**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**
|  | **X** | **ANNUAL                        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF                        1934** |
|--|-------|----------------------------------------------------------------------------------------------------------------------------------------|

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007**

**OR**
|  |   | **TRANSITION                        REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF                        1934** |
|--|--------|--------------------------------------------------------------------------------------------------------------------------------------------|

**FOR THE TRANSITION PERIOD FROM ____ TO ______**

______________

**Mechanical Technology, Incorporated**

**(Exact name of registrant as specified in its charter)**

______________

| **New York**                                            |         | **0-6890**                   |         | **14-1462255**                             |
|---------------------------------------------------------|--------------|------------------------------|--------------|--------------------------------------------|
| **(State or Other Jurisdiction**

**of Incorporation)** |    | **(Commission File Number)** |    | **(IRS Employer**

**Identification No.)** |

 

 

 

**431 New Karner Road, Albany, New York 12205**

**(Address of registrant’s principal executive            office)**

**(518) 533-2200**

**(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 registered |
| Common Stock                                                                                | The NASDAQ Stock Market LLC |
| ($0.01 par value)                                                                           |   |
|                                                                                        |   |
| 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.       Yes                                                                                                                                  No X                                                                                                                                                                                                                                                                                                                                    |
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| Indicate by check mark if the registrant is not required                            to file reports pursuant to Section 13 or Section 15(d) of the                            Act.   Yes                                                                                                                                 No   X                                                                                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| Indicate by check mark whether the registrant (1) has                            filed all reports required to be filed by Section 13 or 15(d) of the                            Securities Exchange Act of 1934 during the preceding 12 months (or for                            such shorter period that the registrant was required to file such                            reports), and (2) has been subject to such filing requirements for the                            past 90 days.                                                                                                                                                             Yes   X   No   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| Indicate by check mark if disclosure of delinquent                            filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this                            chapter) is not contained herein, and will not be contained, to the                            best of the 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 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 definition of “large accelerated                            filer”, “accelerated filer”, and “smaller                            reporting company” in Rule 12b-2 of the Exchange Act (check                            one):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| Large Accelerated                            Filer          Accelerated                            Filer          Non-Accelerated                            Filer           Smaller                            reporting companyX                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
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| Indicate by check mark whether the registrant is a shell                            company (as defined in Rule 12B-2 of the                            Act).                             Yes                                                                                                                                No   X                                                                                                                                                                                                                |

 

The            aggregate market value of the voting and non-voting common equity held by            non-affiliates as of June 30, 2007 (based on the last sale price of $1.26 per share for            such stock reported by NASDAQ for that date) was $43,748,142. Such value excludes            common stock held by executive officers, directors, and 10% or greater stockholders as            of June 30, 2007. The identification of 10% or greater stockholders as of June 30, 2007            is based upon 13G and amended 13G reports publicly filed before June 30, 2007. This            calculation does not reflect a determination that such parties are affiliates for any            other purposes.

 

As of            March 20, 2008, the Registrant had 38,179,888 shares of common stock            outstanding.

 

Documents incorporated by reference: Portions of the registrant’s            Proxy Statement for its 2008 Annual Meeting of Stockholders are incorporated by            reference into Part III of this Form 10-K.

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**PART I**

 

**Item 1: Business**

 

*Unless the context requires otherwise in this Annual Report, the            terms “we”, “us” and “our” refer to Mechanical            Technology, Incorporated, a New York corporation, “MTI Micro” refers to MTI            MicroFuel Cells, Inc., a Delaware corporation and our majority owned subsidiary, and            “MTI Instruments” refers to MTI Instruments, Inc., a New York corporation            and our wholly owned subsidiary. We have a registered trademark in the United States            for “Mobion”. Other trademarks, trade names, and service marks used in this            Annual Report are the property of their respective owners.*

 

We are            developing and commercializing off-the-grid rechargeable power sources for portable            electronics. We have developed a patented, proprietary direct methanol fuel cell            technology platform called Mobion, which generates electrical power using up to 100%            methanol as fuel. Our proprietary fuel cell power solution consists of two primary            components integrated in an easily manufactured device: the direct methanol fuel cell            power engine, which we refer to as our Mobion Chip, and methanol replacement            cartridges. Our current Mobion Chip weighs less than one ounce and is small enough to            fit in the palm of one’s hand. The methanol used by the technology is fully            biodegradable. We believe we are the only micro fuel cell developer to have            demonstrated power density of over 50 mW/cm2 with high energy efficiencies            of 1.4 Wh/cc of methanol for handheld consumer electronic applications. For these            reasons, we believe our technology offers a compelling alternative to current            lithium-ion and similar rechargeable battery systems currently used by original            equipment manufacturers and branded partners, or OEMs, in many handheld electronic            devices, such as mobile phones (including smart phones) and mobile phone accessories,            digital cameras, portable media players, PDAs, and GPS devices. We believe our platform            will facilitate the development of numerous product advantages, including small size,            environmental friendliness, and simplicity of design, all critical for            commercialization in the consumer market, and can be implemented as three different            product options: a compact external charging device, a snap-on or attached power            accessory, or an embedded fuel cell power solution. We have strategic arrangements with            Samsung Electronics and the Duracell division of the Gillette Company. Our goal is to            become a leading provider of portable power for handheld electronic devices and we            intend to commercialize Mobion products beginning in 2009.

 

Our            Mobion technology eliminates the need for active water recirculation pumps or the            inclusion of water as a fuel dilutant. The water required for the electrochemical            process is transferred internally within the Mobion Chip from the site of water            generation on the air-side of the cell. This internal flow of water takes place without            the need for any pumps, complicated re-circulation loops or other micro-plumbing tools.            Our Mobion technology is protected by a patent portfolio that includes over 90            U.S. patent applications covering five key technologies and manufacturing            areas.

 

We also            design, manufacture, and sell high-performance test and measurement instruments and            systems serving three markets: general dimensional gauging, semiconductor, and            aviation. These products consist of: electronic, computerized gauging instruments for            position, displacement and vibration applications for the design, manufacturing and            test markets; semiconductor products for wafer characterization; and engine balancing            and vibration analysis systems for military and commercial aircraft.

 

**The            Portable Power Source Industry**

 

*Industry Background*

 

Consumers demand portable electronics that offer an enhanced experience            through expanded memory, improved display technologies, constant connectivity, robust            software, and a reduced form factor. In addition, technological advances in            semiconductor manufacturing, LED displays, memory costs and availability, wireless            technologies, and software applications have resulted in a dramatic increase in the            number of portable electronic devices, their usage, and power requirements. As a result            of these consumer demands and technological advances, there are a number of handheld            electronic devices, such as mobile phones (including smart phones) and mobile phone            accessories, digital cameras, portable media players, PDAs, and GPS devices, that have            been introduced into the market. Many of these devices provide consumers and mobile            professionals with the ability to communicate any time, anywhere and have effectively            enabled the creation of an “always-on” environment independent of the end            user’s location. This trend towards increased functionality in portable            electronic devices has led to a “power gap” in which the disparity between            a device’s power supply, typically a rechargeable lithium-ion battery, and its            power need are not being met. This power gap leads to a need for the end user to            plug-in their devices to the electrical grid on a regular basis, which limits their            ability to use these electronic devices where and when the need arises.

 

*The            Power Source Bottleneck*

 

Improvements in rechargeable battery technology have not kept pace with            the evolution of consumer electronic device performance. Over the last ten years,            device performance as measured by silicon processor speed has increased by a factor of            128 times, while the energy density of lithium-ion technology has only doubled. We            believe that further gains in lithium-ion technology for portable

 

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electronics will be incremental at best, as any achievable benefits may            be outweighed by the decreasing stability, availability, integrity, and relative safety            of these higher energy output batteries. In addition to their performance shortfalls,            lithium-ion battery technology poses an environmental risk as the various heavy metals            incorporated in these batteries require special disposal to prevent contamination of            waste disposal sites.

 

According to Frost and Sullivan, an independent research firm, the            global battery market was approximately $14.3 billion in 2006 and is projected to            increase to roughly $21.4 billion by 2012. The market for batteries can be divided            into three segments: consumer, industrial, and military. Consumer battery sales            represented approximately 81% of this market and are projected to represent an            overwhelming majority of sales through at least 2012. The same study estimates that            rechargeable batteries accounted for approximately $5.4 billion of this market in            2006.

 

OEMs            are actively seeking improved power sources to replace existing rechargeable            lithium-ion batteries and to power additional improvements to their mobile electronic            devices. The development of new products using technologies that already exist, such as            radio frequency technologies and 4G wireless capabilities, but cannot be            effectively commercialized on mobile devices, will result from the availability of            portable, compact, economical, rechargeable/replaceable higher energy density power            sources, including micro fuel cells.

 

*Our            Solution*

 

At the            core of our solution is our proprietary Mobion Chip engine, a design architecture that            embodies a reduction in the size, complexity, and cost of fuel cell construction, which            results in a reliable, manufacturable, and affordable power solution that we believe            provides improved energy density and portability over competing rechargeable battery            technologies. Our proprietary fuel cell power solution consists of two primary            components integrated in an easily manufactured device: the direct methanol fuel cell            power engine, which we refer to as our Mobion Chip, and methanol replacement            cartridges. Our Mobion Chip weighs less than one ounce and is small enough to fit in            the palm of one’s hand. For these reasons, we believe that our Mobion platform is            ideally suited to provide a replacement for rechargeable lithium-ion batteries. Based            upon our ability to provide a compact, efficient, clean, safe, and long-lasting power            source for lower power applications, we intend to initially target power solutions for            applications, such as mobile phones (including smart phones) and mobile phone            accessories, digital cameras, portable media players, PDAs, and GPS devices.

 

For            handheld consumer electronic applications, we believe we are the only micro fuel cell            developer to have demonstrated power density of over 50 mW/cm2 with energy            efficiencies of 1.4 Wh/cc of fuel, which is a direct result of our Mobion            platform’s ability to use 100% methanol – a widely available,            environmentally friendly, inexpensive, and biodegradable fuel. These advantages result            in higher energy density and reduced size, cost, and complexity of our power solution            offering consumers portable on-demand power, independence from power outlets, and            freedom from the need to constantly recharge their devices.

 

**Our            Strategy**

 

Our            goal is to become a leading provider of portable power for handheld electronic devices.            Key elements of our strategy designed to achieve this objective include the            following:

 

*Business Focus.*We are focusing our efforts            on the development and commercialization of our portable power source products. We            believe this business provides a higher potential, higher growth opportunity than our            test and measurement instrumentation business. We will continue to evaluate our test            and measurement instrumentation business, which contributes positive operating results            and cash flows, but may consider its eventual sale or other disposition.

 

*Design for Mass Manufacturing.*Our portable            power source products will be manufactured using standard processes, such as injection            molding and automated test and assembly, which are broadly employed throughout the            electronics manufacturing industry. In preparing Mobion for commercialization, our            current Mobion Chip is injection molded and is being designed for mass manufacturing.            In addition, we have continued integrating more functionality into our Mobion Chip            while reducing its part count to one molded piece. Our current Mobion Chip is 9ccs in            size, which is small enough to fit in the palm of a hand.

 

*Outsource Manufacturing.*We plan to            outsource manufacturing to expand rapidly and diversify our production capacity. This            strategy will allow us to maintain a variable cost model in which we do not incur most            of our manufacturing costs until our proprietary fuel cell power solution has been            shipped and billed to our customers. We intend to concentrate on our core competencies            of research and development and product design. This approach should reduce our fixed            capital expenditures and allow us to efficiently scale production.

 

*Utilize our Technology to Provide Compelling Products.*We plan to utilize our intellectual property portfolio and technological            expertise

 

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to            develop and offer portable power source products across multiple electronic device            markets. We intend to employ our technological expertise to reduce the overall size and            weight of our portable power source products while increasing their ease of            manufacturing, power capacity, and power duration and decreasing their cost. We believe            that these efforts will enable us to meet customer expectations and to achieve our goal            of supplying on a timely and cost-effective basis the most environmentally friendly            portable power source products to our target markets. We believe our products will            offer advantages in terms of performance, functionality, size, weight, and ease of use.            We plan to continue enhancing our customer’s industrial design alternatives and            device functionality through innovative product development based on our existing            capabilities and technological advances.

 

*Capitalize on Growth Markets.*We intend to            capitalize on the growth of the electronic device markets, including new products that            may be brought about by the convergence of computing, communications, and entertainment            devices. We believe our portable power source products will address the growing need            for portability, connectivity, and functionality in the evolving electronic device            markets. We plan to offer these power solutions to OEM customers to enable them to            offer products that have advantages in terms of size, weight, power duration, and            environmental friendliness. We plan to utilize our existing technologies, as well as            aggressively pursue new technologies and evolving markets that demand enhanced power            solutions.

 

*Develop Strong Customer Relationships.*We            plan to develop strong and long-lasting customer relationships with leading electronic            device OEMs and to provide them with power solutions for their products. We believe            that our portable power source products will enable our OEM customers to deliver a more            positive user experience and to differentiate their products from those of their            competitors. We will attempt to enhance the competitive position of our customers by            providing them with innovative, distinctive, and high-quality portable power supply            products on a timely and cost-effective basis. We will work continually to improve our            portable power source products, to reduce costs, and to speed the delivery of our            products. We will endeavor to streamline our designs and delivery processes through            ongoing design, engineering, and production improvement efforts. We will also devote            considerable effort to support our customers after the purchase of our portable power            source products.

 

*Pursue Strategic Relationships.*We intend            to develop and expand strategic relationships to enhance our ability to offer            value-added customer solutions, penetrate new markets, and strengthen the technological            leadership of our portable power source products.

 

**Products**

 

*Portable Power Source Products*

 

We are            developing three product categories of our Mobion technology: (i) external power            charger products, (ii) snap-on or attached power source products, and            (iii) embedded power source products. In addition, we are working with our            strategic partners and suppliers to develop disposable methanol cartridges that will be            used to fuel our portable power source products. Through our alliance with Duracell, we            are developing fuel cartridges that will be designed and branded for mass market            commercialization. Duracell has experience in the sale and distribution of portable            power through its battery products, as well as in the development, distribution, and            sale of liquid products with similar safety and packaging requirements as the 100%            methanol cartridges.

 

*External Power Charger:*Our design for an            external power charger is a standalone device that uses a standard and widely used            universal serial bus, or USB, interface as a power output connector that can be used to            recharge handheld mobile devices. Our current design for the device is roughly the size            of two decks of playing cards (see photo below) and employs a 100% methanol fuel            cartridge, which occupies the same volume as a pack of chewing gum. Our current            prototype external power charger provides up to one month of power for the typical            mobile phone. It can be designed to enable a professional photographer to take over            5,000 pictures using a high end digital camera from a single fuel tank. Our device is            designed to provide 2.5 watts of power from its USB interface and also offer fast            charge, ultra-long run time and self-charging modes.

 

 

 

 

**Mobion external power charger prototypes**

 

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*Snap-on or Attached Power Source Products:*Similar to aftermarket battery attachments, our snap-on direct methanol            fuel cell power solution is an attached power supply that is compatible with existing            portable electronic devices and offers users extended run-time power. In this category,            we envision a number of product applications, including attachments for digital            cameras, portable media players, GPS devices, and other consumer and electronic            products. Our initial design is a direct methanol fuel cell camera-grip (see photo            below) that replaces comparable rechargeable lithium-ion battery-pack grips and is            designed to provide twice as much energy as similar rechargeable lithium-ion            battery-based products. Our Mobion direct methanol fuel cell camera grip allows            photographers the benefits of extended usage plus the freedom to refill using a            methanol cartridge rather than by plugging into a wall outlet.

 

 

 

 

**Sample Mobion attached power source camera-grip            prototype**

 

*Embedded power source products:*Our goal is            to produce direct methanol fuel cells that can be embedded into portable electronic            devices in order to increase their run time and to provide fast charge capability by            hot-swapping 100% methanol cartridges. We have developed an embedded fuel cell concept            model (see photo below) designed for a smart phone and believe that this concept model            highlights the anticipated future product direction for our portable power source            products in the consumer market.

 

 

 

 

**Concept model of a smart phone with an**

**embedded Mobion power source**

 

*Advantages of our Portable Power Source Products*

 

We            believe that our portable power source products will offer the following            advantages:

 

|   | **•** | *Off-the-grid power source.*Our products provide users of consumer electronic                            devices with mobility by providing power without having to attach to a                            wall outlet to recharge their devices. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Small size and low weight.*The dimensions of our products will enable our OEM                            customers to reduce the overall size and weight of their                            products. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Power density.*Our products                            will have power density of over 50 mW/cm2 and high energy                            efficiencies of 1.4 Wh/cc of methanol. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Power duration.*Our                            products will offer longer run time than currently available portable                            charging systems. |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Ease of manufacturing.*Our                            products will be manufactured using traditional injection molding                            techniques that will easily transfer to mass-manufacturing production                            lines. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Safety.*Our products will                            utilize methanol fuel, which does not require storage under pressure or                            at low temperatures. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | *Environmentally friendly.*Our products will utilize fully biodegradable methanol                            fuel. |
|--------|------------|--------------------------------------------------------------------------------------------------------------------|

 

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*Codes and Standards*

 

In            2004, we became the world’s first company to obtain micro fuel cell safety            compliance certifications for a fuel cell product from Underwriter’s Laboratory            and CSA International. In addition, we received United Nations packaging certification            and our methanol cartridges were deemed compliant by the U.S. Department of            Transportation for worldwide cargo shipment. Certification is required for every            commercial product prior to its shipment. Based upon our previous experiences with            these regulatory agencies, we do not anticipate delays associated with seeking            Underwriter’s Laboratory and CSA International product certifications for our            commercial products, which are anticipated to begin shipping in 2009.

 

Also,            we helped to develop a proposal adopted by the United Nations to provide methanol fuel            cartridges a separate classification and we worked with other micro fuel cell            companies, and the appropriate regulatory bodies, to generate the first draft of the            international standards for methanol safety and use related to transport on commercial            airplanes.

 

As a            result of our industry coalition efforts, the International Civil Aviation Organization            technical instructions and the International Air Transport Association Dangerous Goods            Regulations now permit airline passengers and crew to carry on and use certain fuel            cell power systems and fuel cell cartridges containing methanol. The            U.S. Department of Transportation is currently reviewing the International Civil            Aviation Organization and International Air Transport Association air transport            regulations and issued a notice of proposed rulemaking on September 20, 2007 to            adopt the International Civil Aviation Organization passenger allowance and harmonize            the U.S. requirements with the international standard. The public comment period            on these proposed rules closed on November 19, 2007. We expect the            U.S. Department of Transportation to adopt its proposed rules during            2008.

 

*Test            and Measurement Instrumentation Products*

 

We are            a global supplier of computerized gauging instruments, metrology systems for            semiconductor wafers, and jet engine balancing systems.

 

*General Dimensional Gauging:*Our gauging            instruments employ fiber optic, laser, and capacitance technologies to make precision            measurements in product design, production, and quality related processes. Our gauging            instruments include capacitance gauging systems offering ultra-high precision            measurement, a fiber-optic based vibration sensor system with extremely high frequency            response, a high-speed laser sensor system utilizing the latest complementary            metal-oxide semiconductor/charge-coupled device technology, and a stand-alone data            acquisition system that incorporates multiple sensor technologies. These products are            targeted towards the data storage, semiconductor, and automotive industries.

 

*Semiconductor:*Our family of wafer            metrology systems range from manually operated units to fully automated systems, which            test key wafer characteristics critical to producing high-quality chips used in the            semiconductor industry. These units are used as quality control tools delivering highly            precise measurements for thickness variations, bow, warp, resistivity, and flatness.            These systems can be used on substrates varying widely in size and materials. Our wafer            metrology systems include an automated wafer characterization system, a semi-automated,            full wafer surface scanning system, and a device that provides for manual, non-contact            measurements.

 

*Jet            Engine Balancing Systems:*Our portable and test cell balance            systems automatically collect and record aircraft engine vibration data, identify            vibration or balance issues in an engine, and calculate a solution to the problem.            These units are used by major aircraft engine manufacturers, the U.S. Air Force,            other military and commercial airlines and gas turbine manufacturers.

 

**Technology**

 

A fuel            cell is an electrochemical energy conversion device, which is similar to a battery,            that produces electricity from a liquid or gaseous fuel, such as methanol, and an            oxidant, such as oxygen. Fuel cells are different from batteries in that they consume a            reactant, which must be replenished, while batteries store electrical energy chemically            in a closed system. Generally, the reactants flow in and reaction products flow out of            the fuel cell. While the electrodes within a battery react and change as a battery is            charged or discharged, a fuel cell’s electrodes are catalytic and relatively            stable.

 

The            direct methanol fuel cell relies upon the reaction of water with methanol at the            catalytic anode layer to release protons and electrons, and form carbon dioxide. The            electrons pass through a circuit and generate electricity that can be used to power            external devices. The protons generated through this reaction pass through the proton            exchange membrane to the cathode, where they combine to form water. The anode and            cathode layers of a direct methanol fuel cell are usually made of platinum particles            and platinum ruthenium particles embedded on either side of a proton exchange            membrane.

 

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Methanol fuel cells need water at the anode and therefore pure methanol            cannot be used without the provision of water via either active transport, such as the            pumping of water generated at the cathode back to the anode layer (see Chart A), or a            passive recirculation mechanism that incorporates pressurized internal ducts or piping.            Without either an active or a passive recirculation mechanism, a direct methanol fuel            cell would require the inclusion of water as a dilutant in the methanol fuel, which            limits the energy content of the diluted fuel (see Chart B).

 

**Direct Methanol Fuel Cell with Active Water Transport (Chart            A)**

 

 

**Methanol Fuel Cell With Water As A Fuel Dilutant (Chart            B)**

 

 

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Our            Mobion technology eliminates the need for active water recirculation pumps or the            inclusion of water as a fuel dilutant. The water required for reaction at the anode is            transferred internally within the Mobion Chip from the site of water generation on the            air-side of the cell through a proprietary, passive design that eliminates the need for            water movement by external pumps, complicated re-circulation loops or other            micro-plumbing tools (see Chart C).

 

**Our Mobion Technology with 100% Methanol and Passive Water            Recirculation (Chart C)**

 

 

Our            Mobion solution contains a passive water recirculation sub-system that allows for the            consumption of 100% methanol, results in a reduced parts count design and offers the            advantage of higher energy density than competing fuel cell technologies for portable            electronic devices.

 

**Strategic Agreements**

 

On            May 16, 2006, we entered into an alliance with Samsung Electronics Co., Ltd., or            Samsung, to develop next-generation fuel cell prototypes for Samsung’s mobile            phone business. We developed, and together with Samsung we jointly tested and            evaluated, our Mobion technology for several Samsung mobile phone applications. We are            continuing to work with Samsung on a non-exclusive collaboration under which we            continue to refine our Mobion baseline product design. We will share development            updates with Samsung and loan them prototypes for evaluation. Samsung may also request            changes to product specifications until December 2008 and may purchase commercial            samples as soon as they become available.

 

On            September 19, 2003, we entered into a strategic alliance agreement with the            Duracell division of The Gillette Company, or Duracell, under which we agreed to work            with Duracell to develop and commercialize complementary methanol fuel cell products to            power mass market, high-volume portable consumer devices. The agreement provides for a            multi-year partnership for the design, development, and commercialization of a low            power direct methanol fuel cell power system and a compatible fuel refill system. The            arrangement provides for us to receive a percentage of net revenues related to            Duracell’s sale of fuel refills for methanol fuel cells. The agreement gives            Duracell the ability to make equity investments in MTI Micro. Duracell has made an            initial $1.0 million investment in MTI Micro common stock and may make additional            investments of up to $4.0 million, subject to agreed upon milestones related to            technical and marketing progress. Any further investment by Duracell in MTI Micro will            effectively dilute our ownership interest in MTI Micro, although we do not believe that            such dilution will be substantial.

 

On            August 1, 2004, we entered into a $6.1 million cost-shared development            contract with the U.S. Department of Energy, or the DOE, for the development of            manufacturing techniques and the optimization of our Mobion product solutions. Through            February 2008, the DOE has authorized $5.5 million of spending on a cost-shared            basis.

 

On            December 13, 2007, we entered into an agreement with Trident Systems, Inc. to            pursue opportunities to leverage our consumer market platform into low-power military            markets. Teaming opportunities include demonstrations of unattended ground sensor            prototypes powered by Mobion and evaluations and potential submissions of proposals for            military programs.

 

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**Manufacturing**

 

We plan            to outsource manufacturing of our portable power source products through third-party            relationship contract manufacturers. We believe this strategy will provide us with a            business model that allows us to concentrate on our core competencies of research and            development and technological know-how and reduce our capital expenditures. In            addition, this strategy will significantly reduce our working capital requirements for            inventory because we will not incur most of our manufacturing costs until we have            actually shipped our portable power source products to our customers and billed those            customers for those products. To date, we have established an internal developmental            pilot production line to test our design and engineering capabilities. Although we have            developed an internal developmental pilot production line, we intend to rely upon third            parties to forecast production requirements and have established the basic design,            function, and performance of our in-house engineering capabilities to foster the            successful commercialization of our products.

 

The            commercialization of our Mobion power solution will depend upon our ability to reduce            the costs of our portable power source products, as they are currently more expensive            than existing rechargeable battery technologies. In addition, we continue to work on            enhancing our Mobion power source, including our injection molded Mobion Chip, design            to ensure its manufacturability (including engineering, verification and product            testing), design for assembly, design for testability, and design for serviceability,            all of which are critical to successful high-volume production.

 

We            assemble and test our test and instrumentation measurement products at our facilities            located in Albany, New York. We believe that our existing assembly and test capacity is            sufficient to meet our current needs and short-term future requirements. We believe            that most of the raw materials used in our test and measurement products are readily            available from a variety of vendors.

 

**Sales and Marketing**

 

We plan            to sell our portable power source products for incorporation into the products of our            OEM customers or to be sold as accessories through them. We plan to generate sales to            OEM customers through direct sales employees as well as outside sales representatives            and distributors. We have recently established sales representatives in South Korea and            Japan.

 

We            build awareness in our target markets through a series of targeted campaigns, which            include our website, e-mails, conferences, tradeshows, and other standard marketing            efforts. In addition, we monitor developments in the portable power industry through            subscriptions with well known firms such as Frost and Sullivan, a wide array of            publications, active public relations, updates with industry analysts and the            investment community, and speaking engagements.

 

We            market our test and measurement instrumentation products through a combination of            direct sales personnel and domestic and international distributors. We expect this            business to continue to achieve double digit year over year growth.

 

**Customers**

 

We            expect that our customers for our portable power source products will include a number            of the world’s largest electronic device OEMs.

 

Sales            of our test and measurement instrumentation products to Koyo, our Japanese distributor,            and the U.S. Air Force accounted for 27.8% and 26.4%, respectively, of product            revenue in 2007. In 2006, sales to the U.S. Air Force and Koyo accounted for 23.1%            and 22.9%, respectively, of product revenue. No other customer accounted for more than            10% of our product revenue in either 2006 or 2007.

 

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**Competition**

 

We            expect that the primary competitive factor in our portable power source business will            be market acceptance of our portable power source products as an alternative power            source to conventional lithium-ion and other rechargeable batteries. Market acceptance            of our portable power source products will depend on a wide variety of factors,            including the compatibility of direct methanol fuel cell power sources with portable            electronic devices and the market’s assessment of the advantages offered by our            products in terms of size, weight, power density and duration, safety, reliability, and            environmental friendliness when measured against price disadvantages. We anticipate            direct competition from large Asian-based companies and some of our potential OEM            customers.

 

Competition in the sale of our measurement and instrumentation products            is based on product quality, performance, price, and timely delivery. Our competitors            for test and measurement instrumentation products include National Instruments,            KLA-Tencor, Capacitec, Sigma Tech, Corning Tropel, Chadwick-Helmuth, ACES Systems,            Micro-Epsilon, and Keyence.

 

**Product Development**

 

Over            the past two years, we have developed and built a number of engineering prototypes used            to validate our technology and to generate discussions with potential customers about            the inclusion of our technology in new products. During the same period, we have            created three generations of external power charger prototypes, each of which has shown            a dramatic size reduction over the previous generation. Our latest external power            charger prototype achieved a 60% reduction in volume over our first generation            prototype.

 

We have            improved the capabilities of our Mobion Chip technology during the last two years,            which we expect will continue to evolve as we integrate greater functionality into our            designs. This continuous iterative integration process is intended to reduce the size,            simplify the design and construction, and reduce assembly complexity of our technology.            We continue to improve the product design of the Mobion Chip and believe that future            product generations will deliver performance improvements in terms of energy density,            size, weight, and power duration and should be able to power wireless electronic            devices for longer periods of time than rechargeable lithium-ion batteries.

 

**Intellectual Property and Proprietary Rights**

 

We rely            on a combination of patent (both national and international), trade secret, trademark,            and copyright protection to protect our intellectual property. Our strategy is to apply            for patent protection for all significant design requirements. Additionally, we            systematically analyze the existing intellectual property landscape for direct methanol            fuel cells to determine where the greatest opportunities for developing intellectual            property exist. We also enter into standard confidentiality agreements with our            employees, consultants, vendors, partners and potential customers and seek to control            access to and distribution of our proprietary information.

 

As of            December 31, 2007, we had filed over 90 U.S. patent applications, 43 of which            have been awarded. Of the awarded patents, 34 are assigned to us and 9 are assigned to            Duracell as part of our strategic alliance agreement with them. We have filed 22 Patent            Cooperation Treaty Applications and have filed for National Phase Patent Protection for            12 pieces of intellectual property in multiple countries, including Japan, the European            Union, and South Korea. We have developed a portfolio of patent applications in areas            including fuel cell systems, components, controls, manufacturing processes, and system            packaging.

 

**Research and Development**

 

Our            research and development team is responsible for advanced research, product planning,            design and development, and quality assurance. Through our supply chain, we are also            working with subcontractors in developing specific components of our            technologies.

 

The            primary objective of our research and development program is to advance the development            of our direct methanol fuel cell technology to enhance the commercial value of our            products and technology, as well as to develop next generation fuel cell            products.

 

We have            incurred research and development costs of approximately $9.7 million,            $12.9 million and $11.8 million for the years ended December 31, 2005,            2006, and 2007, respectively. We expect to continue to invest in research and            development in the future.

 

9

 

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**Employees**

 

As of            December 31, 2007, we had 107 employees compared with 132 as of            December 31, 2006. Of these employees, 46 were involved in our portable power            source business (including 25 scientists and engineers, of whom 18 had advanced            degrees) and 46 were involved in our test and measurement instrumentation business.            Fifteen of our employees are involved in corporate functions.

 

**Properties**

 

We            presently lease two premises, one located at 325 Washington Avenue Extension, Albany,            New York and the other at 431 New Karner Road, Albany, New York. Both leases expire at            the end of 2009. The 325 Washington Avenue Extension premise consists of approximately            20,700 useable square feet of space, and the 431 New Karner Road consists of            approximately 23,500 useable square feet of space. Together, the premises are adequate            for our current and foreseeable needs.

 

**Legal Proceedings**

 

We are            not currently involved in any legal proceeding that we believe would have a material            adverse effect on our business or financial condition.

 

**Availability of Information**

We make            available through our website (http://www.mechtech.com), free of charge, our Annual            Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and            amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of            the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable            after such reports are electronically filed with, or furnished to, the SEC. These            reports may be accessed through our website’s Investor Relations page.

 

The            public may read and copy any materials we file with the SEC at the SEC Public Reference            Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain            information on the operation of the Public Reference Room by calling the SEC at            1-800-SEC-0330. We file electronically with the SEC and the SEC maintains an Internet            site (http://www.sec.gov) that contains reports, proxy and information statements, and            other information regarding issuers that file electronically with the SEC.

10

 

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**Item            1A: Risk Factors**

 

**Factors Affecting Future Results**

 

This            Annual Report on Form 10-K and the documents we have filed with the SEC that are            incorporated by reference into this Annual Report on Form 10-K contain forward-looking            statements that involve risks and uncertainties. Any statements contained, or            incorporated by reference, in this Form 10-K that are not statements of historical fact            may be forward-looking statements. When we use the words “anticipate,”            “estimate,” “plans,” “projects,”            “continuing,” “ongoing,” “expects,”            “management believes,” “we believe,” “we intend,”            “should,” “could,” “may,” “will” and            similar words or phrases, we are identifying forward-looking statements.            Forward-looking statements involve risks, uncertainties, estimates and assumptions            which may cause our actual results, performance or achievements to be materially            different from those expressed or implied by forward-looking statements. These factors            include, among others:

 

|   | – | our history of recurring net losses and the risk of                            continued net losses; |
|--------|---------|------------------------------------------------------------------------------------------------------|

|   | – | our independent auditors raising substantial concern                            about our ability to continue as a going concern; |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------------------|

|   | – | the potential delisting of our common stock from The                            Nasdaq Global Market; |
|--------|---------|-------------------------------------------------------------------------------------------------------|

|   | – | sales revenue growth of our test and measurement                            instrumentation business may not be achieved; |
|--------|---------|---------------------------------------------------------------------------------------------------------------------------|

|   | – | the dependence of our test and measurement                            instrumentation business on a small number of customers and potential                            loss of government funding; |
|--------|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | risks related to developing Mobion direct methanol fuel                            cells and whether we will ever successfully develop reliable and                            commercially viable Mobion fuel cell solutions; |
|--------|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our need to raise additional financing; |
|--------|---------|-----------------------------------------|

|   | – | risks relating to the market price of Plug Power common                            stock; |
|--------|---------|-------------------------------------------------------------------------------------------|

|   | – | the risk that current regulations will not be changed to                            permit methanol to be carried onto airplanes; |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------------------|

|   | – | our portable power source products or our                            customers’ products that utilize our portable power source                            products may not be accepted by the market; |
|--------|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our inability to build and maintain relationships with                            our customers; |
|--------|---------|--------------------------------------------------------------------------------------------------|

|   | – | our limited experience in manufacturing fuel cell                            systems on a commercial basis; |
|--------|---------|-------------------------------------------------------------------------------------------------------------|

|   | – | our dependence on others for our production requirements                            for our portable power source products; |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------------|

|   | – | our dependence on our manufacturing subcontractors to                            maintain high levels of productivity and satisfactory delivery                            schedules for our portable power source products; |
|--------|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our dependence on third-party suppliers for most of the                            manufacturing equipment necessary to produce our portable power source                            products; |
|--------|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our inability to obtain sufficient quantities of                            components and other materials, including platinum and ruthenium,                            necessary for the production of our portable power source                            products; |
|--------|---------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our dependence on OEMs integrating Mobion fuel cell                            systems into their devices; |
|--------|---------|------------------------------------------------------------------------------------------------------------|

|   | – | our lack of long-term purchase commitments from our                            customers and the ability of our customers to cancel, reduce, or delay                            orders for our products; |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | risks related to protection and infringement of                            intellectual property; |
|--------|---------|---------------------------------------------------------------------------------------------------|

|   | – | our new technologies may not result in customer or                            market acceptance; |
|--------|---------|--------------------------------------------------------------------------------------------------|

|   | – | our ability to commercialize our proposed portable power                            source solutions and develop new product solutions on a timely                            basis; |
|--------|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | our ability to develop and utilize new technologies that                            address the needs of our customers; |
|--------|---------|-------------------------------------------------------------------------------------------------------------------------|

|   | – | intense competition in the direct methanol fuel cell and                            instrumentation businesses; |
|--------|---------|-----------------------------------------------------------------------------------------------------------------|

|   | – | change in policies by U.S. or foreign governments that                            hinder, disrupt or economically disadvantage international                            trade; |
|--------|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | the impact of future exchange rate                            fluctuations; |
|--------|---------|-----------------------------------------------------------------------------|

|   | – | uncertainty of the U.S. economy; |
|--------|---------|----------------------------------|

|   | – | the historical volatility of our stock price; |
|--------|---------|-----------------------------------------------|

|   | – | the cyclical nature of the electronics                            industry; |
|--------|---------|-----------------------------------------------------------------------------|

|   | – | failure of our strategic alliances to achieve their                            objectives or perform as contemplated and the risk of cancellation or                            early termination of such alliance by either party; |
|--------|---------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | product liability or defects; |
|--------|---------|-------------------------------|

|   | – | risks related to the flammable nature of methanol as a                            fuel source; |
|--------|---------|------------------------------------------------------------------------------------------------|

|   | – | the loss of services of one or more of our key employees                            or the inability to hire, train, and retain key personnel; |
|--------|---------|------------------------------------------------------------------------------------------------------------------------------------------------|

|   | – | significant periodic and seasonal quarterly fluctuations                            in our results of operations; and |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------|

|   | – | other factors referred to under the caption “Risk                            Factors” below. |
|--------|---------|----------------------------------------------------------------------------------------------------------|

 

Except            as may be required by applicable law, we do not undertake or intend to update or revise            our forward-looking statements, and we assume no obligation to update any            forward-looking statements contained in, or incorporated by reference into, this Annual            Report on Form 10-K as a result of new information or future events or developments.            Thus, assumptions should not be made that our silence over time means that actual            events are bearing out as expressed or implied in such forward-looking            statements.

