UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-K





Annual
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934





For the
fiscal year ended December 31, 2009





Commission
file number: 001-31972





TELKONET,
INC.


(Exact
name of registrant as specified in its charter)





Utah
            87-0627421(State
      or Other Jurisdiction of Incorporation or Organization)
            (I.R.S.
      Employer Identification No.)10200 Innovation Drive
      Suite 300, Milwaukee, Wisconsin
            53226(Address
      of Principal Executive Offices)
            (Zip
      Code)





(414)
223-0473


(Registrant’s
Telephone Number, Including Area Code)





Securities
Registered pursuant to section 12(b) of the Act:





Title
      of each class
            
            Name
      of each exchange on which registeredCommon
      Stock, $0.001 par value
            
            None





Securities
Registered pursuant to section 12(g) of the Act: None





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. o Yes  x No





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(b) of the Act. o Yes  x No





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





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





Check if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
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-K or any amendment to this
Form 10-K. x





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.  (Check one):





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





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





Aggregate
market value of the voting stock held by non-affiliates (based upon the closing
sale price of $0.12 per share on the Over the Counter Bulletin Board) of the
registrant as of June 30, 2009: $11,289,512.





Number of
outstanding shares of the registrant’s par value $0.001 common stock as of March
30, 2010: 96,673,771.













TELKONET,
INC.


FORM
10-K


INDEX





PagePart
      IItem
      1.
            Description
      of Business
            3Item
      1A.
            Risk
      Factors
            9Item
      2.
            Properties
            20Item
      3.
            Legal
      Proceedings
            20Item
      4.
            Reserved
            20Part
      IIItem
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      Registrant’s Purchases of Securities
            20Item
      6.
            Selected
      Financial Data
            21Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            21Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk.
            30Item
      8.
            Financial
      Statements and Supplementary Data
            30Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            30Item
      9A(T).
            Controls
      and Procedures
            30Item
      9B.
            Other
      Information
            31Part
      IIIItem
      10.
            Directors,
      Executive Officers and Corporate Governance
            31Item
      11.
            Executive
      Compensation
            33Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            35Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence
            37Item
      14.
            Principal
      Accounting Fees and Services
            37Part
      IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            38











2







PART
I





ITEM
1.  DESCRIPTION OF BUSINESS.




Some
of the statements contained in this Annual Report on Form 10-K discuss future
expectations, contain projections of results of operations or financial
condition or state other “forward-looking” information. Those statements include
statements regarding the intent, belief or current expectations of Telkonet,
Inc. (“we,” “us,” “our” or the “Company”) and our management
team.  Any such forward-looking statements are not guarantees of
future performance and involve risks and uncertainties, and actual results may
differ materially from those projected in the forward-looking statements. These
risks and uncertainties include but are not limited to those risks and
uncertainties set forth in Item 1A of this report.  In light of the
significant risks and uncertainties inherent in the forward-looking statements
included in this report, the inclusion of such statements should not be regarded
as a representation by us or any other person that our objectives and plans will
be achieved.





GENERAL





Business





Telkonet,
Inc., formed in 1999 and incorporated under the laws of the state of Utah,
develops, manufactures and sells proprietary energy efficiency and smart grid
networking technology.  Our SmartEnergy and Series 5 SmartGrid
networking technologies enable us to develop innovative clean technology
products and have helped position us as a leading clean technology
provider.





Our
Telkonet SmartEnergy and Networked Telkonet SmartEnergy energy efficiency
products incorporate our patented Recovery Time technology, allowing for the
continuous monitoring of climate conditions to automatically adjust a room’s
temperature accounting for the presence or absence of an
occupant.  Our SmartEnergy products save energy while at the same time
ensuring occupant comfort and extending equipment life
expectancy.  This technology is particularly attractive to our
customers in the hospitality industry, as well as the education, healthcare and
government/military markets, who are continually seeking ways to reduce costs
without impacting building occupant comfort.  By reducing energy usage
automatically when a space is unoccupied, our customers can realize significant
cost savings without diminishing occupant comfort.  This technology
may also be integrated with property management systems and automation systems
and used in load shedding initiatives providing management companies and
utilities enhanced opportunity for cost savings and control.  Our
energy management systems are lowering heating, ventilation and air
conditioning, or HVAC, costs in over 180,000 rooms and qualify for numerous
state and federal energy efficiency and rebate programs.





Our
Series 5 SmartGrid networking technology allows commercial and consumer users to
connect computers to a communications network using the existing low voltage
building electrical grid.The Telkonet Series 5
SmartGrid networking technology uses powerline communications, or PLC,
technology to transform a site’s existing internal electrical infrastructure
into a communications backbone.  Operating at 200 Mbps, our PLC
platform offers a secure alternative in grid communications, transforming a
traditional electrical distribution system into a “smart grid” that delivers
electricity in a manner that can save energy, reduce cost and increase
reliability.





We
leverage our relationships with utilities to market our Telkonet Series 5
SmartGrid networking technology for network control beyond the commercial and
consumer space.  We believe the Telkonet Series 5 SmartGrid networking
technology provides a compelling solution for substation automation, power
generation, renewable facilities, manufacturing, and research environments, by
providing a rapidly-deployable, low cost alternative to cable or
fiber.  By leveraging the existing low voltage electrical wiring
within a facility to transport data, our PLC solutions enable our customers to
deploy sensing and control systems to locations without the need for new network
wiring, and without the security risks inherent with wireless
systems.





Our
EthoStream Hospitality Network is now one of the largest hospitality HSIA
service providers in the United States, with a customer base of more than 2,300
properties representing approximately 200,000 hotel rooms.  This
network provides us with the opportunity to market our energy efficiency
solutions.  It also provides a marketing opportunity for our more
traditional HSIA offerings, including the Telkonet Series 5 PLC platform. 
The Series 5 system offers a fast and cost effective way to deliver commercial
high-speed broadband access using a building’s existing electrical
infrastructure to convert virtually every electrical outlet into a high-speed
data port without the installation of additional wiring or major disruption of
business activity.  The EthoStream Hospitality Network is backed by a 24/7
U.S.-based in-house support center that uses integrated, web-based centralized
management tools enabling proactive customer support.





We employ
direct and indirect sales channels in all areas of our business.  With
a growing value-added reseller network, we continue to broaden our reach
throughout the industry.  Utilizing key integrators and strategic OEM
partners, we have been able to market and sell our products in each of our
targeted markets.





Our
direct sales efforts target the hospitality, utility, education, commercial and
government/military markets.  Taking advantage of legislation,
including the Energy Independence and Security Act of 2007, or EISA, and the
Energy Policy Act of 2005, we have focused our sales efforts in areas with
available public funding and incentives, such as rebate programs offered by
utilities to the hospitality industry.  Through both our proprietary
platform and technology and partnerships with energy efficiency providers, we
intend to position our company as a leading provider of energy management
solutions.







3





Products





We
believe our energy efficiency product offering, with our patented Recovery Time
technology, delivers significant benefits over competing products,
including:





·
            Maximum
      energy savings by evaluating each room’s environmental conditions,
      including room location, window placement, humidity, weather conditions,
      and operating efficiency of heating, ventilation and air conditioning, or
      HVAC, equipment,·
            Longer
      life and reduced maintenance of HVAC units through effective equipment
      monitoring,·
            Increased
      occupant comfort,·
            Speed
      and ease of installation, and·
            Wide
      range of HVAC system compatibility.





Based on
these product features and capabilities, we have been awarded contracts in the
hospitality utility, military and educational industries.  We believe
that our partnerships with utility rebate programs provide us with a significant
advantage over our competitors in the commercial occupancy-based energy
management market.





Our
SmartEnergy platform has been developed to maximize energy efficiency and
savings.  The technology allows users to decrease heating and cooling
expenses, and extend equipment life without diminishing occupant
comfort.  By providing Internet-based remote control over in-room
energy management, SmartEnergy decreases the cost to operate an enterprise-wide
system by reducing the need for onsite engineering resources.  In
addition, the SmartEnergy platform can be integrated with property management
systems and utility demand/response programs to recognize increased energy
efficiency.





Given the
population growth in the United States and the increasing demand for energy, we
believe additional energy-related infrastructure will be needed.  We
believe the use of smart grid technologies is an affordable alternative to
building additional infrastructure because it leverages existing infrastructure,
allowing additional energy savings.  While it will require investments
that are not typical for utilities, we believe the long-term savings resulting
from these investments will outweigh the costs.





We
believe we are well positioned to play a pivotal role in the development of the
smart grid.  The introduction of an industrial low voltage PLC product
for use within the utility space has created a competitive alternative to
current networking options.  We believe our Series 5 platform provides
a compelling solution for use in the substation, storage, renewable and
transmission and distribution environments because of its ability to utilize
existing electrical wiring within the environment.





Our
Series 5 PLC platform includes the following key features:





·
            Multiple
      physical interfaces, including RS232, RS485 and Ethernet, enabling a wide
      range of devices to be networked;·
            Multiple
      utility-centric protocols supported, including DNP3, Modbus and
      IP;·
            Granular
      QOS support over traditional communications;·
            Ability
      to withstand extended temperature ranges and harsh outdoor
      environments;·
            Stringent
      security features;·
            Support
      for both AC and DC applications;







4




·
            Significant
      speed performance through the use of the Intellon AV chipset;
      and·
            Flexible
      connection technology that avoids interruption of service through
      inductive coupling.





Our
EthoStream Hospitality Network continues to enhance our position in the HSIA
space.  We have established customer and vendor relationships with key
participants in the hospitality industry, including Wyndham Hospitality,
AmericInns, Carlson Hospitality, Intercontinental Hotels Group, Marcus
Hospitality, Destination Hotels and Resorts, and Worldmark by Wyndham (formerly
Trendwest Resorts).





Our
EthoStream Gateway Servers provide industry-leading HSIA technology to the
hospitality industry, with advanced features based on in-house product design
and development, including the following:





·
            Dual
      ISP bandwidth aggregation for faster overall speed;·
            ISP
      redundancy to eliminate network downtime;·
            Enhanced
      quality of service; and·
            Real-time
      meeting room scheduling.





We
maintain a U.S.-based customer support center that operates 24 hours a day,
seven days a week, and employs a dedicated, in-house support team that uses
integrated, web-based centralized management tools enabling proactive
support.  We believe our customer service offerings, along with
established relationships through our vendor agreements with some of the largest
hospitality franchises, distinguish us from our competitors in the hospitality
HSIA industry.





We
believe that growth of the EthoStream Hospitality Network will be derived from
two key areas:





·
            New
      customer growth within the full-service hospitality market and through
      additional preferred vendor agreements with franchisors;
    and·
            Ongoing
      sales to current customers through integration of additional in-room
      technologies such as lighting, telephony, media centers and energy
      management products.





Industry
Outlook





The
National Institute of Standards and Technology, or NIST, an agency of the U.S.
Department of Commerce, has been chartered under EISA to identify and evaluate
existing standards, measurement methods, technologies and other support toward
SmartGrid adoption.  The agency will also be preparing a report to
Congress recommending areas where standards need to be developed.  We
believe these initiatives validate the need for our platform and
technology.





The
hospitality industry is our largest customer base with more than 2,300
properties representing approximately 200,000 hotel rooms.  Through
its continued expansion, the EthoStream Hospitality Network is attracting
additional customers in the full service segment of the market.  This
audience provides us with significant access to potential SmartEnergy
customers.  We continue to expand our operations in this market,
providing energy management services to greater than 180,000 units overall to
date.





Our most
rapidly emerging market is the educational industry.  In July 2008 we
entered into an agreement with New York University under which New York
University uses our networked SmartEnergy products to centrally manage energy
consumption in its dormitories.  We worked with the University to use
existing building infrastructure to remotely manage and track energy
consumption.  As of February 10, 2010, our products were installed in
more than 2,200 rooms across five buildings.  Our program with New
York University has enabled us to demonstrate the cost savings that can be
realized through the use of our products in dormitories.







5





The
educational industry represents more than 2.7 million housing units according
to the U.S. Department of Education, National Center for Education
Statistics, Integrated Postsecondary Education Data System
(IPEDS).  We believe that our SmartEnergy platform is an important
tool for participants in the educational industry seeking to
control student-related energy costs.  We have focused our
sales efforts on members of the educational industry who are seeking to expand
their energy efficiency initiatives.





The
government and military market segments have also seen significant growth in
energy conservation and renewables development.  This movement is
attributed to programs including the American Recovery and Reinvestment Act, or
ARRA, and the Energy Independence and Security Act.  Our SmartEnergy
platform has been successfully incorporated into the energy management
initiatives in military housing and deployments.  We have recognized
success through both our value-added reseller network and direct sales and
continue to target available public funding for energy initiatives within these
industries.





Healthcare
is an additional emerging market for energy management.  We have been
working closely with operators and developers to integrate our SmartEnergy
energy management initiatives into efficiency opportunities supported by state
and federal energy programs.  Offering a commercial environment
similar to the hospitality or educational housing markets, the increasing growth
of the elderly and assisted living markets presents attractive potential for
energy management.  This market is expected to grow rapidly over the
next several years due to its energy saving potential.





We
believe that the utility industry is one of the fastest developing market
segments in the United States.  With more than $4.5 billion being
released to the industry through the American Reinvestment and Recovery Act of
2009for SmartGrid
development and $414 million in investment through 2009, the utility industry
has become a growing percentage of our revenue, both through direct sales to
utilities and partnerships with energy service companies executing state and
local energy efficiency programs.





We
continue to strengthen our focus on our targeted market segments in order to
expand market share and take advantage of existing incentives for energy
management.  We expect continued expansion in the space and
specifically in commercial segments due to increasing state and federal programs
promoting energy efficiency.





Competition





We
currently compete primarily within commercial and industrial markets, including
hospitality, education, healthcare and government and
military.  Within each market, we offer savings through our
occupancy-based energy efficiency products.  Our products offer
significant competitive benefits when compared with alternative offerings
including Building Automation or Building Management Systems, or BAS or BMS,
static temperature occupancy-based systems and high-efficiency HVAC
systems.





We
participate in a relatively small competitive field in the hospitality industry,
with the majority of the energy management sales handled by fewer than seven
manufacturers.  The key competitors in the market segment are Onity,
Inc. Inncom International Inc. and Control4, with each offering comparable
products to our standalone and networked SmartEnergy
products.  Telkonet SmartEnergy’s key differentiators in the
hospitality segment include:





·
            Recovery
      Time technology;·
            Networked
      SmartEnergy platform;·
            Integration
      with property management systems.





The
educational space is a relatively new market for occupancy-based
controls.  We have introduced our SmartEnergy system for use within
student dormitories, which traditionally have been an environment for BAS or BMS
systems.  Since the dormitory environment is very similar to the
hospitality market, we believe we can offer similarly scaled energy
savings.  Since the market is still in its infancy, very few
comparable offerings have entered the market but competitors within the
hospitality segment are beginning to respond.  Our SmartEnergy
platform provides a significant advantage within the educational industry
through:







6





·
            Reduced
      cost as compared to BMS/BAS systems;·
            Ease
      of installation relative to traditional wired systems;
  and·
            Range
      of product compatibility.





The
healthcare and government/military markets are very similar in scope when
relating to energy management systems.  A key differentiator in these
environments is the specific implementation that is being
considered.  Each market utilizes BAS/BMS for wide scale energy
efficiency initiatives.  When specifically addressing housing
environments including elderly care and assisted living environments and
military dormitories or barracks, Telkonet’s SmartEnergy platform is able to
provide increased energy savings and efficiency.  Competitors
operating in the BAS/BMS space include Johnson Controls, Siemens, Trane and
others.





Telkonet’s
Series 5 SmartGrid networking products are targeted largely at the utility
industry with a particular emphasis on the substation
environment.  Competitors in this space are providers of traditional
wired connectivity including fiber, coax and Cat5 and Cat6 and wireless
technologies, including cellular and wifi. Some of the specific products used
within this space include RuggedCom, AT&T and Radius.





Telkonet’s
EthoStream Hospitality Network competes with a wide variety of companies in the
hospitality industry ranging from media companies to traditional HSIA solution
providers.  Although this industry is very widespread, according to
publicly available data, only a few providers offer HSIA services to greater
than 1000 individual hospitality properties.  Those competitors
include Guest-tek, Lodgenet, iBahn and Superclick.  Telkonet’s
competitive advantage in the space includes its end-to-end approach to its
service platform as well as its industry-leading hospitality HSIA gateway and
web-based control center.





Raw
Materials





While we
are dependent, in certain situations, on a limited number of vendors to provide
certain raw materials and components, we have not experienced significant
problems or issues purchasing any essential materials, parts or
components.  We obtain the majority of our raw materials from the
following suppliers: Arrow Electronics, Avnet Electronics Marketing, Digi-Key
Corporation, Intellon Corporation, and Versa Technology.  In addition,
Chesapeake Manufacturing, a U.S. based company, provides substantially all the
manufacturing and assembly requirements for the Telkonet iWire SystemTM and
Series 5 products, and ATR Manufacturing, a Chinese company, provides
substantially all the manufacturing requirements for the Telkonet SmartEnergy
products.





Customers





We are
neither limited to, nor reliant upon, a single or narrowly segmented consumer
base from which we derive our revenues.  Our current primary focus is in
the hospitality, commercial, education, utility, healthcare and
government/military markets and expanding into the consumer market.





For the
year ended December 31, 2009, we had no revenues from major
customers.  Revenues from two major customers approximated
$6,375,000, or 39%, of total revenues for the year ending December 31,
2008.   Continual recurring revenue distributed across a network
of greater than 2,300 customers approximated $4,000,000 for the year ended
December 31, 2009.





Intellectual
Property





We
acquired certain intellectual property in the SSI acquisition, including, but
not limited to, Patent No: 5,395,042, titled “Apparatus and Method for automatic
climate control,” and Patent No. D569,279, titled “Thermostat.”  Patent No:
5,395,042 was issued by the United States Patent and Trademark Office (USPTO) in
March 1995.  This invention calculates and records the amount of time
needed for the thermostat to return the room temperature to the occupant’s set
point once a person re-enters the room.  Patent No. D569,279 issued by the
USPTO in May 2008 was granted on the ornamental design of a thermostat
device.





We have
also applied for patents that cover the unique technology integrated into the
Telkonet iWire SystemTM and Series 5 product suite.  We also continue
to identify, design and develop enhancements to our core technologies that will
provide additional functionality, diversification of application and
desirability for current and future users of the Telkonet iWire SystemTM and
Series 5 product suite.





In
December 2003, we received approval from the USPTO for our “Method and Apparatus
for Providing Telephonic Communication Services” Patent No.:
6,668,058.  This invention covers the utilization of an electrical
power grid, for a concentration of electrical power consumers, and use of
existing consumer power lines to provide for a worldwide voice and data
telephony exchange.





In
December 2005, the USPTO issued Patent No: 6,975,212 titled “Method and
Apparatus for Attaching Power Line Communications to Customer
Premises”.  The patent covers the method and apparatus for modifying a
three-phase power distribution network in a building in order to provide data
communications by using a PLC signal to an electrical central location point of
the power distribution system.  Telkonet’s Coupler technology enables
the conversion of electrical outlets into high-speed data ports without costly
installation, additional wiring, or significant disruption of business
activity.  The Coupler is an integral component of the Telkonet iWire
SystemTM and Series 5 product suites.






7





In August
2006, the USPTO issued Patent No: 7,091,831, titled “Method and Apparatus for
Attaching Power Line Communications to Customer Premises.”  The
patented technology incorporates a safety disconnect circuit breaker into the
Telkonet Coupler, creating a single streamlined unit. In doing so, installation
of the Telkonet iWire SystemTM is faster, more efficient, and more
economical than with separate disconnect switches, delivering optimal signal
quality.  The Telkonet Integrated Coupler Breaker patent covers the
unique technique used for interfacing and coupling its communication devices
onto the three-phase electrical systems that are predominant in commercial
buildings.





In
January 2007, the USPTO issued Patent No: 7,170,395 titled “Methods and
Apparatus for Attaching Power Line Communications to Customer Premises” for
Delta phase power distribution system applications, which are prevalent in the
maritime industry, shipboard systems, along with that of heavy industrial plants
and facilities.





In
addition, we currently have multiple patent applications under examination, and
intend to file additional patent applications that we deem to be economically
beneficial.





There can
be no assurance that any of our current or future patent applications will be
granted, or, if granted, that such patents will provide necessary protection for
our technology or our product offerings, or be of commercial benefit to
us.





Government
Regulation





We are
subject to regulation in the United States by the Federal Communications
Commission, or FCC.  FCC rules permit the operation of unlicensed
digital devices that radiate radio frequency emissions if the manufacturer
complies with certain equipment authorization procedures, technical
requirements, marketing restrictions and product labeling
requirements.





In
January 2003, we received FCC approval to market the Telkonet iWire
System product suite. FCC rules permit the operation of unlicensed digital
devices that radiate radio frequency emissions if the manufacturer complies with
certain equipment authorization procedures, technical requirements, marketing
restrictions and product labeling requirements.  An independent,
FCC-certified testing lab has verified our Gateway complies with the FCC
technical requirements for Class A digital devices.  No further
testing of this device is required and the device may be manufactured and
marketed for commercial use.





In
March 2005, we received final certification of our Telkonet iWire
System product suite from European Union, or EU, authorities, which
certification was required before we could sell and permanently install the
Telkonet iWire System in EU countries. As a result of the certification, the
Telkonet iWire SystemTM that will be sold and installed in EU countries will
bear the Conformite Europeen (CE) mark, a symbol that demonstrates that the
product has met the EU’s regulatory standards and is approved for sale within
the EU.





In
June 2005, we received the National Institute of Standards and
Technology Federal Information Processing Standard, or FIPS, 140-2
validation for the Gateway.  In July 2005, we received FIPS 140-2
validation for the eXtender and iBridge.  The U.S. federal government
requires, as a condition to purchasing certain information processing
applications, that such applications receive FIPS 140-2
validation.  U.S. federal agencies use FIPS 140-2 compliant products
for the protection of sensitive information.  As a result of the
foregoing validations, as of July 2005, all of our powerline carrier
products have satisfied all governmental requirements for security certification
and are eligible for purchase by the U.S. federal government.  In
addition to the foregoing, Canadian provincial authorities use FIPS 140-2
compliant products for the protection of sensitive designate
information.  The Communications-Electronics Security Group, or
CESG, also has stated that FIPS 140-2 compliant products meet its security
criteria for use in data traffic categorized as “Private.”  CESG is
part of the United Kingdom’s National Technical Authority for Information
Assurance, which is a government agency responsible for validating the security
of information processing applications for the government of the United Kingdom,
financial institutions, healthcare organizations, and international governments,
among others.




Future
products designed by us will require testing for compliance with FCC and CE
compliance.  Moreover, if in the future, the FCC or EU changes its
technical requirements, further testing and/or modifications may be necessary in
order to achieve compliance.






8





Research
& Development





During
the year ended December 31, 2009 and 2008, we spent $1,080,148 and $2,036,129
respectively, on research and development activities.  In 2009 and
2008, research and development activities were largely focused on the
development of Telkonet’s SmartEnergy technology, first integrating mesh
networking technologies for remote access and control over the product as well
as a comprehensive web-based platform for control, monitoring and
management.  The primary focus for development within the EthoStream
Hospitality Network was related to features required by full-service hospitality
customers including enhanced Dual-WAN support, idle user checking for increased
property cross-marketing, and integration with external systems to allow
payment, authentication, or quality of service differentiation among customers.
Advancements in our Series 5 product line include the introduction of a low-cost
CPE device to expand the potential customer base, advancements in coupling
technology that allow customers to install Series 5 without disconnecting power
and development of a new DIN-rail style mounting bracket to ease installation in
utility substations.





Other
Information





Employees





As of
March 1, 2010, we had 93 full-time employees.  We intend to hire
additional personnel to meet future operating requirements, when and if our
financial resources permit. We anticipate that we may need to hire additional
staff in the areas of customer support, field services, engineering, sales and
marketing, and administration.





Environmental
Matters





We do not
anticipate any material effect on our capital expenditures, earnings or
competitive position due to compliance with government regulations involving
environmental matters.





ITEM
1A.  RISK FACTORS.





Our
results of operations, financial condition and cash flows can be adversely
affected by various risks. These risks include, but are not limited to, the
principal factors listed below and the other matters set forth in this annual
report on Form 10-K. You should carefully consider all of these
risks.





Risks
Relating to the Ownership of Our Common Stock





The
market price of our common stock has been and may continue to be
volatile.





The
trading price of our common stock has been and may continue to be highly
volatile and could be subject to wide fluctuations in response to various
factors.  Some of the factors that may cause the market price of our
common stock to fluctuate include:





·
            fluctuations
      in our quarterly financial and operating results or the quarterly
      financial results of companies perceived to be similar to
    us;





·
            changes
      in estimates of our financial results or recommendations by securities
      analysts;





·
            changes
      in general economic, industry and market
  conditions;





·
            failure
      of any of our products to achieve or maintain market
      acceptance;





·
            changes
      in market valuations of similar
companies;


·
              failure
      of our products to operate as
advertised





·
            success
      of competitive products;





·
            changes
      in our capital structure, such as future issuances of securities or the
      incurrence of additional debt;





·
            announcements
      by us or our competitors of significant products, contracts, acquisitions
      or strategic alliances;





·
            regulatory
      developments in the United States, foreign countries or
    both;





·
            litigation
      involving our company, our general industry or
  both;





·
            additions
      or departures of key personnel; and





·
            investors’
      general perception of us.






9





In
addition, if the market for technology stocks or the stock market in
general experiences a loss of investor confidence, the trading price of our
common stock could decline for reasons unrelated to our business, financial
condition or results of operations.  If any of the foregoing occurs,
it could cause our stock price to fall and may expose us to class action
lawsuits that, even if unsuccessful, could be costly to defend and a distraction
to management.





If
securities or industry analysts do not continue to publish research or publish
inaccurate or unfavorable research about our business, our stock price and
trading volume could decline.





The
trading market for our common stock depends in part on the research and reports
that securities or industry analysts publish about us or our
business.  We do not control these analysts.  If one or more
of the analysts who covers us downgrades our stock or publishes inaccurate or
unfavorable research about our business, our stock price would likely
decline.  If one or more of these analysts ceases coverage of our
company or fails to publish reports on us regularly, demand for our stock could
decrease, which could cause our stock price and trading volume to
decline.





Anti-takeover
provisions in our charter documents and Utah law could discourage delay or
prevent a change of control of our company and may affect the trading price of
our common stock.





We are a
Utah corporation and the anti-takeover provisions of the Utah Control Shares
Acquisition Act may discourage, delay or prevent a change of control by limiting
the voting rights of control shares acquired in a control share
acquisition.  In addition, our Amended and Restated Articles of
Incorporation and bylaws may discourage, delay or prevent a change in our
management or control over us that shareholders may consider
favorable.  Among other things, our Amended and Restated Articles of
Incorporation and bylaws:





·
            authorize
      the issuance of “blank check” preferred stock that could be issued by our
      board of directors to thwart a takeover
attempt;





·
            provide
      that vacancies on our board of directors, including newly created
      directorships, may be filled only by a majority vote of directors then in
      office, except a vacancy occurring by reason of the removal of a director
      without cause shall be filled by vote of the shareholders;
    and





·
            limit
      who may call special meetings of
shareholders.





These
provisions could have the effect of delaying or preventing a change of control,
whether or not it is desired by, or beneficial to, our
shareholders.





We
do not currently intend to pay dividends on our common stock and, consequently,
the ability to achieve a return on an investment in our common stock will depend
on appreciation in the price of our common stock.





We do not
expect to pay cash dividends on our common stock.  Any future dividend
payments are within the absolute discretion of our board of directors and will
depend on, among other things, our results of operations, working capital
requirements, capital expenditure requirements, financial condition, contractual
restrictions, business opportunities, anticipated cash needs, provisions of
applicable law and other factors that our board of directors may deem
relevant.  We may not generate sufficient cash from operations in the
future to pay dividends on our common stock.





Our
common stock was delisted from NYSE Amex LLC and is currently listed for trading
on the Over-the-counter Bulletin Board.





Prior to
November 13, 2009, our common stock was listed for trading on NYSE Amex LLC, or
the Exchange, under the symbol “TKO.”  On May 18, 2009, we received a
letter from the Exchange notifying us that we were out of compliance with the
Exchange’s continued listing standards due to the impairment of our existing
financial condition.  In the opinion of the Exchange, our historical
losses in relation to our overall operations and existing financial resources
caused our financial condition to become so impaired that it appeared
questionable as to whether we would be able to continue operations and/or meet
our obligations as they mature.  On June 25, 2009, we submitted a plan
to the Exchange advising of the actions we had taken, and planned to take, that
would bring us into compliance with the applicable listing standards within the
six month cure period.  On August 27, 2009, we were notified of the
Exchange’s intention to delist our common stock because our plan did not
reasonably demonstrate the ability to regain compliance with the continued
listing standards of the Exchange.  On November 3, 2009, we received notice
from the Exchange informing us that the Hearing Panel had confirmed the Staff’s
recommendation that our common stock be delisted from the
Exchange.  After considering the costs to us of compliance with the
continued listing requirements of the Exchange and other factors, we determined
that it was not in the best interests of our company and our shareholders to
appeal the delisting of our common stock from the Exchange and approved the
voluntary delisting of the securities.  The Exchange suspended trading
in our common stock effective at the open of business on November 13, 2009, at
which time our common stock began trading on the Over-the-Counter market’s Pink
Sheets under the symbol “TKOI.PK.”  On December 7, 2009, we received
FINRA approval for trading on the OTC Bulletin Board.  Our common
stock began trading on the OTC Bulletin Board on December 8, 2009 under the
symbol “TKOI.”  The delisting of our common stock from the Exchange
may have had a negative impact on the market’s perception of our company and
could also adversely affect our stock price, trading volume, and ability to
effect financing and strategic transactions, such as private placements or
public offerings of our securities and acquisitions of complementary businesses
through shares of our common stock.  In addition, our stockholders’
ability to trade or obtain quotations on our shares may be more limited than
they otherwise would be if our common stock were listed on the Exchange because
of lower trading volumes and transaction delays on the OTC Bulletin
Board.






10





Our common stock
may be subject to “Penny Stock” restrictions.





If the
price of our common stock remains at less than $5 per share, we will be subject
to so-called penny stock rules which could decrease our stock’s market
liquidity.  The Securities and Exchange Commission has adopted
regulations which define a “penny stock” to include any equity security that has
a market price of less than $5 per share or an exercise price of less than $5
per share, subject to certain exceptions.  For any transaction
involving a penny stock, unless exempt, the rules require the delivery to and
execution by the retail customer of a written declaration of suitability
relating to the penny stock, which must include disclosure of the commissions
payable to both the broker/dealer and the registered representative and current
quotations for the securities.  Finally, the broker/dealer must send
monthly statements disclosing recent price information for the penny stocks held
in the account and information on the limited market in penny
stocks.  Those requirements could adversely affect the market
liquidity of such stock.  There can be no assurance that the price of
our common stock will rise above $5 per share so as to avoid these
regulations.





We
have a large number of shares of common stock underlying outstanding debentures
and warrants that may become available for future sale, and the sale of these
shares may result in dilution.





