated,
                providing a high value solution to the customer. We have a variety
                of
                actuators and motors that can be combined in various ways to provide
                actuators and motors for a variety of applications.





Ø
            Design
                to Requirement - Although catalog products can sometimes provide
                a high
                value solution, custom design is often required to meet a particular
                application. We have a suite of technologies that can be combined
                to meet
                a wide variety of spacecraft requirements. Motor technologies include
                brush motors, brushless motors, and stepper motors. Transmission
                technologies include planetary gearboxes, harmonic gearboxes, and
                hybrids.
                We believe that our ability to integrate these technologies into
                a single
                actuator package is a unique capability in our
                industry.




Ø
            Electromechanical
                Systems - Electromechanical Systems are the spacecraft subsystems
                that
                incorporate Starsys' EMCs with control electronics, actuators, sensors,
                power transfer components, and structure. These systems provide critical
                spacecraft functions such as antenna pointing, solar array pointing,
                instrument scanning, and telescope cover operation. Our unique suite
                of
                technological core competencies enable us to deliver these as turn-key
                systems. Areas of expertise relevant to this product area include
                actuator
                design, power transfer design, control electronics, and composite
                structural design. Almost all of our electromechanical systems are
                designed to specific customer requirements, and are known for being
                technologically innovative. One example of this is our Quiet Array
                Drive
                microstepping drive system technology, which is used for both antennae
                pointing and solar array pointing. It provides high accuracy pointing,
                with low jitter, allowing antennas and solar arrays to be pointed
                while
                spacecraft imaging is occurring.





Ø
            At
                times, our customers elect to build spacecraft mechanical subsystems
                in-house. For these customers, we provide components and mechanisms
                that
                are then integrated by our customer into their mechanical subsystems.
                These components provide a wide range of capabilities and include
                hinges,
                latches, release mechanisms, thermal switches, battery bypass switches,
                and thermal actuators. These products encompass a variety of proprietary
                technologies, and in some cases we are the only supplier of these
                items.
                Often these products have previously been designed and qualified
                for
                spacecraft, and therefore are purchased to a part number rather than
                to a
                specification. This allows these products to be manufactured in larger
                quantities.





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·
            Structures


Ø
            The
                  ability of a spacecraft telescope or sensor to operate effectively
                  is
                  directly related to its size. The bigger the sensor, the better
                  it is able
                  to resolve what it is looking at. Since the size of a spacecraft
                  during
                  launch is limited by the diameter of the rocket, there is a need
                  for
                  spacecraft to deploy sensors to a larger size once in orbit. We
                  have
                  proprietary technology and know-how to design and manufacture large
                  deployable structures for spacecraft to provide this capability.
                  These
                  structures are stowed within the confines of the launch vehicle
                  during
                  launch, and then deployed to their full size once the spacecraft
                  reaches
                  orbit. With compaction ratios that can exceed 100 to 1, a structure
                  as
                  long as a football field can be deployed from a spacecraft that
                  is 10 feet
                  in diameter. We develop systems that provide capabilities such
                  as
                  extremely high compaction ratios, the ability to both extend and
                  retract,
                  and the ability to locate sensors and instruments along the full
                  length of
                  the structure. We see this business as an important area for growth
                  as
                  continually larger systems are being fielded to look down at the
                  earth and
                  up at the stars. Our deployable structures technologies enable
                  these
                  systems.


These
      products and services are being marketed and sold directly into primarily
      domestic government, university, military and commercial markets. We consider
      ourselves a project company rather than a product company today, although
      products are generated from projects. Our business is not seasonal to any
      significant extent; however, our business follows normal industry trends such
      as
      increased demand during bullish economic periods, or slow-downs in demand during
      periods of recession.





In
      addition, we are working with potential partners to create new markets that
      can
      generate new space-related service, media, tourism, and commercial revenue
      streams. While we believe that certain space market opportunities are still
      several years away, we are currently working with industry-leading potential
      partners to develop unique enabling technology for the potentially very large
      sub-orbital manned space plane tourism market, and creating a new unmanned
      Beyond Earth Orbit commercial market with spacecraft derived from our NASA
      JPL
      Mars MicroMission and Boeing Lunar Orbiter mission design
      contracts.





**Components
      and Raw Materials**





Although
      our historic SpaceDev business may experience a shortage of certain parts and
      components related to our products, we have many alternative suppliers and
      distributors and are not dependent on any individual supplier or distributor.
      Furthermore, we have not experienced difficulty in our ability to obtain our
      parts or component materials, nor do we expect this to be an issue in the
      future.





We purchase
      a significant percentage of our Starsys product materials , components, structural assemblies and certain key satellite components and
      instruments from third parties. We also occasionally obtain parts and equipment
      that we use in the production of our products or in the provision of our
      services from the U.S. government or customers. Generally, we do not experience
      difficulty while obtaining product materials components and equipment, and
      believe that alternatives to our existing sources of supply are readily
      available. If securing alternative sources of supply is necessary or required,
      increases in costs and delays may be incurred as a result of such actions.
      For
      unique materials or product components, we do rely upon sole sourced suppliers
      to provide such items. While alternative sources may be available, the inability
      of any such supplier to provide us with these items to qualified specifications
      could result in an adverse effect on our ability to manufacture our products
      and
      would impact costing and schedules.




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**Competition**





We
      compete for sales of our products and services based on price, performance,
      technical features, contracting approach, reliability, availability,
      customization, perceived stability, and, in some situations, geography. The
      following table identifies our primary competitors for each of our primary
      product or technology areas:





**Product
                or Technology Area**
            **Competitors**Our
                Spacecraft Products and Services
            AeroAstro
              EADS
                Astrium
              Microsat
                Systems
              Spectrum
                Astro
              Surrey
                Satellite Technology LimitedOur
                Propulsion Products and Services
            Cesaroni
                Technology Incorporated
              Various
                Academic-based OrganizationsOur
                Motors and Actuators
            Aeroflex
                (a subsidiary of UMTC)
              ATK
                Satellite Systems
              CDA
                Astro
              Moog
                Inc.
              MPC
                Products CorporationOur
                Electromechanical Systems
            Aeroflex
                (a subsidiary of UMTC)
              Alliance
              ATK
                Satellite Systems
              Moog
                Inc.
              Prime
                Contractor Internal Mechanisms
              Swales
                AerospaceOur
                Components and Mechanisms
            G&H
                Technologies
              NEA
              Planetary
                Systems Inc.
              TiNi
                AerospaceOur
                Structures Business
            ATK
                Space Systems (formerly AEC AbleEngineering)
              Harris
                Corporation
              NGST
                Astro (formerly SPAR Astro
                Aerospace)





While
      we
      believe that our product and service offerings provide a wide breadth of
      solutions for our customers and prospective customers, some of our competitors
      compete across many of our product lines.  Several of our current and
      potential competitors have greater resources, including technical and
      engineering resources, marketing resources, and political connections. Also,
      customers may perceive larger competitors to be more stable.  We are not
      aware of any established large companies, which have expressed any significant
      corporate goals to design and build inexpensive micro-spacecraft for a mission,
      which would be direct competition for our historic SpaceDev business. However,
      they have resources, expertise, and contracts that would make them formidable
      competitors if they chose to enter our markets.




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Our
      customers are sometimes our competitors.  In the aerospace industry, and
      particularly since our merger with Starsys, we have found that we subcontract
      to
      companies that we also compete with when it comes to responding to requests
      for
      proposals and requests for information. Many
      of
      these competitors are larger and have substantially greater resources than
      we
      do, which is often why we supply them with components and/or subsystems. Part
      of
      our strategy is to remain non-confrontational with the larger aerospace
      companies so that we can both supply and compete with them.  Even the
      larger aerospace companies have this issue with each other as they strive to
      support their customer, e.g., a government agency.





Furthermore,
      it is possible that other domestic or foreign companies or governments, some
      with greater experience in the space and defense industry and many with greater
      financial resources than we possess, will seek to provide products or services
      that compete with our products or services. Any such foreign competitor could
      benefit from subsidies from or other protective measures by its home
      country.





We
      also
      compete with each of our competitors for qualified engineers. There are a
      limited number of individuals with all of the requirements that we seek and
      there can be no assurance that we can locate and recruit these individuals
      in a
      timely and cost-effective manner. Many of our competitors have greater resources
      than we do and can offer higher salaries or better incentives to attract these
      individuals or to hire our existing employees away from us.





**Regulation**





Our
      business activities are regulated by various agencies and departments of the
      U.S. government and, in certain circumstances, the governments of other
      countries.  We
      are
      required to ensure that any disclosure of scientific and technical information
      complies with the Export Administration Regulations and the International
      Traffic in Arms Regulations ("ITAR"). Exports of our products, services and
      technical data require either Technical Assistance Agreements or licenses from
      the United States Department of State, depending on the level of technology
      being transferred. This includes recently published regulations restricting
      the
      ability of United States-based companies to complete offshore launches, or
      to
      export certain satellite components and technical data to any country outside
      the United States. The commercial export of information with respect to
      ground-based sensors, detectors, high-speed computers, and national security
      and
      missile technology items are controlled by the Department of Commerce. The
      government is very strict with respect to compliance and has served notice
      that
      failure to comply with the ITAR and/or the Commerce Department regulations
      may
      subject guilty parties to fines of up to $1 million and/or up to 10 years
      imprisonment per violation. Our failure to comply with any of the foregoing
      regulations could have serious adverse effects. Our ability to market, sell
      and
      deliver products into international markets may be adversely impacted due to
      ITAR and/or Commerce Department requirements. Potential negative impacts
      include, but are not limited to, the inability to sell to certain customers,
      extended sales cycles, and delays in material procurement, manufacturing, test,
      product delivery, and collection of accounts receivable. Our conservative
      position is to consider any material beyond standard marketing material to
      be
      regulated by ITAR.





In
      addition to the standard local, state, and national government regulations
      that
      all businesses must adhere to, the space industry has specific regulations.
      In
      the United States, command and telemetry frequency assignments for space
      missions are primarily regulated by the Federal Communications Commission for
      our domestic commercial products. Our products geared toward domestic government
      customers are regulated by the National Telecommunications Information Agency
      and products sold internationally, if any, are regulated by the International
      Telecommunications Union. All launch vehicles that are launched from a launch
      site in the United States must pass certain launch range safety regulations
      that
      are administered by the United States Air Force. In addition, all commercial
      space launches that we might perform require a license from the Department
      of
      Transportation. Satellites that are launched must obtain approvals for command
      and frequency assignments. For international approvals, the Federal
      Communications Commission and National Telecommunications and Information
      Administration obtain these approvals from the International Telecommunication
      Union.





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We
      are
      also required to obtain permits, licenses, and other authorizations under
      federal, state, local, and foreign statutes, laws, or regulations or other
      governmental restrictions relating to the environment or to emissions,
      discharges or releases of pollutants, contaminants, petroleum or petroleum
      products, chemicals or industrial, toxic or hazardous substances or wastes
      into
      the environment including, without limitation, ambient air, surface water,
      ground water, or land, or otherwise relating to the manufacture, processing,
      distribution, use, treatment, storage, disposal, transport or handling of
      pollutants, contaminants, petroleum or petroleum products, chemicals or
      industrial, toxic or hazardous substances or wastes, or the clean-up or other
      remediation thereof. Presently, we do not have a requirement to obtain any
      special environmental licenses or permits.





We
      may
      need to utilize the Deep Space Network on some of our missions. The Deep Space
      Network is a United States funded network of large antennas that supports
      interplanetary spacecraft missions and radio and radar astronomy observations
      for the exploration of the solar system and the universe. The network also
      supports selected Earth-orbiting missions. The network is a facility of NASA,
      and is managed and operated for NASA by the Jet Propulsion Laboratory. The
      Telecommunications and Mission Operations Directorate manages the program within
      the Jet Propulsion Laboratory.





Also,
      as
      some of our projects with the Department of Defense proceed, we may need special
      clearances to continue working on and continue advancing our projects. 
Classified programs generally will require that we comply with various Executive
      Orders, Federal laws and regulations and customer security requirements that
      may
      include specialized facilities and restrictions on how we develop, store,
      protect, and share information.  Laboratories, manufacturing and assembly
      areas, meeting spaces, office areas, storage areas, computers systems, and
      networks and telecommunications systems may require modification or replacement
      in order to comply with customer requirements.  Classified programs may
      require our employees to obtain government clearances and restrict our ability
      to have key employees work on these programs until these clearances are received
      from the appropriate United States government agencies.  In order to staff
      these programs we may need to recruit personnel with the appropriate
      professional training, experience, and security clearances.  There are a
      very limited number of individuals with all of the requirements that we
      seek.  There is no assurance that we can locate and recruit these
      individuals in a timely and cost-effective manner.  We may be required to
      modify existing facilities and to develop new facilities and capabilities that
      will only be utilized by these classified programs.  We may be required to
      install computer networks, communications systems, and monitoring systems that
      are dedicated to these classified programs.  Some or all of these
      requirements may entail substantial additional expense.  It is uncertain
      whether we will be able to recover any of the costs of these systems from our
      customers.  Many of these classified programs are regulated by Executive
      Orders, various Federal laws and regulations, and customer requirements. 
Failure to comply with any of the foregoing Executive Orders, Federal laws
      and
      regulations and customer requirements could have serious adverse effects. 
Also, our ability to successfully market and sell into the Department of Defense
      markets may be severely hampered if we are unable to meet classified program
      requirements.  There is no assurance that we will be able to successfully
      pass the criteria required in order to win a classified program or to maintain
      current contracts, such as our Missile Defense Agency contract, and there is
      no
      assurance that we will maintain that status once it has been
      obtained.




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**Employees**





At
      December 31, 2006, we employed 174 full-time and 10 part-time persons most
      of
      whom are spacecraft, propulsion, systems, software, mechanical and electrical
      engineers, and technicians. As of March 5, 2007, we employed 13 full-time people
      in Durham, North Carolina, 44 full-time and 2 part time people in Southern
      California, and 146 full-time and 3 part-time people in the Boulder/Denver
      area.
      We do not have any collective bargaining agreements with our employees, and
      we
      believe our employee relations are good.





**Intellectual
      Property**





We
      have
      protected and intend to continue to protect our intellectual property
      through a combination of patents, license agreements, trademarks, service marks,
      copyrights, trade secrets ,
      and
      other methods of restricting disclosure and transferring title. We rely, in
      part, on patents, trade secrets and know-how to develop and maintain our
      competitive position and technological advantage, particularly with respect
      to
      our launch vehicle, satellite products, structures, and mechanisms. We hold
      U.S.
      and foreign patents relating to release devices, deployable truss structures,
      hybrid propulsion, and battery cell shorting mechanisms. The majority of our
      U.S. patents relating to the noted technologies expire between 2019 and 2022.
      We
      have also filed patent applications relating to our hybrid propulsion
      technology, satellite technology and structures technology.  There can be
      no assurance that such applications will be granted. We have entered, and
      intend to continue to enter, into confidentiality agreements with our employees,
      consultants and vendors; enter into license agreements with third parties;
      and,
      generally, seek to control access to and distribution of our intellectual
      property.




In
      August
      1998, we acquired rights to intellectual property
      (including patents and trade secrets) from an individual who had acquired
      them from the former American Rocket Company, which specialized in hybrid rocket
      technology.  We are obligated to issue warrants to this individual to
      purchase a minimum of 100,000 and a maximum of 3,000,000 shares of our common
      stock over ten years beginning at the inception of the agreement, depending
      on
      our annual revenues directly related to sales of hybrid technology-based
      products from the original technology acquisition.  To date, we have issued
      warrants to purchase a total of 100,000 shares of our common stock under the
      agreement, all of which have expired unexercised.





**Quality
      Assurance and Testing**





Our Colorado
      and North Carolina facilities maintain quality management systems that are
      AS9100 and ISO-9001 third party certified. Our Mission Assurance Department
      provides top-level quality engineering, dimensional inspection, and visual
      inspection services. Our dimensional inspection capabilities include state
      of
      the art, high precision coordinate measuring machine work centers with contour
      and model based inspection capability. Our Mission Assurance charter is to
      ensure that all incoming materials, internal fabrication and administrative
      processes, and outgoing products meet all contract and Quality Management System
      requirements.




We
      maintain extensive capabilities for aerospace environmental testing, including
      thermal and thermal/vacuum chambers, and access to certified suppliers for
      vibration, shock, and electromagnetic interference testing. All test and
      measurement activities are performed with equipment calibrated to standards
      traceable to the National Institute of Standards and Technology.




These
      quality standards have not been certified in our California facilities. We
      expect that an expansion of our quality systems to all of our locations may
      occur in the future. We moved our Colorado facility in March 2007, and are
      planning to move our North Carolina facilities in May 2007 to other buildings
      in
      those geographic areas. We will seek certification for the new facilities once
      the moves are completed.




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**Research
      and Development** ****





A
      large
      portion of our total new product development and enhancement programs is funded
      under government and customer contracts. Our research and development expenses,
      other than under such contracts, totaled approximately $284,000 and $32,000
      for
      the years ended December 31, 2006 and 2005, respectively, on a pro forma
      basis, as if SpaceDev and Starsys had been merged since January 1,
      2005.




**United
      States Government Contracts** ****





During
      2006 and 2005 approximately 88% and 88%, respectively, of our total annual
      pro
      forma revenues were derived from contracts with the U.S. government and its
      agencies, or from subcontracts with other U.S. government prime contractors.
      Most of our U.S. government contracts are funded incrementally on a year-to-year
      basis.





Our
      major
      contracts with the United States Government fall into two categories:
      cost-reimbursable contracts and fixed-price contracts. In 2006, approximately
      51% and 49% of revenues from U.S. government contracts were derived from
      cost-reimbursable contracts and fixed-price contracts, respectively. Under
      a
      cost-reimbursable contract, we recover our actual allowable costs incurred,
      allowable overhead costs, and a fee consisting of a base amount that is fixed
      at
      the inception of the contract, and/or an award amount that is based on the
      customer’s evaluation of our performance in terms of the criteria stated in the
      contract. Our fixed-price contracts include firm fixed-price and fixed-price
      incentive fee contracts. Under firm fixed-price contracts, work performed and
      products shipped are paid for at a fixed price without adjustment for actual
      costs incurred in connection with the
      contract. Therefore, we bear the risk of loss if costs increase, although some
      of this risk may be passed on to subcontractors. Fixed-price incentive fee
      contracts provide for sharing by us and the customer of unexpected costs
      incurred or savings realized within specified limits, and may provide for
      adjustments in price depending on actual contract performance other than costs.
      Costs in excess of the negotiated maximum (ceiling) price and the risk of
      loss by reason of such excess costs are borne by us, although some of this
      risk
      may be passed on to subcontractors.





Starsys
      has experienced significant cost overruns on development projects under
      fixed-price contracts, resulting in losses on contracts before application
      of
      any reserves.  Under fixed-price contracts, our customers pay us for work
      performed and products shipped without adjustment for the costs we incur in
      the
      process.  Therefore, we generally bear all or a significant portion of the
      risk of losses as a result of increased costs on these contracts.  Since
      merging with Starsys, we have taken significant steps to try to limit our risk
      on fixed price contracts going forward, including but not limited to obtaining
      voluntary relief from our customer(s), which relief (or additional
      consideration) cannot be assured, altering our bid and proposal process to
      address risk assessment on fixed price contracts, and migrating our contract
      structure toward cost reimbursable contracts. Under cost reimbursable contracts,
      we are reimbursed for allowable incurred costs plus a fee or incentive, which
      may be fixed or variable.  This contract structure allows us to manage the
      risk of a development-type program.





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United
      States Government contracts are dependent on continued political support and
      funding. All of our Unites States Government contracts and, in general, our
      subcontracts with other United States prime contractors provide that such
      contracts may be terminated for convenience at any time by the United States
      Government or the prime contractor, respectively. Furthermore, any of these
      contracts may become subject to a government-issued stop work order under which
      we would be required to suspend our activities under the contract. In the event
      of a termination for convenience, contractors generally are entitled to receive
      the purchase price for delivered items, reasonable reimbursement for allowable
      costs for work in process, and an allowance for reasonable profit thereon or
      adjustment for loss if completion of performance would have resulted in a loss.




***RISK
      FACTORS***




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





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





***We
      have experienced losses from operations in prior periods and have been required
      to seek additional financing to support our
      businesses.***





In
      prior
      years, both SpaceDev and Starsys have experienced operating losses and, in
      some
      periods, revenues from operations have not been sufficient to fund our
      respective operations. On a pro forma basis, our combined company would have
      had
      revenue of approximately $32 million, $27 million and $23 million, and a net
      loss from operations of approximately $1.0 million, $2.9 million and $5.0
      million for the years ended December 31, 2006, 2005 and 2004, respectively,
      assuming the merger had occurred on January 1, 2004. Starsys was insolvent
      at
      the time we acquired it. The success of our combined companies depends upon
      our
      ability to generate revenue from existing contracts, to execute programs
      cost-effectively, to price fixed-price contracts accurately, to attract and
      successfully complete additional government and commercial contracts, and
      possibly to obtain additional financing. The likelihood of our success must
      be
      considered in light of the expenses, difficulties and delays frequently
      encountered in connection with developing businesses, those historically
      encountered by us, and the competitive environment in which we
      operate.





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





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





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





Some
      of
      our government contracts are phased contracts in which the customer may
      determine to terminate the contract between phases for any reason. 
Accordingly, the entire contract amount may not be realized by us.  In the
      event that subsequent phases of some of our government contracts, including
      but
      not limited to the Missile Defense Agency contract, are not awarded to us,
      or if
      awarded to us but not fully funded, it could have a material adverse effect
      on
      our financial position and results of operations. Task
      Order IV of our Missile Defense Agency contract is currently funded for
      $4.5  million. 
      If this funding is not increased and we are not awarded any further task orders,
      we will have garnered a total of only about $18 million of the$43 million
      potentially available under the contract.  We were informed in 2005 that
      the Missile Defense Agency had re-routed the laser communications experiment
      to
      another program and that they would not be exercising their option for the
      additional microsats at that time; however, the contract vehicle remained at
      $43
      million and the MDA has authority to substitute other work within this contract
      vehicle if it wishes to.  The MDA has indicated that it may reduce or
      eliminate funding for the program in GFY 2008 due to government budget
      allocations and reductions.  We are currently negotiating with the Missile
      Defense Agency to extend funding on Task Order IV, which is part of the
      fabrication, integration and test phase of the program.  The Missile
      Defense Agency recently extended the end time of Task Order IV from March 1,
      2007 to June 15, 2007.  We are currently working with the Missile Defense
      Agency on the level of funding and scope of work to be performed during that
      period of time.  We are also working with other government agencies who may
      be interested in our microsat program both in addition to, and possibly in
      place
      of, the MDA program since there can be no assurances that our discussions with
      the MDA will be fruitful or that any additional task orders will be awarded
      in
      the future or that task order funding will be available.




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




Under
      fixed-price contracts, our customers pay us for work performed and products
      shipped without adjustment for the costs we incur in the process. Therefore,
      we
      generally bear all or a significant portion of the risk of losses as a result
      of
      increased costs on these contracts, unless we can obtain voluntary relief from
      our customer, which relief (or additional consideration) cannot be assured.
      Although we have taken significant steps to try to limit our risk on fixed
      price
      contracts going forward, Starsys has experienced significant cost overruns
      on
      development projects under fixed-price contracts, resulting in estimated losses
      on contracts before application of any reserves of approximately $2.9 million
      for Starsys’ fiscal 2005 and approximately $1.7 million for the twelve months
      ended December 31, 2006. As of December 31, 2006, we retained reserves of
      approximately $0.7 million for potential risks on development projects, which
      had begun prior to the merger in January 2006.




As
      a
      particular example, Starsys experienced significant cost overruns throughout
      2006 on a sizable subcontract with Northrop Grumman. In early 2007, we were
      successful in negotiating with our customer for a contract modification based
      on
      performance incentives, which, if the performance targets are achieved, would
      defray some of the cost overruns. Any ongoing significant overruns could
      materially impair our liquidity and operations.




When
      contract
      provisions produce unfavorable results for us, or fixed price development
      contracts result in losses, we generally do not have the legal or economic
      leverage needed to easily obtain renegotiated terms. Our customers generally
      would not fear any threat we might make to withhold future business, and our
      financial and business position make litigation an unfavorable option for us.
      On
      the other hand, the reverse might be true of our customers, who tend to be
      large
      aerospace companies with significant resources. In the particular case of two
      major Starsys fixed-price contracts on which we have experienced significant
      cost overruns, the customers were willing to work with us and negotiations
      resulted in contract amendments providing additional incentive payments based
      on
      performance; however, there can be no assurance that future attempts to
      renegotiate contracts will be successful.




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




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





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




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


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


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


·
            potential
                incompatibility of business cultures;


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


·
            the
                loss of key employees;


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


·
            potential
                incompatibilities of processes, technologies and systems;


·
            potential
                difficulties integrating and harmonizing financial reporting systems;
                and,


·
            potential
                failure to implement systems to properly price and manage the execution
                of
                fixed-price contracts.





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





We
      do not
      believe that the anticipated benefits of the merger were fully realized in
      the
      first year. We believe the market price of our common stock may have declined,
      in part, due to this. Although we believe future results will indicate a more
      positive trend, if this does not occur, we may not meet the expectations of
      investors and financial or industry analysts due to:


·
            the
                unsuccessful integration of the two companies;


·
            the
                costs of or operational difficulties arising from the merger are
                greater
                than anticipated;


·
            the
                combined financial results are not consistent with expectations;


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


·
            the
                fixed price development contracts acquired in the merger continue
                to incur
                major cost overruns or remains unprofitable for other
                reasons.




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





Starsys
      was insolvent at the time of the merger and we have used our cash to fund our
      combined operations, including, but not limited to, integrating the Starsys
      and
      SpaceDev businesses, and funding the completion of fixed price development
      contracts inherited as part of the merger.  Although the number and value
      of Starsys’ historical fixed price development contracts is declining, and we
      believe is being replaced by more stable contract types, further cash may be
      required in 2007 to complete the fixed price development contracts and fund
      the
      remaining integration of the companies.  As stated previously, Starsys and
      the historical SpaceDev business have both experienced losses from operations
      in
      prior periods, requiring that we seek additional financing to support our
      businesses and there can be no assurance that additional financing will be
      available, and if available, at terms and conditions favorable to us.





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***We
      are relocating both our Colorado and our North Carolina facilities in
      2007.***





The
      move
      of our Boulder, Colorado and Durham, North Carolina operations to new
      and larger nearby facilities in the first half of 2007 may be time
      consuming and expensive and may disrupt our operations if it is not completed
      in
      a timely and efficient manner.  In
      addition, we may not achieve anticipated efficiencies or other operational
      benefits of the moves.  We may encounter difficulties, costs, and delays
      involved in recertifying our equipment, reestablishing network and communication
      capabilities, or other required operating essentials.  Failure for us to
      successfully manage the facility moves could damage relationships with our
      customers, divert management attention from other ongoing business
      opportunities, cause additional and unexpected program delays, and create
      additional costs and inefficiencies in personnel productivity.  Moreover,
      if our business does not develop as expected the new facilities may be larger
      than what we require, resulting in rent payments for some unneeded space. 
Our rental costs at the new facilities will be approximately 65% higher than
      we
      had paid at the prior facilities.





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





Our
      concentration of government work makes us susceptible to government budget
      cuts
      and policy changes, which may impact the award of new contracts or future phases
      of existing contracts.  Government budgets (both in general and as to space
      and defense projects) are subject to the prevailing political climate, which
      is
      subject to change at any time.  Additionally, awarded contracts could be
      altered or terminated prior to the time we recognize our projected revenue.
      Many
      contracts are awarded in phases where future phases are not guaranteed to
      us.  For example, in our MDA contract, which was initially valued at $43
      million, if Task
      Order IV of our Missile Defense Agency contract, which is currently funded
      for
      $4.5  million,
      is not increased and we are not awarded any further task orders, we will have
      garnered a total of only about $18 million of the $43 million potentially
      available under the contract.  The MDA has indicated that it may reduce or
      eliminate funding for the program in GFY 2008 due to government budget
      allocations and reductions.  We are currently negotiating with the Missile
      Defense Agency to extend funding on Task Order IV, which is part of the
      fabrication, integration and test phase of the program.  The Missile
      Defense Agency recently extended the end time of Task Order IV from March 1,
      2007 to June 15, 2007.  We are currently working with the Missile Defense
      Agency on the level of funding and scope of work to be performed during that
      period of time.  We are also working with other government agencies who may
      be interested in our microsat program both in addition to, and possibly in
      place
      of, the MDA program since there can be no assurances that our discussions with
      the MDA will be fruitful or that any additional task orders will be awarded
      in
      the future, or that task order funding will be available.





In
      addition, obtaining contracts and subcontracts from government agencies is
      challenging, and contracts often include provisions that are not standard in
      private commercial transactions. For example, government contracts
      may:





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


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


·
            contain
                onerous procurement procedures; and,


·
            be
                subject to cancellation if government funding becomes unavailable.





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





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





***Our
      small size makes it hard for us to win large
      contracts***





Prime
      contracts in our business may be large in dollar amount and critical to national
      interests. As a practical matter, smaller companies are at a disadvantage when
      competing to be awarded such contracts as the prime contractors, due to the
      customer perception that larger companies might be more stable. For this
      purpose, we would currently be considered a "smaller company."





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





As
      of
      December 31, 2006, we are obligated to issue 8,870,116 shares of our common
      stock if all of our outstanding warrants are exercised and shares of preferred
      stock converted.  We would however, obtain a significant amount of cash
      from this exercise. In addition, as of December 31, 2006, we had outstanding
      stock options to purchase an aggregate of 12,395,098 shares of our common stock,
      of which 9,969,598 are currently vested.  The total number of shares,
      issuable upon the exercise or conversion of currently vested warrants, options
      and preferred stock (18,839,713 shares) represents approximately 64% of our
      issued and outstanding shares of common stock as of December 31,
      2006.





***Our
      level of business may be difficult to predict.***





We
      hope
      to sell an increasing percentage of our products and services on a recurring
      basis, but most of our revenue is derived from government contracts and
      government-related work, which may not be recurring. Government contracts can
      be
      defunded or terminated by the Government for convenience. Also, some of our
      products and services may not achieve market acceptance, and our future
      prospects may therefore be difficult to evaluate.





