<PAGE>   1

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   FORM 12b-25
                                 SEC FILE NUMBER
                                     0-23634

                           NOTIFICATION OF LATE FILING

<TABLE>
<S>          <C>            <C>            <C>            <C>           <C>
(Check One): |X| Form 10-K  |_| Form 20-F  |_| Form 11-K  |_| Form 10-Q |_| Form N-SAR
</TABLE>

                  For Period Ended:   December 31, 1999
                  [  ]     Transition Report on Form 10-K
                  [  ]     Transition Report on Form 20-F
                  [  ]     Transition Report on Form 11-K
                  [  ]     Transition Report on Form 10-Q
                  [  ]     Transition Report on Form N-SAR

                  For the Transition Period Ended:
                                                  -----------------------------

If the notification relates to a portion of the filing checked above, identify
the Item(s) to which the notification relates:

--------------------------------------------------------------------------------

PART I - REGISTRANT INFORMATION

KFx Inc.
--------------------------------------------------------------------------------
Full Name of Registrant

--------------------------------------------------------------------------------
Former Name if Applicable

1999 Broadway, Suite 3200
--------------------------------------------------------------------------------
Address of Principal Executive Office (Street and Number)

Denver, Colorado USA 80202
--------------------------------------------------------------------------------
City, State and Zip Code

PART II - RULES 12B-25(b) AND (c)

If the subject report could not be filed without unreasonable effort or expense
and the registrant seeks relief pursuant to Rule 12b-25(b), the following should
be completed. (Check appropriate box)

|X|     (a)   The reasons described in reasonable detail in Part III of this
              form could not be eliminated without unreasonable effort or
              expense;

|X|     (b)   The subject annual report, semi-annual report, transition
              report on Form 10-K, Form 20-F, 11-K or Form N-SAR, or portion
              thereof, will be filed on or before the fifteenth calendar day
              following the prescribed due date; or the subject quarterly report
              of transition report on Form 10-Q, or portion thereof will be
              filed on or before the fifth calendar day following the prescribed
              due date; and

|_|     (c)   The accountant's statement or other exhibit required by Rule
              12b-25(c) has been attached if applicable.
<PAGE>   2

PART III - NARRATIVE

State below in reasonable detail the reasons why Forms 10-K, 20-F, 11-K, 10-Q,
N-SAR, or the transition report or portion thereof, could not be filed within
the prescribed time period.

The Registrant is unable to complete the information for the timely presentation
of its Annual Report on Form 10-K for the period ended December 31, 1999 due to
the fact that the Registrant recently consummated a financing for its
subsidiary, Pegasus Technologies, Inc., as reported on its Current Report on
Form 8-K filed with the SEC on March 24, 2000 and is currently negotiating a
sale of the K-Fuel production facility, in which the Registrant owns a 5%
interest, in Gillette, Wyoming.

PART IV - OTHER INFORMATION

<TABLE>
<S>       <C>                                                <C>                                <C>
(1)       Name and telephone number of person to contact in regard to this notification

                         Seth L. Patterson                                (303)                       297-4982
          --------------------------------------------------  --------------------------------  -------------------
                              (Name)                                    (Area Code)              (Telephone Number)

(2)       Have all other periodic reports required under Section 13 or 15(d) of
          the Securities Exchange Act of 1934 or Section 30 of the Investment
          Company Act of 1940 during the preceding 12 months or for such shorter
          period that the registrant was required to file such report(s) been
          filed? If answer is no, identify report(s). |X| Yes |_| No

-------------------------------------------------------------------------------------------------------------------

(3)       Is it anticipated that any significant change in results of operations
          from the corresponding period for the last fiscal year will be
          reflected by the earnings statements to be included in the subject
          report or portion thereof? |X| Yes |_| No

          If so, attach an explanation of the anticipated change, both
          narratively and quantitatively, and, if appropriate, state the reasons
          why a reasonable estimate of the results cannot be made.
</TABLE>

================================================================================


                                    KFx Inc.
--------------------------------------------------------------------------------
                  (Name of Registrant as Specified in Charter)

has caused this notification to be signed on its behalf by the undersigned
hereunto duly authorized.

Date   March 28, 2000                       By   /s/ Seth L. Patterson
     ----------------------                    ---------------------------------
                                               Seth L. Patterson,
                                               Executive Vice President and
                                               Chief Financial Officer



                                       2
<PAGE>   3




The Registrant expects significant changes in its results of operations for the
fiscal year ended December 31, 1999 compared to the fiscal year ended December
31, 1998. Anticipated condensed financial information for these years is
contained in the table below. The changes from 1998 to 1999 reflect increased
revenues and operating expenses for Pegasus, as Pegasus expanded its business,
grew its marketing and sales organization and increased its research and
development activities. The changes also reflect increased revenues and
decreased operating expenses for K-Fuel resulting primarily from a $1 million
K-Fuel license fee and reduced contract revenues and related expenses. The
information below for 1999 is subject to resolution of issues related to the
potential sale of the K-Fuel production facility, as noted in Part III of this
Form 12b-25, and completion of the audit of the Company's 1999 financial
statements.

                                   Twelve Months       Twelve Months
                                      Ended                Ended
                                     12/31/99            12/31/98
                                   -------------       -------------
STATEMENTS OF OPERATIONS

Operating revenues                  $ 3,063,682         $ 2,220,585

Operating loss                      $(7,318,690)        $(6,419,014)

Net loss                            $(8,572,075)        $(6,783,817)

Basic and diluted loss per share          $(.36)              $(.28)



                                       3
<PAGE>   4
                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K
          (Mark One)

         [X]   Annual Report Pursuant to Section 13 or 15(d) of the Securities
               Exchange Act of 1934 For the Fiscal Year Ended December 31, 1999

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

                         Commission file number 0-23634

                                    KFX INC.
             (Exact Name of Registrant As Specified In Its Charter)

             DELAWARE                                    84-1079971
  (State or other jurisdiction of                     (I.R.S. Employer
   Incorporation or organization)                   Identification Number)

              1999 BROADWAY, SUITE 3200, DENVER, COLORADO USA 80202
                    (Address of Principal Executive Offices)

                                 (303) 293-2992
               (Registrant's Telephone Number Including Area Code)

           Securities registered pursuant to Section 12(b) of the Act:

    TITLE OF EACH CLASS                    NAME OF EXCHANGE ON WHICH REGISTERED
Common Stock, $.001 par value                    American Stock Exchange

         Securities registered pursuant to Section 12(g) of the Act: None

     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, 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 is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

     As of April 13, 2000, the aggregate market value of the Registrant's common
stock held by non-affiliates of the Registrant was approximately $33,147,000. At
April, 2000, 24,934,289 shares of common stock of the Registrant were
outstanding.

     DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's
definitive Proxy Statement for the Annual Meeting of Shareholders to be held on
June 22, 2000 are incorporated by reference into Part III.



<PAGE>   5

                                    KFX INC.

                             FORM 10-K ANNUAL REPORT
                      FOR THE YEAR ENDED DECEMBER 31, 1999

                                TABLE OF CONTENTS

                        --------------------------------


<TABLE>
<CAPTION>

                                                                                                              PAGE
                                                                                                               NO.
                                                                                                              ----

<S>           <C>                                                                                            <C>
PART I

Item 1.       Business.....................................................................................    3

Item 2.       Properties...................................................................................   31

Item 3.       Legal Proceedings............................................................................   31

Item 4.       Submission of Matters to a Vote of Security Holders..........................................   32

PART II

Item 5.       Market for Registrant's Common Equity and Related Stockholder Matters........................   33

Item 6.       Selected Financial Data......................................................................   34

Item 7.       Management's Discussion and Analysis of Financial Condition and Results of
              Operations...................................................................................   35

Item 7A.      Quantitative and Qualitative Disclosures About Market Risk...................................   44

Item 8.       Financial Statements and Supplementary Data..................................................   45

Item 9.       Changes in and Disagreements With Accountants on Accounting and Financial
              Disclosures..................................................................................   45

PART III

Item 10.      Directors and Executive Officers of the Registrant...........................................   46

Item 11.      Executive Compensation.......................................................................   46

Item 12.      Security Ownership of Certain Beneficial Owners and Management...............................   46

Item 13.      Certain Relationships and Related Transactions...............................................   46

PART IV

Item 14.      Exhibits, Financial Statement Schedules and Reports on Form 8-K..............................   47

SIGNATURES
</TABLE>




                                       2
<PAGE>   6


                                     PART I

ITEM 1. BUSINESS

OVERVIEW

     KFX Inc. (the "Company" or "KFx"), a Delaware corporation formed in 1988,
is engaged in developing and delivering various technology and service solutions
to the electric power generation industry to facilitate the industry's
compliance with air quality emission standards on a worldwide basis and its
transformation to intensive competition domestically as the United States power
industry undergoes deregulation. Currently, the Company has technology solutions
that enhance the output of coal-fired electric utility boilers while
simultaneously reducing the related environmental impacts and facilitating
compliance with various environmental standards, most importantly the Clean Air
Act, as amended (the "CAA"). The Company currently considers its business to be
in two operating segments, Pegasus Technologies, Inc ("Pegasus") and K-Fuel
Technology ("K-Fuel"), both of which serve the same end industry and provide
similar benefits, but which have distinctly different technology bases. Prior to
the acquisition of Pegasus in 1998, the Company operated only in the K-Fuel
segment.

     Summary financial information about each segment for 1999 and 1998 follows;
for additional segment information see Note 18 to the Consolidated Financial
Statements.

<TABLE>
<CAPTION>

1999                                              Pegasus             K-Fuel
----                                           --------------    --------------

<S>                                            <C>               <C>
Operating Revenues                             $    1,536,884    $    1,313,916
Operating Loss                                 $   (3,266,584)   $   (1,055,085)
Total Assets                                   $    3,452,104    $    9,052,687

1998
----
Operating Revenues                             $    1,328,491    $      892,094
Operating Loss                                 $   (1,234,038)   $   (1,674,101)
Total Assets                                   $    3,230,954    $   11,843,799
</TABLE>

     Pegasus develops, markets, licenses and installs software that optimizes
the combustion performance of coal-fired electric utility boilers. Its
NeuSIGHT(TM) flagship product has been installed at 12 boiler units and is under
installation or is scheduled to be installed at 15 boiler units, across the
United States and Canada. NeuSIGHT utilizes an artificial intelligence/neural
network software platform licensed from Computer Associates International to
interface with the process control system in coal-fired electric utility boiler
units. NeuSIGHT collects real time operating data and builds a model of optimal
boiler combustion performance, taking into account various safety, environmental
and other constraints. NeuSIGHT can be set to optimize the reduction of various
emissions (such as nitrogen oxide ("NOx")), a boiler's heat rate (a measure of
boiler operating efficiency considering fuel consumed in comparison to
electricity generated) and/or other boiler performance measures. NeuSIGHT
provides the most benefit when operated in a closed loop mode, whereby automatic
adjustments are made to various controllable factors, such as oxygen input.
Pegasus is continuously pursuing the development of improvements to NeuSIGHT as
well as complementary new products and services. Although not currently a



                                       3
<PAGE>   7


product development or marketing focus, NeuSIGHT is expected to be adaptable to
various non-coal fired boiler units as well.

     The Company's K-Fuel segment has developed and begun commercialization of
its patented K-Fuel Technology, which is a process technology that uses heat and
pressure to physically and chemically transform high-moisture, low-energy value
coal and other organic feedstocks into a low-moisture, high-energy solid clean
fuel ("K-Fuel"). The K-Fuel Technology is generally referred to as a coal
beneficiation process, which refers to processes intended to produce, using
run-of-mine coal as feedstock, fuels with improved energy and environmental
values. The principal benefit of the K-Fuel Technology is that the fuel produced
from the process can facilitate the efforts of electric power producers and
other large-scale users of coal to meet the clean air standards imposed by the
CAA. Based on various analyses, the environmental benefits of burning K-Fuel
versus most other coals appear to include significant reductions in emissions of
NOx, sulfur dioxide (SO(2)), carbon dioxide (CO(2)), mercury and chlorine. KFx
plans to license K-Fuel Technology domestically and internationally to various
parties wishing to construct and operate K-Fuel production facilities. In
addition, KFx expects to hold equity interests in selected K-Fuel production
facilities. K-Fuel operations are conducted through KFx Inc. and certain of its
subsidiaries.

     The Company will continue to consider various options to expand its
business by adding other solutions (technologies, products and services) to meet
(a) the needs of the electric power industry as it is transformed by
deregulation into a highly competitive industry and (b) the increasingly
stringent environmental standards triggered by indications of global warming and
other environmental concerns.

     Although the Company is pursuing various international opportunities in
both segments, during each of the three years ended December 31, 1999, most of
the Company's operating activities was conducted domestically. However, certain
Canadian customers of Pegasus generated revenues approximating $224,000 and
$166,000 in 1999 and 1998, respectively.

PEGASUS

GENERAL

     In March 1998 the Company purchased a 60% interest in Pegasus Technologies
Limited, an Ohio limited liability company, (Pegasus Limited). Pegasus Limited
had developed a software technology that optimizes the performance of coal-fired
electric utility boilers. Pegasus' flagship product, NeuSIGHT, provides two
primary benefits: improved combustion performance and reduction in NOx
emissions. NOx is a primary component of ground level smog. See "Market
Drivers--Domestic Market." Additional benefits of NeuSIGHT include (a)
improvements in boiler efficiency (heat rate), which translates into lower fuel
costs, as well as lower emissions of SO(2) and CO(2); (b) an increase in gross
generating capacity, providing more electricity for the power company to sell;
(c) lower carbon in the ash waste by-product, which can convert a related waste
product disposal cost into a marketable ash product; and (d) improvements in
opacity, which refers to the visible exhaust discharged from an emissions stack.



                                       4
<PAGE>   8

     NeuSIGHT dynamically models in real time the operating conditions of the
electric utility boiler combustion process and makes alterations to operating
variables, which improve boiler heat-rate performance, reduce harmful emissions
and lower fuel costs. Maximum benefits are achieved by allowing NeuSIGHT to
operate in closed loop mode wherein its alterations to operating variables are
automatically invoked.

         In August 1998, the Company formed Net Power Solutions, LLC ("NPS"), a
Delaware limited liability company, primarily to provide marketing and sales
services to Pegasus Limited. From late 1998 through November 30, 1999, NPS hired
and trained a marketing and sales staff, developed marketing programs and
materials and generally performed the sales and marketing for Pegasus Limited.
Pursuant to an Agreement dated December 13, 1999, the members of Pegasus Limited
and NPS including the Company, exchanged their membership interests in Pegasus
Limited and NPS for shares of common stock of a new company, Pegasus
Technologies, Inc., effective November 30, 1999. At November 30, 1999 and
December 31, 1999, 75% of the outstanding common stock of Pegasus Technologies,
Inc. was held by KFx, with the 25% balance held by Pegasus management.
Hereafter, references to Pegasus include the activities of Pegasus Limited and
NPS prior to this exchange, as well as the subsequent activities of Pegasus
Technologies, Inc. and its subsidiaries.

     On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott
Energy Company ("Kennecott Energy") resulting in (a) the sale of 4% of the
common stock of Pegasus held by KFx ("Pegasus Common Stock") to Kennecott Energy
for $1,000,000, (b) the issuance by Pegasus to Kennecott Energy, in exchange for
$500,000, of newly authorized 6% cumulative convertible preferred stock
("Pegasus Preferred Stock") equivalent to an additional 2% interest in Pegasus
on an as converted basis, (c) the joint development by KFx, Pegasus and
Kennecott Energy of a work plan for enhancements to NeuSIGHT, new product
development and the completion of other tasks designed to improve the
performance of Pegasus and trigger additional purchases of Pegasus Preferred
Stock by Kennecott Energy of up to $3,500,000, for an additional interest in
Pegasus up to 14%, on an as converted basis, by December 31, 2004 or earlier and
(d) the conversion of secured debt owed by Pegasus to KFx, totaling $3,630,000,
into Pegasus Preferred Stock, at the same price as provided to Kennecott Energy.
As a result of this transaction, at April 13, 2000, the ownership of Pegasus is
approximately as follows: KFx--74%, Pegasus management--20% and Kennecott
Energy--6%. Kennecott has the right to sell the Pegasus Common Stock back to KFx
at any time before March 3, 2001 at a price equal to the greater of $1,000,000
or fair market value.

     In connection with the March 2000 transaction, Pegasus and Kennecott Energy
also formed a 50/50 Colorado limited liability company, Net Power Solutions, LLC
("Net Power Solutions") to facilitate the combined marketing, on a non-exclusive
basis, of technologies, products and services that can be provided by Kennecott
Energy, Pegasus, KFx and other potential parties.

     In the fourth quarter of 1999, Pegasus released (a) the new 5.0 version of
its flagship NeuSIGHT product that is expected to facilitate quicker and more
cost effective installations and provide other benefits to clients and (b)
Performance Calculation Tool(TM), an add-on module to NeuSIGHT that allows power
station engineers to create and run performance calculations, such as heat rate,
without the need to know a specific programming language. During 1999 and 1998




                                       5
<PAGE>   9

Pegasus research and development expenses totaled $335,766 and $138,335,
respectively. Kennecott Energy's investment in Pegasus is expected to accelerate
enhancements to NeuSIGHT, the development of new products and services and other
improvements in the operations of Pegasus in 2000 and beyond, and
correspondingly increase research and development expenses.

     As of March 31, 2000, Pegasus has firm unfilled sales commitments (backlog)
for 18 NeuSIGHT licenses and related installations at an estimated contract
value of $2,485,000, which are generally expected to be filled within
approximately the next 12-18 months. At March 26, 1999, such backlog
approximated $1,263,000 for 12 NeuSIGHT licenses and completion of related
installation services.