As of
March 30, 2010, we had 96,673,771 shares of common stock issued and
outstanding.  In addition, as of that date, YA Global held secured
convertible debentures in an aggregate principal amount of $1,606,023, which we
refer to as the Debentures, under which the principal and accrued interest may
be converted into an estimated 10,706,820 shares of common stock at current
market prices, and outstanding warrants to purchase up to 4,621,212 shares of
common stock.  The number of shares of common stock issuable upon
conversion of the Debentures may increase if the market price of our common
stock declines. The number of shares of common stock issuable by us to YA Global
pursuant to the terms of the Debentures, all other debentures and the warrants
issued to holders of the Debentures cannot exceed an aggregate of 19.99% of the
total issued and outstanding shares (calculated in accordance with applicable
principal market rules and regulations) of our common stock (subject to
appropriate adjustment for stock splits, stock dividends, or other similar
recapitalizations affecting the common stock), unless we first obtain
shareholder approval.  We refer to this limitation as the Exchange
Cap.  The Exchange Cap is applicable for conversion of the Debentures
and exercises of the warrants, in the aggregate, and we are not obligated to
issue any shares of common stock upon conversion of the Debentures or exercise
of the warrants in excess of the Exchange Cap unless and until we first obtain
shareholder approval to exceed the Exchange Cap.  On May 28, 2009, our
shareholders voted against a proposal to remove the Exchange Cap, which would
have allowed YA Global to potentially acquire in excess of 19.99% of the
outstanding shares of our common stock.  If our shareholders later
approve the removal of the Exchange Cap, all of the shares, including all of the
shares issuable upon conversion of the Debentures and upon exercise of our
warrants, may be sold without restriction.  The sale of these shares
may adversely affect the market price of our common stock.





The
continuously adjustable conversion price feature of our outstanding debentures
held by YA Global may encourage investors to make short sales in our common
stock, which could have a negative effect on the price of our common
stock.





Due to
the Exchange Cap, we are not currently under an obligation to issue shares of
common stock to YA Global upon conversion of the Debentures.  If,
however, our shareholders approve the removal of the Exchange Cap, the
Debentures would be convertible into shares of our common stock at a 10%
discount to the ten day volume weighted average trading price of the common
stock prior to the conversion.  The significant downward pressure on
the price of the common stock as YA Global converts and sells material amounts
of common stock could encourage short sales by investors.  This could
place further downward pressure on the price of our common stock.  YA
Global could sell common stock into the market in anticipation of covering the
short sale by converting its securities, which could cause further downward
pressure on the stock price.  In addition, not only the sale of shares
issued upon conversion or exercise of outstanding convertible debt, warrants and
options, but also the mere perception that these sales could occur, may
adversely affect the market price of our common stock.





The
issuance of additional shares of common stock upon conversion of the Debentures
and the exercise of outstanding warrants may cause immediate and substantial
dilution to our existing shareholders.





Due to
the Exchange Cap, we are not currently under an obligation to issue shares of
common stock to YA Global upon conversion of the Debentures.  If,
however, our shareholders approve the removal of the Exchange Cap, this may
result in substantial dilution to the interests of other shareholders because YA
Global may ultimately convert the full outstanding amount under the Debentures
into shares of common stock, exercise the warrants in full and sell the shares
of common stock issued upon such conversion and exercise.  Although YA
Global may not convert its Debentures and/or exercise its warrants if such
conversion or exercise would cause it to own more than 4.99% of our outstanding
common stock, this restriction does not prevent YA Global from converting and/or
exercising some of its holdings and then converting the rest of its
holdings.  In this way, YA Global could sell more than 4.99% of our
outstanding common stock while never holding more than this limit.  If
the Exchange Cap is removed, there is no upper limit on the number of shares
that may be issued which will have the effect of further diluting the
proportionate equity interest and voting power of holders of our common
stock.







11




Further
issuances of equity securities may be dilutive to current
stockholders.





Although
the funds that were raised in our debenture offerings, the note offerings and
the private placement are being used for general working capital purposes, it is
likely that we will be required to seek additional capital in the future. This
capital funding could involve one or more types of equity securities, including
convertible debt, common or convertible preferred stock and warrants to acquire
common or preferred stock. Such equity securities could be issued at or below
the then-prevailing market price for our common stock. Any issuance of
additional shares of our common stock will be dilutive to existing stockholders
and could adversely affect the market price of our common stock.





The
exercise of options and warrants outstanding and available for issuance may
adversely affect the market price of our common stock.





As of
December 31, 2009, we had outstanding employee options to purchase a total of
6,120,883 shares of common stock at exercise prices ranging from $1.00 to $5.99
per share, with a weighted average exercise price of $1.56. As of December 31,
2009, we had outstanding non-employee options to purchase a total of 740,000
shares of common stock at an exercise price of $1.00 per share. As of December
31, 2009, we had warrants outstanding to purchase a total of 12,158,941 shares
of common stock at exercise prices ranging from $0.33 to $4.17 per share, with a
weighted average exercise price of $1.60. The exercise of outstanding options
and warrants and the sale in the public market of the shares purchased upon such
exercise will be dilutive to existing stockholders and could adversely affect
the market price of our common stock.





Risks
Related to Our Business





The
industry within which we operate is intensely competitive and rapidly
evolving.





We
operate in a highly competitive, quickly changing environment, and our future
success will depend on our ability to develop and introduce new products and
product enhancements that achieve broad market acceptance in the markets within
which we compete.  We will also need to respond effectively to new
product announcements by our competitors by quickly introducing competitive
products.





Delays in
product development and introduction could result in:





·
            loss
      of or delay in revenue and loss of market
share;





·
            negative
      publicity and damage to our reputation and the reputation of our product
      offerings; and





·
            decline
      in the average selling price of our
products.








12




Government
regulation of our products could impair our ability to sell such products in
certain markets.





The rules
of the Federal Communications Commission, or FCC, permit the operation of
unlicensed digital devices that radiate radio frequency emissions if the
manufacturer complies with certain equipment authorization procedures, technical
requirements, marketing restrictions and product labeling
requirements.  Differing technical requirements apply to “Class A”
devices intended for use in commercial settings, and “Class B” devices intended
for residential use to which more stringent standards apply.  An
independent, FCC-certified testing lab has verified that our iWire Systemproduct suite complies
with the FCC technical requirements for Class A and Class B digital
devices.  No further testing of these devices is required, and the
devices may be manufactured and marketed for commercial and residential
use.  Additional devices designed by us for commercial and residential
use will be subject to the FCC rules for unlicensed digital
devices.  Moreover, if in the future, the FCC changes its technical
requirements for unlicensed digital devices, further testing and/or
modifications of devices may be necessary.  Failure to comply with any
FCC technical requirements could impair our ability to sell our products in
certain markets and could have a negative impact on our business and results of
operations.





Products
sold by our competitors could become more popular than our products or render
our products obsolete.





The
market for our products and services is highly competitive.  Some of
our competitors have longer operating histories, greater name recognition and
substantially greater financial, technical, sales, marketing and other
resources.  These competitors may, among other things, undertake more
extensive marketing campaigns, adopt more aggressive pricing policies, obtain
more favorable pricing from suppliers and manufacturers and exert more influence
on the sales channel than we can.  As a result, we may not be able to
compete successfully with these competitors, and these competitors may develop
or market technologies and products that are more widely accepted than those
being developed by us or that would render our products obsolete or
noncompetitive.  We anticipate that competitors will also intensify
their efforts to penetrate our target markets.  These competitors may
have more advanced technology, more extensive distribution channels, stronger
brand names, bigger promotional budgets and larger customer bases than we
do.  These companies could devote more capital resources to develop,
manufacture and market competing products than we could.  If any of
these companies are successful in competing against us, our sales could decline,
our margins could be negatively impacted, and we could lose market share, any of
which could seriously harm our business, results of operations, and
prospects.





We
may not be able to obtain patents, which could have a material adverse effect on
our business.





Our
ability to compete effectively in the powerline technology industry will depend
on our success in acquiring suitable patent protection.  We currently
have several patents pending.  We also intend to file additional
patent applications that we deem to be economically beneficial.  If we
are not successful in obtaining patents, we will have limited protection against
those who might copy our technology.  As a result, the failure to
obtain patents could negatively impact our business, results of operations, and
prospects.





Infringement
by third parties on our proprietary technology and development of substantially
equivalent proprietary technology by our competitors could negatively impact our
business.





Our
success depends partly on our ability to maintain patent and trade secret
protection, to obtain future patents and licenses and to operate without
infringing on the proprietary rights of third parties.  There can be
no assurance that the measures we have taken to protect our intellectual
property rights, including intellectual property rights of third parties
integrated into our Telkonet iWire System product suite and Telkonet SmartEnergy
products, will prevent misappropriation or circumvention.  In
addition, there can be no assurance that any patent application, when filed,
will result in an issued patent, or that our existing patents, or any patents
that may be issued in the future, will provide us with significant protection
against competitors.  Moreover, there can be no assurance that any
patents issued to, or licensed by, us will not be infringed upon or circumvented
by others.  Infringement by third parties on our proprietary
technology could negatively impact our business.  Moreover, litigation
to establish the validity of patents, to assert infringement claims against
others, and to defend against patent infringement claims can be expensive and
time-consuming, even if the outcome is in our favor.  We also rely to
a lesser extent on unpatented proprietary technology, and no assurance can be
given that others will not independently develop substantially equivalent
proprietary information, techniques or processes or that we can meaningfully
protect our rights to such unpatented proprietary technology.  If our
competitors develop substantially equivalent technology, and we are unable to
enforce any intellectual property rights with respect to such technology in a
cost-effective manner or at all, our business and operations would suffer
significant harm.








13




We
may incur substantial damages due to litigation.





We cannot
be certain that our products do not and will not infringe issued patents or
other intellectual property rights of others. We are currently a defendant in an
action in which it is alleged that we have infringed the intellectual property
rights of another party.  If it were determined that our products
infringe the intellectual property rights of another, we could be required to
pay substantial damages or be enjoined from licensing or using the infringing
products or technology. Additionally, if it were determined that our products
infringe the intellectual property rights of others, we would need to obtain
licenses from these parties or substantially re-engineer our products in order
to avoid infringement. We might not be able to obtain the necessary licenses on
acceptable terms or at all, or to re-engineer our products successfully. Any of
the foregoing could cause us to incur significant costs and prevent us from
selling our products.





We are
also currently defending an action alleging that we are in breach of an
obligation to make severance and other payments to a former
executive.  If it is determined that we are in breach of any such
obligation, we could be required to pay substantial damages to our former
executive.





We
depend on a small team of senior management, and it may have difficulty
attracting and retaining additional personnel.





Our
future success will depend in large part upon the continued services and
performance of senior management and other key personnel.  If we lose
the services of any member of our senior management team, our overall operations
could be materially and adversely affected.  In addition, our future
success will depend on our ability to identify, attract, hire, train, retain and
motivate other highly skilled technical, managerial, marketing, purchasing and
customer service personnel when they are needed.  Competition for
these individuals is intense.  We cannot ensure that we will be able
to successfully attract, integrate or retain sufficiently qualified personnel
when the need arises.  Any failure to attract and retain the necessary
technical, managerial, marketing, purchasing and customer service personnel
could have a negative effect on our financial condition and results of
operations.  On December 21, 2009, we announced a restructuring which
includes the relocation of our offices from Germantown, Maryland to Milwaukee,
Wisconsin, consolidating our business operations into a single
location.  Also as part of the corporate restructuring, we announced
that our Chief Financial Officer, Rick Leimbach, will be leaving our company to
pursue other opportunities in the near future, although a departure date has yet
to be established.  Until his departure date, Mr. Leimbach will
continue to perform the duties and responsibilities customary and consistent
with his position and will assist us in our transition.  If we are
unable to satisfactorily replace Mr. Leimbach upon his departure, our overall
operations could be materially and adversely affected.





Any
acquisitions we make could result in difficulties in successfully managing our
business and consequently harm our financial condition.





We may
seek to expand by acquiring complementary businesses in our current or ancillary
markets.  We cannot accurately predict the timing, size and success of
our acquisition efforts and the associated capital commitments that might be
required.  We expect to face competition for acquisition candidates,
which may limit the number of acquisition opportunities available to us and may
lead to higher acquisition prices.  There can be no assurance that we
will be able to identify, acquire or profitably manage additional businesses or
successfully integrate acquired businesses, if any, without substantial costs,
delays or other operational or financial difficulties. In addition, acquisitions
involve a number of other risks, including:





·
            failure
      of the acquired businesses to achieve expected
  results;





·
            diversion
      of management’s attention and resources to
  acquisitions;





·
            failure
      to retain key customers or personnel of the acquired
      businesses;





·
            disappointing
      quality or functionality of acquired equipment and people:
    and





·
            risks
      associated with unanticipated events, liabilities or
      contingencies.







14





Client
dissatisfaction or performance problems at a single acquired business could
negatively affect our reputation.  The inability to acquire businesses
on reasonable terms or successfully integrate and manage acquired companies, or
the occurrence of performance problems at acquired companies, could result in
dilution, unfavorable accounting treatment or one-time charges and difficulties
in successfully managing our business.





Our
inability to obtain capital, use internally generated cash or debt, or use
shares of our common stock to finance future acquisitions could impair the
growth and expansion of our business.





Reliance
on internally generated cash or debt to finance our operations or complete
acquisitions could substantially limit our operational and financial
flexibility.  The extent to which we will be able or willing to use
shares of our common stock to consummate acquisitions will depend on the market
value of our common stock which will vary, and our liquidity.  Using
shares of our common stock for this purpose also may result in significant
dilution to our then existing stockholders.  To the extent that we are
unable to use our common stock to make future acquisitions, our ability to grow
through acquisitions may be limited by the extent to which we are able to raise
capital through debt or additional equity financings.  No assurance
can be given that we will be able to obtain the necessary capital to finance any
acquisitions or our other cash needs.  If we are unable to obtain
additional capital on acceptable terms, we may be required to reduce the scope
of any expansion or redirect resources committed to internal
purposes.  In addition to requiring funding for acquisitions, we may
need additional funds to implement our internal growth and operating strategies
or to finance other aspects of our operations.  Our failure to: (i)
obtain additional capital on acceptable terms; (ii) use internally generated
cash or debt to complete acquisitions because it significantly limits our
operational or financial flexibility; or (iii) use shares of our common stock to
make future acquisitions, may hinder our ability to actively pursue any
acquisitions.





The
restrictive covenants contained in the Securities Purchase Agreement pursuant to
which the convertible debentures were sold contain restrictions that could limit
our financing options.





The
Securities Purchase Agreement pursuant to which the convertible debentures were
sold contains limitations on our ability to engage in certain financing
activities without the prior consent of the holders of the convertible
debentures.  As a result of these restrictions, we may be unable to
obtain the financing necessary to fund working capital, operating losses,
capital expenditures or acquisitions.  The failure to obtain such financing
could have a material adverse effect on our business and results of
operations.





Potential
fluctuations in operating results could have a negative effect on the price of
our common stock.





Our
operating results may fluctuate significantly in the future as a result of a
variety of factors, most of which are outside our control,
including:





·
            the
      level of use of the Internet;





·
            the
      demand for high-tech goods;





·
            the
      amount and timing of capital expenditures and other costs relating to the
      expansion of our operations;





·
            price
      competition or pricing changes in the
industry;





·
            technical
      difficulties or system downtime;





·
            economic
      conditions specific to the internet and communications industry;
      and





·
            general
      economic conditions.





Our
quarterly results may also be significantly impacted by certain accounting
treatment of acquisitions, financing transactions or other matters. Such
accounting treatment could have a material impact on our results of operations
and have a negative impact on the price of our common stock.







15





We
rely on a small number of customers and cannot be certain they will consistently
purchase our products in the future.





No customer
accounted for more than 10% of our revenues for the year ended December 31,
2009.  Two customers accounted for 39% of our revenues for the year
ended December 31, 2008.  No other customer accounted for more than
10% of our revenues during those periods.  In the future, a small
number of customers may continue to represent a significant portion of our total
revenues in any given period. We cannot be certain that such customers will
consistently purchase our products at any particular rate over any subsequent
period.  A loss of any of these customers could adversely affect our
financial performance.





We
rely on a limited number of third party suppliers. If these companies fail to
perform or experience delays, shortages, or increased demand for their products
or services, we may face shortages, increased costs, and may be required to
suspend deployment of our products and services.





We depend
on a limited number of third party suppliers to provide the components and the
equipment required to deliver our solutions.  If these providers fail
to perform their obligations under our agreements with them or we are unable to
renew these agreements, we may be forced to suspend the sale and deployment of
our products and services and enrollment of new customers, which would have an
adverse effect on our business, prospects, financial condition and operating
results.





Our
management and operational systems might be inadequate to handle our potential
growth.





We may
experience growth that could place a significant strain upon our management and
operational systems and resources.  Failure to manage our growth
effectively could have a material adverse effect upon our business, results of
operations and financial condition.  Our ability to compete
effectively and to manage future growth will require us to continue to improve
our operational systems, organization and financial and management controls,
reporting systems and procedures.  We may fail to make these
improvements effectively.  Additionally, our efforts to make these
improvements may divert the focus of our personnel.  We must integrate
our key executives into a cohesive management team to expand our
business.  If new hires perform poorly, or if we are unsuccessful in
hiring, training and integrating these new employees, or if we are not
successful in retaining our existing employees, our business may be
harmed.  To manage the growth we will need to increase our operational
and financial systems, procedures and controls.  Our current and
planned personnel, systems, procedures and controls may not be adequate to
support our future operations.  We may not be able to effectively
manage such growth, and failure to do so could have a material adverse effect on
our business, financial condition and results of operations.





We
are exposed to risks relating to evaluations of controls required by Section 404
of the Sarbanes-Oxley Act of 2002.





We are
required to comply with Section 404 of the Sarbanes-Oxley Act of
2002.  We concluded that, as of December 31, 2009, there were material
weaknesses in our internal control over financial reporting relating to the lack
of segregation of duties and the need for a stronger internal control
environment, attributable to the small size of our accounting staff and
continued integration of our 2007 acquisitions of Smart Systems International
and EthoStream LLC.  We retained additional personnel and worked to
remediate these deficiencies during fiscal 2009.  Notwithstanding
those efforts we continue to have material weaknesses in our internal control
over financial reporting.  A material weakness is a control
deficiency, or a combination of control deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material
misstatement of annual or interim financial statements would not be prevented or
detected.  Until this deficiency in our internal control over
financial reporting is remediated, there is reasonable possibility that a
material misstatement to our annual or interim consolidated financial statements
could occur and not be prevented or detected by our internal controls in a
timely manner.





We
may be affected if the United States participates in wars or military or other
action or by international terrorism.





Involvement
in a war or other military action or acts of terrorism may cause significant
disruption to commerce throughout the world.  To the extent that such
disruptions result in (i) delays or cancellations of customer orders, (ii) a
general decrease in consumer spending on information technology, (iii) our
inability to effectively market and distribute our services or products or (iv)
our inability to access capital markets, our business and results of operations
could be materially and adversely affected.  We are unable to predict
whether the involvement in a war or other military action will result in any
long-term commercial disruptions or if such involvement or responses will have
any long-term material adverse effect on our business, results of operations, or
financial condition.





Our
exposure to the credit risk of our customers and suppliers may adversely affect
our financial results.





We sell
our products to customers that have in the past, and may in the future,
experience financial difficulties, particularly in light of the recent global
economic downturn. If our customers experience financial difficulties, we could
have difficulty recovering amounts owed to us from these customers. While we
perform credit evaluations and adjust credit limits based upon each customer’s
payment history and credit worthiness, such programs may not be effective in
reducing our exposure to credit risk. We evaluate the collectability of accounts
receivable, and based on this evaluation make adjustments to the allowance for
doubtful accounts for expected losses. Actual bad debt write-offs may differ
from our estimates, which may have a material adverse effect on our financial
condition, operating results and cash flows.







16




Our
suppliers may also experience financial difficulties, which could result in our
having difficulty sourcing the materials and components we use in producing our
products and providing our services. If we encounter such difficulties, we may
not be able to produce our products for our customers in a timely fashion which
could have an adverse effect on our results of operations, financial condition
and cash flows.





The
recent deterioration of the economy and credit markets may adversely affect our
future results of operations.





Our
operations and performance depend to some degree on general economic conditions
and their impact on our customers’ finances and purchase
decisions.  As a result of recent economic events, potential customers
may elect to defer purchases of capital equipment items, such as the products we
manufacture and supply.  Additionally, the credit markets and the
financial services industry have been experiencing a period of upheaval
characterized by the bankruptcy, failure, collapse or sale of various financial
institutions and an unprecedented level of intervention from the United States
government. While the ultimate outcome of these events cannot be predicted, it
may have a material adverse effect on our customers’ ability to fund their
operations thus adversely impacting their ability to purchase our products or to
pay for our products on a timely basis, if at all.  These and other
economic factors could have a material adverse effect on demand for our
products, the collection of payments for our products and on our financial
condition and operating results.





We
may not be able to obtain to obtain payment and performance bonds, which could
have a material adverse effect on our business.





Our
ability to deploy our SmartEnergy platform into the energy management
initiatives in military housing and deployments may rely on our ability to
obtain payment and performance bonds which may be an essential element to work
orders for the installation of our products and services.  If we are
unable to obtain payment and performance bonds in a timely fashion as required
by an applicable work order, we may not be entitled to payment under the work
order until such bonds have been provided or until such a requirement is
expressly waived.  And any delays due to a failure to furnish bonds
may not entitle us to a price increase for the work or an extension of time to
complete the work and may entitle the other party to terminate our work order
without liability and to indemnify such party from damages suffered as a result
of our failure to deliver the bonds and the termination of the work order. As a
result, the failure to obtain bonds where required could negatively impact our
business, results of operations, and prospects.





Risks
Relating to Our Financial Results and Need for Financing





Our
independent auditors have expressed substantial doubt about our ability to
continue as a going concern, which may hinder our ability to obtain future
financing.





In its
report dated March 31, 2010, our independent auditors stated that our financial
statements for the year ended December 31, 2009 were prepared assuming that we
would continue as a going concern, and that they have substantial doubt about
our ability to continue as a going concern.  Our auditors’ doubts are
based on our net losses and deficits in cash flows from
operations.  We continue to experience net operating
losses.  Our ability to continue as a going concern is subject to our
ability to generate a profit and/or obtain necessary funding from outside
sources, including by the sale of our securities, or obtaining loans from
financial institutions, where possible.  Our continued net operating
losses and our auditors’ doubts increase the difficulty of our meeting such
goals.  If we are not successful in raising sufficient additional
capital, we may not be able to continue as a going concern and our stockholders
may lose their entire investment.





We
have a limited number of shares of common stock available for future issuance
which could adversely affect our ability to raise capital or consummate
acquisitions.





We are
currently authorized to issue 155,000,000 shares of common stock under our
Articles of Incorporation.  As of March 31, 2010, we have outstanding
96,673,771 shares of common stock, or approximately 122,293,353 shares of common
stock after giving effect to the assumed exercise of all outstanding warrants
and options and assumed conversion of preferred stock.  Due to the
limited number of authorized shares available for issuance and because of the
significant competition for acquisitions, we may not able to consummate an
acquisition until we increase the number of shares we are authorized to
issue.  To facilitate the possibility and flexibility of raising
additional capital or the completion of potential acquisitions, we would need to
seek shareholder approval to increase the number of our authorized shares of
common stock.  We can provide no assurance that we will succeed in
amending our Articles of Incorporation to increase the number of shares of
common stock we are authorized to issue.  If we are not successful in
raising sufficient additional capital, we may not be able to continue as a going
concern and our shareholders may lose their entire investment.





We
have a history of operating losses and an accumulated deficit and expect to
continue to incur losses for the foreseeable future.






17





Since
inception through December 31, 2009, we have incurred cumulative losses of
$113,741,481 and have never generated enough funds through operations to support
our business.  Because of the numerous risks and uncertainties
associated with our technology, the industry in which we operate, and other
factors, we are unable to predict the extent of any future losses or when we
will become profitable, if ever.  If we are unable to generate
sufficient revenues from our operations to meet our working capital requirements
for the next twelve months, we expect to finance our future cash needs through
public or private equity offerings, debt financings and interest income earned
on our cash balances.  We cannot be certain that additional funding
will be available on acceptable terms, or at all.





Our
ability to use our net operating loss carryforwards may be subject to limitation
which could result in increased future tax liability for us.





Generally,
a change of more than 50% in the ownership of a company’s stock, by value, over
a three-year period constitutes an ownership change for U.S. federal income tax
purposes. An ownership change may limit a company’s ability to use its net
operating loss carryforwards attributable to the period prior to such change.
The number of shares of our common stock that we issue in the proposed rights
offering described in our registration statement on Form S-1 (File No.
333-164899) may be sufficient, taking into account prior or future shifts in our
ownership over a three-year period, to cause us to undergo an ownership change.
As a result, if we earn net taxable income, our ability to use our pre-change
net operating loss carryforwards to offset U.S. federal taxable income may
become subject to limitations, which could result in increased future tax
liability for us.





Our
business activities might require additional financing that might not be
obtainable on acceptable terms, if at all, which could have a material adverse
effect on our financial condition, liquidity and our ability to operate going
forward.




On
February 12, 2010, we filed a registration statement on Form S-1 in order to
conduct a planned rights offering.  In the rights offering, we will
distribute at no charge to holders of our common stock, other than those who
hold shares of our common stock solely as participants in the Telkonet, Inc.
401(k) plan, and to the holders of our Series A convertible redeemable preferred
stock, transferable subscription rights as set forth in the Form
S-1.





We
believe that the anticipated net proceeds from this offering and cash flow from
operations will be sufficient to meet our working capital, capital expenditure
and other cash needs indefinitely. However, if we do not meet our business plan
targets, we might need to raise additional capital from public or private equity
or debt sources in order to finance future growth, including the expansion of
service within existing markets and to new markets, which can be capital
intensive, as well as unanticipated working capital needs and capital
expenditure requirements.





The
actual amount of capital required to fund our operations and development may
vary materially from our estimates. If our operations fail to generate the cash
that we expect, we may have to seek additional capital to fund our business. If
we are required to obtain additional funding in the future, we may have to sell
assets, seek debt financing or obtain additional equity capital. In addition,
any indebtedness we incur in the future could subject us to restrictive
covenants limiting our flexibility in planning for, or reacting to changes in,
our business. If we do not comply with such covenants, our lenders could
accelerate repayment of our debt or restrict our access to further borrowings.
If we raise funds by selling more stock, your ownership in us will be diluted,
and we may grant future investors rights superior to those of the common stock
that you are purchasing. If we are unable to obtain additional capital when
needed, we may have to delay, modify or abandon some of our expansion plans.
This could slow our growth, negatively affect our ability to compete in our
industry and adversely affect our financial condition.




We
require shareholder approval to increase the number of our authorized shares of
common stock.
 
 In order
to conduct the rights offering, we require shareholder approval to increase the
number of our authorized shares of common stock.  We can provide no
assurance that we will succeed in obtaining shareholder approval to increase the
number of shares of common stock we are authorized to issue.  If we
are not successful in obtaining shareholder approval, we will not have a
sufficient number of shares necessary to the completion of the rights
offering.




A
significant portion of our total assets consists of goodwill, which is subject
to a periodic impairment analysis, and a significant impairment determination in
any future period could have an adverse effect on our results of operations even
without a significant loss of revenue or increase in cash expenses attributable
to such period.





We have
goodwill totaling approximately $11.7 million at December 31, 2009 resulting
from recent and past acquisitions.  We evaluate this goodwill for
impairment based on the fair value of the operating business units to which this
goodwill relates at least once a year.  This estimated fair value
could change if we are unable to achieve operating results at the levels that
have been forecasted, the market valuation of those business units decreases
based on transactions involving similar companies, or there is a permanent,
negative change in the market demand for the services offered by the business
units.  These changes could result in an impairment of the existing
goodwill balance that could require a material non-cash charge to our results of
operations.





Our
failure to comply with restrictive covenants under our revolving credit
facilities and other debt instruments could trigger prepayment
obligations.





Our
failure to comply with the restrictive covenants under our revolving credit
facilities and other debt instruments could result in an event of default,
which, if not cured or waived, could result in us being required to repay these
borrowings before their due date.  If we are forced to refinance these
borrowings on less favorable terms, our results of operations and financial
condition could be adversely affected by increased costs and rates.





If we fail to remain current on our
reporting requirements, we could be removed from the OTC Bulletin Board, which
would limit the ability of broker-dealers to sell our securities and the ability
of stockholders to sell their securities in the secondary
market.







18




Companies
trading on the OTC Bulletin Board, such as us, must be reporting issuers under
Section 12 of the Securities Exchange Act of 1934, as amended, or the Exchange
Act, and must be current in their reports under Section 13 of the Exchange Act
in order to maintain price quotation privileges on the OTC Bulletin
Board.  If we fail to remain current on our reporting requirements, we
could be removed from the OTC Bulletin Board.  As a result, the market
liquidity for our securities could be severely adversely affected by limiting
the ability of broker-dealers to sell our securities and the ability of
stockholders to sell their securities in the secondary market.





We
have substantial debt, and our debt agreements contain certain events of default
and are secured by all of our assets.





As of
December 31, 2009, our indebtedness totaled approximately $2.3 million,
excluding advances on our factoring lines of approximately
$643,000.  As a result, we incur significant interest
expense.  We had $1.6 million of outstanding term debt that
matures in May 2011, approximately $387,000 of our outstanding revolver debt
that matures in September 2010, and a $300,000 loan that matures in December
2016.





Our debt
agreements contain certain events of default, including, among other things,
failure to pay, violation of covenants, and certain other expressly enumerated
events.  Additionally, we have granted to YA Global and Thermo Credit
a first priority security interest in substantially all of our assets, while the
State of Wisconsin holds a subordinated interest in our assets.





The
degree to which we are leveraged could have important consequences, including
the following:





·
            our
      ability to obtain additional financing in the future for operations,
      capital expenditures, potential acquisitions, and other purposes may be
      limited, or financing may not be available on terms favorable to us or at
      all;





·
            a
      substantial portion of our cash flows from operations must be used to pay
      our interest expense and repay our debt, which reduces the funds that
      would otherwise be available to us for our operations and future business
      opportunities; and





·
            our
      ability to continue operations at the current level could be negatively
      affected if we cannot refinance our obligations before their due
      date.





A default
under any of our debt agreements could result in acceleration of debt payments
and permit the lender to foreclose on our assets.  We cannot assure
you that we will be able to maintain compliance with these
covenants.  Failure to maintain compliance could have a material
adverse impact on our financial position, results of operations and cash
flow.





The terms
of ouroutstanding
Debentures put significant restrictions on our ability to:





·
            pay
      cash dividends to our stockholders;





·
            incur
      additional indebtedness;





·
            permit
      liens on assets or conduct sales of assets;
and





·
            engage
      in transactions with affiliates.





These
significant restrictions could have negative consequences, such as:





·
            we
      may be unable to obtain additional financing to fund working capital,
      operating losses, capital expenditures or acquisitions on terms acceptable
      to us, or at all;





·
            we
      may be unable to refinance our indebtedness on terms acceptable to us, or
      at all; and





·
            we
      may be more vulnerable to economic downturns, which would limit our
      ability to withstand competitive
pressures.





Moreover,
any additional debt financing pursued by us may contain terms that include more
restrictive covenants, require repayment on an accelerated schedule or impose
other obligations that limit the ability to grow our business, acquire needed
assets, or take other actions we might otherwise consider appropriate or
desirable.





We
require a waiver under our line of credit facility, without which we will be in
default of our line of credit facility.