 

11

 

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**Risk            Factors**

 

*Set            forth below are certain risks and uncertainties that could adversely affect our results            of operations or financial condition and cause our actual results to differ materially            from those expressed in our forward-looking statements. Also refer to Factors Affecting            Future Results.*

 

***We have incurred recurring net losses and anticipate continued net            losses as we execute our commercialization plan for our portable power source            business.***

We have            incurred recurring net losses, including net losses of $15.1 million in 2005, $13.7            million in 2006, and $9.6 million in 2007, which includes a net gain of $2.5 million            from the sale of securities available for sale and a net gain of $3.0 million on            derivatives in 2007. As a result of ongoing operating losses, we had an accumulated            deficit of approximately $105.1 million as of December 31, 2007. We expect to continue            to make significant expenditures and incur substantial expenses as we develop and            commercialize our proposed portable power source products; develop our manufacturing,            sales, and distribution networks; implement internal systems and infrastructure; and            hire additional personnel. As a result, we expect to continue to incur continued            significant losses as we execute our plan to commercialize our portable power source            business and may never achieve or maintain profitability. We will be unable to satisfy            our current obligations solely from cash generated from operations or become profitable            until we successfully commercialize our portable power source business. If we continue            to incur substantial losses and are unable to secure additional sources of funding, we            could be forced to discontinue or curtail our business operations; sell assets at            unfavorable prices; or merge, consolidate, or combine with a company with greater            financial resources in a transaction that may be unfavorable to us.

 

***We have received a going concern report from our independent            auditors.***

Our            auditors have included an explanatory paragraph in their opinion that accompanies our            audited consolidated financial statements as of December 31, 2007, indicating that            our recurring losses from operations, net capital deficiency, and current liquidity            position raise substantial doubt about our ability to continue as a going concern. The            accompanying consolidated financial statements do not include any adjustments that            might result from the outcome of this uncertainty.

 

***Our common stock may be delisted from The Nasdaq Global Market,            which may adversely affect our ability to raise capital and stockholders’ ability            to sell their shares.***

Nasdaq            notified us on January 9, 2008 that our common stock could be delisted from The Nasdaq            Global Market for failure to maintain a minimum bid price of $1.00 and that we had            until July 7, 2008 to regain compliance with the listing standards of such market. To            regain compliance, the closing bid price of our common stock must meet or exceed $1.00            per share for a minimum of 10 consecutive business days. If compliance is not regained,            Nasdaq will notify us of its determination to delist our common stock, which we may            appeal to its listings qualification panel. We may alternatively apply to transfer our            common stock to The Nasdaq Capital Market if we satisfy all of its requirements, other            than the minimum bid price, for initial inclusion on such market. If we elect to apply            for such a transfer and if such application is approved, we will be afforded the            remainder of a second 180 calendar day-period to regain compliance with the minimum bid            price rule while listed on The Nasdaq Capital Market. A delisting from The Nasdaq            Global Market may result in a decline of the price of our common stock and adversely            affect our ability to raise capital through the sale of common stock.

 

***We currently derive all of our product revenue from our test and            measurement instrumentation business, but our principal focus is the development and            commercialization of our portable power source business.***

We            currently derive all of our product revenue from our test and measurement            instrumentation business, but our principal focus is the development and            commercialization of our portable power source business. Our test and measurement            instrumentation business is subject to a number of risks, including the            following:

|   | **•** | a slow down or cancellation of sales to the military as                            a result of a potential redeployment of governmental                            funding; |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | a failure to expand the business as a result of                            competition, a lack of brand awareness, or market saturation;                            and |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | an inability to launch new products as a result of                            intensive competition, uncertainty of new technology development, and                            developmental timelines. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

In            addition, our test and measurement instrumentation products can be sold in quantity to            a relatively few number of customers, resulting in a customer concentration risk. The            loss of any significant portion of such customers or a material adverse change in the            financial condition of any one of these customers could have a material adverse effect            on our business.

 

12

 

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***We have not generated any product revenue from our portable power            source business and currently have no portable power source commercial            products.***

We have            not generated any product revenue from our portable power source business and currently            have no portable power source commercial products. The successful development and            commercialization of our portable power source products will depend on a number of            factors, including the following:

|   | **•** | continuing our research and development                            efforts; |
|--------|------------|-----------------------------------------------------------------------------|

|   | **•** | finalizing the design of our portable power source                            products; |
|--------|------------|-----------------------------------------------------------------------------------------|

|   | **•** | securing OEM customers to incorporate our portable power                            source products into products sold by them; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | arranging for adequate manufacturing capabilities;                            and |
|--------|------------|-----------------------------------------------------------------------------------|

|   | **•** | completing, refining, and managing our supply chain and                            distribution channels. |
|--------|------------|-----------------------------------------------------------------------------------------------------------|

             

Additionally, our technology is new and complex, and there may be            technical barriers to the development of our portable power source products. The            development of our portable power source products may not succeed or may be            significantly delayed. Our portable power source products will be produced through            manufacturing arrangements that have not been finalized or tested on a commercial            scale. If we fail to successfully develop or experience significant delays in the            development of our portable power source products, or if there are significant delays            in commercialization, we are unlikely to recover those losses, thus making it            impossible for us to become profitable through the sales of these products. This would            materially and adversely affect our business and financial condition. If adequate funds            are not available, we may have to delay development or commercialization of our            portable power source products or license to third parties the rights to commercialize            products or technologies that we would otherwise seek to commercialize. Any of these            factors could harm our business and financial condition.

Any            revenue derived in the relatively near relating to our portable power source business            likely will result from governmental contracts or other governmental funding. We can            offer no assurance that we will be able to secure continued government funding. The            loss of such contracts and the inability to obtain additionally contracts could            materially harm our business.

 

***We currently do not have sufficient funds to commercialize our            portable power source products.***

We will need additional funding to commercialize our portable power            source business. If we are unable to secure the necessary additional funding or to            raise funds from the sale of our test and measurement instrumentation business should            we determine to do so, we may need to delay further commercialization plans. In order            to conserve cash and extend operations while we pursue any additional necessary            financing, we would be required to reduce operating expenses. There is no assurance            that funds raised in any such a financing will be sufficient, that the financing will            be available on terms favorable to us or to existing stockholders and at such times as            required, or that we will be able to obtain the additional financing required for the            continued operation and growth of our business. If we raise additional funds by issuing            equity securities, our stockholders will experience dilution. Debt financing, if            available, may involve restrictive covenants.  Any debt financing or additional            equity financing may contain terms that are not favorable to us or our stockholders. If            we raise additional funds through collaboration and licensing arrangements with third            parties, it may be necessary to relinquish some rights to our technologies or our            products, or grant licenses on terms that are not favorable to us. If we are unable to            raise adequate funds, we may have to liquidate some or all of our assets or delay,            reduce the scope of or eliminate some or all of our research and development            programs.

 

A            primary asset of our company is the Plug Power common stock we own. As of December 31,            2007, we owned 1,137,166 shares of Plug Power common stock. Plug Power common stock is            traded on The Nasdaq Global Market. The market price of the Plug Power common stock may            fluctuate as a result of market conditions and other factors over which we have no            control. Fluctuations in the market price of Plug Power’s common stock may result            in a reduction of resources available to fund operations, which could result in our            requiring additional funding sooner than anticipated.

 

***If current U.S. Department of Transportation, Federal Aviation            Administration, and certain international regulations do not change, passengers will be            unable to carry methanol in the passenger compartments of airplanes, which would            adversely affect our sales and results of operations.***

Current            airline and Federal Aviation Administration regulations and certain international laws,            regulations, and treaties limit the amount and concentration of methanol that any            passenger can carry onboard passenger planes. We believe that these regulations must            change for mass commercialization of Mobion technology products to be possible. The            implementation by the U.S. Department of Transportation, the Federal Aviation            Administration, and other similar international bodies of regulatory changes approved            by the International Civil Aviation Organization will permit direct methanol fuel cell            systems and refill cartridges to be carried in the passenger compartment of airplanes.            If these regulations are not implemented, it would materially and adversely affect our            ability to achieve mass commercialization of Mobion technology products and have a            material adverse effect on our business plans, prospects, results of operations, and            financial condition.

 

13

 

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***Our portable power source products may not be accepted by the            market.***

Any            portable power source products that we develop may not achieve market acceptance. The            development of a successful market for our proposed portable power source products and            our ability to sell those products at favorable prices may be adversely affected by a            number of factors, many of which are beyond our control, including the            following:

|   | **•** | our failure to produce portable power source products                            that compete favorably against other products on the basis of price,                            quality, performance, and life; |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | competition from conventional lithium-ion or other                            rechargeable battery systems; |
|--------|------------|-------------------------------------------------------------------------------------------------------------|

|   | **•** | the ability of our technologies and product solutions to                            address the needs of the electronic device markets, the requirements of                            OEMs, and the preferences of end users; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | our ability to provide OEMs with portable power source                            products that provide advantages in terms of size, weight, peak power,                            power duration, reliability, durability, performance, and value-added                            features compared to alternative solutions; and |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | our failure to develop and maintain successful                            relationships with OEMs, manufacturers, distributors, and others as                            well as strategic partners. |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

Target            markets for our proposed portable power source products, such as those for smart            phones, digital cameras, and portable media players, are volatile, cyclical, and            rapidly changing and could continue to utilize existing technology or adopt other new            competing technologies. The market for certain of these products depends in part upon            the development and deployment of wireless and other technologies, which may or may not            address the needs of users of these new products.

Many            manufacturers of portable electronic devices have well-established relationships with            competitive suppliers. Penetrating these markets will require us to offer better            performance alternatives to existing solutions at competitive costs. The failure of any            of our target markets to continue to expand, or our failure to penetrate these markets            to a significant extent, will impede our sales growth. We cannot predict the growth            rate of these markets or the market share we will achieve in these markets in the            future.

If our            proposed portable power source products fail to gain market acceptance, it could            materially and adversely affect our business and financial condition.

 

***Market acceptance of our customers’ products that utilize            our portable power source products may decline or may not develop and, as a result, our            sales will be harmed.***

We            currently do not anticipate selling our portable power source products directly to end            users. Instead, we plan to produce portable power source products that our OEM            customers incorporate into their products. As a result, the success of our proposed            portable power source products will depend upon the widespread market acceptance of the            products of our OEM customers. We will not control or influence the manufacture,            promotion, distribution, or pricing of the products that incorporate our portable power            source products. Instead, we will depend on our OEM customers to manufacture and            distribute products incorporating our portable power source products and to generate            consumer demand through their marketing and promotional activities. Even if our            technologies and products successfully meet our customers’ price and performance            goals, our sales would be harmed if our OEM customers do not achieve commercial success            in selling their products to consumers that incorporate our portable power source            products.

Any            lack of adoption in the use of our portable power source products by OEM customers in            the electronic device markets, the reduced demand for our OEM customers’            products, or a slowdown in their markets would adversely affect our sales.

 

***If we fail to build and maintain relationships with our customers            and do not satisfy our customers, we may lose future sales and our revenue may stagnate            or decline.***

Because            our success depends on the widespread market acceptance of our customers’            products, we must develop and maintain our relationships with leading global OEMs of            electronic devices, such as smart phones, digital cameras, and portable media players.            In addition, we must identify areas of significant growth potential in other markets,            establish relationships with OEMs in those markets, and assist them in developing            products that use our portable power source products and technologies. Our failure to            identify potential growth opportunities, particularly in new markets, or establish and            maintain relationships with OEMs in those markets, would prevent our business from            growing in those markets.

Our            ability to meet the expectations of our customers will require us to provide portable            power source products for customers on a timely and cost-effective basis and to            maintain customer satisfaction with our product solutions. We must match our design and            production capacity with customer demand, maintain satisfactory delivery schedules, and            meet specific performance goals. If we are unable to achieve these goals for any            reason, our customers could reduce their purchases from us and our sales would decline            or fail to develop.

Our            customer relationships also can be affected by factors affecting our customers that are            unrelated to our performance. These factors can include a myriad of situations,            including business reversals of customers, determinations by customers to change their            product mix or abandon business segments, or mergers, consolidations, or acquisitions            involving our customers.

 

14

 

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***We have no experience manufacturing portable power source products            on a commercial scale.***

To            date, we have focused primarily on research, development, and pilot production, and we            have no experience manufacturing any portable power source products on a commercial            scale. Our pilot production efforts to date have been limited in scale. It is our            intent to manufacture our portable power source products through OEM customers and            third-party manufacturers. Failure to secure manufacturing capabilities could            materially and adversely affect our business and financial condition.

 

***We will rely on others for our production, and any interruptions            of these arrangements could disrupt our ability to fill our customers’            orders.***

We plan            to rely on others for all of our production requirements for our portable power source            products. The majority of this manufacturing is anticipated to be conducted in Asia by            manufacturing subcontractors that also perform services for numerous other companies.            We do not expect to have a guaranteed level of production capacity with any of our            manufacturing subcontractors. Qualifying new manufacturing subcontractors is time            consuming and might result in unforeseen manufacturing and operations problems. The            loss of our relationships with our manufacturing subcontractors or assemblers or their            inability to conduct their manufacturing and assembly services for us as anticipated in            terms of cost, quality, and timeliness could adversely affect our ability to fill            customer orders in accordance with required delivery, quality, and performance            requirements. If this were to occur, the resulting decline in revenue would harm our            business.

 

***We will depend on third parties to maintain satisfactory            manufacturing yields and delivery schedules, and their inability to do so could            increase our costs, disrupt our supply chain, and result in our inability to deliver            our portable power source products, which would adversely affect our results of            operations.***

We will            depend on our manufacturing subcontractors to maintain high levels of productivity and            satisfactory delivery schedules for our portable power source products from            manufacturing and assembly facilities likely located primarily in Asia. We plan to            provide our manufacturing subcontractors with rolling forecasts of our production            requirements. We do not, however, anticipate having long-term agreements with any of            our manufacturing subcontractors that guarantee production capacity, prices, lead            times, or delivery schedules. Our manufacturing subcontractors will serve other            customers, many of which will have greater production requirements than we do. As a            result, our manufacturing subcontractors could determine to prioritize production            capacity for other customers or reduce or eliminate deliveries to us on short notice.            We may experience lower than anticipated manufacturing yields and lengthening of            delivery schedules. Lower than expected manufacturing yields could increase our costs            or disrupt our supply chain. We may encounter lower manufacturing yields and longer            delivery schedules while commencing volume production of any new products. Any of these            problems could result in our inability to deliver our product solutions in a timely            manner and adversely affect our operating results.

 

***We plan to rely on third-party suppliers for most of our            manufacturing equipment.***

We plan            to rely on third-party suppliers for most of the manufacturing equipment necessary to            produce our portable power source products. The failure of suppliers to supply            manufacturing equipment in a timely manner or on commercially reasonable terms could            delay our commercialization plans and otherwise disrupt our production schedules or            increase our manufacturing costs. Further, our orders with certain of our suppliers may            represent a very small portion of their total orders. As a result, they may not give            priority to our business, leading to potential delays in or cancellation of our orders.            If any single-source supplier were to fail to supply our needs on a timely basis or            cease providing us with key components, we would be required to substitute suppliers.            We may have difficulty identifying a substitute supplier in a timely manner and on            commercially reasonable terms. If this were to occur, our business would be            harmed.

 

***Shortages of components and raw materials may delay or reduce our            sales and increase our costs, thereby harming our results of            operations.***

The            inability to obtain sufficient quantities of components and other materials, including            platinum and ruthenium, necessary for the production of our portable power source            products could result in reduced or delayed sales or lost orders. Any delay in or loss            of sales could adversely impact our operating results. Many of the materials used in            the production of our portable power source products will be available only from a            limited number of foreign suppliers, particularly suppliers located in Asia. In most            cases, neither we nor our manufacturing subcontractors will have long-term supply            contracts with these suppliers. As a result, we will be subject to economic instability            in these Asian countries as well as to increased costs, supply interruptions, and            difficulties in obtaining materials. Our customers also may encounter difficulties or            increased costs in obtaining the materials necessary to produce their products into            which our product solutions are incorporated.

From            time to time, materials and components necessary for our portable power source products            or in other aspects of our customers’ products may be subject to allocation            because of shortages of these materials and components. Shortages in the future could            cause delayed shipments, customer dissatisfaction, and lower revenue.

 

15

 

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***We will be subject to lengthy development periods and product            acceptance cycles, which can result in development and engineering costs without any            future revenue.***

We plan            to provide portable power source solutions that are incorporated by OEMs into the            products they sell. OEMs will make the determination during their product development            programs whether to incorporate our portable power source solutions or pursue other            alternatives. This process may require us to make significant investments of time and            resources in the design of portable power source solutions well before our customers            introduce their products incorporating our product solutions and before we can be sure            that we will generate any significant sales to our customers or even recover our            investment. During a customer’s entire product development process, we will face            the risk that our portable power source products will fail to meet our customer’s            technical, performance, or cost requirements or that our products will be replaced by            competitive products or alternative technological solutions. Even if we complete our            design process in a manner satisfactory to our customer, the customer may decide to            delay or terminate its product development efforts. The occurrence of any of these            events could cause sales to not materialize, to be deferred, or to be cancelled, which            would adversely affect our operating results.

 

***We will not have long-term purchase commitments from our            customers, and their ability to cancel, reduce, or delay orders could reduce our            revenue and increase our costs.***

Customers for our portable power source products will not provide us            with firm, long-term volume purchase commitments, but instead will issue purchase            orders to buy a specified number of units. As a result, customers may be able to cancel            purchase orders or reduce or delay orders at any time. The cancellation, delay, or            reduction of customer purchase orders could result in reduced revenue, excess            inventory, and unabsorbed overhead. We currently have no presence in the electronic            device markets. Our success in the electronic device markets will require us to            establish the value added proposition of our products to OEMs that have traditionally            used other portable power solutions. All of the markets we plan to serve are subject to            severe competitive pressures, rapid technological change and product obsolescence,            which may increase our inventory and overhead risks, resulting in increased            costs.

 

***Variability of customer requirements resulting in cancellations,            reductions, or delays may adversely affect our operating results.***

We will            be required to provide rapid product turnaround and respond to short lead times. A            variety of conditions, both specific to individual customers and generally affecting            the demand for OEMs’ products, may cause customers to cancel, reduce, or delay            orders. Cancellations, reductions, or delays by a significant customer or by a group of            customers could adversely affect our operating results. Customers may require rapid            increases in production, which could strain our resources and reduce our            margins.

 

***If we are unable to adequately protect our intellectual property,            our competitors and other third parties could produce products based on our            intellectual property, which would substantially impair our ability to            compete.***

Our            success and ability to compete depends in part upon our ability to maintain the            proprietary nature of our technologies. We rely on a combination of patent, trade            secret, copyright, and trademark law and license agreements, as well as nondisclosure            agreements, to protect our intellectual property. These legal means, however, afford            only limited protection and may not be adequate to protect our intellectual property            rights. We cannot be certain that we were the first creator of inventions covered by            pending patent applications or the first to file patent applications on these            inventions. In addition, we cannot be sure that any of our pending patent applications            will issue. The United States Patent and Trademark Office, or other foreign patent and            trademark offices may deny or significantly narrow claims made under our patent            applications and, even if issued, these patents may be successfully challenged,            designed around, or may otherwise not provide us with any commercial            protection.

We may            in the future need to assert claims of infringement against third parties to protect            our intellectual property. Regardless of the final outcome, any litigation to enforce            our intellectual property rights in patents, copyrights, or trademarks could be highly            unpredictable and result in substantial costs and diversion of resources, which could            have a material and adverse effect on our business and financial condition. In the            event of an adverse judgment, a court could hold that some or all of our asserted            intellectual property rights are not infringed, or are invalid or unenforceable, and            could award attorneys’ fees to the other party.

 

***We may become subject to claims of infringement or            misappropriation of the intellectual property rights of others, which could prohibit us            from selling our products, require us to obtain licenses from third parties or to            develop non-infringing alternatives, and subject us to substantial monetary damages and            injunctive relief.***

We may            receive notices from third parties that the manufacture, use, or sale of any products            we develop infringes one or more claims of their patents. Moreover, because patent            applications can take many years to issue, there may be currently pending applications,            unknown to us, which may later result in issued patents that materially and adversely            affect our business. Third parties could also assert infringement or misappropriation            claims against us with respect to our future product offerings, if any. Whether or not            such claims are valid, we cannot be certain that we have not infringed the intellectual            property rights of such third parties. Any infringement or misappropriation claim could            result in significant costs, substantial damages, and our inability to manufacture,            market, or sell any of our product offerings that are found to infringe. Even if we            were to prevail in any such action, the litigation

 

16

 

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could            result in substantial cost and diversion of resources that could materially and            adversely affect our business. If a court determined, or if we independently            discovered, that our product offerings violated third-party proprietary rights, there            can be no assurance that we would be able to re-engineer our product offerings to avoid            those rights or obtain a license under those rights on commercially reasonable terms,            if at all. As a result, we could be prohibited from selling products that are found to            infringe upon the rights of others. Even if obtaining a license were feasible, it may            be costly and time-consuming. A court could also enter orders that temporarily,            preliminarily, or permanently enjoin us from making, using, selling, offering to sell,            or importing our portable power source products, or could enter orders mandating that            we undertake certain remedial activities. Further, a court could order us to pay            compensatory damages for such infringement, plus prejudgment interest, and could in            addition treble the compensatory damages and award attorneys’ fees. These damages            could materially and adversely affect our business and financial condition.

 

***Confidentiality agreements with employees and others may not            adequately prevent disclosure of our trade secrets and other proprietary information,            which could limit our ability to compete.***

We rely            on trade secrets to protect our proprietary technology and processes. Trade secrets are            difficult to protect. We enter into confidentiality and intellectual property            assignment agreements with our employees, consultants, and other advisors. These            agreements generally require that the other party keep confidential and not disclose to            third parties confidential information developed by the party or made known to the            party by us during the course of the party’s relationship with us. However, these            agreements may not be honored and enforcing a claim that a party illegally obtained and            is using our trade secrets is difficult, expensive and time-consuming, and the outcome            is unpredictable. The failure to obtain and maintain trade secret protection could            adversely affect our competitive position.

 

***Our efforts to develop new technologies may not result in            commercial success, which could cause a decline in our revenue and could harm our            business.***

Our            research and development efforts with respect to our technologies may not result in            customer or market acceptance. Some or all of those technologies may not successfully            make the transition from the research and development lab to cost-effective production            as a result of technology problems, competitive cost issues, yield problems, and other            factors. Even when we successfully complete a research and development effort with            respect to a particular technology, our customers may decide not to introduce or may            terminate products utilizing the technology for a variety of reasons, including the            following:

|   | **•** | difficulties with other suppliers of components for the                            products; |
|--------|------------|----------------------------------------------------------------------------------------------|

|   | **•** | superior technologies developed by our competitors and                            unfavorable comparisons of our solutions with these                            technologies; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | price considerations; and |
|--------|------------|---------------------------|

|   | **•** | lack of anticipated or actual market demand for the                            products. |
|--------|------------|------------------------------------------------------------------------------------------|

             

The            nature of our business will require us to make continuing investments for new            technologies. Significant expenses relating to one or more new technologies that            ultimately prove to be unsuccessful for any reason could have a material adverse effect            on us. In addition, any investments or acquisitions made to enhance our technologies            may prove to be unsuccessful. If our efforts are unsuccessful, our business could be            harmed.

 

***We may not be able to enhance our product solutions and develop            new product solutions in a timely manner.***

Our            future operating results will depend to a significant extent on our ability to provide            new portable power source products that compare favorably with alternative solutions on            the basis of time to introduction, cost, performance, and end-user preferences. Our            success in attracting customers and developing business will depends on various            factors, including the following:

|   | **•** | innovative development of new portable power source                            products for customer products; |
|--------|------------|----------------------------------------------------------------------------------------------------------------|

|   | **•** | utilization of advances in technology; |
|--------|------------|----------------------------------------|

|   | **•** | maintenance of quality standards; |
|--------|------------|-----------------------------------|

|   | **•** | efficient and cost-effective solutions; and |
|--------|------------|---------------------------------------------|

|   | **•** | timely completion of the design and introduction of new                            portable power source products. |
|--------|------------|--------------------------------------------------------------------------------------------------------------------|

             

Our            inability to commercialize our proposed portable power source solutions and develop new            product solutions on a timely basis could harm our operating results and impede our            growth.

 

***If we do not keep pace with technological innovations, our            products may not be competitive and our revenue and operating results may            suffer.***

Technological advances, the introduction of new products, and new design            techniques could adversely affect our business prospects unless we are able to adapt to            the changing conditions. Technological advances could render our proposed portable            power source products obsolete, and we may not be able to respond effectively to the            technological requirements of evolving markets. As a result, we will be required to            expend substantial funds for and commit significant resources to

 

17

 

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|   | **•** | continue research and development activities on portable                            power source products; |
|--------|------------|------------------------------------------------------------------------------------------------------------|

|   | **•** | hire additional engineering and other technical                            personnel; and |
|--------|------------|-------------------------------------------------------------------------------------------|

|   | **•** | purchase advanced design tools and test                            equipment. |
|--------|------------|-------------------------------------------------------------------------------|

             

Our            business could be harmed if we are unable to develop and utilize new technologies that            address the needs of our customers, or our competitors or customers do so more            effectively than we do.

 

***New technologically solutions that achieve significant market            share could harm our business.***

New            portable power source solutions could be developed. Existing electronic devices also            could be modified to allow for a different power source solution. Our business could be            harmed if our products become noncompetitive as a result of a technological            breakthrough that allows a new power source solution to displace our solution and            achieve significant market acceptance.

 

***Our inability to respond to changing technologies will harm our            business.***

The            electronics industry is subject to constant technological change. Our future success            will depend on our ability to respond appropriately to changing technologies and            changes in product function and quality. If we rely on products and technologies that            are not attractive to consumers, we may not be successful in capturing or retaining any            significant market share. In addition, any new technologies utilized in our portable            power source products may not perform as expected or as desired, in which event our            adoption of such products or technologies may harm our business.

 

***International sales and manufacturing risks could adversely affect            our operating results.***

We            anticipate that the manufacturing and assembly operations for our portable power source            products will be conducted primarily in Asia by manufacturing subcontractors. We also            believe that many of our OEM customers will be located and much of our sales and            distribution operations will be conducted in Asia. These international operations will            expose us to various economic, political, and other risks that could adversely affect            our operations and operating results, including the following:

|   | **•** | difficulties and costs of staffing and managing a                            multi-national organization; |
|--------|------------|-----------------------------------------------------------------------------------------------------------|

|   | **•** | unexpected changes in regulatory                            requirements; |
|--------|------------|---------------------------------------------------------------------------|

|   | **•** | differing labor regulations; |
|--------|------------|------------------------------|

|   | **•** | potentially adverse tax consequences; |
|--------|------------|---------------------------------------|

|   | **•** | tariffs and duties and other trade barrier                            restrictions; |
|--------|------------|-------------------------------------------------------------------------------------|

|   | **•** | possible employee turnover or labor unrest; |
|--------|------------|---------------------------------------------|

|   | **•** | greater difficulty in collecting accounts                            receivable; |
|--------|------------|----------------------------------------------------------------------------------|

|   | **•** | the burdens and costs of compliance with a variety of                            foreign laws; |
|--------|------------|------------------------------------------------------------------------------------------------|

|   | **•** | potentially reduced protection for intellectual property                            rights; and |
|--------|------------|-------------------------------------------------------------------------------------------------|

|   | **•** | political or economic instability in certain parts of                            the world. |
|--------|------------|---------------------------------------------------------------------------------------------|

             

The            risks associated with international operations could negatively affect our operating            results.

 

***Our business may suffer if international trade is hindered,            disrupted, or economically disadvantaged.***

Political and economic conditions abroad may adversely affect the            foreign production and sale of our portable power source products. Protectionist trade            legislation in either the United States or foreign countries, such as a change in the            current tariff structures, export or import compliance laws, or other trade policies,            could adversely affect our ability to sell our portable power source products in            foreign markets and to obtain materials or equipment from foreign suppliers.

Changes            in policies by the U.S. or foreign governments resulting in, among other things, higher            taxation, currency conversion limitations, restrictions on the transfer of funds, or            the expropriation of private enterprises also could have a material adverse effect on            us. Any actions by countries in which we conduct business to reverse policies that            encourage foreign investment or foreign trade also could adversely affect our operating            results. In addition, U.S. trade policies, such as “most favored nation”            status and trade preferences for certain Asian nations could affect the attractiveness            of our products to our U.S. customers and adversely impact our operating            results.

 

***Our operating results could be adversely affected by fluctuations            in the value of the U.S. dollar against foreign currencies.***

We plan            to transact our portable power source business predominantly in U.S. dollars and bill            and collect our sales in U.S. dollars. A weakening of the dollar could cause our            overseas vendors to require renegotiation of either the prices or currency we pay for            their goods and services. In the future, customers may negotiate pricing and make            payments in non-U.S. currencies.

 

18

 

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If our            overseas vendors or customers require us to transact business in non-U.S. currencies,            fluctuations in foreign currency exchange rates could affect our cost of goods,            operating expenses, and operating margins and could result in exchange losses. In            addition, currency devaluation can result in a loss to us if we hold deposits of that            currency. Hedging foreign currencies can be difficult, especially if the currency is            not freely traded. We cannot predict the impact of future exchange rate fluctuations on            our operating results.

 

***We expect that a majority of our manufacturing subcontractors will            be located in Asia, increasing the risk that a natural disaster, labor strike, war, or            political unrest in those countries would disrupt our operations.***

We            expect that a majority of our manufacturing subcontractors will be located in Asia.            Events out of our control, such as earthquakes, fires, floods, or other natural            disasters, or political unrest, war, labor strikes, or work stoppages in Asia could            disrupt their operations, which would impact our business. In addition, there is            political tension between Taiwan and China that could lead to hostilities. If any of            these events occur, we may not be able to obtain alternative manufacturing capacity.            Failure to secure alternative manufacturing capacity could cause a delay in the            shipment of our products, which would cause our revenue to fluctuate or            decline.

 

***Continuing uncertainty of the U.S. economy may have serious            implications for the growth and stability of our business and may negatively affect our            stock price.***

The            revenue growth and profitability of our business will depend significantly on the            overall demand for electronic devices. Softening demand in these markets caused by            ongoing economic uncertainty may result in decreased revenue or earnings levels or            growth rates. The U.S. economy has been historically cyclical, and market conditions            continue to be challenging, which has resulted in individuals and companies delaying or            reducing expenditures. Further delays or reductions in spending could have a material            adverse effect on demand for our products, and consequently on our business, financial            condition, results of operations, prospects, and stock price.

 

***The electronics industry is cyclical and may result in            fluctuations in our operating results.***

The            electronics industry has experienced significant economic downturns at various times.            These downturns are characterized by diminished product demand, accelerated erosion of            average selling prices, and production overcapacity. In addition, the electronics            industry is cyclical in nature. We will seek to reduce our exposure to industry            downturns and cyclicality by providing design and production services for leading            companies in rapidly expanding industry segments. We may, however, experience            substantial period-to-period fluctuations in future operating results because of            general industry conditions or events occurring in the general economy.

 

***Our strategic alliances may not achieve their objectives, and            their failure to do so could impede our growth.***

Our            prospectus depends to a significant extent on our strategic allowances with Samsung and            Gillette. In addition, we plan to explore additional strategic alliances designed to            enhance or complement our technology or to work in conjunction with our technology; to            provide necessary know-how, components, or supplies; and to develop, introduce, and            distribute products utilizing our technology. Any strategic alliances may not achieve            their intended objectives, may be cancelled by either party, and parties to our            strategic alliances may not perform as contemplated. The failure of these alliances may            impede our ability to introduce new products and enter new markets.

 

***Product liability claims against us could result in adverse            publicity and potentially significant monetary damages.***

As a            seller of consumer products using a flammable material such as methanol, we will face            an inherent risk of exposure to product liability claims in the event injuries from            product usage by customers. It is possible that our products could result in injury,            whether by product malfunctions, defects, improper installation, or other causes. If            such injuries or claims of injuries were to occur, we could incur monetary damages and            our business could be adversely affected by any resulting negative publicity. The            successful assertion of product liability claims against us could result in potentially            significant monetary damages and, if our insurance protection is inadequate to cover            these claims, could require us to make significant payments from our own            resources.

 

***We expect to face intense competition that could result in failing            to gain market share and suffering reduced revenue from our portable power source            products.***

We plan            to serve intensely competitive markets that are characterized by price erosion, rapid            technological change, and competition from major domestic and international companies.            This intense competition could result in pricing pressures, lower sales, reduced            margins, and lower market share. Most of our competitors have greater market            recognition, larger customer bases, and substantially greater financial, technical,            marketing, distribution, and other resources than we possess and that afford them            competitive advantages. As a result, they may be able to devote greater resources to            the promotion and sale of products, to negotiate lower prices for raw materials and            components, to deliver competitive products at lower prices, and to introduce new            product solutions and

 

19

 

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respond            to customer requirements more quickly than we can. Our competitive position could            suffer if one or more of our customers determine not to utilize our portable power            source products and instead decide to contract with our competitors or to use            alternative technologies.

Our            ability to compete successfully will depend on a number of factors, both within and            outside our control. These factors include the following:

|   | **•** | our success in designing and introducing new portable                            power source products; |
|--------|------------|---------------------------------------------------------------------------------------------------------|

|   | **•** | our ability to predict the evolving needs of our                            customers and to assist them in incorporating our technologies into                            their new products; |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | our ability to meet our customer’s requirements                            for small size, low weight, peak power, long power duration, ease of                            use, reliability, durability, and small form factor; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | the quality of our customer services; |
|--------|------------|---------------------------------------|

|   | **•** | the rate at which customers incorporate our products                            into their own products; |
|--------|------------|----------------------------------------------------------------------------------------------------------|

|   | **•** | product or technology introductions by our competitors;                            and |
|--------|------------|----------------------------------------------------------------------------------------|

|   | **•** | foreign currency fluctuations, which may cause a foreign                            competitor’s products to be priced significantly lower than our                            products. |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

***We depend on key personnel who would be difficult to replace, and            our business will likely be harmed if we lose their services or cannot hire additional            qualified personnel.***

Our            success will depend substantially on the efforts and abilities of our senior management            and key personnel. The competition for qualified management and key personnel,            especially engineers, is intense. Although we maintain noncompetition and nondisclosure            covenants with most of our key personnel, we do not have employment agreements with            most of them. The loss of services of one or more of our key employees or the inability            to hire, train, and retain key personnel, especially engineers and technical support            personnel, and capable sales and customer-support employees outside the United States,            could delay the development and sale of our products, disrupt our business, and            interfere with our ability to execute our business plan.

 

***Our operating results may experience significant            fluctuations.***

In            addition to the variability resulting from the short-term nature of our            customers’ commitments, other factors will contribute to significant periodic and            seasonal quarterly fluctuations in our results of operations. These factors include the            following:

|   | **•** | the cyclicality of the markets we serve; |
|--------|------------|------------------------------------------|

|   | **•** | the timing and size of orders; |
|--------|------------|--------------------------------|

|   | **•** | the volume of orders relative to our                            capacity; |
|--------|------------|---------------------------------------------------------------------------|

|   | **•** | product introductions and market acceptance of new                            products or new generations of products; |
|--------|------------|------------------------------------------------------------------------------------------------------------------------|

|   | **•** | evolution in the life cycles of our customers’                            products; |
|--------|------------|-------------------------------------------------------------------------------------------|

|   | **•** | timing of expenses in anticipation of future                            orders; |
|--------|------------|---------------------------------------------------------------------------------|

|   | **•** | changes in product mix; |
|--------|------------|-------------------------|

|   | **•** | availability of manufacturing and assembly                            services; |
|--------|------------|---------------------------------------------------------------------------------|

|   | **•** | changes in cost and availability of labor and                            components; |
|--------|------------|--------------------------------------------------------------------------------------|

|   | **•** | timely delivery of product solutions to                            customers; |
|--------|------------|-------------------------------------------------------------------------------|

|   | **•** | pricing and availability of competitive                            products; |
|--------|------------|------------------------------------------------------------------------------|

|   | **•** | introduction of new technologies into the markets we                            serve; |
|--------|------------|----------------------------------------------------------------------------------------|

|   | **•** | pressures on reducing selling prices; |
|--------|------------|---------------------------------------|

|   | **•** | our success in serving new markets; and |
|--------|------------|-----------------------------------------|

|   | **•** | changes in economic conditions. |
|--------|------------|---------------------------------|

             

Accordingly, you should not rely on period-to-period comparisons as an            indicator of our future performance. Negative or unanticipated fluctuations in our            operating results may result in a decline in the price of our stock.