     During 1999, two individual clients, Carolina Power & Light, and Houston
Light & Power accounted for greater than 10%, each, of consolidated revenues (19
and 11, respectively%). During 1998, three individual clients accounted for
greater than 10%, each, of consolidated revenues, Houston Light & Power, Union
Electric, and Cinergy (22%, 13%, and 10%, respectively). Although the existence
of such major clients is partly a result of Pegasus' limited customer base,
management also believes it is an indication of the level of client satisfaction
with Pegasus products and services since these relationships involve multiple
license and installation contracts and three of the same clients are included in
both years' statistics.

STRATEGIC RELATIONSHIPS

     In March 1999 Pegasus executed an agreement with Science Applications
International Corporation (SAIC) providing SAIC with certain exclusive rights to
install NeuSIGHT software, as a subcontractor to Pegasus, in North America.
Under the terms of the agreement, SAIC has the right to perform NeuSIGHT
installations related to Pegasus license sales that Pegasus elects not to
perform with its own staff. Subject to certain termination provisions covering
performance and other matters, the agreement expires after SAIC completes 30
installations of NeuSIGHT or three years, whichever occurs first. In exchange
for certain services, investments and preferred billing rates by SAIC, the
agreement also provides for a 50/50 sharing of gross profits from the
installation services provided by SAIC to Pegasus customers under the agreement.
Through December 31, 1999, no payments to SAIC or related accruals have been
required under these profit sharing provisions.

     During the first quarter of 2000, Pegasus entered into value added reseller
("VAR") agreements with Babcock & Wilcox ("B&W") and ABB Centrum ("ABB"). The
VAR agreements grant non-exclusive resale rights for NeuSIGHT and related
installation services to B&W on a worldwide basis and to ABB for Poland, Hungary
and the Czech Republic. Minimum license purchases during the initial one year
terms of these VAR agreements require payments to Pegasus through February 2001
totaling $452,000. The VAR agreements are for one-year renewable terms and
contain provisions preventing competition with Pegasus, requiring Pegasus to
provide certain training and granting preferred pricing to B&W and ABB. Pegasus
will pursue additional VAR arrangements with appropriate parties as a means to
quickly and cost effectively gain access to potential customers.



                                       6
<PAGE>   10

INTELLECTUAL PROPERTY

     NeuSIGHT utilizes a neural network technology licensed from a subsidiary of
Computer Associates International (CA) under an agreement which, among other
terms, grants Pegasus Limited a perpetual, irrevocable, world-wide, exclusive
right and license for use in process monitoring and control applications in the
electric utilities industry. Payments are made to CA for each neural network
license sold, one of which is required for each NeuSIGHT installation. Through
August 1999, CA was also a 15% owner of Pegasus Limited, at which time CA sold
such interest to KFx in exchange for 527,000 common shares of KFx. The
programming code that constitutes NeuSIGHT is a trade secret.

COMPETITION

     Pegasus faces competition from several companies that offer software
products providing combustion optimization benefits to the electric power
industry. Management believes the NeuSIGHT software solution offers several
competitive advantages over competitor's offerings. Most significantly, in an
independent study completed in December 1998, NeuSIGHT has been documented as
providing greater benefits than competing products in the areas of NOx reduction
and heat rate improvement. In addition, NeuSIGHT has demonstrated an ability to
operate in closed-loop supervisory mode for extended time periods without
intervention. NeuSIGHT's neural network model is considerably more extensive and
therefore more effective than competing products, through its ability to manage
higher volumes of input variables (up to 7 times the level of competing
products). While NeuSIGHT's neural network models are sophisticated and complex,
the software has a unique capability to retrain the model automatically as
operating conditions change in the plant. Competing product models are generally
static and require periodic re-tuning, making them more costly to maintain and
less effective over time. In management's opinion, these and other features
provide a much greater ability for the software to adapt to changing
environmental conditions, equipment degradation, instrument calibration drift,
and operating variances.

     In the opinion of management, compared with competing companies, Pegasus
provides more extensive implementation and training programs that result in an
end product more closely correlated to the actual operating conditions of the
specific boiler unit. Pegasus is focused exclusively on the needs of the
electric power generation industry rather than serving various industries with
differing needs. This focus, coupled with the expertise of its personnel in this
market, enable Pegasus to deliver solutions that provide significantly greater
reductions in NOx, higher levels of operating efficiency and other benefits not
provided by competitors. Competing products tend to emphasize price as their
basis of comparison, while Pegasus is focused on cost benefit analysis and
return on investment. While Pegasus believes it is the leader in the industry,
based on the number of installed systems in the electric power generation
industry, certain competing companies may have greater financial and other
resources. In addition, Pegasus may face new competition from other vendors to
the electric power generation industry, many of which have significantly greater
financial and other resources than Pegasus.



                                       7
<PAGE>   11

K-FUEL TECHNOLOGY

GENERAL

     The K-Fuel Technology is comprised of three groups, or Series, of patents.
The Series "A" and Series "B" Technology patents are based on hot gas and steam
heat-transfer mediums, respectively. The Series "C" Technology is based on a
nitrogen heat-transfer medium. The principal difference between the Series "A"
and "B" Technologies and the Series "C" Technology is that Series "C" is based
on a more simplified design with respect to the manufacturing equipment and
facilities, resulting in lower capital costs. The Company expects the Series "C"
Technology to be primarily used for coal fuel product-manufacturing facilities.
The Series "A" and "B" Technologies can also be used for coal fuel product
facilities, but the Company expects they may be more likely used for renewable
resource fuel product manufacturing facilities (e.g., bagasse, municipal solid
waste, sludge and wood waste). The Series "A" and "B" Technology patents were
developed by Edward Koppelman and assigned to the Company under a research and
development contract (the "R&D Contract") with the Company. The Company
purchased the Series "C" Technology patent directly from Mr. Koppelman after
completion of the R&D Contract. The Company is currently focusing its
commercialization efforts on the development of projects for the manufacture of
coal fuel product using the Series "C" Technology. To date, one commercial-scale
K-Fuel manufacturing facility has been constructed, which began operations in
April 1998 and suspended operations in June 1999. See "Strategic
Relationships--Thermo Ecotek Corporation and KFx Fuel Partners" in this section.
The development of future K-Fuel manufacturing facilities is expected to result
primarily in the near term from the K-Fuel, LLC joint venture with Kennecott
Energy. See "Strategic Relationships-Kennecott Energy Company" in this section.

     In the Series "C" process, raw coal is crushed and screened before it is
introduced into a steel alloy processing vessel that is then pressurized and
heated indirectly using vertical tube heat exchangers. Nitrogen, serving as an
inert, non-oxidizing heat-transfer medium, is admitted to the tube side of the
processing vessel at a pressure of approximately 125 pounds per square inch
("psi"). After the nitrogen is inserted, it picks up heat from the walls of the
tube and gradually expands to approximately 800 psi. Water is released from the
coal during this expansion period. When the temperature in the tubes reaches in
excess of 520 degrees Fahrenheit, any water remaining in the coal turns to steam
and continues to process the raw coal. When the temperature of the coal reaches
approximately 650 to 740 degrees Fahrenheit, the process is complete. The
process takes 30 to 40 minutes to complete from initial loading of the raw coal
into the processing vessels to final discharge of finished K-Fuel product.

     The principal benefit of the K-Fuel Technology in the United States is that
the fuel produced from the process can facilitate the efforts of electric power
producers, manufacturers and other large-scale users of coal to meet the clean
air standards imposed by the CAA. Based on various independent and Company
analyses, the environmental benefits of burning K-Fuel versus most other coals
appear to include significant reductions in emissions of NOx, SO2, carbon
dioxide (CO2), mercury and chlorine. K-Fuel is the first beneficiated coal
product that has not exhibited any significant signs of spontaneous combustion.
In addition, K-Fuel has been demonstrated to increase gross power generation,
reduce fuel-pulverizing requirements, blend well with other




                                       8
<PAGE>   12

coals and flow well through coal handling systems. K-Fuel has exhibited a level
of dustiness that requires the use of dust suppression equipment on site at most
domestic coal-fired power plants. Efforts are underway to determine ways in
which dust can be reduced.

     In May 1998, the Southern Research Institute conducted a test burn of
approximately 10 tons of K-Fuel, which was also overseen by a technical services
affiliate of Kennecott Energy. The results of this test burn are summarized in
the table below:

<TABLE>
<CAPTION>

                                                                                      EMISSIONS (PPM)
                                                                   BTU          (CORRECTED TO 3% O2 DRY BASIS)
                                                              (AS RECEIVED)          NOX            SOX
                                                              -------------     -------------    ---------------
<S>                                                          <C>                  <C>           <C>
K-Fuel ..............................................            11,703               142               173
Dry Fork Subbituminous ..............................             8,903               172               215
Lone Mountain Bituminous ............................            13,315               265               530
</TABLE>

     In February 1999, the first commercial burn of K-Fuel was completed. A unit
train (approximately 12,000 tons of K-Fuel produced at the KFP Facility; see
"Strategic Relationships--Thermo Ecotek Corporation and KFx Fuel Partners" in
this section) was burned at Indiana-Kentucky Electric Corporation's Clifty Creek
generating station in southern Indiana. A fuel blend of approximately 60%
K-Fuel, with the balance consisting of a blend of high-Btu, high and low-sulfur
Eastern coals, replaced relatively low-Btu, low-sulfur southern Powder River
Basin ("PRB") coal in one of the station's boiler units. Initial results of the
test burn indicate that K-Fuel appeared to produce: a) a reduction in NOx
emissions while maintaining full load yet reducing auxiliary power, b) no
unusual slagging or fouling of the boiler, c) a reduction in the fuel
pulverizing operations, d) no spontaneous combustion and e) an improvement in
boiler efficiency. Indiana-Kentucky Electric's fuel is procured by American
Electric Power ("AEP").

     The results from this commercial scale burn at Clifty Creek generally
confirm the results of the test burn performed by the Southern Research
Institute. The Company believes that K-Fuel produced a reduction in SO2 and
CO2 emissions but the plant instrumentation precluded clear quantification.
The handling characteristics of K-Fuel were acceptable with proper use of the
power station's existing dust suppressant system. KFx is working to improve the
handling characteristics of K-Fuel.

     One of the Company's subsidiaries has a contract with Western Research
Institute, a non-profit research organization based in Laramie, Wyoming, to
perform research related to the K-Fuel technology. During 1998 revenues from
this contract approximated 15% of consolidated revenues. Such revenues in 1999
were less than 10% of consolidated revenues. The costs under this research
contract and costs related to various support services provided by the Company
to KFP in connection with the development, start-up and operations of the KFP
Facility approximated $414,000, $889,000, and $1,251,000 in 1999, 1998 and 1997,
respectively.

STRATEGIC RELATIONSHIPS

     Kennecott Energy Company and K-Fuel, LLC. In April 1996, the Company
entered into a joint venture agreement (the "Kennecott Agreement") with a
wholly-owned subsidiary of




                                       9
<PAGE>   13
Kennecott Energy Company ("Kennecott Energy"). The joint venture, a Delaware
limited liability company named K-Fuel, L.L.C. ("K-Fuel, LLC"), is expected to
be the vehicle for further technical advancement and the commercialization of
business opportunities arising out of the K-Fuel Technology, including research
and development, sublicensing, marketing and consulting, but not including the
construction of facilities to produce K-Fuel products on a commercial basis
("Commercial Projects"). Any Commercial Projects will be constructed by separate
entities in which Kennecott Energy, the Company or both will have an equity
interest and which will be granted a sublicense from K-Fuel, LLC for the K-Fuel
Technology. In 1996 Kennecott Energy paid a fee of $1 million to the Company to
enter into the K-Fuel, LLC joint venture. In June 1999, in connection with
certain amendments to the Kennecott Agreement, Kennecott Energy paid to KFx a
non-refundable $1,000,000 payment that can be applied only toward the grant of a
future K-Fuel license to Kennecott Energy and an additional $1,000,000, that KFx
was required to invest in K-Fuel, LLC to support the next phase of K-Fuel
commercialization. Any technology related to the Company's technology developed
through the Work Plan funded by the $1,000,000 investment in K-Fuel, LLC will be
owned by Kennecott Energy and licensed free of charge to K-Fuel LLC. The non
refundable payment related to a future K-Fuel license accounted for 35% of
consolidated revenues in 1999. As of April 14, 2000, there were no commitments
to construct any Commercial Projects.

     The Company has a 51% percent interest in K-Fuel, LLC and Kennecott Energy
has a 49% interest. At such time as entities in which Kennecott Energy has an
equity interest have placed into service Commercial Projects with a collective
design capacity equal to or in excess of 3 million tons per year ("TPY") of
K-Fuel product, Kennecott Energy's interest in K-Fuel, LLC will increase to 51%
and the Company's interest will decrease to 49%. During 1999, 1998 and 1997,
Kennecott Energy incurred related research and development costs totaling
approximately $141,000, $51,000 and $879,000, respectively, in connection with
certain commitments to K-Fuel, LLC.

     If Kennecott Energy has not, by December 31, 2006, approved for
construction Commercial Projects in which Kennecott Energy will have an equity
interest having a design capacity equal to 1 million TPY of K-Fuel product, then
the Company may purchase Kennecott Energy's interest in K-Fuel, LLC for a
purchase price equal to: (a) 100% of the aggregate amount expended on third
party costs; and (b) 75% of the aggregate amount charged for internal Kennecott
Energy costs incurred under any Work Plan, plus a reasonable return on such
amounts. The Company waived this purchase right in connection with Kennecott
Energy's investment in Pegasus in March 2000.

     In connection with the Kennecott Agreement, the Company granted K-Fuel, LLC
an exclusive, worldwide, fully-paid, royalty-free right and license (including
the right to grant sublicenses) to and under the K-Fuel Technology, except to
the extent that it pertains to the beneficiation or restructuring of coal or
coal-related feedstocks and related improvements covered under the Heartland
Fuels Corporation License (as defined below) (the "KFx License"). In addition,
Heartland Fuels Corporation, an 85%-owned subsidiary of the Company, granted
K-Fuel,



                                       10
<PAGE>   14


LLC an exclusive, worldwide, fully-paid, royalty-free right and license
(including the right to grant sublicenses) to and under the Series "A" and
Series "B" K-Fuel Technology, as it pertains to the beneficiation or
restructuring of coal or coal-related feedstocks (the "HFC License"). Both the
KFx License and the HFC License specify minimum terms and provisions for any
sublicenses granted by K-Fuel, LLC to third parties.

     Under the Kennecott Agreement, as amended, with respect to future
Commercial Projects to be licensed by K-Fuel, LLC to entities wholly or
partially owned by Kennecott Energy, the Company is entitled to a one-time
license fee approximating $3 per ton of annual design capacity of each project,
times Kennecott's percentage of beneficial ownership, to be paid one-half at the
time the license is granted, with the remaining one-half paid over a period of
three years beginning when the project begins commercial operations. The Company
will also receive a production royalty, to be paid each calendar quarter,
depending on certain levels of the project's selling price per ton of coal
product. With respect to the non-Kennecott Energy portion of production capacity
and production of Commercial Projects in which Kennecott Energy has less than
100% beneficial ownership, the Company is entitled to similar, but higher,
license fees and royalty payments. Such higher license fees and royalty payments
also apply to 100% of the production capacity and production of Commercial
Projects in which Kennecott Energy has no beneficial ownership. In addition, the
Company will be entitled to additional payments based on a percentage of the
excess of (1) annual cash revenue from each project, or (2) annual pre-tax cash
operating costs of each project plus an annual capital charge ("Bonus Royalty")
related to each project. Kennecott Energy has the right to fund 100% of
Commercial Projects that it approves, subject, however, to the Company's right
to fund up to 50% of such projects on the same economic terms as Kennecott
Energy.

     Thermo Ecotek Corporation and KFx Fuel Partners. In August 1995, the
Company entered into a Stock Purchase Agreement (the "Stock Purchase
Agreement"), with Thermo Ecotek Corporation ("TCK"), a Massachusetts-based
company traded on the American Stock Exchange. At that time the Company and TCK
also entered into a separate agreement to construct and operate a 500,000 TPY
commercial-scale K-Fuel production facility.

     Under the Stock Purchase Agreement, in 1995 TCK purchased 3 million shares
of KFx $.001 par value common stock ("Common Stock") for $6 million, or
approximately 14% of the outstanding Common Stock as of December 31, 1996, and
in 1997 purchased an additional 1.25 million shares of Common Stock for $2.5
million, increasing its ownership to approximately 18% of the outstanding Common
Stock. As part of the transaction TCK was also granted (i) a warrant ("Warrant
A") to purchase an additional 7,750,000 shares of Common Stock (subject to
certain adjustments) at an exercise price of $3.65 per share, exercisable on
January 1, 2000 and expiring July 1, 2001; and (ii) a warrant ("Warrant B"),
that gives it the right to purchase the number of shares of Common Stock (at the
then prevailing market price) that, when added to all shares owned by TCK on the
exercise date, including any shares acquired by the exercise of Warrant A, would
be sufficient to give TCK 51% of the outstanding Common Stock, on a fully
diluted basis. Warrant B has the same exercise and termination dates as Warrant
A, but is not exercisable unless Warrant A is fully exercised. TCK has agreed
to cancel two warrants pursuant to agreements entered into on April 12, 2000,
as discussed below.