In
September 2008, we entered into a two-year line of credit facility with a third
party financial institution.  Among other things, we agreed with the
lender that (i) for each monthly period subsequent to March 31, 2009, we will
maintain a ratio of cash flow to scheduled principal payments plus all accrued
interest and related fee on funded debt of not less than 1.00 to 1.00 as of the
end of each fiscal quarter (which we refer to as the minimum cash flow to debt
service ratio)  and (ii) we will maintain a tangible net worth of not
less than $14,400,000 as of the last day of each fiscal quarter (which we refer
to as the tangible net worth requirement).  On March 24, 2010, we
received a notice of waiver of the minimum cash flow to debt service ratio and
the tangible net worth requirement under the line of credit
facility.  The waivers are effective for the quarter ended December
31, 2009 and for a period of ninety (90) days thereafter.   We have no
assurance that we will be granted a further extension.  In the event
we are unable to obtain an extension of the waiver we will be in default of the
minimum cash flow to debt service ratio and the tangible net worth
requirement.  A default could result in acceleration of debt payments
and permit the lender to foreclose on our assets.






19





ITEM
2.  PROPERTIES.





We lease
12,000 square feet of commercial office space, storage and manufacturing in
Milwaukee, Wisconsin as our corporate headquarters for a monthly rental of
$17,289.  The Milwaukee lease expires in February
2019.   In connection with our restructuring, we are in the
process of relocating our personnel from Germantown, Maryland to
Milwaukee.





We also
presently lease 16,400 square feet of commercial office space in Germantown,
Maryland for a monthly rental of $18,327.  This lease expires in
December 2015. As a result of our relocation to Milwaukee, we are actively
looking to sublease all or a portion of the Germantown space for the balance of
the lease term.





ITEM
3.  LEGAL PROCEEDINGS.





Linksmart
Wireless Technology, LLC v. T-Mobile USA, Inc., et al,





On July
1, 2008, Linksmart Wireless Technology, LLC, or Linksmart, filed a civil lawsuit
in the Eastern District of Texas against EthoStream, LLC, our wholly-owned
subsidiary and 22 other defendants (Linksmart Wireless Technology, LLC
v. T-Mobile USA, Inc., et al, U.S. District Court, for the Eastern
District of Texas, Marshall Division, No.2:08-cv-00264-TJW-CE).  This
lawsuit alleges that the defendants’ services infringe a wireless network
security patent held by Linksmart. Linksmart seeks a permanent injunction
enjoining the defendants from infringing, inducing the infringement of, or
contributing to the infringement of its patent, an award of damages and
attorney’s fees.





On August
1, 2008, we timely filed an answer to the complaint denying the allegations. On
February 27, 2009, the United States Patent Office ("USPTO") granted a
reexamination request.  Based upon four highly relevant and material
prior art references that had not been considered by the USPTO in its initial
examination, it found a “substantial new question of patentability” affecting
all claims of the patent allegedly infringed upon.  There is a
possibility that the claims of the patent will be cancelled or narrowed during
the reexamination which may result in the narrowing or elimination of some and
possibly all of the issues in the pending litigation.  The case is
currently in discovery.  A mandatory mediation will likely be held in
April or May, 2010.





Defendant
Ramada Worldwide, Inc. provided us with notice of the suit and demanded that we
defend and indemnify it pursuant to a vendor direct supplier agreement between
EthoStream and WWC Supplier Services, Inc., a Ramada affiliate (wherein we
agreed to indemnify, defend and hold Ramada harmless from and against claims of
infringement).  After a review of that agreement, it was determined
that Ethostream owes the duty to defend and indemnify and it has assumed
Ramada’s defense.  An answer on Ramada’s behalf was filed in U.S.
District Court, for the Eastern District of Texas, Marshall Division on
September 19, 2008. The matter is currently pending in that court.





Ronald Pickett v. Telkonet,
Inc.





On April
29, 2009, Ronald Pickett, our former chief executive officer, filed a lawsuit
against us (Ronald Pickett v.
Telkonet, Inc.), in the Circuit Court for Montgomery County, Maryland,
Case No. 312683V, alleging that he is owed $258,053 in unpaid severance
compensation and benefits and $63,000 in unpaid business and travel expenses and
seeking an award of treble damages on the severance claim alleging that the
claimed benefits constitute “wages” under the Maryland Wage Payment and
Collection Act.  On August 31, 2009, we filed a motion to
dismiss the action for failure to state a claim.  However, the court
rejected our arguments, finding that Mr. Pickett had satisfied the minimum
pleading requirements.  The parties have completed all written
discovery and all depositions of the parties have been completed excluding the
deposition of Thomas Lynch which the parties are attempting to
reschedule.  A pretrial hearing was held on March 26, 2010 in the
Circuit Court, at which time the case was set for trial for May 4 – May 6,
2010.





ITEM
4.   RESERVED.





None.





PART
II





ITEM
5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES.






20





Our
common stock is currently quoted on the OTC Bulletin Board under the symbol
“TKOI.”  From November 13, 2009 to December 7, 2009, our common stock
was listed for trading on the pink sheets, a centralized quotation service
maintained by Pink OTC Markets Inc., under the symbol
“TKOI.PK.”  Between January 1, 2008 and November 12, 2009, our common
stock was listed for trading on the NYSE AMEX LLC under the ticker symbol
“TKO.”





The
following table sets forth (1) the high and low bid prices for our common stock
for the fourth quarter of 2009 and (2) the high and low sales prices for our
common stock for all other periods indicated below.  The price
information represents inter-dealer prices without retail mark-ups, mark-downs
or commissions, and may not necessarily represent actual
transactions.





High
            
            
            LowYear
      Ended December 31, 2009First
      Quarter
            
            $
            0.18
            
            
            $
            0.07Second
      Quarter
            
            $
            0.24
            
            
            $
            0.08Third
      Quarter
            
            $
            0.75
            
            
            $
            0.09Fourth
      Quarter
            
            $
            0.47
            
            
            $
            0.15Year
      Ended December 31, 2008First
      Quarter
            
            $
            1.11
            
            
            $
            0.57Second
      Quarter
            
            $
            1.02
            
            
            $
            0.40Third
      Quarter
            
            $
            0.56
            
            
            $
            0.24Fourth
      Quarter
            
            $
            0.33
            
            
            $
            0.10




Record
Holders





As of
March 30, 2010, we had 243 shareholders of record and 96,673,771 shares of our
common stock issued and outstanding.





Dividend
Policy





The
Company has never paid dividends on its common stock and does not anticipate
paying dividends in the foreseeable future.





Unregistered
Sales of Equity Securities and Use of Proceeds





None.





ITEM
6.  SELECTED FINANCIAL DATA





This item
is not applicable.





ITEM
7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the accompanying financial
statements and related notes thereto.





Overview





Telkonet,
Inc. was formed in 1999 and is incorporated under the laws of the state of
Utah.  We develop, manufacture and sell proprietary energy efficiency
and smart grid networking technology products and platforms that have helped
position us as a leading clean technology provider.





We began
as a developer of powerline communications, or PLC, technology.  Our
proprietary, patented PLC products utilize a building’s internal electrical
wiring to form a data communications network, turning power outlets into data
ports while leaving the electrical functionality unaffected.  In 2003,
we launched our PlugPlusInternet suite of products, designed to maximize the use
of the existing electrical wiring in commercial buildings, such as hotels,
schools, multi-dwelling units, government and military buildings and office
buildings. Our PlugPlusInternet products provided high-speed Internet access
throughout a building, utilizing the electrical wiring already in place,
converting virtually every electrical outlet into a high-speed data network. The
PlugPlusInternet product suite was comprised of the PlugPlus Gateway, the
PlugPlus Coupler and the PlugPlus Modem, which together built an Internet
delivery system throughout an entire building.  We received our first
order for our PlugPlusInternet products in October 2003.





In March
2007, we completed two strategic acquisitions.  On March 15, 2007, we
completed the acquisition of EthoStream, LLC, or EthoStream, a leading
high-speed wireless Internet access, or HSIA, solutions and technology provider
targeting the hospitality industry with a customer base then consisting of
approximately 1,800 hotel and timeshare properties representing in excess of
180,000 guest rooms.  We acquired 100% of the outstanding membership
units of EthoStream for a purchase price of $11,756,097, which was comprised of
$2.0 million in cash and 3,459,609 shares of our common stock.  The
entire stock portion of the purchase price was deposited into escrow upon
closing to satisfy certain potential indemnification obligations of the sellers
under the purchase agreement.  The shares held in escrow are
distributable over the three years following the closing.






21





Our
EthoStream Hospitality Network is now one of the largest hospitality HSIA
service providers in the United States, with a customer base of approximately
2,300 properties representing over 200,000 hotel rooms.  This
network has created a ready opportunity for us to market our energy
efficiency solutions.  It also provides a marketing opportunity for our
more traditional HSIA offerings, including the Telkonet iWire System.  The
iWire System offers a fast and cost effective way to deliver commercial
high-speed broadband access using a building’s existing electrical
infrastructure to convert virtually every electrical outlet into a high-speed
data port without the installation of additional wiring or major disruption of
business activity.  The EthoStream Hospitality Network represents a
significant portion of our hospitality growth and market share.  The
EthoStream Hospitality Network is backed by a 24/7 U.S.-based in-house support
center that uses integrated, web-based centralized management tools enabling
proactive customer support.





While we
continue to grow the EthoStream Hospitality Network, through our March 9, 2007
acquisition of Smart Systems International, or SSI, a leading manufacturer of
in-room energy management systems for the hospitality industry with over 60,000
product installs as of the acquisition date, and the continued development of
our PLC products, we have evolved into a “clean technology” company that
develops, manufactures and sells proprietary energy efficiency and smart grid
networking technology.  We acquired substantially all of the assets of
SSI for cash and shares of our common stock having an aggregate value of
$6,875,000.  The purchase price was comprised of $875,000 in cash and
2,227,273 shares of our common stock.  Of the stock issued in the
transaction, 1,090,909 shares were held in an escrow account for a period of one
year following the closing from which certain potential indemnification
obligations under the purchase agreement could be satisfied.  The
aggregate number of shares held in escrow was subject to adjustment upward or
downward depending upon the trading price of our common stock during the one
year period following the closing date.  On March 12, 2008, we
released these shares from escrow, and on June 12, 2008 we issued an additional
1,882,225 shares pursuant to the adjustment provisions of the SSI asset purchase
agreement.





Our
Telkonet SmartEnergy, or TSE, and Networked Telkonet SmartEnergy, or NTSE,
energy efficiency products incorporate our patented Recovery Time technology,
allowing for the continuous monitoring of climate conditions to automatically
adjust a room’s temperature accounting for the presence or absence of an
occupant.  Our SmartEnergy products save energy while at the same time
ensuring occupant comfort.  This technology is particularly attractive
to our customers in the hospitality area, as well as the education, healthcare
and government/military markets, who are continually seeking ways to reduce
costs without impacting building occupant comfort.  By reducing energy
usage automatically when a space is unoccupied, our customers are able to
realize a significant cost savings without diminishing occupant
comfort.  The hospitality, education, healthcare and
government/military markets represent a significant audience for the
occupancy-based energy management controls offered by the SmartEnergy
platform and provide a large footprint for utility-based consumption
management.  This platform may also be integrated with property management
systems, automation systems and load shedding initiatives to increase the
savings recognized.  Working directly with management companies and
utilities allows us to offer enhanced opportunities to our customers for savings
and control.  Our energy management systems are dynamically lowering
HVAC costs in over 180,000 rooms and are an integral part of the numerous state
and federal energy efficiency and rebate programs.





Our smart
grid networking technology, including the Telkonet iWire System and the 200 Mbps
Telkonet Series 5 PLC products, use PLC technology to quickly, economically and
non-disruptively transform a site’s existing internal electrical infrastructure
into an internet protocol, or IP, network backbone.  Our PLC systems
offer the hard-wired security and reliability of a CAT-5 cabled network, but
without the cost, physical disturbance and business disruption of wiring CAT-5
or the security issues inherent to wireless systems.





The
development of an industrial PLC product for use within the utility space has
introduced a competitive alternative to traditional local area network, or LAN,
solutions. By capitalizing on the shortcomings of previously available
offerings, we have gained traction and opened a new market
opportunity.  Our Series 5 SmartGrid networking technology provides a
compelling solution for power substation automation, power generation, renewable
facilities, manufacturing, and research environments by providing a
rapidly-deployed, low cost alternative to structured cable, wireless and
fiber.  Operating at 200 Mbps, our PLC platform offers a secure new
competitive alternative in grid communications, enabling LAN infrastructure for
power substation command and control, monitoring and grid management,
transforming a traditional power management system into a “smart grid” that
delivers electricity in a manner that can save energy, reduce cost and increase
reliability.  By leveraging the existing electrical wiring within a
facility to transport data, our PLC solutions enable facilities to deploy
sensing and control systems to locations without the need for new network
wiring, and without the security risks associated with wireless
systems.





We employ
direct and indirect sales channels in all areas of our business.  With a
growing value-added reseller network, we continue to broaden our reach
throughout the industry.  Utilizing key integrators and strategic OEM
partners, we have been able to recognize significant success in each of our
targeted markets.  With an increasing share of our business originating
outside of the hospitality industry, we have proven the versatility of our
technology and the savings that can be derived through the use of our
products.






22





Discontinued
Operations





On
January 31, 2006, we acquired a 90% interest in Microwave Satellite
Technologies, Inc. from Frank Matarazzo, its sole stockholder, in exchange for
$1.8 million in cash and 1.6 million unregistered shares of our common stock,
for an aggregate purchase price of $9,000,000.  The cash portion of
the purchase price was paid in two installments, $900,000 at closing and
$900,000 in February 2007.  The stock portion is payable from shares
held in escrow, 400,000 shares of which were paid at closing and the remaining
1,200,000 reserve shares, which shall be issued based on the achievement of
3,300 video and data subscribers over a three year period from the closing
(later extended to July 2009 pursuant to a May 2008 agreement between the
parties).  The escrow agreement terminated on July 31,
2009.  As of August 14, 2009, we had issued 800,000 of the reserve
shares.





On April
22, 2009, we completed the deconsolidation of our subsidiary, MSTI Holdings,
Inc., or MSTI.  To effect the deconsolidation of MSTI, we were
required to reduce our ownership percentage and board membership in
MSTI.  On February 26, 2009, we executed a Stock Purchase Agreement
pursuant to which we sold 2.8 million shares of MSTI common stock and as a
result of this transaction, we reduced our beneficial ownership in MSTI from 58%
to 49% of the issued and outstanding shares of MSTI common stock.  On
April 22, 2009, Warren V. Musser and Thomas C. Lynch, members of our Board of
Directors, submitted their resignations as directors of MSTI.  Because
of these resignations we no longer control a majority of MSTI’s board of
directors.  As a result of the deconsolidation, the financial
statements and accompanying footnotes included in this prospectus include
disclosures of the results of operations of MSTI, for all periods presented, as
discontinued operations.





Loss
on Long-Term Investments





Geeks
on Call America, Inc.





On
October 19, 2007, we completed the acquisition of approximately 30% of the
issued and outstanding shares of common stock of Geeks on Call America, Inc., or
GOCA, a provider of on-site computer services.  Under the terms of the
stock purchase agreement, we acquired approximately 1,160,043 shares of GOCA
common stock from several GOCA stockholders in exchange for 2,940,200 shares of
our common stock for total consideration valued at approximately $4.5
million.  The number of shares issued in connection with this transaction
was determined using a per share price equal to the average closing price of our
common stock on the American Stock Exchange (AMEX) during the ten trading days
immediately preceding the closing date.  The number of shares was subject
to adjustment on the date we filed a registration statement for the shares
issued in this transaction, which occurred on April 25, 2008.  The increase
or decrease to the number of shares issued was determined using a per share
price equal to the average closing price of our common stock on the AMEX during
the ten trading days immediately preceding the date the registration statement
was filed.  We accounted for this investment under the cost method, as
we do not have the ability to exercise significant influence over operating and
financial policies of GOCA.  On April 30, 2008, we issued an
additional 3,046,425 shares of our common stock to the sellers of GOCA to
satisfy the adjustment provision.





On
February 8, 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with GOCA.  As a result of the merger, our common stock in GOCA was
exchanged for shares of common stock of Geeks on Call Holdings Inc., or Geeks
Holdings.  Immediately following the merger, Geeks Holdings completed
a private placement of its common stock for aggregate gross proceeds of
$3,000,000.  As a result of this transaction, our 30% interest in
GOCA became an 18% interest in Geeks Holdings.  We have
determined that our investment in Geeks Holdings is impaired because we believe
that the fair market value of Geeks Holdings has permanently declined. 
Accordingly, we wrote-off $4,098,514 during the year ended December 31
2008.  The remaining value of this investment amounted to $367,653 as of
December 31, 2008.  Management has determined that the entire investment in
GOCA is impaired and the remaining value of $367,653 was written off during the
year ended December 31, 2009.





Multiband
Corporation





On
October 30, 2007, in lieu of a payment of $75,000, we accepted 30,000 shares of
common stock of Multiband Corporation, a Minnesota-based communication services
provider to multiple dwelling units.  We classify these securities as
available for sale, and they are carried at fair market value.  During
the year ended December 31, 2008, we recorded a loss of $6,500 on the sale of
5,000 shares of our investment in Multiband.  In addition, we recorded
an unrealized loss of $32,750 due to a temporary decline in value of these
securities.  The remaining value of this investment amounted to
$29,750 as of December 31, 2008.  We sold our remaining investment in
Multiband and recorded a loss of $29,371 in January 2009.





Private
Placement





On
November 19, 2009 we completed a private offering of our securities in which we
sold 215 shares of our Series A convertible redeemable preferred stock, par
value $0.001 per share, at $5,000 per share, and warrants to purchase an
aggregate of 1,628,800 shares of our common stock at an exercise price of $0.33
per share, the volume-weighted average price of a share of our common stock for
the 30-day period immediately preceding November 12, 2009, and received
gross proceeds of $1,075,000.  Each share of Series A convertible
redeemable preferred stock is convertible into approximately 13,774 shares of
our common stock at a conversion price of $0.363 per share, 110% of the
volume-weighted average price of our common stock for the 30-day period
immediately preceding November 12, 2009.  Except as specifically
provided or as otherwise required by law, the Series A convertible redeemable
preferred stock will vote together with the common stock shares on an
as-if-converted basis and not as a separate class.








23





We are
utilizing the net proceeds from the sale of the Series A convertible redeemable
preferred stock shares and the warrants for general working capital needs and to
repay certain outstanding indebtedness, and to pay expenses of the offering as
well as other general corporate capital purposes.





Critical
Accounting Policies and Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes.  On an ongoing basis, we evaluate
significant estimates used in preparing our financial statements including those
related to revenue recognition, guarantees and product warranties, stock based
compensation and business combinations.  We base our estimates on
historical experience, underlying run rates and various other assumptions that
we believe to be reasonable, the results of which form the basis for making
judgments about the carrying values of assets and liabilities.  Actual
results could differ from these estimates. The following are critical judgments,
assumptions, and estimates used in the preparation of the consolidated financial
statements.





Revenue
Recognition





For
revenue from product sales, we recognize revenue in accordance with FASB’s
Accounting Standards Codification, or ASC, 605-10, and ASC Topic 13 guidelines
that require that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred; (3) the selling price is fixed and determinable; and (4)
collectability is reasonably assured.  Determination of criteria (3)
and (4) are based on management’s judgments regarding the fixed nature of the
selling prices of the products delivered and the collectability of those
amounts.  Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded.  We defer any revenue for which
the product has not been delivered or is subject to refund until such time that
we and the customer jointly determine that the product has been delivered or no
refund will be required.  The guidelines also address the accounting
for arrangements that may involve the delivery or performance of multiple
products, services and/or rights to use assets.





For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts.  All of our leases are accounted for as
operating leases.  At the inception of the lease, no lease revenue is
recognized and the leased equipment and installation costs are capitalized and
appear on the balance sheet as “Equipment Under Operating
Leases.”  The capitalized cost of this equipment is depreciated from
two to three years, on a straight-line basis down to our original estimate of
the projected value of the equipment at the end of the scheduled lease
term.  Monthly lease payments are recognized as rental
income.





Revenue
from sales-type leases for our EthoStream Hospitality Network products is
recognized at the time of lessee acceptance, which follows
installation.  We recognize revenue from sales-type leases at the net
present value of future lease payments.  Revenue from operating leases
is recognized ratably over the lease period.





Fair
Value of Financial Instruments





In
January 2008, we adopted the provisions under FASB for Fair Value Measurements,
which define fair value for accounting purposes, establishes a framework for
measuring fair value and expands disclosure requirements regarding fair value
measurements.  Our adoption of these provisions did not have a
material impact on our consolidated financial statements.  Fair value
is defined as an exit price, which is the price that would be received upon sale
of an asset or paid upon transfer of a liability in an orderly transaction
between market participants at the measurement date.  The degree of
judgment utilized in measuring the fair value of assets and liabilities
generally correlates to the level of pricing observability.  Financial
assets and liabilities with readily available, actively quoted prices or for
which fair value can be measured from actively quoted prices in active markets
generally have more pricing observability and require less judgment in measuring
fair value.  Conversely, financial assets and liabilities that are
rarely traded or not quoted have less price observability and are generally
measured at fair value using valuation models that require more
judgment.  These valuation techniques involve some level of management
estimation and judgment, the degree of which is dependent on the price
transparency of the asset, liability or market and the nature of the asset or
liability.  We have categorized our financial assets and liabilities
measured at fair value into a three-level hierarchy in accordance with these
provisions.





Stock
Based Compensation





We
account for our stock based awards in accordance with ASC 718 (formerly SFAS
123(R) “Share-Based
Payment”), which requires a fair value measurement and recognition of
compensation expense for all share-based payment awards made to our employees
and directors, including employee stock options and restricted stock
awards.






24





We
estimate the fair value of stock options granted using the Black-Scholes
valuation model. This model requires us to make estimates and assumptions
including, among other things, estimates regarding the length of time an
employee will retain vested stock options before exercising them, the estimated
volatility of our common stock price and the number of options that will be
forfeited prior to vesting. The fair value is then amortized on a straight-line
basis over the requisite service periods of the awards, which is generally the
vesting period. Changes in these estimates and assumptions can materially affect
the determination of the fair value of stock-based compensation and
consequently, the related amount recognized in our consolidated statements of
operations.





Goodwill
and Other Intangibles





Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition.  Goodwill is subject
to a periodic impairment assessment by applying a fair value test based upon a
two-step method.  The first step of the process compares the fair
value of the reporting unit with the carrying value of the reporting unit,
including any goodwill.  We utilize a discounted cash flow valuation
methodology to determine the fair value of the reporting unit.  If the
fair value of the reporting unit exceeds the carrying amount of the reporting
unit, goodwill is deemed not to be impaired in which case the second step in the
process is unnecessary.  If the carrying amount exceeds fair value, we
perform the second step to measure the amount of impairment loss.  Any
impairment loss is measured by comparing the implied fair value of goodwill with
the carrying amount of goodwill at the reporting unit, with the excess of the
carrying amount over the fair value recognized as an impairment
loss.





Long-Lived
Assets





We review
long-lived assets for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable in
accordance with ASC 360-10 (formerly Statement of Financial Accounting Standards
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets). Recoverability is measured by comparison of the
carrying amount to the future net cash flows which the assets are expected to
generate.  If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the projected discounted future cash flows arising
from the asset using a discount rate determined by management to be commensurate
with the risk inherent to our current business model.





Results
of Operations





Year
Ended December 31, 2009 Compared to Year Ended December 31,
2008





Revenues





The table
below outlines our product versus recurring revenues for comparable
periods:





Year
      Ended December 31,2009
            
            
            2008
            
            
            VarianceProduct
            
            $
            6,521,906
            
            
            
            62%
            
            
            $
            13,043,114
            
            
            
            79%
            
            
            $
            (6,521,208
            )
            
            
            -50%Recurring
            
            
            3,996,147
            
            
            
            38%
            
            
            
            3,515,887
            
            
            
            21%
            
            
            
            480,260
            
            
            
            14%Total
            
            $
            10,518,053
            
            
            
            100%
            
            
            $
            16,559,001
            
            
            
            100%
            
            
            $
            (6,040,948
            )
            
            
            -36%





Product
revenue





Product
revenue principally arises from the sale and installation of SmartGrid and
broadband networking equipment, including SmartEnergy technology, Telkonet
Series 5 and Telkonet iWire products.  We market and sell to the
hospitality, education, healthcare and government/military
markets.  The Telkonet Series 5 and the Telkonet iWire products
consist of the Telkonet Gateways, Telkonet Extenders, the patented Telkonet
Coupler, and Telkonet iBridges.  The SmartEnergy product suite
consists of thermostats, sensors, controllers, wireless networking products and
a control platform.





For the
year ended December 31, 2009, product revenue decreased by 50% when compared to
the prior year.  Product revenue in 2009 includes approximately $4.2
million attributed to the sale and installation of energy management products,
and approximately $1.9 million for the sale and installation of HSIA
products.  Since our sales of energy management and HSIA products are
primarily concentrated in the hospitality market, we have been significantly
impacted by the current economic downturn, as industry capital expenditures were
reduced and/or eliminated.  We expect to see sales growth in 2010 from
the addition and/or renewal of incentive based programs for energy efficiency,
government stimulus funding through the American Reinvestment and Recovery Act
of 2009, and energy savings initiatives in the commercial market.






25





Recurring
Revenue





Recurring
revenue includes approximately 2,300 hotels in our broadband network
portfolio.  We currently support over 200,000 HSIA rooms, with over
2.1 million monthly users.  For the year ended December 31, 2009,
recurring revenue increased by 14% when compared to the prior
year.  The increase of recurring revenue was primarily attributed to
new HSIA customers added in 2009.





Cost of
Sales





Year
      ended December 31,2009
            
            
            2008
            
            
            VarianceProduct
            
            $
            3,878,988
            
            
            
            59%
            
            
            $
            8,105,304
            
            
            
            62%
            
            
            $
            (4,226,316
            )
            
            
            -52%Recurring
            
            
            1,313,108
            
            
            
            33%
            
            
            
            1,680,832
            
            
            
            48%
            
            
            
            (367,724
            )
            
            
            -22%Total
            
            $
            5,192,096
            
            
            
            49%
            
            
            $
            9,786,136
            
            
            
            59%
            
            
            $
            (4,594,040
            )
            
            
            -47%





Product
Costs





Product
costs include equipment and installation labor related to the sale of
SmartEnergy technology, Telkonet Series 5 and the Telkonet iWire
products.  For the year ended December 31, 2009, our product costs
decreased by 52% when compared to the prior year primarily attributed to lower
sales levels than in 2008.  Product costs also decreased as a
percentage of sales, reflecting increased efficiencies in our installation
process and our reduced reliance on third party contract services.





Recurring
Costs





For the
year ended December 31, 2009 recurring costs decreased by 22% when compared to
the prior year.  This increase was primarily due to the increased
labor efficiencies in our call support center.   As the economy
recovers, and we continued to add new HSIA customers to our portfolio, we may
need to hire additional support center staff which may affect our recurring
product costs and margins.





Gross
Profit





Year
      ended December 31,2009
            
            
            2008
            
            
            VarianceProduct
            
            $
            2,642,918
            
            
            
            41%
            
            
            $
            4,937,810
            
            
            
            38%
            
            
            $
            (2,294,892
            )
            
            
            -35%Recurring
            
            
            2,683,039
            
            
            
            67%
            
            
            
            1,835,055
            
            
            
            52%
            
            
            
            847,984
            
            
            
            46%Total
            
            $
            5,325,957
            
            
            
            51%
            
            
            $
            6,772,865
            
            
            
            41%
            
            
            $
            (1,446,908
            )
            
            
            -21%





Product
Gross Profit





The gross
profit on product revenue for the year ended December 31, 2009 decreased by 35%
compared to the prior year period as a result of decreased product sales and
installations on energy management and HSIA sales.





Recurring
Gross Profit





Our gross
profit associated with recurring revenue increased by 46% for the year ended
December 31, 2009.  The increase was a combination of additional
recurring revenue and a reduction of our support labor costs.





Operating
Expenses





Year
      ended December 31,2009
            
            2008
            
            VarianceTotal
            
            $
            9,559,195
            
            
            $
            14,759,172
            
            
            $
            (5,199,977
            )
            
            
            -35%





During
the year ended December 31, 2009 operating expenses decreased by 35% when
compared to the prior year.  Operating expenses were reduced across
the board in 2009 to meet the demands of the difficult economy and we continued
to see the effects of the restructuring efforts that began in 2008 during which
we significantly reduced research and development and administrative
costs.








26





Research and
Development





Year
      ended December 31,2009
            
            2008
            
            VarianceTotal
            
            $
            1,080,148
            
            
            $
            2,036,129
            
            
            $
            (955,981
            )
            
            
            -47%





Our
research and development costs related to both present and future products are
expensed in the period incurred.  Total expenses for research and
development decreased for the year ended December 31, 2009 primarily attributed
to the reduction in staffing in the Germantown office.  Current
research and development costs are associated with the continued development of
Telkonet Series 5 products and next generation TSE and NTSE
products.





Selling, General and
Administrative Expenses





Year
      ended December 31,2009
            
            2008
            
            VarianceTotal
            
            $
            6,895,624
            
            
            $
            9,252,381
            
            
            $
            (2,356,757
            )
            
            
            -25%





Selling,
general and administrative expenses decreased for the year ended December 31,
2009 over the comparable prior year by 25%.  This decrease was
primarily the result of reduced operating costs in response to lower
than anticipated sales levels, as well as restructuring and relocation efforts
which has resulted in lower in salary and related costs as well as reduced
travel costs, professional fees and rent and related costs, when compared to the
prior year.





Discontinued
Operations





We
had net income from discontinued operations of $6,296,851, or $0.07 per share,
for the year ended December 31, 2009, compared to net loss from discontinued
operations of $(7,905,302), or $(0.10) per share, for the year ended December
31, 2008.  Net income from discontinued operations for the year ended
December 31, 2009 includes the gain on deconsolidation of $6,932,586, offset by
MSTI's net loss of $635,735 through the date of deconsolidation of April 22,
2009.





Liquidity
and Capital Resources





We have
financed our operations since inception primarily through private and public
offerings of our equity securities, the issuance of various debt instruments and
asset based lending.





Working
Capital





Our
working capital decreased by $1,345,503 during the year ended December 31, 2009
from a working capital deficit of $2,439,988 at December 31, 2008 to a working
capital deficit of $3,785,491 at December 31, 2009, excluding working capital
attributed to discontinued operations.  The change in working capital
for the year ended December 31, 2009 is due to a combination of factors, of
which the significant factors include:





·
            Advances
      to our former subsidiary of approximately
  $305,000;





·
            ASeries A preferred stock private
      placement for total proceeds of
$1,075,000;





·
            Net
      repayments on our line of credit of approximately $187,000;
      and





·
            Working
      capital decreases related to our loss from continuing
      operations.





Business
Loan





On
September 11, 2009, we entered into a Loan Agreement to borrow an aggregate
principal amount of $300,000 from the Wisconsin Department of Commerce, or the
Department.  The outstanding principal balance on the loan bears
interest at the annual rate of two percent (2.0%).  Payment of
interest and principal is to be made in the following manner:  (a)
payment of any and all interest that accrues from the date of disbursement
commences on January 1, 2010 and continues on the first day of each consecutive
month thereafter through and including December 31, 2010; (b) commencing on
January 1, 2011 and continuing on the first day of each consecutive month
thereafter through and including November 1, 2016, we are obligated to pay equal
monthly installments of $4,426 each; followed by a final installment on December
1, 2016 which will include all remaining principal, accrued interest and other
amounts owed by us to the Department under the Loan Agreement.  We may
prepay amounts outstanding under the loan in whole or in part at any time
without penalty.  The loan is secured by our assets and the proceeds
from this loan will be used for our working capital requirements.  The
outstanding borrowing under the agreement at December 31, 2009 was
$300,000.