 

20

 

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**Item            2: Properties**

 

We            lease office, manufacturing and research and development space in the following            locations:

 

| **Location** | **Segment**                           | **Primary Use**                                              | **Approximate Number of**

**Square Feet** | **Lease Expiration** |
|--------------|---------------------------------------|--------------------------------------------------------------|--------------------------------------------|----------------------|
|         |                                  |                                                         |                                       |                 |
| Albany, NY   | Test and Measurement

Instrumentation | Manufacturing, office and sales                              | 20,700                                     | 2009                 |
| Albany, NY   | New Energy                            | Corporate headquarters, office and

research and development | 23,500                                     | 2009                 |

 

We            believe our facilities are generally well maintained and adequate for our current needs            and for expansion, if required. We further believe that a lease renewal on reasonable            terms for these properties may be achieved.

 

**Item 3: Legal Proceedings**

 

At any            point in time, we may be involved in various lawsuits or other legal proceedings. Such            lawsuits could arise from the sale of products or services or from other matters            relating to its regular business activities, compliance with various governmental            regulations and requirements, or other transactions or circumstances. We do not believe            there are any such proceedings presently pending which could have a material adverse            effect on our financial condition.

 

**Item 4: Submission of Matters to a Vote of Security            Holders**

 

There were no matters submitted to a vote of our security holders during            the fourth quarter of fiscal 2007.

 

21

 

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**PART II**

 

**Item 5: Market for Registrant’s Common Equity, Related            Stockholder Matters and Issuer Purchases of Equity Securities**

 

**Price Range of Common Stock**

Our            common stock is traded on The Nasdaq Global Market under the symbol “MKTY”.            The following table sets forth the high and low sale prices of our common stock as            reported by Nasdaq for the periods indicated:

 

|                                    |   |   | **High** |   |   | **Low** |
|-----------------------------------------|--------|--------|----------|--------|--------|---------|
| **Fiscal Year Ended December 31, 2006** |   |   |     |   |   |    |
| First Quarter                           |   | $      | 3.90     |   | $      | 2.70    |
| Second Quarter                          |   |   | 5.00     |   |   | 2.00    |
| Third Quarter                           |   |   | 2.49     |   |   | 1.27    |
| Fourth Quarter                          |   |   | 2.96     |   |   | 1.55    |
| **Fiscal Year Ended December 31, 2007** |   |   |     |   |   |    |
| First Quarter                           |   | $      | 1.93     |   | $      | 1.32    |
| Second Quarter                          |   |   | 1.80     |   |   | 1.20    |
| Third Quarter                           |   |   | 1.41     |   |   | 0.90    |
| Fourth Quarter                          |   |   | 1.35     |   |   | 0.72    |

 

**Item            6: Selected Financial Data**

 

The            following table sets forth our summary consolidated financial data for the fiscal years            ended December 31, 2005, 2006, and 2007, which was derived from our audited            consolidated financial statements included elsewhere in this Annual Report on Form            10-K. We derived our summary consolidated financial data for the years ended December            31, 2003 and 2004 set forth in the following table from our audited consolidated            financial statement not included in this report. You should read the following summary            consolidated financial data together with the information under            “Management’s Discussion and Analysis of Financial Condition and Results of            Operations” and our consolidated financial statements, including the related            notes thereto.

| (In thousands, except per share data)                                                                                                                                      |   | **Years Ended December 31,** |    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                                                                                                       |   | **2003**                     |    | **2004** |   | **2005** |   | **2006** |   | **2007** |   |
| **Statement of Operations Data**                                                                                                                                           |   |                         |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product revenue                                                                                                                                                            |   | $                            | 5,547   |   | $ | 7,530 |   | $ | 6,012 |   | $ | 7,667 |   | $ | 9,028 |   |
| Funded research and development revenue                                                                                                                                    |   |                         | 2,311   |   |   | 1,040 |   |   | 1,829 |   |   | 489 |   |   | 1,556 |   |
| Gain (loss) on derivatives                                                                                                                                                 |   |                         | (6      | ) |   | 614 |   |   | (10,407 | ) |   | 182 |   |   | 2,967 |   |
| Net gain (loss) on sale of securities available for                            sale                                                                                        |   |                         | 7,483   |   |   | 3,626 |   |   | 10,125 |   |   | 4,289 |   |   | 2,549 |   |
| (Loss) income from continuing operations before income                            taxes, equity in holdings’ losses and minority                            interest |   |                         | (1,731  | ) |   | (9,121 | ) |   | (14,949 | ) |   | (12,980 | ) |   | (7,609 | ) |
| Income tax (expense) benefit                                                                                                                                               |   |                         | 669     |   |   | 3,564 |   |   | (1,587 | ) |   | (1,895 | ) |   | (2,548 | ) |
| Minority interests in losses of consolidated                            subsidiary                                                                                         |   |                         | 490     |   |   | 1,366 |   |   | 1,442 |   |   | 1,208 |   |   | 582 |   |
| Loss from continuing operations                                                                                                                                            |   |                         | (572    | ) |   | (4,191 | ) |   | (15,094 | ) |   | (13,667 | ) |   | (9,575 | ) |
| Income from discontinued operations, net of                            taxes                                                                                               |   |                         | 13      |   |   | — |   |   | — |   |   | — |   |   | — |   |
| Net (loss) income                                                                                                                                                          |   | $                            | (559    | ) | $ | (4,191 | ) | $ | (15,094 | ) | $ | (13,667 | ) | $ | (9,575 | ) |
|                                                                                                                                                                       |   |                         |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Basic and Diluted (Loss) Earnings Per                            Share**                                                                                                 |   |                         |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss from continuing operations                                                                                                                                            |   | $                            | (0.02   | ) | $ | (0.14 | ) | $ | (0.49 | ) | $ | (0.43 | ) | $ | (0.25 | ) |
| Income from discontinued operations                                                                                                                                        |   |                         | — |   |   | — |   |   | — |   |   | — |   |   | — |   |
| (Loss) earnings per share                                                                                                                                                  |   | $                            | (0.02   | ) | $ | (0.14 | ) | $ | (0.49 | ) | $ | (0.43 | ) | $ | (0.25 | ) |
|                                                                                                                                                                       |   |                         |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data (as of period end):**                                                                                                                                 |   |                         |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Working capital                                                                                                                                                            |   | $                            | 42,426  |   | $ | 34,812 |   | $ | 24,465 |   | $ | 20,820 |   | $ | 11,347 |   |
| Securities available for sale                                                                                                                                              |   |                         | 44,031  |   |   | 17,678 |   |   | 18,947 |   |   | 10,075 |   |   | 4,492 |   |
| Securities available for sale –                            restricted                                                                                                |   |                         | — |   |   | 16,497 |   |   | — |   |   | — |   |   | — |   |
| Total assets                                                                                                                                                               |   |                         | 65,838  |   |   | 66,830 |   |   | 41,267 |   |   | 33,811 |   |   | 18,716 |   |
| Total long-term obligations                                                                                                                                                |   |                         | 24      |   |   | 1,149 |   |   | — |   |   | 3,664 |   |   | 904 |   |
| Total stockholders' equity                                                                                                                                                 |   |                         | 48,266  |   |   | 55,584 |   |   | 32,916 |   |   | 22,871 |   |   | 13,803 |   |

             

22

 

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**Item            7: Management’s Discussion and Analysis of Financial Condition and Results of            Operations**

 

*The            following discussion of our financial condition and results of operations should be            read in conjunction with our Consolidated Financial Statements and the related notes            included elsewhere in this Annual Report. This discussion contains forward-looking            statements, which involve risk and uncertainties. Our actual results could differ            materially from those anticipated in the forward-looking statements as a result of            certain factors, including those discussed in Item 1A: “Risk Factors” and            elsewhere in this Annual Report.*

 

**Overview**

We are            developing and commercializing off-the-grid rechargeable power sources for portable            electronics. We have developed a patented, proprietary direct methanol fuel cell            technology platform called Mobion, which generates electrical power using up to 100%            methanol as fuel. Our proprietary fuel cell power solution consists of two primary            components integrated in an easily manufactured device: the direct methanol fuel cell            power engine, which we refer to as our Mobion Chip, and methanol replacement            cartridges. Our Mobion Chip weighs less than one ounce and is small enough to fit in            the palm of one’s hand. The methanol used by the technology is fully            biodegradable. We are currently the only micro fuel cell developer to have demonstrated            power density of over 50 mW/cm2 with high energy efficiencies of 1.4 Wh/cc            of methanol. For these reasons, we believe our technology offers a compelling            alternative to current lithium-ion and similar rechargeable battery systems currently            used by original equipment manufacturers and branded partners, or OEMs, in many            handheld electronic devices, such as mobile phones (including smart phones) and mobile            phone accessories, digital cameras, portable media players, personal digital            assistants, or PDAs, and global positioning systems, or GPS devices. We believe our            platform will facilitate the development of numerous product advantages, including            small size, environmental friendliness, and simplicity of design, all critical for            commercialization in the consumer market, and can be implemented as three different            product options: a compact external charging device, a snap-on or attached power            accessory, or a lithium-ion battery replacement embedded fuel cell power solution. We            intend to commercialize the Mobion platform in 2009.

Our            Mobion technology eliminates the need for active water recirculation pumps or the            inclusion of water as a fuel dilutant. The water required for the electrochemical            process is transferred internally within the Mobion Chip from the site of water            generation on the air-side of the cell. This internal flow of water takes place without            the need for any pumps, complicated re-circulation loops or other micro-plumbing tools.            Our Mobion technology is protected by a patent portfolio that includes over 90 U.S.            patent applications covering five key technologies and manufacturing areas. Our goal is            to become a leading provider of portable power for handheld electronic            devices.

We also            design, manufacture, and sell high-performance test and measurement instruments and            systems serving three markets: general dimensional gauging, semiconductor, and            aviation. These products consist of: electronic, computerized gauging instruments for            position, displacement and vibration applications for the design, manufacturing and            test markets; semiconductor products for wafer characterization; and engine balancing            and vibration analysis systems for military and commercial aircraft.

Our            cash requirements depend on numerous factors, including completion of our portable            power source products development activities, our ability to commercialize our portable            power source products, market acceptance of our portable power source products, and            other factors. We expect to pursue the expansion of our operations through internal            growth and strategic partnerships.

 

Several            key indicators of our liquidity are summarized in the following table:

 

| (Dollars in thousands)                    |   | **Years ended December 31,** |    |
|-------------------------------------------|--------|------------------------------|---------|
|                                      |   | **2005**                     |    | **2006** |   | **2007** |   |
| Cash and cash equivalents                 |   | $                            | 11,230  |   | $ | 14,545 |   | $ | 7,650 |   |
| Securities available for sale             |   |                         | 18,947  |   |   | 10,075 |   |   | 4,492 |   |
| Working capital                           |   |                         | 24,465  |   |   | 20,820 |   |   | 11,347 |   |
| Net loss                                  |   |                         | (15,094 | ) |   | (13,667 | ) |   | (9,575 | ) |
| Net cash used in operating activities     |   |                         | (12,572 | ) |   | (12,706 | ) |   | (11,683 | ) |
| Purchase of property, plant and equipment |   |                         | (1,004  | ) |   | (1,574 | ) |   | (414 | ) |

 

From            inception through December 31, 2007, we have incurred an accumulated deficit of $105.1            million and we expect to incur losses for the foreseeable future as we continue micro            fuel cell product development and commercialization programs. We expect that losses            will fluctuate from year to year and that such fluctuations may be substantial as a            result of, among other factors, sales of securities available for sale as well as the            operating results of our businesses.

 

23

 

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**Results of Operations**

***Results of Operations for the Year Ended December 31, 2007            Compared to December 31, 2006.***

 

*Product Revenue:*Product revenue in our            test and measurement instrumentation business for 2007 increased by $1.4 million, or            17.8%, to $9.0 million for the fiscal year ended December 31, 2007 from $7.7 million            for the fiscal year ended December 31, 2006. This performance was primarily the result            of a $602,000 increase in activity by the U.S. Air Force, driven by the New PBS-4100            systems contract. Also contributing were increased purchases by our Japanese            distributor (particularly OEM capacitance), as well as increased volume in            semiconductor product shipments. Total product revenue for general dimensional gauging            products increased by $298,000, or 7.2%, to $4.5 million, while total product revenue            for semiconductor products increased by $364,000, or 71.2%, to $875,000.

 

In our            test and measurement instrumentation business during 2007, the U.S. Air Force accounted            for $2.4 million, or 26.3%, of product revenue while during 2006, the U.S. Air Force            accounted for $1.8 million, or 23.1%, of product revenue. Additionally, during 2007,            Koyo Precision, our Japanese distributor, represented $2.5 million, or 27.7%, of            product revenue while during 2006, Koyo Precision represented $1.8 million, or 22.9%,            of product revenue.

 

Information regarding government contracts included in product revenue            is as follows:

| (Dollars in thousands)                                                                         |           |   | **Revenue**

**Year Ended December 31,** |   | **Revenue**

**Contract to Date** |     | **Total Contract**

**Orders Received**

**to Date** |              |
|------------------------------------------------------------------------------------------------|----------------|--------|------------------------------------------|--------|-----------------------------------|----------|------------------------------------------------------|-------------------|
| **Contract(1)**                                                                                | **Expiration** |   | **2006**                                 |   |                              | **2007** |                                                 | **Dec. 31, 2007** |   | **Dec. 31, 2007** |   |
| $2.3 million Air Force New PBS-4100 Systems                                                    | 07/28/2010 (2) | $      | —                                  |   | $                                 | 1,596    |                                                 | $                 | 1,596 |   | $ | 1,596 |   |
| $8.8 million Air Force Retrofit and Maintenance of                            PBS-4100 Systems | 05/19/2008 (3) | $      | 1,417                                    |   | $                                 | 738      |                                                 | $                 | 7,365 |   | $ | 7,365 |   |

**__________________________________________________________________________________________**

| (1) | Contract values represent maximum potential values and                            may not be representative of actual results. |
|-----|--------------------------------------------------------------------------------------------------------------------------------|

| (2) | Date represents expiration of contract, including all                            three potential option extensions. |
|-----|---------------------------------------------------------------------------------------------------------------------|

| (3) | Expiration date was extended during December 2007 from                            December 20, 2007 to May 19, 2008. |
|-----|----------------------------------------------------------------------------------------------------------------------|

 

*Funded Research and Development            Revenue:*Funded research and development revenue in our new            energy business during 2007 increased by $1.1 million, or 218.2%, to $1.6 million for            the year ended December 31, 2007 from $489,000 for the year ended December 31, 2006.            The increase in revenue was primarily the result of billings under the DOE contract,            which had its funding reinstated during May 2007 after it had been suspended during            2006. This DOE funding resumption contributed an additional $613,000 to revenue during            2007. Revenue during 2007 also included $418,000 from the SAFT contract, for which            revenue recognition had been deferred until the delivery under the contract was            accepted during the first quarter of 2007. Revenue recognized under the Samsung            alliance agreement increased by $21,000 during 2007 over 2006.

 

| (Dollars in thousands)  |               |   | **Revenue Year Ended**

**December 31, 2006** | **Revenue Year Ended**

**December 31, 2007** |        | **Revenue**

**Contract to Date** |
|-------------------------|--------------------|--------|-----------------------------------------------|-----------------------------------------------|-------------|-----------------------------------|
| **Contract**            | **Expiration (1)** |   | **Revenue**                                   |                                          | **Percent** | **Revenue**                       |   | **Percent** |   | **Dec. 31, 2007** |
| $3.0 million DOE(2)     | 09/30/08           |   | $                                             | 62                                            |        | 12.7                              | % | $ | 675 |   | 43.4 | % | $ | 1,846 |
| $1.0 million Samsung(3) | 07/31/07           |   |                                          | 427                                           |        | 87.3                              |   |   | 448 |   | 28.8 |   |   | 875 |
| $418,000 SAFT(4)        | 12/31/06           |   |                                          | —                                       |        | —                           |   |   | 418 |   | 26.9 |   |   | 418 |
| $15,000 NCMS(5)         | 06/30/07           |   |                                          | —                                       |        | —                           |   |   | 15 |   | 0.9 |   |   | 15 |
| Total                   |               |   | $                                             | 489                                           |        | 100.0                             | % | $ | 1,556 |   | 100.0 | % | $ | 3,154 |

**__________________________________________________________________________________________**

| (1) | Dates represent expiration of contract, not date of                            final billing. |
|-----|-----------------------------------------------------------------------------------------------|

| (2) | The DOE contract is a cost share contract. DOE funding                            for this contract was suspended during January 2006 and reinstated                            during May 2007. During 2007, we received notifications from the DOE of                            funding releases totaling $1.0 million and also received an extension                            of the termination date for the contract from July 31, 2007 to                            September 30, 2008. During February 2008, we received notification from                            the DOE of a funding release of $500,000 |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (3) | The Samsung contract is a research and prototype                            contract. This contract included one up-front payment of $750,000 and                            two milestone payments of $125,000 each for the delivery of prototypes.                            The contract was amended on October 22, 2007 as we agreed to issue a                            credit in the amount of the last invoice in recognition of our                            continuing collaboration with Samsung. Therefore, revenue under this                            contract totaled $875,000. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (4) | The SAFT contract is a fixed price contract. This is a                            subcontract with SAFT under the U.S. Army CECOM contract. The purchase                            order received in connection with this subcontract was revised on                            November 14, 2006 eliminating one milestone. As a result, the contract                            value was reduced from $470,000 to $418,000 and the expiration date was                            extended from September 30, 2006 to December 31, 2006. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (5) | This contract was a cost plus catalyst research contract                            with the National Center for Manufacturing Sciences, or                            NCMS. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

24

 

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*Cost            of Product Revenue:*Cost of product revenue in our test and            measurement instrumentation business increased by $530,000, or 18.3%, to $3.4 million            during the year ended December 31, 2007 from $2.9 million during the year ended            December 31, 2006. As a percentage of product revenue, the annual cost of product            revenue remained relatively consistent with 2006, and this increase was consistent with            the higher revenue during 2007.

 

Gross            profit as a percentage of product revenue decreased by 0.2% to 62.0% for the year ended            December 31, 2007, remaining relatively consistent with 2006.

 

*Funded Research and Product Development Expenses:*Funded research and development expenses in our new energy business            increased $739,000, or 64.1%, to $1.9 million for the year ended December 31, 2007 from            $1.2 million for the year ended December 31, 2006. While the active contracts were            relatively consistent between periods, costs for the DOE contract increased $1.3            million, reflecting its reinstatement during May 2007, while costs for the Samsung            contract increased by $22,000. These increases were partially offset by a decrease in            costs for the SAFT contract of $576,000, as that contract was completed during the            first quarter of 2007.

 

*Unfunded Research and Product Development Expenses:*Unfunded research and product development expenses decreased $1.9            million, or 16.1%, to $9.9 million for the year ended December 31, 2007 from $11.8            million for the year ended December 31, 2006. This decrease reflects a $2.2 million            decrease in development costs related to (a) the DOE contract that resumed during May            2007, which related increase is reflected in funded research and product development            expenses, and (b) cost savings from the decision to suspend work on our high power            program during March 2007. This decrease was partially offset by a $317,000 increase in            product development expenses in our test and measurement instrumentation business            reflecting increased staffing and external product development costs focused on the            development of the division’s new stand-alone measurement and data acquisition            solution, stand-alone laser head, as well as other precision measurement            solutions.

 

*Selling, General and Administrative            Expenses:*Selling, general and administrative expenses            decreased by $1.3 million, or 13.2%, to $8.7 million for the year ended December 31,            2007 from $10.1 million for the year ended December 31, 2006. This decrease was            primarily the result of (a) a $387,000 decrease in non-cash stock-based compensation            charges reflecting the difference between sign on and promotion grants during 2006            compared with primarily annual compensation grants during 2007 and the reversal of            expense during 2007 related to certain cancelled executive stock-based performance            grants where performance goals were not met, (b) a $528,000 decrease in outside            services, including audit, legal, and consulting fees, (c) a $345,000 decrease in            recruiting and relocation costs, (d) a $178,000 increase in severance costs            attributable to employees terminated as a result of our March 2007 restructuring, (e) a            $632,000 decrease in wages and benefits, which was also attributable to our March 2007            restructuring, (f) a $227,000 decrease in other operating expenses, primarily insurance            and laboratory operating fees, (g) a $647,000 increase related to a decrease in            allocations of expense from SG&A to funded and unfunded research and development            costs for overhead and other costs allocable to research and development programs, and            (h) a $40,000 decrease in other expenses, net.

 

*Operating Loss:*Operating loss for the year            ended December 31, 2007 compared with the operating loss for the year ended December            31, 2006 decreased by $4.4 million to $13.3 million, a 24.7% decrease, as a result of            the factors noted above.

 

*Gain            on Sale of Securities Available for Sale:*The gain on sale of            securities available for sale for the year ended December 31, 2007 was $2.5 million            compared with a gain of $4.3 million for the year ended December 31, 2006. During 2007,            we sold 1,452,770 shares of Plug Power common stock at a weighted average price of            $3.53 per share, with gross proceeds to us of $5.1 million.

 

*Gain            (loss) on Derivatives:*We recorded a gain on derivative            accounting of $3.0 million for the year ended December 31, 2007 and a gain of $182,000            on derivative accounting for the year ended December 31, 2006. Both the 2007 and 2006            gains are the result of derivative treatment of the freestanding warrants issued to            investors in conjunction with our December 2006 capital raise.

 

*Income Tax (Expense) Benefit:*Our income            tax rate for the year ended December 31, 2007 was 33%, while the income tax rate for            the year ended December 31, 2006 was 15%. These tax rates were primarily the result of            losses generated by operations, changes in the valuation allowance, state true-ups upon            tax return filings, permanent deductible differences for the derivative valuation, and            disproportionate effects of reclassification of gains on Plug Power security sales            included in operating loss.

 

The            valuation allowance against our deferred tax assets at December 31, 2007 was $22.3            million and at December 31, 2006 was $18.9 million. We determined that it was more            likely than not that the ultimate recognition of certain deferred tax assets would not            be realized.

 

***Results of Operations for the Year Ended December 31, 2006            Compared to December 31, 2005.***

 

*Product Revenue:*Product revenue in our test            and measurement instrumentation business increased by $1.7 million, or 27.5%, to $7.7            million for the year ended December 31, 2006 from $6.0 million for the year ended            December 31, 2005. This performance was primarily the result of (a) an increase of $1.5            million, or 55.0%, in dimensional gauging sales, particularly direct capacitance sales            through our Japanese distributor, (b) increases in semiconductor sales of $200,000, as            18 manual, one automatic, and one semi-automated metrology

 

25

 

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tool            systems were sold during the year, compared to seven manual, one semi-automated, and            four OEM systems during 2005, (c) commercial aviation equipment sales increases of            $539,000, and (d) lower revenue from the U.S. Air Force of $611,000 as a result of            fewer purchases of new equipment and reduced activity under the existing repair            contract.

 

In our            test and measurement instrumentation business, the U.S. Air Force accounted for $1.8            million, or 23.1%, of product revenue during the year ended December 31, 2006 compared            with $2.4 million, or 39.7%, of product revenue during the year ended December 31,            2005. During 2006, Koyo Precision, our Japanese distributor, represented $1.8 million,            or 22.9%, of product revenue.

 

Information regarding government contracts included in product revenue            is as follows:

 

| (Dollars in thousands)                                                                         |           |   | **Revenue**

**Year Ended December 31,** |   | **Revenue**

**Contract to Date** |     | **Total Contract**

**Orders Received**

**to Date** |              |
|------------------------------------------------------------------------------------------------|----------------|--------|------------------------------------------|--------|-----------------------------------|----------|------------------------------------------------------|-------------------|
| **Contract**                                                                                   | **Expiration** |   | **2005**                                 |   |                              | **2006** |                                                 | **Dec. 31, 2006** |   | **Dec. 31, 2006** |   |
| $8.8 million Air Force Retrofit and Maintenance of                            PBS-4100 Systems | 05/19/2008 (1) | $      | 1,552                                    |   | $                                 | 1,417    |                                                 | $                 | 6,627 |   | $ | 6,637 |   |
|                                                                                                |                |        |                                          |        |                                   |          |                                                      |                   |  |  |  |  |  |

**__________________________________________________________________________________________**

| (1) | Expiration date was extended during December 2007 from                            December 20, 2007 to May 19, 2008. |
|-----|----------------------------------------------------------------------------------------------------------------------|

*Funded Research and Development Revenue:*Funded research and development revenue in our new energy business            decreased $1.3 million, or 73.3%, to $489,000 for the year ended December 31, 2006 from            $1.8 million for the year ended December 31, 2005. The decrease in revenue was            primarily the result of the suspension of previously approved DOE funding for 2006 and            the completion of other programs that were active in 2005, including programs with the            New York State Energy Research and Development Authority, the Army Research Labs, the            Marine Corps, the Cabot Superior Micro Powders subcontract with the National Institute            of Standards and Technology, and Harris. This decrease was partially offset by $427,000            of revenue recognized from the Samsung alliance agreement during 2006.

 

Information regarding government and private company development            contracts included in funded research and development revenue is as follows:

 

| (Dollars in thousands)  |               |   | **Revenue Year Ended**

**December 31, 2005** | **Revenue Year Ended**

**December 31, 2006** |        | **Revenue**

**Contract to Date** |
|-------------------------|--------------------|--------|-----------------------------------------------|-----------------------------------------------|-------------|-----------------------------------|
| **Contract**            | **Expiration (1)** |   | **Revenue**                                   |                                          | **Percent** | **Revenue**                       |   | **Percent** |   | **Dec. 31, 2006** |
| $3.0 million DOE(2)     | 07/31/07           |   | $                                             | 930                                           |        | 50.8                              | % | $ | 62 |   | 12.7 | % | $ | 1,171 |
| $1.3 million NYSERDA(3) | 06/30/06           |   |                                          | 329                                           |        | 18.0                              |   |   | — |   | — |   |   | 1,135 |
| $1.0 million Samsung(4) | 07/31/07           |   |                                          | —                                       |        | —                           |   |   | 427 |   | 87.3 |   |   | 427 |
| $418,000 SAFT(5)        | 12/31/06           |   |                                          | —                                       |        | —                           |   |   | — |   | — |   |   | — |
| $250,000 ARL            | 09/30/05           |   |                                          | 250                                           |        | 13.7                              |   |   | — |   | — |   |   | 250 |
| $210,000 NIST(6)        | 06/30/05           |   |                                          | 100                                           |        | 5.5                               |   |   | — |   | — |   |   | 210 |
| $150,000 Harris(7)      | 06/25/04           |   |                                          | 150                                           |        | 8.2                               |   |   | — |   | — |   |   | 150 |
| $70,000 Marine Corps    | 03/31/05           |   |                                          | 70                                            |        | 3.8                               |   |   | — |   | — |   |   | 70 |
| Total                   |               |   | $                                             | 1,829                                         |        | 100.0                             | % | $ | 489 |   | 100.0 | % | $ | 3,413 |

**__________________________________________________________________________________________**

| (1) | Dates represent expiration of contract, not date of                            final billing. |
|-----|-----------------------------------------------------------------------------------------------|

| (2) | DOE funding for this cost shared contract was suspended                            during 2006. |
|-----|-------------------------------------------------------------------------------------------------|

| (3) | The total contract value for this cost shared contract                            is $1.3 million consisting of four Phases: Phase I for $500,000 was                            from March 12, 2002 through September 30, 2003; Phase II for $200,000                            was from October 28, 2003 through October 31, 2004; Phase III for                            $348,000 was from August 23, 2004 through August 31, 2005; and Phase IV                            for $202,000 which commenced on December 14, 2004 and expired on June                            30, 2006. Phases I, II, and III have been completed, while Phase IV                            expired before it was completed. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (4) | Represents a research and prototype contract that                            includes one up-front payment of $750,000 and two milestone payments                            totaling $250,000 for the delivery of acceptable prototypes. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (5) | Represents a fixed price subcontract with SAFT under the                            U.S. Army CECOM contract. The purchase order received in connection                            with this subcontract was revised on November 14, 2006 eliminating one                            milestone. As a result, the contract value was reduced from $470,000 to                            $418,000 and the expiration date was extended from September 30 to                            December 31, 2006. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (6) | Represents a fixed price subcontract with CSMP under                            NIST and includes the original contract for $200,000 and a contract                            amendment for $10,000. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (7) | Represents a fixed price contract that includes the                            original contract for $200,000, an amendment for $50,000, and a 2005                            amendment reducing the contract by $100,000. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

*Cost            of Product Revenue:*Cost of product revenue in our test and            measurement instrumentation business increased by $519,000, or 21.8%, to $2.9 million            for the year ended December 31, 2006 from $2.4 million for the year ended December 31,            2005. This increase is consistent with higher product revenue during 2006 compared with            2005.

 

26

 

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Gross            profit as a percentage of product revenue increased by 1.8% to 62.2% for the year ended            December 31, 2006. The improvement in gross margin during 2006 was primarily the result            of a five point rise in average margins on capacitance product sales resulting from            higher sales volume and improved pricing strategies.

 

*Funded Research and Product Development            Expenses:*New energy funded research and product development            expenses decreased by $2.4 million, or 67.6%, to $1.2 million for the year ended            December 31, 2006 from $3.6 million for the year ended December 31, 2005. The decreased            costs were attributable to active contracts during 2005, which were no longer active            during 2006. During 2006, we had active contracts with Samsung, DOE and SAFT, while            during 2005 we had active contracts with DOE, NYSERDA, SAFT, NIST, ARL, and the Marine            Corps.

 

*Unfunded Research and Product Development            Expenses:*Unfunded research and product development expenses            increased by $5.7 million, or 92.4%, to $11.8 million for the year ended December 31,            2006 from $6.1 million for the year ended December 31, 2005. This increase reflected a            $5.4 million increase in our new energy business related to increased internal costs            for the development of micro fuel cell systems and costs in connection with developing            prototypes and product intent prototypes, including a $512,000 non-cash charge for            share-based compensation resulting from the adoption of SFAS No. 123R, which requires            that the fair value of share-based compensation be expensed. This increase also            included a $208,000 increase in product development expenses in our test and            measurement instrumentation business for projects related to the development of a glass            thickness gauge, improvements to the portable engine vibration and balancing system,            and updated industrial balancing software.

 

*Selling, General and Administrative            Expenses:*Selling, general and administrative expenses            decreased by $815,000, or 7.5%, to $10.1 million for the year ended December 31, 2006            from $10.9 million for the year ended December 31, 2005. This decrease was primarily            the result of (a) an $892,000 increase in non-cash equity compensation charges            resulting from the adoption of SFAS No. 123R, which required that the fair value of            share-based compensation be expensed, (b) a $1.1 million decrease in salaries and            engineering management costs, partially a result of an increase in costs directly            charged to research and product development and the elimination of the government            systems group during the second quarter of 2005, (c) a $640,000 decrease related to            increases in liquidations to unfunded research and development costs, which was a            result of having charged more time to internal development projects for low power and            high power technology platform developments, the development of prototypes for Samsung,            and the development of the Mobion 30M product, (d) a $259,000 decrease in the Los            Alamos National Laboratory license fees as a result of an amendment of the license            agreement, which resulted in reduced minimum annual license payments, (e) a $152,000            decrease in depreciation costs primarily related to the renewal of the lease on our            main office, (f) a $104,000 increase in commission costs at MTI Instruments, (g) a            $131,000 increase in incentive compensation primarily related to new executive            employment agreements, (h) a $261,000 increase in marketing costs as MTI Micro raised            its emphasis on marketing and business development and MTI Instruments underwent a            major rebranding campaign during 2006, and (i) a $39,000 decrease in other expenses,            net.

 

*Operating Loss:*Operating loss increased by            $2.6 million, or 17.5%, to $17.7 million for the year ended December 31, 2006 compared            with the year ended December 31, 2005 as a result of the factors noted            above.

 

*Gain            on Sale of Securities Available for Sale:*The gain on sale of            securities available for sale for the year ended December 31, 2006 was $4.3 million            compared with $10.1 million for the year ended December 31, 2005. During the year ended            December 31, 2006, we sold 1,103,500 shares of Plug Power common stock at a weighted            average price of $5.66 per share, with gross proceeds to us of $6.2 million.

 

On June            24, 2005, Fletcher International Ltd., or Fletcher, notified us of its election to            exercise in full its right to purchase from us an amount of common stock of Plug Power.            As a result of this election, Fletcher purchased 1,799,791 shares of Plug Power common            stock from us at a price of $0.7226 per share, with proceeds to us of $1.3 million. In            connection with this exercise, we recognized a loss on this embedded derivative            immediately prior to exercise of $7.2 million and a gain on the sale of Plug Power            common shares of $9.6 million.

 

*Gain            (loss) on Derivatives:*We recorded a gain on derivative            accounting of $182,000 for the year ended December 31, 2006 and a loss of $10.4 million            on derivative accounting for the year ended December 31, 2005. The 2006 gain was the            result of derivative treatment of the freestanding warrants issued in conjunction with            our December 2006 capital raise, while the 2005 result related to an embedded            derivative for the purchase of Plug Power common stock, which was issued as part of the            2004 private placement transaction. The warrant derivative was valued using the            Black-Scholes Pricing model, as was the embedded derivative prior to its exercise on            June 24, 2005. Upon exercise, the embedded derivative was valued at its intrinsic            value.

 

*Income Tax (Expense) Benefit:*Our income tax            expense rate for the year ended December 31, 2006 was 15%, while the income tax expense            rate for the year ended December 31, 2005 was 11%. These tax rates were primarily the            result of losses generated by operations, changes in the valuation allowance, and            disproportionate effects of reclassification of gains on Plug Power security sales            included in operating loss.

 

The            valuation allowance against our deferred tax assets at December 31, 2006 was $18.8            million and at December 31, 2005 was $10.9 million. We determined that it was more            likely than not that the ultimate recognition of certain deferred tax assets would not            be realized.

 

27

 

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**Liquidity and Capital Resources**

We have            incurred significant losses as we continue to fund the development and            commercialization of our portable power source business. We expect that losses will            fluctuate from year to year and that such fluctuations may be substantial as a result            of, among other factors, sales of securities available for sale, our operating results,            the availability of equity financing, including warrants issued in connection with the            December 2006 capital raise, and the ability to attract government funding resources to            offset research and development costs. As of December 31, 2007, we had an accumulated            deficit of $105.1 million. During the year ended December 31, 2007, our results of            operations resulted in a net loss of $9.6 million and cash used in operating activities            totaling $11.7 million. This cash use in 2007 was funded primarily by cash and cash            equivalents on hand as of December 31, 2006 of $14.5 million and proceeds from the            sales of securities available for sale of $5.1 million. We expect to continue to incur            losses as we seek to develop and commercialize our portable power source products and            we expect to continue funding our operations from current cash and cash equivalents,            the sales of securities available for sale, proceeds, if any, from equity financings,            including warrants issued in connection with the December 2006 capital raise, and            government funding. We expect to spend approximately $11.7 million on research and            development of Mobion technology and $1.8 million in research and development on MTI            Instruments’ products during 2008.

 

Additional financing during 2008 may not be available to us on            acceptable terms, if at all. Cash used to support operations is expected to total            approximately $11.8 million and cash used for capital expenditures is expected to total            approximately $1.1 million. Capital expenditures will consist of purchases of            manufacturing and laboratory equipment, software, computer equipment, and furniture.            Proceeds from our sale of securities available for sale are subject to fluctuations in            the market value of Plug Power. We may also seek to supplement our resources through            additional equity offerings, sales of assets (including MTI Instruments), and            additional government revenue could also provide more resources.

 

As of            December 31, 2007, we owned 1,137,166 shares of Plug Power common stock. Potential            future sales of Plug Power securities will generate taxable income or loss, which is            different from book income or loss, as a result of the tax bases in these assets being            significantly different from their book bases. Book and tax bases as of December 31,            2007 are as follows:

 

| **Security** |   | **Shares Held** |   | **Average Book**

**Cost Basis** |   | **Average Tax**

**Cost Basis** |
|--------------|--------|-----------------|--------|----------------------------------|--------|---------------------------------|
| Plug Power   |   | 1,137,166       |   | $                                | 1.78   |                            | $ | 0.96 |
|              |        |                 |        |                                  |        |                                 |  |  |

 

Plug            Power stock is currently traded on The Nasdaq Global Market and is therefore subject to            stock market conditions. When acquired, these securities were unregistered. Our Plug            Power securities are considered “restricted securities” as defined in the            securities laws and may not be sold in the future without registration under the            Securities Act, unless in compliance with an available exemption from registration.            While our Plug Power shares remain “restricted securities,” these shares            are now freely transferable in accordance with Rule 144(d) under the Securities Act,            subject to the limitations associated with such rule.