In
      addition to many other risks involving our lines of business, we intend to
      enter
      the launch services market by providing a microsat bus, integration services,
      and a launch vehicle as a package. Until we develop our own launch vehicle,
      we
      will be dependent on the performance of third party companies like Space
      Exploration Technologies, a small company with limited operating history, which
      has not yet had a successful launch, for our first launch vehicle.





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***We
      may not develop products successfully or in a timely
      manner.***





Many
      of
      our products and technologies are currently in various stages of development.
      Further development and testing of our products and technologies will be
      required to prove additional performance capability beyond current levels and
      to
      confirm commercial viability. Additionally, the final cost of development cannot
      be determined until development is complete. Most of our development work is
      in
      fact performed under contracts from our customers. In the past, we have
      contracted to execute development programs under fixed price contracts. Under
      these contracts, even if our costs begin to exceed the amount to be paid by
      the
      customer under the contract, we are required to complete the contract without
      receiving any additional payments from our customer. It is difficult to predict
      accurately the total cost of executing these programs. If the costs to complete
      these programs significantly exceed the payments from our customers under the
      contracts, our results of operations will be harmed. These contracts are
      inherently risky, and in the past have had material adverse affects to the
      company; we intend to limit our acceptance of this sort of contract. This will
      limit our opportunity to develop products at a customer's expense.





Our
      products and services are and will continue to be subject to significant
      technological change and innovation. Our success will generally depend on our
      ability to continue to conceive, design, manufacture, and market new products
      and services on a cost-effective and timely basis. We anticipate that we will
      incur significant expenses in the design and initial manufacture and marketing
      of new products and services. Some of these costs may be covered by our
      customers or partnership arrangements; however, there can be no assurance that
      significant costs will not be incurred by us.




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





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





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





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





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


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


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


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


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


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


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


·
            changes
                in perception of the safety of space
                travel;


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


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


·
            the
                uncertain market for our technology and products;


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


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





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





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





We
      face
      significant competition for our government and commercial contracts. Many of
      our
      competitors have greater resources than we do and may be able to devote greater
      resources than us to research and development, marketing, and lobbying efforts.
      Given the sophistication inherent in any space company's operations, larger
      competitors may have a significant advantage and may be able to more efficiently
      adapt and implement technological advances. In addition, larger and financially
      stronger corporations have advantages over us in obtaining space and defense
      contracts due to their superior marketing (lobbying) resources and the
      perception that they may be a better choice than smaller companies for
      mission-critical projects because of the higher likelihood that they will be
      able to continue in business for the necessary future period.





Furthermore,
      it is possible that other domestic or foreign companies or governments, some
      with greater experience in the space industry and many with greater financial
      resources than we possess, could seek to produce products or services that
      compete with our products or services, including new mechanisms and
      electromechanical subsystems using new technology which could render our
      products less viable. Some of our foreign competitors currently benefit from,
      and others may benefit in the future from, subsidies from or other protective
      measures implemented by their home countries.





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





Most
      of
      our products are technologically advanced and tested, but sometimes are not
      space qualified for performance under demanding operating conditions. Although
      we have never had a failure of our products in space, it is possible that our
      products may not successfully launch or operate, or perform as intended in
      space. Like most organizations that have launched space qualified hardware,
      we
      have experienced and in the future will likely experience some product and
      service failures, cost overruns, schedule delays, and other problems in
      connection with our products.





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





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





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


·
            delays
                in receiving the license(s) necessary to operate the small satellite
                system(s);


·
            delays
                in obtaining our customer's payload;


·
            delays
                related to the launch vehicle;


·
            weather;
                and,


·
            other
                events beyond our control.





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





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





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





***Our
      success depends on our ability to retain our key personnel. We accelerated
      vesting of all outstanding stock options in December 2005, in anticipation
      of
      SFAS 123(R), which reduced the effectiveness of the stock options as a retention
      device.***





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





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





Our
      founder and former chief executive officer, James W. Benson, resigned as our
      Chairman and chief technology officer in September 2006 in order to found a
      new
      company, Benson Space Company. Although Benson Space Company is now one of
      our
      customers, the departure of a founder, who has helped to shape our culture
      and
      vision, is always a special challenge for an emerging company.





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





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





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





We
      expect
      to consider opportunities to acquire or make investments in other technologies,
      products, and businesses that could enhance our capabilities, complement our
      current products, or expand the breadth of our markets or customer base.
      Acquisitions may be necessary to enable us to quickly achieve the size needed
      for some potential customers to seriously consider entrusting us with
      mission-critical contracts or subcontracts. As a company, we have limited
      experience in acquiring other businesses and technologies: the Starsys
      acquisition was our first major acquisition. Potential and completed
      acquisitions and strategic investments involve numerous risks,
      including:





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


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


·
            unanticipated
                costs associated with the acquisition;


·
            diversion
                of management's attention from core businesses;


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


·
            incompatibility
                of business cultures;


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


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


·
            potential
                loss of key employees of acquired businesses; and,


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





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





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





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





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





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





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





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





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





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





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





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





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





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





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





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




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




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





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





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





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





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





·
            deviations
                in our results of operations from
                estimates;


·
            changes
                in estimates of our financial
                performance;


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


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


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


·
            changes
                in technology;


·
            potential
                loss of key personnel;


·
            short
                selling;


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


·
            volume
                fluctuations generally including, but not limited to, resales by
                former
                Starsys stockholders or by Laurus Master Fund;
                and,


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





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





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





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





As
      of
      December 31, 2006, our executive officers and directors together beneficially
      owned approximately 45.7% of the issued and outstanding shares of our common
      stock.  James W. Benson and Susan C. Benson beneficially own approximately
      22% of our common stock.  (Mr. Benson separated from our employ in
      September 2006 and founded Benson Space Company but retains a seat on our Board
      of Directors.)  As a result, executive officers and directors could have
      the ability to exert significant influence over matters concerning us, including
      the election of directors, changes in the size and composition of the Board
      of
      Directors, and mergers and other business combinations involving us. In
      addition, through control of the Board of Directors and voting power, our
      officers and directors may be able to control certain decisions, including
      decisions regarding the qualification and appointment of officers, dividend
      policy, access to capital (including borrowing from third-party lenders and
      the
      issuance of additional equity securities), and the acquisition or disposition
      of
      our assets. In addition, the concentration of voting power in the hands of
      those
      individuals could have the effect of delaying or preventing a change in control
      of our company, even if the change in control would benefit our shareholders.
      A
      perception in the investment community of an anti-takeover environment at our
      company could cause investors to value our stock lower than in the absence
      of
      such a perception.





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





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





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





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





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





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





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





We
      have
      up to 10,000,000 shares of authorized preferred stock in one or more series.
      We
      currently have outstanding 248,460 shares of our Series C Convertible Preferred
      Stock and 4,312 shares of our Series D-1 Preferred Stock. Our Board of Directors
      may determine the terms of future preferred stock offerings without further
      action by our shareholders. If we issue additional preferred stock, it could
      affect your rights or reduce the value of your common stock. In particular,
      specific rights granted to future holders of preferred stock could be used
      to
      restrict our ability to merge with or sell our assets to a third party. These
      terms may include voting rights, preferences as to dividends and liquidation,
      conversion and redemption rights, and sinking fund provisions. Our Series C
      Preferred Stock and Series D-1 Preferred Stock rank senior to the common stock
      with respect to dividends and liquidation and have other important preferred
      rights.





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





On
      September 29, 2006, we entered into a secured revolving credit facility with
      Laurus Master Fund.  Although the maximum size of the facility is
      $5,000,000, actual borrowings are limited by a formula based on our eligible
      accounts receivable and eligible inventory.  Our initial borrowing was
      approximately $1.9 million and our current average borrowing is approximately
      $2.5 million.  We paid a loan fee at closing in the form of common stock
      valued at $350,000.  In addition, we will be required to pay Laurus
      additional loan fees in the form of common stock valued at $200,000 on each
      anniversary date of the facility, if the facility remains in place.  In
      addition, the outstanding balance on the facility bears interest at a floating
      rate of prime plus 2%, and the maximum life of the facility is three years.
      The
      facility is collateralized by substantially all of our assets. The facility
      contains certain default provisions. In the event of a default by us, we will
      be
      required to pay an additional fee per month until the default is cured. Laurus
      has the option of accelerating the entire principal balance and requiring us
      to
      pay a premium in the event of an uncured default. We paid to certain persons
      designated by Laurus the amount of $9,500 for legal fees and expenses in
      structuring the facility, conducting due diligence and escrow fees. In addition,
      we paid a finder’s fee in the amount of $35,000 and paid Laurus a facility fee
      of 3.5%, or approximately $140,000, of the facility amount, which facility
      fee
      is being expensed over the life of the note.





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





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





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





·
            make
                a special written suitability determination for the purchaser;


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


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


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





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







***ITEM
      2.*** ***DESCRIPTIONOF
      PROPERTY***







In
      January 2003, we entered into a sale and 10-year leaseback of our 25,000 square
      foot headquarters facility in Poway, California. Our facility includes a small
      Spacecraft Assembly and Test facility with a 1,800 square foot Class 100,000
      clean room, avionics development lab, machine shop with rocket motor casting
      capability, mechanical assembly lab, and mission control and operations center.
      In March 2005, we leased an additional 11,000 square feet of office and
      warehouse space within a mile of our Poway, California facility and moved our
      machine shop with rocket motor casting capability for hybrid propulsion into
      it.
      This lease is now set to expire on June 30, 2007. We also negotiated an
      arrangement with Northrop Grumman for use of a test pad at their Capistrano
      Test
      Facility approximately one hour from our Poway, California offices. We use
      this
      site to fire and test larger hybrid rocket motors. Key uses of our California
      facilities are program and project conferences and meetings, engineering design,
      engineering analysis, spacecraft assembly, avionics labs, software labs, and
      media outreach. We also have an Internet-based Mission Control and Operations
      Center in our building. Our facilities
      allow for efficient design, assembly, and test for our projects, and of our
      products and technologies.





The
      rent
      on our headquarters building is approximately $29,500 per month with a 3.5%
      COLA
      increase annually. We are responsible for property tax and liability insurance
      on the facility. We were required to make an advance payment in the form of
      a
      security deposit of approximately $25,700, which we carry as an asset on our
      balance sheet. The rent on the second Poway facility was approximately $9,000
      per month in 2006 and included all CAM charges and taxes. The Capistrano
      facility is billed to us by Northrop Grumman only when in use and includes
      all
      support services.





Table
          of Contents
 32


As
      a
      result of our acquisition of Starsys, we acquired a lease for a 41,400 square
      foot facility in Boulder, Colorado (at a rental rate of approximately $55,000
      per month) and a 5,000 square foot facility in Durham, North Carolina (at a
      rental rate of approximately $6,000 per month). The Boulder lease expires in
      March 2007 and we anticipate the relocation of our Starsys manufacturing
      operations from Boulder to Louisville, Colorado, 12 miles southeast of our
      current location. We signed a lease on August 25, 2006 for our new Louisville
      facility, which provides an immediate improvement in product work flow over
      our
      existing site. The new facility has approximately 72,000 square feet, a
      significant expansion in floor space. The rent will be approximately $77,000
      per
      month with a 3.0% COLA increase annually.  We plan to develop this space
      through phased capital equipment additions that will improve our fabrication,
      assembly, and test capabilities. We have an option to lease an additional 19,000
      square feet at the same site.





Finally, our Durham, North Carolina facility lease was also set to expire in
      March 2007. We signed a new lease in March 2007 to relocate our Durham
      manufacturing operations from 633 Davis Drive to 1030 Swabia Court, one mile
      east of our current location in May 2007. We will hold over in the existing
      facility until the tenant improvements are completed on the new
      building. The new Durham facility has approximately 13,500 square feet of
      usable office and laboratory space.  The rent will be approximately $13,000
      per month with an increase annually.










***ITEM
      3.*** ***LEGAL
      PROCEEDINGS***







None.







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







None.





Table
          of Contents
 33


**PART
      II**







***ITEM
      5.***  ***MARKET
      FOR COMMON EQUITY, RELATED STOCKHOLDER MATTER*** **S,
      AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES**







**Market
      Information** ****





Our
      common stock has been traded on the Over-the-Counter Bulletin Board ("OTCBB")
      since August 1998 under the symbol "SPDV" or "SPDV.OB." The following table
      sets
      forth the trading history of our common stock on the OTCBB for each quarter
      from
      fiscal 2005 through March 5, 2007 as reported by Bloomberg L.P. The quotations
      reflect inter-dealer bid prices, without retail mark-up, markdown or commission
      and may not represent actual transactions.





**Quarter
                Ended**
            **Quarterly**
              **High**
            **Quarterly**
              **Low**3/31/2005
            $1.87
            $1.566/30/2005
            $1.70
            $1.529/30/2005
            $1.67
            $1.4412/31/2005
            $1.62
            $1.373/31/2006
            $1.50
            $1.116/30/2006
            $1.35
            $1.259/30/2006
            $1.33
            $0.9712/31/2006
            $1.14
            $0.693/5/2007*
            $1.01
            $0.68





*March
      5,
      2007 high and low from 01/01/2007 to 03/05/2007.





**Holders
      of Record**





As
      of
      March 5, 2007, there were approximately 600 holders of record of SpaceDev common
      stock.





**Dividends**





We
      have
      never paid a cash dividend on our common stock. Payment of common stock
      dividends is at the discretion of the Board of Directors. The Board of Directors
      plans to retain earnings, if any, for operations and does not intend to pay
      common stock dividends in the foreseeable future. Our secured debt and our
      preferred stock outstanding currently restrict our ability to pay common stock
      dividends.





Table
          of Contents
 34


We
      accrued dividends on our Series C Cumulative Convertible Preferred Stock of
      approximately $170,000 and $171,000 for the years ended December 31, 2006 and
      2005, respectively. Approximately $114,000 of the 2005 accrued dividends was
      satisfied by the issuance of our common stock during the twelve-months ended
      December 31, 2005. Payment of future dividends on our Series C Cumulative
      Convertible Preferred Stock may be in cash or shares of common stock, provided
      that the payment of cash dividends on our Series C Cumulative Convertible
      Preferred Stock is prohibited in the event of our noncompliance with our
      obligations under the certificate of designations for Series D-1 Preferred
      Stock. On January 11, 2005, approximately $61,000 of accrued dividends were
      paid
      in the form of 39,589 shares of our common stock.  Also, on May 5, 2005,
      approximately $56,000 of accrued dividends were paid in the form of 36,559
      shares of our common stock, on September 28, 2005, approximately $58,000 of
      accrued dividends were paid in the form of 37,473 shares of our common stock.
      Approximately $184,000 of cash dividends were paid in 2006. On December 31,
      2006, accrued but unpaid dividends were approximately $43,000.





We
      accrued dividends on our Series D-1 Preferred Stock of approximately $443,000
      for the year ended December 31, 2006 and paid $332,000 of that amount in cash
      in
      2006. Shares of Series D-1 Preferred Stock were first issued by us on January
      13, 2006, and the first dividend payment date for the Series D Preferred Stock
      was April 1, 2006. We made voluntary amortization payments on our Series D-1
      Preferred Stock of approximately $535,000 for the year ended December 31, 2006.
      The voluntary amortization payments were similar to voluntary redemptions of
      preferred stock, i.e., we reduced the balance of our preferred stock by
      approximately $535,000 in 2006, which also reduced our dividend
      obligations.  The reduction (or amortization payment) was voluntary on our
      part; however, if we chose not to make the payments, we would have incurred
      an
      increase in the dividend rate pursuant to our Series D Preferred Stock
      agreement.




***ITEM
      6.*** ***MANAGEMENT'SDISCUSSION
      AND ANALYSIS OR PLAN OF
      OPERATION***







The
      following discussion should be read in conjunction with the Company's
      consolidated financial statements and the notes thereto and the other financial
      information appearing elsewhere in this document. Readers are also urged to
      carefully review and consider the various disclosures made by us which attempt
      to advise interested parties of the factors which affect our business, including
      without limitation the Risk Factors set forth herein.





**Overview**





SpaceDev,
      Inc., including our wholly-owned subsidiary, Starsys, Inc., which was acquired
      by us on January 31, 2006, (the "Company," "SpaceDev," "we," "us" or "our")
      is
      engaged in the conception, design, development, manufacture, integration, sale,
      and operation of space technology systems, subsystems, products and services,
      as
      well as the design, manufacture, and sale of mechanical and electromechanical
      subsystems and components for spacecraft. We are currently focused on the
      commercial and military development of low-cost small satellites and related
      subsystems, hybrid rocket propulsion for space and launch vehicles, subsystems
      that enable critical spacecraft functions such as pointing solar arrays and
      communication antennas and restraining, deploying and actuating moving
      spacecraft components.





During
      2006, approximately 89% of our net sales were generated from direct government
      contracts, and from government-related work through subcontracts with others,
      while the remaining 11% was generated from commercial contracts. In 2005,
      approximately 98% of our net sales were generated from direct government
      contracts and from government-related work through subcontracts with others,
      while the remaining 2% was generated from commercial contracts. The mix shift
      was primarily due to our January 2006 acquisition of Starsys. We will continue
      to seek both government and commercial business and anticipate that net sales
      from government sources will continue to represent in excess of 80% of our
      business' net sales for the next several years Currently, we are focusing on
      the
      domestic United States government market, which we believe is only about
      one-half of the global government market for our technology, products and
      services. Although we are interested in exploring international revenue and
      contract opportunities, we are restricted by export control regulations,
      including International Traffic in Arms Regulations, which may limit our ability
      to develop market opportunities outside the United States.





Table
          of Contents
 35


During
      2006, we submitted approximately 100 bids for government or commercial programs
      and continued our work with the United States Congress to identify directed
      funding for our programs.





**Financing**





New
      Revolving Credit Facility.





On
      September 29, 2006, we entered into a $5.0 million financing arrangement with
      Laurus Master Fund, Ltd. (“Laurus”). The financing is effected through a
      revolving note for up to $5.0 million, although the exact principal balance
      at
      any given time will depend on draws made by us on the Facility. We are allowed
      to borrow against the Facility under an investment formula based on accounts
      receivable at an advance rate equal to 90% of eligible receivables and the
      lesser of: (a) 50% of eligible inventory (calculated on the basis of the
      lower-of-cost-or-market, on a first-in-first-out basis); or, (b) $1.0 million,
      provided, however, that no more than $500,000 of such eligible inventory may
      be
      in the form of work-in-process inventory. The balance on this revolving credit
      facility at December 31, 2006 was approximately $805,000. The facility bears
      interest at a rate equal to prime plus 2% and is payable monthly. The rate
      will
      be increased or decreased on the date the Prime Rate is adjusted. Interest
      is
      due on the first business day of each month through maturity. The term of the
      facility is scheduled to end on September 29, 2009. Laurus received 310,009
      unregistered shares of our common stock valued at $350,000 at closing. The
      value
      of these shares was determined based on the $1.13 average trading price for
      the
      stock during the preceding ten (10) business days and the expense is being
      amortized daily over the first year of the note. We will issue additional
      restricted shares of our common stock worth, in the aggregate, $200,000 to
      Laurus on each anniversary date of the facility, if the facility remains in
      place. The pricing of these additional shares will be based on the applicable
      preceding ten (10) business day average trading price. The facility is not
      convertible into any class of our securities.





Laurus
      agreed that if and when it can resell the unregistered shares under Rule 144,
      its resale on any one day cannot exceed 10% of the daily trading volume. Laurus
      has piggyback registration rights subject to certain underwriters’ restrictions,
      but will not be entitled to demand registration of any of the shares received
      under the facility. In addition, Laurus is strictly prohibited from engaging
      in
      any short sales of our common stock during the term of the facility. The
      facility is a secured debt, collateralized by substantially all of our assets.
      The facility contains certain default provisions. In the event of a default
      by
      us, we will be required to pay an additional fee per month until the default
      is
      cured. Laurus has the option of accelerating the entire principal balance and
      requiring us to pay a premium in the event of an uncured default. The facility
      requires us to deposit all funds (other than certain refundable deposits) into
      a
      lockbox that will be swept on a daily basis to reduce any outstanding facility
      balance. Any funds in excess of any outstanding facility balance will be
      transferred to us on a daily basis.





Series
      D-1 Amortizing Convertible Perpetual Preferred Stock.





In
      January 2006, we entered into a securities purchase agreement, which we refer
      to
      as the 2006 purchase agreement, with a limited number of institutional
      accredited investors, led by Omicron Capital. On January 13, 2006, we issued
      and
      sold to these investors 5,150 shares of our Series D-1 Amortizing Convertible
      Perpetual Preferred Stock, par value $0.001 per share, which we refer to as
      Series D-1 Preferred Stock, for an aggregate purchase price of $5,150,000,
      or
      $1,000 per share. We also issued various warrants to these investors under
      the
      2006 purchase agreement.




Table
          of Contents
 36


Common
      Stock and Warrant Financing.





In
      October 2005, we entered into a securities purchase agreement with Laurus Master
      Fund, Ltd. pursuant to which we issued and sold 2,032,520 shares of our common
      stock to Laurus for an aggregate purchase price of $2,500,000 or $1.23 per
      share. The price per share represented 80% of the 20-day volume weighted average
      price of our common stock through October 28, 2005. We also issued to Laurus
      a
      warrant to purchase up to 450,000 shares at $1.93 per share. The warrant is
      exercisable from October 31, 2005 until October 31, 2010.





**Selection
      of Significant Contracts**





In
      June
      2002, Starsys was awarded a contract from Northrop Grumman Space Technology
      for
      the design, development, assembly, and test of two configurations of flat plate
      gimbal drive assemblies.  These gimbals are used to position six dish
      antennas and two nulling antenna systems for each of two spacecraft. 
Subsequent to this award, Northrop Grumman Space Technology modified this
      contract to include a third shipset bringing the total contract value to
      approximately $7.1 million.  In addition to eight flight unit deliveries
      per spacecraft, the program includes development and qualification
      hardware.  This contract was awarded as a firm fixed price contract with
      the final delivery scheduled for March 2007.  We acquired Starsys on
      January 31, 2006. Revenues generated form this contract from February 1, 2006
      through December 31, 2006 totaled approximately $2.9 million. We experienced
      significant cost overruns on this contract.  Prior to our merger with
      Starsys, the contract was modified to add an additional $1.7 million. 
After our merger with Starsys, we negotiated contract modifications in both
      the
      timing of payments and in the amount of additional contract consideration of
      up
      to $1.0 million based on the achievement of specific milestones. Of the
      additional possible $1.0 million, we achieved milestones entitling us to the
      majority, and possibly all, of the incentive payments, which will partially
      mitigate the impact of significant cost, scope and requirements changes and
      overruns.


.


In
      March
      2004, we were awarded a five-year, cost-plus-fixed fee indefinite
      delivery/indefinite quantity contract for up to $43,362,271 to conduct a
      microsatellite distributed sensing experiment (intended to design and build
      up
      to six responsive, affordable, high performance microsatellites to support
      national missile defense), an option for a laser communications experiment,
      and
      other microsatellite studies and experiments as required in support of the
      Advanced Systems Deputate of the Missile Defense Agency. The overall contract
      initially called for us to analyze, design, develop, fabricate, integrate,
      test,
      operate and support a networked cluster of three formation-flying boost phase
      and midcourse tracking microsatellites, with an option to design, develop,
      fabricate, integrate, test, operate and support a second cluster of three
      formation-flying microsatellites to be networked on-orbit with high speed laser
      communications technology. This overall contract is proceeding under a phased
      approach. The first phase, executed under Task Order I for approximately $1.1
      million, was awarded in April 2004, completed in September 2004, and resulted
      in
      a general mission and microsatellite design. The second phase, executed under
      Task Order II for approximately $8.3 million, was awarded in October 2004 and
      was originally expected to be completed by January 2006 but was extended at
      the
      request of the Missile Defense Agency with an increased funding of $1.5 million,
      and subsequently completed in March 2006. Task Order II resulted in a detailed
      mission and microsatellite design, which underwent a successful Critical Design
      Review in March 2006. Task Order III, the first of several task orders expected
      during the third phase was awarded to us in April 2006 for a total of
      approximately $1.5 million, which was later amended to approximately $2.5
      million and ran through June 2006. Task Order IV was awarded by the Missile
      Defense Agency in July 2006, with initial funding of approximately $4.0 million
      through November 2006. Task Order IV was subsequently amended to approximately
      $4.5 million and extended through June 15, 2007. We are currently negotiating
      with the Missile Defense Agency for additional funding under Task Order IV.
      We
      expect continued modifications to the current phase with additional task orders
      for additional funding throughout GFY 2007. Government contract funds will
      expire at the end of the current government fiscal year. It is uncertain whether
      additional funding by the Missile Defense Agency will be available. It is
      possible that another government agency may fund the program; however, there
      can
      be no assurance that funding will be available.





Table
          of Contents
 37


In
      addition to the three networked microsats under our second Task Order, the
      $43
      million contract also originally envisioned an option for a second cluster
      of
      three microsats using laser communication technology.  We were informed in
      2005 that the Missile Defense Agency had re-routed the laser communications
      experiment to another program and that they would not be exercising their option
      for the additional microsats at that time; however, the contract vehicle
      remained at $43 million and left open the opportunity for some other purchase
      to
      take its place. The
      IDIQ
      (indefinite delivery, indefinite quantity) nature of the contract allows for
      replenishment of funds by MDA within the same contract vehicle, as work is
      performed and we recognize revenue. We estimated that the second cluster would
      have represented approximately $10 million of the $43.3 million
      contract .
      It is
      uncertain whether the remaining unbilled contract backlog of approximately
      $28.1
      million will be available from MDA. It is possible that another government
      agency may fund part or all of the program after this year; however, there
      can
      be no assurance that funding will be available. (See Risk Factors: *“Some
      of our government contracts, including our large Missile Defense Agency
      contract, are staged and we cannot guarantee that all stages of the contracts
      will be awarded to us or fully funded”* and *“A
      substantial portion of our net sales are generated from government contracts,
      which makes us susceptible to the uncertainties inherent in the government
      budgeting process. In addition, many of our contracts can be terminated by
      the
      customer”* ).
      We
      recognized approximately $16.8 million in revenue under this contract from
      inception through December 31, 2006.





In
      January 2005, Starsys was awarded a firm fixed price contract from Raytheon
      in
      Goleta, California for the design, development, manufacture, assembly and test
      of the Aerosol Polarimetry Sensor (APS), Scan Mirror Motor/Encoder Assembly
      (SMMA). The APS instrument is slated to fly on the NASA Glory mission. The
      APS
      is also a prime candidate for a secondary payload on NPOESS. The SMMA consists
      of Starsys designed low ripple, precision brushless DC motor and optical encoder
      assembly. The program consists of a development unit, engineering unit,
      qualification / life test unit, and flight units. This contract was awarded
      as a
      cost plus fixed fee contract at a value of $2.5 million. In July 2006, the
      contract was modified to add approximately $2.5 million with incremental funding
      and extend to March 2009. Since our acquisition date of Starsys, revenues from
      February 1, 2006 through December 31, 2006 totaled approximately $2.0
      million.





In
      October 2005, Starsys was awarded a contract from General Dynamics C4 Systems
      to
      design and deliver an antenna pointing gimbal and control electronics for the
      GeoEye-1 program. The contract, valued at $2.0 million, was awarded and work
      has
      already begun on the antenna in anticipation of an on-time delivery to General
      Dynamics. The GeoEye-1 program is a next-generation, high-resolution commercial
      remote-sensing satellite scheduled for launch in 2007. The Starsys antenna
      control system is uniquely designed to operate by greatly reducing motion,
      to
      the GeoEye-1 spacecraft while pictures are being taken and data is
      simultaneously transmitted to earth ground stations, through incorporation
      of a
      low disturbance designed micro-stepping actuator and actuator drive electronics
      (Quiet Array Drive). Since our acquisition date of Starsys, revenues from
      February 1, 2006 through December 31, 2006 totaled approximately $1.26
      million.





In
      February 2006, we were awarded two deployable boom technology contracts for
      advance research and development of a self-deployed articulated boom for
      approximately $950,000 and a jack screw deployed boom for approximately $1.5
      million by the Air Force Research Laboratory (AFRL). We recognized
      approximately $833,000 in revenue under this contract from inception through
      December 31, 2006.





Table
          of Contents
 38


In
      June
      2006, we were awarded a firm fixed price contract from Lockheed Martin
      Commercial Space Systems for the design, and fabrication of the antenna pointing
      gimbals onboard the US Navy’s Mobile User Objective System. The initial award is
      for two flight shipsets and includes two standard A2100 5-meter antenna gimbal
      assemblies, four Ka-Band antenna gimbal assemblies and two 14-meter gimbal
      assemblies. Options are included for additional gimbals supporting three
      additional spacecraft. The contract will include the development and
      qualification of the Ka-Band and 14-meter gimbal designs in addition to delivery
      of standard gimbals and solar array deployment hinges Starsys has previously
      provided for the A-2100 bus. The contract value for the initial award was $1.8
      million; however, if all options are exercised, the total contract value would
      exceed $6.0 million. We recognized approximately $625,000 in revenue under
      this
      contract from inception through December 31, 2006.





In
      August
      2006, we were awarded a government firm fixed price contract to provide the
      solar array drive, antenna pointing actuators, and gimbal control electronic
      assemblies for the Lunar Reconnaissance Orbiter (LRO) program from NASA Goddard
      Space Flight Center and Swales Aerospace. The total contract value is in excess
      of $6.3 million.  The LRO mission is scheduled to launch in the fall of
      2008 as part of NASA's Lunar Precursor and Robotic Program.  The spacecraft
      requires two drive actuators to align the solar panels with the sun, and a
      two
      axis pointing mechanism to align the downlink antenna for communication with
      earth.  We are to provide these actuators for the spacecraft along with the
      electronics to control them. A total of seven actuators and five control
      electronics assemblies will be delivered under the contract.  We recognized
      approximately $1.8 million in revenue under this contract from inception through
      December 31, 2006.





In
      October 2006, we were awarded
      a $330,000 Phase I study contract from Benson Space Company to further the
      SpaceDev Dream Chaser TM spaceship program. The study will contribute to the on-going development of
      the
      spaceship and will result in space vehicle and rocket motor designs ready for
      Phase II vehicle fabrication and testing. The SpaceDev Dream ChaserTM spaceship
      is based on NASA’s design of the ten passenger orbital HL-20 Personnel Launch
      System, and will launch vertically and land horizontally. We recognized
      approximately $76,000 in revenue under this contract from inception through
      December 31, 2006.