                                       11
<PAGE>   15

     In August 1995, the Company and TCK, acting through respective wholly-owned
subsidiaries, formed KFX Fuel Partners, L.P. ("KFP"), a Delaware limited
partnership, and began construction of a 500,000 TPY K-Fuel coal production
facility (the "KFP Facility") near Gillette, Wyoming using the Company's Series
"C" K-Fuel Technology. The Company has a 5% interest in KFP, with the remaining
95% held by TCK. TCK is the managing general partner for KFP and makes all
day-to-day operating decisions. In addition to its 5% ownership of KFP, the
Company has the right to receive a production royalty of 3 percent of the gross
sales of KFP, payable quarterly. See "Patents, Licenses and Royalty Agreements."

     KFP began operations at the KFP facility in April 1998 and completed a
successful test burn in May 1998 and a successful commercial burn in February
1999, as discussed above. The KFP facility operated and produced commercially
salable product in 1998 and 1999 and KFP addressed certain problems previously
encountered, including a 1996 fire at the facility and certain construction
problems, including issues relating to the flow of materials within the facility
and the design and operation of certain pressure release equipment.
Nevertheless, KFP continued to experience certain problems relating to tar and
fines residue build-up within the system during production and product quality
issues related to product dusting. On May 24, 1999, TCK announced that in
connection with certain strategic restructuring decisions made by TCK and its
parent, Thermo Electron Corporation, it had decided to hold for sale its
investment in the KFP Facility and record charges related thereto. Further, TCK
in June 1999 suspended operations at the KFP Facility and K-Fuel is not
currently being produced.

     On April 12, 2000 the Company executed agreements with various parties that
initiate the redevelopment of the KFP Facility. Pursuant to the agreements, if
all conditions to closing are met, (a) a subsidiary of Black Hills Corporation
(BHK) will purchase the KFP Facility and receive 2 million shares of KFx common
stock previously held by TCK in exchange for the assumption of the reclamation
liability associated with the KFP Facility, (b) BHK will be given the right to
one seat on KFx's board of directors and KFx will grant BHK a warrant to
purchase 1.3 million shares of KFx common stock at $3.65 per share, subject to
certain adjustments, (c) KFx will relinquish its 5% interest in KFP and provide
certain releases in exchange for cash proceeds estimated at $1.5 million, will
retain its 5% royalty right and certain real and personal property and has
negotiated a revenue-based service fee, (d) TCK will sell the remaining 2.25
million common shares of KFx it owns to private investors and cancel the
warrants it holds to purchase a control position in KFx's common stock. KFx and
BHK are proceeding to finalize plans and secure the necessary capital to rectify
certain design flaws in the balance-of-plant systems, including the addition of
an incinerator to eliminate certain process waste streams, and to modify the
plant to replace natural gas with waste coal as the facility's energy source.
The cost to implement these plans is estimated at $10 million to $12 million. If
efforts to finalize plant modification plans and secure related capital are not
successful by August 2000, BHK has the option to salvage the equipment and
reclaim the site. The terms of the agreements provide for closing of these
transactions not later than April 28, 2000. The carrying value of the Company's
investment in KFP has been written down effective December 31, 1999 by $1.8
million, to the $1.5 million near term cash proceeds expected if these
transactions close.

     During 1998 and through mid 1999 the Company, in conjunction with K-Fuel
LLC, performed certain marketing activities for KFP, for which the Company was
reimbursed. During


                                       12
<PAGE>   16


1998 certain support service provided by a subsidiary of KFx to KFP approximated
25% of consolidated revenues; such services in 1999 were less than 10% of
consolidated revenues.

     The KFP Facility qualifies for a production tax credit available under
Section 29 of the United States Internal Revenue Code entitled "Credit for
Producing Fuel From a Nonconventional Source" ("Section 29"). Section 29, which
was originally adopted in 1980, provides a tax credit to the producer of fuel
from alternative sources. The credit is equal to $3.00 in 1979 dollars for each
barrel equivalent of crude oil ("OBE"), which is defined as 5.8 million Btu.
Section 29 contains provisions requiring a phase out of the credit that begins
as the reference price of oil (the average price of oil for the year as
announced by the Secretary of the Treasury) exceeds $47.90 per barrel (in 1998
dollars, the latest available information) and is fully phased out if the
reference price exceeds $60.13 (in 1998 dollars). For 1998 the reference price
of oil was $10.88 per barrel. Section 29 applies to qualified fuels which are
produced in a facility placed in service before July 1, 1998 pursuant to a
binding written contract in effect before January 1, 1997, and which are sold
after December 1992 and before January 2008. Calculated in 1998 dollars, the
current tax credit value ranges from $24.75 to $26.36 per ton of the K-Fuel
product (based on a range of K-Fuel Btu content from 11,500 to 12,500 Btu per
pound). The credit per OBE and the phase-out prices for oil are adjusted
annually for inflation. TCK and the Company believe that the KFP Facility meets
the requirements to qualify for Section 29 tax credits. If the KFP Facility were
to be determined to not qualify for the Section 29 tax credit, the ability to
generate an acceptable rate of return from the KFP Facility would be materially
adversely affected.

     Other than alternative minimum tax provisions, generally there is no
provision for carrybacks or carryovers in the event the taxpayer cannot use the
entire alternative fuel production credit available for the taxable year. There
are also no recapture provisions that apply to this credit. The Company is
currently unable to directly utilize any Section 29 tax credits derived from its
5% ownership of KFP because of its cumulative net operating loss carryforward.

PATENTS, LICENSES AND ROYALTY AGREEMENTS

     The Company has patents or patent applications for the K-Fuel Technology
registered in the United States and over 40 foreign countries, including all
major industrialized countries that either have significant reserves of
high-moisture lignite or subbituminous coal, or that are readily accessible to
such reserves via large-scale transportation infrastructure (primarily ocean
barge vessels). Included in the pending patent applications are inventions
developed by the Company as well as seven improvement patent applications
assigned to the Company as a result of the K-Fuel, LLC research activities.

     The only licenses the Company has granted for use of the K-Fuel Technology
are to the KFP Facility (Series "C"), K-Fuel, LLC (Series "C"), and Heartland
Fuels Corporation ("HFC") (Series "A" and "B"). The Company owns 85% of the
common stock of HFC, and as a condition of the Kennecott Agreement, the Company
caused HFC to grant to K-Fuel, LLC an exclusive sublicense to the Series "A" and
"B" Technologies.



                                       13
<PAGE>   17

     A predecessor entity of the Company acquired the Series "A" and "B"
Technologies from Edward Koppelman and other investors (the "Koppelman Group")
in 1984 for $10 million in cash and a royalty agreement of $90 million. In June
1996, the Company entered into a royalty amendment agreement with Edward
Koppelman, the inventor of the K-Fuel Technology. Prior to the agreement, Mr.
Koppelman was entitled to a royalty of 2 percent on the gross sales value of
K-Fuel product produced by any entity, including any product produced by the
Company. As a result of the amended agreement, Mr. Koppelman's royalty is now 25
percent of the Company's worldwide royalty and license fee revenue, computed
after the State of Wyoming's royalty (noted in the table below). The royalty to
Mr. Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. As consideration for the royalty amendment agreement,
the Company paid Mr. Koppelman $300,000 cash and issued a promissory note for
$200,000. See Note 9 to the consolidated financial statements, which begin on
page F-1. The resulting $500,000 prepaid royalty is being amortized based on the
difference between what royalty payments to Mr. Koppelman would have been on the
original royalty agreement and the amended royalty agreement reached in 1996.
Also as part of the royalty agreement, Mr. Koppelman indemnified the Company for
any claims made by the Koppelman Group.

     The following table summarizes the Company's royalty obligations to various
third parties based on licensing and royalty revenues received by the Company
and the geographic source of the revenues:

<TABLE>
<CAPTION>

                                                       UNITED                                 EXPIRATION DATE OR
                    ROYALTY OBLIGATION                 STATES         INTERNATIONAL              MAXIMUM AMOUNT
                    ------------------                 ------         -------------           -------------------

<S>                                                  <C>             <C>                    <C>
Estate of Edward Koppelman..................         25 Percent(1)     25 Percent               $ 75,222,000
State of Wyoming............................         12 Percent(2)       NA--None               $  5,000,000(2)
Fort Union Ltd..............................         20 Percent(3)   Canada, Mexico         Earlier of cumulative
                                                                                              royalties paid of
                                                                                                $  1,500,000 or
                                                                                             September 15, 2015
Ohio Valley Electric........................        0.5 Percent(4)       NA--None                    None
</TABLE>


---------

(1)  Computed after the State of Wyoming's royalty, and applies to both license
     fees and royalties.

(2)  The royalty percentage decreases to 6 percent when $5,000,000 has been
     paid. There is no expiration date or maximum amount on the remaining 6
     percent, and applies to both license fees and royalties.

(3)  Applies to royalties only and is also applicable to any production in
     Canada or Mexico.

(4)  Applies to revenues derived from the sale of K-Fuel only and does not
     include the plant constructed in 1996 by KFP.

COMPETITION

     To the best of the Company's knowledge, there are currently no competitors
producing significant commercial quantities of beneficiated clean coal fuel
products either in the United States or in international markets. However, there
are other clean coal technology ("CCT") companies, primarily in the United
States, that are developing fuel combustion and product



                                       14
<PAGE>   18


technologies that would reduce emission pollutants and/or increase the heating
value of coal feedstock fuel sources. Many of these CCT competitors have greater
financial, technical and operational resources than the Company. To the best of
management's knowledge, however, none of these other efforts have yet resulted
in an economically viable and commercially acceptable beneficiated coal product
with the economic and commercial potential of K-Fuel.

     In the United States market, the Company must also compete with other
naturally low-sulfur coals. Also, sulfur dioxide emission credits ("emission
credits") allow non-compliance users of higher sulfur coal to bundle coal
purchases with these emission credits to meet the CAA requirements. Because of
an over-compliance situation that has developed in Phase I of the CAA, prior to
December 31, 1999 there was an abundant supply of emission credits in the U.S.
market. The impact of Phase II implementation of the CAA, which began in January
2000 is not yet determinable. Additionally, existing supplies of naturally
low-sulfur coal are continually being depleted.

     The Company is not able to predict the impact that competing coal
beneficiation technologies, the availability and pricing of low-sulfur coal
reserves or the availability and pricing of emission credits will have on the
future competitive position of the Company. To the best of the Company's
knowledge however, none of its competitors have been able to demonstrate as many
quantifiable and potential benefits in a commercial setting as K-Fuel achieved
in February 1999 at Indiana-Kentucky Electric Corporation's Clifty Creek
generating station in southern Indiana. Management believes that this is a
significant competitive advantage.


OTHER

     Indonesia In September 1995, KFx Indonesia, a joint venture between the
Company and RCD Development, a Maryland partnership ("RCD"), entered into a
Memorandum of Understanding with PT Tambang Batubara Bukit Asam ("PTBA"), an
Indonesian state-owned coal-mining company, to jointly undertake a feasibility
study on the commercialization of the K-Fuel Technology in Indonesia using
PTBA's high-moisture coal as feedstock. Kennecott Energy, through its interest
in K-Fuel, LLC, subsequently participated in the feasibility study. In 1996, KFx
Indonesia, Kennecott Energy and PTBA completed the feasibility study and
identified a potential K-Fuel project on the southern portion of the Indonesian
island of Sumatra ("Indonesia Project"). The proposed Indonesia Project is an
approximately 1.5 million metric ton-per-year ("MTPY") facility, with an
estimated development and construction cost of approximately $160 million,
including approximately $21 million to develop an existing coal reserve of PTBA
estimated at approximately 180 million metric tons. The Company expects to have
no direct financial ownership in the initial Indonesia Project other than
license fees, royalties and bonus royalty. The funding for the Indonesia
Project, other than the feasibility study costs incurred in 1996, is expected to
be funded 100 percent by Kennecott Energy and PTBA. Feasibility study costs
incurred in 1997 and 1998 for the Indonesia Project were not material. It is
possible that PTBA will participate in the Indonesia Project only as a supplier
of raw coal feedstock, rather than being the coal supplier and a partner in the
Indonesia Project. Also, with the Company's consent, Kennecott Energy may
transfer its rights in the Indonesia Project to one or more international
affiliates.



                                       15
<PAGE>   19

     In January 1997, the Company and K-Fuel, LLC entered into an amended
agreement with RCD regarding certain future performance fees related to a
successful Indonesia K-Fuel project. In the event that the Company and/or
K-Fuel, LLC construct or license an Indonesia K-Fuel project utilizing at least
25 percent raw coal feedstock supplied by PTBA, RCD would be entitled to a fee
of $2.00 per U.S. short ton (2,000 lbs.) for the first 1.5 million tons of
installed capacity, and a fee of $1.33 per ton for the second 1.5 million tons
of installed capacity. The fees RCD derives from individual K-Fuel projects in
Indonesia supplied by PTBA coal are not expected to impact the license fees or
royalties the Company would separately receive under its license agreement with
K-Fuel, LLC.

     Development of the Indonesia Project has suffered from the overall economic
and political problems experienced by Indonesia and other Asian countries
beginning in 1997. Further development of the Indonesian Project (other than
periodic assessment of Indonesian coal trade and overall economic conditions)
has been limited pending primarily the return to a more stable economic and
political environment in Indonesia. The Company is not able to determine if or
when such conditions will materialize to allow the Indonesia Project to commence
construction. There are no assurances that the Indonesia Project or other
possible future projects in Indonesia will be constructed.

     Turkey In June 1996, the Company entered into a non-binding memorandum of
understanding with Soma Komur Isletmerleri A.S. ("SOMA"), a Turkish private
coal-mining company, to cooperate in the development of a proposed 500,000 TPY
K-Fuel project in the Soma Basin coal-mining region in western Turkey ("Turkey
Project"). The intended use of K-Fuel from the Turkey Project would be for
household heating markets in urban areas in Turkey. The Company has provided
K-Fuel pellets produced from Turkish coal to SOMA and the City of Ankara
("Ankara"), which were tested in Turkey by SOMA and Ankara, with satisfactory
results. Development of the Turkey Project is primarily dependent on SOMA and/or
Ankara securing adequate financing. There are not yet any definitive agreements
with respect to a Turkey K-Fuel production facility, and the Company is not able
to predict if or when a K-Fuel production facility will be constructed in
Turkey. There are no assurances that the Turkey Project or other possible future
projects in Turkey will be constructed.

MARKET DRIVERS

DOMESTIC MARKET

     There are two primary market drivers for the NeuSIGHT and K-Fuel Technology
solutions offered by the Company. For a number of years various regulations and
other requirements have placed increasingly stringent standards on the air
emissions generated by the electric power generation industry and others. In
addition, as the power industry undergoes the rigors of deregulation and is
transformed into a market-driven highly competitive industry, there will be
increasing pressure to meet such air emission standards in more cost effective
ways as well as to improve the overall cost efficiency of electric power
generation.



                                       16
<PAGE>   20


     Air Emission Standards The CAA has been the primary historical stimulus for
the developing United States market for beneficiated clean coal fuel products,
such as K-Fuel, and for combustion optimization products, such as NeuSIGHT.
Specifically, Title IV of the CAA requires electric utilities to reduce
emissions of NOx and SO2.

     In September 1998, the United States Environmental Protection Agency
("EPA") issued a rule requiring 22 Midwestern and Southern states and the
District of Columbia to prepare implementation plans to reduce current allowed
levels of NOx by approximately 85%(the "SIP Call"). NOx is a primary component
in ground-level smog and is also a contributor to acid rain. Coal-fired electric
utility power plants are widely considered to be the most likely targets to
achieve the required reductions in NOx. Challenges to the EPA's SIP Call
resulted in a May 1999 federal appeals court action that effectively suspended
the SIP Call pending further review. Subsequently, a March 3, 2000 federal
appeals court action ruled that EPA had not exceeded its authority or followed
improper procedures and the EPA's SIP Call was mostly affirmed. Since this
decision is subject to appeal, the final outcome of this matter cannot be
predicted with certainty. Nonetheless, affirmation of the EPA SIP Call is
expected to accelerate demand for the Company's technologies, products and
services. Furthermore, the validity of the ultimate governing requirements of
the CAA have not been in question, only the specifics of various EPA initiatives
to achieve compliance therewith.

     NeuSIGHT has been demonstrated to typically reduce NOx by 25% to 30%.
K-Fuel Technology can also reduce NOx emissions (when using PRB coal as the
feedstock) as compared to typical eastern coals by levels approximating 25%, as
indicated in the February commercial burn. Through the combination of NeuSIGHT
and K-Fuel, management believes that the Company is in a unique position to
assist the electric power generation industry in achieving required reductions
in NOx more cost effectively than various other solutions, some of which are
highly capital intensive and also can add significant operating costs.

     Title IV of the CAA specifies a two-phase implementation schedule that
primarily targets electric utility companies with annual generating capacities
in excess of 25 megawatts ("MW"). Phase I implementation began on January 1,
1995, and affected 110 large, high-emission generating plants in 21 states
(primarily in the industrial Midwest). The emissions limit for these plants
during Phase I is 2.5 lbs. SO2 per million Btu ("MMBtu") of heat output. Phase
II, which began January 1, 2000 is expected to affect over 1,400 electrical
generating plants and other industrial users of coal. The effective SO2 emission
rate limitation under Phase II is reduced to 1.2 lbs. SO2 per MMBtu. When using
Wyoming PRB coal as feedstock material, the K-Fuel Technology produces a fuel
product that has an SO2 emission rate of approximately 0.7 to 1.0 lbs. SO2 per
MMBtu. NeuSIGHT also produces reductions in SO2 as a byproduct of heat rate
improvements and combustion optimization. The impact of Phase II implementation
of the CAA is not yet determinable.

     The Company's United States marketing emphasis is directed primarily at
electric utilities located in the industrial Midwest and eastern states, more
specifically those under EPA scrutiny. In these states there are approximately
300 utility operated coal-fired boiler units with power

                                       17
<PAGE>   21

generation capacity of 200 megawatts (MW) or greater each. The entire U. S.
contains approximately 500 of such utility operated coal-fired boiler units.