 

Working            capital was $11.3 million at December 31, 2007, a $9.5 million decrease from $20.8            million at December 31, 2006. This decrease was primarily the result of the use of cash            in operations offset by proceeds from sale of securities available for sale.

 

At            December 31, 2007, the Company’s order backlog was $445,000, compared to $220,000            at December 31, 2006.

 

Our            inventory turnover ratios and average accounts receivable days sales outstanding for            the years ended December 31, 2006 and 2007 and their changes are as follows:

 

|                                                                          |   | **Years Ended December 31,** |   |     |   |
|-------------------------------------------------------------------------------|--------|------------------------------|--------|----------|--------|
|                                                                          |   | **2006**                     |   | **2007** |   | **Change** |   |
| Inventory turnover                                                            |   | 2.6                          |   | 2.3      |   | (0.3 | ) |
| Average accounts receivable days sales                            outstanding |   | 45                           |   | 58       |   | 13 |   |

 

The            decline in inventory turnover stemmed from a 13% higher year-end inventory balance            needed to support new product initiatives as these products gain acceptance in their            targeted markets, as well as maintenance of higher stock levels to support continued            growth at strategic end-use customers.

 

The            increase in average accounts receivable days sales outstanding in 2007 compared with            2006 was primarily attributable to our decision to grant our largest commercial            customer 90-day payment terms.

 

Cash            flow used by operating activities was $11.7 million during 2007 compared with $12.7            million during 2006. This cash use decrease of $1.0 million reflected a net decrease of            $3.5 million in cash expenditures to fund operations coupled with net balance sheet            changes, which increased cash expenditures by $2.5 million, reflecting the timing of            cash receipts and payments, particularly recognition of

 

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deferred revenue and payment of certain accrued liabilities.

 

Capital            expenditures were $414,000 during 2007, a decrease of $1.2 million from the prior year.            Capital expenditures during 2007 included computer equipment, software, and            manufacturing and laboratory equipment. Outstanding commitments for capital            expenditures as of December 31, 2007 totaled $35,000 and included expenditures for            laboratory and computer equipment. We expect to finance these expenditures and other            capital expenditures during 2008 with current cash and cash equivalents, the sale of            securities available for sale, equity financing, and other sources, as appropriate and            to the extent available.

 

During            2007, we sold 1,452,770 shares of Plug Power common stock with proceeds totaling $5.1            million and gains totaling $2.5 million. These proceeds reflect our previously            announced strategy to raise additional capital through the sale of Plug Power stock to            fund our micro fuel cell operations. We expect the net gains to be offset by our            operating losses for purposes of computing taxable income. We estimate that as of            December 31, 2007, our remaining net operating loss carry forwards were approximately            $54 million.

 

**Off-Balance Sheet Arrangements**

Pursuant to a financing transaction between us and certain investors on            December 15, 2006, we issued warrants to purchase up to an aggregate 3,027,778 shares            of our common stock exercisable at any time until December 19, 2011 at an exercise            price per share of $2.27. The shares issuable upon exercise of these warrants would be            issued under a shelf registration statement covering the resale of such shares. The            terms of the warrant agreement permits a cash settlement with the holders of the            warrants if we are acquired by, or merge with, a private company. Because of the            possibility of such a settlement, we have classified this agreement as an            asset/liability derivative in accordance with SFAS No. 133 and EITF 00-19.

 

**Critical Accounting Policies and Significant Judgments and            Estimates**

The            following discussion and analysis of its financial condition and results of operations            is based upon our consolidated financial statements, which have been prepared in            accordance with accounting principles generally accepted in the United States of            America. Note 2 to the consolidated financial statements includes a summary of our most            significant accounting policies. The preparation of these financial statements requires            us to make estimates and judgments that affect the reported amounts of assets,            liabilities, revenue and expenses, and related disclosure of assets and liabilities. On            an on-going basis, we evaluate our estimates and judgments, including those related to            revenue recognition, inventories, securities available for sale, income taxes,            share-based compensation and derivatives. We base our estimates on historical            experience and on various other factors that are believed to be reasonable under the            circumstances, the results of which form the basis for making judgments about the            carrying values of assets and liabilities that are not readily apparent from other            sources. Actual results may differ from these estimates under different assumptions or            conditions. We review critical accounting estimates with the Audit Committee of our            Board of Directors.

 

The            significant accounting policies that we believe are most critical to aid in fully            understanding and evaluating our reported financial results include the            following:

 

*Revenue Recognition:*We recognize            revenue from development contracts based upon the relationship of actual costs to            estimated costs to complete the contract. These types of contracts typically provide            development services to achieve a specific scientific result relating to direct            methanol fuel cell technology. Some of these contracts require us to contribute to the            development effort. The customers for these contracts are commercial customers and            various state and federal government agencies. While government agencies are providing            revenue, we do not expect the government to be a significant end user of the resulting            products. Therefore, we do not reduce funded research and product development expense            by the funding received. When it appears probable that estimated costs will exceed            available funding on fixed price contracts and we are not successful in securing            additional funding, we record the estimated additional expense before it is            incurred.

 

We            apply the guidance in SAB No. 104,*Revenue            Recognition*, in the evaluation of commercially funded fuel            cell research and prototype agreements in order to determine when to properly recognize            income. Payments received in connection with commercial research and prototype            agreements are deferred and recognized on a straight-line basis over the term of the            agreement for service-related payments. For milestone and prototype delivery payments,            if and when achieved, revenue is deferred and recognized on a straight-line basis over            the remaining term of the agreement. When revenue qualifies for recognition it will be            recorded as funded research and development revenue. The costs associated with research            and prototype-producing activities are expensed as incurred. Expenses in an amount            equal to revenue recognized are reclassified from unfunded research and product            development to funded research and product development.

 

We also            recognize revenue from product sales in accordance with SAB No. 104. Product revenue is            recognized when there is persuasive evidence of an arrangement, delivery of the product            to the customer or distributor has occurred, at which time title generally is passed to            the customer or distributor, and we have determined that collection of a fixed fee is            probable, all of which occur upon shipment of the product. If the product requires            installation to be performed by us, all revenue related to the product is deferred and            recognized upon the completion of the installation.

 

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*Inventory:*Inventory is valued at            the lower of cost or the current estimated market value of the inventory. We            periodically review inventory quantities on hand and record a provision for excess or            obsolete inventory based primarily on our estimated forecast of product demand, as well            as based on historical usage. Demand and usage for products and materials can fluctuate            significantly. A significant decrease in demand for our products could result in a            short-term increase in the cost of inventory purchases and an increase of excess            inventory quantities on hand. Therefore, although we make every effort to ensure the            accuracy of our forecasts of future product demand, any significant unanticipated            changes in demand could have a significant impact on the value of our inventory and our            reported operating results.

 

*Share-Based Payments**:*We grant options to purchase our common stock and award restricted stock            to our employees and directors under our equity incentive plans. The benefits provided            under these plans are share-based payments subject to the provisions of SFAS No.            123R,*Share-Based Payment,*and SEC            Staff Accounting Bulletin 107,*Share-Based            Payments*. Effective January 1, 2006, we use the fair value            method to apply the provisions of FAS 123R with the modified prospective application,            which provides for certain changes to the method for valuing share-based compensation.            The valuation provisions of FAS 123R apply to new awards and to awards that are            outstanding on the effective date and subsequently modified. Under the modified            prospective application, prior periods are not revised for comparative purposes.            Share-based compensation expense recognized under FAS 123R for the year ended December            31, 2007 was $1.6 million. At December 31, 2007, total unrecognized estimated            compensation expense related to non-vested awards granted prior to that date was $1.6            million, which is expected to be recognized over a weighted average period of 1.31            years.

 

Upon            adoption of FAS 123R, we began estimating the value of share-based awards on the date            of grant using a Black-Scholes option-pricing model. Prior to the adoption of FAS 123R,            the value of each share-based award was estimated on the date of grant using the            Black-Scholes model for the pro forma information required to be disclosed under FAS            123. The determination of the fair value of share-based payment awards on the date of            grant using an option-pricing model is affected by our stock price as well as            assumptions regarding a number of complex and subjective variables. These variables            include our expected stock price volatility over the term of the awards, actual and            projected employee stock option exercise behaviors, risk-free interest rate and            expected dividends.

 

If            factors change and we employ different assumptions in the application of FAS 123R            during future periods, the compensation expense that we record under FAS 123R may            differ significantly from what we have recorded in the current period. Therefore, we            believe it is important for investors to be aware of the high degree of subjectivity            involved when using option-pricing models to estimate share-based compensation under            FAS 123R. Option-pricing models were developed for use in estimating the value of            traded options that have no vesting or hedging restrictions, are fully transferable and            do not cause dilution. Because our share-based payments have characteristics            significantly different from those of freely traded options, and because changes in the            subjective input assumptions can materially affect our estimates of fair values, in our            opinion, existing valuation models, including the Black-Scholes Option Pricing model,            may not provide reliable measures of the fair values of our share-based compensation.            Consequently, there is a risk that our estimates of the fair values of our share-based            compensation awards on the grant dates may bear little resemblance to the intrinsic            values realized upon the exercise, expiration, cancellation or forfeiture of those            share-based payments in the future. Certain share-based payments, such as employee            stock options, may expire worthless or otherwise result in zero intrinsic value as            compared to the fair values originally estimated on the grant date and expensed in our            financial statements. Alternatively, value may be realized from these instruments that            are significantly in excess of the fair values originally estimated on the grant date            and expensed in our financial statements. There is currently neither a market-based            mechanism nor other practical application to verify the reliability and accuracy of the            estimates stemming from these valuation models, nor a way to compare and adjust the            estimates to actual values. Although the fair value of employee share-based awards is            determined in accordance with FAS 123R and SAB 107 using a qualified option-pricing            model, that value may not be indicative of the fair value observed in a willing            buyer/willing seller market transaction. Estimates of share-based compensation expenses            are significant to our financial statements, but these expenses are based on the            aforementioned option valuation model and will never result in the payment of cash by            us.

 

The            guidance in FAS 123R and SAB 107 is still relatively new, and best practices are not            well established. The application of these principles may be subject to further            interpretation and refinement over time. There are significant differences among            valuation models, and there is a possibility that we will adopt different valuation            models in the future. This may result in a lack of consistency in future periods and            materially affect the fair value estimate of share-based payments. It may also result            in a lack of comparability with other companies that use different models, methods and            assumptions.

 

Theoretical valuation models and market-based methods are evolving and            may result in lower or higher fair value estimates for share-based compensation. The            timing, readiness, adoption, general acceptance, reliability and testing of these            methods is uncertain. Sophisticated mathematical models may require voluminous            historical information, modeling expertise, financial analyses, correlation analyses,            integrated software and databases, consulting fees, customization and testing for            adequacy of internal controls.

 

For            purposes of estimating the fair value of stock options granted during the year ended            December 31, 2007 using the Black-Scholes model, we used the historical volatility of            our stock for the expected volatility assumption input to the Black-Scholes model,            consistent with the guidance in FAS 123R and SAB 107. The risk-free interest rate is            based on the risk-free zero-coupon rate for a period consistent with the expected            option term at the time of grant. We do not currently pay nor do we anticipate paying            dividends,

 

30

 

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but we            are required to assume a dividend yield as an input to the Black-Scholes model. As            such, we use a zero dividend rate. The expected option term is estimated using both            historical term measures and projected termination estimates.

 

*Income Taxes:*As part of the process            of preparing our consolidated financial statements, we are required to estimate our            income taxes in each of the jurisdictions in which we operate. This process involves            the estimation of our actual current tax exposure together with assessing temporary            differences resulting from differing treatment of items for tax and accounting            purposes. Included in this assessment is the determination of net operating loss carry            forwards. These differences result in a net deferred tax asset. The Company must assess            the likelihood that our deferred tax assets will be recovered from future taxable            income and, to the extent that we believe that recovery is not likely, we must            establish a valuation allowance.

 

Significant management judgment is required in determining our provision            for income taxes, our deferred tax assets and liabilities and any valuation allowance            recorded against our net deferred tax assets. We have recorded a valuation allowance            due to uncertainties related to our ability to realize certain net deferred tax assets,            primarily consisting of net operating losses being carried forward. In the event that            actual results differ from these estimates or we adjust these estimates in future            periods, we may need to adjust the recorded valuation allowance, which could materially            impact our financial position and results of operations. We have recorded a full            valuation allowance against our net deferred tax assets of $22.3 million as of December            31, 2007. This valuation allowance is due to uncertainties related to our ability to            realize certain of these assets. The valuation allowance is based on estimates of the            recoverability of certain net operating losses. In the event actual results differ from            these estimates or we adjust these estimates in future periods we may need to adjust            our valuation allowance which could materially impact our financial position and            results of operations.

 

In June            2006, the FASB issued Interpretation No. 48,*Accounting for            Uncertainty in Income Taxes, an Interpretation of FASB Statement No.            109*, which became effective for us beginning in fiscal 2007.            FIN 48 addresses the determination of how tax benefits claimed or expected to be            claimed on a tax return should be recorded in the financial statements. Under FIN 48,            we must recognize the tax benefit from an uncertain tax position only if it is more            likely than not that the tax position will be sustained on examination by the taxing            authorities, based on the technical merits of the position. The tax benefits recognized            in the financial statements from such a position are measured based on the largest            benefit that has a greater than 50% likelihood of being realized upon ultimate            resolution. The impact of our reassessment of our tax positions in accordance with FIN            48 did not have a material impact on our results of operations, financial condition or            liquidity.

 

*Derivative Instruments:*We account            for derivative instruments and embedded derivative instruments in accordance with SFAS            No. 133,*Accounting for Derivative Instruments and Hedging            Activities,*as amended. The amended standard requires an            entity to recognize all derivatives as either assets or liabilities in the statement of            financial position and measure these instruments at fair value. Fair value is estimated            using the Black-Scholes Pricing model. We also follow EITF Issue No. 00-19,*Accounting for Derivative Financial Instruments Indexed to and            Potentially Settled in, a Company’s Own Stock*, which            requires freestanding contracts that are settled in a company’s own stock,            including common stock warrants, to be designated as an equity instrument, asset or a            liability. Under the provisions of EITF Issue No. 00-19, a contract designated as an            asset or a liability must be carried at fair value, with any changes in fair value            recorded in the results of operations. A contract designated as an equity instrument            can be included in equity with no fair value adjustments required.

 

Our            asset/liability derivatives are valued on a quarterly basis using the Black-Scholes            Pricing model. Significant assumptions used in the valuation included exercise dates,            closing prices for the Company’s common stock, volatility of our common stock,            and a proxy risk-free interest rate. Gains (losses) on derivatives are included in            “Gain (loss) on derivatives” in the Consolidated Statement of            Operations.

 

**New            Accounting Pronouncements**

*Effect of Recent Accounting            Pronouncements**:*

In            December 2007, the FASB issued SFAS No. 141R,*Business            Combinations—a replacement of FASB Statement No. 141*,            which significantly changes the principles and requirements for how the acquirer of a            business recognizes and measures in its financial statements the identifiable assets            acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The            statement also provides guidance for recognizing and measuring the goodwill acquired in            the business combination and determines what information to disclose to enable users of            the financial statements to evaluate the nature and financial effects of the business            combination. SFAS No. 141R is effective prospectively, except for certain retrospective            adjustments to deferred tax balances, for fiscal years beginning after December 15,            2008. This statement will be effective for the Company for fiscal year 2009. We have            not yet determined the impact, if any, of this statement on our Consolidated Financial            Statements.

 

In            December 2007, the FASB issued SFAS No. 160,*Noncontrolling            Interests in Consolidated Financial Statements—an amendments of ARB No.            51*. SFAS No. 160 requires that accounting and reporting for            minority interests will be recharacterized as noncontrolling interests and classified            as a component of equity. SFAS No. 160 also establishes reporting requirements that            provide sufficient disclosures that clearly identify and distinguish between the            interests of the parent and the interests of the noncontrolling owners. SFAS No. 160            applies to all entities that prepare consolidated financial statements, except            not-for-profit organizations, but will affect only those entities that have an            outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate            a

 

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subsidiary. This statement is effective as of the beginning of an            entity’s first fiscal year beginning after December 15, 2008. This statement will            be effective for us for our fiscal year beginning January 1, 2009. Based upon the            December 31, 2007 balance sheet, the impact of adopting SFAS No. 160 would be to            reclassify from $143,000 minority interests in consolidated subsidiaries to            stockholders’ equity as a separate component of stockholders’            equity.

 

In            February 2007, the FASB issued SFAS No. 159,*The Fair Value            Option for Financial Assets and Financial Liabilities*. SFAS            No. 159 provides companies with an option to report selected financial assets and            financial liabilities at fair value. Unrealized gains and losses on items for which the            fair value option has been elected are reported in earnings at each subsequent            reporting date. SFAS No. 159 is effective beginning January 1, 2008. The adoption of            the provisions of SFAS No. 159 is not expected to have a material effect on our            Consolidated Financial Statements.

 

In            September 2006, the FASB issued SFAS No. 157,*Fair Value            Measurements*. SFAS No. 157 establishes a common definition            for fair value to be applied to United States generally accepted accounting principles            guidance requiring use of fair value, establishes a framework for measuring fair value,            and expands disclosure about such fair value measurements. This Statement is effective            for fiscal years beginning after November 15, 2007. This statement will be effective            for the Company for its fiscal year beginning January 1, 2008. The adoption of the            provisions of SFAS No. 157 is not expected to have a material effect on our            Consolidated Financial Statements.

 

In            September 2006, the FASB issued SFAS No. 158,*Employers’            Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of            FASB Statements No. 87, 88, 106, and 132(R)*. Among other            items, SFAS No. 158 requires recognition of the over-funded or under-funded status of            an entity’s defined benefit postretirement plan as an asset or liability in the            financial statements, requires the measurement of defined benefit postretirement plan            assets and obligations as of the end of the employer’s fiscal year, and requires            recognition of the funded status of defined benefit postretirement plans in other            comprehensive income. This Statement is effective for fiscal years ending after            December 15, 2006. Since we do not maintain any defined benefit or other postretirement            plans, the adoption of this Statement for fiscal year 2007 did not have a material            effect on our Consolidated Financial Statements.

 

In            March 2006, the FASB issued SFAS No. 156,*Accounting for            Servicing of Financial Assets*—an amendment of            FASB*Statement No. 140,*which            provides guidance on accounting for separately recognized servicing assets and            servicing liabilities. In accordance with the provisions of SFAS No. 156, separately            recognized servicing assets and servicing liabilities must be initially measured at            fair value, if practicable. Subsequent to initial recognition, we may use either the            amortization method or the fair value measurement method to account for servicing            assets and servicing liabilities within the scope of this Statement. Our adoption of            this Statement in fiscal year 2007 did not have a material effect on our Consolidated            Financial Statements.

 

In            February 2006, the FASB issued SFAS No. 155,*Accounting for            Certain Hybrid Financial Instruments—*an amendment of            FASB*Statements No. 133 and 140*, to            permit fair value remeasurement for any hybrid financial instrument that contains an            embedded derivative that otherwise would require bifurcation in accordance with the            provisions of SFAS No. 133,*Accounting for Derivative            Instruments and Hedging Activities.*Our adoption of this            Statement in fiscal year 2007 did not have a material effect on our Consolidated            Financial Statements.

 

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**Item 8: Financial Statements and Supplementary Data**

 

The            financial statements filed herewith are set forth on the Index to Consolidated            Financial Statements on Page F-1 of the separate financial section, which follows page            41 of this report and are incorporated herein by reference.

 

*Selected Quarterly Financial Data*

 

| (Unaudited and in thousands except per share                            amounts)       |   | **1st** |   | **2nd** |   | **3rd** |   | **4th** |   |
|----------------------------------------------------------------------------------------|--------|---------|--------|---------|--------|---------|--------|---------|--------|
| **2006**                                                                               |   |    |   |    |   |    |   |    |   |   |   |   |   |
| Product revenue                                                                        |   | $       | 1,513  |    | $      | 1,700   |   | $       | 1,693  |   | $ | 2,761 |   |
| Funded research and development revenue                                                |   |    | 45     |    |   | 93      |   |    | 173    |   |   | 178 |   |
| Gross profit – product revenue                                                   |   |    | 974    |    |   | 974     |   |    | 1,043  |   |   | 1,776 |   |
| Gross loss – funded research and                            development          |   |    | (165   | )       |   | (37     | )      |    | (150   | ) |   | (311 | ) |
| Net loss                                                                               |   | $       | (3,431 | )       | $      | (3,222  | )      | $       | (3,678 | ) | $ | (3,336 | ) |
|                                                                                   |   |    |   |    |   |    |   |    |   |   |   |   |   |
| **Loss per Share (Basic and Diluted):**                                                |   |    |   |    |   |    |   |    |   |   |   |   |   |
| Net loss                                                                               |   | $       | (0.11  | )       | $      | (0.10   | )      | $       | (0.12  | ) | $ | (0.10 | ) |
|                                                                                   |   |    |   |    |   |    |   |    |   |   |   |   |   |
| **2007**                                                                               |   |    |   |    |   |    |   |    |   |   |   |   |   |
| Product revenue                                                                        |   | $       | 1,701  |    | $      | 2,275   |   | $       | 2,196  |   | $ | 2,856 |   |
| Funded research and development revenue                                                |   |    | 615    |    |   | 353     |   |    | 357    |   |   | 231 |   |
| Gross profit – product revenue                                                   |   |    | 963    |    |   | 1,459   |   |    | 1,348  |   |   | 1,828 |   |
| Gross profit (loss) – funded research and                            development |   |    | 391    |    |   | (151    | )      |    | (334   | ) |   | (241 | ) |
| Net loss                                                                               |   | $       | (3,156 | )       | $      | (2,487  | )      | $       | (2,481 | ) | $ | (1,451 | ) |
|                                                                                   |   |    |   |    |   |    |   |    |   |   |   |   |   |
| **Loss per Share (Basic and Diluted):**                                                |   |    |   |    |   |    |   |    |   |   |   |   |   |
| Net loss                                                                               |   | $       | (0.08  | )       | $      | (0.07   | )      | $       | (0.07  | ) | $ | (0.03 | ) |

 

**Item            9: Changes in and Disagreements with Accountants on Accounting and Financial            Disclosure**

 

None.

 

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**Item 9A: Controls and Procedures**

 

**(a)            Evaluation of Disclosure Controls and Procedures**

*Evaluation of Disclosure Controls and Procedures:*Our management, with the participation of our chief executive officer            and chief financial officer, evaluated the effectiveness of MTI’s disclosure            controls and procedures as of December 31, 2007. The term “disclosure controls            and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange            Act, means controls and other procedures of a company that are designed to ensure that            information required to be disclosed by a company in the reports that it files or            submits under the Exchange Act is recorded, processed, summarized and reported, within            the time periods specified in the SEC’s rules and forms. Disclosure controls and            procedures include, without limitation, controls and procedures designed to ensure that            information required to be disclosed by a company in the reports that it files or            submits under the Exchange Act is accumulated and communicated to the company’s            management, including its principal executive and principal financial officers, as            appropriate to allow timely decisions regarding required disclosure. We recognize that            any controls and procedures, no matter how well designed and operated, can provide only            reasonable assurance of achieving their objectives and we necessarily apply our            judgment in evaluating the cost-benefit relationship of possible controls and            procedures. Based on the valuation of our disclosure controls and procedures as of            December 31, 2007, our chief executive officer and chief financial officer concluded            that, as of such date, our disclosure controls and procedures were effective at the            reasonable assurance level.

 

*Changes in Internal Control over Financial            Reporting:*There have been no changes in our internal            control over financial reporting, as such term is defined in Rules 13a-15(f) and            15d-15(f) under the Exchange Act, during our fiscal quarter ended December 31, 2007            that have materially affected, or are reasonable likely to materially affect our            internal control over financial reporting.

 

**(b)            Management’s Report on Internal Control Over Financial Reporting**

Management of our Company is responsible for establishing and            maintaining adequate internal control over financial reporting, as that term is defined            in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial            reporting is a process designed to provide reasonable assurance regarding the            reliability of financial reporting and the preparation of financial statements for            external purposes in accordance with generally accepted accounting            principles.

 

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 of compliance with the policies or procedures may            deteriorate.

 

Under            the supervision and with the participation of our management, including the principal            executive officer and principal financial officer, we conducted an evaluation of the            effectiveness of our internal control over financial reporting using the criteria set            forth in*Internal Control—Integrated            Framework*issued by the Committee of Sponsoring Organizations            of the Treadway Commission. Based on our evaluation using the criteria set forth            in*Internal Control—Integrated Framework,*Management has concluded that our internal control over financial            reporting was effective as of December 31, 2007.

 

This            annual report does not include an attestation report of our registered public            accounting firm regarding internal control over financial reporting. Our report was not            subject to attestation by our registered public accounting firm pursuant to temporary            rules of the SEC that permit us to provide only Management’s report in this            annual report.

 

| /s/ Peng K. Lim               | /s/ Cynthia A. Scheuer                     |
|-------------------------------|--------------------------------------------|
| Chief Executive Officer       | Vice President and Chief Financial Officer |
| (Principal Executive Officer) | (Principal Financial Officer)              |

 

 

**Item            9B: Other Information**

 

None.

 

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**PART III**

 

**Item 10: Directors, Executive Officers and Corporate            Governance**

 

**(a)            Directors**

Incorporated herein by reference is the information appearing under the            captions “Information about our Directors” and “Compliance with            Section 16(a) of the Securities Exchange Act of 1934” in our definitive Proxy            Statement for our 2008 Annual Meeting of Stockholders to be filed with the            SEC.

 

**(b)            Executive Officers**

Incorporated herein by reference is the information appearing under the            captions “Executive Officers” and “Compliance with Section 16(a) of            the Securities Exchange Act of 1934” in our definitive Proxy Statement for our            2008 Annual Meeting of Stockholders to be filed with the SEC.

 

Incorporated herein by reference is the information appearing under the            caption “Board of Director Meetings and Committees – Audit Committee”            in our definitive Proxy Statement for our 2008 Annual Meeting of Stockholders to be            filed with the SEC.

 

*Code of Ethics:*We have adopted a            Code of Ethics for employees, officers and directors. The Code of Ethics is intended to            comply with Item 406 of Regulation S-K of the Exchange Act and with applicable rules of            Nasdaq. A copy may be obtained at no charge by written request to the attention of our            Secretary at 431 New Karner Road, Albany, New York 12205. A copy of the Code of Ethics            is also available on our website at http://www.mechtech.com.

 

**Item            11: Executive Compensation**

 

Incorporated herein by reference is the information appearing under the            caption “Executive Compensation” in the Company’s definitive Proxy            Statement for our 2008 Annual Meeting of Stockholders to be filed with the            SEC.

 

**Item            12: Security Ownership of Certain Beneficial Owners and Management and Related            Stockholder Matters**

 

Incorporated herein by reference is the information appearing under the            caption “Principal Stockholders” in our definitive Proxy Statement for our            2008 Annual Meeting of Stockholders to be filed with the SEC.

 

**Equity Compensation Plans**

As of            December 31, 2007, we have three equity compensation plans, each of which has been            approved by our stockholders; the Mechanical Technology, Incorporated 1996 Stock            Incentive Plan (the “1996 Plan”), 1999 Employee Stock Incentive Plan (the            “1999 Plan”) and 2006 Equity Incentive Plan (the “2006 Plan”),            to which we refer collectively as the Plans. See Note 13 to the Consolidated Financial            Statements referred to in Item 8 for a description of these Plans.

The            following table presents information regarding these plans:

|                                                                                                                              |  

                             

Number of Securities To Be

Issued Upon Exercise of Outstanding

Options, Warrants, Rights(1)

(a) |  

                             

                             

Weighted Average Exercise

Price of Outstanding

Options, Warrants, Rights

(b) | Number of Securities Remaining Available for Future                            Issuance Under

Equity Compensation Plans (excluding securities                            reflected in column (a))

(c) |
|-----------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                              |
|  

                             

                             

                             

Plan Category |
| Equity compensation plans approved by security                            holders                                                 | 6,213,566                                                                                                                                      | $                                                                                                                                                               | 3.24                                                                                                                                                                                                    | 1,265,733 |
|                                                                                                                                   |                                                                                                                                                |                                                                                                                                                                 |                                                                                                                                                                                                         |  |

 

(1) Under the 1996, 1999 and 2006 Plans, the securities available under            the Plans for issuance and issuable pursuant to exercises of outstanding options may be            adjusted in the event of a change in outstanding stock by reason of stock dividend,            stock splits, reverse stock splits, etc.

 

**Item            13: Certain Relationships and Related Transactions, and Director            Independence**

 

Incorporated herein by reference is the information appearing under the            caption “Certain Relationships and Related Transactions” in our definitive            Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the            SEC.

 

**Item            14: Principal Accountant Fees and Services**

 

Incorporated herein by reference is the information appearing under the            caption “Independent Accountants” in our definitive Proxy Statement for the            2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange            Commission.

 

35

 

----

**PART IV**

 

**Item 15: Exhibits, Financial Statement Schedules**

 

**15(a) (1)****Financial            Statements:**The financial statements filed herewith are set            forth on the Index to Consolidated Financial Statements on page F-1 of the separate            financial section which accompanies this Report, which is incorporated herein by            reference.

 

**15(a) (2)****Financial Statement            Schedules:**The following consolidated financial statement            schedule for the years ended December 31, 2005, 2006, and 2007 is included pursuant to            Item 15(d):

             

Report of Independent Registered Public Accounting Firm on Financial            Statements Schedule;

Schedule II - Valuation and Qualifying Accounts.

             

All            other financial statement schedules not listed have been omitted because they are            either not required, not applicable, or the information has been included elsewhere in            the consolidated financial statements or notes thereto.

 

**15(a) (3) Exhibits:**The exhibits listed in            the Exhibit Index immediately preceding the exhibits are filed as part of this Annual            Report on Form 10-K.

 

The            following exhibits are filed as part of this Report:

 

| Exhibit |                                                                                                                                                                                                |
|---------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Number  | Description                                                                                                                                                                                         |
|    |                                                                                                                                                                                                |
| 1.1     | Placement Agreement dated December 15, 2006 with Rodman                            & Renshaw, LLC. (20)                                                                                         |
|    |                                                                                                                                                                                                |
| 3.1     | Certificate of Incorporation of the registrant, as                            amended and restated.                                                                                                 |
|    |                                                                                                                                                                                                |
| 3.3     | By-Laws of the registrant, as amended and restated.                            (25)                                                                                                                 |
|    |                                                                                                                                                                                                |
| 4.1     | Form of Common Stock Purchase Warrant to be issued by                            the Company. (20)                                                                                                  |
|    |                                                                                                                                                                                                |
| 10.14   | Mechanical Technology, Incorporated 1996 Stock Incentive                            Plan. (1)                                                                                                       |
|    |                                                                                                                                                                                                |
| 10.30   | Mechanical Technology, Incorporated 1999 Employee Stock                            Incentive Plan. (2)                                                                                              |
|    |                                                                                                                                                                                                |
| 10.38   | Lease dated August 10, 1999 between Carl E. Touhey and                            Mechanical Technology, Inc. (3)                                                                                   |
|    |                                                                                                                                                                                                |
| 10.43   | Lease dated April 2, 2001 between Kingfisher LLC and                            Mechanical Technology, Inc. (4)                                                                                     |
|    |                                                                                                                                                                                                |
| 10.44   | First Amendment to lease dated March 13, 2003 between                            Kingfisher LLC and Mechanical Technology, Inc. (5)                                                                 |
|    |                                                                                                                                                                                                |
| 10.119  | Strategic Alliance Agreement, dated as of September 19,                            2003, between The Gillette Company and MTI MicroFuel Cells Inc.                            (6)                   |
|    |                                                                                                                                                                                                |
| 10.121  | Agreement, dated January 26, 2004, between Mechanical                            Technology, Inc. and Fletcher International, Ltd. (8)                                                              |
|    |                                                                                                                                                                                                |
| 10.122  | Amendment No. 1 to the Main Agreement dated as of May 4,                            2004 entered into by and between the registrant and Fletcher                            International, Ltd. (9) |
|    |                                                                                                                                                                                                |
| 10.123  | Amendment to the Strategic Alliance Agreement between                            The Gillette Company and MTI MicroFuel Cells Inc. dated August 18,                            2004. (10)           |
|    |                                                                                                                                                                                                |
| 10.129  | Summary of Changes in Compensation of Named Executive                            Officers of the Registrant.                                                                                        |
|    |                                                                                                                                                                                                |
| 10.130  | Cash Compensation for Non-Management Directors of the                            Registrant.                                                                                                        |
|    |                                                                                                                                                                                                |
| 10.131  | Amendment No. 2 to the Strategic Alliance Agreement                            between The Gillette Company and MTI MicroFuel Cells Inc. dated June                            20, 2005. (11)       |
|    |                                                                                                                                                                                                |

 

 

36

 

----

 

| 10.132     | Second Amendment to lease dated December 12, 2005                            between Kingfisher, LLC and Mechanical Technology, Incorporated.                            (12)                            |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                     |
| 10.135     | Employment Agreement dated March 6, 2006 between Russel                            Marvin and MTI MicroFuel Cells Inc. (14)                                                                              |
|       |                                                                                                                                                                                                     |
| 10.136     | Employment Agreement dated September 25, 2002 between                            Cynthia A. Scheuer and Mechanical Technology, Incorporated and MTI                            MicroFuel Cells Inc. (13) |
|       |                                                                                                                                                                                                     |
| 10.137     | Employment Agreement dated November 19, 2004 between                            Juan Becerra and MTI MicroFuel Cells Inc. (13)                                                                           |
|       |                                                                                                                                                                                                     |
| 10.139     | Employment Agreement dated May 4, 2006 between Peng K.                            Lim and MTI MicroFuel Cells Inc. (16)                                                                                  |
|       |                                                                                                                                                                                                     |
| 10.140     | Form of Restricted Stock Agreement for the 1996 and 1999                            Mechanical Technology, Inc. Stock Incentive Plans. (17)                                                              |
|       |                                                                                                                                                                                                     |
| 10.141 (A) | Alliance Agreement dated May 16, 2006 between MTI                            MicroFuel Cells Inc. and Samsung Electronics Co., Ltd. (18)                                                                 |
|       |                                                                                                                                                                                                     |
| 10.142     | Third Amendment to lease dated August 7, 2006 between                            Kingfisher, LLC and Mechanical Technology, Incorporated.                            (18)                                |
|       |                                                                                                                                                                                                     |
| 10.143 (A) | Amendment No. 3 to the Strategic Alliance Agreement                            dated September 13, 2006, between MTI MicroFuel Cells Inc. and The                            Gillette Company. (19)      |
|       |                                                                                                                                                                                                     |
| 10.144     | Form of Subscription Agreement. (20)                                                                                                                                                                     |
|       |                                                                                                                                                                                                     |
| 10.145     | Mechanical Technology, Incorporated 2006 Equity                            Incentive Plan. (15)                                                                                                          |
|       |                                                                                                                                                                                                     |
| 10.146     | Separation Agreement dated March 20, 2007 between Russel                            Marvin and MTI MicroFuel Cells Inc. (21)                                                                             |
|       |                                                                                                                                                                                                     |
| 10.147     | Employment Agreement dated March 27, 2007 between Robert                            Kot and MTI Instruments, Inc. (22)                                                                                   |
|       |                                                                                                                                                                                                     |
| 10.148     | Fourth Amendment to lease dated August 6, 2007 between                            Kingfisher LLC and Mechanical Technology, Incorporated. (23)                                                           |
|       |                                                                                                                                                                                                     |
| 10.150     | Future Collaboration Agreement dated October 22, 2007                            between MTI MicroFuel Cells Inc. and Samsung Electronics Co., Ltd.                            (24)                      |
|       |                                                                                                                                                                                                     |
| 10.151     | Employment Agreement dated April 3, 2006 between James                            K. Prueitt and MTI MicroFuel Cells Inc.                                                                                |
|       |                                                                                                                                                                                                     |
| 14.1       | Code of Ethics. (13)                                                                                                                                                                                     |
|       |                                                                                                                                                                                                     |
| 21         | Subsidiaries of the Registrant. (7)                                                                                                                                                                      |
|       |                                                                                                                                                                                                     |
| 23.2       | Consent of Independent Registered Public Accounting Firm                            – PricewaterhouseCoopers LLP.                                                                                  |
|       |                                                                                                                                                                                                     |
| 31.1       | Rule 13a-14(a)/15d-14(a) Certification of Peng K.                            Lim.                                                                                                                        |
|       |                                                                                                                                                                                                     |
| 31.2       | Rule 13a-14(a)/15d-14(a) Certification of Cynthia A.                            Scheuer.                                                                                                                 |
|       |                                                                                                                                                                                                     |
| 32.1       | Section 1350 Certification of Peng K. Lim.                                                                                                                                                               |
|       |                                                                                                                                                                                                     |
| 32.2       | Section 1350 Certification of Cynthia A.                            Scheuer.                                                                                                                             |
|       |                                                                                                                                                                                                     |

 

 

Certain exhibits were previously filed (as indicated below) and are            incorporated herein by reference. All other exhibits for which no other filing            information is given are filed herewith:

             

| (1) | Filed as Appendix A to the registrant’s Definitive                            Proxy Statement Schedule 14A filed November 19, 1996. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------|

 

37

 

----

| (2) | Filed as an Exhibit to the registrant’s Proxy                            Statement, Schedule 14A, dated February 13, 1999. |
|-----|----------------------------------------------------------------------------------------------------------------------------------|

| (3) | Filed as an Exhibit to the registrant’s Form 10-K                            Report for the fiscal year ended September 30, 1999. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------|

| (4) | Filed as an Exhibit to our Form 10-K Report for the                            fiscal year ended September 30, 2001. |
|-----|----------------------------------------------------------------------------------------------------------------------|

| (5) | Filed as an Exhibit to the registrant’s Form 10-K                            Report for the year ended December 31, 2002. |
|-----|---------------------------------------------------------------------------------------------------------------------------------|

| (6) | Filed as an Exhibit to the registrant’s Form 10-Q                            Report for the fiscal quarter ended September 30, 2003. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------|

| (7) | Filed as an Exhibit to the registrant’s Form 10-K                            Report for the year ended December 31, 2003. |
|-----|---------------------------------------------------------------------------------------------------------------------------------|

| (8) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated January 27, 2004. |
|-----|------------------------------------------------------------------------------------------------------------------|

| (9) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated May 4, 2004. |
|-----|-------------------------------------------------------------------------------------------------------------|

| (10) | Filed as an Exhibit to the registrant’s Form 10-Q                            Report for the quarter ended September 30, 2004. |
|------|-------------------------------------------------------------------------------------------------------------------------------------|

| (11) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated June 20, 2005. |
|------|---------------------------------------------------------------------------------------------------------------|

| (12) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated December 12, 2005. |
|------|-------------------------------------------------------------------------------------------------------------------|

| (13) | Filed as an Exhibit to the registrant’s Form 10-K                            Report for the year ended December 31, 2005. |
|------|---------------------------------------------------------------------------------------------------------------------------------|

| (14) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated March 6, 2006. |
|------|---------------------------------------------------------------------------------------------------------------|

| (15) | Filed as an Exhibit to the registrant’s Proxy                            Statement, Schedule 14A, dated April 3, 2006. |
|------|------------------------------------------------------------------------------------------------------------------------------|

| (16) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated May 4, 2006. |
|------|-------------------------------------------------------------------------------------------------------------|

| (17) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated May 18, 2006. |
|------|--------------------------------------------------------------------------------------------------------------|

| (18) | Filed as an Exhibit to the registrant’s Form 10-Q                            Report for the quarter ended June 30, 2006. |
|------|--------------------------------------------------------------------------------------------------------------------------------|

| (19) | Filed as an Exhibit to the registrant’s Form 10-Q                            Report for the quarter ended September 30, 2006. |
|------|-------------------------------------------------------------------------------------------------------------------------------------|

| (20) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated December 15, 2006. |
|------|-------------------------------------------------------------------------------------------------------------------|

| (21) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated March 22, 2007. |
|------|----------------------------------------------------------------------------------------------------------------|

| (22) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated March 28, 2007. |
|------|----------------------------------------------------------------------------------------------------------------|

| (23) | Filed as an Exhibit to the registrant’s Form 10-Q                            Report for the quarter ended June 30, 2007. |
|------|--------------------------------------------------------------------------------------------------------------------------------|

| (24) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated October 25, 2007. |
|------|------------------------------------------------------------------------------------------------------------------|

| (25) | Filed as an Exhibit to the registrant’s Form 8-K                            Report dated December 14, 2007. |
|------|-------------------------------------------------------------------------------------------------------------------|

 

(A)            Certain portions of this exhibit have been omitted pursuant to a request for            confidential treatment filed with the Securities and Exchange Commission.