In
      January 2007, in
      partnership with the University of Colorado Laboratory for Space Physics, we
      were awarded a $750,000 contract from the Missile Defense Agency to design
      and
      develop a non-sticking cover seal system for the Exo-atmospheric Kill Vehicle
      program, which is the kill vehicle component of the Ground Based Interceptor
      (the weapon element of the Ground-based Midcourse Defense System program).
      The
      contract was awarded under the Small Business Technology Transfer Program that
      provides research funding for partnerships between industry and non-profit
      research institutions. The program is scheduled to complete in 2008 and is
      an
      extension of a Phase 1 program completed in 2006.





In
      February 2007, we were awarded a $1.4 million cost reimbursable design and
      development subcontract with NASA’s Jet Propulsion Laboratory in support of the
      Mars Science Laboratory mission. We will develop and deliver electromechanical
      Descent Brake dampers. The contract period of performance is approximately
      18
      months. NASA’s Mars Science Laboratory mission will deliver an 1800 pound rover
      to the surface of Mars in 2010. Rather than the airbag landing system used
      by
      the Mars Exploration Rover mission, a “Skycrane” landing system will use a
      rocket-decelerated Descent Stage that will hover and gently lower the rover
      on a
      25 feet long bridle cord. A critical component of the “Skycrane” landing system
      is the Descent Brake that will lower the rover in less than seven seconds with
      a
      controlled speed profile that will provide a gentle touch-down on the Martian
      surface.





Table
          of Contents
 39


**Results
      of Operations**





*Year
      Ended December 31,* 2006
      -vs.- Year Ended December 31, 2005





*Net
      Sales*





During
      2006, we had net sales of approximately $32.6 million as compared to net sales
      of approximately $9.0 million for the same period in 2005, an increase of over
      250%.  Sales increased primarily due to our acquisition of Starsys on
      January 31, 2006, which generated revenues from February 1, 2006 through
      December 31, 2006 of approximately $21.4 million, excluding approximately
      $300,000 of inter-company sales.  Approximately $17.7 million, or 83%, of
      the Starsys sales were attributable to government and government-related work,
      with approximately $3.7 million, or 17%, of the Starsys sales being attributable
      to commercial contracts.  Net sales also increased due to revenues of
      approximately $11.1 million from our historic SpaceDev business, which consists
      of government contracts, including our contract with the Missile Defense Agency
      which generated revenues of approximately $8.3 million. During 2006, overall
      revenue from government and government-related work was approximately $28.9
      million and revenue from commercial customers was approximately $3.6
      million.  Our government customers include, but are not limited to, the
      Missile Defense Agency, the Air Force Research Laboratory, NASA, and other
      U.S.
      Department of Defense agencies.  Our government-related work customers
      include, but are not limited to, General Dynamics, Northrop Grumman, and
      Raytheon.  Commercial customers include Lockheed Martin and Sumitomo. 
Revenues during 2005 primarily represented approximately $6.8 million of work
      on
      the Missile Defense Agency contract. Small Business Innovation Research
      contracts with the Air Force Research Laboratory represented sales of
      approximately $1.4 million in 2005 while revenues from all other programs
      totaled approximately $800,000.





*Cost
      of Sales*





For
      the
      year ended December 31, 2006, cost of sales was approximately $25.7 million
      or
      79.0% of net sales, as compared to approximately $6.9 million, or 76.7% of
      net
      sales, during the same period in 2005.  Cost of sales consists of direct
      and allocated costs associated with individual contracts.  The increase in
      cost of sales and the decrease in margin were due to continued losses on certain
      fixed price government-related development contracts we inherited from our
      acquisition of Starsys, especially a Northrop Grumman Space Technology
      contract.  We are focusing our efforts on the successful completion of
      these contracts, as well as altering our bid and proposal processes related
      to
      fixed price contracts and migrating risk to cost reimbursable contracts.
 We are also continuing to focus efforts on managing our growth, including
      but not limited to, recruiting new talented engineers, developing and enhancing
      our project management skills, and creating or expanding systems to assist
      in
      the efficient and effective management of our projects.  In addition, the
      nature of Starsys' business we inherited as a result of the merger has
      proportionally higher levels of depreciation and amortization than the historic
      SpaceDev business and additional amortization of other intangible assets. As
      a
      result, depreciation and amortization (which is a component of cost of sales)
      increased to $983,000 in 2006 from $192,000 in 2005.


.


*Operating
      Expenses*





Operating
      expenses increased from approximately $1.8 million, or 19.9% of net sales,
      for
      the year ended December 31, 2005 to approximately $7.8 million, or 23.9% of
      net
      sales, for the same twelve months ended December 31, 2006. Operating expenses
      include general and administrative expenses, research and development costs
      and
      marketing and sales expenses.





Table
          of Contents
 40


·
            General
                and administrative expenses increased from approximately $1.1 million,
                or
                12.0% of net sales, for the year ended December 31, 2005 to approximately
                $5.3 million, or 16.3%, for the year ended December 31, 2006.  This
                increase is attributed mainly to the acquisition of Starsys’ general and
                administrative costs and the addition of our new chief executive
                officer.
                In addition to our new chief executive officer, we maintained two
                presidents and other key management personnel, whose
                expenses were charged to general and administrative expense.  The
                method of allocation in 2006 was different at Starsys, which also
                resulted
                in higher general and administrative costs, e.g., certain functions
                that
                we historically charged (at least partially) to cost of sales, like
                quality assurance and process and systems, was charged entirely to
                general
                and administrative expense at Starsys and consolidated accordingly.
                 In 2007, we will be altering the allocation method to be consistent
                companywide.  We have created a corporate business management group
                and we expect to recognize some cost saving and efficiencies as the
                companies consolidate and eliminate redundancies in certain general
                and
                administrative functions. We expect to incur approximately $500,000
                of
                expense in 2007 related to the relocation of our Colorado and North
                Carolina facilities.





·
            Research
                and development expenses increased to approximately $284,000, or
                0.9% of
                net sales, for the year ended December 31, 2006, from approximately
                $32,000, or 0.4% of net sales, during the same period in 2005.  The
                total dollar value increased by approximately $252,000, mainly due
                to the
                creation of the chief technology officer position at the end of 2005
                and
                an investment in certain new technologies.  With the addition of our
                new chief executive officer in December 2005, James W. Benson (formerly
                our chief executive officer) became our chief technology officer
                for
                three-quarters of 2006, with his expenses being charged to research
                and
                development.  Mr. Benson resigned at the end of September 2006 to
                found Benson Space Company but remained our consultant at a rate
                equivalent to his salary for the remainder of 2006, which costs were
                charged to general and administrative expenses.  We have not refilled
                the chief technology officer position.  Most of Mr. Benson’s expenses
                in 2005 were charged to marketing and sales, not research and development
                or general and administrative expense.Most
                of our scientific work is performed under contracts and therefore
                is
                accounted for as costs of sales, rather than as research and development
                      expense.





·
            Marketing
                and sales expenses increased to approximately $2.2 million, or 6.8%
                of net
                sales, for the year ended December 31, 2006, from approximately $674,000,
                or 7.5% of net sales, during the same period in 2005. The total dollar
                increase of approximately $1.5 million was mainly due to costs related
                to
                bidding a number of proposals, including approximately $800,000 for
                our
                NASA COTS proposal during 2006, as well as absorbing a larger marketing
                and sales organization as part of the merger with Starsys. Unfortunately,
                we did not win the COTS contract. With the addition of our new chief
                executive officer in December 2005, James Benson (formerly our chief
                executive officer) became our chief technology officer with most
                of his
                2006 expenses being charged to research and development. Most of
                Mr.
                Benson’s expenses in 2005 were charged to marketing and sales.





·
            Our
                stock option expense is based on a calculation using the minimum
                value
                method as prescribed by SFAS 123(R), otherwise known as the Black-Scholes
                method. Under this method, we used a risk-free interest rate at the
                date
                of grant, an expected volatility, an expected dividend yield, and
                an
                expected life of the options to determine the fair value of options
                granted. The risk-free interest rate was estimated at 4.0%, expected
                volatility ranged from 86.7% to 90.8% at the time all options were
                granted, the dividend yield was assumed to be zero, and the expected
                life
                of the options was assumed to be three years based on the average
                vesting
                period of options granted. The total expense for the year ended December
                31, 2006 was approximately $133,000 as compared to no expense during
                the
                same period in 2005, as we adopted SFAS 123(R) on January 1, 2006.
                All of
                the 2006 option expenses relate to options actually granted in 2006,
                as we
                fully vested all outstanding options in December 2005. To minimize
                SFAS
                123(R) stock option expense, we have reduced the number of stock
                options
                we would otherwise be granting.





Table
          of Contents
 41


Non-operating
      expense (income) consisted of amortization of deferred gain on the sale of
      our
      Poway headquarters building, other non-cash loan fees and expenses, and interest
      expense and interest income. Cash interest expense did not comprise a
      significant portion of non-operating expense during the year ended December
      31,
      2006 or 2005, although it might in 2007 if we continue to carry balances on
      the
      Laurus rev olving
      credit facility created in September. We experienced net non-operating income
      of
      approximately $20,000 and $191,000 for the years ended December 31, 2006 and
      2005, respectively.





·
            We
                expensed approximately $66,000 and $3,000 in interest for the years
                ended
                December 31, 2006 and 2005, respectively. The increase was due to
                borrowing under our new revolving credit facility that we entered
                into on
                September 29, 2006. We will continue to pay interest expense on certain
                capital leases and the revolving credit facility in
                2007.





·
            We
                recognized approximately $83,000 and $106,000 in interest income
                in 2006
                and 2005, respectively. The decrease was due to our use of cash in
                our
                acquisition of Starsys in January 2006; thereby, creating lower cash
                balances.





·
            We
                recognized approximately $117,000 of amortized deferred gain on the
                sale
                of our Poway headquarters building during each of the years ended
                December
                31, 2006 and 2005, and we will continue to amortize the remaining
                deferred
                gain of approximately $713,000 into non-operating income over the
                remainder of the lease of the building, which is scheduled to expire
                in
                2013.





·
            We
                recorded loan fees related to our revolving credit facility of
                approximately $115,000 and $29,000 for the years ended December 31,
                2006
                and 2005, respectively. The increase in expense was due to the issuance
                of
                310,009 shares of our common stock, valued at $350,000, to Laurus
                in
                September 2006 under the terms of the new revolving credit facility;
                we
                are amortizing this expense over the life of the credit facility.
                We will
                continue to expense the remaining $235,000 through September 2007.
                If the
                facility is still in place then, we must issue another $200,000 of
                shares
                to Laurus.





*Net
      Income* *(Loss)
      and EBITDA*





Net
      loss
      was approximately $ 952,000,
      or 2.9% of net sales, for the year ended December 31, 2006, compared to a net
      income of approximately $501,000, or 5.6% of net sales, for the year ended
      December 31, 2005 and a net loss of $3,027,054, or 61.9% of net sales, for
      the
      year ending December 31, 2004. During the year ended December 31, 2006, we
      had
      earnings before interest, taxes, depreciation and amortization and stock option
      expense, or EBITDA, of approximately $163,000, or 0.5% of net sales, compared
      to
      approximately $503,000, or 5.6% of net sales, for the year ended December 31,
      2005 and approximately $228,000, or 4.7% of net sales, for the year ending
      December 31, 2004.





The
      following table reconciles EBITDA to net income (loss) for the years ended
      December 31, 2006, 2005 and 2004:





Table
          of Contents
 42


***For
                  the twelve months ended***
              
              
              **December
                  31, 2006**
              
              
              December
                  31, 2005
              
              
              December
                  31, 2004(Audited
              )
              
              (Audited
              )
              
              (Audited
              )**Net
                  Income (Loss)**
              
              ***$***
              ***(952,372***
              ***)***
              *$*
              *501,264*
              
              *$*
              *(3,027,054*
              *)*Interest
                  Income
              
              
              ***(83,362***
              ***)***
              
              *(105,840*
              *)*
              
              *(19,497*
              *)*Cash
                  Interest Expense
              
              
              ***65,713***
              
              
              *2,873*
              
              
              *52,077*Non-Cash
                  Interest Expense
              
              
              ***114,600***
              
              
              *28,875*
              
              
              *3,254,430*Gain
                  on Building Sale
              
              
              ***(117,274***
              ***)***
              
              *(117,272*
              *)*
              
              *(117,272*
              *)*Stock
                  Option Expense
              
              
              ***133,380***
              
              
              *0*
              
              
              *0*Provision
                  for income taxes
              
              
              ***19,290***
              
              
              *1,600*
              
              
              *1,600*Depreciation
                  and Amortization
              
              
              ***982,860***
              
              
              *191,924*
              
              
              *83,531***EBITDA
                  ***
              
              ***$***
              ***162,835***
              
              *$*
              *503,424*
              
              *$*
              *227,815*


*
      Earnings Before Interest, Taxes, Depreciation, and Amortization.





EBITDA
      is
      a non-GAAP financial measure and should not be considered as an alternative
      to
      net income (as an indicator of operating performance) or as an alternative
      to
      cash flow (as a measure of liquidity or ability to service debt obligations).
      Other companies may use the same "EBITDA" phrase as we do, but define or
      calculate it differently than we do. We believe that EBITDA provides an
      important additional perspective on our operating results, our ability to
      service our long-term obligations, our ability to fund continuing growth, and
      our ability to continue as a going concern. Our management regularly evaluates
      our progress based on EBITDA. We showed three consecutive years of positive
      and
      growing revenue and three consecutive years of positive EBITDA.





The
      following charts illustrate our annual trend in total revenue as well as in
      EBITDA for the years ended December 31, 2004, 2005 and 2006.









Table
          of Contents
 43





Table
          of Contents
 44




**SpaceDev,
                  Inc. **and
                  Subsidiaries******Non-
                  GAAP Consolidated Statements of Operations - Supplemental
                  Schedule***Years
                  Ended December 31,*
              
              2006
              
              
              2005**GAAP
                  Operating Income/(Loss)**
              
              **$**
              **(953,405**
              **)**
              
              **-2.93**
              **%**
              
              $
              311,500
              
              
              3.46
              %FAS
                  123(R) stock -based compensation
              
              
              **133,379**
              
              
              **0.58**
              **%**
              
              
              -
              
              
              0.00
              %**Non-GAAP
                  Operating Income/(Loss)**
              
              
              **(820,026**
              **)**
              
              **-2.52**
              **%**
              
              
              311,500
              
              
              3.46
              %**Non-Operating
                  Income/(Expense)**Interest
                  income
              
              
              **83,362**
              
              
              **0.26**
              **%**
              
              
              105,840
              
              
              1.18
              %Interest
                  expense
              
              
              **(65,713**
              **)**
              
              **-0.20**
              **%**
              
              
              (2,873
              )
              
              -0.03
              %Gain
                  on building sale
              
              
              **117,274**
              
              
              **0.36**
              **%**
              
              
              117,272
              
              
              1.30
              %Non-Cash
                  loan fee
              
              
              **(114,600**
              **)**
              
              **-0.35**
              **%**
              
              
              (28,875
              )
              
              -0.32
              %**Total
                  Non-Operating Income**
              
              
              **20,323**
              
              
              **0.06**
              **%**
              
              
              191,364
              
              
              2.13
              %**Non-GAAP
                  Net Income/(Loss) Before Taxes**
              
              **$**
              **(799,703**
              **)**
              
              **-3.51**
              **%**
              
              $
              502,864
              
              
              8.46
              %Income
                  tax provision
              
              
              **19,290**
              
              
              **0.06**
              **%**
              
              
              1,600
              
              
              0.02
              %**Non-GAAP
                  Net Income/(Loss)**
              
              **$**
              **(818,993**
              **)**
              
              **-3.59**
              **%**
              
              $
              501,264
              
              
              8.44
              %**Non-GAAP
                  Net Income/(Loss)**
              
              
              **(818,993**
              **)**
              
              
              
              
              
              501,264Less
                  Preferred Dividend Payments
              
              
              **(610,287**
              **)**
              
              
              
              
              
              (170,956
              )**Adjusted
                  Net Income/(Loss) for EPS Calculation**
              
              
              **(1,429,280**
              **)**
              
              
              
              
              
              330,308**Non-GAAP
                  Net Income/(Loss) Per Share**
              
              **$**
              **(0.05**
              **)**
              
              
              
              
              $
              0.01Weighted-Average
                  Shares Outstanding
              
              
              **28,666,059**
              
              
              
              
              
              
              22,270,997**Fully
                  Diluted Non-GAAP Net Income/(Loss) Per Share:**
              
              **$**
              **(0.05**
              **)**
              
              
              
              
              $
              0.01Fully
                Diluted Weighted-Average Shares
                Outstanding
              
              
              **28,666,059**
              
              
              
              
              
              
              
              
              
              29,631,118


We
      believe that evaluating our ongoing operating results with these non-GAAP
      measurements may be useful as a supplement to our standard GAAP financial
      measurement presentation. Accordingly, we have chosen certain non-GAAP financial
      information to evaluate our ongoing operations and for internal planning and
      forecasting purposes. We believe that non-GAAP financial measures should be
      considered in addition to, and not a substitute for, financial information
      prepared in accordance with GAAP. We present such non-GAAP financial measures
      in
      reporting our financial results to provide additional and supplemental
      disclosure to evaluate operating results. Whenever we use a non-GAAP financial
      measurement, we provide a reconciliation of the non-GAAP financial measure
      to
      the most closely applicable GAAP financial measurement.





**Liquidity
      and Capital Resources**





Net decrease in cash and cash equivalents during the twelve months ended
      December 31, 2006 was approximately $4.3 million compared to a net increase
      of
      approximately $681,000 for the same twelve-month period in 2005.  Net cash
      used in operating activities totaled approximately $2.0 million for the year
      ended December 31, 2006, compared to approximately $397,000 provided by
      operating activities during 2005.  The decline in cash from operating
      activities was primarily due to the need to use our cash resources to pay
      accounts payable and fund accounts receivable, which we assumed upon the
      acquisition of Starsys.





Table
          of Contents
 45


Net cash used in investing activities totaled approximately $2.8 million for
      the
      year ended December 31, 2006, compared to approximately $2.7 million used in
      investing activities during the same twelve-month period in 2005. The cash
      used
      in investing activities is primarily due to $1.4 million of acquisition costs
      in
      connection with our acquisition of Starsys, as well as a $1.4 million increase
      in the purchases of fixed assets. We loaned $1.4 million to Starsys during
      the
      third quarter of 2005, which affected our 2005 figure, and then received no
      corresponding repayment benefit in 2006 because we acquired Starsys in 2006
      and
      forgave the loan.





Net cash provided by financing activities totaled approximately $500,000 for
      the
      year ended December 31, 2006, compared to the approximately $3.0 million
      provided by financing activities during 2005.  This is primarily
      attributable to the sale of our Series D-1 Preferred Stock in January 2006,
      which was then used to fund the merger with Starsys and pay off secured debt
      and
      pay preferred stock dividends; offset in part by our new revolving credit
      facility that we opened in September 2006.





Our cash, cash reserves, and cash available for investment declined to
      approximately $1.4 million at December 31, 2006, compared to approximately
      $5.7
      million December 31, 2005.  The decrease was attributable to cash used in
      the acquisition of Starsys and the financing of Starsys' accounts receivable
      and
      payable.  Cash plus accounts receivable remained the same from
      approximately $7.0 million at December 31, 2005 to approximately $7.0 million
      at
      December 31, 2006.





Our
      backlog of funded and non-funded business was approximately $20 million at
      December 31, 2006, compared to approximately $29 million at December 31,
      2005.  We were informed in September 2005 that the Missile Defense Agency
      had re-routed the laser communications experiment to another program and that
      they would not be exercising their option for a second cluster; however, the
      Missile Defense Agency also informed us of several other opportunities that
      might replace the laser communications experiment.  We cannot be assured of
      any new business from the Missile Defense Agency and t he
      Missile Defense Agency has indicated that it may reduce or eliminate funding
      for
      the program in GFY 2008 due to government budget allocations and
      reductions.  We are currently negotiating with the Missile Defense Agency
      to extend funding on Task Order IV, which is part of the fabrication,
      integration and test phase of the program.  The Missile Defense Agency
      recently extended the end time of Task Order IV from March 1, 2007 to June
      15,
      2007.  We are currently working with the Missile Defense Agency on the
      level of funding and scope of work to be performed during that period of
      time.  The Missile Defense Agency is also considering extending the period
      of performance beyond June 15, 2007.  We are also working with other
      government agencies who may be interested in our microsat program both in
      addition to and possibly in place of the Missile Defense Agency program, since
      there can be no assurances that our discussions with the Missile Defense Agency
      will be fruitful or that any additional task orders will be awarded in the
      future or that task order funding will be available.  As a result
      of this uncertainty, we reduced our backlog by approximately $10 million, which
      was offset by a corresponding increase in backlog from our Starsys product
      lines
      and projects.  The Missile Defense Agency contract is an IDIQ contract,
      meaning it is an indefinite delivery, indefinite quantity contract which can
      be
      re-funded up to the $43 million ceiling with other microsatellites or new
      business without further signature authority for the five year period of the
      contract.  Although the Missile Defense Agency contract was awarded to us,
      there can be no assurance that the contract will be continued through all
      phases, and, if continued, that it will generate the amounts
      anticipated.





Table
          of Contents
 46


In September 2006, we entered into a new revolving financing arrangement with
      Laurus.  The financing is effected through a revolving note for up to $5.0
      million, although the exact principal balance at any given time will depend
      on
      draws made by us on the facility.  We are allowed to borrow against the
      facility under an investment formula based on accounts receivable (See
“Financing:  New Revolving Credit Facility” above).  The balance on
      this revolving credit facility at December 31, 2006 was approximately $805,000.
       The facility is not convertible into any class of our securities. 
The facility is a secured debt, collateralized by substantially all of our
      assets. The facility contains certain default provisions.  We are utilizing
      this facility to support fluctuations in our cash needs.





In January 2006, we entered into a securities purchase agreement, which we
      refer
      to as the 2006 purchase agreement, with a limited number of institutional
      accredited investors, led by Omicron Capital.  We issued and sold to these
      investors 5,150 shares of our Series D-1 Amortizing Convertible Perpetual
      Preferred Stock, par value $0.001 per share, which we refer to as Series D-1
      Preferred Stock, for an aggregate purchase price of $5,150,000, or $1,000 per
      share.  We also issued various warrants to these investors under the 2006
      purchase agreement.





In October 2005, we entered into a securities purchase agreement with Laurus
      pursuant to which we issued and sold 2,032,520 shares of our common stock to
      Laurus for an aggregate purchase price of $2,500,000 or $1.23 per share. 
The price per share represented 80% of the 20-day volume weighted average price
      of our common stock through October 28, 2005. We also issued to Laurus a warrant
      to purchase up to 450,000 shares at $1.93 per share.  The warrant is
      exercisable from October 31, 2005 until October 31, 2010.





At
      December 31, 2006, we had federal and state tax net operating loss and capital
      loss carryforwards (“NOL”) of approximately $10,096,000 and $9,163,000
      respectively.  These amounts include acquired federal and state NOL’s for
      Starsys of approximately $3,667,000 and $6,430,000 respectively, at December
      31,
      2006.  The federal tax loss carryforwards will begin to expire in 2019 and
      2011, respectively, unless previously utilized.




**Critical
      Accounting Standards**





Due
      to
      the acquisition of Starsys, our revenues transitioned in 2006 from being
      primarily cost plus fixed fee contracts, where revenues are recognized as costs
      are incurred and services are performed, to a combination of cost plus fixed
      fee
      contracts and fixed-price contracts, where revenues are recognized using the
      percentage-of-completion method of contract accounting based on the ratio of
      total costs incurred to total estimated costs. Losses on contracts are
      recognized when they become known and reasonably estima ted
      (see
      the Notes to our Consolidated Financial Statements). Actual results of contracts
      may differ from management's estimates and such differences could be material
      to
      the consolidated financial statements. In addition, when the total value of
      a
      contract becomes uncertain (such as when a contract modification to reflect
      cost
      overruns is being negotiated), we may be unable to report further revenues
      on
      the contract under the percentage-of-completion method until the uncertainty
      is
      resolved. This occurred as of the end of the third quarter of 2006 with regard
      to the Northrop Grumman Space Technology contract, but as of December 31, 2006
      the uncertainty was sufficiently resolved to enable us to resume reporting
      under
      this method.





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





Table
          of Contents
 47


In
      October 1995, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards (SFAS) No. 123, *Accounting
      for Stock-Based Compensation.* We
      adopted SFAS No. 123 in 1997. Through December 31, 2005, we elected to measure
      compensation expense for our stock-based employee compensation plans using
      the
      intrinsic value method prescribed by APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* and
      provided pro forma disclosures as if the fair value based method prescribed
      in
      SFAS No. 123 had been utilized. (See Note 7 to our Consolidated Financial
      Statements.)





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





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
      Payment* (SFAS
      123(R)), which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS
      123(R) requires all share-based payments to employees, including grants and
      vesting of employee stock options beginning January 1, 2006, to be recognized
      in
      the financial statements based on their fair values. In addition, the adoption
      of SFAS 123(R) requires additional accounting related to the income tax effects
      and additional disclosure regarding the cash flow effects resulting from
      share-based payment arrangements. SFAS 123(R) became effective January 1, 2006
      for calendar year companies. Accordingly, we implemented the revised standard
      in
      the first quarter of 2006. (See Note 7 to our Consolidated Financial Statements
      for additional information.)





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





**Recent
      Accounting Pronouncements** ****





During
      2006 the Financial Accounting Standards Board (FASB) issued FASB
      Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes* (FIN
      48). This guidance is intended to provide increased consistency in the
      application of FASB Statement No. 109, *Accounting
      for Income Taxes* ,
      by
      providing guidance with regard to the recognition and measurement of uncertain
      tax positions, the accrual of interest and penalties, and increased disclosure
      requirements. In particular, this interpretation requires uncertain tax
      positions to be recognized only if they are “more likely than not” to be upheld
      based on their technical merits. The measurement of the uncertain tax position
      will be based on the largest benefit amount that is more likely than not
      (determined on a cumulative probability basis) to be realized upon settlement.
      Any resulting cumulative effect of applying the provisions of FIN 48 upon
      adoption will be reported as an adjustment to the beginning balance of retained
      earnings (deficit) in the period of adoption. For us, this interpretation is
      effective beginning January 1, 2007.





While
      we
      have historically used the “more likely than not” threshold for recognizing our
      uncertain tax positions, we have not used the concept of cumulative probability
      to measure the uncertain tax positions. However, based on an evaluation of
      the
      Company’s tax positions using the new measurement criteria, this interpretation
      is currently not expected to have a material impact on the Company’s financial
      condition or results of operations.





Table
          of Contents
 48


The
      FASB
      also issued FASB Statement No. 157, *Fair
      Value Measurements,* during
      2006. This statement defines fair value as the price that would be received
      to
      sell an asset or paid to transfer a liability in an orderly transaction between
      market participants at the measurement date. It provides a framework for
      measuring fair value and requires additional disclosures about fair value
      measurements. This statement applies only to fair value measurements already
      required or permitted by other statements; it does not impose additional fair
      value measurements. This statement is effective for fair value measurements
      beginning in fiscal years beginning after November 15, 2007. Currently, we
      do
      not expect this statement to have a material impact on our financial condition
      or results of operations.







***ITEM
      7*** **.
      FINANCIALSTATEMENTS**







Financial
      Statements are attached at the end of this report.







***ITEM
      8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE***







None.







***ITEM
      8A. CONTROLS AND PROCEDURES***







Mark
      N.
      Sirangelo, our chief executive officer, and Richard B. Slansky, our chief
      financial officer, after evaluating the effectiveness of our disclosure controls
      and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities
      Exchange Act of 1934, as amended) have concluded that, as of December 31, 2006,
      our disclosure controls and procedures are effective.







***ITEM
      8B. OTHER INFORMATION***






None.


Table
          of Contents
 49


**PART
      III**







***ITEM
      9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
      PERSONS*** **AND CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE
      ACT**







The
      following are the current directors and executive officers of SpaceDev and
      their
      background and ages as of March
      5,
      2007.


**Name**
              **Age**
              **Title**Mark
                  N. Sirangelo
              46
              Chairman
                  of the Board and Chief Executive OfficerRichard
                  B. Slansky
              49
              President,
                  Chief Financial Officer, Corporate Secretary and
                  DirectorScott
                  Tibbitts
              49
              Managing
                  Director and DirectorJames
                  W. Benson
              61
              DirectorCurt
                  Dean Blake(1)
              49
              DirectorGeneral
                  Howell M. Estes, III (USAF Retired)(1)
              65
              DirectorWesley
                  T. Huntress(1)
              64
              DirectorScott
                  McClendon(1)
              67
              DirectorRobert
                  S. Walker(1)
              64
              Director


(1)
            Denotes
                Independent Director





*Mark
      N. Sirangelo,* until he
      was appointed our Vice Chairman and chief executive officer in December 2005,
      was the managing member and chief executive officer of The Quanstar Group,
      LLC
      from December 2003 until November 2005 and the managing member of QS Advisors,
      LLC from February 1998 to December 2005. Mr. Sirangelo became our Chairman
      in
      September 2006 upon the resignation of James W. Benson. QS Advisors and Quanstar
      are strategic and business advisors and we were a client of them. Mr. Sirangelo
      actively participated in the development in a number of early-stage companies
      in
      aerospace, technical, scientific, and other industries. His work at Quanstar
      also included hands-on involvement with technology commercialization transfer
      for university and government laboratories. From 2001 until 2003, Mr. Sirangelo
      also served as a senior officer of Natexis Bleichroeder, Inc., an international
      investment banking firm. Mr. Sirangelo has a bachelor's degree in science,
      a
      master's degree in business, and juris doctorate, all from Seton Hall
      University. Mr. Sirangelo is a director for the National Center for Missing
      and
      Exploited Children in addition to serving as a director and treasurer of the
      International Center for Missing and Exploited Children, and is a director
      of
      Adam Aircraft Industries.





*Richard
      B. Slansky* is
      currently our president, chief financial officer, director, and corporate
      secretary. He joined us in February 2003 as chief financial officer and
      corporate secretary. In November 2004, Mr. Slansky was appointed as president
      and director. Mr. Slansky served as interim chief executive officer, interim
      chief financial officer, and director for Quick Strike Resources, Inc., an
      IT
      training, services, and consulting firm, from July 2002 to February 2003. From
      May 2000 to July 2002, Mr. Slansky served as chief financial officer, vice
      president of finance, administration and operations, and corporate secretary
      for
      Path 1 Network Technologies Inc., a public company focused on merging broadcast
      and cable quality video transport with IP networks. Mr. Slansky earned a
      bachelor's degree in economics and science from the University of Pennsylvania's
      Wharton School of Business and a master's degree in business administration
      in
      finance and accounting from the University of Arizona.