27




Line
of Credit





In
September 2008, we entered into a two-year line of credit facility with a third
party financial institution.  The line of credit has an aggregate
principal amount of $1,000,000 and is secured by our inventory.  The
outstanding principal balance bears interest at the greater of (i) the Wall
Street Journal Prime Rate plus nine percent (9%) per annum, adjusted on the date
of any change in such prime or base rate, or (ii) sixteen percent
(16%).  Interest is payable monthly in arrears on the last day of each
month until maturity.  We may prepay amounts outstanding under the
credit facility in whole or in part at any time.  In the event of such
prepayment, the lender will be entitled to receive a prepayment fee of four
percent (4.0%) of the highest aggregate loan commitment amount if prepayment
occurs before the end of the first year and three percent (3.0%) if prepayment
occurs thereafter.  The outstanding borrowing under the agreement at
December 31, 2009 was $387,000.  The Company has incurred interest
expense of $131,538 related to the line of credit for the year ended December
31, 2009. The Prime Rate was 3.25% at December 31, 2009.





On March
24, 2010, the Company received a notice of waiver from Thermo Credit LLC on the
cash flow to debt service ratio and tangible net worth requirement, as such
terms are defined in items D(10)a and D(10)b of the line of credit
agreement.  The waiver is in effect as of December 31, 2009 and for
the 90 day period thereafter.





Convertible
Debentures





On May
30, 2008, we entered into a Securities Purchase Agreement with YA Global
pursuant to which we agreed to issue and sell to YA Global up to $3,500,000 of
secured convertible debentures and warrants to purchase up to 2,500,000 shares
of our common stock.  The sale of these debentures and warrants was
effectuated in three separate closings, the first of which occurred on May 30,
2008, and the remainder of which occurred in July 2008.  At the May
30, 2008 closing, we sold debentures having an aggregate principal value of
$1,500,000 and warrants to purchase 2,100,000 shares of our common
stock.  In July 2008, we sold the remaining debentures, with an
aggregate principal value of $2,000,000, and warrants to purchase 400,000 shares
of our common stock.





The
debentures accrue interest at a rate of 13% per annum and mature on May 29,
2011.  We may redeem the debentures at any time, in whole or in part,
by paying a redemption premium equal to 15% of the principal amount of
debentures being redeemed, so long as an “Equity Conditions Failure” (as defined
in the debentures) is not occurring at the time of such
redemption.  YA Global may also convert all or a portion of the
debentures at any time at a price equal to the lesser of (i) $0.58, or (ii)
ninety percent (90%) of the lowest volume weighted average price of our common
stock during the ten trading days immediately preceding the conversion
date.  The warrants expire five years from the date of issuance and
entitle YA Global to purchase shares of our common stock at an exercise price
per share of $0.61.





On
February 20, 2009, we and YA Global entered into an Agreement of Clarification
pursuant to which we agreed with YA Global that interest accrued as of December
31, 2008, in the amount of $191,887 would be added to the principal amount
outstanding under the debentures and that each debenture be amended to reflect
the applicable increase in principal amount.





On May
12, 2009, YA Global met the Exchange Cap for the conversion of its debentures,
and thus could not receive additional shares of our common stock upon the
conversion of its debentures or exercise of its warrants.  In the
Agreement of Clarification, we agreed to seek shareholder approval to remove the
Exchange Cap at our 2009 annual meeting of shareholders, which was held on May
28, 2009. On May 28, 2009, our shareholders voted against the proposal to remove
the Exchange Cap, which would have allowed YA Global to potentially acquire in
excess of 19.99% of the outstanding shares of our common stock.





In
November 2009, we issued warrants to YA Global Investments LP pursuant to
anti-dilution provisions in their existing warrant agreements that were
triggered by the completion of the Series A preferred stock private
placement.  These warrants entitled the holders to purchase up to
2,121,212 shares of our common stock at a price per share of
$0.33.    We have accounted for the warrants, valued at $510,151,
as financing expense using the Black-Scholes pricing model and the following
assumptions: contractual term of 5 years, an average risk-free interest rate of
2.2% a dividend yield of 0% and volatility of 123%.





Senior
Note Payable





On July
24, 2007, we entered into a Senior Note Purchase Agreement with GRQ Consultants,
Inc., or GRQ, pursuant to which we issued to GRQ a Senior Promissory Note in the
aggregate principal amount of $1,500,000.  The note was due and
payable on the earlier to occur of (i) the closing of our next financing, or
(ii) January 28, 2008, and bore interest at a rate of six percent (6%) per
annum.  We incurred approximately $25,000 in fees in connection with
this transaction.  The net proceeds from the issuance of the Note were
used for general working capital needs.  In connection with the
issuance of the Note, we also issued to GRQ warrants to purchase 359,712 shares
of common stock at $4.17 per share.  These warrants expire five years
from the date of issuance.  On February 8, 2008, this note was repaid
in full, including $49,750 in interest from the issuance date through the date
of repayment.





Proceeds
from the issuance of common stock





During
the year ended December 31, 2009, we received $71,526 from the exercise of
common stock purchase warrants issued to various investors.






28





Cash
flow analysis





Cash used
in continuing operations was $619,344 during the year ended December 31, 2009,
compared to cash used in continuing operations of $3,010,196 during the prior
year period.  During the year ended December 31, 2010, our primary
capital needs will be for operating expenses, including funds to support our
business strategy, which primarily includes working capital necessary to fund
inventory purchases, and reducing our trade payables.





We
utilized cash for investing activities from continuing operations of $275,085
and $8,374 during the years ended December 31, 2009, and 2008,
respectively.  In 2009, these activities involved intercompany loans
to MSTI of approximately $305,000, which was partially offset by the sale of our
remaining investment in Multiband for proceeds of $33,129.  In 2008,
these expenditures were primarily due to the purchase of computer and related
equipment and the sale of marketable securities.





We had
cash from financing activities from continuing operations of $1,229,807 and
$3,519,450 during the years ended December 31, 2009 and 2008,
respectively.  In November 2009, we completed a private placement of
our preferred stock for proceeds for $1.75 million and in September 2009 we
received a $300,000 business loan from the Wisconsin Department of Commerce, and
we received $71,526 from the exercise of stock purchase warrants by investors in
July and August 2008.  These proceeds were partially offset by
$187,000 in repayments on our working capital line of credit used for inventory
purchases, and $25,000 for the payment of financing costs related to the
accounts receivable factoring program.  During the year ended December
31, 2008, the financing activities involved the sale of 2.5 million shares of
common stock at $0.60 per share in a private placement for a total of
$1,500,000, in February 2008, the proceeds of which were used to repay the
outstanding principal amount on the GRQ Note.  Additionally, we sold
debentures for gross proceeds of $3,500,000 in May 2008 and July 2008, and, in
May 2008, we received a $400,000 loan from a private investor, which was offset
by $462,511 in financing costs.





We have
reduced cash required for operations by reducing operating costs and reducing
staff levels.  In addition, we are working to manage our current
liabilities while we continue to make changes in operations to improve our cash
flow and liquidity position.





Our
registered independent certified public accountants have stated in their report
dated March 31, 2010 that we have incurred operating losses in the past years,
and that we are dependent upon management’s ability to develop profitable
operations and/or obtain necessary funding from outside sources, including by
the sale of our securities, or obtaining loans from financial institutions,
where possible.  These factors, among others, may raise substantial
doubt about our ability to continue as a going concern.





Management
expects that global economic conditions will continue to present a challenging
operating environment through 2010.  To the extent permitted by
working capital resources, management intends to continue making targeted
investments in strategic operating and growth initiatives.  Working
capital management will continue to be a high priority for 2010.





While we
have been able to manage our working capital needs with the current credit
facilities, additional financing is required in order to meet our current and
projected cash flow requirements from operations.  We cannot predict
whether this new financing will be in the form of equity or debt.  We
may not be able to obtain the necessary additional capital on a timely basis, on
acceptable terms, or at all. Additional investments are being sought, but we
cannot guarantee that we will be able to obtain such
investments.  Financing transactions may include the issuance of
equity or debt securities, obtaining credit facilities, or other financing
mechanisms.  However, the trading price of our common stock and the
downturn in the U.S. stock and debt markets could make it more difficult to
obtain financing through the issuance of equity or debt
securities.  Even if we are able to raise the funds required, it is
possible that we could incur unexpected costs and expenses, fail to collect
significant amounts owed to us, or experience unexpected cash requirements that
would force us to seek alternative financing.  Further, if we issue
additional equity or debt securities, stockholders may experience additional
dilution or the new equity securities may have rights, preferences or privileges
senior to those of existing holders of our common stock.  If
additional financing is not available or is not available on acceptable terms,
we will have to curtail our operations.





Inflation





We do not
believe that inflation has had a material effect on our business, financial
condition or results of operations.  If our costs were to become
subject to significant inflationary pressures, we may not be able to fully
offset such higher costs through price increases.  Our inability or
failure to do so could adversely affect our business, financial condition and
results of operations.





Off-Balance
Sheet Arrangements





We do not
maintain off-balance sheet arrangements nor does it participate in any
non-exchange traded contracts requiring fair value accounting
treatment.








29





Acquisition
or Disposition of Property and Equipment





During
the year ended December 31, 2009, fixed assets purchases totaled approximately
$2,675, net of transfers and disposals.  We do not anticipate the sale or
purchase of any significant property, plant or equipment during the next twelve
months, other than computer equipment and peripherals to be used in our
day-to-day operations.





We
presently lease 16,400 square feet of commercial office space in Germantown,
Maryland, but we are in the process of relocating our personnel to our new
corporate headquarters consisting of approximately 12,000 square feet of office
space in Milwaukee, Wisconsin, pursuant to a restructuring announced in December
2009.  The Germantown lease expires in December 2015.  We
are currently actively pursuing a sublease for all or a portion of this office
space for the remaining term of the lease.





In the
first quarter of 2010, we began the transfer of inventory and certain property
in conjunction with the relocation of our corporate headquarters.  We
anticipate the sale or disposal of the certain furniture, fixtures and computer
equipment during the remainder of 2010.





New
Accounting Pronouncements





See Note
B of the Consolidated Financial Statements for a full description of new
accounting pronouncements, including the respective expected dates of adoption
and effects on results of operations and financial condition.





Disclosure
of Contractual Obligations





We currently have outstanding purchase
orders with the contract manufacturer for our Smart Energy products totaling
$771,000, of which approximately $408,000 represents amounts owed for future
shipments of Smart Energy products which we will need to fulfill existing
purchase orders with our customers.  We are currently negotiating with
the manufacturer and our lenders to ensure the timely payment of these purchases
to prevent any delays in the delivery of these products to our customers which
could negatively impact our results of operations and financial
condition.





ITEM
7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK.





This item
is not applicable.





ITEM
8.    FINANCIAL STATEMENTS.





See the
Financial Statements and Notes thereto commencing on Page F-1.





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





None.





ITEM 9A(T).   CONTROLS AND
PROCEDURES





Evaluation
of Disclosure Controls and Procedures





We
maintain disclosure controls and procedures that are designed to ensure that
material information required to be disclosed in our periodic reports filed
under the Securities Exchange Act of 1934, as amended, or 1934 Act, is recorded,
processed, summarized, and reported within the time periods specified in the
SEC’s rules and forms and to ensure that such information is accumulated and
communicated to our management, including our chief executive officer and chief
financial officer as appropriate, to allow timely decisions regarding required
disclosure. During the quarter ended December 31, 2009 we carried out an
evaluation, under the supervision and with the participation of our management,
including the principal executive officer and the principal financial officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures, as defined in Rule 13(a)-15(e) under the 1934 Act. Based on
that evaluation and due to the lack of segregation of duties and failure to
implement accounting controls of acquired businesses, our principal executive
officer and principal financial officer concluded that our disclosure controls
and procedures were ineffective as of the end of the period covered by this
report.





Management’s
Report on Internal Control over Financial Reporting





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting. The Company’s internal control over financial
reporting is designed to provide reasonable assurances regarding the reliability
of financial reporting and the preparation of the financial statements of the
Company in accordance with U.S. generally accepted accounting principles, or
GAAP. Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree or compliance with the policies or procedures may
deteriorate.







30




With the
participation of our Chief Executive Officer, our management conducted an
evaluation of the effectiveness of our internal control over financial reporting
as of December 31, 2009 based on the framework in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission ("COSO"). Based on our evaluation and the material
weaknesses described below, management concluded that the Company did not
maintain effective internal control over financial reporting as of
December 31, 2009 based on the COSO framework criteria. Management has
identified control deficiencies regarding the lack of segregation of duties and
the need for a stronger internal control environment. Management of the Company
believes that these material weaknesses are due to the small size of the
Company’s accounting staff and continued integration of the 2007 acquisitions of
Smart Systems International and EthoStream, LLC. The small size of the Company’s
accounting staff may prevent adequate controls in the future, such as
segregation of duties, due to the cost/benefit of such
remediation.  We do expect to retain additional personnel to remediate
these control deficiencies in the future.





These
control deficiencies could result in a misstatement of account balances that
would result in a reasonable possibility that a material misstatement to our
financial statements may not be prevented or detected on a timely basis.
Accordingly, we have determined that these control deficiencies as described
above together constitute a material weakness.





In light
of this material weakness, we performed additional analyses and procedures in
order to conclude that our financial statements for the year ended
December 31, 2009 included in this Annual Report on Form 10-K were fairly
stated in accordance with US GAAP. Accordingly, management believes that despite
our material weaknesses, our financial statements for the year ended December
31, 2009 are fairly stated, in all material respects, in accordance with US
GAAP.





This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only management’s report in this Annual
Report on Form 10-K.





Changes
in Internal Controls





During
the fiscal quarter ended December 31, 2009, there have been no changes in our
internal control over financial reporting that have materially affected or are
reasonably likely to materially affect our internal controls over financial
reporting.





ITEM
9B.  OTHER INFORMATION.





None.





PART
III





ITEM
10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE.





The
following table furnishes the information concerning the Company’s directors and
officers as of March 31, 2010. The directors of the Company are elected every
year and serve until their successors are duly elected and
qualified.





Name
            
            Age
            
            PositionJason
      L. Tienor
            
            35
            
            President
      and Chief Executive Officer and DirectorRichard
      J. Leimbach
            
            41
            
            Chief
      Financial OfficerJeffrey
      J. Sobieski
            
            33
            
            Chief
      Operating OfficerWarren
      V. Musser
            
            83
            
            DirectorAnthony
      Paoni
            
            65
            
            Chairman
      of the Board (1)(2)Thomas
      C. Lynch
            
            67
            
            Director
      (1)(2)


_____________________________


(1)
Member of the Audit Committee


(2)
Member of the Compensation Committee





Jason L.
Tienor has served as our President and Chief Executive Officer since
December 2007 and, from August 2007 until December 2007, he served as our Chief
Operating Officer.  In November 2009, he was appointed by our Board of
Directors to fill the vacancy created by the resignation of Seth D. Blumenfeld
as a director.  Mr. Tienor has also served as Chief Executive Officer
of EthoStream, LLC, our wholly-owned subsidiary, since March
2007.  From 2002 until his employment with us, Mr. Tienor served as
Chief Executive Officer of EthoStream, LLC, the company that he co-founded. Mr.
Tienor received a bachelor of business administration in management information
systems and marketing from the University of Wisconsin – Oshkosh and a masters
of business administration with an emphasis on computer science from Marquette
University. We
believe Mr. Tienor’s qualifications to sit on our Board of Directors
include his experience as the founder of our wholly-owned subsidiary,
EthoStream, LLC, including the leadership he has provided to the Company, first
as Chief Operating Officer and then as President and Chief Executive
Officer.






31





Richard J.
Leimbachhas
served as our Chief Financial Officer since December 2007 and, from June 2006
until December 2007, he served as the Vice President of Finance. He also served
as our Controller from January 2004 until June 2006.  Mr. Leimbach is
a certified public accountant with over fifteen years of public accounting and
private industry experience. Prior to joining us, Mr. Leimbach was the
Controller with Ultrabridge, Inc., an applications solution provider. Mr.
Leimbach also served as Corporate Accounting Manager for Snyder Communications,
Inc., a global provider of integrated marketing solutions.





Jeffrey J.
Sobieskiwas named our Chief Operating Officer in June
2008.  Prior to this appointment, Mr. Sobieski served as our Executive
Vice President, Energy Management since December 2007 and from March 2007 until
December 2007, he served as Chief Information Officer of EthoStream, LLC, our
wholly-owned subsidiary.  From 2002 until his employment with us, Mr.
Sobieski served as Chief Information Officer of EthoStream, LLC, the company he
co-founded.  Mr. Sobieski is also the co-founder of Interactive
Solutions, a consulting firm providing support to the Insurance and
Telecommunications Industries.





Anthony J.
Paonihas
served as a director since April 2007. Professor Paoni was elected Chairman of
the Board following Warren V. Musser’s resignation from that position in
November 2009. He has been a faculty member at Northwestern University’s Kellogg
School of Management since 1996.  Previously, he spent 28 years in the
information technology industry with market leading organizations that provided
computer hardware, software and consulting services.  For the first 15
years of his career, Professor Paoni managed sales and marketing organizations
and in the later stages of his career he moved into general management positions
starting with PANSOPHIC Systems Incorporated.  This Lisle, Illinois
based firm was the world’s fifth largest international software company prior to
its acquisition by Computer Associates, Incorporated.  Subsequently,
he became chief operating officer of Cross Access, a venture capital funded
software firm that provided industry-leading solutions to the heterogeneous
database connectivity market segment. In addition, he has been president of two
wholly-owned U.S. subsidiaries of Ricardo Consulting, a U.K.-based international
engineering consulting firm focused on computer based automotive powertrain
design. Prior to joining the Kellogg faculty, Professor Paoni was chief
executive officer of Eolas, an Internet software company with patent pending Web
technology that was one of the key technology drivers responsible for the rapid
adoption of the Internet platform. We
believe Mr. Paoni’s qualifications to sit on our Board of Directors include his
15 year career managing sales and marketing organizations followed by his 28
year career in information technology.





Warren V.
Musserhas
served as a director since January 2003 and most recently served as Chairman of
the Board until his resignation from that position in November 2009. He has
taken over 50 companies public during his distinguished and successful career as
an entrepreneur.  He is the founder and Chairman Emeritus of Safeguard
Scientifics, Inc. (a high-tech venture capital company, formerly Safeguard
Industries, Inc.).  Since January 2003, Mr. Musser has been
the President and CEO of The Musser Group (a business consulting
firm).  In addition, Mr. Musser is Chairman of InfoLogix, Inc. (a
provider of enterprise mobility solutions for the healthcare and commercial
industries), a Director of Internet Capital Group, Inc. (a
business-to-business venture capital company), NutriSystem, Inc. (a weight
management company) and Health Benefits Direct Corp. (a direct marketing/sales
company of health/life insurance).  Mr. Musser serves on a variety of
civic, educational and charitable boards of directors, and serves
as Chairman of the Eastern Technology Council, Economics PA, and
Vice President of Development of Cradle of Liberty Council, Boy Scouts
of America. We
believe Mr. Musser’s qualifications to serve on our Board of Directors
include his expertise in the venture capital and private equity
arena.





Thomas C. Lynchhas served as a director since October 2003.  Mr. Lynchis a
Managing Partner of Jones Lang LaSalle (prior to the merger between Jones Lang
LaSalle and The Staubach Company, Mr. Lynch served as Senior Vice President of
The Staubach Company, a real estate management and advisory services firm) in
the Washington, D.C. area.  Mr. Lynch joined The Staubach Company
in November 2001 after six years as Senior Vice President at Safeguard
Scientifics, Inc. (NYSE: SFE) (a high-tech venture capital company). While at
Safeguard, he served nearly two years as President and Chief Operating Officer
at CompuCom Systems, a Safeguard subsidiary.  After a 31-year career
of naval service, Mr. Lynch retired in the rank of Rear
Admiral.  Mr. Lynch’s naval service included Chief, Navy
Legislative Affairs, command of the Eisenhower Battle Group during Operation
Desert Shield, Superintendent of the United States Naval Academy from 1991 to
1994 and Director of the Navy Staff in the Pentagon from 1994 to
1995.  Mr. Lynch presently serves as a Director of Armed
Forces Benefit Association, Mikros Systems, Buckeye Insurance Company, PRWT
Services and Infologix systems. We
believe Mr. Lynch’s qualifications to sit on our Board of Directors include
his extensive executive leadership and management
experience.





Audit
Committee





The
Company maintains an Audit Committee of the Board of Directors. For the year
ended December 31, 2009, Messrs. Lynch and Paoni served on the Audit Committee.
The Company’s Board of Directors has determined that each of Messrs. Lynch and
Paoni is a “financial expert” as defined by Item 401 of Regulation S-K
promulgated under the Securities Act of 1933 and the Securities Exchange Act of
1934. The Company’s Board of Directors also has determined that each of Messrs.
Lynch and Paoni are “independent” as such term is defined in Rule 10A-3
promulgated under the Securities Exchange Act of 1934. The Board of Directors
has adopted an audit committee charter, which was ratified by the Company’s
stockholders at the 2004 Annual Meeting of Stockholders.  The Audit
Committee held 6 meetings in 2009.





Compensation
Committee





The
Company maintains a Compensation Committee of the Board of Directors. For the
year ended December 31, 2009, Messrs. Lynch and Paoni served on the Compensation
Committee. The Compensation Committee held 2 meetings during 2009.







32




Code
of Ethics





The Board
has approved, and Telkonet has adopted, a Code of Ethics that applies to all
directors, officers and employees of Telkonet. A copy of the Company’s Code of
Ethics was filed as Exhibit 14 to the Company’s Annual Report on Form 10-KSB for
the year ended December 31, 2003 (filed with the Securities and Exchange
Commission on March 30, 2004). In addition, the Company will provide a copy of
its Code of Ethics free of charge upon request to any person submitting a
written request to the Company’s Chief Executive Officer.





SECTION
16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section
16(a) of the Securities Exchange Act of 1934 requires our directors and certain
of our officers to file reports of holdings and transactions in shares of
Telkonet common stock with the Securities and Exchange Commission. Based on our
records and other information, we believe that in 2009 our directors and our
officers who are subject to Section 16 met all applicable filing
requirements.





ITEM
11.  EXECUTIVE COMPENSATION.





The
following table sets forth certain information with respect to compensation for
services in all capacities for the years ended December 31, 2009 and 2008
paid to our Chief Executive Officer (principal executive officer) and the two
other most highly compensated executive officers who were serving as such as of
December 31, 2009.








Name
      and Principal Position
            Year
            
            Salary
      ($)
            
            Bonus
      ($)
            
            
            Option
      Awards
              ($)(1)(2)
            
            
            All
      Other Compensation
              ($)(6)
            
            
            Total
      ($)Jason
      L. Tienor
            2009
            
            $
            200,770
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            8,400
            
            
            $
            209,170President
      and Chief
            2008
            
            $
            194,421
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            7,431
            
            
            $
            201,852Executive
      OfficerRichard.
      J. Leimbach
            2009
            
            $
            190,731
            (4)
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            190,731Chief
      Financial Officer
            2008
            
            $
            180,039
            (4)
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            180,039Jeffrey
      J. Sobieski
            2009
            
            $
            190,731
            (5)
            
            $
            0
            
            
            $
            0
            
            
            $
            8,400
            
            
            $
            199,131Chief
      Operating Officer
            2008
            
            $
            186,421
            (5)
            
            $
            0
            
            
            $
            31,180
            
            
            $
            7,431
            
            
            $
            225,032


_____________________________


(1)
            Amounts
      reflect the compensation cost associated with stock option grants,
      calculated in accordance with FASB ASC Topic 718 and using a Black-Scholes
      valuation method.


(2)
            In
      2008, the following assumptions were used to determine the fair value of
      stock option awards granted: historical volatility of 74%, expected option
      life of 5.0 years and a risk-free interest rate of
  3.0%.


(3)
            Includes
      accrued and unpaid salary to Jason Tienor for the years ended December 31,
      2008 and 2009 of $10,687 and $13,062,
  respectively.


(4)
            Includes
      accrued and unpaid salary to Richard Leimbach for the years ended December
      31, 2008 and 2009 of $9,744 and $24,868,
  respectively.


(5)
            Includes
      accrued and unpaid salary to Jeffrey Sobieski for the years ended December
      31, 2008 and 2009 of $10,175 and $11,628,
  respectively.


(6)
            Other
      compensation represents monthly car allowance paid to certain Telkonet
      executives.





Employment
Agreements





Jason L.
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement with us dated March 15, 2007.  Mr. Tienor’s
employment agreement has a term of three years, which may be extended by mutual
agreement of the parties thereto, and provides, among other things, for an
annual base salary of $148,000 per year and bonuses and benefits based on our
internal policies and participation in our incentive and benefit
plans.  Additional terms of the employment agreement are described
under "Potential Payments upon Termination or Change in Control"
below.  On August 20, 2007, Mr. Tienor’s annual salary was increased
to $200,000.  Notwithstanding
his employment agreement’s expiration, Mr. Tienor continues to be employed and
to perform services pursuant to the terms of his employment agreement pending
completion of a replacement agreement.





Jeffrey
J. Sobieski, Chief Operating Officer, is employed pursuant to an employment
agreement with us dated March 15, 2007.  Mr. Sobieski’s employment
agreement has a term of three years, which may be extended by mutual agreement
of the parties thereto, and provides for a base salary of $148,000 per year and
bonuses and benefits based upon our internal policies and participation in our
incentive and benefit plans.  Additional terms of the employment
agreement are described under "Potential Payments upon Termination or Change in
Control" below.  On December 11, 2007, Mr. Sobieski’s salary was
increased to $190,000. Notwithstanding
his employment agreement’s expiration, Mr. Sobieski continues to be employed and
to perform services pursuant to the terms of his employment agreement pending
completion of a replacement agreement.







33




In
addition, to the foregoing, stock options are periodically granted to our
executive officers under our Amended and Restated Stock Option Plan, or the
Plan, at the discretion of the Compensation Committee of the Board of
Directors.  Executives are eligible to receive stock option grants,
based upon individual performance and the performance of the company as a
whole.





Retirement,
Health and Welfare Benefits





We offer
a variety of health and welfare and retirement programs to all eligible
employees. Our executive officers listed in the Summary Compensation Table
above, or our Named Executive Officers, generally are eligible for the same
benefit programs on the same basis as the rest of the broad-based
employees.  Our health and welfare programs include medical, dental,
vision, life, accidental death and disability, and short and long-term
disability insurance.  In addition to the foregoing, our Named
Executive Officers are eligible to participate in our 401(k) Retirement Savings
Plan or the Telkonet 401(k).  All of our employees are eligible to
participate in the Telkonet 401(k) upon the completion of six months of
employment, subject to minimum age requirements.  Contributions by
employees under the Telkonet 401(k) are immediately vested and each employee is
eligible for distributions upon retirement, death or disability or termination
of employment.  Depending upon the circumstances, these payments may
be made in installments or in a single lump sum.





Grant
of Plan Based Awards





No stock
options were granted in the fiscal year ended December 31, 2009.





Outstanding
Equity Awards at Fiscal Year-End Table





The
following table shows outstanding stock option awards classified as exercisable
and unexercisable as of December 31, 2009 for the Named Executive
Officers.





Option
      AwardsName
            
            Number
      of Securities Underlying Unexercised Options (#)
              Exerciseable
            
            
            Number
      of Securities Underlying Unexercised Options (#)
      Unexerciseable
            
            
            Equity
      Incentive Plan Awards: Number of Securities Underlying Unexercised
      Unearned Options
            
            
            Option
      Exercise Price
              ($)
            
            Option
      Expiration
              DateJason
      L. Tienor
            
            
            50,000
            
            
            
            50,000
            (1)
            
            
            0
            
            
            $
            1.80
            
            4/24/2012
                (4)Richard.
      J. Leimbach
            
            
            87,500
            
            
            
            0
            
            
            
            0
            
            
            
            (3
            )
            4/24/2012
                (4)Jeffrey
      J. Sobieski
            
            
            20,000
            
            
            
            30,000
            (2)
            
            
            0
            
            
            $
            1.00
            
            4/24/2012
                (4)


_____________________________


(1)           Mr.
Tienor’s options were granted on August 10, 2007 and vest ratably on a quarterly
basis over a five year period.


(2)           Mr.
Sobieski’s options were granted on February 19, 2008 and vest ratably on a
quarterly basis over a five year period.


(3)           Includes
37,500 vested options exercisable at $2.59 per share, and 50,000 vested options
exercisable at $5.08 per share.


(4)
            All
      options granted in accordance with the Plan have an outstanding term equal
      to the shorter of ten years, or the expiration of the Plan.  The
      Plan expires on April 24, 2012.


(5)           This
table does not include disclosure of outstanding warrants held by any of our
Named Executive Officers.





Potential
Payments upon Termination





Each of
Mr. Tienor’s and Mr. Sobieski’s employment agreements obligate us to continue to
pay each executive’s base salary and provide continued participation in employee
benefit plans for the duration of the term of their employment agreements in the
event such executive is terminated without “cause” by us or if the executive
terminates his employment for “good reason.”  “Cause” is defined as
the occurrence of any of the following: (i) theft, fraud, embezzlement, or any
other act of dishonesty by the executive; (ii) any material breach by the
executive of any provision of the employment agreement which breach is not cured
within a reasonable time (but not to exceed thirty (30) days after written
notification thereof to the executive by us); (iii) any habitual neglect of duty
or misconduct of the executive in discharging any of his duties and
responsibilities under the employment agreement after a written demand for
performance was delivered to the executive that specifically identified the
manner in which the board believed the executive had failed to discharge his
duties and responsibilities, and the executive failed to resume substantial
performance of such duties and responsibilities on a continuous basis
immediately following such demand; (iv) commission by the executive of a felony
or any offense involving moral turpitude; or (v) any default of the executive’s
obligations under the employment agreement, or any failure or refusal of the
executive to comply with our policies, rules and regulations generally
applicable to our employees, which default, failure or refusal is not cured
within a reasonable time (but not to exceed thirty (30) days) after written
notification thereof to the executive by us.  If cause exists for
termination, the executive shall be entitled to no further compensation, except
for accrued leave and vacation and except as may be required by applicable
law.  “Good reason” is defined as the occurrence of any of the
following: (i) any material adverse reduction in the scope of the executive’s
authority or responsibilities; (ii) any reduction in the amount of the
executive’s compensation or participation in any employee benefits; or (iii) the
executive’s principal place of employment is actually or constructively moved to
any office or other location 50 miles or more outside of Milwaukee,
Wisconsin.







34




In the
event we fail to renew the employment agreements upon expiration of the term,
then we shall continue to pay the executive's base salary and provide the
executive with continued participation in each employee benefit plan in which
the executive participated immediately prior to expiration of the term for a
period of three months following expiration of the term.  Each of
Messrs. Tienor and Sobieski have agreed not to compete with us or solicit
any of our employees for a period of one year following expiration or earlier
termination of the employment agreements.  Assuming Mr. Tienor’s and
Mr. Sobieski’s employment agreements were terminated as of December 31, 2009,
the total estimated compensation that would have been paid under these
agreements would be $78,188 in the aggregate.





Directors’
Compensation





We
reimburse non-management directors for costs and expenses in connection with
their attendance and participation at Board of Directors meetings and for other
travel expenses incurred on our behalf.  We compensate each
non-management director at a rate of $4,000 per month, 10,000 vested stock
options per quarter and $1,000 for each committee meeting of the Board of
Directors such director attends.





In
addition to the non-management directors’ compensation plan described above, Mr.
Paoni is compensated in the amount of $4,000 per month for executive consulting
services.