 

38

 

----

**Signatures**

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities            Exchange Act of 1934, the registrant has duly caused this report to be signed on its            behalf by the undersigned, thereunto duly authorized.

 

|                 | **MECHANICAL TECHNOLOGY, INCORPORATED**             |
|----------------------|-----------------------------------------------------|
|                 |                                                |
|                 |                                                |
| Date: March 27, 2008 | By: /s/ Peng K.                            Lim |
|                 | Peng K. Lim                                         |
|                 | 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.

 

| Signature                                                          | Title                                                                                                                           | Date           |
|--------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|----------------|
| /s/ Peng K. Lim                                                    | Chief Executive Officer and Director                                                                                            | March 27, 2008 |
| Peng K. Lim                                                        |                                                                                                                            |           |
|                                                               |                                                                                                                            |           |
| /s/ Cynthia A. Scheuer

Cynthia A. Scheuer                         | Vice President, Chief Financial Officer, and                            Secretary

(Principal Financial and Accounting Officer) | March 27, 2008 |
|                                                               |                                                                                                                            |           |
| /s/ Steven N. Fischer

Steven N. Fischer                           | Chairman and Director                                                                                                           | March 27, 2008 |
|                                                               |                                                                                                                            |           |
| /s/Thomas J.                            Marusak

Thomas J. Marusak | Director                                                                                                                        | March 27, 2008 |
|                                                               |                                                                                                                            |           |
| /s/ William P. Phelan

William P. Phelan                           | Director                                                                                                                        | March 27, 2008 |
|                                                               |                                                                                                                            |           |
| /s/ E. Dennis O’Connor

E. Dennis O’Connor             | Director                                                                                                                        | March 27, 2008 |
|                                                               |                                                                                                                            |           |
| /s/ Walter L. Robb

Dr. Walter L. Robb                             | Director                                                                                                                        | March 27, 2008 |

 

39

 

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC**

**ACCOUNTING FIRM ON FINANCIAL STATEMENT SCHEDULE**

 

To the            Board of Directors and Stockholders

of            Mechanical Technology, Incorporated

 

Our            audits of the consolidated financial statements referred to in our report dated            February 28, 2008 appearing on page F-2 of this Form 10-K of Mechanical Technology,            Incorporated, also included an audit of the financial statement schedule listed in Item            15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents            fairly, in all material respects, the information set forth therein when read in            conjunction with the related consolidated financial statements.

 

/s/PricewaterhouseCoopers LLP

Buffalo, New York

February 28, 2008

 

40

 

----

**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**VALUATION AND QUALIFYING ACCOUNTS**

**(DOLLARS IN THOUSANDS)**

 

 

| **Description**                                                                                           | **Balance at Beginning of Period** | **Additions Charged to**

**Costs and Expenses** | **Additions Charged to Other Accounts** | **Deductions** | **Balance at End of**

**Period** |
|-----------------------------------------------------------------------------------------------------------|------------------------------------|--------------------------------------------------|-----------------------------------------|----------------|-----------------------------------|
|                                                                                                      |
| **Allowance for doubtful accounts (accounts receivable)                            for the years ended:** |
| December 31, 2005                                                                                         |                               | $                                                | 58                                      |           | $                                 | — |   | $ | — |   | $ | (58 | ) | $ | — |   |   |
| December 31, 2006                                                                                         |                               | $                                                | —                                 |           | $                                 | — |   | $ | — |   | $ | — |   | $ | — |   |   |
| December 31, 2007                                                                                         |                               | $                                                | —                                 |           | $                                 | — |   | $ | — |   | $ | — |   | $ | — |   |   |
| Includes accounts written off as uncollectible and                            recoveries.                 |
|                                                                                                      |
| **Valuation allowance for deferred tax assets for the                            years ended:**           |
| December 31, 2005                                                                                         |                               | $                                                | 1,836                                   |           | $                                 | 9,087 |   | $ | — |   | $ | — |   | $ | 10,923 |   |   |
| December 31, 2006                                                                                         |                               | $                                                | 10,923                                  |           | $                                 | 7,915 |   | $ | (23 | ) | $ | — |   | $ | 18,815 |   |   |
| December 31, 2007                                                                                         |                               | $                                                | 18,815                                  |           | $                                 | 3,518 |   | $ | — |   | $ | — |   | $ | 22,333 |   |   |
|                                                                                                      |                               |                                             |                                    |           |                              |   |   |   |   |   |   |   |   |   |   |   |   |
| **Inventory reserve for the years ended:**                                                                |                               |
| December 31, 2005                                                                                         |                               | $                                                | 67                                      |           | $                                 | 75 |   | $ | 9 |   | $ | (103 | ) | $ | 48 |   |   |
| December 31, 2006                                                                                         |                               | $                                                | 48                                      |           | $                                 | 136 |   | $ | (1 | ) | $ | (33 | ) | $ | 150 |   |   |
| December 31, 2007                                                                                         |                               | $                                                | 150                                     |           | $                                 | 137 |   | $ | 28 |   | $ | 133 |   | $ | 182 |   |   |
|                                                                                                           |                                    |                                                  |                                         |                |                                   |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

41

 

----

             

             

             

             

             

             

 

**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

|                                                                                                        | Page                                            |
|-------------------------------------------------------------------------------------------------------------|-------------------------------------------------|
| Reports of Independent Registered Public Accounting                            Firm                         | F-2                                             |
|                                                                                                        |                                            |
| Consolidated Financial Statements:                                                                          |                                            |
|                                                                                                        |                                            |
| Balance Sheets as of December 31, 2006 and                            2007                                  | F-3                                             |
|                                                                                                        |                                            |
| Statements of Operations for the Years Ended December                            31, 2005, 2006, and 2007   | F-4                                             |
|                                                                                                        |                                            |
| Statements of Stockholders’ Equity and                            Comprehensive Income (Loss) for the |                                            |
| Years Ended December 31, 2005, 2006, and 2007                                                               | F-5                                             |
|                                                                                                        |                                            |
| Statements of Cash Flows for the Years Ended December                            31, 2005, 2006, and 2007   | F-6                                             |
|                                                                                                        |                                            |
| Notes to Consolidated Financial Statements                                                                  | F-7 to F-34

                              |

 

F-1

 

----

             

             

             

             

             

             

 

**Report of Independent Registered Public Accounting            Firm**

 

To the            Board of Directors and Stockholders of

Mechanical Technology, Incorporated:

 

In our            opinion, the accompanying consolidated balance sheets and the related consolidated            statements of operations, stockholders’ equity and comprehensive income (loss),            and of cash flows present fairly, in all material respects, the financial position of            Mechanical Technology, Incorporated and its subsidiaries at December 31, 2006 and 2007,            and the results of their operations and theircash flows for each of the three years in            the period ended December 31, 2007in conformity with accounting principles generally            accepted in the United States of America. These financial statements are the            responsibility of the Company’s management. Our responsibility is to express an            opinion on these financial statements based on our audits. We conducted our audits of            these statements in accordance with the standards of the Public Company Accounting            Oversight Board (United States). Those standards require that we plan and perform the            audit to obtain reasonable assurance about whether the financial statements are free of            material misstatement. An audit includes examining, on a test basis, evidence            supporting the amounts and disclosures in the financial statements, assessing the            accounting principles used and significant estimates made by management, and evaluating            the overall financial statement presentation. We believe that our audits provide a            reasonable basis for our opinion.

 

The            accompanying financial statements have been prepared assuming that the Company will            continue as a going concern. As discussed in Note 1 to the financial statements, the            Company has suffered recurring losses from operations and has a net capital deficiency            that raise substantial doubt about its ability to continue as a going concern.            Management's plans in regard to these matters are also described in Note 1. The            financial statements do not include any adjustments that might result from the outcome            of this uncertainty.

 

/s/            PricewaterhouseCoopers LLP

Buffalo, New York

February 28, 2008

 

F-2

 

----

             

             

             

             

             

             

 

**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**December 31, 2006 and 2007**

 

| (Dollars in thousands)                                                                                                                                                        |   | **December 31,** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------|
|                                                                                                                                                                          |   | **2006**         |   | **2007** |   |
| **Assets**                                                                                                                                                                    |   |
| **Current Assets:**                                                                                                                                                           |   |             |   |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                     |   | $                | 14,545 |   | $ | 7,650 |   |
| Securities available for sale                                                                                                                                                 |   |             | 10,075 |   |   | 4,492 |   |
| Accounts receivable                                                                                                                                                           |   |             | 1,613 |   |   | 1,369 |   |
| Inventories, net                                                                                                                                                              |   |             | 1,216 |   |   | 1,373 |   |
| Prepaid expenses and other current assets                                                                                                                                     |   |             | 442 |   |   | 329 |   |
| Total Current Assets                                                                                                                                                          |   |             | 27,891 |   |   | 15,213 |   |
| Property, plant and equipment, net                                                                                                                                            |   |             | 2,926 |   |   | 2,159 |   |
| Deferred income taxes                                                                                                                                                         |   |             | 2,994 |   |   | 1,344 |   |
| Total Assets                                                                                                                                                                  |   | $                | 33,811 |   | $ | 18,716 |   |
|                                                                                                                                                                          |   |             |   |   |   |   |   |
| **Liabilities and Stockholders’                            Equity**                                                                                                     |   |
| **Current Liabilities:**                                                                                                                                                      |   |             |   |   |   |   |   |
| Accounts payable                                                                                                                                                              |   | $                | 651 |   | $ | 273 |   |
| Accrued liabilities                                                                                                                                                           |   |             | 2,470 |   |   | 2,121 |   |
| Deferred revenue                                                                                                                                                              |   |             | 866 |   |   | 117 |   |
| Income taxes payable                                                                                                                                                          |   |             | 90 |   |   | 11 |   |
| Deferred income taxes                                                                                                                                                         |   |             | 2,994 |   |   | 1,344 |   |
| Total Current Liabilities                                                                                                                                                     |   |             | 7,071 |   |   | 3,866 |   |
| **Long-Term Liabilities:**                                                                                                                                                    |   |             |   |   |   |   |   |
| Uncertain tax position liability                                                                                                                                              |   |             | — |   |   | 208 |   |
| Derivative liability                                                                                                                                                          |   |             | 3,664 |   |   | 696 |   |
| Total Long-Term-Liabilities                                                                                                                                                   |   |             | 3,664 |   |   | 904 |   |
| Total Liabilities                                                                                                                                                             |   |             | 10,735 |   |   | 4,770 |   |
| **Commitments and Contingencies**                                                                                                                                             |   |             |   |   |   |   |   |
| Minority interests                                                                                                                                                            |   |             | 205 |   |   | 143 |   |
| **Stockholders’ Equity:**                                                                                                                                               |   |             |   |   |   |   |   |
| Common stock, par value $0.01 per share, authorized                            75,000,000; 46,084,678 issued in 2006 and 46,220,624 issued in                            2007 |   |             | 461 |   |   | 462 |   |
| Paid-in-capital                                                                                                                                                               |   |             | 130,565 |   |   | 131,661 |   |
| Accumulated deficit                                                                                                                                                           |   |             | (95,385 | ) |   | (105,066 | ) |
| Accumulated Other Comprehensive Income:                                                                                                                                       |   |             |   |   |   |   |   |
| Unrealized gain on securities available for sale, net of                            tax                                                                                       |   |             | 984 |   |   | 500 |   |
| Common stock in treasury, at cost, 8,040,736 shares in                            2006 and 2007                                                                               |   |             | (13,754 | ) |   | (13,754 | ) |
| Total Stockholders’ Equity                                                                                                                                              |   |             | 22,871 |   |   | 13,803 |   |
| Total Liabilities and Stockholders’                            Equity                                                                                                   |   | $                | 33,811 |   | $ | 18,716 |   |

The accompanying notes are an integral part of the consolidated            financial statements.

 

F-3

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**For the Years Ended December 31, 2005, 2006, and 2007**

 

| (Dollars in thousands, except per share)                                           |   | **Years Ended December 31,** |
|------------------------------------------------------------------------------------|--------|------------------------------|
|                                                                               |   | **2005**                     |   | **2006** |   | **2007** |   |
|                                                                               |   |                         |   |   |   |   |   |
| Product revenue                                                                    |   | $                            | 6,012 |   | $ | 7,667 |   | $ | 9,028 |   |
| Funded research and development revenue                                            |   |                         | 1,829 |   |   | 489 |   |   | 1,556 |   |
| Total revenue                                                                      |   |                         | 7,841 |   |   | 8,156 |   |   | 10,584 |   |
| Operating costs and expenses:                                                      |   |                         |   |   |   |   |   |   |   |   |
| Cost of product revenue                                                            |   |                         | 2,381 |   |   | 2,900 |   |   | 3,430 |   |
| Research and product development expenses:                                         |   |                         |   |   |   |   |   |   |   |   |
| Funded research and product development                                            |   |                         | 3,555 |   |   | 1,152 |   |   | 1,891 |   |
| Unfunded research and product development                                          |   |                         | 6,116 |   |   | 11,769 |   |   | 9,874 |   |
| Total research and product development                            expenses         |   |                         | 9,671 |   |   | 12,921 |   |   | 11,765 |   |
| Selling, general and administrative expenses                                       |   |                         | 10,887 |   |   | 10,072 |   |   | 8,738 |   |
| Operating loss                                                                     |   |                         | (15,098 | ) |   | (17,737 | ) |   | (13,349 | ) |
| Gain (loss) on derivatives                                                         |   |                         | (10,407 | ) |   | 182 |   |   | 2,967 |   |
| Gain on sale of securities available for sale                                      |   |                         | 10,125 |   |   | 4,289 |   |   | 2,549 |   |
| Other income, net                                                                  |   |                         | 431 |   |   | 286 |   |   | 224 |   |
| Loss before income taxes and minority                            interests         |   |                         | (14,949 | ) |   | (12,980 | ) |   | (7,609 | ) |
| Income tax (expense)                                                               |   |                         | (1,587 | ) |   | (1,895 | ) |   | (2,548 | ) |
| Minority interests in losses of consolidated                            subsidiary |   |                         | 1,442 |   |   | 1,208 |   |   | 582 |   |
| Net loss                                                                           |   | $                            | (15,094 | ) | $ | (13,667 | ) | $ | (9,575 | ) |
|                                                                               |   |                         |   |   |   |   |   |   |   |   |
| Loss per Share (Basic and Diluted):                                                |   |                         |   |   |   |   |   |   |   |   |
| Loss per share                                                                     |   | $                            | (0.49 | ) | $ | (0.43 | ) | $ | (0.25 | ) |

The accompanying notes are an integral part of the consolidated            financial statements.

 

F-4

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**AND COMPREHENSIVE INCOME (LOSS)**

**For the Years Ended December 31, 2005, 2006, and 2007**

 

| (Dollars in thousands)                                                                                                                                                                      |   | **Years Ended December 31,** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|
|                                                                                                                                                                                        |   | **2005**                     |   | **2006** |   | **2007** |   |
| **Common Stock**                                                                                                                                                                            |   |                         |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   | $                            | 387 |   | $ | 390 |   | $ | 461 |   |
| Issuance of shares – private placement                                                                                                                                                |   |                         | 1 |   |   | — |   |   | — |   |
| Issuance of shares – capital                                                                                                                                                          |   |                         | — |   |   | 60 |   |   | — |   |
| Issuance of shares – anti-dilution                            penalty                                                                                                                 |   |                         | — |   |   | 3 |   |   | — |   |
| Issuance of shares – stock options                                                                                                                                                    |   |                         | 1 |   |   | 7 |   |   | — |   |
| Issuance of shares – restricted stock                                                                                                                                                 |   |                         | 1 |   |   | 1 |   |   | 1 |   |
| Balance, ending                                                                                                                                                                             |   | $                            | 390 |   | $ | 461 |   | $ | 462 |   |
| **Paid-In Capital**                                                                                                                                                                         |   |                         |   |   |   |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   | $                            | 121,033 |   | $ | 122,095 |   | $ | 130,565 |   |
| Private placement, net of expenses                                                                                                                                                          |   |                         | (45 | ) |   | — |   |   | — |   |
| Capital raise and warrant issuance, net of                            expenses                                                                                                              |   |                         | — |   |   | 6,250 |   |   | — |   |
| Issuance of shares – stock options                                                                                                                                                    |   |                         | 325 |   |   | 1,181 |   |   | 59 |   |
| Share-based compensation                                                                                                                                                                    |   |                         | 1,083 |   |   | 2,406 |   |   | 1,558 |   |
| MTI MicroFuel Cell investment                                                                                                                                                               |   |                         | (301 | ) |   | (1,284 | ) |   | (521 | ) |
| Elimination of unearned compensation due to change in                            accounting principle                                                                                       |   |                         | — |   |   | (80 | ) |   | — |   |
| Issuance of shares – anti-dilution                            penalty                                                                                                                 |   |                         | — |   |   | (3 | ) |   | — |   |
| Balance, ending                                                                                                                                                                             |   | $                            | 122,095 |   | $ | 130,565 |   | $ | 131,661 |   |
| **Accumulated Deficit**                                                                                                                                                                     |   |                         |   |   |   |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   | $                            | (66,624 | ) | $ | (81,718 | ) | $ | (95,385 | ) |
| Cumulative effect of adoption of FIN 48                                                                                                                                                     |   |                         | — |   |   | — |   |   | (106 | ) |
| Net loss                                                                                                                                                                                    |   |                         | (15,094 | ) |   | (13,667 | ) |   | (9,575 | ) |
| Balance, ending                                                                                                                                                                             |   | $                            | (81,718 | ) | $ | (95,385 | ) | $ | (105,066 | ) |
| **Accumulated Other Comprehensive Income                            (Loss):**                                                                                                               |   |                         |   |   |   |   |   |   |   |   |
| Unrealized Gain (loss) on Securities Available for Sale,                            Net of Taxes                                                                                            |   |                         |   |   |   |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   | $                            | 14,542 |   | $ | 5,983 |   | $ | 984 |   |
| Change in unrealized (loss) gain on securities available                            for sale (net of taxes of $0 in 2005, 2006, and 2007)                                                   |   |                         | (3,620 | ) |   | (3,212 | ) |   | 68 |   |
| Less reclassification adjustment for gains included in                            net income (net of taxes of $3,293 in 2005, $1,913 in 2006 and $2,518                            in 2007) |   |                         | (4,939 | ) |   | (1,787 | ) |   | (552 | ) |
| Balance, ending                                                                                                                                                                             |   | $                            | 5,983 |   | $ | 984 |   | $ | 500 |   |
| **Restricted Stock Grants – Unearned                            Compensation**                                                                                                        |   |                         |   |   |   |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   |                         | — |   |   | (80 | ) |   | — |   |
| Elimination of unearned compensation due to change in                            accounting principle                                                                                       |   |                         | — |   |   | 80 |   |   | — |   |
| Issuance of shares                                                                                                                                                                          |   |                         | (125 | ) |   | — |   |   | — |   |
| Grants amortization                                                                                                                                                                         |   |                         | 45 |   |   | — |   |   | — |   |
| Balance, ending                                                                                                                                                                             |   | $                            | (80 | ) | $ | — |   | $ | — |   |
| **Treasury Stock**                                                                                                                                                                          |   |                         |   |   |   |   |   |   |   |   |
| Balance, beginning                                                                                                                                                                          |   | $                            | (13,754 | ) | $ | (13,754 | ) | $ | (13,754 | ) |
| Balance, ending                                                                                                                                                                             |   | $                            | (13,754 | ) | $ | (13,754 | ) | $ | (13,754 | ) |
| **Total Stockholders’ Equity**                                                                                                                                                        |   | $                            | 32,916 |   | $ | 22,871 |   | $ | 13,803 |   |
| **Total Comprehensive (Loss):**                                                                                                                                                             |   |                         |   |   |   |   |   |   |   |   |
| Net loss                                                                                                                                                                                    |   | $                            | (15,094 | ) | $ | (13,667 | ) | $ | (9,575 | ) |
| Other comprehensive (loss):                                                                                                                                                                 |   |                         |   |   |   |   |   |   |   |   |
| Reclassification adjustment for gains included in net                            income, net of taxes                                                                                       |   |                         | (4,939 | ) |   | (1,787 | ) |   | (552 | ) |
| Change in unrealized (loss) gain on securities available                            for sale, net of taxes                                                                                  |   |                         | (3,620 | ) |   | (3,212 | ) |   | 68 |   |
| Total comprehensive (loss)                                                                                                                                                                  |   | $                            | (23,653 | ) | $ | (18,666 | ) | $ | (10,059 | ) |

The accompanying notes are an integral part of the consolidated            financial statements.

 

F-5

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**For the Years Ended December 31, 2005, 2006, and 2007**

 

| (Dollars in thousands)                                                                                 |   | **Years Ended December 31,** |
|--------------------------------------------------------------------------------------------------------|--------|------------------------------|
|                                                                                                   |   | **2005**                     |   | **2006** |   | **2007** |   |
| **Operating Activities**                                                                               |   |                         |   |   |   |   |   |   |   |   |
| Net loss                                                                                               |   | $                            | (15,094 | ) | $ | (13,667 | ) | $ | (9,575 | ) |
| Adjustments to reconcile net loss to net cash used by                            operating activities: |   |                         |   |   |   |   |   |   |   |   |
| (Gain) loss on derivatives                                                                             |   |                         | 10,407 |   |   | (182 | ) |   | (2,967 | ) |
| Gain on sale of securities available for sale                                                          |   |                         | (10,125 | ) |   | (4,289 | ) |   | (2,549 | ) |
| Depreciation and amortization                                                                          |   |                         | 1,253 |   |   | 1,101 |   |   | 1,129 |   |
| Minority interests in losses of consolidated                            subsidiary                     |   |                         | (1,442 | ) |   | (1,208 | ) |   | (582 | ) |
| Allowance for bad debts                                                                                |   |                         | (58 | ) |   | (1 | ) |   | — |   |
| Loss on disposal of fixed assets                                                                       |   |                         | 130 |   |   | 40 |   |   | 39 |   |
| Deferred income taxes                                                                                  |   |                         | 1,617 |   |   | 1,890 |   |   | 2,518 |   |
| Stock based compensation                                                                               |   |                         | 1,003 |   |   | 2,406 |   |   | 1,558 |   |
| Changes in operating assets and liabilities:                                                           |   |                         |   |   |   |   |   |   |   |   |
| Accounts receivable                                                                                    |   |                         | 832 |   |   | (614 | ) |   | 244 |   |
| Other receivables – related parties                                                              |   |                         | — |   |   | 3 |   |   | — |   |
| Inventories                                                                                            |   |                         | 78 |   |   | (158 | ) |   | (157 | ) |
| Prepaid expenses and other current assets                                                              |   |                         | 53 |   |   | 9 |   |   | 113 |   |
| Accounts payable                                                                                       |   |                         | 362 |   |   | 277 |   |   | (379 | ) |
| Income taxes payable                                                                                   |   |                         | 25 |   |   | 25 |   |   | 23 |   |
| Deferred revenue                                                                                       |   |                         | (359 | ) |   | 746 |   |   | (749 | ) |
| Accrued liabilities - related parties                                                                  |   |                         | 2 |   |   | (2 | ) |   | — |   |
| Accrued liabilities                                                                                    |   |                         | (1,256 | ) |   | 918 |   |   | (349 | ) |
| Net cash used by operating activities                                                                  |   |                         | (12,572 | ) |   | (12,706 | ) |   | (11,683 | ) |
| **Investing Activities**                                                                               |   |                         |   |   |   |   |   |   |   |   |
| Purchases of property, plant and equipment                                                             |   |                         | (1,004 | ) |   | (1,574 | ) |   | (414 | ) |
| Proceeds from sale of property, plant and                            equipment                         |   |                         | 10 |   |   | 2 |   |   | 12 |   |
| Proceeds from sale of securities available for                            sale                         |   |                         | 1,969 |   |   | 6,249 |   |   | 5,130 |   |
| Net cash provided by investing activities                                                              |   |                         | 975 |   |   | 4,677 |   |   | 4,728 |   |
| **Financing Activities**                                                                               |   |                         |   |   |   |   |   |   |   |   |
| Gross proceeds from capital raise and warrants                            issued                       |   |                         | — |   |   | 10,900 |   |   | — |   |
| Costs of private placement                                                                             |   |                         | (45 | ) |   | — |   |   | — |   |
| Cost of capital raise                                                                                  |   |                         | — |   |   | (744 | ) |   | — |   |
| Proceeds from stock option exercises                                                                   |   |                         | 327 |   |   | 1,188 |   |   | 60 |   |
| Net cash provided by financing activities                                                              |   |                         | 282 |   |   | 11,344 |   |   | 60 |   |
| (Decrease) increase in cash and cash                            equivalents                            |   |                         | (11,315 | ) |   | 3,315 |   |   | (6,895 | ) |
| Cash and cash equivalents - beginning of year                                                          |   |                         | 22,545 |   |   | 11,230 |   |   | 14,545 |   |
| Cash and cash equivalents - end of year                                                                |   | $                            | 11,230 |   | $ | 14,545 |   | $ | 7,650 |   |

The            accompanying notes are an integral part of the consolidated financial            statements.

 

F-6

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

| **1.** | **Nature of Operations** |
|--------|--------------------------|

 

**Description of Business**

Mechanical Technology, Incorporated, (“MTI” or the            “Company”), a New York corporation, was incorporated in 1961. MTI operates            in two segments; the new energy segment which is conducted through MTI MicroFuel Cells            Inc. (“MTI Micro”), a majority owned subsidiary, and the test and            measurement instrumentation segment, which is conducted through MTI Instruments, Inc.            (“MTI Instruments”), a wholly owned subsidiary.

 

At its            MTI Micro subsidiary, the Company’s Mobion® cord-free power packs are being            developed to replace current lithium ion and similar rechargeable battery systems in            many handheld electronic devices for the military and consumer markets. Mobion®            power packs are based on direct methanol fuel cell technology which has been recognized            as enabling technology for advanced portable power sources by the scientific community            and industry analysts. As the need for advancements in portable power increases, MTI            Micro is developing Mobion® cord-free rechargeable power pack technology as a            superior solution for powering the multi-billion dollar portable electronics            market.

 

At its            MTI Instruments subsidiary, the Company continues to be a worldwide supplier of            precision non-contact physical measurement solutions, condition based monitoring            systems, portable balancing equipment and semiconductor wafer inspection tools. MTI            Instruments’ products use a comprehensive array of technologies to solve complex            real world applications in numerous industries including manufacturing, semiconductor,            commercial/military aviation, automotive and data storage. The Company’s products            consist of electronic gauging instruments for position, displacement and vibration            applications within the design, manufacturing/production, test and research markets;            semiconductor products for wafer characterization of semi-insulating and            semi-conducting wafers within the semiconductor industry; and engine balancing and            vibration analysis systems for both military and commercial aircraft.

 

**Liquidity and Going Concern**

The            Company has incurred significant losses as it continues to fund MTI Micro’s            direct methanol fuel cell product development and commercialization programs, and has            an accumulated deficit of $105,066 thousand and working capital of $11,347 thousand at            December 31, 2007. Because of these losses, limited current cash, cash equivalents and            securities available for sale, negative cash flows and accumulated deficit, the report            of the Company’s independent registered public accounting firm for the year ended            December 31, 2007 expressed substantial doubt about the Company’s ability to            continue as a going concern.

During            2007, the Company sold 1,452,770 shares of Plug Power Inc. (“Plug Power”)            common stock with proceeds totaling $5,130 thousand and gains totaling $2,549 thousand.            These proceeds reflect the Company’s previously announced strategy to raise            additional capital through the sale of Plug Power stock in order to fund MTI Micro            operations.

 

Based            on the Company’s projected cash requirements for operations and capital            expenditures for 2008 and its current cash, cash equivalents and marketable securities            of $12,142 thousand at December 31, 2007, management believes it will have adequate            resources to fund operations and capital expenditures for the next twelve months based            on current cash and cash equivalents, current cash flow requirements, revenue and            expense projections and the potential sale of securities available for sale at current            market values.

However, the Company may need to do one or more of the following to            raise additional resources, or reduce its cash requirements:

|   | **•** | reduce its current expenditure run-rate; |
|--------|------------|------------------------------------------|

|   | **•** | sell additional shares of Plug Power; |
|--------|------------|---------------------------------------|

|   | **•** | obtain additional government or private funding of the                            Company’s direct methanol fuel cell research, development,                            manufacturing readiness and commercialization; |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | sell operating divisions of the Company; or |
|--------|------------|---------------------------------------------|

|   | **•** | secure additional equity financing. |
|--------|------------|-------------------------------------|

There            is no guarantee that such resources will be available to the Company on terms            acceptable to it, or at all, or that such resources will be received in a timely            manner, if at all, or that the Company will be able to reduce its expenditure run-rate            without materially and adversely affecting its business.

 

F-7

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**2.**       **Accounting Policies**

 

**Principles of Consolidation**

The            consolidated financial statements include the accounts of the Company and its            majority-owned subsidiaries. All significant inter-company transactions are eliminated            in consolidation.

 

Minority interest in subsidiaries consists of equity securities issued            by a subsidiary of the Company. No gain or loss was recognized as a result of the            issuance of these securities, and the Company owned a majority of the voting equity of            the subsidiary both before and after the transactions. The Company reflects the impact            of the equity securities issuances in its investment in subsidiary and additional            paid-in-capital accounts for the dilution or anti-dilution of its ownership interest in            the subsidiary.

 

**Use of Estimates**

The            preparation of the consolidated financial statements in conformity with accounting            principles generally accepted in the United States of America (“U.S. GAAP”)            which requires management to make estimates and assumptions that affect the reported            amounts of assets and liabilities and disclosure of contingent assets and liabilities            at the date of the consolidated financial statements and the reported amounts of            revenues and expenses during the reporting period. Actual results could differ from            those estimates.

 

**Fair Value of Financial Instruments**

The            Company’s financial instruments consist of cash and cash equivalents, marketable            securities, accounts receivable, unbilled contract costs and fees, derivatives and            accounts payable. The estimated fair values of these financial instruments approximate            their carrying values at December 31, 2006 and 2007. The estimated fair values have            been determined through information obtained from market sources, where available, or            Black-Scholes Option Pricing model valuations.

 

**Accounting for Derivative Instruments**

The            Company accounts for derivative instruments and embedded derivative instruments in            accordance with Statement of Financial Accounting Standards (“SFAS”) No.            133,*Accounting for Derivative Instruments and Hedging            Activities,*as amended. The amended standard requires an            entity to recognize all derivatives as either assets or liabilities in the statement of            financial position and measure these instruments at fair value. Fair value is estimated            using the Black-Scholes Option Pricing model. The Company also follows Emerging Issues            Task Force (“EITF”) Issue No. 00-19,*Accounting            for Derivative Financial Instruments Indexed to and Potentially Settled in, a            Company’s Own Stock*, which requires freestanding            contracts that are settled in a company’s own stock, including common stock            warrants, to be designated as an equity instrument, asset or a liability. Under the            provisions of EITF Issue No. 00-19, a contract designated as an asset or a liability            must be carried at fair value, with any changes in fair value recorded in the results            of operations. A contract designated as an equity instrument can be included in equity,            with no fair value adjustments are required.

 

The            asset/liability derivatives are valued on a quarterly basis using the Black-Scholes            Option Pricing model. Significant assumptions used in the valuation include exercise            dates, closing market prices for the Company’s common stock, volatility of the            Company’s common stock, and proxy risk-free interest rates. Gains (losses) on            derivatives are included in “Gain (loss) on derivatives” in the            Consolidated Statement of Operations.

 

**Accounts Receivable and Allowance for Doubtful            Accounts**

Trade            accounts receivable are recorded at the invoiced amount and do not bear interest. An            allowance for doubtful accounts, if necessary, represents the Company’s best            estimate of the amount of probable credit losses in its existing accounts receivable.            The Company determines the allowance based on historical write-off experience and            current exposures identified. The Company reviews its allowance for doubtful accounts            monthly. Past due balances over 90 days and over a specified amount are reviewed            individually for collectability. All other balances are reviewed on a pooled basis by            type of receivable. Account balances are charged off against the allowance when the            Company believes it is probable the receivable will not be recovered. The Company does            not have any off-balance-sheet credit exposure related to its customers.