Table
          of Contents
 50


*Scott
      Tibbitts* was
      appointed our managing director and a director at the closing of the Starsys
      merger on January 31, 2006. Mr. Tibbitts co-founded Starsys Research Corporation
      in 1988 and has served as president, chief executive officer, and a member
      of
      the Board of Directors from 1988 until May 2005; and from May 2005 to January
      2006 served as chief executive officer and a member of the Board of Directors.
      Mr. Tibbitts has a bachelor's degree in chemical engineering from the University
      of Wisconsin.




*James
      W. Benson* is
      our
      founder and served as our Chairman of the Board from October 1997 until
      September 2006. Mr. Benson also served as our chief executive officer from
      October 1997 until December 2005, at which time he was succeeded by Mark N.
      Sirangelo in such position, and became our chief technology officer. In
      September 2006, Mr. Benson resigned from SpaceDev to found Benson Space Company,
      but remained a member of our Board or Directors. In 1984, Mr. Benson founded
      Compusearch Corporation (later renamed Compusearch Software Systems) in McLean,
      Virginia, which was engaged in the development of software algorithms and
      applications for personal computers and networked servers to create full text
      indexes of government procurement regulations and to provide instant full text
      searches for any word or phrase. In 1989, Mr. Benson started the award-winning
      ImageFast Software Systems, which later merged with Compusearch. In 1995, Mr.
      Benson sold Compusearch and ImageFast, and retired at age fifty. Mr. Benson
      started SpaceDev, Inc., a Nevada corporation, which was acquired by Pegasus
      Development Corp, a Colorado corporation, in October of 1997. Mr. Benson
      acquired a controlling ownership in Pegasus and later changed its name to
      SpaceDev, Inc. Mr. Benson holds a bachelor's degree in Geology from the
      University of Missouri. He founded the non-profit Space Development Institute,
      and introduced the $5,000 Benson Prize for Amateur Discovery of Near Earth
      Objects. He is also Vice Chairman and private sector representative on NASA's
      national Space Grant Review Panel, and is a member of the American Society
      of
      Civil Engineers subcommittee on Near Earth Object Impact Prevention and
      Mitigation.




*Curt
      Dean Blake* was
      appointed to our Board of Directors as an independent director in September
      2000. He serves as Chairman of our Audit Committee and is a member of our
      Compensation Committee. In 2003 Mr. Blake formed, and currently remains the
      chief executive officer of, GotVoice, Inc., a startup company in the voicemail
      consolidation and messaging business. From 1999 to 2002, Mr. Blake provided
      consulting services to various technology companies, including Apex Digital,
      Inc. and SceneIt.com. Mr. Blake has a master's degree and juris doctorate from
      the University of Washington.




*General
      Howell M. Estes, III (USAF Retired)* was
      appointed to our Board of Directors as an independent director in April 2001,
      is
      Chairman of our Nominating and Corporate Governance Committee and is a member
      of
      our Compensation Committee. General Estes retired from the United States Air
      Force in 1998 after serving for 33 years. At that time he was the
      Commander-in-Chief of the North American Aerospace Defense Command and the
      United States Space Command, and the Commander of the Air Force Space Command
      headquartered at Peterson Air Force Base, Colorado. In addition to a bachelor
      of
      science degree from the Air Force Academy, he holds a master of arts degree
      in
      public administration from Auburn University and is a graduate of the Program
      for Senior Managers in Government at Harvard's J.F.K. School of Government.
      Since 1998 General Estes has been the president of, Howell Estes &
Associates, Inc., a consulting firm to chief executive officers, presidents
      and
      general managers of aerospace and telecommunications companies worldwide. He
      serves as vice Chairman of the Board of Trustees at The Aerospace Corporation.
      He served as a consultant to the Defense Science Board Task Force on Space
      Superiority and more recently as a commissioner on the U.S. Congressional
      Commission to Assess United States National Security Space Management and
      Organization, also known as the Rumsfeld Commission.




Table
          of Contents
 51


*Wesley
      T. Huntress* was
      appointed to our Board of Directors as an independent director in June 1999,
      and
      is a member of our Audit Committee and Nominating and Corporate Governance
      Committee. Since 1998, Dr. Huntress has been the director of the Geophysical
      Laboratory at the Carnegie Institution of Washington in Washington, D.C., where
      he leads an interdisciplinary group of scientists in the fields of high-pressure
      science, astrobiology, petrology and biogeochemistry. From October 1993 to
      September 1998, Dr. Huntress served as the associate administrator for Space
      Science at NASA where he was responsible for NASA's programs in astrophysics,
      planetary exploration, and space physics. Dr. Huntress received his bachelor's
      degree in chemistry from Brown University, and his doctorate in chemical physics
      from Stanford. He became a permanent research scientist at Jet Propulsion
      Laboratory, or JPL, in 1969. At JPL Dr. Huntress served as co-investigator
      for
      the ion mass spectrometer experiment in the Giotto Halley's Comet mission,
      and
      as an interdisciplinary scientist for the Upper Atmosphere Research Satellite
      and Cassini missions. He also assumed a number of line and research program
      management assignments while at JPL, and spent a year as a visiting professor
      in
      the Department of Planetary Science and Geophysics at Caltech.




*Scott
      McClendon* was
      appointed to our Board of Directors as an independent director in July 2002.
      He
      is currently Chairman of our Compensation Committee and a member of our Audit
      Committee. Mr. McClendon is currently acting president as well as a member
      of
      the Board of Directors for Overland Storage, Inc., a public data storage
      company, where he is also the Chairman of the Board. He became the Chairman
      of
      the Board after serving as president and chief executive officer from October
      1991 to March 2001. In addition to SpaceDev and Overland Storage, Mr. McClendon
      is currently serving on the Board of Directors of Procera Networks, Inc., a
      global provider of intelligent network traffic identification, control, and
      service management infrastructure equipment. Mr. McClendon received a bachelor's
      degree in electrical engineering, and a master's degree in electrical
      engineering from Stanford University School of Engineering.




*Robert
      S. Walker* was
      appointed to our Board of Directors as an independent director in April 2001.
      He
      is currently a member of our Nominating and Corporate Governance Committee.
      Mr.
      Walker has acted as Chairman of Wexler & Walker Public Policy Associates in
      Washington, D.C. since January 1997. Mr. Walker was a member of the U.S. House
      of Representatives from 1977-1997, during which time he served as Chairman
      of
      the House Science Committee, Vice Chairman of the Budget Committee, and
      participated in House Republican leadership activities. Mr. Walker was the
      first
      sitting member of the U.S. House of Representatives to be awarded NASA's highest
      honor, the Distinguished Service Medal. Mr. Walker was on the Board of Directors
      of The Aerospace Corporation, from March 1997 to November 2005. Mr. Walker
      became Chairman of the Board of the Space Foundation in January
      2006.




**Committees
      Of The Board Of Directors** ****





*Audit
      Committee.* We
      have a
      standing Audit Committee comprised of Messrs. Blake (Chairman), McClendon and
      Dr. Huntress, all of whom are independent within the meaning of the listing
      standards of The Nasdaq Stock Market and Securities Exchange Act Rule 10A-3.
      Mr.
      Blake is an Audit Committee financial expert, as defined by SEC regulations.
      On
      April 19, 2002, the Board of Directors adopted and approved a charter for the
      Audit Committee, which is attached as Appendix B to our Definitive Proxy
      Statement filed July 7, 2004. The primary function of the Audit Committee is
      to
      assist the Board of Directors in fulfilling its oversight responsibilities
      by
      reviewing the financial information that will be provided to the stockholders
      and others, the preparation of our internal financial statements, and our audit
      and financial reporting process, including internal control over financial
      reporting. In addition, our Audit Committee is responsible for maintaining
      free
      and open lines of communication among the Committee, the independent auditors
      and management. Our Audit Committee consults with our management and independent
      auditors prior to the presentation of financial statements to stockholders
      and,
      as appropriate, initiates inquiries into various aspects of our financial
      affairs. The Committee is also responsible for considering, appointing, and
      establishing fee arrangements with our independent auditors and, if necessary,
      dismissing them. It is not responsible for preparing our financial statements
      or
      for planning or conducting the audits. Our Audit Committee took action four
      (4)
      times during the last fiscal year, each time at a regular meeting attended
      by a
      quorum of the members of the Committee either personally or
      telephonically.


Table
          of Contents
 52





*Compensation
      Committee.* Our
      Compensation Committee is comprised of Messrs. McClendon (Chairman), Blake
      and
      General Estes. Each member of the Compensation Committee is independent within
      the meaning of the listing standards for The Nasdaq Stock Market and SEC rules.
      The Committee is required to maintain a minimum of three (3) members. The
      Compensation Committee is responsible for: (a) determining or recommending
      to
      our Board of Directors for determination the compensation and benefits of all
      of
      our executive officers; (b) reviewing our compensation and benefit plans to
      ensure that they meet corporate objectives; (c) administering our equity
      compensation plans; and (d) such other matters as are specifically delegated
      to
      the Compensation Committee by our Board of Directors from time to time or which
      are otherwise included in the Committee's charter, which is available via our
      website at www.spacedev.com. Our Compensation Committee took action one time
      during the last fiscal year, at a regular meeting attended by a quorum of the
      members of the Committee either personally or telephonically.





*Nominating
      and Corporate Governance Committee.* Our
      Nominating and Corporate Governance Committee is comprised of General Estes
      (Chairman), Dr. Huntress and Mr. Walker. Each member of the Nominating and
      Corporate Governance Committee is independent within the meaning of the listing
      standards for The Nasdaq Stock Market and SEC rules. The Committee is required
      to maintain a minimum of three (3) members. Our Nominating and Corporate
      Governance Committee took action one time during the last fiscal year, at a
      regular meeting attended by a quorum of the members of the Committee either
      personally or telephonically.





The
      Nominating and Corporate Governance Committee has the responsibility to
      identify, evaluate, recruit and recommend qualified candidates to our Board
      of
      Directors for nomination or election. Each of the director nominees included
      in
      our proxy statements is recommended by the Nominating and Corporate Governance
      Committee. In addition, it is the responsibility of the Committee to make
      recommendations to the Board of Directors regarding the size and composition
      of
      the Board of Directors, Committee structures and makeup, monitor our performance
      in meeting our obligations of fairness in internal and external matters and
      our
      principles of corporate governance, and such other matters that are specifically
      delegated to the Committee by our Board of Directors from time to time or which
      are otherwise included in the Committee's charter, which is available via our
      website at www.spacedev.com.





The
      Board
      of Directors has an objective that its membership be composed of experienced
      and
      dedicated individuals with diversity of backgrounds, perspectives, and skills
      relevant to our business. The Nominating and Corporate Governance Committee
      selects candidates for director based on their character, judgment, diversity
      of
      experience relevant to our business, business acumen, and ability to act on
      behalf of all stockholders based on standards outlined in its written charter.
      Each director nominee is selected by the Nominating and Corporate Governance
      Committee based on his/her experience in management or accounting and finance,
      or industry and technology knowledge, personal and professional ethics, and
      the
      willingness and ability to devote sufficient time to effectively carry out
      his/her duties as a director.





In
      2006,
      we reduced the size of our Board from 11 to 9 in order to maintain a majority
      of
      independent directors within the meaning of the listing standards for The Nasdaq
      Stock Market and SEC rules.  We are seeking additional outside directors
      who qualify as “independent” directors under the rules and may, in the future,
      increase the size of our Board of Directors.


Table
          of Contents
 53





Any
      shareholder who desires to recommend a nominee for director must submit a
      letter, addressed to the Secretary, SpaceDev, Inc., 13855 Stowe Drive, Poway,
      California 92064, which is clearly identified as a "Director Nominee
      Recommendation." All recommendation letters must identify the author as a
      shareholder and provide a brief summary of the candidate's qualifications,
      as
      well as contact information for both the candidate and the shareholder, to
      enable the Committee to contact the nominee for additional information to
      evaluate the person's qualifications against established criteria. Any
      shareholder nominee will be required to meet the criteria established by the
      Committee and will be interviewed by at least one member of the Committee.
      If
      the nominee is found to be eligible during the initial interview, the nominee
      will then be invited to meet with the full Committee or the Board of Directors
      for further evaluation. The Committee will consider all proposed nominees whose
      names are submitted in accordance with the above-stated requirements. We have
      never received a shareholder nominee for director, but if we do we would
      evaluate him or her based on the same standards used for other
      candidates.





Our
      Board
      of Directors took action ten (10) times during the last fiscal year, with eight
      (8) being at regular or special meetings attended by the members of the Board
      either personally or telephonically.  There were two (2) unanimous written
      consents in 2006. Each current director attended, in 2006, at least 75% of
      the
      Board of Directors meetings, and the Committee meetings of which he was a
      member.





**Section
      16 Beneficial Ownership Reporting Compliance**





Based
      upon a review of the Forms 3 and 4 furnished to us during 2006, each of the
      Directors and/or executive officers timely filed any required initial Form
      3 and
      Form 4 under Section 16(a) of the Securities Exchange Act of 1934 during 2006
      with the following exceptions: James W. Benson on September 11, 2006 and
      November 6, 2006; Susan C. Benson on January 11, 2006 and January 12, 2006;
      Robert Walker on June 2, 2006 and December 18, 2006; Richard B. Slansky on
      June
      2, 2006; Randall K. Simpson on June 2, 2006 and December 6, 2006; Wesley
      Huntress on June 2, 2006 and September 11, 2006; Howell Estes on June 20, 2006
      and August 29, 2006; Robert Vacek on August 29, 2006; Frank Macklin on August
      29, 2006 and December 6, 2006; and Curt Blake on August 29, 2006 and December
      12, 2006.





**Code
      of Ethics Disclosure**





Our
      Board
      of Directors adopted a Code of Ethics and Business Conduct applicable to the
      members of the Board of Directors and our officers. Our chief executive officer,
      chief financial officer and other senior officers, specifically are subject
      to
      the Code. A copy of the Code may be obtained, at no cost, by contacting Richard
      B. Slansky, Corporate Secretary.  A copy of the Code of Ethics is also
      attached as Exhibit 10.15 to our Form 10-KSB dated March 28, 2003.







***ITEM
      10.***  ***EXECUTIVE
      COMPENSATION***




**Executive
      Officer Compensation**





Total
      compensation paid to our "named executive officers" for the past three fiscal
      years is set forth below. The named executive officers consist of each person
      who was our principal executive officer at any time in 2006, our two most highly
      compensated executive officers other than the PEO(s) who were serving as
      executive officers on December 31, 2006, and up to two additional individuals
      who would have been within the two-other-most-highly compensated but were not
      serving as executive officers on December 31, 2006.


Table
          of Contents
 54


**Summary
      Compensation Table**




**Name
                    and principal position**
                
                **Year**
                
                
                **Salary
                    ($**
                **)**
                
                **Bonus
                    ($**
                **)**
                
                **Stock
                    awards ($**
                **)**
                
                **Option
                    awards ($**
                **)**
                
                **Non-equity
                    incentive plan compensation ($)**
                
                
                **Change
                    in pension value and non-qualified deferred compensation earnings
                    ($)**
                
                
                **All
                    other compensation ($)**
                
                
                **Total**Mark
                    N. Sirangelo
                
                2006
                
                
                292,730
                
                
                25,000
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                **$**
                **317,730**Chief
                    Executive Officer
                
                2005
                
                
                1,038
                
                
                -
                
                
                354,050
                
                
                1,391,305
                
                
                -
                
                
                -
                
                
                -
                
                
                **1,746,394**James
                    W. Benson (1)
                
                2006
                
                
                144,623
                
                
                22,500
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                32,308
                
                
                **199,431**Former
                    Chief Technology Officer
                
                2005
                
                
                180,000
                
                
                2,587
                
                
                -
                
                
                805,492
                
                
                -
                
                
                -
                
                
                1400
                
                
                **989,480**Richard
                    B. Slansky
                
                2006
                
                
                195,877
                
                
                25,000
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                101,458
                
                
                **322,335**President
                    and Chief Financial Officer
                
                2005
                
                
                150,000
                
                
                2,448
                
                
                -
                
                
                1,334,933
                
                
                -
                
                
                -
                
                
                111,254
                
                
                **1,598,635**Scott
                    Tibbitts
                
                2006
                
                
                140,871
                
                
                100,000
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                2,374
                
                
                **243,245**Managing
                    Director
                
                2005
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                **-**Robert
                    Vacek (1)
                
                2006
                
                
                224,319
                
                
                -
                
                
                -
                
                
                104,795
                
                
                -
                
                
                -
                
                
                3,400
                
                
                **332,514**Former
                    President, Starsys, Inc.
                
                2005
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                **-**


(1)
            Mr.
                Benson resigned as an officer on September 26, 2006 to found Benson
                Space
                Company. Mr. Vacek resigned on November 20, 2006, with an effective
                departure date of December 15, 2006.


On
      December 20,
      2005,
      we eliminated all vesting requirements on all stock options then outstanding.
      Options granted in 2006 are subject to a 3 year vesting requirement.




**Outstanding
      Equity Awards at Fiscal Year-End**




The
      following table reflects information for our executive officers named in the
      Summary Compensation Table, effective December 31, 2006:


Name
              Number
                  of securities underlying unexercised options exercisable
                  (#)
              Number
                  of securities underlying unexercised options unexercisable
                  (#)
              Equity
                  incentive plan award: number of securities underlying unexercised
                  unearned
                  options (#)
              Option
                  exercise price($)
              Option
                  expiration dateMark
                  N. Sirangelo
              1,900,000
              -
              -
              $
                  1.40
              12/20/2010James
                  W. Benson (1)
              1,100,000
              -
              -
              1.40
              12/20/2010500,000
              -
              -
              1.00
              1/18/2010Richard
                  B. Slansky
              1,400,000
              -
              -
              1.40
              12/20/2010330,000
              -
              -
              0.51
              2/10/2009395,000
              -
              -
              0.92
              3/25/2010Scott
                  Tibbitts
              -
              -
              -
              -
              -Robert
                  Vacek (2)
              125,000
              -
              700,000
              1.46
              3/15/2007


(1)
            Mr.
                Benson resigned as an officer on September 26, 2006 to found Benson
                Space
                Company;
                however, he remained a consultant to the
                Company.




(2)
            Mr.
                Vacek resigned on November 20, 2006, with
                an effective departure date of December 15, 2006 and all options
                expired
                unexercised on March 15, 2007.




Table
          of Contents
 55


**Director
      Compensation**





The
      following table sets forth the remuneration paid to our directors during the
      fiscal year ended December 31, 2006. The table is empty because, due to the
      adoption of SFAS 123(R) in January 2006, we paid no compensation to our
      directors in 2006. We issued options for director compensation at the end of
      2005 for anticipated services in 2006 in anticipation of the impact of SFAS
      123(R), and until a new director compensation arrangement could be discussed
      and
      implemented. The Board will address independent director compensation for 2007
      and beyond during their meetings in early 2007. We do not pay directors who
      are
      also our officers additional compensation for their service as
      directors.





Our
      independent directors received options for attending 2005 meetings of the Board
      as follows: each director received an option to purchase 6,000 shares for each
      telephonic meeting attended and an option to purchase 12,000 shares for each
      meeting attended in person, with a cap of options on 36,000 shares per year.
      Our
      independent directors also received compensation for attending 2005 Committee
      meetings as follows: each director received an option to purchase 5,000 shares
      for each Audit Committee meeting attended, each director received an option
      to
      purchase 2,500 shares for each Compensation Committee meeting attended and
      each
      director received an option to purchase 2,500 shares for each Nominating and
      Governance Committee meeting attended, which options were not subject to a
      cap.
      In addition to the above, independent directors receive options for 5,000 shares
      on the date of election or appointment. All such options were issued pursuant
      to
      the 1999 Stock Option Plan at fair market value as of the date of the meeting
      attended, were initially scheduled to vest 50% on the first anniversary date
      of
      the date of grant and 50% on the second anniversary date of grant, and expire
      on
      the three-year anniversary of the grant date.


Name
              Fees
                  Earned or Paid in Cash ($)
              Stock
                  Awards ($)
              Option
                  Awards
              Non-Equity
                  Incentive Plan Compensation ($)
              Nonqualified
                  Deferred Compensation Earnings ($)
              All
                  other Compensation ($)
              **Total
                  ($)**Mark
                  N. Sirangelo
              -
              -
              -
              -
              -
              -
              **-**Richard
                  B. Slansky
              -
              -
              -
              -
              -
              -
              **-**James
                  W. Benson (1)
              19,385
              -
              -
              -
              -
              -
              **19,385**Scott
                  Tibbitts
              -
              -
              -
              -
              -
              -
              **-**Curt
                  Dean Blake
              -
              -
              -
              -
              -
              -
              **-**General
                  Howell M. Estes, III
              -
              -
              -
              -
              -
              -
              **-**Wesley
                  T. Huntress
              -
              -
              -
              -
              -
              -
              **-**Scott
                  McClendon
              -
              -
              -
              -
              -
              -
              **-**Robert
                  S. Walker
              -
              -
              -
              -
              -
              -
              **-**Susan
                  Benson (2)
              -
              -
              -
              -
              -
              -
              **-**Stuart
                  Schaffer (2)
              -
              -
              -
              -
              -
              -
              **-**




(1)
            Mr.
                Benson resigned asChairman
                of theBoard
                on September 26, 2006 to found Benson Space Company;
              however,
                he remained a member of the Board of Directors of SpaceDev,
                Inc.


(2)
            On
                August 10, 2006,Ms. Benson and Mr. Schaffer, who in connection with the reduction
                of ourBoard
                Of
              Directors'
                size from 11 to 9, agreed not to seek
                re-election.





On
      December 20, 2005, the vesting on all outstanding options, including those
      held
      by independent directors, was accelerated such that all outstanding options
      became fully-vested. No options were granted to members of the Board of
      Directors in 2006.


Table
          of Contents
 56


**Employment
      Agreements, Termination of Employment Arrangements and Change of Control
      Agreements**





On
      January 31, 2006, we entered into a three year executive employment agreement
      with Scott Tibbitts, pursuant to which Mr. Tibbitts is employed as our managing
      director. Under the agreement, Mr. Tibbitts earns an annual base salary of
      $150,000 and will be eligible for quarterly performance bonuses, as determined
      by our Board of Directors or Compensation Committee, up to an annual aggregate
      amount of 50% of his base salary. Bonus milestones will be mutually agreed
      upon
      in good faith by Mr. Tibbitts and by our Board of Directors or Compensation
      Committee. We will pay severance to Mr. Tibbitts if his employment is terminated
      by us without cause or by Mr. Tibbitts for good reason. The severance payment
      is
      equal to: (1) if Mr. Tibbitts' employment is terminated by us without cause,
      his
      then-current base salary per month multiplied by the number of months remaining
      in the term of the agreement (prorated with respect to any partial month);
      or,
      (2) if Mr. Tibbitts' employment is terminated by Mr. Tibbitts for good reason,
      his then-current base salary per month multiplied by the lesser of twelve months
      and the number of months remaining in the term of the agreement. Under the
      agreement, we will indemnify Mr. Tibbitts to the extent provided in our articles
      of incorporation, as may be amended from time to time, and pursuant to our
      standard indemnification agreement with our officers and directors, provided
      that we will have no obligation to indemnify or defend Mr. Tibbitts for any
      action, suit or other proceeding to the extent based on acts, omissions, events,
      or circumstances occurring prior to the Starsys merger.





On
      January 31, 2006, we entered into an executive employment agreement with Robert
      Vacek pursuant to which Mr. Vacek was employed as the president of Starsys,
      Inc., our subsidiary. The agreement had an initial term of two years, and
      provided for automatic renewal for a third year unless either we or
      Mr. Vacek provided written notice of an intent not to renew. Under the
      agreement, Mr. Vacek was entitled to receive; (1) a base salary of $17,000
      per
      month, subject to adjustment up to $19,000 per month upon the happening of
      certain events or by the sixteenth month of service; (2) performance-based
      cash
      bonuses based on the achievement of specific goals set forth in the agreement;
      and, (3) an option to purchase up to 825,000 shares of our common stock under
      the terms and conditions of our 2004 Equity Incentive Plan, as amended. The
      option had an exercise price equal to $1.46 per share, which was the closing
      sale price reported on the OTCBB on the date of grant, and was to expire 90
      days
      after the termination of Mr. Vacek's continuous employment. We agreed to pay
      severance to Mr. Vacek if his employment was terminated by us without cause
      or
      by Mr. Vacek for good reason. The severance payment was equal to: (1) if Mr.
      Vacek's employment was terminated by us without cause, his then-current base
      salary per month multiplied by the greater of (A) 12 months or (B) the number
      of
      months remaining in the term of the agreement (prorated with respect to any
      partial month); or, (2) if Mr. Vacek's employment was terminated by Mr. Vacek
      for good reason, his then-current base salary per month multiplied by the lesser
      of (A) 12 months or (B) the number of months remaining in the term of the
      agreement provided that such number of months was not deemed to be less than
      six
      months. Under the agreement, we agreed to indemnify Mr. Vacek to the extent
      provided in our articles of incorporation, as amended from time to time, to
      the
      maximum extent permitted by law and pursuant to our standard indemnification
      agreement, if any, with our officers and directors. Mr. Vacek resigned on
      November 20, 2006 with an effective departure date of December 15, 2006 and
      received no severance payment as a result of his resignation.




Table
          of Contents
 57


On
      December 20, 2005, we
      entered into an executive employment agreement with Mark N. Sirangelo pursuant
      to which Mr. Sirangelo was employed as our chief executive officer and Vice
      Chairman. The agreement has an initial term of two years, and will be
      automatically renewed for a third year unless either we or Mr. Sirangelo
      provides written notice of an intent not to renew. Under the agreement, Mr.
      Sirangelo is entitled to receive; (1) a base salary of $22,500 per month,
      subject to adjustment up to $27,500 per month upon the happening of certain
      events or by the sixteenth month of service; (2) performance-based cash bonuses
      based on the achievement of specific goals set forth in the agreement (including
      a bonus of $25,000 upon the completion of the merger with Starsys); and, (3)
      a
      fully-vested option to purchase up to 1,900,000 shares of our common stock
      under
      the terms and conditions of a non-plan stock option agreement between us and
      Mr.
      Sirangelo. The option has an exercise price equal to $1.40 per share, which
      was
      the closing sale price reported on the OTCBB on the date of grant, and will
      expire five years after the date of grant. Some of the shares subject to the
      option are subject to sale restrictions that expire upon the achievement of
      certain specific milestones or four years from the date of grant, whichever
      comes first. Subject to certain limitations, the option may be exercised by
      means of a net exercise provision by surrendering shares with a fair market
      value equal to the exercise price upon exercise. We will pay severance to Mr.
      Sirangelo if his employment is terminated by us without cause or by Mr.
      Sirangelo for good reason. The severance payment is equal to: (1) if Mr.
      Sirangelo's employment is terminated by us without cause, his then-current
      base
      salary per month multiplied by the greater of (A) 12 months or (B) the number
      of
      months remaining in the term of the agreement (prorated with respect to any
      partial month); or (2) if Mr. Sirangelo's employment is terminated by Mr.
      Sirangelo for good reason, his then-current base salary per month multiplied
      by
      the lesser of (A) 12 months or (B) the number of months remaining in the term
      of
      the agreement provided that such number of months will not be deemed to be
      less
      than six months.




On
      December 20, 2005, we entered into an amended and restated executive employment
      agreement with Richard B. Slansky pursuant to which Mr. Slansky is employed
      as
      our president and chief financial officer. The agreement supersedes in full
      the
      employment agreement dated February 10, 2003 between us and Mr. Slansky. The
      agreement has an initial term of two years, and will be automatically renewed
      for a third year unless either we or Mr. Slansky provides written notice of
      an intent not to renew. Under the agreement, Mr. Slansky is entitled to receive:
      (1) a base salary of $14,500 per month, subject to adjustment up to $20,000 per
      month upon the happening of certain events or by the sixteenth month of service;
      (2) performance-based cash bonuses based on the achievement of specific goals
      set forth in the agreement (including a bonus of $25,000 upon the completion
      of
      the merger with Starsys); and, (3) a fully-vested option to purchase up to
      1,400,000 shares of our common stock under the terms and conditions of a
      non-plan stock option agreement between us and Mr. Slansky. The option has
      an
      exercise price equal to $1.40 per share, which was the closing sale price
      reported on the OTCBB on the date of grant, and will expire five years after
      the
      date of grant. Some of the shares subject to the options are subject to sale
      restrictions that expire upon the achievement of certain specific milestones
      or
      four years from the date of grant, whichever comes first. Subject to certain
      limitations, the option may be exercised by means of a net exercise provision
      by
      surrendering shares with a fair market value equal to the exercise price upon
      exercise. We will pay severance to Mr. Slansky if his employment is terminated
      by us without cause or by Mr. Slansky for good reason. The severance payment
      is
      equal to: (1) if Mr. Slansky's employment is terminated by us without cause,
      his
      then-current base salary per month multiplied by the greater of (A) 12 months
      or
      (B) the number of months remaining in the term of the agreement (prorated with
      respect to any partial month); or (2) if Mr. Slansky's employment is terminated
      by Mr. Slansky for good reason, his then-current base salary per month
      multiplied by the lesser of (A) 12 months or (B) the number of months remaining
      in the term of the agreement provided that such number of months will not be
      deemed to be less than six months.