     The combustion characteristics of cyclone furnace boilers, a common boiler
type of Midwestern utilities originally designed to burn high-sulfur Midwestern
coal, are particularly well suited to the K-Fuel product manufactured from PRB
coal. As reported by the U.S. Department of Energy, the total domestic market
for coal fuel is approximately 1 billion TPY, of which electric utility
companies use the majority of the tonnage (approximately 83%). Coal-fired
electricity generation currently accounts for approximately 56% of the nation's
total electricity supply. The Company has estimated, based on published utility
coal consumption data and responses to Phase I and Phase II requirements of the
CAA, that a market of approximately 100 to 150 million TPY of clean coal fuel
products will develop between the years 2000 and 2010. Any amendments to the CAA
that reduce the specified limits on industrial SO2 emissions would likely
negatively impact the potential size of the market and the domestic growth
prospects of the Company.

     In addition to the electric utility industry, the Company believes there is
potential for a market for K-Fuel with manufacturers and other large-scale
industrial coal users that are either subject to the NOx and SO2 provisions of
the CAA or that desire to improve their fuel combustion performance. Fuel
combustion performance is becoming more important to electric utilities and
others because of the need to cut costs and become more efficient in an
increasingly competitive market environment.

     Carbon dioxide (CO2) is widely considered to be a primary component of
greenhouse gases that have given rise to worldwide concerns of global warming.
The December 1997 Kyoto Protocol to the United Nations Framework Convention on
Climate Change ("Kyoto Protocol") targets CO2 and certain other greenhouse gas
emissions for aggressive reduction in the years 2008 to 2012. In addition, the
Kyoto Protocol notes electric power generation as one of the specific industry
sectors that should be reviewed to achieve the targeted reductions. A very
important by-product of the efficiency gains at electric power generation boiler
units achievable through the use of NeuSIGHT and/or K-Fuel is a corresponding
reduction in the level of CO2. Management believes that the level of CO2
reduction available through the use of NeuSIGHT and K-Fuel approximate up to 5%
and 6%, respectively. As of January 13, 2000, eighty-four countries, including
the European Community, have signed the Kyoto Protocol. Although the United
States signed the Kyoto Protocol in December, 1998, it has not yet been ratified
by the United States Senate, as would be required to be applicable in the United
States. The Company is not able to predict if and when the United States Senate
might ratify the Kyoto Protocol and the impact that such action or inaction
could have on the demand for K-Fuel and NeuSIGHT. Nevertheless, initiatives such
as the Kyoto Protocol, targeted at reducing CO2 and other greenhouse gases, are
expected to continue to progress and create additional demand for alternatives
to achieve significant reductions in such emissions.

     In February 1998, the EPA submitted a report to Congress that found that
mercury emissions from coal-fired power plants were the hazardous pollutant from
utilities of greatest concern. Under the CAA the EPA required that all
coal-fired electric utility steam generating boiler units provide certain
information in 1999 that will allow the EPA to calculate the annual mercury



                                       18
<PAGE>   22


emissions from each unit. This information will be used to determine if it is
appropriate and necessary to regulate emissions of hazardous pollutants, as
defined, which include mercury, from electric utility boiler units. The EPA is
not expected to release its analysis of this data until May 31, 2000 and it has
until December 2000 to decide if it will regulate mercury emissions from power
plants. According to an analysis by Resource Data International ("RDI"), a
subsidiary of the Financial Times, there are no mercury removal technologies
operating commercially on coal-fired power plants in the United States.
Activated carbon injection and carbon bed technologies were identified by RDI as
likely, but high cost, remedies. RDI identified other mercury reduction
techniques including the use of low or zero mercury fuels, such as K-Fuel.
According to independent research, a significant level of mercury is removed
from run-of-mine coal during the K-Fuel production process. These tests indicate
any mercury contained in K-Fuel is below detectable levels of .05 parts per
million (ppm), compared to mercury levels of typical Eastern bituminous coals of
 .15 ppm to .20 ppm. Based on these test results, if the EPA adopts regulations
to restrict the level of mercury emissions, K-Fuel may offer significant
competitive advantages over other high-energy value coals. The EPA has until the
end of 2000 to decide whether it will pursue mercury emission control
regulations. In addition, the mercury tests of K-Fuel indicate that the chlorine
content of K-Fuel is also below the detectable levels of .05 ppm. Although the
Company is not aware of any initiatives underway to regulate emissions of
chlorine, it is commonly considered to be a hazardous material that is regulated
in various settings, and emissions of chlorine are generally considered to be
undesirable. Accordingly, regulation of chlorine emissions could develop in the
future, which could create another competitive advantage for K-Fuel.

     Deregulation of the United States Power Industry Deregulation in the
electric power industry is expected to result in intensified price competition,
increased price volatility, shorter-term wholesale electricity transactions, and
industry consolidation and structural changes. The electric power industry is
moving toward retail competition while the wholesale market has already been
established as full-scale open competition. While the electric power industry is
experiencing consolidation through mergers and acquisitions, the industry is
concurrently unbundling generation, transmission and distribution services from
the traditionally integrated structure.

     This restructuring is expected to cause some electricity generators to
operate as merchant plants without a guaranteed market for their production
output. In such an environment these businesses will be under constant
competition for the sales of their products and services. As a result, plant
operators will be expected to look to cut costs and improve operating
efficiencies wherever possible.

     According to 1998 investor-owned power utility information, of the $125
billion in operation and maintenance ("O&M") expenses (including fuels), 25%
went to fuel costs 14% to other power production costs, 37% to power purchases,
11% to G&A expenses, 8% to transmission and distribution costs and 5% to sales
and related expenses. Although the cost of power generation has been reduced
overall to an average cost of 3.8 cents per kilowatt-hour ("kWh") in 1998, from
4.6 cents per kWh in 1986, much of this reduction has been attributed to
reductions in force. Employment at major utilities from 1986 to 1998 was reduced
by about 30%, or more than 150,000 employees. In the opinion of management,
competition in a deregulated power



                                       19
<PAGE>   23

industry will require further reductions in the cost of power generation. To
further reduce the cost of power generation, savings must begin to come from
areas other than personnel reductions, such as more effective fuel purchase
practices and efficiency gains in the core processes in the generation of power.

     The need for these expense reductions by power generating companies to
remain competitive in the deregulated market comes at a time when EPA
regulations are causing the power generation industry to consider further
capital investment in plants to achieve emissions compliance. Management
believes that power-generating companies will look for solutions, such as
NeuSIGHT software and K-Fuel, to reduce these capital investments, cut operating
costs and run their plants more efficiently.

     These developments are expected to produce a strong incentive for
electricity generators to become low cost producers and expand market share in
order to remain profitable in the deregulated environment. In a fully
competitive retail electricity market, only those generators with costs low
enough to produce electricity at market acceptable prices, not simply low enough
to meet regulatory oversight, will be able to sell electricity profitably and
remain viable.

FOREIGN MARKETS

     The international coal-fired power generation industry is approximately
four times the size of the United States industry. The Company's objective, with
respect to international opportunities for K-Fuel, is to concentrate on markets
where there is either a significant need for more energy efficient and
environmentally responsible fuel products, or where abundant coal reserves can
be utilized in conjunction with the K-Fuel Technology to develop a value-added
export product. The principal benefit of the K-Fuel Technology in foreign
markets is that low-rank indigenous coal reserves can be upgraded to provide a
more cost effective and less environmentally damaging fuel source for power
producers, manufacturers and households, either in internal markets or for
export. The Company currently has international commercialization opportunities
related to K-Fuel in Indonesia and Turkey, as discussed above.

     In addition, although management expects to initially concentrate its
marketing and sales efforts with respect to Pegasus domestically, for reasons
similar to those cited above relative to K-Fuel and certain of the U. S. market
drivers, management believes there is significant market potential for NeuSIGHT
and related products internationally and Pegasus currently derives certain
revenues from Canada. Pegasus announced the execution of a non-exclusive
world-wide value added reseller agreement with Babcock & Wilcox in January 2000
and a non-exclusive value added reseller agreement with ABB Centrum covering
Poland, Hungary and the Czech Republic, in February 2000. See "Pegasus-Strategic
Relationships" above.

CHARCO REDONDO, LLC

     In December 1997, the Company purchased a 12.6% interest in Charco Redondo,
LLC, a Texas limited liability company ("Charco"), in consideration for its
commitment to contribute $540,000 to Charco as working capital. Funding under
this commitment began in January 1998,



                                       20
<PAGE>   24

and during 1998 the Company contributed $629,000 to Charco to satisfy this
commitment and additional capital calls.

     Charco was formed to develop and complete a project intended to demonstrate
the effectiveness of Synthetic Energy Corporation's ("Synthetic") patented
process, which uses mining techniques in connection with superheated steam and
moderate pressure to extract crude oil that otherwise cannot be extracted by
conventional production techniques. The technology licensed to Charco is based
on a patent held by John A. Masek (the "Masek Technology"). Charco has an
exclusive sublicense to use the Masek Technology in a four-county area of Texas
(the "AMI"), which is believed to have reservoirs containing approximately 1
billion barrels of crude oil which would be appropriate targets for application
of the Masek Technology. The pilot project (the "Charco Pilot Project") has been
conducted on a mineral lease covering approximately 1800 acres in southern Texas
(the "Charco Redondo Lease"). Drilling, completion and start-up activities were
completed late in the second quarter of 1998 and injection operations were
conducted for five months until December 1998, when the pilot project was shut
down because of depressed crude oil prices even though daily oil production was
increasing. The Charco Pilot Project achieved its initial objectives of
demonstrating the technical and operational feasibility of the Masek Technology.
Charco is pursuing further improvements to the technology. Efforts at KFx and
Charco are currently underway to obtain outside financing to complete
development of the Charco Redondo Lease. There can be no assurance that such
financing will be obtained. If such financing cannot be obtained on satisfactory
terms or at all, this project could be abandoned. Additionally, KFx may consider
alternatives to dispose of this investment and expects that if such an
alternative is pursued its investment could be recovered in full.

     The Company also entered into an option agreement with Synthetic with
respect to the use of the Masek Technology outside the AMI. The option agreement
provides that the Company and Synthetic will form a joint venture to be owned
55% by the Company and 45% by Synthetic. Exercise of the option requires that
the Company pay a total of $2,000,000 to Synthetic, of which a total of $50,000
was paid upon execution of the option agreement and $50,000 was paid when the
option was amended in 1999. The Company is not committed to pay any additional
amounts to Synthetic under the option agreement until certain performance
milestones of the Charco Pilot Project are met. The option will expire if it is
not exercised after such milestones are met. One of the two milestones was met
during 1999. The remaining milestone will be achieved only if the Charco Redondo
Lease is placed in production after further development.

GOVERNMENT AND ENVIRONMENTAL REGULATION

     Generally, environmental permitting and operating regulations in countries
outside the United States that the Company is currently pursuing for
international development are not as stringent as those within the United
States. Nevertheless, international initiatives, such as the Kyoto Protocol, are
expected to create increasing pressures on the electric power generation
industry on a world-wide basis to reduce emissions of various pollutants, which
management expects will create additional demand for its products and services.




                                       21
<PAGE>   25

PEGASUS

      The operations of Pegasus are not significantly impacted by governmental
regulation with respect to the development and delivery of NeuSIGHT and related
software products and services.

K-FUEL



     In the United States, the K-Fuel product is not expected to be subject to
significant levels of local, state or federal regulation with respect to its
transportation and distribution. However, any future United States production
plants will require numerous permits, approvals and certificates from
appropriate federal, state and local governmental agencies before construction
of each facility can begin, and will be subject to periodic maintenance and
review requirements once facilities begin production. Typically, state laws
govern most permitting requirements, but the EPA has the authority to overrule
certain state permitting decisions. The types of permits that are typically
required for commercial production facilities include air quality, wastewater
discharge, land use, and hazardous waste treatment, storage and disposal. KFP
has in place all permits for the operation of the KFP Facility. The K-Fuel
Technology process generates only waste gas, waste discharge water, and a small
amount of fuel liquid as by-products of the process. The KFP Facility has waste
gas and water treatment facilities to treat and dispose of the waste
by-products.

     Future international K-Fuel production plants will also be subject to
various permitting and operational regulations specific to each country.

CHARCO REDONDO, LLC

     The operations of Charco are regulated to the extent of environmental
permitting by various state and local governmental authorities and by the Mine
Safety and Health Administration ("MSHA") with regard to its mining activities
to excavate subsurface production rooms. In addition, the Texas Railroad
Commission regulates oil drilling and production activities in the State of
Texas. To the best of the Company's knowledge, Charco is currently in compliance
with all such governmental regulations.

EMPLOYEES

     The Company currently has approximately 9 full-time employees who work in
the areas of corporate and K-Fuel marketing, finance and administration, and
operation of the K-Fuel demonstration plant and laboratory. Pegasus currently
has approximately 27 full-time employees who work in the areas of sales and
marketing, software development, software implementation, finance and
administration. The Company considers its relations with all employees to be
good.



                                       22
<PAGE>   26


RISK FACTORS

WE WILL NEED ADDITIONAL CAPITAL TO FUND OUR BUSINESS AND TO PAY INTEREST AND
PRINCIPAL, AT MATURITY, ON OUR 6% CONVERTIBLE DEBENTURES

         We require substantial working capital to fund our business. At
December 31, 1999 we had a working capital deficit of $3,873,922. In past years,
we have experienced operating losses and negative cash flow and expect this
situation to continue in the future. As a result, we have been and are dependent
on sales of our equity securities , short term loans from our directors and
third parties and strategic relationships to fund construction of our K-Fuel
facility and operating costs associated with our businesses.

         By selling our 6% convertible debentures in July 1997, we incurred an
additional $17,000,000 in principal amount of indebtedness. Through April 13,
2000, holders of $1.65 million of these debentures have exercised their
conversion rights and converted their debentures into 410,959 shares of our
common stock. At December 31, 1999 we had a stockholders deficit of $9.7
million.

         Our current cash balances (and payments expected to be received in
connection with the sale of the K-Fuel plant and other expected services of
cash) are expected to fund our operations and debt service requirements until
approximately year end 2000 based on current operating plans. Accordingly, we
will require substantial amounts of cash to fund scheduled payments of principal
and interest on our 6% convertible debentures, working capital requirements, and
any future acquisitions and capital expenditures. We will be required to raise
additional funds through public or private financings, strategic relationships
or other arrangements. We currently do not have any commitments with respect to
any funding. We cannot be assured that such additional funding will be available
at all or on terms satisfactory to us. A lack of adequate financing may
adversely affect our ability to:

     o    make necessary interest and principal payments on our indebtedness;

     o    respond to changing business and economic conditions and competitive
          pressures;

     o    make future acquisitions;

     o    absorb negative operating results; or

     o    fund capital expenditures or increased working capital requirements.

WE HAVE CONTRACTUAL LIMITATIONS ON OUR ABILITY TO SECURE ADDITIONAL FUNDING

         Our ability to secure additional financing is limited by the terms of
the indenture related to our 6% convertible debentures. Our ability to raise
additional capital is also limited by a stock purchase and related agreements
between us and Thermo Ecotek Corporation, one of our major stockholders. If,
however, there is a closing of the transactions contemplated under the various
agreements executed on April 12, 2000, which are intended to sell the KFP
Facility, TCK is obligated to cancel these agreements.



                                       23
<PAGE>   27

WE HAVE NOT CONSISTENTLY ACHIEVED MATERIAL REVENUE SINCE OUR INCEPTION AND HAVE
INCURRED SIGNIFICANT OPERATING LOSSES

         We have not consistently achieved material licensing, royalty or
product sales revenues since we were formed in 1988. In addition, no significant
revenue was earned prior to our formation when similar operations to ours were
conducted by various predecessor entities. We have incurred significant net
operating losses, including net losses of $12,730,427, $6,783,817 and $5,095,160
in 1999, 1998 and 1997, respectively. At December 31, 1999, we had an
accumulated deficit of $58,801,132, and we expect to incur additional losses in
the future. We cannot assure you that we will ever achieve profitability, or be
able to generate earnings sufficient to meet our interest and principal payment
obligations.

IT IS DIFFICULT TO EVALUATE OUR BUSINESS AND PROSPECTS BECAUSE WE ARE SHIFTING
OUR STRATEGIC FOCUS TO THE DEVELOPMENT OF PEGASUS

         KFx was organized in 1988 and in August 1995, we commenced the initial
application of our K-Fuel(TM) technology and began construction of a facility
near Gillette, Wyoming, which is owned by KFP, in order to produce K-Fuel(TM).
Until early 1998, our primary enterprise has been the business of licensing and
commercializing a patented technology that in general uses heat and pressure to
physically and chemically transform high-moisture, low-energy per pound coal and
other organic feedstocks into a low-moisture, high-energy solid fuel known as
K-Fuel(TM). Operations at the K-Fuel facility began in the second quarter of
1998. In March 1998 we acquired, through our purchase of a controlling ownership
interest in Pegasus, the software product NeuSIGHT(TM). Accordingly, we have a
limited operating history upon which an evaluation of our prospects and future
performance can be made. Although we continue to believe that K-Fuel(TM)
technology has significant long term value, we believe that the software
business of Pegasus offers more near term value. Our prospects must be
considered in light of the risks, expenses and difficulties frequently
encountered in the operation of a new business based on innovative technologies
in a highly competitive industry.

THE MARKET FOR SOFTWARE IN CONNECTION WITH THE EFFICIENCY OF THE COMBUSTION OF
COAL IS NEW AND UNCERTAIN

         Combustion and other optimization software relating to the production
of coal or other similar products has only been used by the electric power
business for a few years and has just recently gained market acceptance. We
believe that market pressures caused by the developing deregulation of the
electric power industry and the CAA will accelerate demand for and market
acceptance of NeuSIGHT(TM) and related software products being developed at
Pegasus. There can be no assurance, however, that NeuSIGHT(TM) or any related
software products will experience growth or market acceptance.