 

**Inventories**

Inventories are valued at the lower of cost (first-in, first-out) or            market. The Company provides estimated inventory allowances for excess, slow moving and            obsolete inventory as well as inventory whose carrying value is in excess of net            realizable value.

 

F-8

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**Property, Plant, and Equipment**

Property, plant and equipment are stated at cost and depreciated using            primarily the straight-line method over their estimated useful lives:

| Leasehold improvements                   | Lesser of the life of the lease or the useful life of                            the improvement |
|------------------------------------------|--------------------------------------------------------------------------------------------------|
| Computers and related software           | 3 to 5 years                                                                                     |
| Machinery and equipment                  | 3 to 10 years                                                                                    |
| Office furniture, equipment and fixtures | 2 to 10 years                                                                                    |

Significant additions or improvements extending assets’ useful            lives are capitalized; normal maintenance and repair costs are expensed as incurred.            The costs of fully depreciated assets remaining in use are included in the respective            asset and accumulated depreciation accounts. When items are sold or retired, related            gains or losses are included in net (loss) income.

 

**Income Taxes**

The            Company accounts for taxes in accordance with SFAS No. 109,*Accounting for Income Taxes*(“SFAS            No. 109”), which requires the use of the asset and liability method of accounting            for income taxes. Under the asset and liability method, deferred income taxes are            recognized for the tax consequences of “temporary differences” by applying            enacted statutory tax rates applicable for future years to differences between            financial statement and tax bases of existing assets and liabilities. Under SFAS No.            109, the effect of tax rate changes on deferred taxes is recognized in the income tax            provision in the period that includes the enactment date. The provision for taxes is            reduced by investment and other tax credits in the years such credits become available.            A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets            unless it is more likely than not those assets will be realized.

 

Effective January 1, 2007, the Company adopted the provisions of FASB            Interpretation (FIN) No. 48,*Accounting for Uncertainty in            Income Taxes—an Interpretation of FASB Statement No.            109*. FIN 48 contains a two-step approach to recognizing and            measuring uncertain tax positions (tax contingencies) accounted for in accordance with            SFAS No. 109. The first step is to evaluate the tax position for recognition by            determining if the weight of available evidence indicates it is more likely than not            that the position will be sustained on audit, including resolution of related appeals            or litigation processes, if any. The second step is to measure the tax benefit as the            largest amount which is more than 50% likely of being realized upon ultimate            settlement. The Company considers many factors when evaluating and estimating its tax            positions and tax benefits, which may require periodic adjustments and which may not            accurately forecast actual outcomes.

 

**Revenue Recognition**

The            Company applies the guidance within SEC Staff Accounting Bulletin (“SAB”)            No. 104,*Revenue Recognition*(“SAB No. 104”)in the evaluation of its contracts to            determine when to properly recognize revenue. Under SAB No. 104, revenue is recognized            when title and risk of loss have passed to the customer, there is persuasive evidence            of an arrangement, the fee is fixed or determinable, delivery has occurred or services            have been rendered, the sales price is determinable, and collectability is reasonably            assured.

 

***Product Revenue***

Product            revenue is recognized when there is persuasive evidence of an arrangement, the            collection of a fixed fee is probable or determinable, delivery of the product to the            customer or distributor has occurred, at which time title generally is passed to the            customer or distributor, all of which generally occur upon shipment of the product. If            the product requires installation to be performed by the Company, all revenue related            to the product is deferred and recognized upon the completion of the installation. If            the product requires specific customer acceptance, revenue is deferred until customer            acceptance occurs or the acceptance provisions lapse, unless the Company can            objectively and reliably demonstrate that the criteria specified in the acceptance            provisions are satisfied.

 

MTI            Instruments, a wholly-owned subsidiary of MTI, currently has distributor agreements in            place for the international sale of general instrument and semiconductor products in            certain global regions. Such agreements grant a distributor the right of first refusal            to act as distributor for such products in the distributor’s territory. In            return, the distributor agrees to not market other products which are considered by MTI            Instruments to be in direct competition with MTI Instruments’ products. The            distributor is allowed to purchase MTI Instruments’ equipment at a price which is            discounted off the published domestic/international list prices. Such list prices can            be adjusted by MTI Instruments during the term of the distributor agreement, but MTI            Instruments must provide advance notice at least 90 days before the price adjustment            goes into effect. Generally, payment terms with the distributor are standard net 30            days; however, on occasion, extended payment terms have been granted. Title and risk of            loss of the product passes to the distributor upon delivery to the independent carrier            (standard “free-on-board” factory), and the distributor is responsible for            any required training and/or service with the end-user. The sale (and subsequent            payment) between MTI Instruments and the distributor is not contingent upon the            successful resale of the product by the distributor. Distributor sales are covered by            MTI Instruments’ standard one-year warranty and there are no special return            policies for distributors.

 

F-9

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

Some of            MTI Instruments’ direct sales, particularly sales of semi-automatic and            fully-automated semiconductor metrology equipment, or rack-mounted vibration systems,            involve on-site customer acceptance and/or installation. In those instances, revenue            recognition does not take place at time of shipment. Instead, MTI Instruments            recognizes the sale after the unit is installed and/or an on-site acceptance is given            by the customer. Agreed-upon acceptance terms and conditions, if any, are negotiated at            the time of purchase.

 

***Funded Research and Development Revenue***

The            Company performs funded research and development for government agencies under both            cost reimbursement and fixed-price contracts. Cost reimbursement contracts provide for            the reimbursement of allowable costs. On fixed-price contracts, revenue is generally            recognized on the percentage of completion method based upon the proportion of costs            incurred to the total estimated costs for the contract. Revenue from reimbursement            contracts is recognized as the services are performed. In each type of contract, the            Company generally receives periodic progress payments or payments upon reaching interim            milestones. When the current estimates of total contract revenue for commercial            development contracts indicate a loss, a provision for the entire loss on the contract            is recorded. Any losses incurred in performing funded research and development projects            are recognized as research and development expense as incurred. When government            agencies are providing funding they do not expect the government to be the only            significant end user of the resulting products. These contracts do not require delivery            of products that meet defined performance specifications, but are best efforts            arrangements to achieve overall research and development objectives. Included in            accounts receivable are billed and unbilled work-in-progress on contracts. Billings in            excess of contract revenues earned are recorded as deferred revenue. While the            Company’s accounting for government contract costs is subject to audit by the            sponsoring entity, in the opinion of management, no material adjustments are expected            as a result of such audits. Adjustments are recognized in the period made.

 

***Commercial Research and Prototype Agreement            Income***

The            Company also applies the guidance in SAB No. 104 in the evaluation of commercially            funded fuel cell research and prototype agreements in order to determine when to            properly recognize income. Payments received in connection with commercial research and            prototype agreements are deferred and recognized on a straight-line basis over the term            of the agreement for service-related payments, and for milestone and prototype delivery            payments, if and when achieved, revenue is deferred and recognized on a straight-line            basis over the remaining term of the agreement. Under this policy, when revenue            qualifies for recognition it will be recorded in the Consolidated Statements of            Operations in the line “Funded research and development revenue.” The costs            associated with research and prototype-producing activities are expensed as incurred.            Expenses in an amount equal to revenues recognized are reclassified from            “Unfunded research and product development” to “Funded research and            product development” in the Consolidated Statements of Operations.

 

Information regarding MTI Micro’s government and commercial funded            research and development contracts is as follows:

|                                                   |
|--------------------------------------------------------|
| **Contract Name**                                      |   | **Expiration (1)** |
| $3,000 thousand DOE**(2)**                             |   |   |   | 09/30/08 |
| $1,250 thousand NYSERDA**(3)**                         |   |   |   | 06/30/06 |
| $1,000 thousand Samsung**(4)**                         |   |   |   | 07/31/07 |
| $418 thousand                            SAFT**(5)**   |   |   |   | 12/31/06 |
| $250 thousand ARL                                      |   |   |   | 09/30/05 |
| $210 thousand                            NIST**(6)**   |   |   |   | 06/30/05 |
| $150 thousand                            Harris**(7)** |   |   |   | 06/25/04 |
| $70 thousand Marine Corps                              |   |   |   | 03/31/05 |
| $15 thousand                            NCMS**(8)**    |   |   |   | 06/30/07 |

**__________________________________________________________________________________________**

| (1) | Dates represent expiration of contract, not date of                            final billing. |
|-----|-----------------------------------------------------------------------------------------------|

| (2) | The DOE contract is a cost share contract. DOE funding                            for this contract was suspended during January 2006 and reinstated                            during May 2007. During 2007, the Company received notifications from                            the DOE of funding releases totaling $1.0 million and also received an                            extension of the termination date for the contract from July 31, 2007                            to September 30, 2008. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (3) | The total contract value for this cost shared contract                            is $1.3 million consisting of four Phases: Phase I for $500,000 was                            from March 12, 2002 through September 30, 2003; Phase II for $200,000                            was from October 28, 2003 through October 31, 2004; Phase III for                            $348,000 was from August 23, 2004 through August 31, 2005; and Phase IV                            for $202,000 which commenced on December 14, 2004 and expired on June                            30, 2006. Phases I, II, and III have been completed, while. Phase IV                            expired before it was completed. |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

F-10

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

| (4) | The Samsung contract is a research and prototype                            contract. This contract included one up-front payment of $750,000 and                            two milestone payments of $125,000 each for the delivery of prototypes.                            The contract was amended on October 22, 2007 as MTI Micro agreed to                            issue a credit in the amount of the last invoice in recognition of the                            Company’s continuing collaboration with Samsung. Therefore,                            revenue under this contract totaled $875,000. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (5) | The SAFT contract is a fixed price contract. This is a                            subcontract with SAFT under the U.S. Army CECOM contract. The purchase                            order received in connection with this subcontract was revised on                            November 14, 2006 eliminating one milestone. As a result, the contract                            value was reduced from $470,000 to $418,000 and the expiration date was                            extended from September 30, 2006 to December 31, 2006. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (6) | Represents a fixed price subcontract with CSMP under                            NIST and includes the original contract for $200,000 and a contract                            amendment for $10,000. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (7) | Represents a fixed price contract that includes the                            original contract for $200,000, an amendment for $50,000, and a 2005                            amendment reducing the contract by $100,000. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (8) | This contract was a cost plus catalyst research contract                            with the National Center for Manufacturing Sciences                            (“NCMS”). |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

The            Company’s cost-shared contracts require that MTI Micro conduct research, deliver            direct methanol fuel cell prototypes, and other deliverables pursuant to predefined            work plans and schedules. For cost-shared contracts spanning multiple years, the            following table summarizes as of December 31, 2007 the total expenditures incurred or            expected to be incurred by MTI Micro along with the related funded research and            development revenue received or expected to be received:

| (Dollars in thousands) |   | **Total Contract Value** |   |
|------------------------|--------|--------------------------|--------|
| **Contract**           |   | **Funded Expense**       |   | **Funded Revenue** |   |
| DOE                    |   | $                        | 6,144  |   | $ | 3,000 |   |
| NYSERDA                |   |                     | 2,702  |   |   | 1,250 |   |

 

MTI            Micro retains ownership of the intellectual property (“IP”) generated by            MTI Micro under each of its federal government contract and under the contract with            Samsung. Each federal government agency retains a government use license and march-in            rights if MTI Micro fails to commercialize technology generated under the contract. In            addition, under the New York State Energy Research and Development Authority            (“NYSERDA”) contract, MTI Micro has the right to elect to retain any            invention made under the NYSERDA contract within six months of invention. NYSERDA also            retains rights to a government use license for New York State and its political            subdivisions for any inventions made under the contract. Additionally, MTI Micro agreed            to pay NYSERDA a royalty of 5.0% of the sales price of any product sold incorporating            IP developed pursuant to the NYSERDA contract. If the product is manufactured by a New            York State manufacturer, this royalty is reduced to 1.5%. Total royalties are subject            to a cap equal to two times the total contract funds paid by NYSERDA to MTI Micro, and            may potentially be reduced to reflect any New York State jobs created by MTI            Micro.

 

**Cost of Product Revenue**

Cost of            product revenue includes material, labor and overhead. Costs incurred in connection            with funded research and development arrangements are included in funded research and            product development expenses.

 

**Deferred Revenue**

Deferred revenue consists of payments received from customers in advance            of services performed, completed installation or customer acceptance.

 

**Warranty**

The            Company records a warranty reserve at the time product revenue is recorded based on a            historical rate. The reserve is reviewed during the year and is adjusted, if            appropriate, to reflect new product offerings or changes in experience. Actual warranty            claims are tracked by product line.

 

**Accounting for Goodwill and Other Intangible Assets**

Intangible assets include patents and trade names. Goodwill and other            intangible assets are accounted for in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*.            Intangible assets with finite useful lives are amortized over those periods. Indefinite            life intangible assets are tested for impairment annually, and will be tested for            impairment between annual tests if an event occurs or circumstances change that would            indicate that the carrying amount may be impaired. Definite life assets are tested for            impairment whenever events or circumstances indicate that a carrying amount of an asset            may not be recoverable. An impairment loss would be recognized when the carrying amount            of an asset exceeds the estimated undiscounted cash flows used in determining the fair            value of the asset. The amount of the impairment loss to be recorded is calculated by            the excess of the assets carrying value over its fair value. Fair value is generally            determined using a discounted cash flow analysis. Costs related to internally-developed            intangible assets are expensed as incurred.

 

F-11

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**Accounting for Impairment or Disposal of Long-Lived            Assets**

The            Company accounts for impairment or disposal of long-lived assets in accordance with            SFAS No. 144,*Accounting for the Impairment or Disposal of            Long-Lived Assets*. This Statement addresses financial            accounting and reporting for the impairment or disposal of long-lived assets and            specifies how impairment will be measured and how impaired assets will be classified in            the consolidated financial statements. On a quarterly basis, the Company analyzes the            status of its long-lived assets at each subsidiary for potential impairment. As of            December 31, 2007, the Company does not believe that any of its long-lived assets have            suffered any type of impairment that would require an adjustment to that asset’s            recorded value.

 

**Cash and Cash Equivalents**

Cash            and cash equivalents consist of cash and highly liquid short-term investments with            original maturities of less than three months.

 

**Securities Available for Sale**

Management determines the appropriate classification of its investments            in marketable securities at the time of purchase and reevaluates such determinations at            each balance sheet date. Marketable securities for which the Company does not have the            intent or ability to hold to maturity are classified as available for sale. Securities            available for sale are carried at fair value, with the unrealized gains and losses, net            of income taxes, reported as a separate component of stockholders’ equity. The            Company has had no investments that qualify as trading or held to maturity. Realized            gains and losses are included in the caption “Gain (loss) on sale of securities            available for sale” in the Consolidated Statements of Operations. The cost of            securities sold is based on the specific identification method.

 

**Net            (Loss) Income per Common Share**

The            Company reports net (loss) income per basic and diluted common share in accordance with            SFAS No. 128,*Earnings Per Share*,            which establishes standards for computing and presenting (loss) income per share. Basic            earnings (loss) per common share are computed by dividing net (loss) income by the            weighted average number of common shares outstanding during the reporting period.            Diluted (loss) income per share reflects the potential dilution, if any, computed by            dividing net (loss) income by the combination of dilutive common share equivalents,            comprised of shares issuable under outstanding investment rights, warrants and the            Company’s share-based compensation plans, and the weighted average number of            common shares outstanding during the reporting period. Dilutive common share            equivalents include the dilutive effect of in-the-money stock options, which are            calculated based on the average share price for each period using the treasury stock            method. Under the treasury stock method, the exercise price of a stock option, the            amount of compensation cost, if any, for future service that the Company has not yet            recognized, and the amount of windfall tax benefits that would be recorded in            additional paid-in capital, if any, when the stock option is exercised are assumed to            be used to repurchase shares in the current period.

 

**Share-Based Payments**

The            Company has three share-based employee compensation plans and MTI Micro has one            share-based employee compensation plan, all of which are described more fully in Note            13, Stock Based Compensation.

 

In            December 2004, the Financial Accounting Standards Board (“FASB”) revised            SFAS No. 123 (“FAS 123R”),*Share-Based            Payment*, which establishes accounting for share-based awards            exchanged for employee services and requires companies to expense the estimated fair            value of these awards over the requisite employee service period. The accounting            provisions of FAS 123R were adopted by the Company as of January 1, 2006. In March            2005, the SEC issued SAB 107,*Share-Based Payment*(“SAB 107”) to assist filers by simplifying some of the            implementation challenges of FAS 123R. In particular, SAB 107 provides supplemental            implementation guidance on FAS 123R, including guidance on valuation methods,            classification of compensation expense, inventory capitalization of share-based            compensation cost, income tax effects, disclosures in Management’s Discussion and            Analysis and several other issues. The Company applied the principles of SAB 107 in            conjunction with its adoption of FAS 123R.

 

Under            FAS 123R, share-based compensation cost is measured at the grant date, based on the            estimated fair value of the award, and is recognized as expense over the            employee’s requisite service period. The Company has awards with performance            conditions, but no awards with market conditions. The Company adopted the provisions of            FAS 123R on January 1, 2006, the first day of the Company’s fiscal year, using            the modified prospective application, which provided for certain changes to the method            for valuing share-based compensation. Under the modified prospective application, prior            periods were not revised for comparative purposes. The valuation provisions of FAS 123R            apply to new awards and to awards that are outstanding on the effective date and            subsequently modified or cancelled. Estimated compensation expense for awards            outstanding at the effective date will be recognized over the remaining service period            using the compensation cost calculated for pro forma disclosure purposes under the            original FASB Statement No. 123,*Accounting for Stock-Based            Compensation*(“FAS 123”).

 

F-12

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

In            November 2005, the FASB issued Staff Position No. FAS 123(R)-3,*Transition Election Related to Accounting for Tax Effects of            Share-Based Payment Awards*. The Company elected to adopt the            alternative transition method provided in this FASB Staff Position for calculating the            tax effects of share-based compensation pursuant to FAS 123R. This method included a            simplified method to establish the beginning balance of the additional paid-in capital            pool related to the tax effects of employee share-based compensation, which is            available to absorb tax deficiencies recognized subsequent to the adoption of FAS            123R.

 

Prior            to the adoption of FAS 123R, the Company accounted for stock-based awards to employees            and directors using the intrinsic value method in accordance with Accounting Principles            Board (“APB”) Opinion No. 25,*Accounting for Stock            Issued to Employees*, and related Interpretations as permitted            under FAS 123. Under the intrinsic value method, stock-based compensation was typically            only recognized by the Company due to modifications in option provisions, since the            exercise price of the Company’s and MTI Micro’s common stock options            granted to employees and directors generally equaled the fair market value of the            underlying stock at the date of grant.

 

Stock-based compensation represents the cost related to stock-based            awards granted to employees and directors. The Company measures stock-based            compensation cost at grant date based on the estimated fair value of the award, and            recognizes the cost as expense on a straight-line basis (net of estimated forfeitures)            over the option’s requisite service period. The Company estimates the fair value            of stock-based awards using a Black-Scholes valuation model. Stock-based compensation            expense is recorded in “Selling, general and administrative expenses” and            “Unfunded research and product development expenses” in the Consolidated            Statements of Operations based on the employees’ respective functions.

 

The            Company records deferred tax assets for awards that potentially can result in            deductions on the Company’s income tax returns based on the amount of            compensation cost recognized and the Company’s statutory tax rate. Differences            between the deferred tax assets recognized for financial reporting purposes and the            actual tax deduction reported on the Company’s income tax return are recorded in            Additional Paid-In Capital (if the tax deduction exceeds the deferred tax asset) or in            the Consolidated Statement of Operations (if the deferred tax asset exceeds the tax            deduction and no historical pool of windfall tax benefits exists). Since the adoption            of FAS123R, no tax benefits have been recognized related to share-based compensation            since the Company has incurred net operating losses and has established a full            valuation allowanced to offset all potential tax benefits associated with these            deferred tax assets. The Company continues to record the fair market value of stock            options and warrants granted to non-employees and non-directors in exchange for            services in accordance with EITF Issue No. 96-18,*Accounting            for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in            Conjunction with Selling, Goods or Services*, in the            Consolidated Statements of Operations.

 

**Advertising**

The            costs of advertising are expensed as incurred. Advertising expense was approximately            $45, $110, and $102 thousand for the years ended December 31, 2005, 2006, and 2007,            respectively.

 

**Concentration of Credit Risk**

Financial instruments that subject the Company to concentrations of            credit risk principally consist of cash equivalents, marketable securities, trade            accounts receivable and unbilled contract costs.

 

The            Company’s trade accounts receivable and unbilled contract costs and fees are            primarily from sales to commercial customers, the U.S. government and state agencies.            The Company does not require collateral and has not historically experienced            significant credit losses related to receivables or unbilled contract costs and fees            from individual customers or groups of customers in any particular industry or            geographic area.

 

The            Company deposits its cash and invests in marketable securities primarily through            commercial banks and investment companies. Credit exposure to any one entity is limited            by Company policy.

 

**Research and Development Costs**

The            Company expenses research and development costs as incurred.

 

**Comprehensive (Loss) Income**

Comprehensive (loss) income includes net (loss) income, as well as            changes in stockholders’ equity, other than those resulting from investments by            stockholders (i.e., issuance or repurchase of common shares and dividends).

 

F-13

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**Effect of Recent Accounting Pronouncements**

In            December 2007, the FASB issued SFAS No. 141R,*Business            Combinations—a replacement of FASB Statement No. 141*(“SFAS No. 141R”), which significantly changes the            principles and requirements for how the acquirer of a business recognizes and measures            in its financial statements the identifiable assets acquired, the liabilities assumed,            and any noncontrolling interest in the acquiree. The statement also provides guidance            for recognizing and measuring the goodwill acquired in the business combination and            determines what information to disclose to enable users of the financial statements to            evaluate the nature and financial effects of the business combination. SFAS No. 141R is            effective prospectively, except for certain retrospective adjustments to deferred tax            balances, for fiscal years beginning after December 15, 2008. This statement will be            effective for the Company for fiscal year 2009. The Company has not yet determined the            impact, if any, of this statement on its Consolidated Financial Statements.

 

In            December 2007, the FASB issued SFAS No. 160,*Noncontrolling            Interests in Consolidated Financial Statements—an amendments of ARB No.            51*(“SFAS No. 160”). SFAS No. 160 requires that            accounting and reporting for minority interests will be recharacterized as            noncontrolling interests and classified as a component of equity. SFAS No. 160 also            establishes reporting requirements that provide sufficient disclosures that clearly            identify and distinguish between the interests of the parent and the interests of the            noncontrolling owners. SFAS No. 160 applies to all entities that prepare consolidated            financial statements, except not-for-profit organizations, but will affect only those            entities that have an outstanding noncontrolling interest in one or more subsidiaries            or that deconsolidate a subsidiary. This statement is effective as of the beginning of            an entity’s first fiscal year beginning after December 15, 2008. This statement            will be effective for the Company for its fiscal year beginning January 1, 2009. Based            upon the December 31, 2007 balance sheet, the impact of adopting SFAS No. 160 would be            to reclassify from $143 thousand minority interests in consolidated subsidiaries to            stockholders’ equity as a separate component of stockholders’            equity.

 

In            February 2007, the FASB issued SFAS No. 159,*The Fair Value            Option for Financial Assets and Financial Liabilities*(“SFAS No. 159”). SFAS No. 159 provides companies with an            option to report selected financial assets and financial liabilities at fair value.            Unrealized gains and losses on items for which the fair value option has been elected            are reported in earnings at each subsequent reporting date. SFAS No. 159 is effective            beginning January 1, 2008. The adoption of the provisions of SFAS No. 159 is not            expected to have a material effect on the Company’s Consolidated Financial            Statements.

 

In            September 2006, the FASB issued SFAS No. 157,*Fair Value            Measurements*(“SFAS No. 157”). SFAS No. 157            establishes a common definition for fair value to be applied to United States generally            accepted accounting principles guidance requiring use of fair value, establishes a            framework for measuring fair value, and expands disclosure about such fair value            measurements. This Statement is effective for fiscal years beginning after November 15,            2007. This statement will be effective for the Company for its fiscal year beginning            January 1, 2008. The adoption of the provisions of SFAS No. 157 is not expected to have            a material effect on the Company’s Consolidated Financial Statements.

 

In            September 2006, the FASB issued SFAS No. 158,*Employers’            Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of            FASB Statements No. 87, 88, 106, and 132(R)*(“SFAS No.            158”). Among other items, SFAS No. 158 requires recognition of the over-funded or            under-funded status of an entity’s defined benefit postretirement plan as an            asset or liability in the financial statements, requires the measurement of defined            benefit postretirement plan assets and obligations as of the end of the            employer’s fiscal year, and requires recognition of the funded status of defined            benefit postretirement plans in other comprehensive income. This Statement is effective            for fiscal years ending after December 15, 2006. Since the Company does not maintain            any defined benefit or other postretirement plans, the adoption of this Statement for            fiscal year 2007 did not have a material effect on the Company’s Consolidated            Financial Statements.

 

In            March 2006, the FASB issued SFAS No. 156,*Accounting for            Servicing of Financial Assets*—an amendment of            FASB*Statement No. 140*(“SFAS            No. 156”) that provides guidance on accounting for separately recognized            servicing assets and servicing liabilities. In accordance with the provisions of SFAS            No. 156, separately recognized servicing assets and servicing liabilities must be            initially measured at fair value, if practicable. Subsequent to initial recognition,            the Company may use either the amortization method or the fair value measurement method            to account for servicing assets and servicing liabilities within the scope of this            Statement. The adoption of this Statement by the Company in fiscal year 2007 did not            have a material effect on the Company’s Consolidated Financial            Statements.

 

In            February 2006, the FASB issued SFAS No. 155,*Accounting for            Certain Hybrid Financial Instruments—*an amendment of            FASB*Statements No. 133 and 140*(“SFAS No. 155”), to permit fair value remeasurement for any            hybrid financial instrument that contains an embedded derivative that otherwise would            require bifurcation in accordance with the provisions of SFAS No. 133,*Accounting for Derivative Instruments and Hedging            Activities.*The adoption of this Statement by the Company in            fiscal year 2007 did not have a material effect on the Company’s Consolidated            Financial Statements.

 

F-14

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**3.**       **Accounts Receivable and Allowance for Doubtful            Accounts**

 

Receivables consist of the following at December 31:

| (Dollars in thousands)          |   | **2006** |   | **2007** |   |
|---------------------------------|--------|----------|--------|----------|--------|
| U.S. and State Government:      |   |     |   |     |   |   |   |
| Amount billable                 |   | $        | 194    |     | $      | 0 |   |
| Amount billed                   |   |     | 9      |     |   | 79 |   |
| Total U.S. and State Government |   |     | 203    |     |   | 79 |   |
| Commercial                      |   |     | 1,410  |     |   | 1,290 |   |
| Total                           |   | $        | 1,613  |     | $      | 1,369 |   |

 

As of            December 31, 2006 and 2007, the Company concluded that a reserve for doubtful trade            accounts receivable was not considered necessary.

 

| **4.** | **Issuance of Stock by Subsidiary** |
|--------|-------------------------------------|

 

MTI            Micro was formed on March 26, 2001 and as of December 31, 2007; the Company owns            approximately 96% of MTI Micro’s outstanding common stock.

 

On            December 31, 2005, as a result of an option exchange between the Company and MTI Micro,            MTI Micro issued 105,701 shares of its common stock at a price of $2.22 per share to            the Company as compensation for minority stockholder benefit in connection with the            transaction. Additionally, on December 31, 2005, MTI Micro issued 1,103,604 shares of            its common stock at a price of $2.22 per share to the Company in connection with the            conversion of its $2,450 thousand loan receivable to equity.

 

On            December 31, 2006, MTI Micro issued 3,772,727 shares of its common stock at a price of            $1.10 per share to the Company in connection with the conversion of its $4,150 thousand            loan receivable to equity; on December 1, 2006, MTI Micro issued 739 shares of its            common stock at a price of $1.61 per share to the Company as compensation for the            minority stockholder benefit in connection with the Company issuing Company options to            MTI Micro employees; on November 11, 2006, MTI Micro issued 1,960,506 shares of its            common stock at a price of $1.06 per share to the Company in connection with the            transfer of $2,070 thousand worth of Plug Power common stock to MTI Micro; on September            30, 2006, MTI Micro issued 2,574,627 shares of its common stock at a price of $1.34 per            share to the Company in connection with the conversion of its $3,450 thousand loan            receivable to equity; on September 1, 2006, MTI Micro issued 56,055 shares of its            common stock at a price of $3.10 per share to the Company as compensation for the            minority stockholder benefit in connection with the Company issuing Company options to            MTI Micro employees; on May 27, 2006, MTI Micro issued 50,158 shares of its common            stock at a price of $2.32 to the Company as compensation for the minority stockholder            benefit in connection with the Company issuing Company options to MTI Micro employees;            between April 11 and April 18, 2006, MTI Micro issued 1,662,400 shares of its common            stock at a price of $2.50 per share to the Company in connection with the transfer of            $4,156 thousand worth of Plug Power common stock to MTI Micro; and on March 31, 2006,            MTI Micro issued 1,400,000 shares of its common stock at a price of $2.50 per share to            the Company in connection with the conversion of its $3,500 thousand loan receivable to            equity.

 

Between            October 10 and October 25, 2007, MTI Micro issued 4,050,488 shares of its common stock            at a price between $0.37 and $0.41 per share to the Company in connection with the            transfer of $2,808 thousand worth of Plug Power common stock to MTI Micro; on November            16, 2007, MTI Micro issued 1,630,339 shares of its common stock at a price of $0.33 per            share to the Company in connection with the transfer of $1,113 thousand worth of Plug            Power common stock to MTI Micro; on September 1, 2007, MTI Micro issued 35,625 shares            of its common stock at a price of $0.62 per share to the Company as compensation for            the minority stockholder benefit in connection with the Company issuing Company options            to MTI Micro employees; on September 30, 2007, MTI Micro issued 2,740,715 shares of its            common stock at a price of $0.69 per share to the Company in connection with the            conversion of its $1,900 thousand loan receivable to equity; on June 1, 2007, MTI Micro            issued 8,653 shares of its common stock at a price of $0.94 per share to the Company as            compensation for the minority stockholder benefit in connection with the Company            issuing Company options to MTI Micro employees; on June 30, 2007, MTI Micro issued            6,083,334 shares of its common stock at a price of $0.60 per share to the Company in            connection with the conversion of its $3,650 thousand loan receivable to equity; on            March 1, 2007, MTI Micro issued 682 shares of its common stock at a price of $0.98 per            share to the Company as compensation for the minority stockholder benefit in connection            with the Company issuing Company options to MTI Micro employees; and on March 31, 2007,            MTI Micro issued 4,243,721 shares of its common stock at a price of $0.84 per share to            the Company in connection with the conversion of its $3,550 thousand loan receivable to            equity.

 

The            decrease in the Company’s paid-in-capital of $301, $1,284, and $521 thousand in            2005, 2006, and 2007, respectively, represents the changes in the Company’s            equity investment in MTI Micro, which resulted from the anti-dilutive impact of the            Company’s investments

 

F-15

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

into            MTI Micro stock.

 

| **5.** | **Inventories** |
|--------|-----------------|

 

Inventories, net consist of the following at December 31:

| (Dollars in thousands) |   | **2006** |   | **2007** |   |
|------------------------|--------|----------|--------|----------|--------|
| Finished goods         |   | $        | 279    |     | $      | 467 |   |
| Work in process        |   |     | 238    |     |   | 168 |   |
| Raw materials, net     |   |     | 699    |     |   | 738 |   |
|                   |   | $        | 1,216  |     | $      | 1,373 |   |

 

| **6.** | **Property, Plant and Equipment** |
|--------|-----------------------------------|

 

Property, plant and equipment consist of the following at December            31:

| (Dollars in thousands)         |   | **2006** |   | **2007** |   |
|--------------------------------|--------|----------|--------|----------|--------|
| Leasehold improvements         |   | $        | 1,213  |     | $      | 1,213 |   |
| Computers and related software |   |     | 2,186  |     |   | 2,241 |   |
| Machinery and equipment        |   |     | 3,625  |     |   | 3,895 |   |
| Office furniture and fixtures  |   |     | 303    |     |   | 303 |   |
|                           |   |     | 7,327  |     |   | 7,652 |   |
| Less accumulated depreciation  |   |     | 4,401  |     |   | 5,493 |   |
|                           |   | $        | 2,926  |     | $      | 2,159 |   |

 

Depreciation expense was $1,253, $1,101, and $1,129 thousand for 2005,            2006, and 2007, respectively. Repairs and maintenance expense was $105, $75, and $82            thousand for 2005, 2006, and 2007, respectively.

 

| **7.** | **Securities Available for Sale** |
|--------|-----------------------------------|

 

Securities available for sale are classified as current assets and            accumulated net unrealized gains (losses) are charged to other comprehensive income            (loss).

 

The            principal components of the Company’s securities available for sale consist of            the following at:

| (Dollars in thousands, except stock price and share                            data) |
|--------------------------------------------------------------------------------------|
| **Security**                                                                         |   | **Book Basis** |   | **Unrealized Gain** |   | **Recorded Fair Value** |   | **Quoted Market Price**

**Per NASDAQ** |   | **Ownership** |   | **Shares** |   |
| December 31, 2006                                                                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Plug Power                                                                           |   | $ | 4,602 |   | $ | 5,473 |   | $ | 10,075 |   | $ | 3.89 |   | 2.99 | % | 2,589,936 |   |
|                                                                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| December 31, 2007                                                                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Plug Power                                                                           |   | $ | 2,021 |   | $ | 2,471 |   | $ | 4,492 |   | $ | 3.95 |   | 1.29 | % | 1,137,166 |   |

 

 

F-16

 

----

             

             

**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

| The book basis roll forward of Plug Power securities as                            of December 31 is as follows:                                                                         |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| (Dollars in thousands)                                                                                                                                                                   |   | **2006** |   | **2007** |   |   |   |   |
| Securities available for sale, beginning of                            period                                                                                                            |   | $ | 6,562 |   | $ | 10,075 |   |   |   |   |   |
| Sale of shares                                                                                                                                                                           |   |   | (1,960 | ) |   | (8,054 | ) |   |   |   |   |
| Securities book basis                                                                                                                                                                    |   |   | 4,602 |   |   | 2,021 |   |   |   |   |   |
| Unrealized gain on securities available for                            sale                                                                                                              |   |   | 5,473 |   |   | 2,471 |   |   |   |   |   |
| Securities available for sale, end of period                                                                                                                                             |   | $ | 10,075 |   | $ | 4,492 |   |   |   |   |   |
|                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |
| Accumulated unrealized gains related to securities                            available for sale for each of the years ended December 31 are as                            follows:      |   |
| (Dollars in thousands)                                                                                                                                                                   |   | **2006** |   | **2007** |   |   |   |   |   |
| Accumulated unrealized gains                                                                                                                                                             |   | $ | 5,473 |   | $ | 2,471 |   |   |   |   |   |
| Accumulated deferred tax expense on unrealized                            gains                                                                                                          |   |   | (4,489 | ) |   | (1,971 | ) |   |   |   |   |
| Accumulated net unrealized gains                                                                                                                                                         |   | $ | 984 |   | $ | 500 |   |   |   |   |   |
|                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |
| Realized gains related to Plug Power securities                            available for sale sold during each of the years ended December 31 are                            as follows: |
| (Dollars in thousands, except shares)                                                                                                                                                    |   | **2006** |   | **2007** |   |   |   |   |   |
| Shares sold                                                                                                                                                                              |   |   | 1,103,500 |   |   | 1,452,770 |   |   |   |   |   |
| Proceeds                                                                                                                                                                                 |   | $ | 6,249 |   | $ | 5,130 |   |   |   |   |   |
| Total net gain on sales                                                                                                                                                                  |   | $ | 4,289 |   | $ | 2,549 |   |   |   |   |   |
|                                                                                                                                                                                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

The            Company regularly reviews its securities available for sale to determine if any            declines in value of those securities available for sale are other than temporary. The            Company assesses whether declines in the value of its securities in publicly traded            companies, measured by comparison of the current market price of the securities to the            carrying value of the Company’s securities, are considered to be other than            temporary based on factors that include the length of time carrying value exceeds fair            market value, the Company’s assessment of the financial condition and the near            term prospects of the companies and the Company’s intent with respect to the            securities.