Until his
resignation as Chairman of the Board of Directors in November 2009,
Mr. Musser was compensated $8,333 per month (consisting of monthly payments
in the amount of $4,000, which payments were consistent with the monthly
payments made to the other non-management directors, and $4,333 per month, which
payments were in lieu of the 10,000 vested stock options per quarter and $1,000
for each committee meeting that the other non-management directors
receive).  Payments to Mr. Musser for Board services were made to
The Musser Group pursuant to a September 2003 consulting
agreement.  Mr. Musser is the sole principal and owner of The Musser
Group.  Mr. Musser currently serves on the Board of Directors
according to the terms of Telkonet’s non-management directors’ compensation
plan.





The
following table summarizes all compensation paid to our directors in the year
ended December 31, 2009.





Name
            
            Fees
      Earned or
              Paid
      in Cash
              ($)
      (6)
            
            
            Stock
      Awards
              ($)
            
            
            Option
      Awards ($)(1)
            
            Non-Equity
      Incentive Plan Compensation
              ($)
            
            
            Change
      in Pension Value and Nonqualified Deferred Compensation
      Earnings
            
            
            All
      Other
              Compensation
              ($)
            
            Total
      ($)Warren
      V. Musser
            
            $
            48,000
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            52,000
            (2)
            
            $
            100,000Thomas
      M. Hall (4)
            
            $
            48,000
            
            
            $
            0
            
            
            $
            12,196
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            60,196Thomas
      C. Lynch
            
            $
            48,000
            
            
            $
            0
            
            
            $
            12,196
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            60,196Seth
      D. Blumenfeld (5)
            
            $
            48,000
            
            
            $
            0
            
            
            $
            12,196
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            60,196Anthony
      J. Paoni
            
            $
            48,000
            
            
            $
            0
            
            
            $
            12,196
            (3)
            
            $
            0
            
            
            $
            0
            
            
            $
            48,000
            (7)
            
            $
            108,196


_____________________________


(1)
            Amounts
      reflect the compensation cost associated with stock option grants,
      calculated in accordance with FASB ASC Topic 718 (formerly SFAS 123R) and
      using a Black-Scholes valuation
method.


(2)
            Fees
      for director services performed by Mr. Musser and paid to the Musser Group
      pursuant to a September 2003 consulting
  agreement.


(3)
            Stock
      options granted pursuant to the 2009 non-management director compensation
      plan.  The following assumptions were used to determine the fair
      value of stock option awards: historical volatility of 81%, expected
      option life of 5.0 years and a risk-free interest rate of
      3.5%.


(4)
            Dr.
      Hall resigned from our Board of Directors on November 13,
      2009.


(5)
            Mr.
      Blumenfeld resigned from our Board of Directors on November 16,
      2009.


(6)
            Compensation
      earned by non-employee directors for services rendered during 2009 was
      accrued and unpaid as of December 31,
2009.


(7)
            Fees
      for consulting services performed by Mr. Paoni in
  2009.








ITEM
12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS.





The
following table provides information concerning securities authorized for
issuance pursuant to equity compensation plans approved by the Company’s
stockholders and equity compensation plans not approved by the Company’s
stockholders as of December 31, 2009.




35





Number
      of securities to be issuedupon
      exercise
              of
      outstanding options,
              warrants
      and rights
            
            
            Weighted-average
              exercise
      price of
              outstanding
      options,
              warrants
      and rights
            
            
            Number
      of securities
              remaining
      available for
              future
      issuance
              under
      equity
              compensation
      plans
              (excluding
      securities
              reflected
      in column (a))(a)
            
            
            (b)
            
            
            (c)Equity
      compensation plans approved by security holders
            
            
            6,120,883
            
            
            $
            1.50
            
            
            
            4,173,329Equity
      compensation plans not approved by security holders
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            
            6,120,883
            
            
            $
            1.50
            
            
            
            4,173,329





The
following table sets forth, as of March 30, 2010, the number of shares of the
Company’s common stock beneficially owned by each director and executive officer
of the Company, by all directors and executive officers as a group, and by each
person known by the Company to own beneficially more than 5.0% of the Company’s
outstanding common stock.





Amount and Nature of Beneficial OwnershipName and Address (1)
            
            Number of Shares (2)
            
            Percentage of ClassDirectors
      and Executive OfficersJason
      L. Tienor, President, Chief Executive Officer and
      Director
            
            
            837,203
            
            (3)
            
            
            *Richard
      J. Leimbach, Chief Financial Officer
                20374
      Seneca Meadows Parkway
                Germantown,
      MD 20876
            
            
            481,200
            
            (4)
            
            
            *Jeffrey
      J. Sobieski, Chief Operating Officer
            
            
            807,203
            
            (5)
            
            
            *Anthony
      J. Paoni, Chairman
            
            
            226,750
            
            (6)
            
            
            *Warren
      V. Musser, Director
            
            
            2,000,000
            
            (7)
            
            
            1.9
            %Thomas
      C. Lynch, Director
            
            
            250,000
            
            (8)
            
            
            *All
      Directors and Executive Officers as a group (six
      persons)
            
            
            4,602,356
            
            
            
            
            4.4
            %





*
            Less
      than one percent (1%).(1)
            Unless
      otherwise indicated, the address of each named holder is in care of
      Telkonet, Inc., 10200 Innovation Drive, Suite 300, Milwaukee,
      Wisconsin 53226.(2)
            According
      to Securities and Exchange Commission rules, beneficial ownership includes
      shares as to which the individual or entity has voting power or investment
      power and any shares, which the individual or entity has the right to
      acquire within 60 days of the date of this table through the exercise
      of any stock option or other right.(3)
            Includes
      701,803 shares of our common stock, options exercisable within 60 days to
      purchase 50,000 shares of our common stock at $1.80 per share, and Series
      A convertible redeemable preferred stock and warrants convertible into
      85,400 shares of our common stock.(4)
            Includes
      351,000 shares of our common stock, options exercisable within 60 days to
      purchase 37,500 and 50,000 shares of our common stock at $2.59 and $5.08
      per share, respectively, and Series A convertible redeemable preferred
      stock and warrants convertible into 42,700 shares of our common
      stock.(5)
            Includes
      701,803 shares of our common stock, options exercisable within 60 days to
      purchase 12,500 shares of our common stock at $1.00 per share, and Series
      A convertible redeemable preferred stock and warrants convertible into
      85,400 shares of our common stock.(6)
            Includes
      options exercisable within 60 days to purchase 80,000 and 40,000 shares of
      our common stock at $1.00 and $2.30 per share, and Series A convertible
      redeemable preferred stock and warrants convertible into 106,750 shares of
      our common stock.(7)
            Includes
      options exercisable within 60 days to purchase 2,000,000 shares of our
      common stock at $1.00 per share.(8)
            Includes
      options exercisable within 60 days to purchase 80,000, 20,000, 70,000 and
      80,000 shares of our common stock at $1.00, $2.00, $2.66 and $3.45 per
      share, respectively.







36





ITEM
13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE





Description
of Related Party Transactions





Several
of our officers and directors participated in our November 2009 private
placement of Series A convertible redeemable preferred stock and
warrants.  On November 16, 2009, we entered into an Executive Officer
Reimbursement Agreement with each of Messrs. Tienor, Sobieski and Leimbach, our
Chief Executive Officer, Chief Operating Officer and Chief Financial Officer,
respectively, pursuant to which these executive officers participated in the
private placement by converting a portion of our outstanding indebtedness owed
to them into shares of Series A convertible redeemable preferred stock and
warrants to purchase shares of our common stock.  Mr. Tienor converted
$20,000 of outstanding indebtedness into four shares of Series A
convertible redeemable preferred stock (convertible into 55,096 shares of common
stock) and warrants to purchase 30,304 shares of common stock; Mr. Leimbach
converted $10,000 of outstanding indebtedness into two shares of Series A
convertible redeemable preferred stock (convertible into 27,548 shares of common
stock) and warrants to purchase 15,152 shares of common stock; and Mr. Sobieski
converted $20,000 of outstanding indebtedness into four shares of Series A
convertible redeemable preferred stock (convertible into 55,096 shares of common
stock) and warrants to purchase 30,304 shares of common
stock.  Anthony Paoni, Chairman of our Board of Directors, also
participated in the private placement, purchasing five shares of Series A
convertible redeemable preferred stock (convertible into 68,870 shares of common
stock) and warrants to purchase 37,880 shares of common stock, for an aggregate
purchase price of $25,000.




Anthony
Paoni, Chairman of the Company’s Board of Directors, participated in the private
placement of Series A Preferred Stock, purchasing five shares of Series A
convertible redeemable preferred stock (convertible into 68,870 shares of common
stock) and warrants to purchase 37,880 shares of common stock, for an aggregate
purchase price of $25,000.




Anthony
Paoni, Chairman, also is compensated $4,000 per month for executive
consulting  services.




From time
to time the Company may receive advances from certain of its officers to meet
short term working capital needs.  These advances may not have formal
repayment terms or arrangements.  As of December 31, 2009, the Company
owed deferred salary payments to certain executive officers in the amount of
$13,062 to Jason L. Tienor, President and Chief Executive Officer, $24,868 to
Richard J. Leimbach, Chief Financial Officer, and $11,628 to Jeffrey J.
Sobieski, Chief Operating Officer.


Indemnification
Agreements


On March
30, 2010, the Company entered into Indemnification Agreements with directors
Anthony Paoni, Warren Musser and Thomas Lynch, and executives Jason Tienor,
President and Chief Executive Officer and Richard Leimbach, Chief Financial
Officer.
  The
Indemnification Agreements provide that the Company will indemnify the Company's
officers and directors, to the fullest extent permitted by law, relating to,
resulting from or arising out of any threatened, pending or completed action,
suit or proceeding, or any inquiry or investigation by reason of the fact that
such officer or director (i) is or was a director, officer, employee or agent of
the Company or (ii) is or was serving at the request of the Company as a
director, officer, employee or agent of another corporation, partnership, joint
venture, trust or other enterprise if he acted in good faith and in a manner he
reasonably believed to be in or not opposed to the best interests of the
Company, and, with respect to any criminal action or proceeding, had no
reasonable cause to believe his or her conduct was unlawful.. In addition, the
Indemnification Agreements provide that the Company will make an advance payment
of expenses to any officer or director who has entered into an Indemnification
Agreement, in order to cover a claim relating to any fact or occurrence arising
from or relating to events or occurrences specified in this paragraph, subject
to receipt of an undertaking by or on behalf of such officer or director to
repay such amount if it shall ultimately be determined that he is not entitled
to be indemnified by the Company as authorized under this
Agreement,.
  The
foregoing summary of the Indemnification Agreements is subject to, and qualified
in its entirety by, the Form of Indemnification Agreement, which is
included as Exhibit 10.12 to this Annual Report on Form 10-K.


Company’s
Policies on Related Party Transactions





Under the
Company’s policies and procedures, related-party transactions that must be
publicly disclosed under the federal securities laws require prior approval
of the Company’s independent directors without the participation of
any director who may have a direct or indirect interest in the transaction in
question. Related parties include directors, nominees for director, principal
shareholders, executive officers and members of their immediate families. For
these purposes, a “transaction” includes all financial transactions,
arrangements or relationships, ranging from extending credit to the provision of
goods and services for value and includes any transaction with a company in
which a director, executive officer immediate family member of a director or
executive officer, or principal shareholder (that is, any person who
beneficially owns five percent or more of any class of the Company’s voting
securities) has an interest by virtue of a 10-percent-or-greater equity
interest. The Company’s policies and procedures regarding related-party
transactions are not a part of a formal written policy, but rather, represent
the Company’s historical course of practice with respect to approval of
related-party transactions.





Director
Independence





The Board
of Directors has determined that Messrs. Lynch and Paoni are “independent” under
the listing standards of the NYSE AMEX.  Each of Messrs. Lynch and
Paoni serve on, and are the only members of, the Company’s Audit Committee and
Compensation Committee.  Although the Company does not maintain a
standing Nominating Committee, nominees for election as directors are considered
and nominated by a majority of the Company’s independent directors in accordance
with the NYSE AMEX listing standards. “Independence” for these purposes is
determined in accordance with Section 121(A) of the NYSE AMEX Rules and Rule
10A-3 under the Securities Exchange Act of 1934.





ITEM
14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES.





The
following table sets forth fees billed to the Company by our auditors during the
fiscal years ended December 31, 2009 and 2008.





December
      31,
              2009
            
            
            December
      31,
              20081.
      Audit Fees
            
            $
            185,413
            
            
            $
            309,7552.
      Audit Related Fees
            
            
            24,250
            
            
            
            46,2623.
      Tax Fees
            
            
            --
            
            
            
            --4.
      All Other Fees
            
            
            --
            
            
            
            --Total
      Fees
            
            $
            209,663
            
            
            $
            356,017





Audit
fees consist of fees billed for professional services rendered for the audit of
the Company’s consolidated financial statements and review of the interim
consolidated financial statements included in quarterly reports and services
that are normally provided by RBSM LLP in connection with statutory and
regulatory filings or engagements.





Audit-related
fees consists of fees billed for assurance and related services that are
reasonably related to the performance of the audit or review of the Company’s
consolidated financial statements, which are not reported under “Audit
Fees.”






37




Tax fees
consist of fees billed for professional services for tax compliance, tax advice
and tax planning. The tax fees relate to federal and state income tax reporting
requirements.





All other
fees consist of fees for products and services other than the services reported
above.





Prior to
the Company’s engagement of its independent auditor, such engagement is approved
by the Company’s audit committee. The services provided under this engagement
may include audit services, audit-related services, tax services and other
services. Pre-approval is generally provided for up to one year and any
pre-approval is detailed as to the particular service or category of services
and is generally subject to a specific budget. Pursuant to the Company’s Audit
Committee Charter, the independent auditors and management are required to
report to the Company’s audit committee at least quarterly regarding the extent
of services provided by the independent auditors in accordance with this
pre-approval, and the fees for the services performed to date. The audit
committee may also pre-approve particular services on a case-by-case basis. All
audit fees, audit-related fees, tax fees and other fees incurred by the Company
for the year ended December 31, 2009 were approved by the Company’s audit
committee.





PART
IV





ITEM
15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.





(a)
              Documents
      filed as part of this report.(1)
              Financial
      Statements. The following financial statements are included in
      Part II, Item 8 of this Annual Report on Form
      10-K:Report
      of RBSM LLP on Consolidated Financial Statements as of and for the periods
      ended December 31, 2009 and December 31, 2008Consolidated
      Balance Sheets as of December 31, 2009 and 2008Consolidated
      Statements of Operations for the Years ended December 31, 2009 and
      2008Consolidated
      Statements of Equity for the Years ended December 31, 2009 and
      2008Consolidated
      Statements of Cash Flows for Years ended December 31, 2009 and
      2008Notes
      to Consolidated Financial Statements(2)
              Financial
      Statement Schedules.Additional
      Schedules are omitted as the required information is inapplicable or the
      information is presented in the financial statements or related
      notes.(3)
              Exhibits
      required to be filed by Item 601 of Regulation
    S-K.See
      Exhibit Index located immediately following this
      Item 15.The
      exhibits filed herewith are attached hereto (except as noted) and those
      indicated on the Exhibit Index which are not filed herewith were
      previously filed with the Securities and Exchange Commission as
      indicated.







38




EXHIBIT INDEX





The
following exhibits are included herein or incorporated by
reference:





Exhibit
              Number
            Description
      Of Document2.1
            MST
      Stock Purchase Agreement and Amendment (incorporated by reference to our
      8-K filed on February 2, 2006)2.2
            Asset
      Purchase Agreement by and between Telkonet, Inc. and Smart Systems
      International, dated as of February 23, 2007 (incorporated by reference to
      our Form 8-K filed on March 2, 2007)2.3
            Unit
      Purchase Agreement by and among Telkonet, Inc., EthoStream, LLC and the
      members of EthoStream, LLC dated as of March 15, 2007 (incorporated by
      reference to our Form 8-K filed on March 16, 2007)3.1
            Articles
      of Incorporation of the Registrant (incorporated by reference to our Form
      8-K (No. 000-27305), filed on August 30, 2000 and our Form S-8 (No.
      333-47986), filed on October 16, 2000)3.2
            Bylaws
      of the Registrant (incorporated by reference to our Registration Statement
      on Form S-1 (No. 333-108307), filed on August 28, 2003)3.3
            Amendment
      to Articles of Incorporation (incorporated by reference to our Form 8-K
      (No. 001-31972), filed November 18, 2009)4.1
            Form
      of Series A Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.2
            Form
      of Series A Non-Detachable Warrant (incorporated by reference to our Form
      10- KSB (No. 000-27305), filed on March 31, 2003)4.3
            Form
      of Series B Convertible Debenture (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.4
            Form
      of Series B Non-Detachable Warrant (incorporated by reference to our Form
      10-KSB (No. 000-27305), filed on March 31, 2003)4.5
            Form
      of Senior Note (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)4.6
            Form
      of Non-Detachable Senior Note Warrant (incorporated by reference to our
      Registration Statement on Form S-1 (No. 333-108307), filed on August 28,
      2003)4.7
            Senior
      Convertible Note by Telkonet, Inc. in favor of Portside Growth &
      Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.8
            Senior
      Convertible Note by Telkonet, Inc. in favor of Kings Road Investments Ltd.
      (incorporated by reference to our Form 8-K (No. 001-31972), filed on
      October 31, 2005)4.11
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Portside Growth
      & Opportunity Fund (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.12
            Warrant
      to Purchase Common Stock by Telkonet, Inc. in favor of Kings Road
      Investments Ltd. (incorporated by reference to our Form 8-K (No.
      001-31972), filed on October 31, 2005)4.13
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K (No. 001-31972), filed on September 6,
      2006)4.14
            Form
      of Accelerated Payment Option Warrant to Purchase Common Stock
      (incorporated by reference to our Registration Statement on Form S-3 (No.
      333-137703), filed on September 29, 2006.4.15
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our
      Current Report on Form 8-K filed on February 5,
  2007)4.16
            Senior
      Note by Telkonet, Inc. in favor of GRQ Consultants, Inc. (incorporated by
      reference to our Form 10-Q (No. 001-31972), filed November 9,
      2007)4.17
            Warrant
      to Purchase Common Stock by Telkonet, Inc in favor of GRQ Consultants,
      Inc. (incorporated by reference to our Form 10-Q (No. 001-31972), filed
      November 9, 2007)4.18
            Form
      of Promissory Note (incorporated by reference to our Form 8-K (No.
      001-31972) filed on May 12, 2008)4.19
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our Form
      8-K (No. 001-31972) filed on May 12, 2008)4.20
            Form
      of Convertible Debenture (incorporated by reference to our Form 8-K (No.
      001-31972) filed on June 5, 2008)4.21
            Form
      of Warrant to Purchase Common Stock (incorporated by reference to our Form
      8-K (No. 001-31972) filed on June 5,
2008)







39




10.1
              Amended
      and Restated Stock Option Plan (incorporated by reference to our
      Registration Statement on Form S-8 (No. 333-161909), filed on September
      14, 2009)10.2
              Securities
      Purchase Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP, Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.3
              Registration
      Rights Agreement, dated February 1, 2007, by and among Telkonet, Inc.,
      Enable Growth Partners LP, Enable Opportunity Partners LP and Pierce
      Diversified Strategy Master Fund LLC, Ena, Hudson Bay Fund LP and Hudson
      Bay Overseas Fund, Ltd. (incorporated by reference to our Current Report
      on Form 8-K filed on February 5, 2007)10.4
              Employment
      Agreement by and between Telkonet, Inc. and Jason Tienor, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)10.5
              Employment
      Agreement by and between Telkonet, Inc. and Jeff Sobieski, dated as of
      March 15, 2007 (incorporated by reference to our Form 10-K (No.
      001-31972), filed March 16, 2007)10.6
              Securities
      Purchase Agreement, dated May 30, 2008, by and between Telkonet, Inc. and
      YA Global Investments LP (incorporated by reference to our Current Report
      on Form 8-K filed on June 5, 2008)10.7
              Registration
      Rights Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA
      Global Investments LP (incorporated by reference to our Current Report on
      Form 8-K filed on June 5, 2008)10.8
              Security
      Agreement, dated May 30, 2008, by and between Telkonet, Inc. and YA Global
      Investments LP (incorporated by reference to our Current Report on Form
      8-K filed on June 5, 2008)10.9
              Commercial
      Business Loan Agreement, dated September 9, 2008, by and between Telkonet,
      Inc. and Thermo Credit, LLC (incorporated by reference to our Form 8-K
      filed on September 10, 2008)10.10
              Loan
      Agreement, dated September 11, 2009, by and between Telkonet, Inc. and the
      Wisconsin Department of Commerce (incorporated by reference to our Form
      8-K (No. 001-31972) filed on September 17, 2009)10.11
              General
      Business Security Agreement, dated September 11, 2009, by and between
      Telkonet, Inc. and the Wisconsin Department of Commerce (incorporated by
      reference to our Form 8-K (No. 001-31972) filed on September 17,
      2009)10.12
              Form
      of Director and Officer Indemnification Agreement14
              Code
      of Ethics (incorporated by reference to our Form 10-KSB (No. 001-31972),
      filed on March 30, 2004).21
              Telkonet,
      Inc. Subsidiaries (incorporated by reference to our Form 10-K (No.
      001-31972) filed March 16, 2007)
 23.1
              Consent
      of RBSM LLP , Independent Registered Certified Public Accounting Firm,
      filed herewith24
              Power
      of Attorney (incorporated by reference to our Registration Statement on
      Form S-1 (No. 333-108307), filed on August 28, 2003)31.1
              Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason
      Tienor31.2
              Certification
      Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard J.
      Leimbach32.1
              Certification
      of Jason L. Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant
      to Section 906 of the Sarbanes-Oxley Act of 200232.2
              Certification
      of Richard J. Leimbach pursuant to 18 U.S.C. Section 1350, as adopted
      pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002








40




SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.





TELKONET,
      INC.Dated:
      March 31, 2010
            /s/
      Jason L. TienorJason
      L. Tienor
              Chief
      Executive Officer





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.





Name
            
            Position
            Date/s/
      Jason L. Tienor
            
            Chief
      Executive Officer and Director
            March
      31, 2010Jason
      Tienor
            
            (principal
      executive officer)/s/
      Richard J. Leimbach
            
            Chief
      Financial Officer
            March
      31, 2010Richard
      J. Leimbach
            
            (principal
      financial officer)
              (principal
      accounting officer)/s/
      Anthony J. Paoni
            
            Chairman
      of the Board
            March
      31, 2010Anthony
      J. Paoni/s/
      Warren V. Musser
            
            Director
            March
      31, 2010Warren
      V. Musser/s/
      Thomas C. Lynch
            
            Director
            March
      31, 2010Thomas
      C. Lynch








41











SECURITIES
AND EXCHANGE COMMISSION





WAS

HINGTON, D.C. 20549








FINANCIAL
STATEMENTS AND SCHEDULES





DECEMBER
31, 2009 AND 2008








FORMING
A PART OF ANNUAL REPORT


PURSUANT
TO THE SECURITIES EXCHANGE ACT OF 1934








TELKONET,
INC.

















TELKONET,
INC.





Index
to Financial Statements








Report
      of Independent Registered Certified Public Accounting
      Firm
            F-2Consolidated
      Balance Sheets at December 31, 2009 and 2008
            F-3Consolidated
      Statements of Operations and Comprehensive Income (Losses) for the
      Years ended December 31, 2009 and 2008
            F-4Consolidated
      Statements of Equity for the Years ended December 31, 2009 and
      2008
            F-5Consolidated
      Statements of Cash Flows for the Years ended December 31, 2009 and
      2008
            F-7Notes
      to Consolidated Financial Statements
            F-9








F-1





RBSM
LLP


CERTIFIED
PUBLIC ACCOUNTANTS





REPORT OF INDEPENDENT
REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM





Board of
Directors


Telkonet,
Inc.


Milwaukee,
WI





We have
audited the accompanying consolidated balance sheets of Telkonet, Inc. and its
subsidiaries (the "Company") as of December 31, 2009 and 2008 and the related
consolidated statements of operations, equity, and cash flows for each of the
two years in the period ended December 31, 2009. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based upon our
audit.





We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States of America). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatements. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe 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 financial position of Telkonet, Inc. and its
subsidiaries as of December 31, 2009 and 2008, and the results of its operations
and its cash flows for each of the two years in the period ended
December 31, 2009, in conformity with accounting principles generally
accepted in the United States of America.





The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern. As discussed in the Note A to the
accompanying financial statements, the Company has incurred significant
operating losses in current year and also in the past. These factors, among
others, raise substantial doubt about the Company's ability to continue as a
going concern. The financial statements do not include any adjustments that
might result from the outcome of this uncertainty.





/s/
      RBSM LLPCertified
      Public Accountants





New York,
New York


March 31,
2010







F-2


TELKONET,
INC.


CONSOLIDATED
BALANCE SHEETS


DECEMBER
31, 2009 AND 2008


December
      31,
              2009
            
            
            December
      31,
              2008ASSETSCurrent
      assets:Cash
      and cash equivalents
            
            $
            503,870
            
            
            $
            168,492Accounts
      receivable, net
            
            
            251,684
            
            
            
            836,336Inventories
            
            
            906,583
            
            
            
            1,733,940Other
      current assets
            
            
            246,936
            
            
            
            230,539Current
      assets from discontinued operations
            
            
            -
            
            
            
            476,459Total
      current assets
            
            
            1,909,073
            
            
            
            3,445,766Property
      and equipment, net
            
            
            254,499
            
            
            
            403,593Other
      assets:Marketable
      securities
            
            
            -
            
            
            
            397,403Deferred
      financing costs, net
            
            
            227,767
            
            
            
            432,136Goodwill
      and other intangible assets, net
            
            
            13,895,792
            
            
            
            15,137,469Other
      assets
            
            
            8,000
            
            
            
            98,807Other
      assets from discontinued operations
            
            
            -
            
            
            
            6,593,169Total
      other assets
            
            
            14,131,559
            
            
            
            22,658,984Total
      Assets
            
            $
            16,295,131
            
            
            $
            26,508,343





LIABILITIES
      AND EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            2,866,120
            
            
            $
            2,561,213Accrued
      liabilities and expenses
            
            
            2,271,838
            
            
            
            1,996,044Line
      of credit
            
            
            387,000
            
            
            
            574,005Other
      current liabilities
            
            
            169,606
            
            
            
            278,034Current
      Liabilities from discontinued operations
            
            
            -
            
            
            
            13,450,362Total
      current liabilities
            
            
            5,694,564
            
            
            
            18,859,658Long-term
      liabilities:Convertible
      debentures, net of debt discounts of $457,560 and $825,585,
      respectively
            
            
            1,148,463
            
            
            
            1,311,065Derivative
      liability
            
            
            1,881,299
            
            
            
            2,573,126Note
      payable
            
            
            300,000
            
            
            
            -Deferred
      lease liability and other
            
            
            50,791
            
            
            
            50,791Long-term
      liabilities from discontinued operations
            
            
            -
            
            
            
            -Total
      long-term liabilities
            
            
            3,380,553
            
            
            
            3,934,982Commitments
      and contingencies
            
            
            
            
            
            
            -Redeemable
      preferred stock, Series A; par value $.001 per share; 215 shares
      authorized, 215 and 0 shares issued and outstanding at December 31, 2009
      and 2008, respectively, net (Face value $1,075,000 and $0,
      respectively)
            
            
            732,843
            
            
            
            -EquityPreferred
      stock, undesignated, par value $.001 per share; 14,999,785 shares
      authorized; none issued and outstanding at December 31,2009 and 2008,
      respectively
            
            
            -
            
            
            
            -Common
      stock, par value $.001 per share; 155,000,000 shares authorized;
      96,563,771 and 87,525,495 shares issued and outstanding at
      December 31, 2009 and 2008, respectively
            
            
            96,564
            
            
            
            87,526Additional
      paid-in-capital
            
            
            120,132,088
            
            
            
            118,197,450Accumulated
      deficit
            
            
            (113,741,481
            )
            
            
            (114,801,318
            )Accumulated
      comprehensive loss
            
            
            -
            
            
            
            (32,750
            )Total
      stockholders’ equity attributable to Telkonet, Inc.
            