                                       24
<PAGE>   28

THE MARKET FOR NEUSIGHT(TM) AND RELATED SOFTWARE DEPENDS ON SUCCESSFUL SALES AND
MARKETING STRATEGIES PRODUCT IMPROVEMENT STRATEGIES

         The market for NeuSIGHT(TM) and related software is uncertain. In our
opinion, realization of near term value from the software business of Pegasus
requires, among other things, the successful implementation of new sales and
marketing programs. We have taken numerous steps to implement a variety of such
programs and strategies, however, any evaluation or prediction of their
effectiveness would be premature. We cannot assure you that our sales and
marketing strategies for NeuSIGHT(TM) and related software will be successful.

         Additionally, we believe that increased market acceptance of
NeuSIGHT(TM) is dependent, IN part, on our ability to simplify and streamline
its installation process. Product improvements directed at this objective have
been made and were released to the market in late 1999 and additional
improvements are under development. We cannot assure you that our efforts to
further improve NeuSIGHT(TM) to more fully meet our objectives will be
successful.

OUR GENERAL PROJECT DEVELOPMENT IS UNCERTAIN

         The process of developing, permitting, financing and constructing
K-Fuel(TM) production facilities is complex, lengthy and costly and subject to
numerous risks, uncertainties and factors beyond our control, including cost
overruns, delays, damage and technical delays. Only a small percentage of the
projects that we evaluate and pursue may ultimately result in operating
projects. As a result, we may not be able to recover any expenses that we incur
in the evaluation and development of certain projects.

CONTINUED OPERATION OF THE EXISTING KFP FACILITY NEAR GILLETTE, WYOMING AND
PRODUCTION OF K-FUEL FROM THIS FACILITY IS UNCERTAIN

     KFP began operations at the KFP Facility in April 1998 and completed a
successful test burn in May 1998 and a successful commercial burn in February
1999, as discussed above. The KFP Facility operated and produced commercially
salable product in 1998 and 1999 and KFP addressed certain problems previously
encountered, including a 1996 fire at the facility and certain construction
problems, including issues relating to the flow of materials within the facility
and the design and operation of certain pressure release equipment.
Nevertheless, KFP continued to experience certain problems relating to tar and
fines residue build-up within the system during production and product quality
issues related to product dusting. On May 24, 1999, TCK announced that in
connection with certain strategic restructuring decisions made by TCK and its
parent, Thermo Electron Corporation, it had decided to hold for sale its
investment in the KFP Facility and record charges related thereto. Further, TCK
in June 1999 suspended operations at the KFP Facility and K-Fuel is not
currently being produced.

         On April 12, 2000 the Company executed agreements with various parties
that initiate the redevelopment of the KFP Facility. Necessary modifications to
the KFP Facility are estimated to cost $10 million to $12 million and such
modifications will not be feasible unless substantial capital is obtained. There
is no assurance such capital can be obtained on satisfactory terms, if at all.
There can be no assurances, however, that the KFP Facility will be successfully
restarted and K-Fuel production from this facility resumed. In addition,
although KFP believes that the KFP Facility qualifies for the Federal Oil Barrel
Equivalent Tax



                                       25
<PAGE>   29


Credit, promulgated under Section 29 of the Internal Revenue Code of 1986, as
amended, which is a significant incentive for the potential new owners of the
KFP Facility, there can be no assurance that such a position will not be
successfully challenged by the Internal Revenue Service. Such a successful
challenge would have a material adverse effect, on the operating economics of
the KFP Facility and our ability to generate any royalty and revenue-based
service fee income.

TECHNICAL AND OPERATIONAL PROBLEMS MAY ADVERSELY IMPACT OUR ABILITY TO DEVELOP
K-FUEL PROJECTS OR FACILITIES

We cannot assure you that any K-Fuel facilities planned by Kennecott Energy will
not experience technical or operational problems similar or in addition to those
experienced at the Wyoming K-Fuel facility. To the extent that other technical
or operational problems materialize, they may adversely impact our ability to
develop other K-Fuel(TM) projects or facilities.

LOCAL OPPOSITION TO K-FUEL PROJECTS COULD SUBSTANTIALLY DELAY OR PREVENT
DEVELOPMENT OF NEW K-FUEL FACILITIES

         Development, construction and operation of K-Fuel production facilities
requires numerous environmental and other permits. The process of obtaining
these permits can be lengthy and expensive. In addition, local opposition to a
particular project can substantially increase the cost and time associated with
developing a project, and can potentially render a project unfeasible or
uneconomic. We may incur substantial costs or delays or may be unsuccessful in
developing K-Fuel production facilities as a result of such opposition.

DEREGULATION IN THE UNITED STATES POWER INDUSTRY MAY RESULT IN INCREASED
COMPETITION FOR OUR PRODUCTS

         We expect that deregulation in the United States power industry will
result in utilities and other power generators placing a high emphasis on
reducing costs in their operations. This may in turn result in increased
competition from other producers of beneficiated coal products or other fuel
sources to the extent that such competing fuels result in cost savings for
utilities and other power producers.

NO ESTABLISHED MARKET FOR BENEFICIATED FUEL PRODUCTS EXISTS

         Although we believe that a substantial market will develop both
domestically and internationally for clean coal fuel products, an established
market does not currently exist. As a result, the availability of accurate and
reliable pricing information and transportation alternatives is not fully known.
Our future success will depend on our ability to establish a market for clean
coal fuel products among potential customers such as electrical utility
companies and industrial coal users. Further, potential users of our fuel
products may be able to choose among alternative fuel supplies. Although we have
successfully operated a K-Fuel(TM) technoloGY demonstration plant, the market
viability of the K-Fuel(TM) technology will not be known until WE complete
construction of one or more commercial-scale production facilities, either in
the United States or internationally, that produce, on a consistent basis,
commercial quantities of fuel and meet





                                       26
<PAGE>   30


certain minimum performance specifications. We face the risk that
commercial-scale production facilities when completed will be unable to generate
sufficient market interest to continue in business. Further, we cannot assure
you that the any commercial-scale K-Fuel facility will be successful.

WE ARE SUBJECT TO RISKS OF CHANGING LAWS

         A significant factor driving the creation of the United States market
for K-Fuel(TM), othER beneficiated coal products, NeuSIGHT(TM) and other
optimization software products is the CAA, whiCH specifies various air emission
requirements for electrical utility companies and industrial coal users. We
believe that compliance with the air emission regulations by these coal users
can be fully or partially met through the use of clean-burning fuel
technologies, like K-Fuel(TM), aND combustion optimization software, like
NeuSIGHT(TM). We are unable to predict future regulatoRY changes and their
impact on the demand for our products. A full or partial repeal or revision of
the CAA would have a material adverse effect on our prospects.

WE RELY ON STRATEGIC PARTNERS

         We have established relationships with various strategic partners to
exploit the K-Fuel(TM) technology, enhance the application of NeuSIGHT(TM) and
further penetrate the NeuSIGHT(TM) maRKet. Kennecott Energy has been a strategic
partner in the development of K-Fuel(TM) technology since earLY 1996 and also
became a strategic partner in Pegasus in early 2000. Our success will depend
upon our ability to maintain existing strategic relationships with Kennecott
Energy and others and develop and maintain additional relationships for the
further development of our technologies. We are and will continue to be
dependent upon our strategic partners to, among other things, fund the
operations of the partnerships or the joint venture entities in which we own
interests and to provide necessary technical, operational, personnel and other
resources. While each of our strategic partners has an economic motivation to
further the development of their respective joint ventures or projects with us,
the amount of time and resources devoted to such joint ventures or projects will
be controlled by our strategic partners and not by us. A decline in the
financial prospects of a particular strategic partner could adversely affect
such partner's commitment to a joint venture, which could materially harm us.
Moreover, joint ventures or similar arrangements require us to have financial
and other arrangements to meet our commitments to the joint ventures. We cannot
assure you that we will be able to maintain existing strategic relationships,
develop or maintain additional strategic relationships, meet our commitments
with respect to our joint ventures or that our strategic partners will meet
their commitments to any respective joint venture or project.

WE ARE REQUIRED TO PAY THIRD PARTIES A PORTION OF LICENSING AND ROYALTY REVENUES

         We anticipate that a significant portion of our future revenues with
respect to K-Fuel(TM) will be in the form of licensing and royalty payments from
third party licensees operating commercial-scale production facilities of
K-Fuel(TM). Pursuant to various license agreements we haVE executed, we are
required to pay third parties a substantial portion of licensing and royalty
revenues we receive. Amounts due under these agreements may restrict or limit
our ability to



                                       27
<PAGE>   31

pursue other commercialization opportunities with respect to K-Fuel(TM) because
such payments wiLL decrease cash flow from operations.

A SIGNIFICANT PORTION OF THE POTENTIAL OF THE K-FUEL AND PEGASUS BUSINESSES IS
SUBJECT TO INTERNATIONAL RISKS

         Although our current operations are primarily in the United States, we
believe a significant portion of the growth opportunity for both our Pegasus and
K-Fuel businesses lies outside the United States. Our doing business in foreign
countries exposes us to many risks that are not present in the United States and
with which we lack significant experience, including political, military,
privatization, currency exchange and repatriation risks, and higher credit risks
associated with fuel purchasers. In addition, it may be more difficult for us to
enforce legal obligations in foreign countries and we may be at a disadvantage
in any legal proceeding within the local jurisdiction. Local laws may also limit
our ability to hold a majority interest in the projects that we develop.

OUR MARKETS ARE COMPETITIVE

         We face competition from other companies in the clean coal and
alternative fuel technology industries as well as the emission control equipment
industry. Many of these companies have financial and managerial resources
greater than ours and therefore may be able to offer products more competitively
priced and more widely available than ours. Also, competitors' products may make
our technology and products obsolete or non-competitive. Our future success may
depend on our ability to adapt to such changing technologies and competition.

OUR INABILITY TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR
BUSINESS

         Our success depends upon our proprietary technology. We rely on a
combination of patent, copyright, trademark and trade secret rights to establish
and protect our proprietary rights. We currently have a series of patents on our
K-Fuel(TM) technology, however, competitors may successfulLY challenge the
validity or scope of one or more of our patents or any future allowed patents.
These patents alone and our rights with respect to NeuSIGHT(TM) may not provide
us with any significaNT competitive advantage.

         Third parties could copy or otherwise obtain and use our products or
technology without authorization or develop similar technology independently. We
cannot easily police unauthorized use of our technologies. The protection of our
proprietary rights may be inadequate and our competitors could independently
develop similar technology, duplicate our solutions or design around any patents
or other intellectual property rights we hold.

         As is common in the software industry, we may from time to time receive
notices from third parties claiming infringement by our NeuSIGHT(TM) product or
similar software of third party pateNT and other property rights. At this time,
we have not filed suit against any competitor nor has another company claimed
that our products infringe on its patent or intellectual property



                                       28
<PAGE>   32

rights. Any claims, with or without merit, could be time-consuming or result in
costly litigation that may materially harm our business.

WE RELY ON KEY PERSONNEL AND MUST BE ABLE TO RETAIN OR ATTRACT QUALIFIED
PERSONNEL

         We believe that our performance is substantially dependent on the
performance of senior management and key technical personnel. The inability to
retain key managerial and technical personnel or attract and retain additional
highly qualified managerial or technical personnel in the future could harm our
business or financial condition.

OUR ABILITY TO TAKE ADVANTAGE OF NET OPERATING LOSSES IF WE ACHIEVE
PROFITABILITY COULD BE LIMITED

         Under Section 382 of the Internal Revenue Code of 1986, the use of
prior net operating losses is limited after an "ownership change," as defined in
Section 382. The limitation, if applicable, is equal to the value of the loss
corporation's outstanding stock immediately before the date of the ownership
change multiplied by a long-term interest rate specified by the Internal Revenue
Code. The quoted market value of a stock is a factor to consider, but not
necessarily a conclusive factor, in determining the fair value of a
corporation's stock. Additional issuances of equity interests by us, including
the issuance of shares of common stock upon the conversion of our 6% convertible
debentures or on the exercise of outstanding warrants or options to purchase our
common stock may result in an ownership change. In the event we achieve
profitable operations, any significant limitation on the use of our net
operating losses would have the effect of increasing our tax liability and
reducing net income and available cash resources.

THERE ARE WARRANTS OUTSTANDING THAT, IF EXERCISED, WOULD RESULT IN A CHANGE IN
CONTROL OF KFX

TCK holds warrants allowing them to purchase control of KFx. If these warrants
are not cancelled in connection with the series of agreements recently executed
in connection with the sale of the KFP Facility, KFx's ability to obtain
additional equity capital may be adversely affected. In addition exercise of
these warrants would substantially dilute existing shareholders and allow TCK to
control KFX.




                                       29
<PAGE>   33

YEAR 2000 COMPLIANCE

     We are aware of the issues associated with the programming code in existing
computer systems related to the Year 2000. Prior to December 31, 1999 we
completed various analyses and remediation procedures related to the Year 2000
issue and to date we have not experienced any significant disruptions or
difficulties associated with the Year 2000 issue. Nevertheless, we may still
experience significant disruptions and difficulties associated with this matter.

WE DO NOT EXPECT TO PAY CASH DIVIDENDS

We have never paid any cash dividends and do not anticipate paying cash
dividends in the foreseeable future. In addition, we are prohibited from paying
dividends as long as any of our 6% convertible debentures are outstanding.



                                       30
<PAGE>   34







ITEM 2. PROPERTIES

     For its principal executive offices, the Company has leased approximately
5,900 square feet of office space through September 2004 located at 1999
Broadway, Suite 3200, Denver, Colorado 80202. The current base rent under the
lease is $7,839 per month, escalating gradually to $11,593 per month by the
final year of the lease. The Company is also obligated to pay, as additional
rent, allocable operating costs. During 1998 and 1999 the Pegasus and K-Fuel
segments used a portion of this office space.

     The Company has leased approximately 2,300 square feet of office space
through June 30, 2003 located at 2300 Clarendon Boulevard, Suite 401, Arlington,
Virginia 22201. The base rent under the lease is approximately $5,078 per month,
with escalations of 2.5 percent for each subsequent year of the lease term. The
Company is also obligated to pay, as additional rent, an allocable share of
increases in certain operating costs. The Company has the option to renew the
lease for one additional five-year term. A portion of this office space is
sublet under short term leases to third parties.

     Pegasus has leased approximately 7,600 square feet of office space through
October 2004 located at 5970 Heisley Road, Suite 300, Mentor, Ohio 44060. The
current base rent under the lease is approximately $7,254 per month, escalating
gradually to $9,146 per month by the final year of the lease. Pegasus is also
obligated to pay, as additional rent, allocable operating costs. Pegasus has
options to renew the lease for two additional 3-year terms, at a base rent
escalated by the Consumer Price Index from the final base rent in the current
term.

     The Company, through its KFX Technology, Inc. ("KFxT") subsidiary, owns a
demonstration plant and leases from KFP (on a rent-free basis) a research and
development laboratory adjacent to the KFP Facility (the "Gillette Facility").
The Gillette Facility is located on approximately 80 acres of land, inside the
rail loop of Fort Union Mine, in Campbell County, Wyoming, approximately 5 miles
northeast of Gillette, Wyoming. The Gillette Facility is comprised of three
buildings totaling approximately 7,100 square feet.

ITEM 3. LEGAL PROCEEDINGS

         On November 4, 1999, Link Resources, Inc., a Georgia corporation,
(Link) and its two shareholders, Linda E. Kobel (Kobel) and Gary A. Sanden
(Sanden), filed a complaint against the Company in US District Court for the
District of Colorado. The complaint alleges that KFx, Link, Kobel and Sanden had
entered into an agreement requiring KFx to acquire Link and that KFx breached
such agreement. The complaint seeks damages in excess of $5.3 million. Although
this matter is still in discovery and its ultimate resolution cannot be
predicted with certainty, based on a preliminary review of the underlying facts
and discussion with counsel,



                                       31
<PAGE>   35

management believes that this complaint is without merit. KFx intends to contest
this complaint vigorously. Accordingly, management does not believe that this
matter will have a material impact on the results of operation or financial
position of the Company.

     On March 9, 1998, Fidelity and Deposit of Maryland ("F&D"), as subrogee of
Walsh Construction Company ("Walsh"), a division of Guy F. Atkinson Company,
filed a construction lien against KFP with respect to the construction of the
KFP Facility in the amount of approximately $5.9 million. It is not possible at
this time to evaluate the merits of the claim or the range of potential loss.
However, the Company believes that the ultimate resolution of this action will
not have a material adverse impact on the Company's financial position or
results of operations. In connection with this action, KFP has filed a
counterclaim in excess of $29 million against F&D, the surety for Walsh. The
counterclaim asserts various claims of faulty construction performed by Walsh at
the KFP facility. The counterclaim is in discovery and it is not possible to
predict the outcome of this action; however the Company believes that the
counterclaim will not have a material adverse impact on the Company's financial
position or results of operations.

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

     No matters were submitted to a vote of security holders during the fourth
quarter of 1999.




                                       32
<PAGE>   36



                                     PART II

ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS

     The Common Stock trades on the American Stock Exchange (under the trading
symbol "KFX"). The following table presents the reported sales prices on the
American Stock Exchange for the two-year period ended December 31, 1999.