 

| **8.** | **Income Taxes** |
|--------|------------------|

 

| Income tax (expense) benefit for each of the years ended                            December 31 consists of the following:                                                                 |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (Dollars in thousands)                                                                                                                                                                     |   | **2005** |   | **2006** |   | **2007** |   |
| Operations before minority interest                                                                                                                                                        |   |   |   |   |   |   |   |   |   |   |
| Federal                                                                                                                                                                                    |   | $ | — |   | $ | — |   | $ | — |   |
| State                                                                                                                                                                                      |   |   | 54 |   |   | (5 | ) |   | (30 | ) |
| Deferred                                                                                                                                                                                   |   |   | (1,641 | ) |   | (1,890 | ) |   | (2,518 | ) |
| Total                                                                                                                                                                                      |   | $ | (1,587 | ) | $ | (1,895 | ) | $ | (2,548 | ) |
|                                                                                                                                                                                       |   |   |   |   |   |   |   |   |   |   |
| Income tax benefit (expense) allocated directly to                            stockholders’ equity for each of the years ended December 31 is                            as follows: |
| (Dollars in thousands)                                                                                                                                                                     |   | **2005** |   | **2006** |   | **2007** |   |
| Change in unrealized (gain) loss on securities available                            for sale:                                                                                              |   |   |   |   |   |   |   |   |   |   |
| Deferred tax benefit (expense)                                                                                                                                                             |   | $ | 1,448 |   | $ | 1,285 |   | $ | (27 | ) |
| Valuation allowance (expense)                                                                                                                                                              |   |   | (1,448 | ) |   | (1,285 | ) |   | 27 |   |
| Tax effect of reclassification adjustment for                            gains       included in                            net income (loss)           |   |   | 3,293 |   |   | 1,913 |   |   | 2,518 |   |
| Expenses for employee stock options recognized                            differently for financial reporting/tax purposes:                                                                |   |   |   |   |   |   |   |   |   |   |
| Federal tax benefit                                                                                                                                                                        |   |   | 87 |   |   | — |   |   | — |   |
| Valuation allowance (expense)                                                                                                                                                              |   |   | (87 | ) |   | — |   |   | — |   |
|                                                                                                                                                                                       |   | $ | 3,293 |   | $ | 1,913 |   | $ | 2,518 |   |

 

 

F-17

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

 

| The significant components of deferred income tax                            (expense) benefit from operations before minority interest for each of                            the years ended December 31 consists of the following:        |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (Dollars in thousands)                                                                                                                                                                                                                       |   | **2005** |   | **2006** |   | **2007** |   |
| Deferred tax benefit (expense)                                                                                                                                                                                                               |   | $ | 238 |   | $ | 1,158 |   | $ | 1,181 |   |
| Net operating loss carry forward                                                                                                                                                                                                             |   |   | 5,673 |   |   | 3,983 |   |   | 3,069 |   |
| Valuation allowance                                                                                                                                                                                                                          |   |   | (4,259 | ) |   | (5,118 | ) |   | (4,250 | ) |
| Disproportionate tax effect of reclassification                            adjustment for gains included in net income (loss)                                                                                                                |   |   | (3,293 | ) |   | (1,913 | ) |   | (2,518 | ) |
|                                                                                                                                                                                                                                         |   | $ | (1,641 | ) | $ | (1,890 | ) | $ | (2,518 | ) |
|                                                                                                                                                                                                                                         |   |   |   |   |   |   |   |   |   |   |
| The Company’s effective income tax rate from                            operations before minority interest differed from the Federal statutory                            rate for each of the years ended December 31 is as follows: |
|                                                                                                                                                                                                                                         |   | **2005** |   | **2006** |   | **2007** |   |
| Federal statutory tax rate                                                                                                                                                                                                                   |   |   | 34 | % |   | 34 | % |   | 34 | % |
| State taxes, net of federal tax effect                                                                                                                                                                                                       |   |   | 3 |   |   | 3 |   |   | 1 |   |
| Change in valuation allowance                                                                                                                                                                                                                |   |   | (29 | ) |   | (37 | ) |   | (56 | ) |
| Disproportionate tax effect of reclassification                            adjustment for gains included in net income (loss)                                                                                                                |   |   | (19 | ) |   | (13 | ) |   | (28 | ) |
| Permanent tax difference on derivative                            valuation                                                                                                                                                                  |   |   | — |   |   | — |   |   | 16 |   |
| Other, net                                                                                                                                                                                                                                   |   |   | — |   |   | (2 | ) |   | — |   |
| Tax Rate                                                                                                                                                                                                                                     |   |   | (11 | )% |   | (15 | )% |   | (33 | )% |

 

Pre-tax            loss before minority interests was $14,949, $12,980, and $7,609 thousand for 2005,            2006, and 2007, respectively. The deferred tax assets and liabilities as of December 31            consist of the following tax effects relating to temporary differences and carry            forwards:

| (Dollars in thousands)                        |   | **2006** |   | **2007** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|
| Current deferred tax (liabilities) assets:    |   |     |   |     |   |   |   |
| Inventory valuation                           |   | $        | 60     |     | $      | 73 |   |
| Inventory capitalization                      |   |     | 14     |     |   | 13 |   |
| Securities available for sale                 |   |     | (3,039 | )        |   | (1,362 | ) |
| Vacation pay                                  |   |     | 161    |     |   | 147 |   |
| Warranty and other sale obligations           |   |     | 8      |     |   | 29 |   |
| Other reserves and accruals                   |   |     | 58     |     |   | 56 |   |
|                                          |   |     | (2,738 | )        |   | (1,044 | ) |
| Valuation allowance                           |   |     | (256   | )        |   | (300 | ) |
| Net current deferred tax liabilities          |   | $        | (2,994 | )        | $      | (1,344 | ) |
| Noncurrent deferred tax assets (liabilities): |   |     |   |     |   |   |   |
| Net operating loss                            |   | $        | 19,661 |     | $      | 21,037 |   |
| Property, plant and equipment                 |   |     | (239   | )        |   | 27 |   |
| Stock options                                 |   |     | 1,379  |     |   | 1,800 |   |
| Other                                         |   |     | 239    |     |   | — |   |
| Research and development tax credit           |   |     | 459    |     |   | 459 |   |
| Alternative minimum tax credit                |   |     | 54     |     |   | 54 |   |
|                                          |   |     | 21,553 |     |   | 23,377 |   |

 

 

F-18

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

 

| Valuation allowance                 |   |   | (18,559 | )      |   | (22,033 | )      |
|-------------------------------------|--------|--------|---------|--------|--------|---------|--------|
| Non-current net deferred tax assets |   | $      | 2,994   |   | $      | 1,344   |   |

 

 

F-19

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

The            valuation allowance at December 31, 2006 and 2007 was $18,815 and $22,333 thousand,            respectively. The net change in the valuation allowance was $7,892 thousand in 2006 and            $3,518 thousand in 2007. The valuation allowance at December 31, 2006 and 2007 reflects            the estimate that it is more likely than not that the net deferred tax assets may not            be realized. In addition to changes in valuation allowance of $4,250 thousand reflected            in continuing operations, the valuation allowance was increased by $1,201 thousand            reflected in stockholders’ equity and decreased by $1,933 thousand as a result of            the adoption of FIN 48.

 

At            December 31, 2007, the Company has unused Federal net operating loss carry forwards of            approximately $53,918 thousand. Of these carry forwards, $1,325 thousand represents            windfall tax benefits from stock option transactions, the tax effect of which are not            included in the Company’s net deferred tax assets. The Federal net operating loss            carry forwards, if unused, will begin to expire in 2010. As of December 31, 2007, the            Company has approximately $459 thousand of research and development tax credit carry            forwards, which begin to expire in 2018, and approximately $54 thousand of alternative            minimum tax credit carry forwards, which have no expiration date. Deferred tax assets            and liabilities are determined based on the temporary differences between the financial            statement and tax bases of assets and liabilities as measured by the enacted tax            rates

 

The            Company adopted the provisions of FIN 48 on January 1, 2007, the first day of its 2007            fiscal year. As a result of the implementation of FIN 48, the Company recorded a $106            thousand increase in the net liability for uncertain tax positions, which was recorded            as an adjustment to the Company’s opening balance of retained earnings on January            1, 2007. Additionally, the same tax position that triggered the Company’s FIN 48            adoption charge caused the Company to reclassify $80 thousand from current income taxes            payable to non-current liabilities for uncertain tax positions.

 

A            reconciliation of the beginning and ending amount of unrecognized tax benefits for 2007            is as follows:

| (Dollars in thousands)                                                             |   |   |
|------------------------------------------------------------------------------------|--------|--------|
| Balance as of January 1, 2007                                                      |   | $      | 2,024 |
| Additions for tax positions related to the current                            year |   |   | — |
| Additions for tax positions of prior years                                         |   |   | 20 |
| Reductions for tax positions of prior years                                        |   |   | — |
| Settlements                                                                        |   |   | — |
| Balance as of December 31, 2007                                                    |   | $      | 2,044 |

In            future periods, if $1,836 thousand of these unrecognized benefits become supportable,            the Company may not recognize a change in its effective rate as long as it remains in a            full valuation allowance position, $208 thousand of these unrecognized tax benefits            would affect the Company’s effective tax rate if recognized. Included in the            balance of unrecognized tax benefits at January 1, 2007 is $239 thousand related to tax            positions for which it is reasonably possible that the total amounts could            significantly change during the next twelve months. This amount represents unrecognized            tax benefits comprising potential recognition for tax purposes of losses in a            partnership in which the Company held a minority stake. In accordance with the            Company’s accounting policy, it recognizes interest and penalties related to            uncertain tax positions as a component of tax expense. This policy did not change as a            result of the adoption of FIN 48. As of January 1, 2007, accrued interest included in            Uncertain Tax Position Liability totaled $34 thousand. During the year ended December            31, 2007, the Company recognized $15 thousand in potential interest expense on            uncertain tax positions, and the Company’s Consolidated Balance Sheet as of that            date includes total interest of $49 thousand associated with these            positions.

 

The            Company files income tax returns, including returns for its subsidiaries, with federal            and state jurisdictions. The Company is no longer subject to IRS examination for its            federal returns for any periods prior to 2003, although carryforward attributes that            were generated prior to 2004 may still be adjusted upon examination by the IRS if they            either have been or will be used in a future period. The Company has an ongoing tax            examination by New York State for the years 2002 through 2004. The Company does not            believe that the net outcome of this examination will have a material impact on its            financial statements.

 

| **9.** | **Accrued Liabilities** |
|--------|-------------------------|

 

Accrued liabilities consist of the following at December 31:

| (Dollars in thousands)               |   | **2006** |   | **2007** |   |
|--------------------------------------|--------|----------|--------|----------|--------|
| Salaries, wages and related expenses | $      | 781      | $      | 937      |   |
| Acquisition and disposition costs    |   | 363      |   | 363      |   |
| Legal and professional fees          |   | 311      |   | 230      |   |
| Warranty and other sale obligations  |   | 19       |   | 72       |   |
| Commissions                          |   | 139      |   | 95       |   |
| Other                                |   | 857      |   | 424      |   |
|                                 | $      | 2,470    | $      | 2,121    |   |

 

F-20

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

| **10.** | **Stockholders’ Equity** |
|---------|--------------------------------|

 

**Common Shares**

Changes            in common shares are as follows for the years ended December 31:

|                                                                                       |   | **2005**   |   | **2006**   |   | **2007**   |   |
|--------------------------------------------------------------------------------------------|--------|------------|--------|------------|--------|------------|--------|
| Balance, beginning                                                                         |   | 38,650,949 |   | 38,965,937 |   | 46,084,678 |   |
| Issuance of shares for stock option exercises                                              |   | 148,575    |   | 719,791    |   | 85,946     |   |
| Issuance of shares for private placement                            shares                 |   | 66,413     |   | —    |   | —    |   |
| Issuance of shares for restricted and unrestricted stock                            grants |   | 100,000    |   | 76,080     |   | 55,000     |   |
| Issuance of shares for capital raise                                                       |   | —    |   | 6,055,556  |   | —    |   |
| Issuance of shares for anti-dilution penalty                                               |   | —    |   | 267,314    |   | —    |   |
| Forfeiture of restricted stock grants                                                      |   | —    |   | —    |   | (5,000     | )      |
| Balance, ending                                                                            |   | 38,965,937 |   | 46,084,678 |   | 46,220,624 |   |

 

**Treasury Stock**

Changes            in treasury stock are as follows for the years ended December 31:

|               |   | **2005**  |   | **2006**  |   | **2007**  |   |
|--------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Balance, beginning |   | 8,040,736 |   | 8,040,736 |   | 8,040,736 |   |
| Balance, ending    |   | 8,040,736 |   | 8,040,736 |   | 8,040,736 |   |

 

**Sale            of Common Stock**

*Capital Raise:*On December 15, 2006, the            Company entered into agreements with certain investors to sell 6,055,556 shares of            common stock and warrants to purchase 3,027,778 shares of common stock for an aggregate            purchase price of $10,900 thousand. The common stock and warrants were sold in units,            with each unit consisting of 100 shares of common stock and a warrant to purchase 50            shares of common stock, at an exercise price of $2.27 per share. Each non-certificated            unit was sold at a negotiated price of $180.00. The shares of common stock and warrants            are immediately separable and were issued separately (see Warrants Issued below). The            common stock, the warrants and shares issuable upon exercise of the warrants are            registered with the SEC on the Company’s filed and effective registration            statement.

 

In            connection with the 2006 capital raise, in December 2006, the Company paid Rodman &            Renshaw, LLC placement fees, recorded in equity against the proceeds of the capital            raise, of $570 thousand.

 

*Private Placement:*The Company entered into            a financing transaction with Fletcher on January 29, 2004 and amended the terms of such            transaction on May 4, 2004. Fletcher purchased 2,680,671 shares of the Company’s            common stock for $18,000 thousand pursuant to such financing transaction –            1,418,842 shares at $7.048 per share and 1,261,829 shares at $6.34 per share. In            addition, Fletcher had the right to purchase an additional $20,000 thousand of the            Company’s common stock, on one or more occasions, at a price of $6.023 (adjusted            from $6.34) per share at any time prior to December 31, 2006. Fletcher had the right to            receive Company shares without payment upon the occurrence of certain events, including            but not limited to, failing to register for resale with the SEC shares purchased by            Fletcher on the agreed upon time table, a restatement of the Company’s financial            statements, change of control of the Company and issuance of securities at a price            below Fletcher’s purchase price. The Company has filed registration statements            covering all of the shares purchased by Fletcher.

 

The            Company filed a registration statement on January 6, 2005 covering the resale of            1,261,829 shares of the Company’s common stock purchased by Fletcher on December            22, 2004. The Company failed to meet its contractual obligation with Fletcher to have            such registration statement declared effective by March 22, 2005 and therefore under            the terms of the Fletcher agreement the Company was required to issue additional shares            of common stock to Fletcher and the exercise price for the Fletcher additional            investment rights has been reduced to $6.023 per share. The Company was required to            issue a number of shares of common stock that resulted in Fletcher having effectively            made its December 2004 investment at a price per share that was lower than the actual            price paid. The Company refers to this reduced exercise price as the “deemed            exercise price.” More specifically, for each month during which the Company            failed to satisfy the registration requirement, the deemed exercise price was reduced            by $0.317 per share. As a consequence, on April 20, 2005 the Company issued 66,413            shares of common stock to Fletcher without any additional payment required by Fletcher,            representing a deemed exercise price for Fletcher’s December 2004 investment of            $6.023 per share.

 

F-21

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

In            addition, since the Company was required to file a registration statement covering the            resale of any such additional shares issued to Fletcher, the Company amended the            registration statement initially filed in January 2005 to include the additional 66,413            shares of common stock. That registration statement, covering the resale of 1,328,242            shares of common stock, was declared effective by the SEC on April 21, 2005.

 

*Dilutive Issuances:*If, after December 31,            2004 and ending December 31, 2006, the Company issued any equity securities at a price            below $7.048 as it relates to the initial $10,000 thousand investment and $6.34 as it            relates to any additional investments which have been made, the exercise price for the            additional investment rights would be adjusted to provide Fletcher “weighted            average” anti-dilution protection and the Company would have to issue to Fletcher            a number of additional shares such that all prior investments will have been            effectively made at such adjusted exercise price.

 

On            December 7, 2006, Fletcher agreed to lower the dilutive issuance provision by 25% of            the original calculation for the remainder of the provision’s original term and            in connection with the issuance of common stock in the Company’s December 2006            capital raise, the Company issued Fletcher 267,314 of its common shares. Through a            release dated January 5, 2007, between the Company and Fletcher, the Company is not            required to register these shares with the SEC since these shares may be sold by            Fletcher pursuant to Rule 144(k) under the Securities Act of 1933, as            amended.

 

The            Company does not presently have any outstanding agreements with Fletcher concerning            additional investment rights or dilutive stock issuance.

 

**Warrants Issued**

On            December 20, 2006, the Company issued warrants to investors to purchase 3,027,778            shares of the Company’s common stock at an exercise price of $2.27 per share.            These warrants will be fair valued by the Company until expiration or exercise of the            warrants. The warrants became exercisable on June 20, 2007 and expire on December 19,            2011.

 

**Reservation of Shares**

The            Company has reserved common shares for future issuance as follows as of December 31,            2007:

| Stock options outstanding            | 6,213,566  |
|--------------------------------------|------------|
| Stock options available for issuance | 1,265,733  |
| Warrants outstanding                 | 3,027,778  |
| Number of common shares reserved     | 10,507,077 |

 

**Completion of Option Exchange with MTI Micro Option            Holders**

On            December 30, 2005, the Company issued options to acquire 1,021,213 shares of MTI common            stock, par value $0.01 per share, to certain employees, officers and directors of MTI            and MTI Micro who previously held MTI Micro options (the “Optionees”). The            options have an exercise price per share of $2.80 (the closing price of the            Company’s common stock on December 30, 2005). The Company issued the options            pursuant to a November 28, 2005 stock option exchange offer. MTI Micro options            outstanding for a purchase of a total of 2,392,947 shares of MTI Micro common stock,            par value $0.01 per share, were tendered by the Optionees and then cancelled by MTI            Micro as a result of this exchange. Each option is exercisable for one share of MTI            common stock. The exchange rate was one option for each two MTI Micro options, rounded            down to the nearest whole option, or if an individual had an MTI Micro option balance            in excess of 150,000 options, then at a rate of one option for each four MTI Micro            options in excess of 150,000 options. The exchange was accounted for in accordance with            EITF 00-23 Issue 1,*Issues Related to the Accounting for Stock            Compensation under APB Opinion No. 25 and FASB Interpretation No. 44*and no compensation expense was recorded.

 

| **11.** | **Retirement Plan** |
|---------|---------------------|

 

The            Company maintains a voluntary savings and retirement plan under Internal Revenue Code            Section 401(k) covering substantially all employees. Employees must complete six months            of service and have attained the age of twenty-one prior to becoming eligible for            participation in the plan. The Company plan allows eligible employees to contribute a            percentage of their compensation on a pre-tax basis and the Company matches employee            contributions dollar for dollar up to a discretionary amount, currently 4%, of the            employee’s salary, subject to annual tax deduction limitations. Company matching            contributions vest at a rate of 25% annually for each year of service completed.            Company matching contributions were $272, $269, and $283 thousand for 2005, 2006, and            2007, respectively. The Company may also make additional discretionary contributions in            amounts as determined by management and the Board of Directors. There were no            additional discretionary contributions by the Company for the years 2005, 2006, or            2007.

 

F-22

 

----

             

             

**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**12.**     **Earnings per Share**

 

The            following table sets forth the reconciliation of the numerators and denominators of the            basic and diluted per share computations for continuing operations for the years ended            December 31:

| (Dollars in thousands, except shares)                                                                                 |   | **2005** |       | **2006** |   | **2007**   |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|--------|------------|--------|
| Numerator:                                                                                                            |   |     |       |     |   |       |   |   |   |   |
| Net loss                                                                                                              |   | $        | (15,094    | )        | $      | (13,667    | )      | $ | (9,575 | ) |
|                                                                                                                  |   |     |       |     |   |       |   |   |   |   |
| Denominator:                                                                                                          |   |     |       |     |   |       |   |   |   |   |
| Basic EPS:                                                                                                            |   |     |       |     |   |       |   |   |   |   |
| Common shares outstanding, beginning of                            period                                             |   |     | 30,610,213 |     |   | 30,925,201 |   |   | 38,043,942 |   |
| Weighted average common shares issued during the                            period                                    |   |     | 127,395    |     |   | 700,267    |   |   | 72,887 |   |
| Weighted average restricted shares forfeited during the                            period                             |   |     | —    |     |   | —    |   |   | (2,877 | ) |
| Less Weighted average non-vested restricted                            stock                                          |   |     | —    |     |   | (3,123     | )      |   | (5,575 | ) |
| Denominator for basic earnings per common shares                            –

Weighted average common shares   |   |     | 30,737,608 |     |   | 31,622,345 |   |   | 38,108,377 |   |
|                                                                                                                  |   |     |       |     |   |       |   |   |   |   |
| Diluted EPS:                                                                                                          |   |     |       |     |   |       |   |   |   |   |
| Common shares outstanding, beginning of                            period                                             |   |     | 30,610,213 |     |   | 30,925,201 |   |   | 38,043,942 |   |
| Weighted average common shares issued during the                            period                                    |   |     | 127,395    |     |   | 700,267    |   |   | 72,887 |   |
| Weighted average restricted shares forfeited during the                            period                             |   |     | —    |     |   | —    |   |   | (2,877 | ) |
| Less Weighted average non-vested restricted stock due to                            anti-dilutive effect              |   |     | —    |     |   | (3,123     | )      |   | (5,575 | ) |
| Denominator for diluted earnings per common shares                            –

Weighted average common shares |   |     | 30,737,608 |     |   | 31,622,345 |   |   | 38,108,377 |   |

Not            included in the computation of earnings per share-assuming dilution for the year ended            December 31, 2005 were options to purchase 5,041,242 shares of the Company’s            common stock, additional investment rights to purchase approximately 3,320,604 shares            of the Company’s common stock, warrants to purchase 28,377 shares of the            Company’s common stock and options to purchase 78,461 shares of MTI Micro’s            common stock. These potentially dilutive items were excluded because the Company            incurred a loss for this period and their inclusion would be anti-dilutive. The            additional investment rights expired on December 31, 2006.

 

Not            included in the computation of earnings per share-assuming dilution for the year ended            December 31, 2006 were options to purchase 5,509,194 shares of the Company’s            common stock, 5,000 unvested restricted shares of the Company’s common stock and            options to purchase 33,668 shares of MTI Micro’s common stock. These potentially            dilutive items were excluded because the Company incurred a loss for this period and            their inclusion would be anti-dilutive. The MTI options expire between January 4, 2007            and November 9, 2016, while the MTI Micro options expire between September 29, 2012 and            September 18, 2015. The Company also has 3,027,778 warrants outstanding as of December            31, 2006; however, these were excluded in the computation earnings per share because            they were not eligible to be exercised until June 20, 2007.

 

Not            included in the computation of earnings per share-assuming dilution for the year ended            December 31, 2007 were options to purchase 6,213,566 shares of the Company’s            common stock, warrants to purchase 3,027,778 shares of the Company’s stock, 5,000            unvested restricted shares of the Company’s common stock and options to purchase            22,668 shares of MTI Micro’s common stock. These potentially dilutive items were            excluded because the Company incurred a loss for this period and their inclusion would            be anti-dilutive.

 

| **13.** | **Stock Based Compensation** |
|---------|------------------------------|

 

**MTI            Option Plans**

Stock-based incentive awards are provided to employees and directors            under the terms of the Company’s 1996 Stock Incentive Plan (“1996            Plan”), 1999 Employee Stock Incentive Plan (“1999 Plan”) and 2006            Equity Incentive Plan (“2006 Plan”), the (collectively, the            “Plans”). Awards under the Plans have generally included at-the-money            options and restricted stock grants. MTI Micro also issued awards under the MTI            MicroFuel Cells Inc. 2001 Employee, Director and Consultant Stock Option Plan            (“2001 MTI Micro Plan”). During 2005, MTI Micro ceased making grants under            the 2001 MTI Micro Plan and determined that it would make no new awards under this plan            in the future.

 

F-23

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

The            1996 Plan was approved by stockholders during December 1996. The 1996 Plan provided an            initial aggregate number of 500,000 shares of common stock to be awarded or issued. The            number of shares available to be awarded under the 1996 Plan and awards outstanding            were adjusted for stock splits and rights offerings. The number of shares which may be            awarded under the 1996 Plan was 3,746,813 during 2005, 2006, and 2007. Under the 1996            Plan, the Board of Directors was authorized to issue stock options, stock appreciation            rights, restricted stock, and other stock-based incentives to officers, employees and            others.

 

The            1999 Plan was adopted by the Company’s Board of Directors and approved by            stockholders on March 18, 1999. The 1999 Plan provides that an initial aggregate number            of 1,000,000 shares of common stock may be awarded or issued. The number of shares            which may be awarded under the 1999 Plan and awards outstanding have been adjusted for            stock splits, and during 2005, 2006, and 2007, the total number of shares which may be            awarded under the 1999 Plan was 4,500,000 shares. Under the 1999 Plan, the Board of            Directors is authorized to issue stock-based awards to officers, employees and            others.

 

The            2006 Plan was adopted by the Company’s Board of Directors on March 16, 2006 and            approved by stockholders on May 18, 2006. The 2006 Plan provides that an initial            aggregate number of 2,000,000 shares of common stock may be awarded or issued. The            number of shares which may be awarded under the 2006 Plan and awards outstanding will            be adjusted for stock splits and other similar events. Under the 2006 Plan, the Board            of Directors is authorized to issue stock options, stock appreciation rights,            restricted stock, and other stock-based incentives to officers, employees and            others.

 

Stock-based compensation expense for the year ended December 31, 2007            was generated from stock options and restricted stock grants. Stock options are awards            which allow holders to purchase shares of the Company’s common stock at a fixed            price. Stock options issued to employees generally vest 25% per year beginning one year            after grant. Options issued to non-employee members of the MTI Board of Directors            generally vest upon grant. Certain options granted may be fully or partially            exercisable immediately, may vest on other than a four year schedule or vest upon            attainment of specific performance criteria. Restricted stock awards generally vest one            year after the date of grant; however, certain awards may vest immediately or vest upon            attainment of specific performance criteria. Option exercise prices are generally            equivalent to the closing market value price of the Company’s common stock on the            date of grant. Unexercised options generally terminate either seven or ten years after            date of grant.

 

*Share-Based Compensation Information under FAS 123 and APB            25*

Prior            to January 1, 2006, the Company had elected to follow APB Opinion No. 25,*Accounting for Stock Issued to Employees (“APB Opinion No.            25”)*and related Interpretations in accounting for            employee stock-based compensation and to provide the disclosures required under FAS            123. APB Opinion No. 25 requires no recognition of compensation expense for most of the            stock-based compensation arrangements provided by the Company, namely, broad-based            employee option grants where the exercise price is equal to market value at the date of            grant. However, APB Opinion No. 25 requires recognition of compensation expense for            variable award plans over the vesting periods of such plans, based upon the            then-current market values of the underlying stock. In contrast, FAS 123 requires            recognition of compensation expense for grants of stock, stock options, and other            equity instruments, over the vesting periods of such grants, based on the estimated            grant-date fair values of those grants. Under the intrinsic-value-based method,            compensation cost is the excess, if any, of the market value of the stock at grant over            the amount an employee must pay to acquire the stock.

 

During            2005, the Company awarded 50,000 shares each of common stock and restricted common            stock which vested over a one-year period. Presented below is a summary of compensation            expense related to the intrinsic value of performance-based, time-based and            unrestricted awards, which is included in the summary of the Company’s            compensation expense under all share-based awards, for the Plans which was recorded in            the financial statement line “Selling, general and administrative expenses”            for the year ended December 31:

| (Dollars in thousands)                 |   | **2005** |
|----------------------------------------|--------|----------|
| Stock                                  |   | $        | 124 |
| Restricted stock                       |   |     | 45 |
| Stock options                          |   |     | 633 |
| Total stock-based compensation expense |   | $        | 802 |

The            2005 stock-based compensation expense included $438 thousand of stock-based            compensation expense recorded as a result of accelerating the vesting and/or extending            the time to exercise options after termination but not in excess of the original            contractual life of the options. These changes were made in connection with employment,            termination and change in status (employee to consultant) arrangements.

 

*Pro            Forma Information under FAS 123 for Periods Prior to Fiscal 2006*

Prior            to adopting the provisions of FAS 123R, the Company recorded estimated compensation            expense for employee stock options based upon their intrinsic value on the date of            grant pursuant to APB Opinion No. 25 and provided the required pro forma

 

F-24

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

disclosures of FAS 123. Because the Company generally established the            exercise price based on the fair market value of the Company’s stock at the date            of grant, the stock options generally had no intrinsic value upon grant, and therefore            compensation expense was recorded primarily for grant modifications prior to adopting            FAS 123R. Each accounting period, the Company reported the potential dilutive impact of            stock options in its diluted earnings per common share using the treasury-stock method.            Out-of-the-money stock options (i.e., the average stock price during the period was            below the strike price of the stock option) were not included in diluted earnings per            common share as their effect was anti-dilutive.

 

For            purposes of pro forma disclosures under FAS 123 for the year ended December 31, 2005,            the estimated fair value of the stock options was assumed to be amortized to expense            over the stock options’ vesting periods. The pro forma effects of recognizing            estimated compensation expense under the fair value method on net (loss) and (loss) per            common share for the year ended December 31 was as follows:

| (Dollars in thousands, except per share data)                                                                                                                                                      |   | **2005** |    |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|
| Net loss, as reported                                                                                                                                                                              |   | $        | (15,094 | ) |
| Add: Total stock-based employee compensation expense                            already recorded in financial statements,

net of related tax effects                                              |   |     | 1,003   |   |
| Deduct: Total stock-based employee compensation expense                            determined under fair value based

method for all awards, net of related tax                            effects |   |     | (2,963  | ) |
| Pro forma net loss                                                                                                                                                                                 |   | $        | (17,054 | ) |
| Loss per Share:                                                                                                                                                                                    |   |     |    |   |
| Basic and diluted - as reported                                                                                                                                                                    |   | $        | (0.49   | ) |
| Basic and diluted - pro forma                                                                                                                                                                      |   | $        | (0.55   | ) |

 

|                              |   | **2005** |      |
|-----------------------------------|--------|----------|-----------|
| Fair value of each option granted |   | $        | 2.85      |   |
| Number of options granted         |   |     | 1,467,880 |   |
| Fair value of all options granted |   | $        | 4,187,301 |   |

 

The            fair value of options granted, which is amortized to expense over the option vesting            period in determining the pro forma impact, is estimated on the date of grant using the            Black-Scholes Option Pricing model with the following weighted average assumptions for            each of the year ended December 31:

|                                                                            |   | **2005** |   |
|---------------------------------------------------------------------------------|--------|----------|--------|
| Expected life of option                                                         |   |     | 5      | years |
| Risk-free interest rate                                                         |   |     | 4.28   | % |
| Expected volatility of the Company’s                            stock     |   |     | 77.3   | % |
| Expected dividend yield on the Company’s                            stock |   |     | 0      | % |

 

The            weighted average grant-date fair value of stock awarded and vested for each of the year            ended December 31 is as follows:

|                             |   | **2005** |    |
|----------------------------------|--------|----------|---------|
| Fair value of each share granted |   | $        | 2.49    |   |
| Number of shares granted         |   |     | 50,000  |   |
| Fair value of all shares granted |   | $        | 124,500 |   |

 

The            weighted average grant-date fair value of restricted stock awarded for each of the year            ended December 31 is as follows:

|                                        |   | **2005** |    |
|---------------------------------------------|--------|----------|---------|
| Fair value of each restricted share granted |   | $        | 2.49    |   |
| Number of restricted shares granted         |   |     | 50,000  |   |
| Fair value of all restricted shares granted |   | $        | 124,500 |   |

 

 

F-25

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

*Share-Based Compensation Information under FAS 123R*

As            discussed in Note 2 “Significant Accounting Policies,” effective January 1,            2006, the Company adopted the fair value recognition provisions for stock-based awards            granted to employees using the modified prospective application method provided by FAS            123R. Stock-based compensation cost is measured at grant date, based on the fair value            of the award, and is recognized as expense over the employee requisite service            period.

 

The            Company estimates the fair value of stock options using a Black-Scholes valuation model            consistent with the provisions of FAS 123R and SAB 107. Key inputs and assumptions used            to estimate the fair value of stock options include the grant price of the award, the            expected option term, volatility of the Company’s stock, an appropriate risk-free            rate, and the Company’s dividend yield. Estimates of fair value are not intended            to predict actual future events or the value ultimately realized by employees who            receive equity awards, and subsequent events are not indicative of the reasonableness            of the original estimates of fair value made by the Company.

 

The            fair value of each stock option grant was estimated at the date of grant using a            Black-Scholes Option Pricing model. The following table presents the weighted-average            assumptions used for options granted:

|                                                                      |   | **2006** |        | **2007** |
|---------------------------------------------------------------------------|--------|----------|-------------|----------|
| Option term (years) A                                                     |   |     | 4.26        |     |   | 3.61 |   |
| Volatility B                                                              |   |     | 73.14       | %        |   | 72.76 | % |
| Risk-free interest rate range C                                           |   |     | 4.60 - 5.29 | %        |   | 3.23 - 5.04 | % |
| Dividend yield D                                                          |   |     | 0           | %        |   | 0 | % |
| Weighted-average fair value per option                            granted |   | $        | 2.51        |     | $ | 0.77 |   |

A The option term is the number of years that the Company            estimates, based upon historical experience and the full contractual term of the            options outstanding, those options will be outstanding prior to exercise.

B The expected stock price volatility as of the grant date is            based on the historical volatility of the Company’s common stock price over a            period corresponding to the expected term of the option, adjusted for activity that is            not expected to occur in the future.

C The risk-free interest rate is the implied yield on U.S.            Treasury zero coupon issues with a remaining term equal to the expected term used as            the assumption in the model.

D The dividend yield assumption is based on the            Company’s history and expectation of future dividend payouts, which may be            subject to substantial change in the future.

 

Share-based compensation expense recognized in the Consolidated            Statements of Operations is based on awards ultimately expected to vest, therefore,            awards are reduced for estimated forfeitures. FAS 123R requires forfeitures to be            estimated at the time of grant and revised, if necessary, in subsequent periods if            actual forfeitures differ from those estimates.

 

*Stock-Based Compensation Expense – All Accounting            Treatments*

Total            share-based compensation expense, related to all of the Company’s share-based            awards, recognized for the years ended December 31, was comprised as            follows:

| (Dollars in thousands, except EPS)                                        |   | **2005** |    | **2006** |   | **2007** |   |
|---------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| Unfunded research and product development                                 |   | $        | — |     | $      | 512      |   | $ | 216 |   |
| Selling, general and                            administrative***B***     |   |     | 1,003   |     |   | 1,894    |   |   | 1,342 |   |
| Share-based compensation expense before taxes                             |   |     | 1,003   |     |   | 2,406    |   |   | 1,558 |   |
| Related income tax benefits***A***                                        |   |     | — |     |   | —  |   |   | — |   |
| Share-based compensation expense, net of                            taxes |   | $        | 1,003   |     | $      | 2,406    |   | $ | 1,558 |   |
| Impact on basic and diluted EPS                                           |   |     |    |     | $      | (0.08    | )      | $ | (0.04 | ) |

*A*Income tax effect is zero due            to the Company maintaining a full valuation allowance.

***B***Compensation expense            for the year ended December 31, 2005 was calculated under APB 25.

 

As of            January 1, 2006, the adoption of FAS 123R resulted in the elimination of unearned            compensation related to restricted stock (contra equity account) against additional            paid-in capital totaling approximately $80 thousand. Total unrecognized compensation            costs related to non-vested awards as of December 31, 2007 is $1,595 thousand and is            expected to be recognized over a weighted-average vesting period of approximately 1.31            years.