            
            6,487,171
            
            
            
            3,450,908Non
      controlling interest
            
            
            -
            
            
            
            262,795Total
      equity
            
            
            6,487,171
            
            
            
            3,713,703Total
      Liabilities and Equity
            
            $
            16,295,131
            
            
            $
            26,508,343





See
accompanying notes to consolidated financial statements


F-3




TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSSES)


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





2009
            
            
            2008Revenues,
      net:Product
            
            $
            6,521,906
            
            
            $
            13,043,114Recurring
            
            
            3,996,147
            
            
            
            3,515,887Total
      Revenue
            
            
            10,518,053
            
            
            
            16,559,001Cost
      of Sales:Product
            
            
            3,878,988
            
            
            
            8,105,304Recurring
            
            
            1,313,108
            
            
            
            1,680,832Total
      Cost of Sales
            
            
            5,192,096
            
            
            
            9,786,136Gross
      Profit
            
            
            5,325,957
            
            
            
            6,772,865Operating
      Expenses:Research
      and Development
            
            
            1,080,148
            
            
            
            2,036,129Selling,
      General and Administrative
            
            
            6,895,624
            
            
            
            9,252,381Impairment
      of Goodwill and Long Lived Assets
            
            
            1,000,000
            
            
            
            2,380,000Stock
      Based Compensation
            
            
            235,234
            
            
            
            699,639Depreciation
      and Amortization
            
            
            348,189
            
            
            
            391,023Total
      Operating Expenses
            
            
            9,559,195
            
            
            
            14,759,172Loss
      from Operations
            
            
            (4,233,238
            )
            
            
            (7,986,307
            )Other
      Income (Expenses):Financing
      Expense, net
            
            
            (1,384,502
            )
            
            
            (2,814,795
            )Gain
      (Loss) on Derivative Liability
            
            
            777,750
            
            
            
            (1,174,121
            )Loss
      on Sale of Investments
            
            
            (29,371
            )
            
            
            (6,500
            )Impairment
      of Investment in Marketable Securities
            
            
            (367,653
            )
            
            
            (4,098,514
            )Total
      Other Income (Expenses)
            
            
            (1,003,776
            )
            
            
            (8,093,930
            )Loss
      from Continuing Operations Before Provision for Income
      Tax
            
            
            (5,237,014
            )
            
            
            (16,080,237
            )Provision
      for Income Tax
            
            
            -
            
            
            
            -Loss
      from Continuing Operations
            
            $
            (5,237,014
            )
            
            $
            (16,080,237
            )Discontinued
      OperationsLoss
      from Discontinued Operations
            
            
            (635,735
            )
            
            
            (7,905,302
            )Gain
      on Deconsolidation
            
            
            6,932,586
            
            
            
            -Net
      Income (Loss) attributable to common stockholders
            
            $
            1,059,837
            
            
            $
            (23,985,539
            )Net
      Income (Loss) per share:Loss
      per share from continuing operations – basic and
    diluted
            
            $
            (0.06
            )
            
            $
            (0.20
            )Income
      (Loss) per share from discontinued operations – basic and
      diluted
            
            $
            0.07
            
            
            $
            (0.10
            )Net
      Income (Loss) per share – basic
            
            $
            0.01
            
            
            $
            (0.30
            )Net
      Income (Loss per share – diluted
            
            $
            0.01
            
            
            $
            (0.30
            )Weighted
      average common shares outstanding – basic
            
            
            94,486,950
            
            
            
            79,153,788Weighted
      average common shares outstanding – diluted
            
            
            102,866,200
            
            
            
            79,153,788Comprehensive
      Income (Loss):Net
      Income (Loss)
            
            $
            1,059,837
            
            
            $
            (23,985,539
            )Unrealized
      gain (loss) on investment
            
            
            32,750
            
            
            
            (32,750
            )Comprehensive
      Income (Loss)
            
            $
            1,092,587
            
            
            $
            (24,018,289
            )





See
accompanying notes to consolidated financial statements








F-4





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF EQUITY


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





Preferred
      Shares
            
            
            Preferred
              Stock
              Amount
            
            
            Common
              Shares
            
            
            Common
              Stock
              Amount
            
            
            Additional
              Paid
      in
              Capital
            
            
            Accumulated
      Deficit
            
            
            Comprehensive
      Income
              (Loss)
            
            
            Noncontrolling
      Interest
            
            
            TotalBalance
      at January 1, 2008
            
            
            
            
            
            
            
            
            70,826,544
            
            
            $
            70,827
            
            
            $
            112,013,093
            
            
            $
            (90,815,779
            )
            
            $
            -
            
            
            $
            -
            
            
            $
            21,268,141Shares
      issued in exchange for services rendered  and accrued at
      approximately $1.00 per share
            
            
            -
            
            
            
            -
            
            
            
            346,244
            
            
            
            346
            
            
            
            345,060
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            345,406Shares
      issued for cashless warrants exercised
            
            
            -
            
            
            
            -
            
            
            
            1,000,000
            
            
            
            1,000
            
            
            
            (1,000
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Shares
      issued in connection with Private Placement
            
            
            -
            
            
            
            -
            
            
            
            2,500,000
            
            
            
            2,500
            
            
            
            1,497,500
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,500,000Adjustment
      shares issued for investment in affiliate
            
            
            -
            
            
            
            -
            
            
            
            3,046,425
            
            
            
            3,046
            
            
            
            (3,046
            )
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            -Adjustment
      shares issued for purchase of subsidiary
            
            
            -
            
            
            
            -
            
            
            
            1,882,225
            
            
            
            1,882
            
            
            
            (1,882
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Shares
      issued from escrow contingency in purchase of
    subsidiary
            
            
            -
            
            
            
            -
            
            
            
            600,000
            
            
            
            600
            
            
            
            379,400
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            380,000Shares
      issued in exchange for convertible debentures
            
            
            -
            
            
            
            -
            
            
            
            7,324,057
            
            
            
            7,324
            
            
            
            1,356,026
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            287,106Value
      of additional warrants issued in conjunction with anti-dilution
      provision
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            200,459
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            200,459Stock-based
      compensation expense related to the re-pricing of investor
      warrants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,598,203
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,598,203Stock-based
      compensation expense related to employee stock
    options
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            559,478
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            559,478Value
      of warrants attached to note payable
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            254,160
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            254,160Holding
      loss on available for sale securities
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (32,750
            )
            
            
            -
            
            
            
            (32,750
            )Non-controlling
      interest
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            262,795
            
            
            
            262,795Loss
      from discontinued operations
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (7,905,302
            )
            
            
            -
            
            
            
            -
            
            
            
            (7,905,302
            )Loss
      from continuing operations
            
            -
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            (16,080,237
            )
            
            
            -
            
            
            -
            
            
            (16,080,237
            )Balance
      at December 31, 2008
            
            -
            
            
            -
            
            
            87,525,495
            
            
            $
            87,526
            
            
            $
            118,197,450
            
            
            $
            (114,801,318
            )
            
            $
            (32,750
            )
            
            $
            262,795
            
            
            $
            3,717,703





See
accompanying notes to consolidated financial statements






F-5





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF EQUITY (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





Preferred
      Shares
            
            
            Preferred
              Stock
              Amount
            
            
            Common
              Shares
            
            
            Common
              Stock
              Amount
            
            
            Additional
              Paid
      in
              Capital
            
            
            Accumulated
      Deficit
            
            
            Comprehensive
      Income
              (Loss)
            
            
            Noncontrolling
      Interest
            
            
            TotalBalance
      at January 1, 2009
            
            
            
            
            
            
            
            
            87,525,495
            
            
            $
            87,526
            
            
            $
            118,197,450
            
            
            $
            (114,801,318
            )
            
            $
            (32,750
            )
            
            $
            262,795
            
            
            $
            3,713,703Shares
      issued in exchange for services rendered at approximately $0.12 per
      share
            
            
            -
            
            
            
            -
            
            
            
            83,333
            
            
            
            83
            
            
            
            9,917
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            10,000Shares
      issued for warrants exercised at $0.09 per share
            
            
            -
            
            
            
            -
            
            
            
            780,000
            
            
            
            780
            
            
            
            70,746
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            71,526Shares
      issued in exchange for convertible debentures
            
            
            -
            
            
            
            -
            
            
            
            8,174,943
            
            
            
            8,175
            
            
            
            714,339
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            722,514Stock-based
      compensation expense related to employee stock
    options
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            216,842
            
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            216,842Re-pricing
      of investor warrants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            70,486
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            70,486Issuance
      of investor warrants
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            510,151
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            510,151Warrants
      issued with redeemable convertible preferred stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            287,106
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            287,106Beneficial
      conversion feature of redeemable convertible preferred
      stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            70,922
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            70,922Accretion
      of preferred discount
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (5,967
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (5,967
            )Accretion
      of preferred dividends
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (9,904
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (9,904
            )Unrealized
      Gain on available for sale securities
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            32,750
            
            
            
            -
            
            
            
            32,750Reclass
      of non-controlling interest
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (262,795
            )
            
            
            (262,795
            )Income
      from discontinued operations
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            6,296,851
            
            
            
            -
            
            
            
            -
            
            
            
            6,296,851Loss
      from continuing operations
            
            -
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            (5,237,014
            )
            
            
            -
            
            
            -
            
            
            (5,237,014
            )Balance
      at December 31, 2009
            
            -
            
            
            $
            -
            
            
            96,563,771
            
            
            $
            96,564
            
            
            $
            120,123,088
            
            
            $
            (113,741,481
            )
            
            $
            -
            
            
            $
            -
            
            
            $
            6,487,171





See
accompanying notes to consolidated financial statements






F-6




TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





2009
            
            
            2008Increase
      (Decrease) In Cash and EquivalentsCash
      Flows from Operating Activities:Net
      income (loss) attributable to common shareholders
            
            $
            1,059,837
            
            
            $
            (23,985,539
            )Net
      (income) loss from discontinued operations
            
            
            (6,296,851
            )
            
            
            7,905,302Net
      loss from continuing operations
            
            
            (5,237,014
            )
            
            
            (16,080,237
            )Adjustments
      to reconcile net loss from operations to cash used in operating
      activities:Amortization
      of debt discounts and financing costs
            
            
            683,317
            
            
            
            745,392Impairment
      of goodwill and long-lived assets
            
            
            1,000,000
            
            
            
            2,380,000Impairment
      of investment in affiliate
            
            
            367,653
            
            
            
            4,098,514Loss
      on sale of investment
            
            
            29,371
            
            
            
            6,500(Gain)
      loss on derivative liability
            
            
            (777,750
            )
            
            
            1,174,121Stock
      based compensation
            
            
            226,842
            
            
            
            699,639Fair
      value of issuance of warrants and re-pricing  (financing
      expense)
            
            
            580,637
            
            
            
            2,052,822Depreciation
      and Amortization
            
            
            348,188
            
            
            
            417,888Increase
      / decrease in:Accounts
      receivable, trade and other
            
            
            1,341,211
            
            
            
            1,090,538Inventories
            
            
            827,357
            
            
            
            871,349Prepaid
      expenses and deposits
            
            
            65,184
            
            
            
            406,246Deferred
      revenue
            
            
            (943
            )
            
            
            (37,099
            )Other
      Assets
            
            
            (46,492
            )
            
            
            115,379Accounts
      payable, accrued expenses, net
            
            
            (26,905
            )
            
            
            (951,248
            )Cash
      used in continuing operations
            
            
            (619,344
            )
            
            
            (3,010,196
            )Cash
      used in discontinued operations
            
            
            (287,997
            )
            
            
            (1,048,189
            )Net
      Cash Used In Operating Activities
            
            
            (907,341
            )
            
            
            (4,058,385
            )Cash
      Flows From Investing Activities:Purchase
      of property and equipment
            
            
            (2,675
            )
            
            
            (14,374
            )Advances
      to unconsolidated subsidiary
            
            
            (305,539
            )
            
            
            -Proceeds
      from sale of investment
            
            
            33,129
            
            
            
            6,000Cash
      used in continuing operations
            
            
            (275,085
            )
            
            
            (8,374
            )Cash
      used in discontinued operations
            
            
            (5,979
            )
            
            
            (1,128,255
            )Net
      Cash Used In Investing Activities
            
            
            (281,064
            )
            
            
            (1,136,629
            )Cash
      Flows From Financing Activities:Proceeds
      from sale of common stock, net of costs and fees
            
            
            -
            
            
            
            1,500,000Proceeds
      from issuance of convertible debentures, net of
costs
            
            
            -
            
            
            
            3,037,434Proceeds
      from issuance of note payable
            
            
            300,000
            
            
            
            -Proceeds
      from the issuance of preferred stock
            
            
            1,075,000
            
            
            
            -Proceeds
      (repayments) from line of credit
            
            
            (187,005
            )
            
            
            574,005Financing
      fees for line of credit and factoring agreement
            
            
            (25,000
            )
            
            
            (84,861
            )Repayment
      of notes payable
            
            
            -
            
            
            
            (1,500,000
            )Proceeds
      from exercise of stock options and warrants
            
            
            71,526
            
            
            
            -Repayment
      of capital lease and other
            
            
            (4,714
            )
            
            
            (7,128
            )Cash
      provided by continuing operations
            
            
            1,229,807
            
            
            
            3,519,450Cash
      provided by discontinued operations
            
            
            293,976
            
            
            
            1,237,438Net
      Cash Provided By Financing Activities
            
            
            1,523,783
            
            
            
            4,756,888Net
      Increase (Decrease) In Cash and Equivalents
            
            
            335,378
            
            
            
            (438,126
            )Cash
      and cash equivalents at the beginning of the year
            
            
            168,492
            
            
            
            606,618Cash
      and cash equivalents at the end of the year
            
            $
            503,870
            
            
            $
            168,492





See
accompanying notes to consolidated financial statements







F-7





TELKONET,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)


FOR
THE YEARS ENDED DECEMBER 31, 2009 AND 2008





2009
            
            
            2008Supplemental
      Disclosures of Cash Flow Information:Cash
      transactions:Cash
      paid during the period for financing expenses
            
            $
            350,926
            
            
            $
            333,435Income
      taxes paid
            
            
            -
            
            
            
            -Non-cash
      investing and financing transactions:Beneficial
      conversion feature of redeemable convertible preferred
      stock
            
            
            70,922
            
            
            
            -Value
      of warrants issued with redeemable convertible preferred
      stock
            
            
            287,106
            
            
            
            -Value
      of warrants attached to senior note
            
            
            -
            
            
            
            254,160Value
      of common stock issued for conversion debenture
      principal
            
            
            722,514
            
            
            
            1,363,350Accrued
      interest reclassified as convertible debenture
    principal
            
            
            191,887
            
            
            
            -Equipment
      purchased under capital lease obligations
            
            
            -
            
            
            
            226,185





See
accompanying notes to consolidated financial statements





F-8





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
A - SUMMARY OF ACCOUNTING POLICIES





A summary
of the significant accounting policies applied in the preparation of the
accompanying consolidated financial statements follows.





Business and Basis of
Presentation





Telkonet,
Inc., formed in 1999 and incorporated under the laws of the state of Utah, has
evolved into a Clean Technology company that develops and manufactures
proprietary energy efficiency and SmartGrid networking technology. Prior to
January 1, 2007, the Company was primarily engaged in the business of
developing, producing and marketing proprietary equipment enabling the
transmission of voice and data communications over electric utility
lines.





In
January 2006, following the acquisition of Microwave Satellite Technologies
(MST), the Company began offering complete sales, installation, and service
of VSAT and business television networks, and became a full-service
national Internet Service Provider (ISP). In 2009, the Company completed the
deconsolidation of MST by reducing its ownership percentage and board
membership.  Financial statements and accompanying notes included in
this report include disclosure of the results of operations for MST, for all
periods presented, as discontinued operations.





In March
2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada.





In March
2007, the Company acquired 100% of the outstanding membership units of
EthoStream, LLC, a network solutions integration company that offers
installation, sales and service to the hospitality industry. The EthoStream
acquisition will enable Telkonet to provide installation and support for PLC
products and third party applications to customers across North
America.





The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries, Telkonet Communications, Inc. and EthoStream, LLC.
Significant intercompany transactions have been eliminated in
consolidation.





In 2009,
the Company completed the deconsolidation of MST by reducing its ownership
percentage and board membership.  Financial statements and
accompanying notes included in this report include disclosure of the results of
operations for MST, for all periods presented, as discontinued
operations.  These notes to the consolidated financial statements are
presented on a continuing operations basis, except where otherwise
indicated.





Investments
in entities over which the Company has significant influence, typically those
entities that are 20 to 50 percent owned by the Company, are accounted for
using the equity method of accounting, whereby the investment is carried at cost
of acquisition, plus the Company’s equity in undistributed earnings or losses
since acquisition.





Going
Concern





The
accompanying consolidated financial statements have been prepared in conformity
with accounting principles generally accepted in the United States of America,
which contemplate continuation of the Company as a going concern.
However, the Company has reported a net loss from continuing operations of
$(5,237,014) for the year ended December 31, 2009, accumulated deficit of
$(113,741,481) and a working capital deficit of $(3,785,491) as of December 31,
2009.







F-9





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





The
Company believes that anticipated revenues from operations will be insufficient
to satisfy its ongoing capital requirements for at least the next 12
months.  If the Company’s financial resources from
operations are insufficient, the Company will
require additional financing in order to execute its operating plan
and continue as a going concern. The Company cannot predict whether
this additional financing will be in the form of equity or debt, or be
in another form. The Company may not be able to obtain the
necessary additional capital on a
timely basis, on acceptable terms, or at
all.  In any of these events, the Company may be unable to
implement its current plans for expansion,
repay its debt obligations as they become due,
or respond to competitive pressures, any of
which circumstances would have a material adverse effect on its
business, prospects, financial condition and results of operations.





Management intends
to raise capital through asset-based financing and/or the sale of its stock in
private placements.  Management believes that with this financing, the
Company will be able to generate additional revenues that will allow the Company
to continue as a going concern. There can be no assurance that the Company
will be successful in obtaining additional funding.





Concentrations of Credit
Risk





Financial
instruments and related items, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash, cash equivalents and
trade receivables. The Company places its cash and temporary cash investments
with credit quality institutions. At times, such investments may be in excess of
the FDIC insurance limit.





The
allowance for doubtful accounts was $175,000 and $176,400 at December 31, 2009
and December 31, 2008, respectively. Management
identifies a delinquent customer based upon the delinquent payment status of an
outstanding invoice, generally greater than 30 days past due
date.  The delinquent account designation does not trigger an
accounting transaction until such time the account is deemed uncollectible. The
allowance for doubtful accounts is determined by examining the reserve history
and any outstanding invoices that are over 30 days past due as of the end of the
reporting period.  Accounts are deemed uncollectible on a case-by-case
basis, at management’s discretion based upon an examination of the communication
with the delinquent customer and payment history.  Typically, accounts
are only escalated to “uncollectible” status after multiple attempts have been
made to communicate with the customer.





Cash and Cash
Equivalents





For
purposes of the Statements of Cash Flows, the Company considers all highly
liquid debt instruments purchased with an original maturity date of three months
or less to be cash equivalents.





Property and
Equipment





Property
and equipment is stated at cost. Depreciation is calculated using the
straight-line method over the estimated useful lives of the assets. The
estimated useful life ranges from 2 to 10 years.





Fair Value of Financial
Instruments





In
January 2008, we adopted the provisions under FASB for Fair Value Measurements,
which define fair value for accounting purposes, establishes a framework for
measuring fair value and expands disclosure requirements regarding fair value
measurements.  Our adoption of these provisions did not have a
material impact on our consolidated financial statements.  Fair value
is defined as an exit price, which is the price that would be received upon sale
of an asset or paid upon transfer of a liability in an orderly transaction
between market participants at the measurement date.  The degree of
judgment utilized in measuring the fair value of assets and liabilities
generally correlates to the level of pricing observability.  Financial
assets and liabilities with readily available, actively quoted prices or for
which fair value can be measured from actively quoted prices in active markets
generally have more pricing observability and require less judgment in measuring
fair value.  Conversely, financial assets and liabilities that are
rarely traded or not quoted have less price observability and are generally
measured at fair value using valuation models that require more
judgment.  These valuation techniques involve some level of management
estimation and judgment, the degree of which is dependent on the price
transparency of the asset, liability or market and the nature of the asset or
liability.  We have categorized our financial assets and liabilities
that are recurring, at fair value into a three-level hierarchy in accordance
with these provisions.








F-10




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008








Goodwill and Other
Intangibles





Goodwill
represents the excess of the cost of businesses acquired over fair value or net
identifiable assets at the date of acquisition.  Goodwill is subject
to a periodic impairment assessment by applying a fair value test based upon a
two-step method.  The first step of the process compares the fair
value of the reporting unit with the carrying value of the reporting unit,
including any goodwill.  We utilize a discounted cash flow valuation
methodology to determine the fair value of the reporting unit.  If the
fair value of the reporting unit exceeds the carrying amount of the reporting
unit, goodwill is deemed not to be impaired in which case the second step in the
process is unnecessary.  If the carrying amount exceeds fair value, we
perform the second step to measure the amount of impairment loss.  Any
impairment loss is measured by comparing the implied fair value of goodwill with
the carrying amount of goodwill at the reporting unit, with the excess of the
carrying amount over the fair value recognized as an impairment
loss.





Long-Lived
Assets





We review
long-lived assets for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable in
accordance with ASC 360-10 (formerly Statement of Financial Accounting Standards
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets). Recoverability is measured by comparison of the
carrying amount to the future net cash flows which the assets are expected to
generate.  If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the projected discounted future cash flows arising
from the asset using a discount rate determined by management to be commensurate
with the risk inherent to our current business model.





Inventories





Inventories
consist of Telkonet Series 5TM products and the Telkonet iWire SystemTM, which the
primary components are Gateways, Extenders, iBridges and Couplers, and the
primary components of the Telkonet SmartEnergyTM (TSE) and the Networked Telkonet
SmartEnergyTM (NTSE) product suites, which are thermostats, sensors and
controllers.  Inventories are stated at the lower of cost or market
determined by the first in, first out (FIFO) method.





Investments





Telkonet
maintained investments in two publicly-traded companies during the year ended
December 31, 2009.  The Company classified these securities as
available for sale.  Such securities are carried at fair market
value.  Unrealized gains and losses on these securities, if any, are
reported as accumulated other comprehensive income (loss), which is a separate
component of stockholders’ equity.  Unrealized gains on the sale of
one investment resulted in a gain of $32,750 recorded for the year ended
December 31, 2009 and an unrealized loss of $32,750 was recorded for the year
ended December 31, 2008.  Realized gains and losses and declines in
value judged to be other than temporary on securities available for sale, if
any, are included in operations.   Realized losses of $397,024 were
recognized for the year ended December 31, 2009, of which, a $29,371 loss was
recorded in February 2009 for the sale of the Company’s remaining investment in
Multiband, and a $367,653 loss was recorded in September 2009 for the write-off
of the Company’s remaining investment in Geeks on Call America,
Inc.  A realized loss of $4,098,514 was recorded for the write-down of
the Company’s investment in Geeks on Call America, Inc. and a loss of $6,500 was
recognized for the sale of a portion of the Company’s investment in Multiband,
during the year ended December 31, 2008.





Deferred Financing
Costs





Deferred
financing costs are being amortized under the straight-line method over the
terms of the related indebtedness, which approximates the effective interest
method and is included in interest expense in the accompanying consolidated
statements of operations.








F-11







TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008




Income
Taxes





The
Company accounts for income taxes in accordance with FASB ASC 740-10 “Income
Taxes.” Under this method, deferred taxes (when required) are provided based on
the difference between the financial reporting and income tax bases of assets
and liabilities and net operating losses at the statutory rates enacted for
future periods. The Company has a policy of establishing a valuation allowance
when it is more likely than not that the Company will not realize the benefits
of its deferred tax assets in the future.





In June
2006, the FASB issued FASB ASC 740-10-25, which prescribes a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. ASC
740-10-25 also provides guidance on derecognition, classification, treatment of
interest and penalties, and disclosure of such positions. Effective
January 1, 2007, the Company adopted the provisions of ASC 740-10-25, as
required. As a result of implementing ASC 740-10-25, there has been no
adjustment to the Company’s financial statements and the adoption of ASC
740-10-25 did not have a material effect on the Company’s consolidated financial
statements for the years ended December 31, 2009 and 2008.




Net Income (Loss) per Common
Share




The
Company computes earnings per share under Accounting Standards Codification
subtopic 260-10, Earnings Per Share (“ASC 260-10”).  Basic net income
(loss) per common share is computed by dividing net loss by the weighted average
number of shares of common stock.  Diluted earnings per share is computed
using the weighted average number of common and common stock equivalent shares
outstanding during the period.  Dilutive common stock equivalents
consist of shares issuable upon conversion of convertible notes and the exercise
of the Company's stock options and warrants.
 
 For the
year ended December 31, 2009, the dilutive income per share includes the dilutive effect of
shares issuable upon conversion of convertible notes.  For the year
ended December 31, 2009, outstanding stock options and warrants were excluded
from the dilutive common stock equivalents since their exercise prices were
greater than the average market price during the year.
 
 During
2008, common stock equivalents are not considered in the calculation of the
weighted average number of common shares outstanding because they would be
anti-dilutive, thereby decreasing the net loss per common
share.





Use of
Estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect certain reported amounts and disclosures. Accordingly, actual results
could differ from those estimates.





Revenue
Recognition





For
revenue from product sales, we recognize revenue in accordance with FASB’s
Accounting Standards Codification, or ASC, 605-10, and ASC Topic 13 guidelines
that require that four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred; (3) the selling price is fixed and determinable; and (4)
collectability is reasonably assured.  Determination of criteria (3)
and (4) are based on management’s judgments regarding the fixed nature of the
selling prices of the products delivered and the collectability of those
amounts.  Provisions for discounts and rebates to customers, estimated
returns and allowances, and other adjustments are provided for in the same
period the related sales are recorded.  We defer any revenue for which
the product has not been delivered or is subject to refund until such time that
we and the customer jointly determine that the product has been delivered or no
refund will be required.  The guidelines also address the accounting
for arrangements that may involve the delivery or performance of multiple
products, services and/or rights to use assets.





For
equipment under lease, revenue is recognized over the lease term for operating
lease and rental contracts. All of the Company’s leases are accounted for as
operating leases. At the inception of the lease, no lease revenue is recognized
and the leased equipment and installation costs are capitalized and appear on
the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of
this equipment is depreciated from two to three years, on a straight-line basis
down to the Company’s original estimate of the projected value of the equipment
at the end of the scheduled lease term. Monthly lease payments are recognized as
rental income.





Revenue
from sales-type leases for EthoStream products is recognized at the time of
lessee acceptance, which follows installation. The Company recognizes revenue
from sales-type leases at the net present value of future lease payments.
Revenue from operating leases is recognized ratably over the lease
period






F-12




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Guarantees and Product
Warranties





Accounting
Standards Codification subtopic 460-10, Guarantees (“ASC 460-10”), requires that
upon issuance of a guarantee, the guarantor must disclose and recognize a
liability for the fair value of the obligation it assumes under that
guarantee.





The
Company’s guarantees were issued subject to the recognition and disclosure
requirements of ASC 460-10 as of December 31, 2009 and 2008. The Company records
a liability for potential warranty claims. The amount of the liability is based
on the trend in the historical ratio of claims to sales, the historical length
of time between the sale and resulting warranty claim, new product introductions
and other factors. The products sold are generally covered by a warranty for a
period of one year. In the event the Company determines that its current or
future product repair and replacement costs exceed its estimates, an adjustment
to these reserves would be charged to earnings in the period such determination
is made. During the year ended December 31, 2009 and 2008, the Company
experienced approximately three percent of units returned. As of December 31,
2009 and 2008, the Company recorded warranty liabilities in the amount of
$104,917 and $146,951, respectively, using this experience factor.





Advertising





The
Company follows the policy of charging the costs of advertising to expenses
incurred. The Company incurred $4,735 and $92,410 in advertising costs during
the years ended December 31, 2009 and 2008, respectively.





Research and
Development





The
Company accounts for research and development costs in accordance with the
Accounting Standards Codification subtopic 730-10, Research and Development
(“ASC 730-10”). Under ASC 730-10, all research and development costs must be
charged to expense as incurred. Accordingly, internal research and development
costs are expensed as incurred. Third-party research and development costs are
expensed when the contracted work has been performed or as milestone results
have been achieved. Company-sponsored research and development costs related to
both present and future products are expensed in the period incurred. Total
expenditures on research and product development for 2009 and 2008 were
$1,080,148 and $2,036,129, respectively.





Comprehensive
Income





The
Company adopted Statement of Accounting Standards Codification subtopic 220-10,
Comprehensive Income (“ASC 220-10”). ASC 220-10 establishes standards for the
reporting and displaying of comprehensive income and its components.
Comprehensive income is defined as the change in equity of a business during a
period from transactions and other events and circumstances from non-owners
sources. It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners. ASC 220-10
requires other comprehensive income (loss) to include foreign currency
translation adjustments and unrealized gains and losses on available for sale
securities.





Non-controlling
Interest





As a
result of adopting FASB ASC 810-10 Consolidations – Variable Interest Entities,
on January 1, 2009, we present non-controlling interests (previously shown as
minority interest) as a component of equity on our Consolidated Balance Sheets
and Consolidated Statement of Equity.  The adoption of this guidance
did not have any other material impact on our financial position, results of
operations or cash flow.





Segment
Information




Operating
segments are defined as components of an enterprise for which separate financial
information is available and evaluated regularly by the chief operating decision
maker, or decision making group, in deciding the method to allocate resources
and assess performance. With the exception to the discontinued operations of
MST, the Company has one reportable segment for financial reporting purposes,
which represents our core business.  The Company’s management makes
financial decisions and allocates resources based on the information it receives
from its internal management system. The Company’s management relies on the
internal management system to provide sales, cost and asset information for the
business as a whole.





Stock Based
Compensation





We
account for our stock based awards in accordance with Accounting Standards
Codification subtopic 718-10, Compensation (“ASC 718-10”), which requires a fair
value measurement and recognition of compensation expense for all share-based
payment awards made to our employees and directors, including employee stock
options and restricted stock awards.






F-13





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





We
estimate the fair value of stock options granted using the Black-Scholes
valuation model. This model requires us to make estimates and assumptions
including, among other things, estimates regarding the length of time an
employee will retain vested stock options before exercising them, the estimated
volatility of our common stock price and the number of options that will be
forfeited prior to vesting. The fair value is then amortized on a straight-line
basis over the requisite service periods of the awards, which is generally the
vesting period. Changes in these estimates and assumptions can materially affect
the determination of the fair value of stock-based compensation and
consequently, the related amount recognized in our consolidated statements of
operations.





The
expected term of the options represents the estimated period of time until
exercise and is based on historical experience of similar awards, giving
consideration to the contractual terms, vesting schedules and expectations of
future employee behavior. For 2008 and prior years, expected stock price
volatility is based on the historical volatility of the Company’s stock for the
related vesting periods.





Stock-based
compensation expense for the years ended December 31, 2009 and 2008 was $226,842
and $699,639, respectively, net of tax effect.





Reclassifications





Certain
reclassifications have been made in prior year's financial statements to conform
to classifications used in the current year.





NOTE B -NEW ACCOUNTING PRONOUNCEMENTS





In
January 2010, the FASB issued FASB ASU 2010-06, “Improving Disclosures about Fair
Value Measurements”, which clarifies certain existing disclosure
requirements in ASC 820 as well as requires disclosures related to significant
transfers between each level and additional information about Level 3 activity.
FASB ASU 2010-06 begins phasing in the first fiscal period after December 15,
2009. The Company is currently assessing the impact on its consolidated results
of operations and financial condition.





In
January 2010, the FASB issued Update No. 2010-05 “Compensation—Stock
Compensation—Escrowed Share Arrangements and Presumption of Compensation”
(“2010-05”). 2010-05 re-asserts that the Staff of the Securities Exchange
Commission (the “SEC Staff”) has stated the presumption that for certain
shareholders escrowed shareS represent a compensatory arrangement. 2010-05
further clarifies the criteria required to be met to establish a position
different from the SEC Staff’s position. The Company does not have any escrowed
shares held at this time. As such, the Company does not believe this
pronouncement will have any material impact on its financial position, results
of operations or cash flows.





In
January 2010, the FASB issued Update No. 2010-04 “Accounting for Various
Topics—Technical Corrections to SEC Paragraphs” (“2010-04”). 2010-04
represents technical corrections to SEC paragraphs within various sections of
the Codification. Management is currently evaluating whether these changes will
have any material impact on its financial position, results of operations or
cash flows.





In
January 2010, the FASB issued Update No. 2010-02 “Accounting and Reporting for
Decreases in Ownership of a Subsidiary—a Scope Clarification” (“2010-02”)
an update of ASC 810 “Consolidation.” 2010-02 clarifies the scope of ASC 810
with respect to decreases in ownership in a subsidiary to those of a: subsidiary
or group of assets that are a business or nonprofit, a subsidiary that is
transferred to an equity method investee or joint venture, and an exchange of a
group of assets that constitutes a business or nonprofit activity to a
non-controlling interest including an equity method investee or a joint venture.
Management does not expect adoption of this standard to have any material impact
on the Company’s financial position, results of operations or operating cash
flows.





In
January 2010, the FASB issued Update No. 2010-01 “Accounting for Distributions
to Shareholders with Components of Stock and Cash—a consensus of the FASB
Emerging Issues Task Force” (“2010-03”) an update of ASC 505 “Equity.” 2010-03
clarifies the treatment of stock distributions as dividends to shareholders and
their affect on the computation of earnings per shares. The Company has not and
does not intend to declare dividends for preferred to common stock holders.
Management does not expect adoption of this standard to have any material impact
on the Company’s financial position, results of operations or operating cash
flows.








F-14







TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





FASB ASC
TOPIC 860 - "Accounting for
Transfer of Financial Assets and Extinguishment of Liabilities." In June
2009, the FASB issued additional guidance under Topic 860 which improves the
relevance, representational faithfulness, and comparability of the information
that a reporting entity provides in its financial statements about a transfer of
financial assets; the effects of a transfer on its financial position, financial
performance, and cash flows; and a transferor's continuing involvement, if any,
in transferred financial assets. This additional guidance requires that a
transferor recognize and initially measure at fair value all assets obtained
(including a transferor's beneficial interest) and liabilities incurred as a
result of a transfer of financial assets accounted for as a sale. Enhanced
disclosures are required to provide financial statement users with greater
transparency about transfers of financial assets and a transferor's continuing
involvement with transferred financial assets. This additional guidance must be
applied as of the beginning of each reporting entity's first annual reporting
period that begins after November 15, 2009, for interim periods within that
first annual reporting period and for interim and annual reporting periods
thereafter. Earlier application is prohibited. This additional guidance must be
applied to transfers occurring on or after the effective date. The adoption of
this Topic is not expected to have a material impact on the Company's financial
statements and disclosures.