<TABLE>
<CAPTION>

  YEAR                    PERIOD                           HIGH             LOW
  ----                    ------                           ----             ---

<S>                   <C>                               <C>             <C>
  1999                First Quarter                     $  2  3/16       $  1 1/4
                      Second Quarter                       1 15/16            7/8
                      Third Quarter                        1  7/8           1 1/16
                      Fourth Quarter                       1  3/4           1 5/16

  1998                First Quarter                     $  3  7/8        $  2 5/8
                      Second Quarter                       3  5/8           2 1/2
                      Third Quarter                        3  1/4           2
                      Fourth Quarter                       2  3/8           1 1/8
</TABLE>

     As of April 13, 2000, the Company had 193 holders of record of the Common
Stock. This does not include holdings in street or nominee names. On April 13,
2000, the closing price of the Common Stock on the American Stock Exchange was
$2 7/8 per share.

     The Company has never paid cash dividends and does not anticipate paying
dividends in the foreseeable future. The Company is also restricted from paying
dividends pursuant to the terms of the Convertible Debenture Indenture. In
addition, pursuant to the Stock Purchase Agreement, so long as TCK, together
with its affiliates, owns at least 1,000,000 shares of Common Stock and either
of the related warrants are outstanding, the Company may not declare or pay any
dividends on the Common Stock other than dividends payable solely in shares of
Common Stock. See "ITEM 1--BUSINESS--Strategic Relationships--Thermo Ecotek
Corporation and KFx Fuel Partners."

     On August 27, 1999, the Company sold 527,000 of its $.001 par value common
stock valued at approximately $763,000 to Computer Associates International in
exchange for a 15% interest in Pegasus in a private placement pursuant to the
exemption provided by Regulation D. This common stock was later registered, with
the SEC.





                                       33
<PAGE>   37


ITEM 6. SELECTED FINANCIAL DATA

         The following selected consolidated financial data should be read in
conjunction with the Company's consolidated financial statements and related
notes thereto and "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included in Item 7. The consolidated statement of
operations data for each of the three years in the period ended December 31,
1999 and the consolidated balance sheet data at December 31, 1998 and 1999 are
derived from the audited consolidated financial statements indexed on page F-1.
The consolidated statement of operations data for each of the two years in the
period ended December 31, 1996, and the consolidated balance sheet data at
December 31, 1995, 1996 and 1997 are derived from audited consolidated financial
statements not included in this Annual Report on Form 10-K.

<TABLE>
<CAPTION>

                                                 1999            1998            1997            1996            1995
                                            ------------    ------------    ------------    ------------    ------------

<S>                                         <C>             <C>             <C>             <C>             <C>
STATEMENT OF OPERATIONS DATA FOR THE
   YEAR ENDED DECEMBER 31:
     Operating revenues .................   $  2,850,800    $  2,220,585    $  1,084,823    $  1,596,298    $    254,363
     Operating loss .....................     (7,477,042)     (6,419,014)     (4,930,551)     (4,827,874)     (8,243,306)
     Loss before extraordinary item .....    (12,730,427)     (6,783,817)     (5,095,160)     (5,628,541)     (7,923,078)
     Net loss ...........................    (12,730,427)     (6,783,817)     (5,095,160)     (5,628,541)     (6,228,720)
     Basic and diluted loss before
        extraordinary item per share ....           (.53)           (.28)           (.21)           (.25)           (.47)
     Average shares of common stock
        outstanding .....................     24,137,000      23,931,000      23,820,000      22,458,000      18,578,000


BALANCE SHEET DATA AT DECEMBER 31:
     Current assets .....................   $  1,605,466    $  7,004,806    $ 14,461,198    $  1,957,005    $  4,680,784
     Working capital (deficit) ..........     (3,873,922)      4,481,499      12,565,373        (166,521)      2,253,682
     Total assets .......................     14,267,995      22,672,289      29,057,706      14,923,567      18,611,493
     Long-term debt .....................     17,484,625      17,890,793      17,500,000       1,110,000       1,399,851
     Stockholders' equity (deficit) .....     (9,696,018)      2,258,289       8,495,881      10,524,041      13,752,528
</TABLE>




                                       34
<PAGE>   38



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

     This 10-K filing contains, in addition to historical information,
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended, that include risks and uncertainties. The Company's actual results
may differ materially from those anticipated in these forward-looking
statements. The forward looking statements contained in this filing include,
among others, statements regarding potential future investments in Pegasus by
Kennecott Energy and others; potential debt and/or equity funding sources for
KFx, including those related to the redevelopment of the KFP Facility; potential
conversions of the Debentures, under current terms or otherwise; expected future
operating results and financial condition; KFx's ability to dispose of its
investment in Charco and expected proceeds; the expected impact of and changes
in environmental and other regulations and their enforcement; effects of
deregulation of the electric power generation industry; expected effects of
certain organizational changes at Pegasus implemented in early 2000; expected
benefits to customers of and related market demand for current products and
products under development; commercialization of the K-Fuel Technology and
expected issuance of K-Fuel licenses; timing of filling of sales commitments;
effects of the Company's competition; impact on the Company of future possible
costs at the KFP Facility; results of test burns of K-Fuel; proposed projects in
Poland, Turkey and Indonesia; anticipated markets for the Company's products and
services; expected resolution and impact of litigation; and potential expansions
of product and service offerings. Important factors that could cause actual
results to differ materially from those anticipated include, but are not limited
to those discussed under "Risk Factors", adverse market and various other
conditions that could inhibit the Company's ability to obtain financing;
competition and technological developments by competitors; lack of market
interest in the Company's existing and any new products and services; changes in
environmental, electric utility and other governmental regulations; availability
of Section 29 or similar tax credits related to any future K-Fuel facilities;
actions of the Company's strategic partners; breadth or degree of protection
available to the Company's intellectual property; availability of key management
and skilled personnel; unanticipated problems that arise from research and
development activities; cost overruns, delays and damage that may occur in
developing, permitting, financing and constructing K-Fuel production facilities;
and domestic and international economic and political conditions. The Company
does not undertake to update, revise or correct any of the forward-looking
statements.



                                       35
<PAGE>   39



OVERVIEW

     Through the acquisition of 60% of Pegasus in early 1998, KFx significantly
broadened its technology solutions, by adding NeuSIGHT, Pegasus' artificial
intelligence based combustion optimization software, to K-Fuel Technology, its
patented clean coal technology, in order to better meet the evolving needs of
the electric power industry that are being stimulated by domestic industry
deregulation and increasingly stringent air quality standards worldwide. In the
fourth quarter of 1998 Pegasus began hiring a software marketing team. During
August 1999, KFx increased its ownership of Pegasus to 75% and in early March
2000, KFx sold 4% of its interest in Pegasus to Kennecott Energy for $1 million,
KFx converted $3.6 million of debt Pegasus owed it to preferred stock and
Pegasus secured a $500,000 preferred stock investment in Pegasus from Kennecott
Energy. At April 14, 2000, the ownership of Pegasus is approximately as follows:
KFx--74%, Pegasus management--20% and Kennecott Energy--6%. It is expected that
Kennecott Energy will make additional investments totaling $3.5 million for an
additional 14% interest in Pegasus as certain product development and other
milestones are met, through 2004 or earlier.

     In connection with Kennecott Energy's Pegasus investment, Pegasus and
Kennecott formed Net Power Solutions, an entity that is intended to offer total
energy solutions to the electric utility industry on a worldwide basis. Net
Power Solutions has the non-exclusive right to market the products of KFx,
Pegasus, and Kennecott Energy in combination in order to optimize the available
synergies and value added opportunities.

         Although Pegasus generated 1999 revenues of $1.5 million, representing
an increase over the 1998 level of approximately 16%, 1999 order and revenue
growth was significantly hampered by two May 1999 federal appeals court
decisions that effectively suspended two NOx reduction programs initiated by the
EPA. The two programs affected were the 8-hour national ambient air quality
standard for ozone ("8 Hour Ozone Standard"), of which NOx is a primary
component, and a requirement for 22 eastern and midwestern states and the
District of Columbia to submit implementation plans in the fall of 1999 to
achieve a reduction in NOx emissions of approximately 85% beginning in 2003
("SIP Call"). Although the ultimate governing requirements of the CAA continue
to be in place, these court actions created confusion as to the manner of
achieving compliance with the CAA. As a result of these developments, during the
latter half of 1999, utilities tended to delay or abandon certain previously
planned activities designed to achieve compliance with the relevant sections of
the CAA, which activities the Company believes included purchase and
installation of Pegasus products. On March 3, 2000 most of the EPA's initiative
related to the SIP Call was affirmed by a federal appeals court action, which,
although subject to appeal, is expected to accelerate demand for Pegasus
products and services. At March 31, 2000, Pegasus' order backlog was
$2,485,000, which is expected to be recognized as revenue during the next 12-18
months.

         In early 2000, after completion of an analysis of issues impacting the
growth and success of Pegasus, the Company decided to move the Denver, Colorado
headquarters activities of Pegasus, which included marketing and sales
administration, general accounting and financial reporting, to the Pegasus
Cleveland, Ohio area offices, which include its operations and research





                                       36
<PAGE>   40


and development activities. Implementation of this decision is underway and is
expected to be substantially completed during the second quarter of 2000.
Benefits of this action are expected to include more effective management and
coordination of and communication among Pegasus' various activities. These
benefits are expected to translate into improvements in the growth and financial
performance of Pegasus. Costs associated with this decision are expected to
approximate $__________, and will be charged to expense when incurred.

     Progress to commercialize K-Fuel Technology continued during 1999, with a
successful first commercial burn of a unit train load of product (approximately
12,000 tons) at a generating station in southern Indiana in February 1999. In
addition, K-Fuel, LLC, the joint venture established in 1996 between KFx and
Kennecott Energy to commercialize K-Fuel Technology, advanced in June 1999 with
(a) the formal completion of Kennecott's due diligence phase, (b) a $1 million
K-Fuel license fee payment by Kennecott Energy to KFx, (c) an additional $1
million payment by Kennecott Energy to KFx that was required to be invested in
K-Fuel, LLC to fund further development activities and (d) certain other
provisions to facilitate the next phase of K-Fuel Technology's
commercialization. The near term mission of K-Fuel, LLC is to pursue the
development of a 3 million ton-per-year K-Fuel production facility that is
economic in today's energy markets.

     During June 1999, operations at the KFP Facility were suspended and the KFP
Facility was put up for sale largely due to certain May 1999 strategic
restructuring decisions at TCK and its parent company, Thermo Electron
Corporation. Although the KFP Facility operated and produced commercially
salable K-Fuel product in 1998 and 1999, TCK advised that optimal and sustained
operations had been significantly hampered by certain design and construction
deficiencies. KFP is involved in a dispute with the primary construction
contractor regarding the withholding of $5.9 million in payments under the KFP
Facility construction contract and has filed a counterclaim in excess of $29
million against the contractor for damages related to various claims of faulty
construction.

     On April 12, 2000 the Company executed agreements with various parties that
initiate the redevelopment of the KFP Facility. Pursuant to the agreements, if
all conditions to closing are met, (a) a subsidiary of Black Hills Corporation
(BHK) will purchase the KFP Facility and receive 2 million shares of KFx common
stock previously held by TCK in exchange for the assumption of the reclamation
liability associated with the KFP Facility, (b) BHK will be given the right to
one seat of KFx's board of directors and KFx will grant BHK a warrant to
purchase 1.3 million shares of KFx common stock at $3.65 per share, subject to
certain adjustments, (c) KFx will relinquish its 5% interest in KFP and provide
certain releases in exchange for cash proceeds estimated at $1.5 million, will
retain royalty right and certain real and personal property and has negotiated a
revenue-based service fee, (d) TCK will sell the remaining 2.25 million common
shares of KFx it owns to private investors and cancel the warrants it holds to
purchase a control position in KFx's common stock. KFx and BHK are proceeding to
finalize plans and secure the necessary capital to rectify certain design flaws
in the balance-of-plant systems, including the addition of an incinerator to
eliminate certain process waste streams, and to modify the plant to replace
natural gas with waste coal as the facility's energy source. The cost to
implement these plans is estimated at $10 million to $12 million. If efforts to
finalize plant modification plans and secure related capital are not successful
by August 2000, BHK has





                                       37
<PAGE>   41


the options to salvage the equipment and reclaim the site. The terms of the
agreements provide for closing of these transactions not later than April 28,
2000. The carrying value of the Company's investment in KFP has been written
down effective December 31, 1999 by $1.8 million, to the $1.5 million near term
cash proceeds expected if these transactions close. In addition, the estimated
$2.2 million value of the warrants expected to be issued to Black Hills has
been charged to expense effective December 31, 1999.


     As a company still in the process of developing its businesses, it is
rather difficult to predict financial results with meaningful accuracy, which
also leads to difficulties in achieving positive and stable financial results in
the short term. Nevertheless, the continued progress of both Pegasus and the
K-Fuel Technology, reaffirm management's confidence in the opportunity to create
long-term value for KFx shareholders.



                                       38
<PAGE>   42



RESULTS OF OPERATIONS

Year Ended December 31, 1999 vs. Year Ended December 31, 1998

         The consolidated operating loss in 1999 of $7,477,000, which includes
$2,765,000 of non-cash charges, was $1,058,000, or 16% greater than the 1998
operating loss due primarily to an increase approximating $2,033,000 in
operating losses at Pegasus partially offset by reduced operating losses for
K-Fuel approximating $619,000 and a reduction in KFx corporate and other costs
approximating $356,000.

         Consolidated operating revenues increased approximately $630,000, or
28% from 1998 to 1999 due primarily to the $1 million K-Fuel license fee from
Kennecott Energy. In addition, Pegasus revenues increased approximately
$208,000, or 16%, but K-Fuel contract revenue declined approximately $578,000,
or 65%. This decrease was primarily due to a $351,000 decline in contract
revenues associated with services provided by the K-Fuel demonstration plant and
laboratory to the KFP Facility, stemming from TCK's suspension of operations at
the KFP Facility in June 1999. In addition, there was a $227,000 decline in
revenues from a K-Fuel research and development contract with a third party,
related to the K-Fuel demonstration plant and laboratory, due to certain
administrative changes at the third party research and development contracting
agency.

         Consolidated operating costs and expenses in 1999 exceeded the 1998
level by approximately $1,688,000, or 20%, principally due to increased costs at
Pegasus approximating $2,241,000, partially offset by comparative declines in
K-Fuel costs of $197,000 and in KFx and other costs of $356,000.

         Pegasus costs increased from 1998 to 1999, in part, because 1998
included three fewer months of Pegasus activity. Pegasus cost increases included
(a) $426,000 (56%) in increased cost of sales associated with increased revenue,
(b) $1,445,000 (118%) increased marketing, general and administrative costs
resulting largely from efforts begun in late 1998 to develop a professional
marketing and sales organization, (c) $197,000 (143%) in research and
development costs associated with activities to develop enhancements to NeuSIGHT
and new products and (d) $173,000 (39%) in depreciation and amortization
primarily due to increased goodwill amortization

         Declines in K-Fuel costs include $474,000 (53%) in reduced K-Fuel
demonstration plant and laboratory expense associated with the decline in
related revenue discussed above partially offset by a $250,000 royalty expense
associated with the K-Fuel license fee from Kennecott Energy. Declines in KFx
corporate and other costs included (a) $224,000 (8%) in reduced marketing,
general and administrative expenses and (b) $132,000 (20%) in reduced
depreciation and amortization.

         The above factors produced a consolidated 1999 operating loss of
$7,477,000. In addition, the Company experienced an $4,889,000 net increase in
net non-operating expense items from 1998 to 1999. This increase was primarily
due to (a) the recognition in 1998 of a $701,000



                                       39
<PAGE>   43

gain on sale of mine, (b) a decline in interest and other income approximating
$320,000, due largely to a decline in the average balance of cash investments,
partially offset by (c) a $175,000 reduction in KFx's share of losses at K-Fuel,
LLC, due to lower R&D expenses, (d) a $4,000,000 impairment of investment in
KFx Fuel Partners, L.P.

     The Company does not record a deferred tax benefit from its net operating
loss carryforwards, which approximate $36 million at December 31, 1999, because
there is no assurance that the Company will be able to realize such benefit as
an offset to future income taxes payable.



                                       40
<PAGE>   44



Year Ended December 31, 1998 vs. Year Ended December 31, 1997

     The consolidated operating loss in 1998 of $6,419,000, which includes
$3,003,000 of non-cash charges, exceeded the 1997 consolidated operating loss by
$1,488,000, or 30%, primarily due to the operating loss of Pegasus that
approximated $1,234,000.

     Consolidated operating revenues for 1998 of $2,221,000 were $1,136,000, or
51%, higher than for 1997 primarily due to $1,328,000 in revenues from the
software licenses and services generated by Pegasus. A decline approximating
$192,000 in K-Fuel contract revenues stemmed from a reduction in work performed
for K-Fuel, LLC.

     Consolidated operating costs and expenses in 1998 exceeded the level of
1997 by approximately $2,624,000, or 44%, largely due to $2,563,000 in operating
costs of Pegasus, which was acquired in late March 1998. Pegasus operating costs
included $755,000 of costs associated with revenues, $1,225,000 in marketing,
general and administrative costs, $138,000 of research and development
activities, and $444,000 in depreciation and amortization. Costs associated with
operating the K-Fuel demonstration plant and laboratory decreased in 1998 by
$362,000 largely due to the reduction in work performed of K-Fuel, LLC as noted
above. KFx corporate and other depreciation and amortization for 1998 increased
over the 1997 level by $297,000 primarily due to a $287,000 increase in
amortization of deferred costs associated with the issuance of convertible
debentures in August 1997.