 

F-26

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

Presented below is a summary of the Company’s stock option            plans’ activity for the years ended December 31:

|                                                                          |   | **2005**  |   | **2006**  |   | **2007**  |   |
|-------------------------------------------------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Shares under option, beginning                                                |   | 3,752,063 |   | 5,041,242 |   | 5,509,194 |   |
| Granted                                                                       |   | 1,467,880 |   | 1,564,750 |   | 1,853,750 |   |
| Exercised                                                                     |   | (148,575  | )      | (719,791  | )      | (85,946   | )      |
| Canceled/Forfeited                                                            |   | (10,126   | )      | (175,099  | )      | (520,921  | )      |
| Expired                                                                       |   | (20,000   | )      | (201,908  | )      | (542,511  | )      |
| Shares under option, ending                                                   |   | 5,041,242 |   | 5,509,194 |   | 6,213,566 |   |
|                                                                          |   |      |   |      |   |      |   |
| Options exercisable                                                           |   | 4,197,029 |   | 4,053,286 |   | 4,628,348 |   |
| Remaining shares available for granting of                            options |   | 1,363,214 |   | 2,096,159 |   | 1,265,733 |   |

 

The            weighted average exercise price is as follows for each of the years ended December            31:

|                           |   | **2005** |   | **2006** |   | **2007** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Shares under option, beginning |   | $        | 4.06   |     | $      | 3.76     |   | $ | 4.04 |   |
| Granted                        |   | $        | 2.85   |     | $      | 4.04     |   | $ | 1.37 |   |
| Exercised                      |   | $        | 2.20   |     | $      | 1.65     |   | $ | 0.70 |   |
| Canceled/Forfeited             |   | $        | 4.26   |     | $      | 4.29     |   | $ | 3.55 |   |
| Expired                        |   | $        | 6.17   |     | $      | 5.30     |   | $ | 5.13 |   |
| Shares under option, ending    |   | $        | 3.76   |     | $      | 4.04     |   | $ | 3.24 |   |
| Options exercisable, ending    |   | $        | 3.85   |     | $      | 4.12     |   | $ | 3.55 |   |

 

The            following table summarizes information for options outstanding and exercisable at            December 31, 2007:

| **Outstanding Options**  | **Options Exercisable** |
|--------------------------|-------------------------|
| **Exercise Price Range** |                    | **Number** |   | **Weighted Average Remaining Contractual                            Life** |   | **Weighted Average Exercise Price** |   | **Number** |   | **Weighted Average Exercise Price** |
| $                        | 0.76                    | - | $ | 1.13 |   | 154,000 |   | 4.9 |   | $ | 0.88 |   | 75,000 |   | $ | 0.92 |
| $                        | 1.23                    | - | $ | 1.78 |   | 1,982,700 |   | 5.6 |   | $ | 1.40 |   | 1,035,825 |   | $ | 1.46 |
| $                        | 1.91                    | - | $ | 2.83 |   | 1,163,199 |   | 4.8 |   | $ | 2.58 |   | 1,113,254 |   | $ | 2.58 |
| $                        | 2.86                    | - | $ | 4.17 |   | 1,308,667 |   | 4.9 |   | $ | 3.63 |   | 1,214,144 |   | $ | 3.63 |
| $                        | 4.30                    | - | $ | 6.28 |   | 1,402,500 |   | 4.9 |   | $ | 5.20 |   | 987,625 |   | $ | 5.52 |
| $                        | 9.25                    | - | $ | 12.97 |   | 202,500 |   | 2.1 |   | $ | 10.55 |   | 202,500 |   | $ | 10.55 |
|                     |                    |   |   |   |   | 6,213,566 |   | 5.0 |   | $ | 3.24 |   | 4,628,348 |   | $ | 3.55 |

 

The            aggregate intrinsic value (i.e. the difference between the closing stock price and the            price to be paid by the option holder to exercise the option) is zero for both the            Company’s outstanding and exercisable options as of December 31, 2007. The            amounts are based on the Company’s closing stock price of $0.75 as of December            31, 2007.

 

The            total intrinsic value of options exercised during the years ended December 31, 2005,            2006, and 2007 was $217, $1,307, and $44 thousand, respectively. The total cash            received by the Company as a result of stock option exercises for the year ended            December 31, 2007 was approximately $60 thousand. In connection with these exercises,            there was no tax benefit or expense realized by the Company for the year ended December            31, 2007. The Company settles employee stock option exercises with newly issued shares            of Company common stock.

 

F-27

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

The            number and weighted average grant-date fair value of unvested restricted stock for the            period ended December 31, 2007 is as follows:

|                                 |   | **Number** |   | **Weighted Average Grant-Date Fair Value** |   |
|--------------------------------------|--------|------------|--------|--------------------------------------------|--------|
| Unvested restricted stock, beginning |   | 5,000      |   | $                                          | 4.05   |   |
| Granted                              |   | 55,000     |   |                                       | 1.34   |   |
| Forfeited                            |   | (5,000     | )      |                                       | 4.05   |   |
| Vested                               |   | (50,000    | )      |                                       | 1.34   |   |
| Unvested restricted stock, ending    |   | 5,000      |   | $                                          | 1.34   |   |

The            aggregate intrinsic value of restricted stock vested during the year ended December 31,            2007 was $67 thousand.

 

**MTI            Micro Option Plan**

The            2001 MTI Micro Plan was approved by MTI Micro’s stockholders in 2001 and provided            an initial aggregate number of 1,766,000 shares of MTI Micro common stock to be            awarded. The number of shares which may be awarded under the 2001 MTI Micro Plan and            awards outstanding have been adjusted for a 2004 reverse stock split, and during 2005,            2006, and 2007, the total number of shares which may be awarded under the 2001 MTI            Micro Plan were 3,416,667 shares. Under the 2001 MTI Micro Plan, the MTI Micro Board of            Directors was authorized to award stock options to officers, directors, employees and            consultants. No further grants will be made under this plan.

 

Options            issued to employees generally vest 25% per year beginning one year after grant. Option            exercise prices were determined by MTI Micro’s Board of Directors. Unexercised            options generally terminate ten years after date of grant. Up until January 1, 2006,            MTI Micro followed APB Opinion No. 25 and related Interpretations, in accounting for            employee stock-based compensation and to provide the disclosures required under SFAS            No. 123. APB Opinion No. 25 requires no recognition of compensation expense for most of            the stock-based compensation arrangements provided by MTI Micro, namely, broad-based            employee stock purchase plans and option grants where the exercise price is equal to or            not less than the market value at the date of grant. However, APB Opinion No. 25            requires recognition of compensation expense for variable award plans over the vesting            periods of such plans, based upon the then-current market values of the underlying            stock. As of January 1, 2006, MTI Micro is accounting for employee stock-based            compensation under FAS 123R.

 

Presented below is a summary of compensation expense, which is included            in the summary of the Company’s compensation expense under all share-based awards            above, for the MTI Micro plan:

| (Dollars in thousands)                 |   | **2005** |   | **2006** |   | **2007** |   |
|----------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Stock options                          |   | $        | 201    |     | $      | 25       |   | $ | 12 |   |
| Total stock-based compensation expense |   | $        | 201    |     | $      | 25       |   | $ | 12 |   |

 

Presented below is a summary of the 2001 MTI Micro stock option plans            activity for the years ended December 31:

|                                                                          |   | **2005** |       | **2006** |   | **2007**  |   |
|-------------------------------------------------------------------------------|--------|----------|------------|----------|--------|-----------|--------|
| Shares under option, beginning                                                |   |     | 2,876,881  |     |   | 78,461    |   |   | 33,668 |   |
| Granted                                                                       |   |     | 358,000    |     |   | —   |   |   | — |   |
| Exercised                                                                     |   |     | (10        | )        |   | —   |   |   | — |   |
| Canceled/Forfeited                                                            |   |     | (3,156,410 | )        |   | (44,793   | )      |   | (11,000 | ) |
| Shares under option, ending                                                   |   |     | 78,461     |     |   | 33,668    |   |   | 22,668 |   |
| Options exercisable                                                           |   |     | 35,752     |     |   | 17,003    |   |   | 18,626 |   |
| Remaining shares available for granting of                            options |   |     | 3,280,403  |     |   | 3,325,196 |   |   | 3,336,196 |   |

 

The            weighted average exercise price for MTI Micro options is as follows for each of the            years ended December 31:

|                           |   | **2005** |   | **2006** |   | **2007** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Shares under option, beginning |   | $        | 3.00   |     | $      | 3.22     |   | $ | 3.61 |   |
| Granted                        |   |     | 3.68   |     |   | —  |   |   | — |   |
| Exercised                      |   |     | 2.55   |     |   | —  |   |   | — |   |
| Canceled/Forfeited             |   |     | 3.12   |     |   | 2.93     |   |   | 3.42 |   |
| Shares under option, ending    |   |     | 3.22   |     |   | 3.61     |   |   | 3.70 |   |
| Options exercisable, ending    |   |     | 2.93   |     |   | 3.57     |   |   | 3.63 |   |

 

 

F-28

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

The            fair value of MTI Micro options granted in 2005, which is amortized to expense over the            option vesting period in determining the pro forma impact, was estimated on the date of            grant using the Black-Scholes Option Pricing model with the following weighted average            assumptions for the year ended December 31:

|                                                                          |   | **2005** |   |
|-------------------------------------------------------------------------------|--------|----------|--------|
| Expected life of option                                                       |   | 5        | years  |
| Risk-free interest rate                                                       |   | 4.28     | %      |
| Expected volatility of the MTI Micro’s                            stock |   | 77.3     | %      |
| Expected dividend yield on MTI Micro’s                            stock |   | 0        | %      |

 

The            weighted average fair value of MTI Micro options granted for the year ended December 31            is as follows:

|                              |   | **2005** |    |
|-----------------------------------|--------|----------|---------|
| Fair value of each option granted |   | $        | 3.68    |   |
| Fair value of all options granted |   | $        | 930,890 |   |

 

In            accordance with SFAS No. 123, the weighted average fair value of stock options granted            is required to be based on a theoretical statistical model using the preceding            Black-Scholes Option Pricing model assumptions.

| **Outstanding Options**  | **Options Exercisable** |
|--------------------------|-------------------------|
| **Exercise Price Range** |                    | **Number** |   | **Weighted Average Remaining Contractual                            Life** |   | **Weighted Average Exercise Price** |   | **Number** |   | **Weighted Average Exercise Price** |
| $                        | 2.39                    | - | $ | 2.55 |   | 6,500 |   | 6.4 |   | $ | 2.44 |   | 5,375 |   | $ | 2.45 |
| $                        | 2.76                    | - | $ | 3.80 |   | 4,501 |   | 5.7 |   | $ | 3.03 |   | 4,501 |   | $ | 3.03 |
| $                        | 4.06                    | - | $ | 4.66 |   | 11,667 |   | 6.2 |   | $ | 4.66 |   | 8,750 |   | $ | 4.66 |
|                     |                    |   |   |   |   | 22,668 |   | 6.2 |   | $ | 3.70 |   | 18,626 |   | $ | 3.63 |

 

Based            upon an estimated common stock price of $0.51 at December 31, 2007, the intrinsic value            of all MTI Micro’s outstanding and exercisable options are zero, since all            exercise prices are above the estimated common stock fair value price.

 

On            December 30, 2005, the Company granted options to acquire 1,021,213 shares of MTI            common stock, par value $0.01 per share, to certain Optionees. The options have an            exercise price per share of $2.80 (the closing price of the Company’s common            stock on December 30, 2005). The Company issued the options pursuant to a November 28,            2005 stock option exchange offer. MTI Micro options outstanding for a purchase of a            total of 2,392,947 shares of MTI Micro common stock, par value $0.01 per share, were            tendered by the Optionees and then cancelled by MTI Micro as a result of this exchange.            Each option is exercisable for one share of MTI common stock. The exchange rate was one            option for each two MTI Micro options, rounded down to the nearest whole option, or if            an individual had an MTI Micro option balance in excess of 150,000 options, then at a            rate of one option for each four MTI Micro options in excess of 150,000 options. The            exchange was accounted for in accordance with EITF 00-23 Issue 1 and no compensation            expense was recorded.

 

| **14.** | **Cash Flows - Supplemental Information** |
|---------|-------------------------------------------|

 

| (Dollars in thousands)                                                                                                                |   | **Years Ended December 31,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                                                  |   | **2005**                     |   | **2006** |   | **2007** |   |
| **Non-Cash Investing and Financing                            Activities:**                                                           |   |                         |   |   |   |   |   |
| Change in investment and paid-in capital resulting from                            other investors’ activity in MTI Micro stock |   | $                            | (301   | ) | $ | (1,284 | ) | $ | (521 | ) |
| **Cash Payments:**                                                                                                                    |   |                         |   |   |   |   |   |   |   |   |
| Taxes paid (tax refunds), net                                                                                                         |   |                         | 37     |   |   | 3 |   |   | (10 | ) |

 

 

F-29

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**15.**     **Derivatives**

 

The            Company held or has outstanding as of December 31, the following derivative financial            instruments:

|                                                                                                                                                                                                               |   | **2006**  |   | **2007**  | **Expiration** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|--------|-----------|----------------|
| **Derivatives issued:**                                                                                                                                                                                            |   |      |   |      |           |
| Warrants, exercisable beginning June 20, 2007, to                            purchase the Company’s common stock issued to three investors at                            a purchase price of $2.27 per share |   | 3,027,778 |   | 3,027,778 | 12/19/2011     |

 

*Plug            Power Investment Right Derivative:*The Company placed            2,700,000 shares of Plug Power common stock in escrow that was available for purchase            by Fletcher in certain instances. Fletcher could, on one or multiple occasions, from            June 1, 2005 to December 31, 2006, exercise its right to purchase from the Company a            number of shares of Plug Power common stock totaling $10,000 thousand divided by the            prevailing price (as defined below) per share of Plug Power common stock, but only to            the extent of the number of shares remaining in escrow. Commencing immediately after            the SEC declared effective on May 20, 2004 the registration statement relating to            shares of the Company’s common stock owned by Fletcher, the Company had the right            to have 250,000 of such shares released from escrow to the Company, on a monthly basis,            in the event that on any day during such month, the prevailing price of the            Company’s common stock exceeds $6.343 (which price may have been adjusted to            reflect stock splits, recombinations, stock dividends or the like).

 

The            exercise price for the Plug Power investment right was $10,000 thousand less the            positive difference between $18,000 thousand and the product of the sum of 2,680,671            shares multiplied by the prevailing price per share of the Company’s common stock            on the date Fletcher elected to exercise such right, all divided by the quotient            obtained by dividing $10,000 thousand by the prevailing price of Plug Power common            stock on the date.

 

Fletcher elected to exercise such right. As used herein, a prevailing            price is the average of the daily volume-weighted average price per share of common            stock during the sixty-business-day period ending three days prior to the date Fletcher            elects to exercise such right, provided however that the price may not exceed the            average of the daily volume-weighted average prices for any ten business days within            such sixty-business day period.

 

On June            24, 2005, Fletcher notified the Company of their election to exercise in full its right            to purchase from the Company certain shares of common stock of Plug Power. As a result            of this election, Fletcher purchased 1,799,791 shares of Plug Power common stock from            the Company at a price of $0.7226 per share, with proceeds to the Company of $1,301            thousand. This transaction closed on June 28, 2005 and, in connection with this            exercise, the Company recognized a loss based on the intrinsic value of the derivative            immediately prior to exercise of $7,173 thousand and a gain on the sale based on the            fair value of the underlying Plug Power common shares of $9,635 thousand.

 

*Warrant Derivative to Purchase MTI Common Stock:*The warrants issued during the Company’s December 2006 capital            raise were legally freestanding, detachable and transferable by the holders. The            features of the warrant allowed both straight cash exercises as well as cashless            exercises. Due primarily to a stipulation in the warrant agreement which allowed a            potential cash settlement with the holders if the Company was acquired by, or merged            with a private company, these warrants were classified as an asset/liability derivative            in accordance with SFAS No. 133 (paragraph 11) and EITF 00-19.

 

The            estimated fair value of this warrant at the date issued was $1.27 per share, using a            Black-Scholes Option Pricing model and assumptions similar to those used for valuing            the Company’s employee share-based compensation. The fair value of the derivative            is recorded in the “Derivative Liability” line on its financial statements,            and is valued quarterly using the Black-Scholes Option Pricing Model. The assumptions            used for the valuations as of December 31 were as follows:

|                           | **2006** |   | **2007** |   |
|--------------------------------|----------|--------|----------|--------|
| Expected life of option (days) | 1,815    |   | 1,450    |   |
| Risk-free interest rate        | 4.70     | %      | 3.45     | %      |
| Expected volatility of stock   | 80.34    | %      | 73.46    | %      |
| Expected dividend yield        | None     |   | None     |   |

 

The            Company recognizes changes in fair value in its Consolidated Statements of Operations            in the line titled “Gain on derivatives.”

 

F-30

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

**16.**     **Commitments and Contingencies**

 

**Lawrence Litigation**

On            September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc. (“Lawrence”)            and certain other Lawrence-related entities (“Plaintiffs”) initially filed            suit in the United States Bankruptcy Court for the Northern District of New York            (“Bankruptcy Court”) and the United States District Court for the Northern            District of New York (“District Court”), which were subsequently            consolidated in the District Court, against First Albany Corporation, now known as            Broadpoint Capital, Inc. (“BCI”), the Company, Dale Church, Edward Dohring,            Beno Sternlicht, Alan Goldberg and George McNamee (Church, Dohring, Sternlicht,            Goldberg and McNamee are former Directors of the Company), Marty Mastroianni (former            President and Chief Operating Officer of the Company) and 33 other individuals            (“Defendants”) who purchased a total of 820,909 shares(2,462,727            post-split) of the Company’s stock from the Plaintiffs. The case concerns the            Defendants’ 1997 purchase of the Company’s common stock from the Plaintiffs            at the price of $2.25 per share ($0.75 per share post split). BCI acted as Placement            Agent in connection with the negotiation and sale of the shares, including in            proceedings before the Bankruptcy Court, which approved the sale in September            1997.

 

Plaintiffs claim that the Defendants failed to disclose material inside            information to the Plaintiffs in connection with the sale and that the $2.25 per share            ($0.75 per share post split) purchase price was unfair. Plaintiffs are seeking damages            of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion            to dismiss the amended complaint, which was denied by the Bankruptcy Court. On appeal            in October 2000, Plaintiffs’ claims were dismissed by the District Court. In            November 2000, Plaintiffs filed an appeal of that dismissal with the United States            Court of Appeals for the Second Circuit. In June 2002, the Second Circuit Court of            Appeals reversed the District Court decision in part and remanded the case for further            consideration of the Plaintiffs’ claims as motions to modify the Bankruptcy Court            sale order. The Plaintiffs’ claims have now been referred back to Bankruptcy            Court for such consideration. By order and decision dated September 30, 2003, the            Bankruptcy Court allowed certain limited discovery to proceed, and this process is            still underway.

 

The            Company believes the claims have no merit and intends to defend them vigorously. The            Company cannot predict theoutcome of the claims nor reasonably estimate a range of            possible loss given the current status of the litigation. Accordingly, no amounts have            been reserved for this matter.

 

**Leases**

The            Company and its subsidiaries lease certain manufacturing, laboratory and office            facilities. The leases generally provide for the Company to pay either an increase over            a base year level for taxes, maintenance, insurance and other costs of the leased            properties or the Company’s allocated share of insurance, taxes, maintenance and            other costs of leased properties. The leases contain renewal provisions.

 

Future            minimum rental payments required under non-cancelable operating leases are (dollars in            thousands): $694 in 2008, $659 in 2009, $1 in 2010 and $0 in 2011 and 2012. Rent            expense under all leases was $746, $748, and $687 thousand for 2005, 2006, and 2007,            respectively. Contingent rent included in the rent expense was $11, $3, and $3 thousand            for 2005, 2006, and 2007, respectively.

 

**Warranties**

Below            is a reconciliation of changes in product warranty liabilities at December            31:

| (Dollars in thousands)                                                                                  |   | **2006** |   | **2007** |   |
|---------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Balance, beginning of period                                                                            |   | $        | 20     |     | $      | 19 |   |
| Accruals for warranties issued                                                                          |   |     | 25     |     |   | 126 |   |
| Accruals related to pre-existing warranties (including                            changes in estimates) |   |     | (12    | )        |   | — |   |
| Settlements made (in cash or in kind)                                                                   |   |     | (14    | )        |   | (73 | ) |
| Balance, end of period                                                                                  |   | $        | 19     |     | $      | 72 |   |

 

**Licenses**

On            January 24, 2008, the Company cancelled its non-exclusive licensing agreement with Los            Alamos National Laboratory (“LANL”) covering certain direct methanol fuel            cell technology. This agreement, which was last amended on May 17, 2006, prescribed            annual license fees ranging from $35,000 in 2008 to $100,000 in 2019. The Company paid            a one-time fee of $50,000 to cancel the agreement, and no future royalties will be            paid. The Company cancelled this agreement because it no longer considers the direct            methanol fuel cell technology licensed from LANL to be applicable to its future            products.

 

F-31

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

Under            the NYSERDA contract, MTI Micro agreed to pay NYSERDA a royalty of 5.0% of the sales            price of any product sold incorporating IP developed pursuant to the NYSERDA contract.            If the product is manufactured by a New York State manufacturer, this royalty is            reduced to 1.5%. Total royalties are subject to a cap equal to two times the total            contract funds paid by NYSERDA to MTI Micro, and may be reduced to reflect any New York            State jobs created by MTI Micro.

 

**Employment Agreements**

The            Company has employment agreements with certain employees that provide severance            payments, certain other payments, accelerated vesting and exercise extension periods of            certain options upon termination of employment under certain circumstances, as defined            in the applicable agreements. As of December 31, 2007, the Company’s potential            minimum obligation to these employees was approximately $753 thousand.

 

**Contract Losses**

During            2005, MTI Micro entered into a fixed price contract with Saft America, Inc.            (“SAFT”) under the U.S. Army CECOM contract. The total fixed price to be            paid at the completion was amended on November 14, 2006 from $470 thousand to $418            thousand, in recognition of the elimination of Milestone 4. As of December 31, 2006,            MTI Micro forecasted costs in excess of this revised contract value of $66 thousand,            and accrued this amount for the anticipated cost overrun for this project. The project            was completed during February 2007.

 

| **17.** | **Related Party Transactions** |
|---------|--------------------------------|

 

Management believes transactions among related parties are as fair to            the Company as obtainable from unaffiliated third parties.

 

The            Company purchases materials from E.I. du Pont de Nemours and Company            (“DuPont”), a stockholder in MTI Micro. Such purchases totaled $130 for the            year ended December 31, 2005.

 

During            the Company’s December 2006 capital raise, Sidney V. Gold, a stockholder in MTI            Micro, purchased 5,000 units consisting of 500,000 shares of the Company’s common            stock and warrants exercisable for five years to purchase an additional 250,000 shares            of its common stock at $2.27 per share. The purchase price per unit was            $180.00.

 

| **18.** | **Geographic and Segment Information** |
|---------|----------------------------------------|

 

The            Company sells its products on a worldwide basis with its principal markets listed in            the table below where information on product revenue and funded research and            development revenue is summarized by geographic area for the Company as a whole for            each of the years ended December 31:

| (Dollars in thousands)                                                  |   | **2005** |    | **2006** |   | **2007** |   |
|-------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| **Product revenue:**                                                    |   |     |    |     |   |     |   |   |   |   |
| United States                                                           |   | $        | 4,751   |     | $      | 4,737    |   | $ | 5,453 |   |
| Japan                                                                   |   |     | 628     |     |   | 1,762    |   |   | 2,516 |   |
| Singapore                                                               |   |     | 31      |     |   | 355      |   |   | 286 |   |
| Other Pacific Rim                                                       |   |     | 202     |     |   | 279      |   |   | 307 |   |
| Europe                                                                  |   |     | 96      |     |   | 175      |   |   | 161 |   |
| Rest of World                                                           |   |     | 304     |     |   | 359      |   |   | 305 |   |
| Total product revenue                                                   |   | $        | 6,012   |     | $      | 7,667    |   | $ | 9,028 |   |
|                                                                    |   |     |    |     |   |     |   |   |   |   |
| **Funded research and development                            revenue:** |   |     |    |     |   |     |   |   |   |   |
| South Korea                                                             |   | $        | — |     | $      | 427      |   | $ | 448 |   |
| United States                                                           |   |     | 1,829   |     |   | 62       |   |   | 1,108 |   |
| Total funded research and development revenue                           |   | $        | 1,829   |     | $      | 489      |   | $ | 1,556 |   |
| Total revenue                                                           |   | $        | 7,841   |     | $      | 8,156    |   | $ | 10,584 |   |

 

Revenues are attributed to regions based on the location of            customers.

 

F-32

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

The            Company operates in two business segments**,**New Energyand Test and Measurement Instrumentation. The New energy            segment is focused on commercializing direct methanol fuel cells. The Test and            measurement Instrumentation segment designs, manufactures, markets and services            computer-based balancing systems for aircraft engines, high performance test and            measurement instruments and systems, and wafer characterization tools for the            semiconductor industry. The Company’s principal operations are located in North            America.

 

The            accounting policies of the new energy and test and measurement instrumentation segments            are similar to those described in the summary of significant accounting policies (See            Note 2). The Company evaluates performance based on profit or loss from operations            before income taxes, accounting changes, items management does not deem relevant to            segment performance, and interest income and expense. Inter-segment sales are not            significant.

 

Total            product revenues contributed by the test and measurement instrumentation products            segment and their percentage of total product revenue for each of the years ended            December 31 are shown below:

| (Dollars in thousands)      |   | **2005** |   |   | **2006** |   |   | **2007** |
|-----------------------------|--------|----------|--------|--------|----------|--------|--------|----------|
|                        |   |     | Sales  |   | %        |   |   |     |   | Sales |   | % |   |   |   |   | Sales |   | % |   |
| Aviation                    |   | $        | 3,013  |   | 50.12    | %      |   |     | $ | 2,990 |   | 39.00 | % |   |   | $ | 3,664 |   | 40.58 | % |
| General Gauging             |   |     | 2,688  |   | 44.71    |   |   |     |   | 4,165 |   | 54.32 |   |   |   |   | 4,489 |   | 49.72 |   |
| Semiconductor               |   |     | 311    |   | 5.17     |   |   |     |   | 512 |   | 6.68 |   |   |   |   | 875 |   | 9.70 |   |
| Total                       |   | $        | 6,012  |   | 100.00   | %      |   |     | $ | 7,667 |   | 100.00 | % |   |   | $ | 9,028 |   | 100.00 | % |
| Total Foreign-Based Revenue |   | $        | 1,261  |   | 20.97    | %      |   |     | $ | 2,930 |   | 38.22 | % |   |   | $ | 3,557 |   | 39.40 | % |

In the            test and measurement instrumentation segment, the U.S. Air Force accounted for $2,385            thousand or 30.4% of total revenue in 2005, $1,774 thousand or 23.1% of total product            revenue in 2006, and $2,375 thousand or 26.3% of total product revenue in 2007. Sales            to a Japanese distributor accounted for $1,757 thousand or 22.9% of total product            revenue in 2006, and $2,501 thousand or 27.7% of total product revenue in            2007.

 

In the            new energy Segment, the DOE accounted for $930 thousand or 11.9% of total funded            research and development revenue in 2005, $63 thousand or 12.8% of total funded            research and development revenue in 2006, and $675 thousand or 43.4% of total funded            research and development revenue in 2007. Samsung accounted for $426 thousand or 87.2%            of total funded research and development revenue in 2006 and $448 thousand or 28.9% of            total funded research and development revenue in 2007, while SAFT accounted for $418            thousand or 26.8% of total funded research and development revenue in 2007.

 

Summarized financial information concerning the Company’s            reportable segments is shown in the following table. The “Other” column            includes corporate related items and items such as income taxes or unusual items, which            are not allocated to reportable segments. The “Reconciling Items” column            includes minority interests in a consolidated subsidiary. In addition, segments’            non-cash items include any depreciation and amortization in reported profit or loss.            The new energy segment figures include the Company’s MFC operations, equity            securities of Plug Power, gains on the sale of these securities, and (losses) gains            related to the embedded derivative for the purchase of Plug Power common            stock.

| (Dollars in thousands)                                                                                                                                                              |   |   | **New Energy** |   |   | **Test and**

**Measurement Instrumentation** |   |   | **Other** |   |   | **Reconciling Items** |   |   | **Consolidated Totals** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|----------------|--------|--------|-----------------------------------------------|--------|--------|-----------|--------|--------|-----------------------|--------|--------|-------------------------|--------|
| **Year Ended December 31, 2005**                                                                                                                                                    |   |   |           |   |   |                                          |   |   |      |   |   |                  |   |   |                    |   |
| Product revenue                                                                                                                                                                     |   | $      | —        |   | $      | 6,012                                         |   | $      | —   |   | $      | —               |   | $      | 6,012                   |   |
| Funded research and development revenue                                                                                                                                             |   |   | 1,829          |   |   | —                                       |   |   | —   |   |   | —               |   |   | 1,829                   |   |
| Research and product development expenses                                                                                                                                           |   |   | 8,546          |   |   | 1,125                                         |   |   | —   |   |   | —               |   |   | 9,671                   |   |
| Selling, general and administrative expenses                                                                                                                                        |   |   | 3,772          |   |   | 2,188                                         |   |   | 4,927     |   |   | —               |   |   | 10,887                  |   |
| Gain on securities available for sale                                                                                                                                               |   |   | 10,125         |   |   | —                                       |   |   | —   |   |   | —               |   |   | 10,125                  |   |
| Loss on derivatives                                                                                                                                                                 |   |   | (10,407        | )      |   | —                                       |   |   | —   |   |   | —               |   |   | (10,407                 | )      |
| Segment (loss) profit from continuing operations before                            income taxes, equity in holdings’ losses and minority                            interests |   |   | (13,708        | )      |   | (74                                           | )      |   | (1,167    | )      |   | —               |   |   | (14,949                 | )      |
| Segment (loss) profit                                                                                                                                                               |   |   | (13,708        | )      |   | (74                                           | )      |   | (2,754    | )      |   | 1,442                 |   |   | (15,094                 | )      |
| Total assets                                                                                                                                                                        |   |   | 20,996         |   |   | 1,962                                         |   |   | 18,309    |   |   | —               |   |   | 41,267                  |   |
| Securities available for sale                                                                                                                                                       |   |   | 18,947         |   |   | —                                       |   |   | —   |   |   | —               |   |   | 18,947                  |   |
| Capital expenditures                                                                                                                                                                |   |   | 783            |   |   | 123                                           |   |   | 98        |   |   | —               |   |   | 1,004                   |   |
| Depreciation and amortization                                                                                                                                                       |   |   | 576            |   |   | 69                                            |   |   | 608       |   |   | —               |   |   | 1,253                   |   |

 

 

F-33

 

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**MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

             

             

             

 

| (Dollars in thousands)                                                                                                                                                              |   | **New Energy** |    | **Test and**

**Measurement Instrumentation** |   | **Other** |   | **Reconciling Items** |    | **Consolidated Totals** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|---------|-----------------------------------------------|--------|-----------|--------|-----------------------|---------|-------------------------|--------|
| **Year Ended December 31, 2006**                                                                                                                                                    |   |           |    |                                          |   |      |   |                  |    |                    |   |   |   |   |   |   |
| Product revenue                                                                                                                                                                     |   | $              | — |                                          | $      | 7,667     |   | $                     | — |                    | $      | — |   | $ | 7,667 |   |
| Funded research and development revenue                                                                                                                                             |   |           | 489     |                                          |   | —   |   |                  |    |                    |   | — |   |   | 489 |   |
| Research and product development expenses                                                                                                                                           |   |           | 11,588  |                                          |   | 1,333     |   |                  |    |                    |   | — |   |   | 12,921 |   |
| Selling, general and administrative expenses                                                                                                                                        |   |           | 2,733   |                                          |   | 2,457     |   |                  | 4,882   |                    |   | — |   |   | 10,072 |   |
| Gain on securities available for sale                                                                                                                                               |   |           | 4,289   |                                          |   | —   |   |                  | — |                    |   | — |   |   | 4,289 |   |
| Segment (loss) profit from continuing operations before                            income taxes, equity in holdings’ losses and minority                            interests |   |           | (12,847 | )                                             |   | 662       |   |                  | (795    | )                       |   | — |   |   | (12,980 | ) |
| Segment (loss) profit                                                                                                                                                               |   |           | (12,847 | )                                             |   | 662       |   |                  | (2,690  | )                       |   | 1,208 |   |   | (13,667 | ) |
| Total assets                                                                                                                                                                        |   |           | 15,565  |                                          |   | 2,782     |   |                  | 15,464  |                    |   | — |   |   | 33,811 |   |
| Securities available for sale                                                                                                                                                       |   |           | 10,075  |                                          |   | —   |   |                  |    |                    |   | — |   |   | 10,075 |   |
| Capital expenditures                                                                                                                                                                |   |           | 1,284   |                                          |   | 200       |   |                  | 90      |                    |   | — |   |   | 1,574 |   |
| Depreciation and amortization                                                                                                                                                       |   |           | 604     |                                          |   | 94        |   |                  | 403     |                    |   | — |   |   | 1,101 |   |
|                                                                                                                                                                                     |        |                |         |                                               |        |           |        |                       |         |                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| (Dollars in thousands)                                                                                                                                                              |   | **New Energy** |    | **Test and Measurement Instrumentation** |   | **Other** |   | **Reconciling Items** |    | **Consolidated Totals** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|---------|------------------------------------------|--------|-----------|--------|-----------------------|---------|-------------------------|--------|
| **Year Ended December 31, 2007**                                                                                                                                                    |   |           |    |                                     |   |      |   |                  |    |                    |   |   |   |   |   |   |
| Product revenue                                                                                                                                                                     |   | $              | — |                                     | $      | 9,028     |   | $                     | — |                    | $      | — |   | $ | 9,028 |   |
| Funded research and development revenue                                                                                                                                             |   |           | 1,556   |                                     |   | —   |   |                  | — |                    |   | — |   |   | 1,556 |   |
| Research and product development expenses                                                                                                                                           |   |           | 10,115  |                                     |   | 1,650     |   |                  | — |                    |   | — |   |   | 11,765 |   |
| Selling, general and administrative expenses                                                                                                                                        |   |           | 1,921   |                                     |   | 2,650     |   |                  | 4,167   |                    |   | — |   |   | 8,738 |   |
| Gain on securities available for sale                                                                                                                                               |   |           | 2,549   |                                     |   | —   |   |                  | — |                    |   | — |   |   | 2,549 |   |
| Segment (loss) profit from continuing operations before                            income taxes, equity in holdings’ losses and minority                            interests |   |           | (11,189 | )                                        |   | 789       |   |                  | 2,791   |                    |   | — |   |   | (7,609 | ) |
| Segment (loss) profit                                                                                                                                                               |   |           | (11,189 | )                                        |   | 789       |   |                  | 243     |                    |   | 582 |   |   | (9,575 | ) |
| Total assets                                                                                                                                                                        |   |           | 8,128   |                                     |   | 3,018     |   |                  | 7,570   |                    |   | — |   |   | 18,716 |   |
| Securities available for sale                                                                                                                                                       |   |           | 4,492   |                                     |   | —   |   |                  | — |                    |   | — |   |   | 4,492 |   |
| Capital expenditures                                                                                                                                                                |   |           | 212     |                                     |   | 177       |   |                  | 25      |                    |   | — |   |   | 414 |   |
| Depreciation and amortization                                                                                                                                                       |   |           | 715     |                                     |   | 117       |   |                  | 297     |                    |   | — |   |   | 1,129 |   |

 

The            following table presents the details of “Other” segment (loss) profit for            each of the years ended December 31:

| (Dollars in thousands)                 |   | **2005** |    | **2006** |   | **2007** |   |
|----------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| Corporate and other (expenses) income: |   |     |    |     |   |     |   |   |   |   |
| Depreciation and amortization          |   | $        | (608    | )        | $      | (403     | )      | $ | (297 | ) |
| Interest income                        |   |     | 309     |     |   | 486      |   |   | 413 |   |
| Gain on derivatives                    |   |     | — |     |   | 182      |   |   | 2,967 |   |
| Income tax (expense) benefit           |   |     | (1,587  | )        |   | (1,895   | )      |   | (2,548 | ) |
| Other expense, net                     |   |     | (868    | )        |   | (1,060)  |   |   | (292) |   |
| Total (expense) income                 |   | $        | (2,754  | )        | $      | (2,690   | )      | $ | 243 |   |

 

| **19.** | **Restructuring** |
|---------|-------------------|

 

In            March 2007, the Company announced the suspension of MTI Micro’s high power direct            methanol fuel cell program in response to decreased funding and sales opportunities in            the military market. In connection with this action, the Company accrued restructuring            charges of $344 thousand pre-tax, consisting primarily of cash-based employee severance            and benefit costs related to the reduction of 23 positions within its new energy            segment and Corporate staff. Restructuring expenses were classified as selling, general            and administrative expenses within the Company’s Consolidated Statements of            Operations for the period. As of December 31, 2007, all employees participating in this            reduction in force had been terminated. For the year ended December 31, 2007, the            Company paid $330 thousand in employee severance, benefits and job placement assistance            costs. The remaining accrual at December 31, 2007 was $10 thousand, reflecting a $3            thousand reduction in estimated remaining liability from the Company’s original            restructuring accrual due to benefit elections made by employees participating in this            action. This remaining liability is expected to be paid by the end of the first quarter            of 2008.

 

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