In
October 2009, the FASB issued FASB ASU No. 2009-13, Revenue Recognition (Topic
605): “Multiple Deliverable
Revenue Arrangements – A Consensus of the FASB Emerging Issues Task
Force.” This standard provides application guidance on whether multiple
deliverables exist, how the deliverables should be separated and how the
consideration should be allocated to one or more units of accounting. This
update establishes a selling price hierarchy for determining the selling price
of a deliverable. The selling price used for each deliverable will be based on
vendor-specific objective evidence, if available, third-party evidence if
vendor-specific objective evidence is not available, or estimated selling price
if neither vendor-specific or third-party evidence is available. ASU 2009-13 may
be applied retrospectively or prospectively for new or materially modified
arrangements in fiscal years beginning on or after June 15, 2010, with early
adoption permitted.  The Company is currently assessing the impact on
its consolidated financial position and results of operations





In
October 2009, the FASB issued ASC 985-605, “Software Revenue
Recognition.” This ASC changes the accounting model for revenue
arrangements that include both tangible products and software elements that are
“essential to the functionality,” and scopes these products out of current
software revenue guidance. The new guidance will include factors to help
companies determine what software elements are considered “essential to the
functionality.” The amendments will now subject software-enabled products to
other revenue guidance and disclosure requirements, such as guidance surrounding
revenue arrangements with multiple-deliverables. The amendments in this ASC are
effective prospectively for revenue arrangements entered into or materially
modified in the fiscal years beginning on or after June 15, 2010. Early
application is permitted. The Company is currently assessing the impact on its
consolidated financial position and results of operations





In
February 2010, the FASB issued FASB ASU 2010-09, Subsequent Events, Amendments to
Certain Recognition and Disclosure Requirements, which clarifies certain
existing evaluation and disclosure requirements in ASC 855 related to subsequent
events. FASB ASU 2010-09 requires SEC filers to evaluate subsequent events
through the date in which the financial statements are issued and is effectively
immediately. The new guidance does not have an effect on the Company’s
consolidated results of operations and financial condition.





Management
does not believe that any other recently issued, but not yet effective,
accounting standards if currently adopted would have a material effect on the
accompanying financial statements.





NOTE
C - INTANGIBLE ASSETS AND GOODWILL





Total
identifiable intangible assets acquired and their carrying values at December
31, 2008 are:





Gross
              Carrying
              Amount
            
            
            Accumulated
      Amortization/
              Impairment
            
            
            Net
            
            
            Residual
              Value
            
            
            Weighted
              Average
              Amortization
              Period
      (Years)Amortized
      Identifiable Intangible Assets: EthoStream subscriber
      lists
            
            $
            2,900,000
            
            
            $
            (432,986
            )
            
            $
            2,467,014
            
            
            
            -
            
            
            
            12.0Total
      Amortized identifiable Intangible Assets
            
            2,900,000
            
            
            
            (432,986)
            
            
            
            2,467,014
            
            
            
            
            
            
            
            12.0Goodwill
      - EthoStream
            
            8,796,439
            
            
            
            (2,000,000
            )
            
            
            6,796,439
            
            
            
            -Goodwill
      - SSI
            
            5,874,016
            
            
            
            -
            
            
            
            5,874,016
            
            
            
            -Total
            
            $
            17,570,455
            
            
            $
            (2,432,986
            )
            
            $
            15,137,469
            
            
            $
            -









F-15


TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Total
identifiable intangible assets acquired and their carrying values at December
31, 2009 are:


Gross
              Carrying
              Amount
            
            
            Accumulated
      Amortization/
              Impairment
            
            
            Net
            
            
            Residual
              Value
            
            
            Weighted
              Average
              Amortization
              Period
      (Years)Intangible
      Assets and Goodwill:Amortized
      Identifiable Intangible Assets: EthoStream subscriber
      lists
            
            $
            2,900,000
            
            
            $
            (674,663
            )
            
            $
            2,225,337
            
            
            $
            -
            
            
            
            12.0Total
      Amortized identifiable Intangible Assets
            
            2,900,000
            
            
            
            (674,663)
            
            
            
            2,225,337
            
            
            
            
            
            
            
            12.0Goodwill
      - EthoStream
            
            8,796,439
            
            
            
            (3,000,000
            )
            
            
            5,796,439
            
            
            
            -Goodwill
      - SSI
            
            5,874,016
            
            
            
            -
            
            
            
            5,874,016
            
            
            
            -Total
            
            $
            17,570,455
            
            
            $
            (3,674,663
            )
            
            $
            13,895,792
            
            
            $
            -





Total
amortization expense charged to operations for the year ended December 31,
2009 and 2008 was $241,677 and $241,666, respectively. Estimated amortization
expense as of December 31, 2009 is as follows:





Years
      Ended December 31,2010
            
            $
            241,6672011
            
            
            241,6672012
            
            
            241,6672013
            
            
            241,6672014
      and after
            
            
            1,258,670Total
            
            $
            2,225,337





The
Company does not amortize goodwill. The Company recorded goodwill in the amount
of $14,670,455 as a result of the acquisitions of EthoStream and SSI during the
year ended December 31, 2007.   The Company evaluates goodwill
for impairment based on the fair value of the operating business units to which
this goodwill relates at least once a year. The Company generally determines the
fair value of a reporting unit using a combination of the income approach, which
is based on the present value of estimated future cash flows, and the market
approach, which compares the business unit's multiples to its competitors. At
December 31, 2009 and 2008, the Company has determined that a portion of the
value of EthoStream’s goodwill has been impaired based upon management’s
assessment of operating results and forecasted discounted cash flow and has
written off $1,000,000 and $2,000,000, respectively, of its
value.  During the year ended December 31, 2008, the Company recorded
a goodwill impairment charge, included in discontinued operations, of $380,000
related to the additional shares issued upon the release of the purchase price
contingency escrow with the MSTI acquisition.





The
estimated fair value of our goodwill could change if the Company is unable to
achieve operating results at the levels that have been forecasted, the market
valuation of our business decreases based on transactions involving similar
companies, or there is a permanent, negative change in the market demand for the
services offered by the Company. These changes could result in a further
impairment of the existing goodwill balance that could require a material
non-cash charge to our results of operations.





NOTE
D - ACCOUNTS RECEIVABLE





Components
of accounts receivable as of December 31, 2009 and 2008 are as
follows:





2009
            
            
            2008Accounts
      receivable  (factored)
            
            $
            736,781
            
            
            $
            1,961,535Advances
      from factor
            
            
            (462,957
            )
            
            
            (1,075,879
            )Due
      from factor
            
            
            273,824
            
            
            
            885,656Accounts
      receivable  (non-factored)
            
            
            152,860
            
            
            
            127,080Allowance
      for doubtful accounts
            
            
            (175,000
            )
            
            
            (176,400
            )Total
            
            $
            251,684
            
            
            $
            836,336








F-16





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





In
February 2008, the Company entered into a factoring agreement to sell, without
recourse, certain receivables to an unrelated third party financial institution
in an effort to accelerate cash flow.  Under the terms of the
factoring agreement the maximum amount of outstanding receivables at any one
time is $2.5 million.  Proceeds on the transfer reflect the face value
of the account less a discount.  The discount is recorded as interest
expense in the Consolidated Statement of Operations in the period of the
sale.  Net funds received reduced accounts receivable outstanding
while increasing cash.  Fees paid pursuant to this arrangement are
included in “Financing expense” in the Consolidated Statement of Operations and
amounted to $197,570 for the year ended December 31, 2009. The amounts borrowed
are collateralized by the outstanding accounts receivable, and are reflected as
a reduction to accounts receivable in the accompanying consolidated balance
sheets.





NOTE
E - INVENTORIES





Components
of inventories as of December 31, 2009 and 2008 are as follows:





2009
            
            
            2008Raw
      Materials
            
            $
            540,434
            
            
            $
            843,978Finished
      Goods
            
            
            566,149
            
            
            
            1,089,962Reserve
      for Obsolescence
            
            
            (200,000
            )
            
            
            (200,000
            )Total
            
            $
            906,583
            
            
            $
            1,733,940





NOTE F -
OTHER CURRENT ASSETS





Components
of other current assets as of December 31, 2009 and 2008 are as
follows:





2009
            
            
            2008Investment
      in sales-type lease - current
            
            $
            899
            
            
            $
            10,270Prepaid
      expenses and deposits
            
            
            246,037
            
            
            
            220,269Total
            
            $
            246,936
            
            
            $
            230,539





EthoStream,
LLC’s net investment in sales-type leases, included in other assets, as of
December 31, 2009 and 2008 consists of the following:





2009
            
            
            2008Total
      Minimum Lease Payments to be Received
            
            $
            912
            
            
            $
            11,709Less:
      Unearned Interest Income
            
            
            (13
            )
            
            
            (540
            )Net
      Investment in Sales-Type Leases
            
            
            899
            
            
            
            11,169Less:
      Current Maturities
            
            
            (899
            )
            
            
            (10,270
            )Non-Current
      Portion
            
            $
            -
            
            
            $
            899





Aggregate
future minimum lease payments to be received under the above leases are as
follows as of December 31, 2009:





2010
            
            
            9122011
            
            
            -2012
            
            
            -$
            912








F-17





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE G
- PROPERTY AND EQUIPMENT





The
Company’s property and equipment at December 31, 2009 and 2008 consists of the
following:





2009
            
            
            2008Telecommunications
      and related equipment
            
            
            117,637
            
            
            
            117,493Development
      Test Equipment
            
            
            153,487
            
            
            
            153,484Computer
      Software
            
            
            160,894
            
            
            
            160,894Leasehold
      Improvements
            
            
            228,017
            
            
            
            248,778Office
      Equipment
            
            
            371,251
            
            
            
            382,851Office
      Fixtures and Furniture
            
            
            246,298
            
            
            
            265,318Total
            
            
            1,277,584
            
            
            
            1,328,818Accumulated
      Depreciation
            
            
            (1,023,085
            )
            
            
            (925,225
            )$
            254,499
            
            
            $
            403,593





Depreciation
expense included as a charge to income was $106,513 and $90,364 for December 31,
2009 and 2008 respectively.





NOTE H -
MARKETABLE SECURITIES





Geeks on Call America,
Inc.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares was subject to adjustment on the date the
Company filed a registration statement for the shares issued in this
transaction, which occurred on April 25, 2008. The increase or decrease to the
number of shares issued was determined using a per share price equal to the
average closing price of the Company’s common stock on the AMEX during the ten
trading days immediately preceding the date the registration statement was
filed.  The Company accounted for this investment under the cost
method, as the Company does not have the ability to exercise significant
influence over operating and financial policies of GOCA.  On April 30,
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of GOCA to satisfy the adjustment provision.





On
February 8 2008, Geeks on Call Acquisition Corp., a newly formed, wholly-owned
subsidiary of Geeks On Call Holdings, Inc., (formerly Lightview, Inc.) merged
with Geeks on Call America, Inc (“GOCA”). As a result of the merger, the
Company’s common stock in GOCA was exchanged for shares of common stock of Geeks
on Call Holdings Inc.  Immediately following the merger, Geeks on Call
Holdings Inc. completed a private placement of its common stock for aggregate
gross proceeds of $3,000,000. As a result of this transaction, the Company’s 30%
interest in GOCA became an 18% interest in Geeks on Call Holdings
Inc.  The Company has determined that its investment in GOCA is
impaired because it believes that the fair market value of GOCA has permanently
declined.   Accordingly, the Company wrote-off $4,098,514 during
the year ended December 31 2008.   The remaining value of this
investment, which amounted to $367,653 was determined to be permanently impaired
and therefore was completely written off during the year ended December 31,
2009.





Multiband
Corporation





In
connection with a payment of $75,000 of accounts receivable, the company
received 30,000 shares of common stock of Multiband Corporation, a
Minnesota-based communication services provider to multiple dwelling
units.  The Company classifies this security as available for sale,
and is carried at fair market value.  During the year ended December
31, 2008, the Company recorded a loss of $6,500 on the sale of 5,000 shares of
its investment in Multiband.  In addition, the Company recorded an
unrealized loss of $32,750 due to a temporary decline in value of this
security.  The remaining value of this investment amounted to $29,750
as of December 31, 2008.  The Company sold its remaining investment in
Multiband and recorded a loss of $29,371 in January 2009.






F-18




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE I -
OTHER LONG TERM ASSETS





Components
of other long term assets as of December 31, 2009 and 2008 are as
follows:





2009
            
            
            2008Long-term
      investments – Amperion, Inc.
            
            $
            8,000
            
            
            $
            8,000Investments
      in sales-type leases – non current
            
            
            -
            
            
            
            899Deposits
      and other
            
            
            -
            
            
            
            89,908Total
            
            $
            8,000
            
            
            $
            98,807





On
November 30, 2004, the Company entered into a Stock Purchase Agreement
(“Agreement”) with Amperion, Inc. ("Amperion"), a privately held company.
Amperion is engaged in the business of developing networking hardware and
software that enables the delivery of high-speed broadband data over
medium-voltage power lines. Pursuant to the Agreement, the Company invested
$500,000 in Amperion in exchange for 11,013,215 shares of Series A Preferred
Stock for an equity interest of approximately 0.8%. The Company accounted for
this investment under the cost method, as the Company does not have the ability
to exercise significant influence over operating and financial policies of the
investee. The carrying value of the Company’s investment in Amperion is
$8,000 at December 31, 2009 and 2008.





NOTE J
- ACCOUNTS PAYABLE AND ACCRUED LIABILITIES





Accounts
payable and accrued liabilities at December 31, 2009 and 2008 are as
follows:





2009
            
            
            2008Accounts
      payable
            
            $
            2,866,120
            
            
            $
            2,561,213Accrued
      expenses and liabilities
            
            
            1,101,036
            
            
            
            826,276Accrued
      payroll and payroll taxes
            
            
            1,042,268
            
            
            
            832,593Accrued
      interest
            
            
            23,617
            
            
            
            190,224Warranty
            
            
            104,917
            
            
            
            146,951Total
            
            $
            5,137,958
            
            
            $
            4,557,257








F-19





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE K -
LINE OF CREDIT





In
September 2008, the Company entered into a two-year line of credit facility with
Thermo Credit LLC, a third party financial institution.  The line of
credit has an aggregate principal amount of $1,000,000 and is secured by the
Company’s inventory.  The outstanding principal balance bears interest
at the greater of (i) the Wall Street Journal Prime Rate plus nine (9%) percent
per annum, adjusted on the date of any change in such prime or base rate, or
(ii) Sixteen percent (16%).  Interest, computed on a 365/360 simple
interest basis, and fees on the credit facility are payable monthly in arrears
on the last day of each month and continuing on the last day of each month until
the maturity date.  The Company may prepay amounts outstanding under
the credit facility in whole or in part at any time.  In the event of
such prepayment, the lender will be entitled to receive a prepayment fee of four
percent (4.0%) of the highest aggregate loan commitment amount if prepayment
occurs before the end of the first year and three percent (3.0%) if prepayment
occurs thereafter.  The outstanding borrowing under the agreement at
December 31, 2009, and 2008, was $387,000 and $574,005,
respectively.  The Company has incurred interest expense of $131,538
related to the line of credit for the year ended December 31, 2009. The Prime
Rate was 3.25% at December 31, 2009.





On March
24, 2010, the Company received a notice of waiver from Thermo Credit LLC on the
cash flow to debt service ratio and tangible net worth requirement, as such
terms are defined in items D(10)a and D(10)b of the line of credit
agreement.  The waiver is in effect as of December 31, 2009 and for
the 90 day period thereafter.





NOTE L
- SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE





Senior Convertible
Debenture





A summary
of convertible debentures payable at December 31, 2009 and December 31, 2008 is
as follows:





December
      31, 2009
            
            
            December
      31, 2008Senior
      Convertible Debentures, accrue interest at 13% per annum and mature on May
      29, 2011
            
            $
            1,606,023
            
            
            $
            2,136,650Debt
      Discount - beneficial conversion feature, net of accumulated amortization
      of $558,256 and $295,508 at December 31, 2009 and December 31, 2008,
      respectively.
            
            
            (248,633
            )
            
            
            (425,458
            )Debt
      Discount - value attributable to warrants attached to notes, net of
      accumulated amortization of $469,113 and $277,913 at December 31, 2009 and
      December 31, 2008, respectively.
            
            
            (208,927
            )
            
            
            (400,127
            )Total
            
            $
            1,148,463
            
            
            $
            1,311,065Less:
      current portion
            
            
            -
            
            
            
            -$
            1,148,463
            
            
            $
            1,311,065








F-20





TELKONET, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





On May
30, 2008, the Company entered into a Securities Purchase Agreement with YA
Global Investments, L.P. (the “Buyer”) pursuant to which the Company agreed to
issue and sell to the Buyer up to $3,500,000 of secured convertible debentures
(the “Debentures”) and warrants to purchase (the “Warrants”) up to 2,500,000
shares of the Company’s Common Stock, par value $0.001 per share (the “Common
Stock”).  The sale of the Debentures and Warrants was effectuated in
three separate closings, the first of which occurred on May 30, 2008, and the
remainder of which occurred in June 2008.  At the May 30, 2008
closing, the Company sold Debentures having an aggregate principal value of
$1,500,000 and Warrants to purchase 2,100,000 shares of Common
Stock.  In July 2008, the Company sold the remaining Debentures having
an aggregate principal value of $2,000,000 and Warrants to purchase 400,000
shares of Common Stock.





During
the year ended December 31, 2009, $722,514 of the principal value of the
debentures was converted into 8,174,943 shares of common
stock.  Accordingly, as of December 31, 2009, the Company has
$1,606,023 outstanding in convertible debentures.





The
Debentures accrue interest at a rate of 13% per annum and mature on May 29,
2011.  The Debentures may be redeemed at any time, in whole or in
part, by the Company upon payment by the Company of a redemption premium equal
to 15% of the principal amount of Debentures being redeemed, provided that an
Equity Conditions Failure (as defined in the Debentures) is not occurring at the
time of such redemption.  The Buyer may also convert all or a portion
of the Debentures at any time at a price equal to the lesser of (i) $0.58, or
(ii) ninety percent (90%) of the lowest volume weighted average price of the
Company’s Common Stock during the ten (10) trading days immediately preceding
the conversion date.  The Warrants expire five years from the date of
issuance and entitle the Buyers to purchase shares of the Company’s Common Stock
at a price per share of $0.61.





In
November 2009, the Company re-priced all of the outstanding warrants issued to
YA Global Investments LP to $0.33 per share and issued additional warrants
pursuant to anti-dilution provisions in the YA Global warrant agreements which
were triggered by the completion of the Series A preferred stock private
placement on November 19, 2009.  The warrants entitled the holders to
purchase up to 2,121,212 shares of the Company’s common stock at a price per
share of $0.33.    The Company valued the warrants at $510,151
using the Black-Scholes pricing model and the following assumptions: contractual
term of 5 years, an average risk-free interest rate of 2.2% a dividend yield of
0% and volatility of 123%.





The
Debenture meets the definition of a hybrid instrument, as defined in ASC Topic
815 “Derivatives and
Hedging”. The hybrid instrument is comprised of a i) a debt instrument,
as the host contract and ii) an option to convert the debentures into common
stock of the Company, as an embedded derivative. The embedded derivative derives
its value based on the underlying fair value of the Company’s common stock. The
Embedded Derivative is not clearly and closely related to the underlying host
debt instrument since the economic characteristics and risk associated with this
derivative are based on the common stock fair value.





The
embedded derivative does not qualify as a fair value or cash flow hedge under
ASC 815. Accordingly, changes in the fair value of the embedded derivative are
immediately recognized in earnings and classified as a gain or loss on the
embedded derivative financial instrument in the accompanying statements of
operations. There was a gain of $777,750 recognized for the year ended December
31, 2009 and a loss of 1,174,121 for the year ended December 31,
2008.





The
Company determines the fair value of the embedded derivatives and records them
as a discount to the debt and a derivative liability on the date of issue. The
Company recognizes an immediate financing expense for any excess in the fair
value of the derivatives over the debt amount.  Upon conversion of the
debt to equity, any remaining unamortized discount is charged to financing
expense.





The
Company amortized the beneficial conversion feature and the value of the
attached warrants, and recorded non-cash interest expense in the amount of
$453,948, and $573,421, respectively, for the year ended December 31, 2009 and
2008.





At
December 31, 2009, the Senior Convertible Debenture had an estimated fair value
of $1.6 million.








F-21





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Senior Note
Payable





On July
24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ
Consultants, Inc. (“GRQ”) pursuant to which the Company issued to GRQ a Senior
Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000.
The Note was due and payable on the earlier to occur of (i) the closing of
the Company’s next financing, or (ii) January 28, 2008, and bore interest
at a rate of nine (6%) percent per annum. The Company incurred
approximately $25,000 in fees in connection with this transaction. The net
proceeds from the issuance of the Note were for general working capital
needs.  On February 8, 2008, this note was repaid in full including
$49,750 in accrued but unpaid interest from the issuance date through the date
of repayment.





In
connection with the issuance of the Note, the Company also issued to GRQ
warrants to purchase 359,712 shares of common stock at $4.17 per share. These
warrants expire five years from the date of issuance. The Company valued the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 4.00%, a
dividend yield of 0%, and volatility of 76%. The $195,924 of debt discount
attributed to the value of the warrants issued is amortized over the note
maturity period (six months) as non-cash interest expense. The Company amortized
the value of the attached warrants, and recorded non-cash interest expense in
the amount of $29,180, respectively, during the year ended December 31,
2008.





Business
Loan





On
September 11, 2009, the Company entered into a Loan Agreement in the
aggregate principal amount of $300,000 with the Wisconsin Department of Commerce
(the “Department”).  The outstanding principal balance bears interest
at the annual rate of two (2.00) percent. Payment of interest and principal is
to be made in the following manner:   (a) payment of any and all
interest that accrues from the date of disbursement commences on January 1, 2010
and continues on the first day of each consecutive month thereafter through and
including December 31, 2010; (b) commencing on January 1, 2011 and continuing on
the first day of each consecutive month thereafter through and including
November 1, 2016, the Company shall pay equal monthly installments of $4,426
each; followed by a final installment on December 1, 2016 which shall include
all remaining principal, accrued interest and other amounts owed by the Company
to the Department under the Loan Agreement.  The Company may prepay
amounts outstanding under the credit facility in whole or in part at any time
without penalty.  The credit facility is secured by the Company’s
assets and the proceeds from this loan were used for the working capital
requirements of the Company.  The outstanding borrowing under the
agreement at December 31, 2009 was $300,000.





Aggregate
maturities of long-term debt as of December 31, 2009 are as
follows:





For the twelve months
      ended December 31,
            
            Amount2010
            
            $
            -2011
            
            
            1,653,5292012
            
            
            48,4652013
            
            
            49,4432014
      and thereafter
            
            
            154,586$
            1,906,023





Note
Payable





On May 6,
2008, Telkonet executed a Promissory Note (the “Note”) in favor of Ralph W.
Hooper (the “Note”) in the aggregate principal amount of Four Hundred Thousand
Dollars ($400,000). The Note was due and payable on the earlier to occur of (i)
the closing of the Company’s next financing, or (ii) November 6, 2008. As of
December 31, 2008, there was no outstanding liability.





In
connection with the issuance of the Note, the Company also issued to Mr. Hooper
warrants to purchase 800,000 shares of common stock at $0.60 per share. These
warrants expire five years from the date of issuance. The Company valued the
warrants using the Black-Scholes pricing model and the following assumptions:
contractual terms of 5 years, an average risk free interest rate of 3.2%, a
dividend yield of 0%, and volatility of 82%. The Company recorded non-cash
interest expense in the amount of $254,160 for the value of the attached
warrants during the year ended December 31, 2008.




F-22







TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
M - REDEEMABLE PREFERRED STOCK





The
Company has designated 215 shares of preferred stock as Series A Preferred Stock
(“Series A”). Each share of Series A shall be convertible, at the option of the
holder thereof, at any time, into shares of our Common Stock at an initial
conversion price of $0.363 per share, subject to adjustmentsfor anti-dilution
provisions.  In the event of a change of control (as defined in the
purchase agreement with respect to the Series A), or at the holder’s option, on
November 19, 2014 and for a period of 180 days thereafter, provided that at
least fifty percent (50%) of the shares of Series A issued on the Series A
Original Issue Date remain outstanding as of November 19, 2014, and the holders
of at least a majority of the then outstanding shares of Series A provide
written notice requesting redemption of all shares of Series A, we are required
to redeem the Series A for the purchase price plus any accrued but unpaid
dividends. The Series A accrues dividends at an annual rate of 8% of the
original purchase price, and shall be payable only when, as, and if declared by
the Board of Directors of Telkonet.





On November 16, 2009, the Company sold
215 shares of Series A with attached warrants to purchase an aggregate of
1,628,800 shares of the Company’s common stock at $0.33 per share.The Series A shares were sold at a
price per share of $5,000 and each Series A share is convertible into
approximately 13,774 shares of common stock at a conversion price of $0.363 per
share. The Company received $1,075,000 from the sale of the Series A
shares.  Since
the Series A may ultimately be redeemable at the option of the holder, the
carrying value of the preferred stock, net of discount and accumulated
dividends, has been classified as temporary equity on the balance sheet at
December 31, 2009.





In
accordance with ASC Topic “Debt”, a portion of the proceeds
were allocated to the warrants based on their relative fair value, which
totaled $287,106 using the Black Scholes option pricing model. Further, the
Company attributed a beneficial conversion feature of $70,922 to the
Series A preferred shares based upon the difference between the effective
conversion price of those shares and the closing price of the Company’s common
stock on the date of issuance. The assumptions used in the Black-Scholes model
are as follows:  (1) dividend yield of 0%; (2) expected
volatility of 123%, (3) weighted average risk-free interest rate
of 2.2%, (4) expected life of 5 years, and (5) estimated fair
value of Telkonet common stock of $0.24 per share. The expected term of the
warrants represents the estimated period of time until exercise and is based on
historical experience of similar awards and giving consideration to the
contractual terms. The amounts attributable to the warrants and beneficial
conversion feature, aggregating $358,028, have been recorded as a discount and
deducted from the face value of the preferred stock. Since the preferred stock
is classified as temporary equity, the discount will be amortized over the
period from issuance to November 19, 2014 (the initial redemption date) as a
charge to additional paid-in capital (since there is a deficit in retained
earnings).





The
charge to additional paid in capital for amortization of discount and costs for
the year ended December 31, 2009 was $5,967.  There was no
amortization of discounts for Series A preferred stock for the year ended
December 31, 2008.





For the
year ended December 31, 2009 we have accrued dividends in the amount of $9,904.
The accrued dividends have been charged to additional paid-in capital (since
there is a deficit in retained earnings) and the net unpaid accrued dividends
been added to the carrying value of the preferred stock. There were no accrued
dividends for Series A preferred stock for the year ended December 31,
2008.








F-23




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE N
- CAPITAL STOCK





The
Company has authorized 15,000,000 shares of preferred stock, with a par value of
$.001 per share. As of December 31, 2009 the Company has 215 shares of preferred
stock issued and outstanding, designated Series A preferred stock. As of
December 31, 2008 the Company had no shares of preferred stock issued and
outstanding. The company has authorized 155,000,000 shares of common stock, with
a par value of $.001 per share. As of December 31, 2009 and 2008, the Company
has 96,563,771 and 87,525,495, respectively, of shares of common stock issued
and outstanding.





In
February 2008, the Company amended certain stock purchase warrants held by
private placement investors to reduce the exercise price under such warrants
from $4.17 per share to $0.6978258 per share.  The warrants entitled
the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet
common stock.   Subsequently, these private placement investors
exercised all of their warrants on a cashless basis using the five day volume
average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the
issuance of 1,000,000 shares of Company common stock.





During
the year ended December 31, 2008, the Company issued 346,244 shares of common
stock to consultants for services performed and services accrued in fiscal
2007.  These shares were valued at $345,407, which approximated the
fair value of the shares issued during the period services were completed and
rendered.





In
February 2008, Telkonet completed a private placement with one investor for
aggregate gross proceeds of $1.5 million.  Pursuant to this private
placement, the Company issued 2,500,000 shares of common stock valued at $0.60
per share.





In April
2008, Telkonet issued an additional 3,046,425 shares of its common stock to the
sellers of Geeks on Call America, Inc. to satisfy the adjustment provision in
the stock purchase agreement dated October 19, 2007.





In June
2008, Telkonet issued an additional 1,882,225 shares of its common stock to the
sellers of Smart Systems International (SSI), to satisfy the adjustment
provision in the purchase agreement dated March 9, 2007.





During
the year ended December 31, 2008, Telkonet issued an aggregate of 600,000 shares
of its common stock to Frank T. Matarazzo pursuant to the stock purchase
agreement between Telkonet and MST, dated January 31, 2006.  These
shares were valued at $380,000, which approximated the fair value of the shares
on the date the shares were issued.





During
the year ended December 31, 2008, Telkonet issued 7,324,057 shares of common
stock at approximately $0.19 per share to its senior convertible debenture
holders in exchange for $1,363,350 of debentures.





During
the year ended December 31, 2009, the Company issued 83,333 shares of common
stock to consultants for services performed and services accrued in fiscal
2008.  These shares were valued at $10,000, which approximated the
fair value of the shares when they were issued.





During
the year ended December 31, 2009, the Company issued 780,000 shares of common
stock at approximately $0.09 per share to warrant holders in exchange for the
exercise of their stock purchase warrants.





During
the year ended December 31, 2009, the Company issued 8,174,943 shares of common
stock at approximately $0.09 per share to its senior convertible debenture
holders in exchange for $722,514 of debentures.





NOTE O
- STOCK OPTIONS AND WARRANTS





Employee Stock
Options





The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to employees of the
Company under a non-qualified employee stock option plan.







F-24





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Options
      Outstanding
            
            
            Options
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
              (Years)
            
            
            Weighted
              Average
              Exercise
              Price
            
            
            Number
              Exercisable
            
            
            Weighted
              Average
              Exercise
              Price$
            1.00
      - $1.99
            
            
            
            4,417,133
            
            
            
            3.93
            
            
            $
            1.02
            
            
            
            4,273,550
            
            
            $
            1.01$
            2.00
      - $2.99
            
            
            
            997,500
            
            
            
            5.48
            
            
            $
            2.52
            
            
            
            957,250
            
            
            $
            2.51$
            3.00
      - $3.99
            
            
            
            536,250
            
            
            
            6.08
            
            
            $
            3.23
            
            
            
            413,500
            
            
            $
            3.28$
            4.00
      - $4.99
            
            
            
            70,000
            
            
            
            5.83
            
            
            $
            4.33
            
            
            
            58,500
            
            
            $
            4.33$
            5.00
      - $5.99
            
            
            
            100,000
            
            
            
            5.57
            
            
            $
            5.17
            
            
            
            88,000
            
            
            $
            5.166,120,883
            
            
            
            4.42
            
            
            $
            1.56
            
            
            
            5,790,800
            
            
            $
            1.52





Transactions
involving stock options issued to employees are summarized as
follows:





Number
      of
              Shares
            
            
            Weighted
              Average
              Price
              Per
      ShareOutstanding
      at January 1, 2008
            
            
            8,105,429
            
            
            $
            1.98Granted
            
            
            185,000
            
            
            
            1.00Exercised
            
            
            -
            
            
            
            -Cancelled
      or expired
            
            
            (1,296,500
            )
            
            
            2.71Outstanding
      at December 31, 2008
            
            
            6,993,929
            
            
            $
            1.82Granted
            
            
            320,000
            
            
            
            1.00Exercised
            
            
            -
            
            
            
            -Cancelled
      or expired
            
            
            (1,193,046
            )
            
            
            2.91Outstanding
      at December 31, 2009
            
            
            6,120,883
            
            
            $
            1.56





The
weighted-average fair value of stock options granted to employees during the
years ended December 31, 2009 and 2008 and the weighted-average significant
assumptions used to determine those fair values, using a Black-Scholes option
pricing model are as follows:





2009
            
            
            2008Significant
      assumptions (weighted-average):Risk-free
      interest rate at grant date
            
            
            3.5
            %
            
            
            2.9
            %Expected
      stock price volatility
            
            
            81
            %
            
            
            78
            %Expected
      dividend payout
            
            
            -
            
            
            
            -Expected
      option life (in years)
            
            
            5.0
            
            
            
            5.0Fair
      value per share of options granted
            
            $
            0.30
            
            
            $
            0.55








F-25





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





The
expected life of awards granted represents the period of time that they are
expected to be outstanding. We determine the expected life based on historical
experience with similar awards, giving consideration to the contractual terms,
vesting schedules, exercise patterns and pre-vesting and post-vesting
forfeitures. We estimate the volatility of our common stock based on the
calculated historical volatility of our own common stock using the trailing 24
months of share price data prior to the date of the award. We base the risk-free
interest rate used in the Black-Scholes-Merton option valuation model on the
implied yield currently available on U.S. Treasury zero-coupon issues with an
equivalent remaining term equal to the expected life of the award. We have not
paid any cash dividends on our common stock and do not anticipate paying any
cash dividends in the foreseeable future. Consequently, we use an expected
dividend yield of zero in the Black-Scholes-Merton option valuation model. We
use historical data to estimate pre-vesting option forfeitures and record
share-based compensation for those awards that are expected to vest. In
accordance with ASC 718-10, we adjust share-based compensation for changes to
the estimate of expected equity award forfeitures based on actual forfeiture
experience.