     The above factors produced a consolidated 1998 operating loss of
$6,419,000. In addition the Company experienced a $200,000 net increase in net
non-operating income/expense items from 1997 to 1998. This increase was
primarily due to (a) a $613,000 increase in interest expense associated with the
July 1997 issuance of the 6% Convertible Debentures, (b) a $305,000 increase in
equity in loss of unconsolidated subsidiaries stemming from the April 1998
commencement of operations at the KFP Facility, partially offset by (c) a
$701,000 gain on sale of mine.



                                       41
<PAGE>   45
LIQUIDITY AND CAPITAL RESOURCES

         During 1999 the Company used approximately $3,458,000 of cash for its
operating activities, which included (a) approximately $1,952,000 used to
support and accelerate the growth of Pegasus' business, (b) $1,148,000 used for
interest payments, (c) approximately $1,496,000 provided and (c) $1,854,000 used
for KFx corporate and other activities. Offsetting these uses of cash, was
approximately $1,496,000 of cash provided from the continued development of the
K-Fuel business. The principal source of this cash was the agreement in June
1999 with Kennecott Energy which resulted in an addition to operating cash flow,
net of related royalty expense payments, of $1,750,000. Of this amount,
$1,000,000 was invested in the K-Fuel, LLC joint venture with Kennecott Energy,
as required by the agreements with Kennecott Energy. Operating cash used in KFx
corporate and other activities was used (a) to oversee the development of the
Pegasus and K-Fuel businesses, (b) to pursue opportunities to expand the
Company's product and service offerings, and (c) for general corporate
activities. In addition to the $1,000,000 investment in K-Fuel, LLC, cash
investing activities included approximately $207,000 related to maintenance and
further development of the K-Fuel patent estate and approximately $111,000 for
miscellaneous capital expenditures. Financing activities used approximately
$219,000 of cash for scheduled debt payments, primarily related to the Pegasus
acquisition.

         During the first quarter of 2000, the Company closed a series of
transactions resulting in (a) the sale to Kennecott Energy of 4% of the
outstanding common stock of Pegasus held by KFx for $1,000,000, (b) the creation
of a 6% cumulative convertible preferred class of Pegasus stock, in which
Kennecott Energy invested $500,000, for an additional 2% of Pegasus, and (c) the
development in conjunction with Kennecott Energy of a work plan for product
development and other achievements that is expected to trigger up to $3.5
million in additional investments at the discretion of Kennecott Energy for up
to an additional 14% interest in Pegasus by the end of 2004. Kennecott Energy
has the right to sell the Pegasus common stock that it purchased for $1,000,000
back to KFx at any time until March 3, 2001 for the greater of its purchase
price or fair market value. In addition, KFx converted approximately $3.6
million of secured debt owed by Pegasus to KFx into shares of the new Pegasus
preferred stock, on the same terms as Kennecott Energy. Included in the
agreements among KFx, Kennecott Energy and Pegasus are provisions governing the
terms of investments from any new investors in Pegasus, limiting the borrowings
of Pegasus, and limiting the payment of dividends by Pegasus. KFx is actively
seeking additional strategic investors to further expand the capital base of
Pegasus.

         During the first quarter of 1999, the Company announced its desire to
restructure its 6% Convertible Debentures (Debentures), which are convertible
into KFx common stock at a conversion price of $3.65. As of April 13, 2000,
Debentures with a face value of $1,650,000, have been converted into 452,049
shares of the Company's common stock at the contract conversion price of $3.65.
The Company continuing to evaluate alternatives to strengthen its balance sheet
including ways to induce conversion of all of substantially all of the
Debentures.


                                       42

<PAGE>   46

         The Company expects its cash requirements over the balance of 2000 with
respect to day-to-day operations and debt service requirements to be satisfied
by (a) cash on hand, which as of April 13, 2000 approximated $287,000; (b)
expected cash proceeds approximating $1.5 million from the KFP Sale, (c)
approximately $1.5 million of Kennecott Energy's discretionary investments in
Pegasus in connection with the achievement of milestones under the work plan,
pursuant to provisions of the agreements executed in March 2000; (d) potential
investments in Pegasus from interested participants in the power generation
industry; (e) potential debt and/or equity offerings of the Company; (f)
potential fees from licensing new K-Fuel facilities; (g) potential partners in
connection with opportunities to expand the Company's product and service
offerings to the power industry; (g) certain contract revenues relating to the
K-Fuel demonstration plant and laboratory; and (h) unsecured borrowings from one
or more of its directors.

         The Company has contacted and has been contacted by several large
suppliers to the power generation industry about the potential of making an
investment in Pegasus. In addition, the Company has contacted several prominent
investment banking firms about the potential for debt and/or equity offerings of
the Company and/or Pegasus. At this stage, discussions with all of these parties
are preliminary, but the Company intends to continue such discussions and
negotiate definitive agreements if acceptable terms can be reached. The Company
and Kennecott Energy are continuing to work diligently on an optimal design for
a 3 million ton-per-year K-Fuel plant and toward the objective of licensing such
a plant within approximately the next 12 months. Such a license, if agreed to,
would a generate gross initial license fee at the granting of the license
approximating $3.5 million, or approximately $2.2 million in cash, net of
related royalty obligations. The Company has had discussions with various
parties about potential transactions to add product and/or service offerings
relevant to the power generation industry. Such discussions have included
consideration of acquisitions and related transactions to raise equity capital
for the Company and/or Pegasus. Although there are no currently active
discussions, the Company will continue to evaluate the merits of pursuing such a
strategy, in view of the Company's evolving financial condition. In addition,
from time to time, directors of the Company have provide to the Company short
term unsecured financing and the Company expects that such financing, on at
least a short term basis, will continue to be available if needed.

         Depending on the outcome of various uncertainties, including those
discussed herein, the Company may be required to seek additional debt and/or
equity financing for general operating purposes and/or to meet debt service
requirements. The timing of collection of accounts receivable and payment of
accounts payable could significantly alter the Company's need for at least
temporary financing. Should the Company be required to seek any additional debt
and/or equity financing, its ability to do so will be affected by the terms of
the Debentures, under which the Company may only incur unsecured indebtedness of
up to $8.0 million (of which approximately $611,000 was outstanding as of April
14,, 2000) and indebtedness that is secured only by the assets of a particular
project and is non-recourse to the Company and its subsidiaries. In addition,
certain agreements with TCK contain restrictions on the Company's ability to
sell its common stock and incur indebtedness. Such TCK restrictions will be
cancelled if the KFP Sale closes, as expected on or before April 28, 2000.

         There are no assurances that any of these potential funding sources
will materialize, and the Company does not currently have any commitments with
respect to any such funding sources. If the overall outcome of the various
uncertainties affecting the Company is not favorable, the Company may be forced
to seek debt and/or equity financing on terms and conditions that may be
unfavorable to the Company, if available at all. If the Company requires
additional financing and cannot obtain it when needed or if Kennecott Energy
elects to sell the Pegasus common stock that it purchased from the Company back
to the Company, the Company may default on payments when due.

NEW ACCOUNTING PRONOUNCEMENTS

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 133, "Accounting for Derivative Instruments
and Hedging Activities" (SFAS 133). SFAS 133 establishes methods of accounting
for derivative financial instruments and hedging activities related to those
instruments as well as other hedging activities. SFAS 133,



                                       43
<PAGE>   47

as amended, is effective for fiscal years beginning after June 15, 2000. To date
the Company has not entered into any derivative financial instruments or hedging
activities.

     In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" (SAB
101). SAB 101 provides specific guidance, among other things, as to the
recognition of revenue related to up-front non-refundable fees and services
received in connection with a contractual arrangement. The Company has applied
the provisions of SAB 101 for the year ended December 31, 1999 and its
application did not have a material impact on the Company's results of
operations or financial condition.

YEAR 2000 COMPLIANCE

     Prior to December 31, 1999, the Company completed various analyses and
remediation procedures, as it considered necessary and prudent, to identify and
remediate potential Year 2000 issues that could create significant disruptions
or other difficulties related to the Company's business. Such analyses and
remediation procedures covered all internal systems of the Company and the
Pegasus products and also included surveys and other procedures, as considered
appropriate, related to the Company's suppliers and customers. These analyses
and remediation procedures were completed at a nominal cost to the Company. To
date the Company has not experienced any disruptions or other difficulties
related to the Year 2000 issue. Based on the results of analyses and remediation
procedures completed prior to December 31, 1999 and the absence of Year 2000
disruptions or other difficulties to date, management believes that its systems
and products are substantially Year 2000 compliant and the systems of its
suppliers and vendors are at least sufficiently Year 2000 compliant so as to
avoid any significant disruptions or other difficulties to the Company's
business.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company is not currently subject to a significant level of direct
market risk related to interest rates, foreign currency exchange rates,
commodity prices or equity prices. The Company has no derivative instruments or
any floating rate debt and does not expect to derive a material amount of its
revenues from interest bearing securities. Currently the Company has no
significant foreign operations. To the extent that the Company establishes
significant foreign operations in the future, it will attempt to mitigate risks
associated with foreign currency exchange rates contractually and through the
use of hedging activities and other means considered appropriate. The Company is
indirectly exposed to fluctuations in fuel commodity prices. To the extent that
fuel prices rise, there may be a tendency for greater demand for certain of the
Company's products and services, since K-Fuel and NeuSIGHT have been shown to
result in lower usage of coal and coal beneficiated fuel products when used to
generate electric power. The Company's fuel-related products provide various
environmental benefits that management believes significantly mitigate the fuel
commodity risk associated with the Company's business. The Company holds no
equity market securities, but does face equity market risk relative to its own



                                       44
<PAGE>   48

equity securities. This risk is most likely to be manifested by influencing the
Company's ability to raise debt or equity financing, if needed.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

     The consolidated financial statements and notes thereto included in this
item are indexed on page F-1 "Index to Consolidated Financial Statements."


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

     None.




                                       45
<PAGE>   49



                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

ITEM 11. EXECUTIVE COMPENSATION

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by items 10 through 13 is set forth under the
captions "Election of Directors," "Executive Officers," "Executive
Compensation," "Stock Ownership," and "Related Party Transactions" in the
Company's definitive proxy statement to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of
1934, as amended, not later than 120 days after the close of the Company's
fiscal year on December 31, 1999, and is incorporated herein by reference as if
set forth in full.


                                       46
<PAGE>   50
                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

     (1) Exhibits List

     The following exhibits are filed herewith or are incorporated by reference
to exhibits previously filed with the Securities and Exchange Commission. The
Company shall furnish copies of exhibits for a reasonable fee (covering the
expense of furnishing copies) upon written request. (Breaks in the sequence of
10.x exhibits listed below result from material contracts that have expired or
been cancelled.)


<TABLE>
<CAPTION>

EXHIBIT                                                                                      PAGE
  NO.                           DESCRIPTION                                                 NUMBER
-------                         -----------                                                 ------

<S>          <C>                                                                            <C>
3.1(1)       Restated Certificate of Incorporation of the Company                              -

3.2(1)       Certificate of Amendment to Certificate of Incorporation of the
             Company                                                                           -

3.3(5)       Second Amended and Restated Bylaws of the Company                                 -

4.1(5)       Sample Common Stock Certificate                                                   -

4.2(9)       Indenture dated July 25, 1997 by and between the Company and
             Colorado National Bank                                                            -

4.3          See item 10.18 below                                                              -
             [4.4-4.12 below]

10.1(1)      Amendments to Agreements between Theodore Venners, S.A. Wilson,
             Koppelman Fuel Development Company, and the Koppelman Group dated
             December 29, 1992                                                                 -

10.2(1)      Assignment of U.S. Patents by K-Fuel Limited Partnership to the
             Company dated July 23, 1993                                                       -

10.3(1)      Assignment of U.S. Trademark Registration by K-Fuel Limited
             Partnership to the Company dated July 23, 1993                                    -

10.4(1)      Royalty Agreement dated December 29, 1992 between the Company and
             the Koppelman Group                                                               -

10.5(1)      Agreement dated December 19, 1991 among K-Fuel Partnership, Edward
             Koppelman, K-Fuel Limited Partnership and KSA Inc.                                -

10.8(5)      Fourth Amendment to Office Lease dated August 17, 1995 between 1999
             Broadway Partnership and the Company                                              -

10.9(1)      Restricted Stock Plan for Directors and Selected Officers dated
             December 16, 1993                                                                 -

10.10(4)     Restricted Stock Plan for Selected Independent Contractors dated
             February 16, 1994                                                                 -

10.11(1)     Stock Option Plan dated December 16, 1993                                         -

10.12(1)     Settlement Agreement dated December 14, 1992                                      -

10.13(1)     Stock Exchange Agreement Dated December 14, 1992                                  -

10.14(1)     Stipulation and Agreement dated February 28, 1994 between Energy
             Brothers Technology, Inc., State of Wyoming, the Company, Theodore
             Venners, Edward Koppelman and Energy Brothers Holding, Inc.                       -

10.15(4)     Internal Revenue Service Private Letter ruling dated March 20, 1995               -
</TABLE>






                                       47
<PAGE>   51



<TABLE>
<CAPTION>

EXHIBIT                                                                                      PAGE
  NO.                           DESCRIPTION                                                 NUMBER
-------                         -----------                                                 ------

<S>          <C>                                                                            <C>

10.16(4)     Extension of Stock Forfeiture Agreement between Theodore Venners
             and Rudolph G. Swenson; Joyce M. Goldman; David Bretzlauf; Joseph
             M. Butler; R.C. Whitner; Hillari Koppelman; Thomas D. Smart and
             Susan M. Thevenet; Charles F. Vance                                               -

10.17(2)     Stock Purchase Agreement dated August 18, 1995 between the Company
             and Thermo Ecotek Corporation                                                     -

10.18(2)     Stock Purchase Warrants dated August 18, 1995 between the Company
             and Thermo Ecotek Corporation                                                     -

10.19(2)     Stockholders' Voting and Co-Sale Agreement dated August 18, 1995
             among the Company, Thermo Ecotek Corporation and Theodore Venners                 -

10.20(2)     Registration Rights Agreement dated August 18, 1995 between the
             Company and Thermo Ecotek Corporation                                             -

10.21(3)     Limited Partnership Agreement of KFX Fuel Partners, L.P. dated
             August 18, 1995                                                                   -

10.22(3)     Letter Agreement dated August 18, 1995 between Eco Fuels, Inc. and
             KFX Wyoming, Inc. regarding the Management, Operations and
             Maintenance Agreement                                                             -

10.23(3)     Gross Royalty Share Agreement dated August 17, 1995 between the
             Company and Fort Union, Ltd.                                                      -

10.24(3)     Indemnity Agreement dated August 18, 1995 between the Company and
             Thermo Ecotek Corporation                                                         -

10.25(3)     Letter of Agreement dated August 15, 1995 between the Company and
             Edward Koppelman                                                                  -

10.26(3)     Assignment dated August 29, 1995 executed by Edward Koppelman in
             favor of the Company                                                              -

10.28(3)     Patent and Technology License dated August 17, 1995 between Edward
             Koppelman and KFX Fuel Partners, L.P.                                             -

10.29(3)     Notice of Termination dated August 16, 1995 between Edward
             Koppelman and Energy Brothers Holding, Inc.                                       -

10.30(5)     Letter Agreement dated February 28, 1995 between RCD Development
             and the Company                                                                   -

10.31(6)     Limited Liability Company Agreement of K-Fuel, L.L.C. dated April
             19, 1996                                                                          -

10.32(6)     Pledge Agreement executed by Theodore Venners in favor of Kennecott
             Energy and Coal Company dated April 19, 1996                                      -

10.33(6)     Letter Agreement between Theodore Venners and Kennecott Energy and
             Coal Company dated April 22, 1996                                                 -

10.34(6)     Amended and Restated Heartland License Agreement between Heartland
             Fuels Corporation and the Company dated April 19, 1996                            -

10.35(7)     Royalty Amendment Agreement dated June 3, 1996 between the Company,
             Edward Koppelman and Theodore Venners                                             -

10.37(8)     Design-Build Agreement between the Company and Yanke Energy dated
             December 30, 1996                                                                 -

10.38(8)     Amendment to Agreement between the Company and RCD Development
             dated January 16, 1997                                                            -
</TABLE>




                                       48
<PAGE>   52

<TABLE>

<S>          <C>                                                                            <C>

10.39(9)     Purchase Agreement dated March 23, 1998 among the Company and
             Pegasus Technologies, Ltd. and the Lucier Group and The Radl Group                -

10.40(9)     Amended and Restated Operating Agreement of Pegasus Technologies
             dated March 23, 1998                                                              -

10.41(10)    1998 Directors Nonqualified Stock Option Plan                                     -

10.42(10)    1998 Advisory Committee Nonqualified Stock Option Plan                            -

10.43(10)    Non-qualified Stock Option Agreement dated October 1, 1998 between
             the Company and Seth L. Patterson                                                 -
             [10.44-10.52 below]

21.1(10)     Subsidiaries                                                                     30

23.1*        Consent of Independent Accountants                                               31

27.1*        Financial Data Schedule                                                           -

4.4(11)      Common Stock Purchase Warrant dated January 30, 1998 between the
             Company and George D. Crowley, Jr.

4.5(11)      Common Stock Purchase Warrant dated January 15, 1996 between the
             Company and Richard C. Whitner

4.6(11)      Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and Richard C. Whitner

4.7(11)      Company Stock Purchase Warrant dated January 30, 1998 between the
             Company and John F. Reim

4.8(11)      Company Stock Purchase Warrant dated June 19, 1997 and Amendment
             No. 2 dated August 3, 1998 between the Company and Peter G. Martin

4.9(11)      Common Stock Purchase Warrant dated August 2, 1995 and Amendment
             No. 1 dated August 3, 1998 between the Company and Peter G. Martin

4.10(11)     Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and Dawson Mathis

4.11(11)     Common Stock Purchase Warrant dated November 15, 1996 and Amendment
             No. 1 dated August 3, 1998 between the Company and Innovative
             Research Associates, Inc.