Table
          of Contents
 58


On
      December 20, 2005, we entered into an executive employment agreement with James
      W. Benson pursuant to which Mr. Benson is employed as our Chairman and chief
      technology officer. The agreement superseded all prior employment agreements
      between us and Mr. Benson. The agreement had an initial term of two years,
      and
      provided for automatic renewal for a third year unless either we or
      Mr. Benson provided written notice of an intent not to renew. Under the
      agreement, Mr. Benson was entitled to receive: (1) a base salary of $14,000
      per
      month, subject to adjustment up to $17,000 per month upon the happening of
      certain events or by the sixteenth month of service; (2) performance-based
      cash
      bonuses based on the achievement of specific goals set forth in the agreement
      (including a bonus of $22,500 upon the completion of the merger with Starsys);
      and, (3) a fully-vested option to purchase up to 950,000 shares of our common
      stock under the terms and conditions of a non-plan stock option agreement
      between us and Mr. Benson. The option had an exercise price equal to $1.40
      per
      share, which was the closing sale price reported on the OTCBB on the date of
      grant, and were
      originally set to expire five years after the date of grant; however, due to
      Mr.
      Benson’s resignation and
      change in status to our consultant, the options will expire on the earlier
      of:
      a) ninety (90) days after the termination of his consulting agreement; or,
      b)
      December 20, 2010, whichever is earlier.  Some
      of
      the shares subject to the options are subject to sale restrictions that expire
      upon the achievement of certain specific milestones or four years from the
      date
      of grant, whichever comes first. Subject to certain limitations, the option
      may
      be exercised by means of a net exercise provision by surrendering shares with
      a
      fair market value equal to the exercise price upon exercise. We had agreed
      to
      pay severance to Mr. Benson if his employment was terminated by us without
      cause
      or by Mr. Benson for good reason. The severance payment is equal to: (1) if
      Mr.
      Benson's employment was terminated by us without cause, his then-current base
      salary per month multiplied by the greater of (A) 12 months or (B) the number
      of
      months remaining in the term of the agreement (prorated with respect to any
      partial month); or (2) if Mr. Benson's employment was terminated by Mr. Benson
      for good reason, his then-current base salary per month multiplied by the lesser
      of (A) 12 months or (B) the number of months remaining in the term of the
      agreement provided that such number of months will not be deemed to be less
      than
      six months. Mr. Benson resigned on September 26, 2006, and received no severance
      payment as a result of his resignation. However, he did remain as an independent
      contractor through December 31, 2006 and still serves on our Board of Directors.
      Mr. Benson received approximately $56,000 for his consulting services from
      the
      date of his resignation through December 31, 2006. Mr. Benson remains one of
      our
      major shareholders.





On
      December 20, 2005, Mr. Benson also received an option to purchase up to 150,000
      shares of our
      common stock in connection with his services as our Chairman pursuant to the
      terms of a separate non-plan stock option agreement between us and Mr. Benson.
      The option has an exercise price equal to $1.40 per share, which was the closing
      sale price reported on the OTCBB on the date of grant, and were originally
      set
      to expire five years after the date of grant; however, due to Mr. Benson’s
      resignation and
      change in status to our consultant, the options will expire on the earlier
      of:
      a) ninety (90) days after the termination of his consulting agreement; or,
      b)
      December 20, 2010, whichever is earlier. Some of
      the shares subject to the option are subject to sale restrictions that expire
      upon the achievement of certain specific milestones or four years from the
      date
      of grant, whichever comes first. Subject to certain limitations, the option
      may
      be exercised by means of a net exercise provision by surrendering shares with
      a
      fair market value of the exercise price upon exercise. Mr. Benson resigned
      as
      Chairman on September 26, 2006 but remained a member of our Board of Directors
      and one of our major shareholders.






***ITEM
      11.*** ***SECURITYOWNERSHIP
      OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
      AND RELATED STOCKHOLDER MATTERS***




The
      following table provides information as of March 5, 2007 concerning the
      beneficial ownership of our common stock, which is our only class or series
      of
      voting securities, by; (i) each director; (ii) each named executive officer;
      (iii) each stockholder known by us to be the beneficial owner of more than
      5% of
      our outstanding Common Stock; and, (iv) the directors and executive officers
      as
      a group. Except as otherwise indicated, the persons named in the table have
      sole
      voting and investing power with respect to all shares of common stock owned
      by
      them.





Table
          of Contents
 59


Name
                  and Address of Beneficial Owner
              Amount
                  and Nature of Beneficial Ownership(1)
              
              Percent
                  of OwnershipMark
                  N. Sirangelo
              2,142,500
              (2)
              6.81%Richard
                  B. Slansky
              2,237,886
              (3)
              7.06%James
                  W. Benson
              7,407,707
              (4)
              23.77%Susan
                  C. Benson
              7,675,907
              (5)
              24.63%Scott
                  F. Tibbitts
              845,501
              
              2.86%Wesley
                  T. Huntress Jr.
              284,530
              (6)
              0.95%Curt
                  Dean Blake
              298,452
              (7)
              1.00%General
                  Howell M. Estes, III
              219,667
              (8)
              0.74%Robert
                  S. Walker
              166,190
              (9)
              0.56%Scott
                  McClendon
              272,460
              (10)
              0.91%Officers
                  and Directors as a group (9 Persons)
              16,833,093
              (11)
              46.42%


The
      business address for each of these persons is 13855 Stowe Drive, Poway, CA
      92064, with the exception of Susan Benson, whose address is 13592 Ranch Creek
      Lane, Poway, CA 92064.




(1)
            Where
                persons listed on this table have the right to obtain additional
                shares of
                our common stock through the exercise of outstanding options or warrants
                or the conversion of convertible securities within 60 days from March
                5,
                2007, these additional shares are deemed to be outstanding for the
                purpose
                of computing the percentage of common stock owned by such persons,
                but are
                not deemed outstanding for the purpose of computing the percentage
                owned
                by any other person. Percentages are based on total outstanding shares
                of
                29,560,342 on March 5, 2007.




(2)
            Represents
                242,500 shares to which he has direct beneficial ownership interest,
                these
                shares are held by The Quanstar Group LLC. Mr. Sirangelo also holds
                vested
                options to purchase up to an aggregate of 1,900,000 shares.




(3)
            Includes
                vested options to purchase up to an aggregate of 2,125,000 shares.






(4)
            Represents
                2,690,000 shares held directly by Mr. James W. Benson as a result
                of a
                stipulated order entered May 24, 2005 identifying the shares as a
                separate
                property asset of Mr. Benson, plus beneficial ownership in 2,620,294
                shares held jointly with Susan C. Benson, as to which he shares voting
                and
                investing power with Ms. Benson, indirect beneficial ownership interest
                in
                497,413 shares held in Space Development Institute (where Mr. Benson
                is a
                member of the Board of Directors along with Susan C. Benson), as
                to which
                he shares voting and investing power with Ms. Benson, and beneficial
                ownership in vested options to purchase up to an aggregate of 1,600,000
                shares (which may constitute as community property with Susan C.
                Benson).
                Excludes approximately 1.2 million shares held by children of Mr.
                Benson,
                for which Mr. Benson disclaims beneficial ownership.




(5)
            Represents
                2,658,200 shares held directly by Ms. Susan Benson as a result of
                a
                stipulated order entered May 24, 2005 identifying the shares as a
                separate
                property asset of Ms. Benson, plus beneficial ownership in 2, 620,294
                shares held jointly with James W. Benson, as to which she shares
                voting
                and investing power with Mr. Benson, indirect beneficial ownership
                interest in 497,413 shares held in Space Development Institute (where
                Ms.
                Benson is a member of the Board of Directors along with James W.
                Benson),
                as to which she shares voting and investing power with Mr. Benson,
                and
                beneficial ownership in vested options issued in the name of James
                W.
                Benson on 1,600,000 shares (which may constitute as community property
                with James W. Benson), but as to which she no longer has shared voting
                and
                investment power. Excludes approximately 1.2 million shares held
                by
                children of Ms. Benson, for which Ms. Benson disclaims beneficial
                ownership.




(6)
            Includes
                vested options to purchase up to an aggregate of 239,647 common
                shares.




Table
          of Contents
 60


(7)
            Includes
                vested options to purchase up to an aggregate of 231,000 common shares.




(8)
            Includes
                vested options to purchase up to an aggregate of 183,000 common
                shares.




(9)
            Includes
                vested options to purchase up to an aggregate of 150,000 common
                shares.




(10)
            Includes
                vested options to purchase up to an aggregate of 272,460 common shares.




(11)
            Executive
                officers and directors as a group include our nine Board members,
                two of
                whom are also executive officers.





**Equity
      Compensation Plan Information**





The
      following table reflects information as of December 31, 2006.


(a)
              (b)
              (c)Plan
                  category
              Number
                  of securities
              Weighted-average
              Number
                  of securitiesto
                  be issued upon
              exercise
                  price of
              remaining
                  available forexercise
                  of outstanding
              outstanding
              future
                  issuance underoptions,
                  warrants, and
              options,
                  warrants
              equity
                  compensation plansrights
              and
                  rights
              (excluding
                  securitiesreflected
                  in column (a))Equitycompensation
                  plans
              7,495,098
              $1.17
              2,180,284approved
                  bysecurity
                  holdersEquity
              4,900,000
              1.36
              -compensation
                  plansnot
                  approved bysecurity
                  holdersTotal
              12,395,098
              $1.24
              2,180,284


The
      options granted to our executives, under the equity compensation plans not
      approved by security holders, are fully vested and exercisable on the date
      of
      grant, have an exercise price of $1.00 to $1.40 per share, which was the closing
      sale price, reported on the OTCBB on the date of grant, and will expire five
      to
      ten years after the date of grant.  Some of the shares subject to the
      options are subject to sale restrictions that expire upon the achievement of
      certain milestones or four years from the date of grant, whichever comes
      first.  Subject to certain limitations, these options may be exercised by
      means of a net exercise provision by surrendering shares with a fair market
      value equal to the exercise price upon exercise.


Table
          of Contents
 61




***ITEM
        12.***  ***CERTAIN
        RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
        INDEPENDENCE***


James
      W.
      Benson, our former chief technology officer and former Chairman of the Board
      of
      Directors, and Susan Benson, our former corporate secretary and director, are
      married. Mr. Benson has personally guaranteed the building lease on our Poway,
      California headquarters facility and has placed his home in Poway as collateral.
      Mr. Benson remained a member of our Board of Directors and one of our major
      shareholders. On September 26, 2006, Mr. Benson **** stepped
      down from his role as Chairman andchief technology officer in order to launch
      a
      new independent venture, Benson Space Company, focused on the marketing of
      commercial space tourism.





Until
      joining us, Mark N. Sirangelo, chief executive officer, and Chairman of our
      Board of Directors, was a member of QS Advisors, LLC, and also a member of
      The
      QuanStar Group LLC, business advisors to us. We entered into an agreement with
      QS Advisors for which QS Advisors was paid a monthly fee of $5,000. In addition,
      under the agreement, upon the consummation of the merger with Starsys, and
      for
      services performed in relation to the merger and considered part of the purchase
      price, QS Advisors received $200,000 cash and 250,000 shares of our common
      stock. QS Advisors subsequently distributed 7,500 shares of our common stock
      to
      Mr. Daniel Avrutsky for services performed and retained 242,500 shares. This
      agreement terminated upon consummation of Mr. Sirangelo's employment with us.





On
      January 31, 2006, we
      entered into a non-competition agreement with Scott Tibbitts, pursuant to which
      Mr. Tibbitts has agreed not to be employed by or have any interest in an entity
      that engages in a similar business to Starsys related to the aerospace industry
      for three years, shall not solicit any business from any of our past or present
      customers, not solicit or encourage any of our employees to leave or reduce
      his
      or her employment, not to encourage a consultant under contract with us to
      cease
      or diminish his or her work with us, not to use our intellectual property other
      than for the benefit of us and not to make any negative or disparaging
      statements regarding us to any third party. Mr. Tibbitts has received $100,000
      for 2006 and will continue to receive $100,000 annually each year he abides
      by
      the covenant not to compete.




**Director
      Independence**





We
      currently have a policy that a majority of our board be comprised of
“independent directors.” In determining whether a Board member is “independent,”
we apply the definition of “independence” as set by the listing standards for
      the Nasdaq Stock Market and SEC rules. Accordingly, Curt Dean Blake, General
      Howell Estes, III, Wesley T. Huntress, Jr., Scott McClendon, and Robert Walker
      currently meet the definition of “independent director.”





All
      members of our, Audit Committee, Compensation Committee and Nominating and
      Corporate Governance Committee are independent in accordance with Nasdaq
      independence standards for members of these Committees.







Table
          of Contents
 62


***ITEM
        13.*** ***EXHIBITS*** ******





Exhibit
                No.
            Description
            Filed
              Herewith
            Incorporated
                by Reference
            Form
            Date
                Filed with SEC
            Exhibit
                No.2.1
            Agreement
                and Plan of Merger and Reorganization dated October 24, 2005
                (Starsys)
            
            X
            8-K
            Oct.
                26, 2005
            2.12.2
            Amendment
                No. 1 to the Agreement and Plan of Merger and Reorganization dated
                December 7, 2005 (Starsys)
            
            X
            8-K
            Dec.
                13, 2005
            2.12.3
            Amendment
                No. 2 to the Agreement and Plan of Merger and Reorganization dated
                January
                31, 2006 (Starsys)
            
            X
            8-K
            Feb.
                6, 2006
            2.32.4
            Escrow
                Agreement dated January 31, 2006 (Starsys)
            
            X
            8-K
            Feb.
                6, 2006
            2.43.1
            Articles
                of Incorporation dated December 20, 1996
            
            X
            10-SB
            Jan.
                18, 2000
            2.13.2
            Articles
                of Amendment to Articles of Incorporation dated November 4,
                1997
            
            X
            10-SB
            Jan.
                18, 2000
            2.23.3
            Articles
                of Amendment to Articles of Incorporation dated December 17,
                1997
            
            X
            10-SB
            Jan.
                18, 2000
            2.33.4
            Articles
                of Amendment to Articles of Incorporation dated February 1,
                2006
            
            X
            10-KSB
            March
                28, 2006
            3.43.5
            Amended
                and Restated Bylaws
            
            X
            8-K
            Dec.
                23, 2005
            3.13.6
            Certificate
                of Designation of Series C Convertible Preferred Stock
            
            X
            8-K
            Aug.
                30, 2004
            3.13.7
            Certificate
                of Designations of Series D-1 Preferred Stock
            
            X
            8-K
            Jan.
                17, 2006
            3.13.8
            Certificate
                of Designations of Series D-2 Preferred Stock
            
            X
            8-K
            Jan.
                17, 2006
            3.23.9
            Form
                of Warrant issued to Laurus Master Fund August 25, 2004
            
            X
            8-K
            Aug.
                30, 2004
            4.24.1
            Form
                of Common Stock Certificate
            
            X
            10-SB
            Jan.
                18, 2000
            3.14.2
            Laurus
                Secured Revolving Note dated as of September 29, 2006
            
            X
            8-K/A
            Oct.
                10, 2006
            99.110.1
            Secured
                Loan Agreement with Starsys Research Corporation dated September
                8,
                2005
            
            X
            10-QSB
            Nov.
                14, 2005
            10.110.2
            Promissory
                Note with Starsys Research Corporation dated September 8,
                2005
            
            X
            10-QSB
            Nov.
                14, 2005
            10.2




Table
          of Contents
 63


10.3
              Subcontract
                  Agreement with Andrews Space, Inc. awarded June 27, 2005
              
              X
              10-QSB/A
              Dec.
                  22, 2005
              10.110.4
              Sublease
                  between Gateway and SpaceDev dated March 31, 2005
              
              X
              8-K
              April
                  15, 2005
              10.110.5
              Consent
                  to Sublease between Gateway and SpaceDev dated April 1, 2005
              
              X
              8-K
              April
                  15, 2005
              10.210.6
              Missile
                  Defense Agency Contract with SpaceDev dated March 31, 2004
              
              X
              10-KSB
              April
                  6, 2004
              10.4010.7
              Common
                  Stock Purchase Warrant issued June 3, 2003 by SpaceDev to Laurus
                  Master
                  Fund, Ltd.
              
              X
              8-K
              June
                  18, 2003
              10.310.8
              Registration
                  Rights Agreement between SpaceDev and Laurus Master Fund, Ltd.
                  dated June
                  3, 2003
              
              X
              8-K
              June
                  18, 2003
              10.410.9
              Securities
                  Purchase Agreement with Laurus Master Fund, Ltd. dated August 25,
                  2004
              
              X
              8-K
              Aug.
                  30, 2004
              10.110.10
              Registration
                  Rights Agreement with Laurus Master Fund, Ltd. dated August 25,
                  2004
              
              X
              8-K
              Aug.
                  30, 2004
              10.210.11
              Letter
                  Agreement with Laurus Master Fund Ltd. dated August 25, 2004
              
              X
              8-K
              Aug.
                  30, 2004
              10.310.12
              Agreement
                  of License and Purchase of Technology between SpaceDev and AMROC
                  dated
                  August 1998
              
              X
              10-SB
              Jan.
                  18, 2000
              6.410.13
              1999
                  Stock Option Plan #
              
              X
              SB-2
              July
                  25, 2003
              4.810.14
              First
                  Amendment to 1999 Stock Option Plan #
              
              X
              SB-2
              July
                  25, 2003
              4.1410.15
              1999
                  Employee Stock Purchase Plan #
              
              X
              10-SB
              Jan.
                  18, 2000
              6.710.16
              2004
                  Equity Incentive Plan #
              
              X
              S-8
              Mar.
                  29, 2005
              99.110.17
              First
                  Amendment to 1999 Employee Stock Purchase Plan #
              
              X
              10-KSB
              Mar.
                  28, 2006
              10.3910.18
              Executive
                  Employment Agreement between SpaceDev, Inc., and James W. Benson
                  dated
                  December 20, 2005 #
              
              X
              8-K
              Dec.
                  23, 2005
              10.310.19
              Executive
                  Employment Agreement between SpaceDev, Inc., and Mark N. Sirangelo
                  dated
                  December 20, 2005 #
              
              X
              8-K
              Dec.
                  23, 2005
              10.110.20
              Amended
                  and Restated Executive Employment Agreement between SpaceDev, Inc.,
                  and
                  Richard B. Slansky dated December 20, 2005 #
              
              X
              8-K
              Dec.
                  23, 2005
              10.2
  Table
            of Contents
 64
 10.21
              Non-Plan
                  Stock Option Agreement with James W. Benson (evidencing an option
                  to
                  purchase up to 950,000 shares) dated December 20, 2005 #
              
              X
              8-K
              Dec.
                  23, 2005
              10.610.22
              Non-Plan
                  Stock Option Agreement with Mark N. Sirangelo dated December 20,
                  2005
                  #
              
              X
              8-K
              Dec.
                  23, 2005
              10.410.23
              Non-Plan
                  Stock Option Agreement with Richard B. Slansky dated December 20,
                  2005
                  #
              
              X
              8-K
              Dec.
                  23, 2005
              10.510.24
              Falcon
                  Launch Services Agreement with Space Exploration Technologies Corporation
                  dated November 15, 2005 *
              
              X
              8-K/A
              Dec.
                  22, 2005
              10.110.25
              Amendment
                  No. 1 to the Secured Promissory Note with Starsys Research Corporation,
                  dated December 20, 2005
              
              X
              8-K
              Dec.
                  23, 2005
              10.1110.26
              Non-Plan
                  Stock Option Agreement with James W. Benson (evidencing an option
                  to
                  purchase up to 150,000 shares) dated December 20, 2005 #
              
              X
              8-K
              Dec.
                  23, 2005
              10.710.27
              Statement
                  of Work with Andrews Space, Inc. awarded June 27, 2005
              
              X
              10-QSB/A
              Dec.
                  23, 2005
              10.210.28
              Securities
                  Purchase Agreement dated January 11, 2006 (Omicron et. al.)
              
              X
              8-K
              Jan.
                  17, 2006
              99.110.29
              Registration
                  Rights Agreement dated January 17, 2006 (Omicron et. al.)
              
              X
              8-K
              Jan.
                  17, 2006
              99.210.30
              Form
                  of Preferred Stock Warrant (Omicron et. al.)
              
              X
              8-K
              Jan.
                  17, 2006
              99.310.31
              Form
                  of Common Stock Warrant (Omicron et. al.)
              
              X
              8-K
              Jan.
                  17, 2006
              99.410.32
              Executive
                  Employment Agreement with Scott Tibbitts dated January 31, 2006
                  #
              
              X
              8-K
              Feb.
                  6, 2006
              99.110.33
              Executive
                  Employment Agreement with Robert Vacek dated January 31, 2006
                  #
              
              X
              8-K
              Feb.
                  6, 2006
              99.210.34
              Non-Competition
                  Agreement with Scott Tibbitts dated January 31, 2006
              
              X
              8-K
              Feb.
                  6, 2006
              99.310.35
              Form
                  of Standstill and Lock-up Agreement
              
              X
              8-K
              Feb.
                  6, 2006
              99.410.36
              Amendment
                  No. 2 to the SpaceDev 2004 Equity Incentive Plan #
              
              X
              8-K
              Feb.
                  6, 2006
              99.510.37
              Security
                  Agreement dated as of September 29, 2006 (Laurus)
              
              X
              8-K/A
              Oct.
                  10, 2006
              99.214.1
              Code
                  of Ethics
              
              X
              10-KSB
              Mar.
                  28, 2003
              10.15
  Table
            of Contents
 65
 99.1
              Audited
                  Financial Statements of Starsys Research Corporation for the years
                  ended
                  December 31, 2004 and 2003
              
              X
              8-K
              Feb.
                  6, 2006
              99.699.2
              Unaudited
                  Financial Statements of Starsys Research Corporation for the nine-month
                  period ended September 30, 2005
              
              X
              8-K
              Feb.
                  6, 2006
              99.799.3
              Unaudited
                  Pro Forma Combined Consolidated Financial Statements of SpaceDev,
                  Inc. and
                  Starsys Research Corporation for the nine-month period ended September
                  30,
                  2005 and for the year ended December 31, 2004
              
              X
              8-K
              Feb.
                  6, 2006
              99.821.1
              List
                  of Subsidiaries
              X23.1
              Consent
                  of PKF, Certified Public Accountants A Professional
                  Corporation
              X31.1
              Rule
                  13a-14(a) certification of Principal Executive Officer
              X31.2
              Rule
                  13a-14(a) certification of Principal Financial Officer
              X32.1
              Section
                  1350/Rule 13a-14(b) certifications
              X


*
      Registrant requested confidential treatment pursuant to Rule 406 for a portion
      of the referenced exhibit and has separately filed such exhibit with the
      Commission.





#
      Management contract or compensatory plan or arrangement.





Table
          of Contents
 66




***ITEM
        14.***  ***PRINCIPAL
        ACCOUNTANT FEES AND SERVICES***


The
      following are the fees billed us by our auditors, PKF, Certified Public
      Accountants, A Professional Corporation, respectively, for services rendered
      thereby during 2006 and 2005:




**2006**
              
              
              2005Audit
                  Fees
              
              **$**
              **101,690**
              
              $
              46,380Audit
                  Related Fees
              
              **$**
              **82,445**
              
              $
              -Tax
                  Fees
              
              **$**
              **24,088**
              
              $
              7,500All
                  Other Fees
              
              **$**
              **285**
              
              $
              42,275Total
              
              **$**
              **208,507**
              
              $
              96,155


The
          increase in fees was due to the acquisition of Starsys in January 2 006
          as
          well as the required filing and additional work performed for the cut-off
          financial information at the time of the merger. The acquisition of Starsys
          added additional complexities and consolidation issues to the Company's
          reporting requirements.




*Audit
      Fees* consist
      of the aggregate fees billed for professional services rendered for the audit
      of
      our annual financial statements and the reviews of the financial statements
      included in our Forms 10-QSB and for any other services that were normally
      provided by PKF in connection with our statutory and regulatory filings or
      engagements.





*Audit
      Related Fees* consist
      of the aggregate fees billed for professional services rendered for assurance
      and related services that were reasonably related to the performance of the
      audit or review of our financial statements and were not otherwise included
      in
      Audit Fees. The 2006 fees in this category related to specific research of
      accounting treatment under new FASB rules as well as capital
      raises.





*Tax
      Fees* consist
      of the aggregate fees billed for professional services rendered for tax
      compliance, tax advice and tax planning. Included in such Tax Fees were fees
      for
      preparation of our tax returns and consultancy and advice on other tax planning
      matters.





*All
      Other Fees* consist
      of the aggregate fees billed for products and services provided by PKF and
      not
      otherwise included in Audit Fees, Audit Related Fees or Tax Fees. Included
      in
      such Other Fees were fees for services rendered by PKF in connection with our
      private and public offerings conducted during such periods.





Our
      Audit
      Committee has considered whether the provision of the non-audit services
      described above is compatible with maintaining PKF's independence and determined
      that such services are appropriate.





Before
      the auditors are engaged to provide us audit or non-audit services, such
      engagement is (without exception, required to be) approved by the Audit
      Committee of our Board of Directors.


Table
          of Contents
 67


SIGNATURES





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





**SpaceDev,
      Inc.**





Date:
                  April 2, 2007
              By:
              /s/
                  Mark N. SirangeloMark
                  N. Sirangelo, CEO (Principal Executive Officer) and Chairman of
                  the Board
                  of DirectorsDate:
                  April 2, 2007
              By:
              /s/
                  Richard B. SlanskyRichard
                  B. Slansky, President and CFO (Principal Financial and Accounting
                  Officer)


In
      accordance with the Exchange Act, this report has been signed below by the
      following persons on behalf of the Registrant and in the capacities and on
      the
      dates indicated.







Date:
                  April 2, 2007
              /s/
                  Mark N. SirangeloMark
                  N. Sirangelo, Chairman of the Board of DirectorsDate:
                  April 2, 2007
              /s/
                  James W. BensonJames
                  W. Benson, DirectorDate:
                  April 2, 2007
              /s/
                  Curt D. BlakeCurt
                  D. Blake, DirectorDate:
                  April 2, 2007
              /s/
                  Howell M. Estes, IIIGen.
                  Howell M. Estes, III, DirectorDate:
                  April 2, 2007
              /s/
                  Wesley T. HuntressWesley
                  T. Huntress, DirectorDate:
                  April 2, 2007
              /s/
                  Scott McClendonScott
                  McClendon, DirectorDate:
                  April 2, 2007
              /s/
                  Richard B. SlanskyRichard
                  B. Slansky, DirectorDate:
                  April 2, 2007
              /s/
                  Scott TibbittsScott
                  Tibbitts, DirectorDate:
                  April 2, 2007
              /s/
                  Robert S. WalkerRobert
                  S. Walker, Director


Table
          of Contents
 68




**SpaceDev,
      Inc.**


**and
      Subsidiaries**




**Contents**





**CONSOLIDATED
      FINANCIAL STATEMENTS**







Report
                    of Independent Registered Public Accounting Firm
                F-2Financial
                    StatementsConsolidated
                    Balance Sheets
                F-3Consolidated
                    Statements of Operations
                F-4Consolidated
                    Statements of Stockholders' Equity
                F-5Consolidated
                    Statements of Cash Flows
                F-6Notes
                    to Consolidated Financial Statements
                F-8





Table
          of Contents
 F-1





Report
      of
      Independent Registered Public Accounting Firm








Board
      of
      Directors and Stockholders


**SpaceDev,
      Inc.**





We
      have
      audited the accompanying consolidated balance sheets of **SpaceDev,
      Inc. and Subsidiaries** as of
      December 31, 2006 and 2005, and the related consolidated statements of
      operations, stockholders' equity and cash flows for the years then ended. These
      consolidated financial statements are the responsibility of the Company's
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audits to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. An audit
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the consolidated financial statements. An audit also includes
      assessing the accounting principles used and significant estimates made by
      management, as well as evaluating the overall consolidated financial statement
      presentation. We believe that our audits provide a reasonable basis for our
      opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of **SpaceDev,
      Inc. and Subsidiaries** as of
      December 31, 2006 and 2005, and the consolidated results of their operations
      and
      their cash flows for the years then ended, in conformity with accounting
      principles generally accepted in the United States of America.





As
      discussed in Note 1, to the consolidated financial statements, the Company
      adopted Statement of Financial Accounting Standards ("SFAS") No. 123(R),
      " *Shared-Based
      Payment* ,"
      as of
      January 1, 2006.