There
were no options exercised during the years ended December 31, 2009 and
2008.  Additionally, the total fair value of shares vested during the
year ended December 31, 2009 and 2008 was $216,842 and $559,478,
respectively.





Total
stock-based compensation expense recognized in the consolidated statement of
earnings for the year ended December 31, 2009 and 2008 was $235,234 and
$699,639, respectively, net of tax effect. Additionally, the aggregate intrinsic
value of options outstanding and unvested as of December 31, 2009 and 2008 was
$0.





Non-Employee Stock
Options





The
following table summarizes the changes in options outstanding and the related
prices for the shares of the Company’s common stock issued to the Company
consultants.  These options were granted in lieu of cash compensation
for services performed.





Options
      Outstanding
            
            Options
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
      Average
              Remaining
      Contractual
              Life
      (Years)
            
            
            Weighted
      Average
              Exercise
      Price
            
            Number
              Exercisable
            
            Weighted
      Average
              Exercise
      Price$
            1.00
            
            
            
            740,000
            
            
            
            1.56
            
            
            $
            1.00
            
            740,000
            
            $
            1.00







F-26




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Transactions
involving options issued to non-employees are summarized as
follows:





Number
      of
              Shares
            
            
            Weighted
              Average
      Price
              Per
      ShareOutstanding
      at January 1, 2008
            
            
            1,815,937
            
            
            $
            1.00Granted
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2008
            
            
            1,815,937
            
            
            $
            1.00Granted
            
            
            -
            
            
            
            -Exercised
            
            
            -
            
            
            
            -Canceled
      or expired
            
            
            (1,075,937
            )
            
            
            1.00Outstanding
      at December 31, 2009
            
            
            740,000
            
            
            $
            1.00





There
were no non-employee stock options vested during the years ended December
31, 2009 and 2008, respectively.





Warrants





The
following table summarizes the changes in warrants outstanding and the related
prices for the shares of the Company’s common stock issued to non-employees of
the Company.  These warrants were granted in lieu of cash compensation
for services performed or financing expenses and in connection with placement of
convertible debentures.





Warrants
      Outstanding
            
            
            
            
            
            Warrants
      ExercisableExercise
      Prices
            
            
            Number
              Outstanding
            
            
            Weighted
      Average
              Remaining
      Contractual
              Life
      (Years)
            
            
            Weighed
              Average
              Exercise
      Price
            
            
            Number
              Exercisable
            
            
            Weighted
              Average
              Exercise
      Price$
            0.33
            
            
            
            6,326,751
            
            
            
            4.27
            
            
            $
            0.33
            
            
            
            6,326,751
            
            
            $
            0.33$
            0.60
            
            
            
            800,000
            
            
            
            3.35
            
            
            $
            0.60
            
            
            
            800,000
            
            
            $
            0.60$
            1.00
            
            
            
            500,000
            
            
            
            2.00
            
            
            $
            1.00
            
            
            
            500,000
            
            
            $
            1.00$
            2.59
            
            
            
            862,452
            
            
            
            1.62
            
            
            $
            2.59
            
            
            
            862,452
            
            
            $
            2.59$
            3.82
            
            
            
            3,310,026
            
            
            
            2.01
            
            
            $
            3.98
            
            
            
            3,310,026
            
            
            $
            3.98$
            4.17
            
            
            
            359,712
            
            
            
            2.56
            
            
            $
            4.17
            
            
            
            359,712
            
            
            $
            4.1712,158,941
            
            
            
            3.26
            
            
            $
            1.60
            
            
            
            12,158,941
            
            
            $
            1.60








F-27





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





Transactions
involving warrants are summarized as follows:





Number
      of
              Shares
            
            
            Weighted
              Average
      Price
              Per
      ShareOutstanding
      at January 1, 2008
            
            
            7,673,627
            
            
            $
            4.15Issued
            
            
            4,164,140
            
            
            
            1.31Exercised
            
            
            (3,380,000
            )
            
            
            0.70
            *Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2008
            
            
            8,457,767
            
            
            $
            2.19Issued
            
            
            4,481,174
            
            
            
            0.58Exercised
            
            
            (780,000
            )
            
            
            0.09Canceled
      or expired
            
            
            -
            
            
            
            -Outstanding
      at December 31, 2009
            
            
            12,158,941
            
            
            $
            1.60


______________





*The
warrants were issued to Enable Capital and originally priced at $4.17 per
share.  In February 2008, these warrants were re-priced to $0.6978258
per share and the holders exercised the warrants on a cashless basis and
received 1,000,000 shares.





The
Company issued 2,121,212 warrants to a Convertible Debenture holder, 1,628,800
warrants to Series A preferred stockholders, and 231,162 to Convertible Senior
Notes holders during the year ended December 31, 2009.   The Company
issued 2,500,000 to a Convertible Debenture holder, 864,140 warrants to
Convertible Senior Notes holders and 800,000 to a Note holder, During the year
ended December 31, 2008.  The Company did not issue any compensatory
warrants during the years ended December 31, 2009 or
2008.





The
purchase price of the warrants issued to Convertible Senior Note holders was
adjusted from $4.70 to $3.82 per share and approximately 231,162 additional
warrants were issued during the year ended December 31, 2009 in accordance with
the anti-dilution protection provision of the Convertible Senior Notes Payable
Agreement (the “Agreement”) dated October 27, 2005, upon the occurrence of
certain events as defined in the Agreement.





In
February 2008, the Company amended certain stock purchase warrants held by
private placement investors to reduce the exercise price under such warrants
from $4.17 per share to $0.6978258 per share.  The warrants entitled
the holders to purchase an aggregate of up to 3,380,000 shares of Telkonet’s
common stock.   Subsequently, these private placement investors
exercised all of their warrants on a cashless basis using the five day volume
average weighted price (VWAP) as of January 31, 2008 of $.99 resulting in the
issuance of 1,000,000 shares of Company common stock.  The Company has
accounted for the amended warrants issued, valued at $1,224,236, as other
expense using the Black-Scholes pricing model and the following assumptions:
contractual term of 5 years, an average risk-free interest rate of 3.5% a
dividend yield of 0% and volatility of 70%.  In addition, during the
year ended December 31, 2008, the Company recorded non-cash expenses of $454,619
for issuing additional warrants and the re-pricing of outstanding warrants in
accordance with the anti-dilution provision of the warrant
agreements.





In July
2009, the Company amended certain stock purchase warrants held by private
placement investors to reduce the exercise price under such warrants from $0.60
per share to approximately $0.09 per share.  The warrants entitled the
holders to purchase an aggregate of up to 780,000 shares of the Company’s common
stock.   Subsequently, these private placement investors
exercised all of their warrants, and the Company has accounted for the amended
warrants issued, valued at $70,486, as financing expense using the Black-Scholes
pricing model and the following assumptions: contractual term of 5 years, an
average risk-free interest rate of 1.6% a dividend yield of 0% and volatility of
103%.





In
November 2009, the Company issued warrants to YA Global Investments LP pursuant
to anti-dilution provisions in their existing warrant agreements that were
triggered by the completion of the Series A preferred stock private
placement.  These warrants entitled the holders to purchase up to
2,121,212 shares of the Company’s common stock at a price per share of
$0.33.   The Company has accounted for the warrants, valued at
$510,151, as financing expense using the Black-Scholes pricing model and the
following assumptions: contractual term of 5 years, an average risk-free
interest rate of 2.2% a dividend yield of 0% and volatility of
123%.








F-28




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE P
- RELATED PARTY TRANSACTIONS





In
connection with the Series A Preferred Stock private placement transaction, on
November 16, 2009, the Company entered into an Executive Officer Reimbursement
Agreement with each of (i) Jason L. Tienor, the Company’s President and Chief
Executive Officer, (ii) Richard J. Leimbach, the Company’s Chief Financial
Officer, and (iii) Jeffrey J. Sobieski, the Company’s Chief Operating Officer
(collectively, the “Executive Officers”), pursuant to which the Executive
Officers agreed to convert a portion of outstanding indebtedness of the Company
owed to such Executive Officers into Series A shares and Warrants pursuant to
the Securities Purchase Agreement.  Mr. Tienor converted $20,000 of
outstanding indebtedness into 4 Series A shares and Warrants to purchase
30,304 shares of Common Stock. Mr. Leimbach converted $10,000 of outstanding
indebtedness into 2 Series A shares and Warrants to purchase 15,152 shares
of Common Stock. Mr. Sobieski converted $20,000 of outstanding indebtedness into
4 Series A shares and Warrants to purchase 30,304 shares of Common
Stock.





Anthony
Paoni, Chairman of the Company’s Board of Directors, participated in the private
placement of Series A Preferred Stock, purchasing five shares of Series A
convertible redeemable preferred stock (convertible into 68,870 shares of common
stock) and warrants to purchase 37,880 shares of common stock, for an aggregate
purchase price of $25,000.





Anthony
Paoni, Chairman, also is compensated $4,000 per month for executive
consulting  services.





From time
to time the Company may receive advances from certain of its officers to meet
short term working capital needs.  These advances may not have formal
repayment terms or arrangements.  As of December 31, 2009, the Company
owed deferred salary payments to certain executive officers in the amount of
$13,062 to Jason L. Tienor, President and Chief Executive Officer, $24,868 to
Richard J. Leimbach, Chief Financial Officer, and $11,628 to Jeffrey J.
Sobieski, Chief Operating Officer.





NOTE Q
- INCOME TAXES
 
 The
Company has adopted ASC 740, Subtopic 10 (formerly, FASB No. 109, Accounting for Income Taxes)which requires the recognition of deferred tax liabilities and assets for
the expected future tax consequences of events that have been included in the
financial statement or tax returns. Under this method, deferred tax liabilities
and assets are determined based on the difference between financial statements
and tax bases of assets and liabilities using enacted tax rates in effect for
the year in which the differences are expected to reverse.
 
 A
reconciliation of tax expense computed at the statutory federal tax rate on loss
from operations before income taxes to the actual income tax expense is as
follows:
 
 2009
              
              
              2008Tax
      provision computed at the statutory rate
              
              $
              (1,780,535
              )
              
              $
              (1,608,115
              )Stock-based
      compensation
              
              
              79,980
              
              
              
              237,877Impairment
      of marketable securities
              
              
              147,061
              
              
              
              1,393,496Book
      expenses not deductible for tax purposes
              
              
              68,000
              
              
              
              68,000Fair
      value of warrant re-pricing
              
              
              197,417
              
              
              
              697,959Change
      in valuation allowance for deferred tax assets
              
              
              1,314,371
              
              
              
              (800,000
              )Other
              
              
              (26,294
              )
              
              
              10,783Income
      tax expense
              
              $
              --
              
              
              $
              --
   F-29
  TELKONET,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2009 AND 2008
 Deferred
income taxes include the net tax effects of net operating loss (NOL)
carryforwards and the temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for
income tax purposes. Significant components of the Company's deferred tax assets
are as follows:
 
 2009
              
              
              2008Deferred
      Tax Assets:Net
      operating loss carryforwards
              
              $
              35,002,294
              
              
              $
              34,000,000Other
              
              
              639,642
              
              
              
              874,863Total
      deferred tax assets
              
              
              35,641,935
              
              
              
              34,874,863Deferred
      Tax Liabilities:Intangibles
              
              
              (4,724,569
              )
              
              
              (5,146,739
              )Other
              
              
              (155,570
              )
              
              
              (280,699
              )Total
      deferred tax liabilities
              
              
              (4,880,140
              )
              
              
              (5,146,739
              )Valuation
      allowance
              
              
              (30,761,795
              )
              
              
              (29,447,424
              )Net
      deferred tax assets
              
              $
              --
              
              
              $
              --
 
 
 The
Company has provided a valuation reserve against the full amount of the net
deferred tax assets, because in the opinion of management, it is more likely
than not that these tax assets will not be realized.
 
 At
December 31, 2009 and 2008, the Company had net operating loss carryforwards of
approximately $103 million and $100 million, respectively, for federal income
tax purposes which will expire at various dates from 2020 through
2029.
 
 The
Company’s NOL and tax credit carryovers may be significantly limited under
Section 382 of the Internal Revenue Code (IRC). NOL and tax credit carryovers
are limited under Section 382 when there is a significant “ownership change” as
defined in the IRC. During 2005 and in prior years, the Company may have
experienced such ownership changes.
 
 The
limitation imposed by Section 382 would place an annual limitation on the amount
of NOL and tax credit carryovers that can be utilized. When the Company
completes the necessary studies, the amount of NOL carryovers available may be
reduced significantly. However, since the valuation allowance fully reserves for
all available carryovers, the effect of the reduction would be offset by a
reduction in the valuation allowance.
 
 The
Company has not filed corporate income tax returns since 2006.
 NOTE R
- LOSSES PER COMMON SHARE





The
following table presents the computations of basic and dilutive loss per
share:





2009
            
            
            2008Loss
      from Continuing Operations
            
            $
            (5,237,014
            )
            
            $
            (16,080,237
            )Income
      (Loss) from Discontinued Operations
            
            
            6,384,851
            
            
            
            (7,905,302
            )Net
      Income (Loss)
            
            $
            1,059,837
            
            
            $
            (23,985,539
            )Net
      income (loss) per share:Loss
      per share from continuing operations – basic and
    diluted
            
            $
            (0.06
            )
            
            $
            (0.20
            )Income
      (loss) per share from discontinued operations – basic and
      diluted
            
            $
            0.07
            
            
            $
            (0.10
            )Net
      income (loss) per share – basic
            
            $
            0.01
            
            
            $
            (0.30
            )Net
      income (loss) per share – diluted
            
            $
            0.01
            
            
            $
            (0.30
            )Weighted
      average common shares outstanding – basic
            
            
            94,486,950
            
            
            
            79,153,788Weighted
      average common shares outstanding – diluted
            
            
            102,866,200
            
            
            
            79,153,788







F-30





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
S - COMMITMENTS AND CONTINGENCIES





Office Leases
Obligations





The
Company presently leases approximately 12,000 square feet of office space in
Milwaukee, WI for its corporate headquarters.  The Milwaukee lease
expires in February 2019.





The
Company presently leases 16,400 square feet of commercial office space in
Germantown, Maryland.  This lease expires in December
2015.





Commitments
for minimum rentals under non cancelable leases at December 31, 2009 are as
follows:





2010
            
            $
            452,4482011
            
            
            451,0632012
            
            
            456,3032013
            
            
            461,5912014
      and thereafter
            
            
            1,784,045Total
            
            $
            3,605,450





Rental
expenses charged to operations for the years ended December 31, 2009
and 2008 are $429,657 and $454,450, respectively.





Employment and Consulting
Agreements





The
Company has employment agreements with certain of its key employees which
include non-disclosure and confidentiality provisions for protection of the
Company’s proprietary information.





The
Company has consulting agreements with outside contractors to provide marketing
and financial advisory services. The Agreements are generally for a term of 12
months from inception and renewable automatically from year to year unless
either the Company or Consultant terminates such engagement by written
notice.





The
Company entered into an exclusive financial advisor and consulting agreement in
January 2007. The agreement provides a minimum consideration fee, not less than
$250,000, in the event of an equity or financing transaction where the advisor
is engaged. The agreement may be terminated with sixty days notification by
either party.





F-31




TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





On August
1, 2007, the Company entered into an agreement with Barry Honig, President of
GRQ Consultants, Inc. (“GRQ”). Telkonet has agreed to pay Mr. Honig 50,000
shares of common stock per month for six (6) months, to provide the Company with
transaction advisory services. As of December 31, 2007, GRQ held a Senior
Promissory Note issued by Telkonet on July 24, 2007, in the principal amount of
$1,500,000.  On February 8, 2008, this note was repaid in full
including $49,750 in accrued but unpaid interest from the issuance date through
the date of repayment.





Jason
Tienor, President and Chief Executive Officer, is employed pursuant to an
employment agreement dated March 15, 2007.  Mr. Tienor’s employment
agreement has a term of three years and provides for a base salary of $200,000
per year. Notwithstanding
his employment agreement’s expiration, Mr. Tienor continues to be employed and
to perform services pursuant to the terms of his employment agreement pending
completion of a replacement agreement.


Jeff
Sobieski, Chief Operating Officer, is employed pursuant to an employment
agreement, dated March 15, 2007. Mr. Sobieski’s employment agreement has a term
of three years for a base salary of $190,000 per year.  Notwithstanding
his employment agreement’s expiration, Mr. Sobieski continues to be employed and
to perform services pursuant to the terms of his employment agreement pending
completion of a replacement agreement. Litigation





The
Company is subject to legal proceedings and claims which arise in the ordinary
course of its business. Although occasional adverse decisions or settlements may
occur, the Company believes that the final disposition of such matters should
not have a material adverse effect on its financial position, results of
operations or liquidity.




On July
1, 2008, Linksmart Wireless Technology, LLC, or Linksmart, filed a civil lawsuit
in the Eastern District of Texas against EthoStream, LLC, our wholly-owned
subsidiary and 22 other defendants (Linksmart Wireless Technology, LLC
v. T-Mobile USA, Inc., et al, U.S. District Court, for the Eastern
District of Texas, Marshall Division, No.2:08-cv-00264-TJW-CE).  This
lawsuit alleges that the defendants’ services infringe a wireless network
security patent held by Linksmart. Linksmart seeks a permanent injunction
enjoining the defendants from infringing, inducing the infringement of, or
contributing to the infringement of its patent, an award of damages and
attorney’s fees.
 
 On August
1, 2008, we timely filed an answer to the complaint denying the allegations. On
February 27, 2009, the United States Patent Office ("USPTO") granted a
reexamination request.  Based upon four highly relevant and material
prior art references that had not been considered by the USPTO in its initial
examination, it found a “substantial new question of patentability” affecting
all claims of the patent allegedly infringed upon.  There is a
possibility that the claims of the patent will be cancelled or narrowed during
the reexamination which may result in the narrowing or elimination of some and
possibly all of the issues in the pending litigation.  The case is
currently in discovery.  A mandatory mediation will likely be held in
April or May, 2010.
 
 Defendant
Ramada Worldwide, Inc. provided us with notice of the suit and demanded that we
defend and indemnify it pursuant to a vendor direct supplier agreement between
EthoStream and WWC Supplier Services, Inc., a Ramada affiliate (wherein we
agreed to indemnify, defend and hold Ramada harmless from and against claims of
infringement).  After a review of that agreement, it was determined
that Ethostream owes the duty to defend and indemnify and it has assumed
Ramada’s defense.  An answer on Ramada’s behalf was filed in U.S.
District Court, for the Eastern District of Texas, Marshall Division on
September 19, 2008. The matter is currently pending in that
court.


Senior Convertible
Noteholder Claim





The
August 14, 2006 Settlement Agreement with the Senior Convertible Debenture
Noteholders provided that the number of shares issued to the Noteholders shall
be adjusted based upon the arithmetic average of the weighted average price of
the Company’s common stock on the American Stock Exchange for the twenty trading
days immediately following the settlement date.  The Company has
concluded that, based upon the weighted average of the Company's common stock
between August 16, 2006 and September 13, 2006, the Company is entitled to a
refund from the two Noteholders.  One of the Noteholders has informed
the Company that it does not believe such a refund is required.  As a
result, the Company has declined to deliver to the Noteholders certain stock
purchase warrants issued to them pursuant to the Settlement Agreement pending
resolution of this disagreement. The Noteholder has alleged that the Company has
failed to satisfy its obligations under the Settlement Agreement by failing to
deliver the warrants. In addition, the Noteholder maintains that the Company has
breached certain provisions of the Registration Rights Agreement and, as a
result of such breach, such Noteholder claims that it is entitled to receive
liquidated damages from the Company. In the Company’s opinion, the ultimate
disposition of these matters will not have a material adverse effect on the
Company’s results of operations or financial position.





Purchase Price
Contingency





In
conjunction with the acquisition of MST on January 31, 2006, the purchase price
contingency shares are price protected for the benefit of the former owner of
MST. In the event the Company’s common stock price is below $4.50 per share upon
the achievement of thirty three hundred (3,300) subscribers a pro rata
adjustment in the number of shares will be required to support the aggregate
consideration of $5.4 million. The price protection provision provides a cash
benefit to the former owner of MST if the as-defined market price of the
Company’s common stock is less than $4.50 per share at the time of issuance from
the escrow on or before January 31, 2009. The issuance of additional shares or
distribution of other consideration upon resolution of the contingency based on
the Company’s common stock prices will not affect the cost of the acquisition.
When the contingency is resolved or settled, and additional consideration is
distributable, the Company will record the current fair value of the additional
consideration and the amount previously recorded for the common stock issued
will be simultaneously reduced to the lower current value of the Company’s
common stock. In addition, the Company agreed to fully fund the MST three year
business plan, established on January 31, 2006, to satisfy the benchmarks
established to achieve 3,300 subscribers. In the event, for any reason, the
Company materially fails to satisfy its obligations under the acquisition
agreement, then the former owners of MST shall be entitled to the release of any
and all consideration held in reserve. In May 2008, the Company executed an
agreement for a minimum commitment of $2.3 million to fund MST's business plan
in accordance with Section 11.1 of the Purchase Agreement between Telkonet and
Frank T. Matarazzo. In addition, the adjustment date for the achievement of
MST's 3,300 subscribers has been extended an additional six months from January
31, 2009 to July 31, 2009. Additionally, in April 2008 the Company issued from
escrow 200,000 shares of the purchase price contingency and advanced 400,000
shares in June 2008 in exchange for Mr. Matarazzo’s agreement to a debt covenant
restricting the use of proceeds in the Company’s debenture financing with YA
Global Investments LP.







F-32





TELKONET,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





On March
9, 2007, the Company acquired substantially all of the assets of Smart Systems
International (SSI), a leading provider of energy management products and
solutions to customers in the United States and Canada for cash and Company
common stock having an aggregate value of $6,875,000. The purchase price was
comprised of $875,000 in cash and 2,227,273 shares of the Company’s common
stock. The Company was obligated to register the stock portion of the purchase
price on or before May 15, 2007. Pursuant to the registration rights agreement,
the registration statement was required to be effective no later than July 14,
2007.  The registration rights agreement does not expressly provide
for penalties in the event this deadline is not met.  This
registration statement was declared effective on March 14, 2008.





Of the
stock issued in the SSI acquisition, 1,090,909 shares were held in an
escrow account for a period of one year following the closing from which certain
potential indemnification obligations under the purchase agreement could be
satisfied. The aggregate number of shares held in escrow was subject
to adjustment upward or downward depending upon the trading price of the
Company’s common stock during the one year period following the closing
date.   On March 12, 2008, the Company released these shares from
escrow and issued an additional 1,882,225 shares on June 12, 2008 pursuant
to the adjustment provision in the SSI asset purchase agreement.





On
October 19, 2007, the Company completed the acquisition of approximately 30.0%
of the issued and outstanding shares of common stock of Geeks on Call America,
Inc. (“GOCA”), the nation's premier provider of on-site computer services. 
Under the terms of the stock purchase agreement, the Company acquired
approximately 1,160,043 shares of GOCA common stock from several GOCA
stockholders in exchange for 2,940,200 shares of the Company’s common stock for
total consideration valued at approximately $4.5 million. The number of shares
issued in connection with this transaction was determined using a per share
price equal to the average closing price of the Company’s common stock on the
American Stock Exchange (AMEX) during the ten trading days immediately preceding
the closing date. The number of shares was subject to adjustment on the date the
Company filed a registration statement for the shares issued in this
transaction, which occurred on April 25, 2008.  The increase or
decrease to the number of shares issued was determined using a per share price
equal to the average closing price of the Company’s common stock on the AMEX
during the ten trading days immediately preceding the date the registration
statement was filed.  The Company accounted for this investment under
the cost method, as the Company does not have the ability to exercise
significant influence over operating and financial policies of
GOCA.  On April 30, 2008, Telkonet issued an additional 3,046,425
shares of its common stock to the sellers of GOCA to satisfy the adjustment
provision.





NOTE T
- NON-CONTROLLING INTEREST IN DISCONTINUED OPERATIONS





The
non-controlling interest in the consolidated balance sheet reflects the original
investment by these non-controlling shareholders in the consolidated
subsidiaries of MST, along with their proportional share of the earnings or
losses of the subsidiaries.  As of December 31, 2009, the MST
subsidiary was deconsolidated.  The non-controlling interest at
December 31, 2008 amounted to $262,795.





NOTE U
- BUSINESS CONCENTRATION





There was
no revenue from major customers for the year ending December 31, 2009. Revenue
from two (2) major customer approximated $6,375,182 or 39% of total
revenues for the year ending December 31, 2008.  Total accounts
receivable of $486,906, or 58% of total accounts receivable, was due from these
customers as of December 31, 2008.





Purchases
from one (1) and two (2) major suppliers approximated $1,022,886 or
62% of purchases and $2,426,570 or 56% of purchases for the years ended December
31, 2009 and 2008, respectively. Total accounts payable of approximately $62,210
or 2% was due to this supplier as of December 31, 2009, and $185,711 or 7% of
total accounts payable was due to these suppliers as of December 31,
2008.





NOTE V
- FAIR VALUE MEASUREMENTS





The
financial assets of the Company measured at fair value on a recurring basis are
cash equivalents, and long-term marketable securities. The Company’s long term
marketable securities are generally classified within Level 1 of the fair
value hierarchy because they are valued using quoted market prices, broker or
dealer quotations, or alternative pricing sources with reasonable levels of
price transparency. The Company’s long-term investments are classified within
Level 3 of the fair value hierarchy because they are valued using unobservable
inputs, due to the fact that observable inputs are not available, or situations
in which there is little, if any, market activity for the asset or liability at
the measurement date.  The Company’s derivative liabilities and
convertible debentures are classified within Level 3 of the fair value hierarchy
because they are valued using inputs which are not actively observable, either
directly or indirectly.







F-33




●
            Level
      1: Unadjusted quoted prices in active markets that are accessible at the
      measurement date for identical, unrestricted assets or
      liabilities;●
            Level
      2: Quoted prices in markets that are not active, or inputs which are
      observable, either directly or indirectly, for substantially the full term
      of the asset or liability; or●
            Level
      3: Prices or valuation techniques that require inputs that are both
      significant to the fair value measurement and are
      unobservable.





The
following table sets forth the Company’s short- and long-term investments as
of December 31, 2009 which are measured at fair value on a recurring
basis by level within the fair value hierarchy. These are classified based on
the lowest level of input that is significant to the fair value measurement, (in
thousands):





(in
      thousands)
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3
            
            
            TotalLong-term
      investments
            
            
            -
            
            
            
            -
            
            
            
            8
            
            
            
            8Total
            
            $
            -
            
            
            $
            -
            
            
            $
            8
            
            
            $
            8Derivative
      liabilities
            
            
            -
            
            
            
            -
            
            
            
            1,881
            
            
            
            1,881Convertible
      debenture
            
            
            -
            
            
            
            -
            
            
            
            1,148
            
            
            
            1,148Total
            
            $
            -
            
            
            $
            -
            
            
            $
            3,029
            
            
            $
            3,029







F-34





TELKONET, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE
X - DISCONTINUED OPERATIONS





On April
22, 2009, the Company completed the deconsolidation of MST by reducing its
ownership percentage and board membership.  The deconsolidation of MST
has been accounted for as discontinued operations and accordingly, the assets
and liabilities have been segregated in the accompanying consolidated balance
sheet and reclassified as discontinued operations. The operating results
relating to MST have been reclassified from continuing operations and reported
as discontinued operations in the accompanying consolidated statements of
operations.





On April
22, 2009, Warren V. Musser and Thomas C. Lynch, members of the Company’s Board
of Directors, submitted their resignations as directors of MSTI.  As a
result of these resignations, and the decrease in beneficial ownership resulting
from the transaction described above, the Company is no longer required to
consolidate MSTI as a majority- owned subsidiary and the Company’s investment in
MSTI will now be accounted for under the cost method.





On June
26, 2009, MSTI entered into an Agreement and Consent to Acceptance of Collateral
(“Agreement”) with its senior secured lenders, Alpha Capital Anstalt, Gemini
Master Fund, Ltd., Whalehaven Capital Fund Limited and Brio Capital L.P.
(“Secured Lenders”).   The Secured Lenders were the senior
secured creditors of MSTI with regard to obligations in the total principal
amount of $1,893,295 (together, the “Secured Lender
Obligations”).





Under the
Agreement: (a) MSTI (i) agreed and consented to the transfer to MST
Acquisition Group LLC (the “Designee”), for the benefit of the Secured
Lenders, of all of the assets of MSTI (the “Pledged Collateral”) in full
satisfaction of the Secured Lender Obligations, and (ii) waived and released (x)
all right, title and interest it has or might have in or to the Pledged
Collateral, including any right to redemption, and (y) any claim for a surplus;
and (b) the Secured Lenders agreed to accept the Pledged Collateral in
full satisfaction of the Secured Lender Obligations and waived and released MSTI
from any further obligations with respect to the Secured Lender
Obligations.





Net
income (loss) from discontinued operations on the consolidated statement of
operations for the year ended December 31, 2009 includes the gain on
deconsolidation of $6,932,586, offset by MSTI's net losses of
$(635,735) for the period January 1, 2009 through April 30, 2009, the date
of deconsolidation.  The market value of the MSTI common
shares owned by the Company as of December 31, 2009 was deemed permanently
impaired by management and as a result the Company has fully written off its
investment in MSTI and has not included any value for MSTI in the balance sheet
as of December 31, 2009.





The
following table summarizes net income from discontinued operations for the year
ended December 31, 2009.





Year
      Ended December 31,2009
            
            
            2008Loss
      from operations
            
            $
            (635,735
            )
            
            $
            (7,905,302
            )Elimination
      of Liabilities, net of assets
            
            
            7,000,185
            
            
            
            -Other
      expenses
            
            
            (67,599
            )
            
            
            -Income
      (loss) from discontinued operations
            
            $
            6,296,851
            
            
            $
            (7,905,302
            )








F-35





TELKONET, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2009 AND 2008





NOTE Y
- SUBSEQUENT EVENTS




As part
of a settlement agreement and mutual release we entered into on February 19,
2010 with Strategic Business Consulting, LLC (“SBC”), we issued and delivered to
SBC, or its designee, One Hundred Ten Thousand (110,000) unrestricted shares of
Telkonet, Inc. common stock, par value $0.001 per share.








F-36