/s/ PKF


San
      Diego, California PKF


March
      28,
      2007  Certified
      Public Accountants


A
      Professional Corporation







Table
          of Contents
 F-2





**SpaceDev,
                  Inc. **and
                  Subsidiaries******Consolidated
                  Balance Sheets***December
                  31,*
              
              
              **2006**
              
              
              2005**Assets****Current
                  Assets**Cash
                  and cash equivalents (Notes 1(o) and 9(a))
              
              **$**
              **1,438,146**
              
              $
              5,750,038Accounts
                  receivable (Notes 1(d) and 9(b))
              
              
              **7,289,720**
              
              
              1,279,027Inventory
                  (Note
                  1(q))
              
              
              **309,205**
              
              
              21,340Other
                  current assets (Note 1(n))
              
              
              **599,565**
              
              
              -Note
                  receivable (Note 10)
              
              
              **-**
              
              
              1,353,440Total
                  Current Assets
              
              
              **9,636,636**
              
              
              8,403,845**Asset**s
                  -
                  Net (Notes 1(f) and 2)
              
              
              **3,793,365**
              
              
              1,073,773**Intangible
                  Assets (Notes 1(f) and 3)**
              
              
              **841,133**
              
              
              -**Goodwill
                  (Notes 3)**
              
              
              **11,233,665**
              
              
              -**Other
                  Assets (Note 1 (n))**
              
              
              **626,086**
              
              
              1,531,031**Total
                  Assets**
              
              **$**
              **26,130,885**
              
              $
              11,008,649**Liabilities
                  and Stockholders' Equity****Current
                  Liabilities**Accounts
                  payable and accrued expenses
              
              **$**
              **1,755,985**
              
              $
              1,237,099Current
                  portion of notes payable (Note 4(a))
              
              
              **-**
              
              
              9,457Current
                  portion of capitalized lease obligations (Note 8(a))
              
              
              **35,441**
              
              
              1,469Accrued
                  payroll, vacation and related taxes
              
              
              **1,184,457**
              
              
              290,914Billings
                  in
                  excess of costs and deferred revenue (Note 1(r))
              
              
              **2,816,072**
              
              
              153,440Revolving
                  line
                  of credit (Note 4(b))
              
              
              **805,172**
              
              
              -Other
                  accrued liabilities (Note 1(e) and 8(b))
              
              
              **1,602,561**
              
              
              516,380**Total
                  Current Liabilities**
              
              
              **8,199,688**
              
              
              2,208,759**Notes
                  Payable, Less Current Maturities**
              
              
              **50,193**
              
              
              -**Capitalized
                  Lease Obligations, Less Current Maturities (Note 8(a))**
              
              
              **136,709**
              
              
              -**Deferred
                  Gain - Assets held for sale (Notes 2 and 4)**
              
              
              **713,405**
              
              
              830,677**Other
                  Long Term Liabilities**
              
              
              **15,266**
              
              
              -**Total
                  Liabilities**
              
              
              **9,115,261**
              
              
              3,039,436**Commitments
                  and Contingencies (Note 8)****Stockholders’
                  Equity (Note 7)**Convertible
                  preferred stock, $.001 par value, 10,000,000 shares
                  authorized,and
                  252,963 and 248,460 shares issued and outstanding, respectivelySeries
                  C Convertible Preferred Stock (Note 7(a))
              
              
              **248**
              
              
              248Series
                  D-1 Convertible Preferred Stock (Note 7(b))
              
              
              **5**
              
              
              -Common
                  stock, $.0001 par value; 100,000,000 shares authorized, and29,550,342
                  and
                  24,606,275 shares issued and outstanding, respectively (Note 7(c))
              
              
              2,953
              
              
              2,460Additional
                  paid-in capital
              
              
              **33,150,566**
              
              
              22,541,994Accumulated
                  deficit
              
              
              **(16,138,148**
              **)**
              
              (14,575,489
              )**Total
                  Stockholders’ Equity**
              
              
              **17,015,624**
              
              
              7,969,213**Total
                  Liabilities and Stockholders' Equity**
              
              **$**
              **26,130,885**
              
              $
              11,008,649


*The
        accompanying notes are an integral part of these consolidated financial
        statements.*
  F-3


**SpaceDev,
                Inc. and Subsidiaries****Consolidated
                Statements of Operations***Years
                Ended December 31,*
            
            
            2006
            
            
            
            
            
            2005**Net
                Sales**
            
            **$**
            **32,555,570**
            
            
            **100.0**
            **%**
            $
            9,005,011
            
            
            100.0
            %**Cost
                of Sales***
            
            
            **25,720,581**
            
            
            **79.0**
            **%**
            
            6,905,902
            
            
            76.7
            %**Gross
                Margin**
            
            
            **6,834,989**
            
            
            **21.0**
            **%**
            
            2,099,109
            
            
            23.3
            %**Operating
                Expenses**Marketing
                and
                sales
            
            
            **2,196,838**
            
            
            **6.7**
            **%**
            
            673,636
            
            
            7.5
            %Research
                and
                development
            
            
            **284,346**
            
            
            **0.9**
            **%**
            
            31,940
            
            
            0.4
            %General
                and administrative
            
            
            **5,307,210**
            
            
            **16.3**
            **%**
            
            1,082,033
            
            
            12.0
            %**Total
                Operating Expenses***
            
            
            **7,788,394**
            
            
            **23.9**
            **%**
            
            1,787,609
            
            
            19.9
            %**Income/(Loss)
                from Operations**
            
            
            **(953,405**
            **)**
            
            **-2.9**
            **%**
            
            311,500
            
            
            3.5
            %**Non-Operating
                Income/(Expense)**Interest
                and
                other income
            
            
            **83,362**
            
            
            **0.3**
            **%**
            
            105,840
            
            
            1.2
            %Interest
                expense
            
            
            **(65,713**
            **)**
            
            **-0.2**
            **%**
            
            (2,873
            )
            
            0.0
            %Gain
                on
                building sale (Note 4(a))
            
            
            **117,274**
            
            
            **0.4**
            **%**
            
            117,272
            
            
            1.3
            %Non-Cash
                loan
                fee (Note 4(b))
            
            
            **(114,600**
            **)**
            
            **-0.4**
            **%**
            
            (28,875
            )
            
            -0.3
            %**Total
                Non-Operating Income/(Expense)**
            
            
            **20,323**
            
            
            **0.1**
            **%**
            
            191,364
            
            
            2.1
            %**Income
                (Loss) Before Income Taxes**
            
            
            **(933,082**
            **)**
            
            **-2.9**
            **%**
            
            502,864
            
            
            5.6
            %Income
                tax provision (Notes 1(h) and 5)
            
            
            **19,290**
            
            
            **0.1**
            **%**
            
            1,600
            
            
            0.0
            %**Net
                Income/(Loss)**
            
            **$**
            **(952,372**
            **)**
            
            **-2.9**
            **%**
            $
            501,264
            
            
            5.6
            %**Net
                Income/(Loss)**
            
            
            **(952,372**
            **)**
            
            
            
            
            501,264Less:
                Preferred Dividend Payments
            
            
            **(610,287**
            **)**
            
            
            
            
            (170,956
            )**Adjusted
                Net Income (Loss) for EPS Calculation**
            
            
            **(1,562,659**
            **)**
            
            
            
            
            330,308**Net
                Income/(Loss) Per Share:**
            
            **$**
            **(0.05**
            **)**
            
            
            
            $
            0.01Weighted-Average
                Shares Used in Calculation
            
            
            **28,666,059**
            
            
            
            
            
            22,270,997**Fully
                Diluted Net Income/(Loss) Per Share:**
            
            **$**
            **(0.05**
            **)**
            
            
            
            $
            0.01Fully
                Diluted Weighted-Average Shares Outstanding
            
            
            **28,666,059**
            
            
            
            
            
            24,606,882*
                The following table shows how the Company's stock option expense
                would be
                allocated to all expenses.Cost
                of sales
            
            **$**
            **24,339**
            
            
            
            
            $
            -Marketing
                and sales
            
            
            **4,840**
            
            
            
            
            
            -Research
                and development
            
            
            **-**
            
            
            
            
            
            -General
                and administrative
            
            
            **104,200**
            
            
            
            
            
            -**$**
            **133,379**
            
            
            
            
            $
            -


*The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 F-4
  **SpaceDev,
                  Inc. and Subsidaries****Consolidated
                  Statements of Stockholders' Equity**AdditionalPaid-InAdditional
              
              
              Capital
                  -Preferred
                  Stock
              
              
              Common
                  Stock
              
              
              Paid-in
              
              
              Stock
              
              
              Deferred
              
              
              AccumulatedShares
              
              
              Amount
              
              
              Shares
              
              
              Amount
              
              
              Capital
              
              
              Options
              
              
              Compensation
              
              
              Deficit
              
              
              **Total****Balance
                  at January 1, 2005**
              
              
              **250,000**
              
              **$**
              **250**
              
              
              **21,153,660**
              
              **$**
              **2,114**
              
              **$**
              **18,739,090**
              
              **$**
              **750,000**
              
              **$**
              **(250,000**
              **)**
              **$**
              **(14,905,797**
              **)**
              **$**
              **4,335,657**Preferred
                  stock issued for cash (Note 7(a) and 7(b))
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              
              
              
              
              
              
              -
              
              
              **-**Common
                  stock issued for cash from employee stock purchase plan (Note 6(c)
                  and
                  7(c))
              
              
              -
              
              
              -
              
              
              27,540
              
              
              3
              
              
              38,323
              
              
              -
              
              
              -
              
              
              -
              
              
              **38,326**Common
                  stock issued from conversion of preferred stock (Note 7(a) and
                  7(b))
              
              
              (1,540
              )
              
              (2
              )
              
              10,000
              
              
              1
              
              
              1
              
              
              -
              
              
              -
              
              
              -
              
              
              **-**Common
                  stock issued from employee stock options (Notes 6(b) and
                  7(e))
              
              
              -
              
              
              -
              
              
              237,000
              
              
              24
              
              
              241,021
              
              
              -
              
              
              -
              
              
              -
              
              
              **241,045**Common
                  stock issued from private placement memorandum warrants (Note
                  7(d))
              
              
              -
              
              
              -
              
              
              1,014,327
              
              
              101
              
              
              500,840
              
              
              -
              
              
              -
              
              
              -
              
              
              **500,941**Common
                  stock issued from convertible debt program warrants (Notes 4 and
                  7(d))
              
              
              -
              
              
              -
              
              
              17,607
              
              
              2
              
              
              28,874
              
              
              -
              
              
              -
              
              
              -
              
              
              **28,876**Common
                  stock issued from securities purchase agreement (Note
                  7(c))
              
              
              -
              
              
              -
              
              
              2,032,520
              
              
              204
              
              
              2,318,880
              
              
              -
              
              
              -
              
              
              -
              
              
              **2,319,084**Common
                  stock issued from conversion of declared dividends (Note 7(a) and
                  7(b))
              
              
              -
              
              
              -
              
              
              113,621
              
              
              11
              
              
              174,965
              
              
              -
              
              
              -
              
              
              -
              
              
              **174,976**Stock
                  option forfeiture (Notes 6(b) and 7(e))
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              500,000
              
              
              (750,000
              )
              
              250,000
              
              
              -
              
              
              **-**Declared
                  dividends
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (170,956
              )
              
              **(170,956**
              **)**-
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              501,264
              
              
              **501,264**-
              
              
              -**Balance
                  at December 31, 2005**
              
              
              **248,460**
              
              
              **248**
              
              
              **24,606,275**
              
              
              **2,460**
              
              
              **22,541,994**
              
              
              **-**
              
              
              **-**
              
              
              **(14,575,489**
              **)**
              
              **7,969,213**Preferred
                  stock issued for cash (Note 7(a) and 7(b))
              
              
              5,150
              
              
              6
              
              
              -
              
              
              -
              
              
              3,587,984
              
              
              -
              
              
              
              
              
              -
              
              
              **3,587,990**Common
                  stock issued for acquisition and acquisition costs (Note 3 and
                  7(c))
              
              
              -
              
              
              -
              
              
              4,046,756
              
              
              405
              
              
              5,943,641
              
              
              -
              
              
              -
              
              
              -
              
              
              **5,944,046**Common
                  stock issued for cash from employee stock purchase plan (Note 6(c)
                  and
                  7(c))
              
              
              -
              
              
              -
              
              
              104,845
              
              
              10
              
              
              133,256
              
              
              -
              
              
              -
              
              
              -
              
              
              **133,266**Common
                  stock issued from conversion of preferred stock (Note 7(a) and
                  7(b))
              
              
              (647
              )
              
              (1
              )
              
              50,676
              
              
              5
              
              
              74,995
              
              
              -
              
              
              -
              
              
              -
              
              
              **74,999**Common
                  stock issued from employee stock options (Notes 6(b) and
                  7(e))
              
              
              -
              
              
              -
              
              
              230,281
              
              
              21
              
              
              173,193
              
              
              -
              
              
              -
              
              
              -
              
              
              **173,214**Common
                  stock issued for services (Note 7(c))
              
              
              -
              
              
              -
              
              
              1,500
              
              
              0
              
              
              2,175
              
              
              -
              
              
              -
              
              
              -
              
              
              **2,175**Common
                  stock issued from warrants (Notes 4(b) and 7(d))
              
              
              -
              
              
              -
              
              
              200,000
              
              
              20
              
              
              209,980
              
              
              -
              
              
              -
              
              
              -
              
              
              **210,000**Common
                  stock issued under revolving credit facility (Note 4(b) and
                  7(c))
              
              
              -
              
              
              -
              
              
              310,009
              
              
              31
              
              
              349,969
              
              
              -
              
              
              -
              
              
              -
              
              
              **350,000**Common
                  stock issued from conversion of declared dividends (Note 7(a) and
                  7(b))
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              **-**Stock
                  option expense under SFAS 123(R) (Notes 6(b) and 7(e))
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              133,379
              
              
              -
              
              
              -
              
              
              -
              
              
              **133,379**Declared
                  dividends
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (610,287
              )
              
              **(610,287**
              **)**-
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (952,372
              )
              
              **(952,372**
              **)****Balance
                  at December 31, 2006**
              
              
              **252,963**
              
              **$**
              **253**
              
              
              **29,550,342**
              
              **$**
              **2,953**
              
              **$**
              **33,150,566**
              
              **$**
              **-**
              
              **$**
              **-**
              
              **$**
              **(16,138,148**
              **)**
              **$**
              **17,015,624**
 *The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 F-5
  **SpaceDev,
                  Inc. and Subsidaries****Consolidated
                  Statements of Cash
                  Flows***Years
                  Ended December 31,*
              
              
              **2006**
              
              
              2005**Cash
                  Flows From Operating Activities**Net
                  income/(loss)
              
              **$**
              (952,372
              )
              $
              501,264Adjustments
                  to reconcile net loss to net cashprovided
                  by (used in) operating activities:Depreciation
                  and amortization
              
              
              **982,860**
              
              
              191,978Gain
                  on disposal of building sale
              
              
              (117,274
              )
              
              (117,272
              )Stock
                  option expense
              
              
              **133,379**
              
              
              -Non-cash
                  loan fees
              
              
              **114,600**
              
              
              28,874Common
                  stock issued for compensation and services
              
              
              **2,175**
              
              
              -Change
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (783,250
              )
              
              (658,930
              )Inventory
              
              
              (58,136
              )
              
              (21,340
              )Prepaid
                  and other assets
              
              
              **979,059**
              
              
              (605,721
              )Accounts
                  payable and accrued expenses
              
              
              (1,162,717
              )
              
              898,290Accrued
                  payroll, vacation and related taxes
              
              
              (99,523
              )
              
              95,869Billings
                  in excess of costs incurred and deferred revenue
              
              
              **1,292,145**
              
              
              (5,000
              )Other
                  accrued liabilities
              
              
              (2,318,851
              )
              
              89,008**Net
                  cash provided by (used in) operating activities**
              
              
              (1,987,905
              )
              
              397,020**Cash
                  Flows From Investing Activities**Notes
                  receivable
              
              
              **-**
              
              
              (1,353,440
              )Acquisition
                  costs, net of cash
              
              
              (1,408,134
              )
              
              (375,930
              )Purchases
                  of fixed assets
              
              
              (1,389,293
              )
              
              (986,370
              )**Net
                  cash used in investing activities**
              
              
              (2,797,427
              )
              
              (2,715,740
              )**Cash
                  Flows From Financing Activities**Principal
                  payments on notes payable
              
              
              (4,675,832
              )
              
              (36,670
              )Principal
                  payments on capitalized lease obligations
              
              
              (35,749
              )
              
              (3,784
              )Proceeds
                  from revolving credit facility
              
              
              **805,172**
              
              
              -Employee
                  stock purchase plan
              
              
              **133,266**
              
              
              58,369Other
                  assets, capitalized preferred stock issuance costs
              
              
              (175,000
              )
              
              (78,828
              )Proceeds
                  from issuance of preferred stock
              
              
              **4,038,361**
              
              
              -Proceeds
                  from issuance of common stock
              
              
              **383,222**
              
              
              3,061,070**Net
                  cash provided by financing activities**
              
              
              **473,440**
              
              
              3,000,157Net
                  Increase/(Decrease) in Cash and Cash Equivalents
              
              
              (4,311,892
              )
              
              681,437**Cash
                  and Cash Equivalents at Beginning of Year**
              
              
              **5,750,038**
              
              
              5,068,601**Cash
                  and Cash Equivalents at End of Year**
              
              **$**
              **1,438,146**
              
              $
              5,750,038
 *The
        accompanying notes are an integral part of these consolidated financial
        statements.*
 F-6
   **SpaceDev,
                  Inc. and Subsidaries****Consolidated
                  Statements of Cash Flows***Years
                  Ended December 31,*
              
              
              **2006**
              
              
              2005**Supplemental
                  Disclosures of Cash Flow Information:**Cash
                  paid during the year for:Interest
              
              **$**
              **65,713**
              
              $
              2,873Income
                  Taxes
              
              
              **19,290**
              
              
              1,600**Noncash
                  Investing and Financing Activities:**During
                  2006, the Company entered into capital leases in the amount of
                  approximately $225,000.During
                  2006 and 2005, the Company converted $133,266 and $38,326 of employee
                  stock purchase plancontributions
                  into 104,845 and 27,540 shares of common stock, respectively.During
                  2006 and 2005, the Company declared preferred stock dividends payable
                  of
                  $610,287 and $170,956,respectively
                  to the holder's of its series C and series D-1 preferred stock.During
                  2006, the Company issued 310,009 shares of its common stock and
                  expensed
                  $114,600 as well as accrued$233,482
                  to be spread over the next nine months in non-cash loan fees for
                  the
                  addition expensesincurred
                  under our new revolving credit facilty with the Laurus Master Fund.During
                  2005, the Company converted preferred stock dividends payable in
                  the
                  amount of$174,976
                  into 113,621 shares of common stock, for its preferred stockholders.During
                  2005, the Company issued 17,607 shares of its common stock to the
                  participants in its' prior convertibledept
                  program. In this noncash transaction, 25,000 warrants were converted
                  into
                  17,607 shares of common stock.The
                  Company recorded additional non-cash loan fees of $28,875 for the
                  difference between the warrant priceand
                  the current share price, and charged these fees to expense.
 *The
          accompanying notes are an integral part of these consolidated financial
          statements.*
  F-7




**1.**  **Summary
        of Significant Accounting Policies**
 A
        summary
        of the Company's significant accounting policies applied in the preparation
        of
        the accompanying consolidated financial statements follows.
 
 *(a* )  *Nature
        of operations*
  **SpaceDev,
        Inc.** ,
        including its wholly-owned subsidiary, Starsys, Inc., which was acquired
        on
        January 31, 2006, (and its inactive subsidiaries: SpaceDev, Inc., an Oklahoma
        corporation and Dream Chaser, Inc., a Delaware corporation), (the "Company")
        is
        engaged in the conception, design, development, manufacture, integration,
        sale,
        and operations of space technology systems, subsystems, products and services,
        as well as the design, manufacture, and sale of mechanical and electromechanical
        subsystems and components for spacecraft. The Company is currently focused
        on
        the commercial and military development of low-cost small satellites and
        related
        subsystems, hybrid rocket propulsion for space and launch vehicles, subsystems
        that enable critical spacecraft functions such as pointing solar arrays and
        communication antennas and restraining, deploying and actuating moving
        spacecraft components.
 
 The
        Company’s primary products, mission solutions and services include the
        following:
 
 ·
            Small
                Spacecraft.
                Sophisticated small, micro- and nano- satellites for remote sensing,
                military, scientific, and commercial missions and space-related technical
                support services. 
 ·
            Launch
                Vehicles.
                The Company is in the process of developing hybrid rocket-based launch
                vehicles, orbital maneuvering and orbital transfer vehicles, as well
                as
                safe sub-orbital and orbital hybrid rocket-based propulsion systems.
                It is
                also developing commercial hybrid rocket motors for possible use
                in small
                launch vehicles, targets and sounding rockets, and small high performance
                space vehicles and subsystems. 
 ·
            Space
                Components and Mechanisms.
                The Company manufactures a wide range of products that include High
                Output
                Paraffin ("HOP") actuators, hinges, battery bypass switches, bi-axis
                gimbals, flat plate gimbals, solar array pointing mechanisms, restraint
                devices, and cover systems. These products are sold both as
                "off-the-shelf" catalog products, which represent previously qualified
                devices with spaceflight history, and as custom systems that are
                developed
                for specific applications. The Company’s products are typically sold
                directly to spacecraft manufacturers. 
 ·
            Structures.The Company designs and manufactures deployable booms, separation
                systems
                and, thermal louvers. 
 The
        historic SpaceDev business approach was to provide smaller spacecraft -
        generally 250 kg (550 pounds) mass and less - and cleaner, safer hybrid
        propulsion systems to commercial, government, university, and limited
        international customers. The Company is developing smaller spacecraft and
        miniaturized subsystems using proven, lower cost, high-quality off-the-shelf
        components. Its space products are modular and reproducible, which allows
        us to
        create affordable space solutions for our customers. By utilizing its innovative
        technology and experience, and space-qualifying commercial industry-standard
        hardware, software and interfaces, the Company provides increased reliability
        with reduced costs and risks.
 
 F-8
 The
        acquisition of Starsys on January 31, 2006 fundamentally changed the Company’s
        profile. SpaceDev had 2005 revenues of approximately $9.0 million and a 2005
        profit of approximately $0.5 million. Starsys is a mature operating company
        with
        2005 revenues of approximately $18 million and 2005 losses of approximately
        $3.4
        million.  In 2006, SpaceDev and Starsys merged and had combined revenues of
        approximately $32 million and losses of less than $1.0 million. The Company
        believes there are numerous potential synergies between the historic SpaceDev
        business, and the newly acquired Starsys' business. The Company has been
        integrating certain functions within SpaceDev and Starsys as it deems
        appropriate.
 
 In
        January 2006, the Company acquired Starsys Research Corporation. After the
        merger, the Company maintained its headquarters in California and operating
        centers in California, Colorado and North Carolina. As a result of the merger,
        the Company grew from just over 50 employees to over 200.
 
 *(b)*  *Principles
        of consolidation*
  The
        consolidated financial statements include the accounts of the Company and
        its
        wholly-owned active subsidiary, Starsys, Inc., a Colorado corporation, and
        its
        wholly-owned inactive subsidiaries, SpaceDev, Inc., an Oklahoma corporation
        and
        Dream Chaser, Inc., a Delaware corporation. As
        of
        December 31, 2006 and 2005, the Company had no partially owned
        subsidiaries. All significant intercompany balances and transactions have
        been
        eliminated.
 
 *(c)
        Preparation of consolidated financial statements*
  The
        preparation of consolidated financial statements, in conformity with generally
        accepted accounting principles in the United States, requires management
        to make
        estimates and assumptions, including estimates of future contract costs and
        earnings. Such estimates and assumptions affect the reported amounts of assets
        and liabilities at the date of the consolidated financial statements and
        the
        reported amounts of revenues and earnings during the current reporting period.
        Management periodically assesses and evaluates the adequacy and/or deficiency
        of
        estimated liabilities recorded for various reserves, liabilities, contract
        risks
        and uncertainties. Actual results could differ from these estimates. All
        financial amounts are stated in U.S. dollars unless otherwise indicated.
 
 *(d)*  *Accounts
        receivable and allowances for uncollectible accounts*
 
 Accounts
        receivable are stated at the historical carrying amount net of write-offs
        and
        allowances for uncollectible accounts as well as costs and estimated earnings
        in
        excess of billings on uncompleted contracts which represents approximately
        $1.7
        million at December 31, 2006. The Company establishes an allowance for
        uncollectible accounts based on historical experience and any specific customer
        collection issues that the Company has identified. Uncollectible accounts
        receivable are written-off when a settlement is reached for an amount that
        is
        less than the outstanding balance or when the Company has determined that
        balance will not be collected. At December 31, 2006 and 2005, the allowance
        for
        uncollectible accounts was $75,131 and $32,281, respectively.
 
 *(e)*
              *Revenue,
                  expense, and profitability
                  recognition*
  The
        Company's revenues in 2006 were derived primarily from fixed price contracts
        and
        commercial sales of component and subsystem products that the Company acquired
        in its 2006 acquisition of Starsys along with some United States government
        cost
        plus fixed fee (CPFF) contracts, which is compared to primarily CPFF contracts
        for the same period in 2005. Revenues from the CPFF contracts for 2006 and
        2005
        were recognized as expenses were incurred. Estimated contract profits are
        taken
        into earnings in proportion to revenues recorded. Time and material revenues
        are
        recognized as services are performed and costs incurred. Certain fixed price
        contracts were prepared according to the "percentage-of-completion" method
        of
        accounting for long-term contracts. The amount of revenues recognized is
        that
        portion of the total contract amount that the actual cost expended bears
        to the
        anticipated final total cost based on current estimates of cost to complete
        the
        project (cost-to-cost method). Recognition of profit commences on an individual
        project only when cost to complete the project can reasonably be estimated
        and
        after there has been some meaningful performance achieved on the project.
        Recognition of losses on projects are taken as soon as the loss is reasonably
        determinable and accrued on the balance sheet in other accrued liabilities.
        The
        current accrual for potential losses on existing projects represents
        approximately $719,000. As projects are completed, the accrual is adjusted
        as
        projects move toward completion and more accurate estimates are established.
        Changes in job performance, job conditions, and estimated profitability,
        including those arising from contract penalty provisions (when applicable),
        and
        final contract settlements may result in revisions to costs and income, and
        are
        recognized in the period in which the revisions are determined. Contract
        costs
        include all direct material, direct labor and subcontractor costs, and other
        costs such as supplies, tools and travel which are specifically related to
        a
        particular contract. All other selling, general and administrative costs
        are
        expensed as incurred.
 
 F-9
  *(f)*
              *Depreciation
                  and amortization*
  Fixed
        assets and intangible assets are depreciated over their estimated useful
        lives
        of three-to-fifteen years using the straight-line method of
        accounting.
 
 In
        December 2002, the Company entered an agreement to sell its interest in its
        Poway headquarters facility, which sale closed in January 2003. The escrow
        transaction included the sale of the land and building at 13855 Stowe Drive,
        Poway, CA 92064. In conjunction with this sale, the Company entered into
        a
        non-cancelable operating lease with the buyer to lease-back its facilities
        for
        ten years. The base rent is increased by 3.5% per year (see Note 2).
 
 *(g)*
              *Research
                  and development*
  The
        Company is engaged in design and development activities with its commercial
        and
        government customers. The Company has Small Business Innovation Research
        ("SBIR") grants from the government and continues to seek new SBIR
        opportunities. Costs incurred under SBIR grants are charged against revenues
        received under SBIR grants. Non-reimbursable research and development
        expenditures relating to possible future products are expensed as incurred.
        The
        Company incurred $284,346 and $31,940 in non-reimbursable research and
        development costs during 2006 and 2005, respectively.
 
 *(h)*
              *Income
                  taxes*
  Deferred
        income taxes are recognized for the tax consequences in future years of the
        differences between the tax basis of assets and liabilities and their financial
        reporting amounts at each year-end based on enacted tax laws and statutory
        tax
        rates applicable to the years in which the differences are expected to affect
        taxable income. Valuation allowances are established when necessary to reduce
        deferred tax assets to the amount expected to be realized. Income tax expense
        is
        the combination of the tax payable for the year and the change during the
        year
        in deferred tax assets and liabilities.
 
 *(i)*
              *Stock-based
                  compensation*
  The
        Company adopted SFAS 123(R) to account for its stock-based compensation
        beginning January 1, 2006. Previously, the Company elected to account for
        its
        stock-based compensation plans under APB 25. The Company computed, for pro
        forma
        disclosure purposes, the value of all options granted during 2005 using the
        minimum value method as prescribed by SFAS 123 and amended by SFAS 148. Under
        this method, the Company used the risk-free interest rate at the date of
        grant,
        the expected volatility, the expected dividend yield and the expected life
        of
        the options to determine the fair value of options granted. The risk-free
        interest rates ranged from 4.0% to 6.5%, expected volatility was 75% to 117%,
        the dividend yield was assumed to be zero, and the expected life of the options
        was assumed to be three to five years based on the average vesting period
        of
        options granted.
 
 F-10
 If
        the
        Company had accounted for its options in accordance with SFAS 123(R) in 2005,
        the total value of options granted during the year ended December 31, 2005
        would
        have been amortized over the vesting period of the options. In December 2005,
        in
        order to avoid adverse financial reporting effects in future years under
        SFAS
        123(R), the Company eliminated all future vesting requirements on all of
        our
        8,031,036 stock options then outstanding and in the hands of employees,
        officers, and directors. All of such options vested fully before the end
        of such
        year. Thus, the Company's consolidated net income (loss) would have been
        as
        follows:
  **Net
                      Income**
                  
                  
                  2005As
                      reported
                  
                  $
                  501,264Less:
                      Preferred Dividend Payments
                  
                  $
                  (170,956
                  )Adjusted
                      Net Income (Loss) for EPS Calculation
                  
                  
                  330,308Add:
                      Stock based employee compensation expense included in reported
                      net income
                  
                  
                  -Deduct:
                      Stock based employee compensation expense determined under
                      the fair value
                      based method for all awards
                  
                  
                  (7,488,859
                  )Pro
                      forma
                  
                  $
                  (6,987,595
                  )**Net
                      Income (Loss) Per Share:**As
                      reported - basic
                  
                  $
                  0.01As
                      reported - diluted
                  
                  $
                  0.01Pro
                      forma - basic
                  
                  $
                  (0.31
                  )Pro
                      forma - diluted
                  
                  $
                  (0.31
                  )
 During
        fiscal 2006, the Company expensed stock options based on a calculation using
        the
        minimum value method as prescribed by SFAS 123(R), otherwise known as the
        Black-Scholes method. Under this method, the Company used a risk-free interest
        rate at the date of grant, an expected volatility, an expected dividend yield
        and an expected life of the options to determine the fair value of options
        granted. The risk-free interest rate was estimated at 4.0%, expected volatility
        ranged from 86.7% to 90.8% at the time all options were granted, the dividend
        yield was assumed to be zero, and the expected life of the options was assumed
        to be three years based on the average vesting period of options granted.
        For
        the year ended December 31, 2006, the Company expensed approximately $133,000
        of
        stock option expenses due to SFAS 123(R) in its financial
        statements.
  F-11
 *(j)*  *Net
        income (loss) per common share*
  Net
        income per common share has been computed on the basis of the weighted average
        number of shares outstanding, according to the rules of SFAS No. 128, *Earnings
        per Share* .
        Diluted
        net loss per share was not computed in 2006, as the computation would result
        in
        anti-dilution.
  **Year
                  Ended December 31,****2006**
              
              
              **2005**Numerator:Net
                  income (loss)
              $
              (952,372
              )
              $
              501,264Minus:
                  Dividends on convertible preferred stock
              
              **(610,287**
              **)**
              
              (170,956
              )$
              (1,562,659
              )
              $
              330,308Denominator:Weighted-average
                  shares used to compute basic EPS
              
              **28,666,059**
              
              
              22,270,997Adjusted
                  weighted-average shares for conversion and exercise of preferred
                  stock,
                  options, and warrants
              
              **N/A**
              
              
              2,335,885Weighted-average
                  shares used to compute diluted EPS
              
              **28,666,059**
              
              
              24,606,882Net
                  earnings per share:Basic
              $
              (0.05
              )
              $
              0.01Diluted
              $
              N/A
              
              $
              0.01
 F-12
  The
        potential shares, which are included in the computation of diluted net income
        per share, are as follows:
 
 **Year
                    Ended December 31,****2006**
                
                **2005**Incremental
                    shares from assumed conversions and exercises:Warrants
                N/A
                
                -Options
                N/A
                
                2,335,885Convertible
                    preferred stock
                N/A
                
                1,722,158Dilutive
                    potential common shares
                N/A
                
                4,058,043Anti-dilutive
                    shares
                N/A
                
                (1,722,158
                )Adjusted
                    weighted-average shares
                N/A
                
                2,335,885
 
 *(k)*
              *Financial
                  instruments*
 
 The
        Company's financial instruments consist primarily of cash, short-term notes
        receivable, accounts receivable, capital leases, accounts payable, and notes
        payable. These financial instruments are stated at their respective carrying
        values, which approximate their fair values.
 
 *(l)*
              *Segment
                  reporting*
  The
        Company has determined that it operates in one business segment dedicated
        to
        space technology.
 
 *(m)*
              *New
                  accounting standards*
 
 During
        2006, the Financial Accounting Standards Board (FASB) issued FASB
        Interpretation No. 48, *Accounting
        for Uncertainty in Income Taxes* (FIN
        48). This guidance is intended to provide increased consistency in the
        application of FASB Statement No. 109, *Accounting
        for Income Taxes* ,
        by
        providing guidance with regard to the recognition and measurement of uncertain
        tax positions, the accrual of interest and penalties, and increased disclosure
        requirements. In particular, this interpretation requires uncertain tax
        positions to be recognized only if they are “more likely than not” to be upheld
        based on their technical merits. The measurement of the uncertain tax position
        will be based on the largest benefit amount that is more likely than not
        (determined on a cumulative probability basis) to be realized upon settlement.
        Any resulting cumulative effect of applying the provisions of FIN 48 upon
        adoption will be reported as an adjustment to the beginning balance of retained
        earnings (deficit) in the period of adoption. For SpaceDev, Inc., this
        interpretation is effective beginning January 1, 2007.
  While
        management has historically used the “more likely than not” threshold for
        recognizing our uncertain tax positions, we have not used the concept of
        cumulative probability to measure the uncertain tax positions. However, based
        on
        an evaluation of the Company’s uncertain tax positions using the new measurement
        criteria, this interpretation is currently not expected to have a material
        impact on the Company’s financial condition or results of operations.
 
 F-13
 The
        FASB
        also issued FASB Statement No. 157, *Fair
        Value Measurements* ,
        during
        2006. This statement defines fair value as the price that would be received
        to
        sell an asset or paid to transfer a liability in an orderly transaction between
        market participants at the measurement date. It provides a framework for
        measuring fair value and requires additional disclosures about fair value
        measurements. This statement applies only to fair value measurements already
        required or permitted by other statements; it does not impose additional
        fair
        value measurements. This statement is effective for fair value measurements
        in
        fiscal years beginning after November 15, 2007. Currently, management does
        not
        expect this statement to have a material impact on our financial condition
        or
        results of operations.
 
 *(n)*
              *Other
                  assets*
  *Other
        Current Assets*
  Other
        current assets consist of a variety of prepaid and other cash advances for
        items
        which are expected to occur within the next year. The following is a listing
        of
        items that constitute the Company’s other current assets at December 31,
        2006.
 Other
                    Current Assets - December 31,
                
                
                **2006**
                
                
                2005Financing
                    Fees
                
                **$**
                **303,174**
                
                $
                -Software
                    Prepaid License
                
                
                **93,009**
                
                
                -Insurance
                    Prepaid
                
                
                **60,435**
                
                
                -2006
                    Property Tax Prepayment
                
                
                **3,210**
                
                
                -Rental
                    Prepaid Short Term
                
                
                **40,103**
                
                
                -All
                    Other Deposits
                
                
                **99,634**
                
                
                -Total
                    Other Current Assets
                
                **$**
                **599,565**
                
                $
                -
 
 *Other
        Assets*
  Other
        assets consist of prepaid and other cash advances for items which are expected
        to occur at a date beyond twelve months into the future. The following is
        a
        listing of items that constitute the Company’s other assets at December 31,
        2006.
 
 F-14
  Other
                    Assets - December 31,
                
                
                **2006**
                
                
                2005Prepaid
                    Rent
                
                **$**
                **188,130**
                
                $
                -Cost
                    Accrued in Conjunction with Starsys Acquisition
                
                
                **-**
                
                
                724,127Cost
                    Accrued in Conjunction with 2006 Securities Purchase
                    Agreement
                
                
                **-**
                
                
                78,828Financing
                    Fees
                
                
                **116,666**
                
                
                -Deposits
                
                
                **321,290**
                
                
                728,076Total
                    Other Assets
                
                **$**
                **626,086**
                
                $
                1,531,031
  *(o)*  *Cash
        and cash equivalents*
  Cash
        and
        cash equivalents are made up of cash as well as short term treasury instruments
        that will mature in a relatively short amount of time and represents only
        the
        present value of the instrument. These treasury instruments can be redeemed
        at
        any time, which is also why they are deemed to be cash and cash equivalents.
        As
        of December 31, 2006 all of the Company’s treasury instruments have
        matured.
 
 *(p)*  *Advertising
        costs*
  Direct
        advertising costs are expensed as they are incurred by the Company.
 
 *(q)
        Inventory*
 
 Inventory
        is valued based on the lower-of-cost-or-market method and is disbursed on
        a
        First-In, First-Out (FIFO) basis, unless required by customer contract to
        be
        distributed by specific identification for lot control purposes. Inventory
        includes raw material inventory, finished goods inventory, and work-in-process
        inventory Actual results of contracts may differ from management's estimates
        and
        such differences could be material to the consolidated financial statements.
        Professional fees are billed to customers on a time and materials basis.
        Time
        and material revenues are recognized as services are performed and costs
        incurred.
 
 *(r)
        Billings in excess of costs and deferred revenue*
 
 In
        2006,
        billings in excess of costs incurred and estimated earnings represent the
        excess
        of amounts billed over the amounts called for to be billed under the contractual
        billing terms. Costs in excess of billings represent the excess of actual
        costs
        incurred to the amount that is billed to date.
 
 Deferred
        revenue represents amounts collected from customers for projects, products,
        or
        services to be provided at a future date.
 
 **2.**  **Fixed
        Assets**
 
 In
        January 2003, the Company sold the land and building at 13855 Stowe Drive,
        Poway, CA 92064. In conjunction with the sale, the Company entered into a
        10-year lease agreement with the buyer to lease-back this facility (see Note
        8(c)). The gain on the sale of the facility was deferred and is being amortized
        over the remaining term of the lease. This amortization is included in the
        Company's non-operating income and expense.
 
 F-15
 The
        gain
        of $1,172,720 on the sale of the facility was deferred and is being amortized
        on
        a straight-line basis over the ten (10) year term of the lease at the rate
        of
        $117,272 per year. As of December 31, 2006 and 2005, the deferred gain was
        $713,405 and $830,677, respectively. This amortization is included in the
        Company's non-operating income and expense and totaled $117,274 and $117,272
        in
        2006 and 2005, respectively.
 
 Deferred
        Gain consisted of the following:
 *December
                    31,*
                
                **2006**
                
                2005Deferred
                    Gain
                
                **$**
                **1,172,720**
                
                $
                1,172,720Less
                    Amortization to date
                
                
                **(459,315**
                **)**
                
                (342,043
                )**$**
                **713,405**
                
                $
                830,677
 
 Fixed
                    assets consisted of the following:*December
                    31,*
                
                
                **2006**
                
                
                2005Capital
                    leases
                
                **$**
                **472,687**
                
                $
                155,499Computer
                    equipment
                
                
                **952,895**
                
                
                699,592Building
                    improvements
                
                
                **1,959**
                
                
                -Furniture
                    and fixtures
                
                
                **2,525,833**
                
                
                241,564Rocket
                    Motor Test Center
                
                
                **1,205,468**
                
                
                446,621**5,158,843**
                
                
                1,543,276Less
                      accumulated depreciationand amortization
                
                
                **(1,365,478**
                **)**
                
                (469,503
                )**$**
                **3,793,365**
                
                $
                1,073,773
 
 Depreciation
        and amortization expense for fixed assets was approximately $983,000 and
        $192,000 for the years ended December 31, 2006 and 2005, respectively.
        Depreciation and amortization expense was higher during 2006 due to the
        acquisition of Starsys in January 2006 as well as the purchase of new fixed
        assets, mainly new computer hardware and software, during 2006 and the
        construction of the Company’s fabrication and test facilities for its hybrid
        rocket motor systems, also located in Poway, California. Of the above
        depreciation, approximately $20,000 and $17,000, for the years ended December
        31, 2006 and 2005, respectively, was for depreciation on equipment under
        capital
        leases.
 
 **3.**  **Acquisitions**
 
 On
        January 31, 2006, the Company completed the acquisition of Starsys Research
        Corporation by reverse triangular merger. The merger agreement was dated
        October
        24, 2005 and amended on December 7, 2005 and January 31, 2006.
 
 F-16
 The
        following is a schedule of the goodwill incurred in the Starsys
        acquisition.
  Starsys
                    Total Assets
                
                $
                (7,851,494
                )Starsys
                    Total Liabilities
                
                
                13,054,140Cash
                    to Starsys Stockholders
                
                
                410,791Equity
                    to Starsys Stockholders
                
                
                5,576,846Fees
                    Associated with Acquisition
                
                
                1,056,079$
                12,246,362
 
 Starsys
        shareholders received approximately $411,000 in cash and approximately 3.8
        million shares of the Company's common stock at the consummation of the merger.
        The Company also paid approximately $705,000 in Starsys transaction expenses
        connected to the merger, and reclassified from Other Assets to Investment
        in
        Subsidiaries approximately $500,000 in certain legal and accounting expenses
        incurred during the merger. The Company incurred approximately $11.2 million
        in
        goodwill because of the acquisition with Starsys as well as other assets
        and
        intangible assets valued at approximately $1.0 million. The weighted average
        amortization period for these intangible assets is approximately 10 years.
        In
        addition, the Company recognized approximately $350,000 of deferred tax
        liability associated with the acquisition of intangible assets.
 
 Following
        the merger, the pre-merger Starsys shareholders may also be entitled to receive
        additional performance consideration, based on the achievement by the Starsys
        business of specific financial performance criteria for fiscal years 2005,
        2006
        and 2007. This consideration could have originally consisted of up to an
        aggregate of $1,050,000 in cash and shares of the Company's common stock
        valued
        at up to $18 million, subject to reduction for some merger related expenses
        and
        to escrow arrangements, as follows:
 
 For
        the
        fiscal year ended December 31, 2005, up to $350,000 in cash and up to an
        aggregate number of shares of the Company's common stock equal to (A) up
        to $3.0
        million divided by (B) the volume weighted average price of the Company's
        common
        stock for the 20 trading days preceding the date of the audit opinion for
        Starsys’ fiscal year ended December 31, 2005, but not less than $2.00 per share.
        This portion of the additional performance consideration was not
        earned;
 
 For
        the
        fiscal year ended December 31, 2006, up to $350,000 in cash and up to an
        aggregate number of shares of the Company's common stock equal to (A) up
        to $7.5
        million divided by (B) the volume weighted average price of the Company's
        common
        stock for the 20 trading days preceding the date of the audit opinion for
        Starsys’ fiscal year ended December 31, 2006, but not less than $2.50 per share.
        This portion of the additional performance consideration was not earned;
        and,
 
 For
        the
        fiscal year ending December 31, 2007, up to $350,000 in cash and up to an
        aggregate number of shares of the Company's common stock equal to (A) up
        to $7.5
        million divided by (B) the volume weighted average price of the Company's
        common
        stock for the 20 trading days preceding the date of the audit opinion for
        Starsys’ fiscal year ended December 31, 2007, but not less than $3.00 per share.
        This portion of the additional performance consideration will be determined
        in
        early 2008.
 
 Starsys
        shareholders will be entitled to receive the maximum amount of performance
        consideration for a particular fiscal year if the Company breaches specified
        covenants of the merger agreement and is unable to cure the breach within
        the
        applicable cure period set forth in the merger agreement.
 
 F-17
 Approximately
        one-half of the shares issued to Starsys shareholders at the closing have
        been
        placed in escrow to satisfy any indemnification obligations of Starsys
        shareholders under the merger agreement and to pay reasonable expenses of
        the
        shareholder agent. The indemnification escrow will generally last until ten
        days
        following the date of audited financial statements prepared for the Starsys
        business for the fiscal year ending December 31, 2006 (approximately April
        2007).
 
 On
        August
        14, 1998, the Company entered an Agreement for License and Purchase of
        Technology from American Rocket Company (AMROC) with an unrelated individual
        who
        had obtained ownership of such technology from AMROC. The intellectual property
        acquired was hybrid rocket technology that has been modified and may be used
        in
        the future operations of the Company. Upon execution of the Agreement, the
        Company issued the seller a warrant to purchase 25,000 shares of restricted
        common stock. This warrant expired in 2003.
 
 For
        each
        of the three years following the Agreement date, the licensor received warrants
        to purchase 25,000 shares of restricted common stock. In the fourth through
        tenth year following the Agreement date, the licensor may receive a warrant
        to
        purchase a number of shares, if revenue is generated from the acquired
        technology. All revenue based warrants are earned at a rate of one share
        per
        $125 of revenue generated from the technology acquired. Under the terms of
        the
        Agreement, the minimum number of shares to be issued is 100,000 and the maximum
        consideration shall not exceed warrants to purchase 3,000,000 shares of common
        stock or $6,000,000 in recognized value. Recognized value is the sum of (a)
        the
        cumulative difference between the market price of the common stock and the
        strike price and (b) the cumulative difference between the market price on
        the
        date of exercise and the strike price for each warrant previously exercised.
        To
        date, no revenue has been generated from the acquired technology and all
        75,000
        additional warrants expired by August 2006.
 
 All
        of
        the Company’s acquisitions have been accounted for using the purchase method of
        accounting. Intangible assets, were amortized using the straight-line method
        and
        totaled approximately $87,000 for the year ending December 31, 2006. The
        initial
        purchase price included stock issued at the date of acquisition, direct
        acquisition costs, and any guaranteed future consideration.
 
 **4.**  **Notes
        Payable**
 *(a)*  *Building
        and settlement notes*
 In
        January 2003, the Company sold the land and building at 13855 Stowe Drive,
        Poway, CA 92064. In conjunction with the sale, the Company entered into a
        lease
        agreement with the buyer to leaseback this facility. Net fixed assets were
        reduced by approximately $1.9 million and notes payable were reduced by
        approximately $2.4 million, while a deferred gain was recorded.
 
 In
        2001,
        the Company entered into three settlement loan agreements with various vendors.
        The total of $171,402 for all three loans called for payment between 24 and
        50
        months with interest that ranged from 0% to 8%. At December 31, 2005, the
        outstanding balance on these notes were and $9,457 with interest expense
        of
        $1,474. The remaining notes were paid in full during 2006.
 
 *(b)*  *Revolving
        credit facility*
 
 New
        Revolving Credit Facility .
        On
        September 29, 2006, the Company entered into a $5.0 million financing
        arrangement with Laurus Master Fund, Ltd. (“Laurus”). The financing is effected
        through a revolving note for up to $5.0 million, although the exact principal
        balance at any given time will depend on draws made by the Company on the
        Facility. The Company will be allowed to borrow against the Facility under
        an
        investment formula based on accounts receivable at an advance rate equal
        to 90%
        of eligible receivables and the lesser of: (a) 50% of eligible inventory
        (calculated on the basis of the lower-of-cost-or-market, on a first-in-first-out
        basis); or, (b) $1.0 million, provided, however, that no more than $500,000
        of
        such eligible inventory may be in the form of work-in-process inventory.
        The
        balance on this revolving credit facility at December 31, 2006 was
        $805,172.
 
 F-18
 The
        facility bears interest at a rate equal to prime plus 2% (10.25% at December
        31,
        2006) and is payable monthly. The rate will be increased or decreased on
        the
        date the Prime Rate is adjusted. Interest is due on the first business day
        of
        each month through maturity. The term of the facility is scheduled to end
        on
        September 29, 2009. Laurus received 310,009 unregistered shares of the Company’s
        common stock valued at $350,000 at closing. The value of these shares was
        determined based on the $1.13 average trading price for the stock during
        the
        preceding ten (10) business days and the expense is being amortized daily
        over
        the first year of the note. The Company will issue additional restricted
        shares
        of its common stock worth, in the aggregate, $200,000 to Laurus on each
        anniversary date of the facility, if the facility remains in place. The pricing
        of these additional shares will be based on the applicable preceding ten
        (10)
        business day average trading price. The facility is not convertible into
        any
        class of our securities.
 
 Laurus
        agreed that if and when it can resell the unregistered shares under Rule
        144,
        its resale on any one day cannot exceed 10% of the daily trading volume.
        Laurus
        has piggyback registration rights subject to certain underwriters’ restrictions,
        but will not be entitled to demand registration of any of the shares received
        under the facility. In addition, Laurus is strictly prohibited from engaging
        in
        any short sales of the Company’s common stock during the term of the
        facility.
 
 The
        facility is a secured debt, collateralized by substantially all of the Company's
        and its subsidiaries' assets. The facility contains certain default provisions.
        In the event of a default by the Company, the Company will be required to
        pay an
        additional fee per month until the default is cured. Laurus has the option
        of
        accelerating the entire principal balance and requiring the Company to pay
        a
        premium in the event of an uncured default.
 
 The
        facility requires the Company to deposit all funds (other than certain
        refundable deposits) into a lockbox that will be swept on a daily basis to
        reduce any outstanding facility balance. Any funds in excess of any outstanding
        facility balance will be transferred to the Company on a daily basis.
 
 The
        Company paid $9,500 for legal fees and expenses in structuring the facility,
        conducting due diligence and escrow fees. In addition, the Company paid a
        finder’s fee in the amount of $35,000 and paid Laurus a facility fee of
        approximately $140,000, which facility fee is being expensed over the life
        of
        the note.
 
 Previous
        Revolving Credit Facility .
        In June
        2003, the Company entered into a $1.0 million financing arrangement with
        Laurus
        in the form of a three-year Convertible Note secured by its assets subject
        to
        the amount of eligible accounts receivables. In August 2004, after the initial
        $1.0 million was converted, the revolving credit facility was increased to
        $1.5
        million. The net proceeds from the Convertible Notes were used for general
        working capital purposes. Advances on the Convertible Notes were repayable
        at
        the Company's option, in cash or through the issuance of the Company's shares
        of
        common stock. The Convertible Notes carried an interest rate of Wall Street
        Journal Prime plus 0.75% on any outstanding balance. In addition, the Company
        was required to pay a collateral management payment plus an unused line payment.
        Availability of funds under the old revolving credit facility was based on
        the
        Company's accounts receivable. Laurus exercised its conversion rights from
        time-to-time on outstanding balances. Laurus converted an aggregate of $2.5
        million of revolving debt into 3,406,417 shares of the Company’s common stock
        during the term of the revolving credit facility. There was no outstanding
        balance on the revolving credit facility at December 31, 2005 and thereafter
        and
        there were no conversions during the twelve months of 2005 or during 2006
        until
        expiration. This
        revolving credit facility with Laurus expired on June 3, 2006 and the Company
        has since entered into a new revolving note with Laurus on September 29,
        2006,
        as mentioned above.
 
 F-19
 In
        conjunction with the June 2003 transaction, Laurus received a warrant to
        purchase 200,000 shares of the Company's common stock for the initial $1.0
        million revolving credit facility. The warrant exercise price was $0.63 per
        share for the purchase of up to 125,000 shares; $0.69 per share for the purchase
        of an additional 50,000 shares; and $0.80 per share for the purchase of an
        additional 25,000 shares. The warrant exercise price may be paid in cash,
        in
        shares of the Company's common stock, or by a combination of both. The warrant
        expiration date is June 3, 2008. In addition to the initial warrant, the
        Company
        issued two warrants: 1) to purchase 50,000 shares at an exercise price of
        $1.0625 per share, which warrant was exercised by Laurus on April 19, 2005;
        and,
        2) to purchase 50,000 shares at an exercise price of $1.925 per share, which
        has
        an expiration date of August 25, 2009.
 
 **5.**  **Income
        Taxes**
  At
        December 31, 2006, the Company had federal and state tax net operating loss
        carryforwards (“NOL”) of approximately $10,096,000 and $9,163,000, respectively.
        These amounts include acquired federal and state NOL's of Starsys of $3,667,000
        and $6,430,000. The federal and state tax loss carryforwards will begin to
        expire in 2019 and 2011, respectively, unless previously utilized.
 
 At
        December 31, 2006, the Company had federal and state research tax credits
        of
        approximately $3,489,000 and $39,000, respectively. The federal research
        tax
        credits will begin to expire in 2018. The state research tax credits will
        carryforward indefinitely.
 
 Pursuant
        to Internal Revenue Code Sections 382 and 383, the Company’s use of its net
        operating loss and credit carryforwards relating to Starsys will be limited
        as a
        result of cumulative changes in ownership of more than 50% over a three-year
        period. Management is currently in the process of calculating these
        limitations.
 
 As
        a
        result of the adoption of SFAS No. 123(R), the Company will recognize excess
        tax
        benefits associated with the exercise of stock options directly to stockholders’
equity only when realized. Accordingly, deferred tax assets are not recognized
        for net operating loss carryforwards resulting from excess tax benefits.
        As of
        December 31, 2006, deferred tax assets do not include $254,000 of these excess
        tax benefits from employee stock option exercises that are a component of
        the
        Company’s net operating loss carryforwards. Additional paid in capital will be
        increased up to $254,000 if such excess tax benefits are realized.
 
 The
        Company also recorded a valuation allowance of $4,500,000 related to federal
        and
        state loss and tax credit carryforwards and other temporary differences of
        Starsys. The tax benefit of these carryforwards, if and when realized, will
        first reduce the existing value of goodwill up to a total of $4,500,000,
        then,
        if applicable, remaining amounts will be applied first to other intangible
        assets with any excess amount recognized as an income tax benefit.
 
 Significant
        components of the Company's deferred tax assets are shown below. A valuation
        allowance has been established to offset the deferred tax assets, as realization
        of such assets has not met the more likely than not threshold required under
        SFAS No. 109.
  F-20
 
 *December
                  31,*
              
              
              **2006**
              
              
              **2005**Deferred
                  tax assets:Net
                  operating loss carryforwards
              
              **$**
              **3,715,800**
              
              **$**
              **3,941,400**Deferred
                  gain on sale of building
              
              
              **291,000**
              
              
              **338,000**Reserve
                  for loss on contracts
              
              
              **285,000**
              
              
              **608,500**Other
              
              
              **200,500**
              
              
              **307,900**Tax
                  credit carryforwards
              
              
              **3,537,700**
              
              
              **1,966,800**Gross
                  deferred tax assets
              
              
              **8,030,000**
              
              
              **7,162,600**Fixed
                  Assets and Intangibles
              
              
              **-744,600**
              
              
              **-593,400****7,285,400**
              
              
              **6,569,200**Valuation
                  allowance
              
              
              **-7,285,400**
              
              
              **-6,569,200****$**
              -
              
              **$**
              **-**
  Significant
        components of the provision for income taxes for the years ended December
        31,
        2006 and 2005 are as follows:
  **2006**
                
                
                **2005**CurrentFederal
                
                **$**
                **15,000**
                
                **$**
                **-**State
                
                
                **4,200**
                
                
                **1,600****19,200**
                
                
                **1,600**DeferredFederal
                
                
                **-**
                
                
                **-**State
                
                
                **-**
                
                
                **-**Income
                    tax expense
                
                **$**
                **19,200**
                
                **$**
                **1,600**
 
 Reconciliation
        of the statutory federal income tax benefit to the Company's effective tax
        benefit:
 
 *Years
                  Ended December 31,*
              
              
              **2006**
              
              
              **2005**Statutory
                  U.S. federal rate
              
              
              **35.00**
              **%**
              
              **35.00**
              **%**State
                  income taxes - net of federal benefit
              
              
              **3.79**
              **%**
              
              **5.70**
              **%**Permanent
                  differences
              
              
              **-14.42**
              **%**
              
              **7.40**
              **%**NOL
                  and tax credit prior year true up
              
              
              **-15.99**
              **%**Other
              
              
              **.82**
              **%**Tax
                  Credits
              
              
              **91.18**
              **%**Change
                  in valuation allowance
              
              
              **-100.38**
              **%**
              
              **-48.10**
              **%**Provision
                  for income taxes
              
              
              **0.00**
              **%**
              
              **0.00**
              **%**
 
 F-21
 **6.**  **Employee
        Benefit Plans**
 *(a)*  *Profit
        sharing 401(k) plan*
  The
        Company's amended 401(k) retirement savings plan allowed each eligible employee
        to voluntarily make pre-tax salary contributions up to 93% of their compensation
        or statutory limits per year, whichever is lower, for the years ended December
        31, 2006 and 2005. The Company has elected to make a matching contribution
        of
        10% of employee contributions, which matching portion vests over five years
        as
        specified in the plan amendment. During 2006 and 2005, the Company contributed
        $24,698 and $18,235 to the Plan, respectively.
 
 Upon
        the
        merger with Starsys, the Company added the Starsys 401(k) retirement saving
        plan
        which allows each eligible Starsys employee to make elective deferrals to
        the
        Plan and elect to reduce his or her compensation in an amount of 2% up to
        a
        maximum of 15% of compensation, for contributions to this Plan as an elective
        deferral. There is a four year vesting period for the Company’s match (25% each
        year for four years). The Company elected to make matching contributions on
        employee contributions at a rate of 25% on the first 4% of employee
        contributions.  The matching portions vest over a four year period in equal
        increments of 25% per year.  During 2006, the Company contributed $76,218
        to the Plan.
 
 *(b)*
              *Stock
                  option plans*
  In
        1999,
        the Company adopted a stock option plan under which its Board of Directors
        had
        the ability to grant its employees, directors and affiliates Incentive Stock
        Options, Non-Statutory Stock Options and other forms of stock-based
        compensation, including bonuses or stock purchase rights. Incentive Stock
        Options, which provided for preferential tax treatment, were only available
        to
        employees, including officers and affiliates, and were not issued to
        non-employee directors. The exercise price of the Incentive Stock Options
        is
        100% of the fair market value of the stock on the date the options are granted.
        Pursuant to the plan, the exercise price for the non-statutory stock options
        was
        to be not less than 95% of the fair market value of the stock on the date
        the
        option was granted.
 
 In
        2000,
        the Company amended the 1999 Stock Option Plan, increasing the number of
        shares
        eligible for issuance under the Plan to 30% of the then outstanding common
        stock
        to 4,184,698 and allowing the Board of Directors to make annual adjustments
        to
        the Plan to maintain a 30% ratio to outstanding common stock at each annual
        meeting of the Board of Directors. The Board has not made any such adjustment
        since.
 
 In
        2004,
        the Company adopted the 2004 Equity Incentive Plan authorizing options on
        2,000,000 shares. It was first amended in August 2005 increasing the authorized
        options under the plan by 2,000,000 for a total of 4,000,000 shares and was
        further amended on January 31, 2006 increasing the authorized options by
        3,000,000 for a total of 7,000,000 under the plan. As of December 31, 2006,
        11,184,698 shares were authorized for issuance under both plans, 7,495,098
        of
        which were subject to outstanding options and awards and 1,509,316 which
        have
        been exercised for the Company's common stock.
 
 During
        2005, the Company issued non-statutory options to purchase 629,000 shares
        to its
        independent directors for their 2005 service and their anticipated 2006 service.
 
 *(c)
        Employee stock purchase plan*
 
 In
        1999,
        the Company adopted the 1999 Employee Stock Purchase Plan with 1,000,000
        shares
        reserved under the plan and authorized the Board of Directors to make twelve
        consecutive semiannual offerings of common stock to its employees. The first
        shares of common stock were issued under the Plan in February 2004. The exercise
        price for the Employee Stock Purchase Plan will not be less than 95% of the
        fair
        market value of the stock on the date the stock is purchased. During 2006
        and
        2005 employees contributed approximately $156,000 and $58,000 to the Employee
        Stock Purchase Plan, and 104,845 and 27,540 shares were issued under the
        plan as
        of December 31, 2006 and 2005, respectively. The 1999 Employee Stock Purchase
        Plan was to expire in June 2005; however, the Board of Directors extended
        the
        plan until June 30, 2010 or until all of the shares have been bought under
        the
        plan, whichever is first.
 
 F-22
 **7.**  **Stockholders'
        Equity**
  *a)
        Series C Preferred Stock.*
 
 On
        August
        25, 2004, the Company issued 250,000 shares of its Series C Non-Redeemable
        Convertible Preferred Stock, par value $0.001 per share (the "Series C Preferred
        Shares"), to Laurus for an aggregate purchase price of $2.5 million or $10.00
        per share (the "Stated Value"). The Series C Preferred Shares are convertible
        into shares of the Company's common stock at a rate of $1.54 per share, and
        accrue quarterly, cumulative dividends at a rate of 6.85%. On September 22,
        2005
        1,540 shares of the Company’s Series C Preferred Stock was converted into 10,000
        shares of the Company’s common stock. The first payment was due on January 1,
        2005. The Company declared dividends payable of approximately $170,000 for
        the
        same two years of 2006 and 2005, respectively, to the holders of its Series
        C
        preferred stock. These dividends are payable in cash or shares of our common
        stock at the holder's option with the exception that dividends must be paid
        in
        shares of our common stock for up to 25% of the aggregate dollar trading
        volume
        if the fair market value of the Company's common stock for the 20-days preceding
        the conversion date exceeds 120% of the conversion rate. On January 11, 2005,
        $60,967 of accrued dividends were paid in the form of 39,589 shares of the
        Company's common stock. Also, on May 5, 2005, $56,301 of accrued dividends
        were
        paid in the form of 36,559 shares of the Company's common stock, on September
        28, 2005, $57,708 of accrued dividends were paid in the form of 37,473 shares
        of
        the Company's common stock. Approximately $184,000 of cash dividends were
        paid
        in 2006. On December 31, 2006, accrued but unpaid dividends were approximately
        $43,000. The Series C Preferred Shares are redeemable by the Company in whole
        or
        in part at any time after issuance for (a) 115% of the Stated Value if the
        average closing price of the common stock for the 22 days immediately preceding
        the date of conversion does not exceed $1.48 per share or (b) the Stated
        Value
        if the average closing price of our common stock for the 22 days immediately
        preceding the date of conversion exceeds $1.48 per share. The Series C Preferred
        Shares have a liquidation right equal to the Stated Value upon the Company's
        dissolution, liquidation or winding-up. The Series C Preferred Shares have
        no
        voting rights, except as required by law.
 
 In
        conjunction with the Series C Preferred Shares, the Company issued a five-year
        common stock warrant to Laurus for the purchase of 487,000 shares of the
        Company's common stock at an exercise price of $1.77 per share.
 
 *b)
        Series D-1 Preferred Stock.*
 
 On
        January 12, 2006, the Company entered into a Securities Purchase Agreement
        with
        a limited number of institutional accredited investors, including Tailwind
        Capital, Bristol Capital Management, Nite Capital, Laurus and Omicron Capital,
        (which has since transferred their preferred shares to Portside Growth &
Opportunity Fund and Rockmore Investment Master Fund). On January 13, 2006,
        the
        Company issued and sold to these investors 5,150 shares of Series D-1 Amortizing
        Convertible Perpetual Preferred Stock, par value $0.001 per share, for an
        aggregate purchase price of $5.15 million, or $1,000 per share. As of December
        31, 2006, 4,502.7777 shares of Series D-1 Amortizing Convertible Perpetual
        Preferred Stock remain outstanding and 647.2223 shares of the Series D-1
        Amortizing Convertible Perpetual Preferred Stock were voluntary repurchased
        or
        converted to the Company’s common stock. In 2006, 75.0000 shares of
        the
        Series D-1 Amortizing Convertible Perpetual Preferred Stock were
        converted into 50,676 shares of the Company's common stock and 572.2223 shares
        of the Series D-1 Amortizing Convertible Perpetual Preferred Stock have been
        voluntary repurchased, as provided for in the Agreement. The Company also
        issued
        various warrants to these investors as described below. The Company paid
        cash
        fees and expenses of $119,209 to a finder for the introduction of potential
        investors in this financing, and paid $60,000 to the lead investor's counsel
        for
        legal expenses incurred in the transaction. The preferred shares are convertible
        into shares of the Company's common stock at a rate of $1.48 per share and
        accrue quarterly, cumulative dividends at a rate of LIBOR plus 4% on the
        first
        day of the applicable quarter. The first payment was due on April 1, 2006.
        As of
        December 31, 2006, the Company had paid approximately $332,000 of accrued
        Series
        D-1 dividends in cash. On December 31, 2006, accrued but unpaid dividends
        were
        approximately $111,000.
 
 F-23
 Under
        the
        purchase agreement, from the date of the effectiveness of the initial
        registration statement filed pursuant to the registration rights agreement
        (February 15, 2006), until the one-year anniversary of that date, if: (1)
        on any
        trading day during such period the volume weighted average price of the
        Company's common stock for each of the twenty (20) trading days immediately
        prior to such date exceeds $1.63; and, (2) the average daily trading volume
        of
        the Company's common stock exceeds $100,000 on each of those days, then the
        Company has the option, subject to a number of additional conditions, to
        put to
        the investors "units" at $1,000 per unit for an aggregate purchase price
        of up
        to $2.0 million (or a lesser amount to the extent the preferred stock warrants
        issued at the initial closing of the financing, which are described below,
        have
        been exercised to purchase these units). Each "unit" consists of one share
        of
        Series D-1 Preferred Stock and a common stock warrant, which entitles the
        holders to purchase up to an aggregate of 440,829 shares of common stock
        at an
        exercise price of $1.51 and otherwise has the same terms as the warrants
        described in the following paragraph. The right of the Company to “put” these
        units to the investors expired on February 15, 2007, without
        exercise.
 
 Certain
        warrants the Company issued to the Series D-1 investors at the closing entitle
        the investors to purchase up to an aggregate of 1,135,138 shares of the
        Company's common stock at an exercise price of $1.51 per share. The warrants
        are
        exercisable for five (5) years following the date of grant. The warrants
        have
        "ratchet" anti-dilution provisions reducing the warrant exercise price if
        the
        Company issues equity securities (other than in specified exempt transactions)
        at an effective price below the warrant exercise price to such lower exercise
        price.
 
 The
        Company also issued certain other warrants to the Series D-1 investors at
        the
        closing (the "preferred stock warrants"). These warrants entitle the holder
        to
        purchase an aggregate number of 2,000 "units", which are identical to the
        "units" described above, at an exercise price of $1,000 per unit. The preferred
        stock warrants are exercisable from the effective date (i.e., February 15,
        2006)
        until the one-year anniversary of that date. If any units subject to the
        preferred stock warrants remain unsold after (1) their expiration date and
        (2)
        the exercise of the Company's put option, if applicable, and any holder of
        a
        preferred stock warrant issued in the financing has exercised the warrant
        in
        full, then the preferred stock warrant would supplementally grant that holder
        the right to purchase 440,829 shares of common stock, times the number of
        "units" which the holder's preferred stock warrant initially overlaid, with
        a
        strike price of $1.51 per share, and the warrant, as so supplemented, would
        have
        a five (5) year term from January 12, 2006 to January 11, 2011. The preferred
        stock warrants expired on February 15, 2007, without exercise.
 
 The
        purchase agreement contained a number of covenants by the Company, which
        included:
 
 ·
            A
                grant of preemptive rights to the investors to participate in future
                financings; however, this right expired on January 13, 2007;
                and, 
 ·
            An
                agreement not to effect any transaction involving the issuance of
                securities convertible, exercisable or exchangeable for the Company's
                common stock at a price per share or rate which may change over time,
                so
                long as any shares of Series D-1 Preferred Stock are
                outstanding. 
 F-24
 In
        connection with this financing, Laurus consented to and waived certain
        contractual rights. The Company paid Laurus Capital Management, L.L.C., and
        the
        manager of Laurus, an amount of $87,000 in connection with Laurus' delivery
        of
        the consent and waiver, and paid $1,000 to Laurus' counsel for their related
        fees.
 
 *(c)*
              *Common
                  stock*
  On
        October 31, 2005, the Company entered into a Securities Purchase Agreement
        with
        Laurus Master Fund, Ltd. pursuant to which the Company issued and sold 2,032,520
        shares of the Company's common stock to Laurus for an aggregate purchase
        price
        of $2,500,000 or $1.23 per share. The price per share represents 80% of the
        20-day volume weighted average price of the Company's common stock through
        October 28, 2005. The Company also issued to Laurus a warrant to purchase
        up to
        450,000 shares at $1.93 per share. The warrant is exercisable from October
        31,
        2005 until October 31, 2010. The Company also paid Laurus a fee equal to
        $87,500
        in connection with this financing.
 
 *(d)*
            *Warrant*  As
        of
        December 31, 2006, the Company had warrants outstanding issued as part of
        its
        private placements and other equity raising ventures as well as services
        that
        allow the holders to purchase up to 2,422,138 shares of common stock at prices
        between $0.63 and $2.58 per share. The warrants may be exercised any time
        within
        three (3) and five (5) years of issuance.
 
 *(e)*  *Stock
        options and employment agreements*
  In
        November 1997, the Company entered into an employment agreement with James
        W.
        Benson, its chief executive officer. On July 16, 2000, the Company amended
        the
        employment agreement with Mr. Benson extending the term until July 16, 2005.
        As
        part of the amendment to the original employment agreement, the Company granted
        options to Mr. Benson to purchase up to 2,500,000 of non-plan, non-registered
        shares of the Company's common stock. Options for 500,000 of these shares
        were
        vested prior to the expiration of Mr. Benson's employment agreement and those
        options remain outstanding, and the balance expired unvested. The vested
        options
        have an exercise price of $1.00 and are scheduled expire on March 31,
        2007.
 
 On
        December 20, 2005, the Company entered into employment agreements and
        non-qualified stock option agreements with each of Mark N. Sirangelo, Richard
        B.
        Slansky and James W. Benson. Each employment agreement has an initial term
        of
        two years, and will be automatically renewed for a third year unless either
        party provides written notice of its intent not to renew.
 
 The
        employment agreement with Mr. Sirangelo sets forth the terms of his employment
        with the Company as chief executive officer and Vice Chairman and provides
        for,
        among other matters: a base salary, performance-based cash bonuses based
        on the
        achievement of specific goals set forth in the agreement and an option to
        purchase up to 1,900,000 shares of the Company's common stock. (Mr. Sirangelo
        was appointed Chairman upon the resignation of Mr. Benson as chief technology
        officer and Chairman of the Board in September 2006.)
 
 The
        employment agreement with Mr. Slansky amends and restates his employment
        agreement dated February 10, 2003. This agreement sets forth the terms of
        his
        continued employment with the Company as president and chief financial officer
        and provides for, among other matters: a base salary, performance-based cash
        bonuses based on the achievement of specific goals set forth in the agreement
        and an option to purchase up to 1,400,000 shares of the Company's common
        stock.
 
 F-25
 The
        employment agreement with Mr. Benson set forth the terms of his employment
        with
        the Company as chief technology officer and provided for, among other matters:
        a
        base salary, performance-based cash bonuses based on the achievement of specific
        goals set forth in the agreement and an option to purchase up to 950,000
        shares
        of the Company's common stock. Mr. Benson also received an additional option
        to
        purchase up to 150,000 shares of the Company's common stock in connection
        with
        his services as Chairman. Mr. Benson resigned as our Chairman and chief
        technology officer in September 2006. Mr. Benson remained a consultant to
        the
        Company through December 31, 2006, and remain ed
        a
        member of the Company’s Board of Directors. The options granted to Mr. Benson in
        his recent agreement will expire on the earlier of: a) ninety (90) days after
        the termination of his consulting agreement; or, b) December 20, 2010, whichever
        is earlier.
 
 Under
        each of the above employment agreements, the executive is an “at-will” employee,
        which means that either the Company or the executive may terminate employment
        at
        any time. However, if the executive’s employment with the Company is terminated
        without cause (as that term is defined in the employment agreements), that
        executive will be entitled to a severance payment equal to his then-current
        base
        salary per month multiplied by the greater of (A) 12 months or (B) the number
        of
        months remaining in the term. If the executive’s employment is terminated for
        good reason (as that term is defined in the employment agreements), that
        executive will be entitled to a severance payment equal to his then-current
        base
        salary per month multiplied by the lesser of (A) 12 months or (B) the number
        of
        months remaining in the term, but in no event less than six months.
 
 The
        options granted to each executive are fully vested and exercisable on the
        date
        of grant, have
        an
        exercise price of $1.40 per share, which was the closing sale price, reported
        on
        the OTCBB on the date of grant, and will expire five years after the date
        of
        grant, unless they expire sooner as a result of termination of employment. Some
        of
        the shares subject to the options are subject to sale restrictions that expire
        upon the achievement of certain milestones or four years from the date of
        grant,
        whichever comes first. Subject to certain limitations, these options may
        be
        exercised by means of a net exercise provision by surrendering shares with
        a
        fair market value equal to the exercise price upon exercise.
 WeightedOptions
                
                
                AverageOutstanding
                
                
                Exercise
                    PricesBalance
                    at January 1, 2005
                
                
                6,353,766
                
                $
                1.39Granted
                
                
                6,368,000
                
                
                1.45Exercised
                
                
                (237,000
                )
                
                (1.02
                )Expired
                
                
                (2,162,206
                )
                
                (2.19
                )Balance
                    at December 31, 2005
                
                
                10,322,560
                
                
                1.27Granted
                
                
                3,307,000
                
                
                1.18Exercised
                
                
                (230,281
                )
                
                (0.83
                )Expired
                
                
                (1,004,181
                )
                
                (1.35
                )Balance
                    at December 31, 2006
                
                
                12,395,098
                
                $
                1.24
 The
        weighted average fair value of options granted to employees under the 1999
        Stock
        Option Plan and the 2004 Equity Incentive Plan during 2006 and 2005 was $1.17
        and $1.45, respectively. At December 31, 2006 and 2005, there were 12,395,098
        and 10,347,560 options exercisable at a weighted average exercise price of
        $1.24
        and $1.27 per share, respectively. The weighted average remaining life of
        outstanding options under the plans at December 31, 2006 was 3.5
        years.
 
 F-26
 Weighted-AverageRange
                    of
                
                
                
                
                
                Remaining
                    ContractualExercise
                
                
                Number
                    of Shares
                
                
                Life
                    of Shares
                
                
                Number
                    of Shares
                
                
                Weighted-AveragePrice
                
                
                Outstanding
                
                
                Outstanding
                
                
                Exercisable
                
                
                Exercisable
                    Price$0.42-0.99
                
                
                3,774,271
                
                
                2.98
                
                
                1,944,271
                
                $
                0.721.00-1.99
                
                
                8,478,605
                
                
                3.73
                
                
                7,883,105
                
                
                1.402.00-2.99
                
                
                102,222
                
                
                3.72
                
                
                102,222
                
                
                2.113.00-3.99
                
                
                20,000
                
                
                4.59
                
                
                20,000
                
                
                3.204.00-4.80
                
                
                20,000
                
                
                5.92
                
                
                20,000
                
                
                4.8012,395,098
                
                
                3.50
                
                
                9,969,598
                
                $
                1.29
 **8.**  **Commitments
        and Contingencies**
  *(a)*  *Capital
        leases*
  The
        Company leases certain equipment under non-cancelable capital leases, which
        are
        included in fixed assets as follows:
  *December
                    31,*
                
                
                **2006**
                
                
                2005Computer
                    and office equipment
                
                **$**
                **452,481**
                
                $
                155,499Less
                    accumulated depreciation
                
                
                **(226,535**
                **)**
                
                (152,960
                )**$**
                **225,947**
                
                $
                2,539
 
 Future
        minimum lease payments are as follows:
 Year
                    Ending December 31, 20062007
                
                $
                48,7552008
                
                
                48,7552009
                
                
                48,7552010
                
                
                48,7552011
                
                
                10,562Total
                    minimum lease payments
                
                
                205,582Amount
                    representing interest
                
                
                33,432Present
                    value of minimum lease payments
                
                
                172,150Total
                    obligation
                
                
                172,150Less
                    current portion
                
                
                (35,441
                )Long-term
                    portion
                
                $
                136,709
 
 F-27
 *(b)*  *Other
        accrued liabilities*
  Other
        accrued liabilities at December 31, 2006 and 2005 consisted of the
        following:
 
 Other
                    Accrued Liabilities - December 31,
                
                
                **2006**
                
                
                2005Employee
                    Accruals
                
                **$**
                **145,847**
                
                $
                160,000Legal,
                    Royalty and Customer Accuals
                
                
                **316,231**
                
                
                243,608Customer
                    deposits and Other Accruals
                
                
                **184,080**
                
                
                -Property
                    and Income Tax Accruals through 12-31-05
                
                
                **30,730**
                
                
                26,452Employee
                    Stock Purchase Plan
                
                
                **52,462**
                
                
                29,375Provision
                    for Anticipated Loss
                
                
                **719,125**
                
                
                -Laurus
                    - Dividend (Preferred Stock Series C)
                
                
                **42,898**
                
                
                56,945Laurus
                    - Dividend -All Series D
                
                
                **111,188**
                
                
                -Total
                    Other Accrued Liabilities
                
                **$**
                **1,602,561**
                
                $
                516,380
 
 *(c)*  *Building
        lease*
 
 In
        conjunction with the sale of its headquarters facility, the Company entered
        into
        a non-cancelable operating lease with the buyer to lease-back its facilities
        for
        ten years (see Note 2). The base rent was $25,678 per month at lease inception
        and is currently $28,470 as of December 31, 2006 and will continue to increase
        by 3.5% per year. Total expense for 2006 and 2005 amounted to approximately
        $341,000 and $325,000, respectively.
 
 On
        April
        14, 2005, the Company entered into a 16-month lease to expand its fabrication
        and test facilities. The additional facility is also located in Poway,
        California. It is approximately 11,000 square feet and is dedicated to
        fabrication of the Company's hybrid rocket motors. The cost to the Company
        is
        approximately $107,000 over the term of the lease. The Company was able to
        extend the facility lease on a short-term basis until June 30, 2007. Total
        monthly rent from January 2007 to June 2007 is approximately $10,000 per
        month,
        for a total of approximately $60,000 for the six month term ending on June
        30,
        2007.
 
 On
        August
        25, 2006, the Company entered into a ten-year lease on a 72,000 square foot
        development and manufacturing facility located in the Colorado Technology
        Center
        in Louisville, Colorado, for its subsidiary, Starsys, Inc. Starsys will be
        relocating from its facility in Boulder, Colorado in March 2007, as its current
        lease expires. The new facility will be leased from RE Hill Properties, LLC
        and
        Quartz Mountain Properties, LLC. The lease includes an option for an additional
        19,000 square feet, which could bring the total available Starsys space to
        approximately 92,000 square feet.
 
 F-28
 Building
                    Leases - Year Ending December 31,2007
                
                **$**
                **1,204,818**2008
                
                
                **1,257,675**2009
                
                
                **1,309,548**2010
                
                
                **1,373,882**2011
                
                
                **1,422,052**Thereafter
                
                
                **4,977,711**Total
                    minimum lease payments
                
                **$**
                **11,545,686**
 **9.**  **Concentrations**
  *(a)*  *Credit
        risk*
  The
        Company maintains cash balances at various financial institutions primarily
        located in San Diego, California, Boulder, Colorado and New York, New York.
        The
        accounts at these institutions are secured by the Federal Deposit Insurance
        Corporation up to $100,000. The Company has balances in excess of the insured
        amount; however, the Company has not experienced any losses in such accounts.
 
 *(b)*  *Customer*
  During
        2006 and 2005, the Company had five major customers that accounted for sales
        of
        approximately $18,741,780, or 58% and $8,133,000, or 90% of consolidated
        net
        sales, respectively. At December 31, 2006 and 2005, the amount receivable
        from
        these customers was approximately $2,256,700 and $967,400,
        respectively.
 
 **10.
        Note Receivable**
 
 On
          September 8, 2005, the Company made a secured loan in the principal amount
          of
          $1.2 million to Starsys Research Corporation, prior to the merger. The
          loan
          accrued interest at 8% per annum and matured on January
          31, 2006 .
          No
          principal or interest payments were due before maturity. The loan was secured
          by
          a security interest in all of the assets of Starsys Research Corporation,
          subject to an intercreditor agreement with Vectra Bank Colorado, National
          Association. In addition, Starsys Research Corporation agreed to pay the
          Company
          a placement agent fee and to reimburse the Company expenses in the aggregate
          amount of $120,000. This amount was deferred until the closing of the
          contemplated merger agreement (see Note 3) and added to the principal balance
          of
          the note evidencing the loan.
  In
        connection with making the loan, the Company entered into an exclusivity
        agreement with Starsys Research Corporation which provided that Starsys would
        not discuss a material sale of its assets, a material sale of its stock,
        a
        merger, or similar transaction with any other party until October 31, 2005.
        Prior to completion of the loan described above, the Company and Starsys
        Research Corporation entered into a non-binding letter of intent concerning
        an
        acquisition. On October 26, 2005, the Company and Starsys Research Corporation
        entered into a definitive merger agreement and on January 31, 2006, the Company
        completed the merger with Starsys, and cancelled and terminated the secured
        note
        as well as all interest and fees related to the note.
 
 **11.
        Unaudited Pro Forma Combined Consolidated Statements of
        Operations**
 
 The
        following unaudited pro forma combining and combined statements of operations
        give effect to the merger of SpaceDev and Starsys using the purchase method
        of
        accounting, as required by SFAS No. 141, *Business
        Combinations.* The
        Company acquired Starsys Research Corporation on January 31, 2006 and is
        the
        "accounting acquirer" for accounting purposes. Under this method of accounting,
        the combined company will allocate the purchase price to the fair value of
        assets of Starsys deemed to be acquired, including identifiable intangible
        assets and goodwill. The purchase price allocation is subject to revision
        when
        the combined company obtains additional information regarding asset valuation.
        The unaudited pro forma combined statements of operations are based on
        respective historical consolidated financial statements and the accompanying
        notes of the Company.
  F-29
 The
        unaudited pro forma combined statement of operations for the year ended December
        31, 2006 assumes the merger took place on January 1, 2006. The unaudited
        pro
        forma combined statement of operations for the year ended December 31, 2005
        combines SpaceDev's historical statement of operations for the year ended
        December 31, 2005 with the Starsys historical statement of operations for
        the
        year ended December 31, 2005 assuming the merger took place on January 1,
        2005.
        The unaudited pro forma combined statements of operations should be read
        in
        conjunction with the related notes included in this Form 10-KSB and the
        consolidated audited financial statements of SpaceDev. The unaudited pro
        forma
        combined statements of operations are not necessarily indicative of what
        the
        actual results of operations and financial position would have been had the
        merger taken place on January 1 of each period presented and do not indicate
        future results of operations.
 
 F-30
  **SpaceDev,
        Inc. and Subsidiaries**
 **Pro
        Forma Combined Consolidating and Consolidated Statement of
        Operations**
 **(Unaudited)**
  ***For
                    the Twelve Months Ended ***December
                    31, 2006********Consolidated**
                
                
                **Pro
                    Forma Adjustments**
                
                
                Consolidated
                    Pro Forma
                
                
                %**Net
                    Sales**
                
                $
                34,397,113
                
                $
                (257,205
                )
                $
                34,139,909
                
                
                100.00
                %**Cost
                    of Sales ***
                
                
                27,087,542
                
                
                (91,380
                )
                
                26,996,162
                
                
                79.08
                %**Gross
                    Margin**
                
                
                7,309,572
                
                
                (165,825
                )
                $
                7,143,747
                
                
                20.92
                %**Operating
                    Expenses**Marketing
                    and sales expense
                
                
                2,430,673
                
                
                (165,825
                )
                
                2,264,848
                
                
                6.63
                %Research
                    and development
                
                
                279,063
                
                
                -
                
                
                279,063
                
                
                0.82
                %General
                    and administrative
                
                
                5,617,689
                
                
                -
                
                
                5,617,689
                
                
                16.45
                %**Total
                    Operating Expenses ***
                
                
                8,327,425
                
                
                (165,825
                )
                
                8,161,600
                
                
                23.91
                %**Income/(Loss)
                    from Operations**
                
                
                (1,017,853
                )
                
                -
                
                
                (1,017,853
                )
                
                -2.98
                %**Non-Operating
                    Income/(Expense)**Interest
                    income
                
                
                111,668
                
                
                -
                
                
                111,668
                
                
                0.33
                %Interest
                    expense
                
                
                (88,196
                )
                
                -
                
                
                (88,196
                )
                
                -0.26
                %Non-cash
                    interest expense
                
                
                (114,600
                )
                
                -
                
                
                (114,600
                )
                
                -0.34
                %Gain
                    on Building Sale
                
                
                117,274
                
                
                -
                
                
                117,274
                
                
                0.34
                %**Total
                    Non-Operating Income/(Expense)**
                
                
                28,935
                
                
                -
                
                
                28,935
                
                
                0.08
                %**Income
                    (Loss) Before Income Taxes**
                
                
                (988,918
                )
                
                -
                
                
                (988,918
                )
                
                -2.90
                %Income
                    tax provision
                
                
                19,290
                
                
                -
                
                
                19,290
                
                
                0.06
                %**Net
                    Income (Loss)**
                
                $
                (1,008,208
                )
                $
                -
                
                $
                (1,008,208
                )
                
                -2.95
                %Less:
                    Preferred Dividend Payments
                
                
                (610,287
                )
                
                -
                
                
                (610,287.00
                )**Adjusted
                    Net Income (Loss) for EPS Calculation**
                
                
                (1,618,495
                )
                
                -
                
                
                (1,618,495
                )**Net
                    Income/(Loss) Per Share:**
                
                $
                (0.06
                )
                
                -
                
                $
                (0.06
                )Weighted-Average
                    Shares Outstanding
                
                
                28,666,059
                
                
                -
                
                
                28,666,059**Fully
                    Diluted Net Income/(Loss) Per Share:**
                
                $
                (0.06
                )
                
                -
                
                
                (0.06
                )Fully
                    Diluted Weighted-Average Shares Outstanding
                
                
                28,666,059
                
                
                -
                
                
                28,666,059*
                    The following table shows how the Company's amortization expense
                    of stock
                    options would be allocated to all expenses.Cost
                    of Sales
                
                $
                24,339
                
                $
                -
                
                $
                24,339
                
                
                0.07
                %Marketing
                    and sales
                
                
                4,840
                
                
                -
                
                
                4,840
                
                
                0.01
                %Research
                    and development
                
                
                -
                
                
                -
                
                
                -
                
                
                0.00
                %General
                    and administrative
                
                
                104,201
                
                
                -
                
                
                104,201
                
                
                0.31
                %$
                133,379
                
                $
                -
                
                $
                133,379
                
                
                0.39
                %
 F-31
 **SpaceDev,
        Inc. and Subsidiaries**
 **Pro
        Forma Combined Consolidated Statement of Operations**
 **(Unaudited)**
 ***For
                    the twelve months ended December 31, 2005*****Consolidated**
                
                
                **Adjustments**
                
                
                **Consolidated
                    Pro Forma****Net
                    Sales**
                
                $
                26,767,741
                
                $
                -
                
                $
                26,767,741**Cost
                    of sales**
                
                $
                21,627,078
                
                
                -
                
                
                21,627,078**Gross
                    Margin**
                
                
                5,140,663
                
                
                -
                
                
                5,140,663**Operating
                    Expenses**Marketing
                    and sales expense
                
                
                673,636
                
                
                -
                
                
                673,636Research
                    and development
                
                
                31,940
                
                
                -
                
                
                31,940General
                    and administrative
                
                
                7,082,709
                
                
                -
                
                
                7,082,709**Total
                    Operating Expenses**
                
                
                7,788,285
                
                
                -
                
                
                7,788,285**Income/(Loss)
                    from Operations**
                
                
                (2,647,622
                )
                
                -
                
                
                (2,647,622
                )**Non-Operating
                    Income/(Expense)**Interest
                    income
                
                
                105,840
                
                
                **-**
                
                
                105,840Rental
                    income
                
                
                88,146
                
                
                
                
                
                88,146Interest
                    expense
                
                
                (509,398
                )
                
                -
                
                
                (509,398
                )Gain
                    on building sale
                
                
                117,272
                
                
                -
                
                
                117,272Loan
                    fee - equity compensation
                
                
                (28,875
                )
                
                -
                
                
                (28,875
                )**Total
                    Non-Operating Income/(Expense)**
                
                
                (227,015
                )
                
                -
                
                
                (227,015
                )**Income/(Loss)
                    Before Income Taxes**
                
                
                (2,874,637
                )
                
                -
                
                
                (2,874,637
                )Income
                    tax provision
                
                
                1,600
                
                
                -
                
                
                1,600**Net
                    Income/(Loss)**
                
                $
                (2,876,237
                )
                $
                -
                
                
                (2,876,237
                )**Net
                    Income/(Loss) Per Share:**Net
                    Income/(Loss)
                
                $
                (0.08
                )
                
                
                
                $
                (0.08
                )Shares
                    Outstanding
                
                
                29,551,305
                
                
                4,836,696
                
                
                34,388,001
 F-32
 **12.
        Related Party Transactions**
 
 James
        W.
        Benson, the Company’s former chief technology officer and former Chairman of the
        boaRd of Directors, has personally guaranteed the building lease on the
        Company’s Poway, California headquarters facility and has placed his home in
        Poway as collateral.  Mr. Benson remained a member of our Board of
        Directors and one of our major shareholders. On September 26, 2006, Mr. Benson
        resigned from his role as our chief technology officer in order to launch
        a new
        independent venture, Benson Space Company, focused on the marketing of
        commercial space tourism.  SpaceDev currently has a study contract with
        Benson Space Company which could lead to future business between the two
        entities.
 
 **13.
        Subsequent Events**
 
 In
        January 2007, the
        Company concluded a negation on a contract modification with Northrop Grumman
        Space Technology.  The contract was originally awarded to the Company in
        June 2002, for the design, development, assembly, and test of configurations
        of
        flat plate gimbal drive assemblies.  The contract was awarded as a firm
        fixed price contract with the final delivery scheduled for March 2007.  The
        Company experienced significant cost overruns on this contract.  The
        contract modifications in 2006 and 2007 reflected discussions to change the
        timing of payments, as well as, the amount of additional contract
        consideration.  The 2007 modifications included up to an additional $1.0
        million based on the achievement of specific milestones, which, if achieved,
        would partially mitigate the impact of significant cost, scope and requirements
        changes, and overruns incurred or accrued.
 
 In
        January 2007, in
        partnership with the University of Colorado Laboratory for Space Physics,
        the
        Company was awarded a $750,000 contract from the Missile Defense Agency to
        design and develop a non-sticking cover seal system for the Exo-atmospheric
        Kill
        Vehicle program, which is the kill vehicle component of the Ground Based
        Interceptor (the weapon element of the Ground-based Midcourse Defense System
        program). The contract was awarded under the Small Business Technology Transfer
        Program that provides research funding for partnerships between industry
        and
        non-profit research institutions. The program is scheduled to complete in
        2008
        and is an extension of a Phase 1 program completed in 2006.
 
 In
        February 2007, the Company was awarded a $1.4 million cost reimbursable design
        and development subcontract with NASA’s Jet Propulsion Laboratory in support of
        the Mars Science Laboratory mission. The Company will develop and deliver
        electromechanical Descent Brake dampers. The contract period of performance
        is
        approximately 18 months. NASA’s Mars Science Laboratory mission will deliver an
        1800 pound rover to the surface of Mars in 2010. Rather than the airbag landing
        system used by the Mars Exploration Rover mission, a “Skycrane” landing system
        will use a rocket-decelerated Descent Stage that will hover and gently lower
        the
        rover on a 25 feet long bridle cord. A critical component of the “Skycrane”
landing system is the Descent Brake that will lower the rover in less than
        seven
        seconds with a controlled speed profile that will provide a gentle touch-down
        on
        the Martian surface.
 
 In
        February 2007, the Company entered into a five year capital equipment lease
        in
        connection with the move to its new
        Louisville facility, to provide furniture and equipment valued at approximately
        $360,000.
 
 F-33
 In
        March
        2007, the Company moved from Boulder, CO to Louisville, CO, due to the
        expiration of its lease.  The Company signed
        a
        lease in August 2006 for its new Louisville facility, which provides an
        immediate improvement in product work flow over its existing site. The new
        facility has approximately 72,000 square feet, a significant expansion in
        floor
        space. The rent will increase to approximately $77,000 per month due to the
        additional space but decrease on a square foot basis.  The Company plans to
        develop this space through phased capital equipment additions that will improve
        its fabrication, assembly, and test capabilities.   The Company also
        has an option to lease an additional 19,000 square feet at the same
        site.
 
 Also
        in
        March 2007, the Company signed a new lease to relocate its Durham, North
        Carolina facility, which lease also was set to expire in March 2007.  The
        Company anticipates the relocation of its Durham manufacturing operations
        in May
        2007.  The new Durham facility has approximately 13,500 square feet of
        usable office and laboratory space.  The rent will be approximately $13,000
        per month with an increase annually.
 
 F-34