4.12(11)     Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and John P. Venners

10.44(11)    Stock Purchase Agreement dated March 26, 1997 between the Company
             and Theodore Venners

10.45(11)**  Professional Installation Services Master Agreement dated March 5,
             1999, between Net Power Solutions, a subsidiary of the Company, and
             the Energy Systems Group of Science Applications International
             Corporation

10.46(12)    1999 Stock Incentive Plan

10.47(13)**  First Amended Limited Liability Company Agreement of K-Fuel, L.L.C.
             dated June 29, 1999

</TABLE>


                                       49
<PAGE>   53

<TABLE>

<S>          <C>                                                                            <C>
10.48(14)**  Common Stock and Series A Preferred Stock Purchase Agreement among
             Pegasus Technologies, Inc., KFx Inc. and Kennecott Energy Company
             dated March 3, 2000

10.49(14)    Statement Respecting Rights of Series A Preferred Stock of Pegasus
             Technologies, Inc.

10.50(14)    Pegasus Technologies, Inc. Stockholders and Voting Agreement dated
             March 3, 2000

10.51(14)    Put Agreement dated March 3, 2000 between KFx Inc. and Kennecott
             Energy Company

10.52(14)    Marketing Services Agreement dated March 3, 2000 among Pegasus
             Technologies, Inc., Net Power Solutions, LLC, KFuel LLC, KFx Inc.
             and Kennecott Energy Company
</TABLE>


*         Filed herewith.

**        Certain portions of this Exhibit were omitted based upon a request for
          confidential treatment. The omitted portions were separately filed
          with the Securities and Exchange Commission.

(1)       Document previously filed with the U.S. Securities and Exchange
          Commission on March 1, 1994 as an exhibit to the Company's Form 10-SB
          and incorporated herein by reference.

(2)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Current Report on Form 8-K dated August
          18, 1995 and incorporated herein by reference.

(3)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Registration Statement on Form SB-2
          (File No. 33-97418) and incorporated herein by reference.

(4)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Registration Statement on Form SB-2
          (File No. 33-90128) and incorporated herein by reference.

(5)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-KSB, as
          amended, for the year ended December 31, 1995 and incorporated herein
          by reference.

(6)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Current Report on Form 8-K dated April
          19, 1996 and incorporated herein by reference.

(7)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Quarterly Report on Form 10-Q for the
          quarter ended June 30, 1996 and incorporated herein by reference.

(8)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1996 and incorporated herein by reference.




                                       50
<PAGE>   54

(9)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1997 and incorporated herein by reference.

(10)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1998 and incorporated herein by reference.

(11)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Quarterly Report on Form 10-Q for the
          quarter ended March 31, 1999 and incorporated herein by reference.

(12)      Document previously filed with the U.S. Securities and Exchange
          Commission on May 4, 1999 as Annex A-1 of the Company's Proxy
          Statement on Schedule 14A and incorporated herein by reference.

(13)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Registrant's Current Report on Form 8-K dated June
          29, 1999 and incorporated herein by reference.

(14)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Registrant's Current Report on Form 8-K dated
          March 7, 2000 and incorporated herein by reference.


     (2) Financial Statement Schedules

NA--None.

     (3) Reports on Form 8-K The Registrant filed a Current Report on Form 8-K
dated August 27, 1999 on October 1, 1999 with the U.S. Securities and Exchange
Commission regarding its acquisition of a 15% ownership interest in Pegasus from
AIW/P Holdings, Inc., a subsidiary of Computer Associates International in
exchange for 527,000 shares of the Registrant's common stock.



                                       51
<PAGE>   55


                                   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.

Date: April 14, 2000
                                     KFX INC.


                                     By: /s/ Theodore Venners
                                        ---------------------------------------
                                        Theodore Venners
                                        Chairman of the Board of Directors
                                        President and 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.


<TABLE>
<CAPTION>

         SIGNATURE                                        TITLE                                        DATE
         ---------                                        -----                                        -----

<S>                                          <C>                                                  <C>
/s/ Theodore Venners
-------------------------------------        Chairman of the Board of Directors President and      April 14, 2000
Theodore Venners                             Chief Executive Officer (Principal Executive
                                             Officer)
/s/ Seth L. Patterson
-------------------------------------        Executive Vice President and Chief Financial          April 14, 2000
Seth L. Patterson                            Officer (Principal Financial and Accounting
                                             Officer)
/s/ Stanford M. Adelstein
-------------------------------------        Director                                              April 14, 2000
Stanford M. Adelstein

/s/ Vincent N. Cook
-------------------------------------        Director                                              April 14, 2000
Vincent N. Cook

/s/ Mark S. Sexton
-------------------------------------        Director                                              April 14, 2000
Mark S. Sexton

/s/ David H. Russell
-------------------------------------        Director                                              April 14, 2000
David H. Russell

/s/ Jack C. Pester
-------------------------------------        Director                                              April 14, 2000
Jack C. Pester

/s/ Stanley G. Tate
-------------------------------------        Director                                              April 14, 2000
Stanley G. Tate
</TABLE>




                                       52
<PAGE>   56
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<S>                                                                <C>
Report of Independent Accountants............................              F-2


Consolidated Balance Sheets..................................              F-3


Consolidated Statements of Operations........................              F-4


Consolidated Statements of Stockholders' Equity (Deficit)....              F-5


Consolidated Statements of Cash Flows........................              F-6


Notes to Consolidated Financial Statements...................      F-7 to F-20
</TABLE>


                                      F-1
<PAGE>   57

                        REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and
Stockholders of KFx Inc.

     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity (deficit)
and of cash flows present fairly, in all material respects, the financial
position of KFx Inc. and its subsidiaries at December 31, 1999 and 1998, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1999, in conformity with accounting principles
generally accepted in the United States. 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 auditing standards generally
accepted in the United States which 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 the opinion expressed above.


/s/ PRICEWATERHOUSECOOPERS LLP
PricewaterhouseCoopers LLP


Denver, Colorado
April 14, 2000


                                      F-2
<PAGE>   58

                                    KFX INC.

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                                         DECEMBER 31,
                                                                                             ---------------------------------
                                                                                                 1999                  1998
                                                                                             ------------         ------------
<S>                                                                                          <C>                  <C>
                                             ASSETS
Current assets
     Cash and cash equivalents ......................................................        $    654,429         $  5,649,992
     Accounts receivable, including unbilled revenue ................................             673,320              952,977
     Accounts receivable-affiliates .................................................              24,252              193,842
     Accrued interest receivable ....................................................                  --               17,200
     Prepaid expenses ...............................................................              69,715              190,795
     Deferred job costs .............................................................             183,750                   --
                                                                                             ------------         ------------
          Total current assets ......................................................           1,605,466            7,004,806
Property, plant and equipment, net of accumulated depreciation ......................           2,258,426            3,243,812
Patents, net of accumulated amortization ............................................           2,297,708            2,722,069
Investment in and advances to KFx Fuel Partners, L.P. ...............................           1,527,048            3,779,412
Investment in K-Fuel, L.L.C .........................................................           1,171,585              159,967
Investment in Charco Redondo, L.L.C .................................................             629,238              629,238
Goodwill, net of accumulated amortization ...........................................           2,298,250            2,066,669
Debt issue costs, net of accumulated amortization ...................................           1,246,565            1,738,565
Prepaid royalty .....................................................................             498,000              498,500
Other assets ........................................................................             735,709              829,251
                                                                                             ------------         ------------
                                                                                             $ 14,267,995         $ 22,672,289
                                                                                             ============         ============
                         LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

Current liabilities
     Accounts payable ...............................................................        $    551,194         $    188,578
     Accrued expenses ...............................................................             308,102              247,011
     Due to related parties .........................................................                  --              471,504
     Interest payable ...............................................................             543,068              531,007
     Liability to issue warrants ....................................................           2,200,000                   --
     Deferred revenue ...............................................................             985,858              381,000
     Current maturity of long-term debt .............................................             891,167              704,207
                                                                                             ------------         ------------
          Total current liabilities .................................................           5,479,388            2,523,307
Deferred income .....................................................................           1,000,000                   --
Long-term debt, less current maturities .............................................             484,625              890,793
Convertible debentures ..............................................................          17,000,000           17,000,000
                                                                                             ------------         ------------
          Total liabilities .........................................................          23,964,013           20,414,100
                                                                                             ------------         ------------
Commitments and contingencies (Notes 3, 9, 14, 16, 19)

Stockholders' equity (deficit)
     Preferred stock, $.001 par value, 20,000,000 shares authorized; none issued ....                  --                   --
     Common stock, $.001 par value, 80,000,000 shares authorized;
        24,482,240 and 23,951,740 shares issued and outstanding, respectively .......              24,482               23,952
     Additional paid-in capital .....................................................          49,080,632           48,304,942
     Accumulated deficit ............................................................         (58,801,132)         (46,070,705)
                                                                                             ------------         ------------
          Total stockholders' equity (deficit) ......................................          (9,996,018)           2,258,189
                                                                                             ------------         ------------
                                                                                             $ 14,264,995         $ 22,672,289
                                                                                             ============         ============
</TABLE>


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


                                      F-3
<PAGE>   59

                                    KFX INC.

                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                                     YEAR ENDED DECEMBER 31,
                                                                     ------------------------------------------------------
                                                                         1999                 1998                 1997
                                                                     ------------         ------------         ------------
<S>                                                                  <C>                  <C>                  <C>
OPERATING REVENUES
Pegasus software licenses and services ......................        $  1,536,884         $  1,328,491         $         --
K-Fuel contract revenue .....................................             313,916              892,094            1,084,823
K-Fuel license fee ..........................................           1,000,000                   --                   --
                                                                     ------------         ------------         ------------
     Total operating revenues ...............................           2,850,800            2,220,585            1,084,823
                                                                     ------------         ------------         ------------
OPERATING COSTS & EXPENSES
Cost of Pegasus software licenses and services ..............           1,181,321              755,281                   --
K-Fuel royalty expense ......................................             250,000                   --                   --
K-Fuel demonstration plant and laboratory operations ........             414,246              888,616            1,250,692
Marketing, general and administrative expenses ..............           5,394,970            4,146,797            2,795,121
Pegasus research and development ............................             335,766              138,335                   --
Depreciation and amortization ...............................           2,751,539            2,710,570            1,969,561
                                                                     ------------         ------------         ------------
     Total operating costs & expenses .......................          10,327,842            8,639,599            6,015,374
                                                                     ------------         ------------         ------------
OPERATING LOSS ..............................................          (7,477,042)          (6,419,014)          (4,930,551)
Interest and other income ...................................             347,459              667,702              650,353
Interest expense ............................................          (1,160,098)          (1,159,925)            (546,985)
Equity in loss of unconsolidated affiliates .................            (440,746)            (573,080)            (267,977)
Loss on impairment of investment in KFx Fuel
  Partners, L.P. ............................................           4,000,000                   --                   --
Gain of sale of mine ........................................                  --              700,500                   --
                                                                     ------------         ------------         ------------
NET LOSS ....................................................        $(12,730,427)        $ (6,783,817)        $ (5,095,160)
                                                                     ============         ============         ============
BASIC AND DILUTED NET LOSS PER COMMON SHARE .................        $       (.53)        $       (.28)        $       (.21)
                                                                     ============         ============         ============
Weighted average common shares outstanding ..................          24,137,000           23,931,000           23,820,000
                                                                     ============         ============         ============
</TABLE>


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


                                      F-4
<PAGE>   60

                                    KFX INC.

            CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>

                                                                     COMMON STOCK                  ADDITIONAL
                                                            ------------------------------          PAID-IN            ACCUMULATED
                                                              SHARES            AMOUNT              CAPITAL              DEFICIT
                                                            ----------        ------------        ------------        ------------
<S>                                                         <C>               <C>                 <C>                 <C>
Balance, December 31, 1996 ............................     22,676,040        $     22,676        $ 44,693,093        $(34,191,728)
Stock issued for cash .................................      1,250,000               1,250           2,498,750                  --
Warrants issued in connection with placement of
convertible debentures ................................             --                  --             567,000                  --
Net loss ..............................................             --                  --                  --          (5,095,160)
                                                            ----------        ------------        ------------        ------------
Balance, December 31, 1997 ............................     23,926,040              23,926          47,758,843         (39,286,888)
Warrants and options issued for services ..............             --                  --             196,000                  --
Options issued in connection with acquisition .........             --                  --             253,750                  --
Stock issued for services .............................         25,700                  26              96,349                  --
Net loss ..............................................             --                  --                  --          (6,783,817)
                                                            ----------        ------------        ------------        ------------
Balance, December 31, 1998 ............................     23,951,740              23,952          48,304,942         (46,070,705)
Stock issued in connection with acquisition ...........        527,000                 527             762,569                  --
Stock issued for services .............................          3,500                   3              13,121
Net loss ..............................................             --                  --                  --         (12,730,427)
                                                            ----------        ------------        ------------        ------------
Balance, December 31, 1999 ............................     24,482,240        $     24,482        $ 49,080,632        $(58,801,132)
                                                            ==========        ============        ============        ============
</TABLE>


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


                                      F-5
<PAGE>   61

                                    KFx INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                            YEAR ENDED DECEMBER 31,
                                                                              ---------------------------------------------------
                                                                                  1999                1998               1997
                                                                              ------------         ------------      ------------
<S>                                                                           <C>                  <C>               <C>
OPERATING ACTIVITIES
   Net loss ..........................................................        $(12,730,427)        $ (6,783,817)     $ (5,095,160)
   Adjustments to reconcile net loss to cash used in operating
   activities:
          Depreciation and amortization ..............................           2,751,539            2,710,570         1,969,561
          Loss in impairment of investment in KFx Fuel
            Partners, L.P. ...........................................           4,000,000                   --                --
          Gain on sale of mine .......................................                  --             (700,500)               --
          Equity in loss of unconsolidated affiliates ................             440,746              573,080           267,977
          Common stock issued for services ...........................              13,124              292,375                --
          Other, net .................................................                  --              (81,070)          (16,197)
   Changes in operating assets and liabilities:
          Accounts receivable, affiliates ............................             169,590              (41,131)               --
          Receivables, unbilled revenue, deferred job
          cost, unearned revenue .....................................             715,303             (441,692)         (155,332)
          Due to related parties .....................................            (471,504)             (41,131)          (73,804)
          Trade payables .............................................             348,078              (92,493)         (516,911)
          Accrued interest and other liabilities .....................              90,352               86,649           435,452
          Deferred income ............................................           1,000,000                   --                --
          Other ......................................................             215,122             (122,898)         (147,281)
                                                                              ------------         ------------      ------------
Cash used in operating activities ....................................          (3,458,077)          (4,642,058)       (3,331,695)
                                                                              ------------         ------------      ------------
INVESTING ACTIVITIES
   Acquisition of Pegasus Technologies, Limited ......................                  --           (1,610,657)               --
   Patent acquisition and pending patent applications ................            (207,183)            (269,016)          (59,260)
   Investments in K-Fuel, L.L.C. .....................................          (1,000,000)             (98,876)         (334,813)
   Investments in KFx Fuel Partners, L.P. ............................                  --             (215,183)         (733,120)
   Investments in Charco Redondo, LLC ................................                  --             (629,238)               --
   Purchases of property and equipment ...............................            (111,095)            (302,075)          (16,175)
   Other .............................................................                  --             (701,878)          (36,224)
                                                                              ------------         ------------      ------------
Cash used in investing activities ....................................          (1,318,278)          (3,826,923)       (1,179,592)
                                                                              ------------         ------------      ------------
FINANCING ACTIVITIES
   Net proceeds from sale of common stock ............................                  --                   --         2,500,000
   Proceeds from issuance of notes/debentures ........................                  --              115,000        17,000,000
   Debenture placement fees ..........................................                  --                   --        (1,868,565)
   Payments on promissory notes ......................................            (219,208)             (74,800)         (445,000)
                                                                              ------------         ------------      ------------
Cash provided by (used in) financing activities ......................            (219,208)              40,200        17,186,435
                                                                              ------------         ------------      ------------
Increase (decrease) in cash and cash equivalents .....................          (4,995,563)          (8,428,781)       12,675,148
Cash and cash equivalents, beginning of period .......................           5,649,992           14,078,773         1,403,625
                                                                              ------------         ------------      ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD .............................        $    654,429         $  5,649,992      $ 14,078,773
                                                                              ============         ============      ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest ...............................................        $  1,148,037         $  1,130,437      $    134,605
                                                                              ============         ============      ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:
     See Notes 2, 12, 13, 14 and 15, 19
</TABLE>


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


                                      F-6
<PAGE>   62

                                    KFx INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.     NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CONSOLIDATION POLICY

     The consolidated financial statements include the accounts of KFx Inc.
("KFx" or the "Company"), its wholly-owned subsidiary, KFx Wyoming, Inc.
("KFxW"), and its majority-owned subsidiaries, Pegasus Technologies, Inc.
("Pegasus"), KFx Technology, Inc. ("KFxT"), and Heartland Fuels Corporation
("HFC"). The Company's 51 percent interest in K-Fuel, L.L.C. ("K-Fuel, LLC"),
and its 5 percent interest in KFx Fuel Partners, L.P. ("KFP") are accounted for
as equity investments as the Company does not have the authority or ability to
control these entities. All significant inter-company transactions have been
eliminated in consolidation.


NATURE OF OPERATIONS

     The Company is engaged in developing and delivering various technology and
service solutions to the electric power generation industry to facilitate the
industry's compliance with air emission standards and transformation to
intensive competition as the domestic power industry undergoes deregulation.

     Currently the Company has technology solutions that enhance the output of
coal-fired electric utility boilers while simultaneously reducing the related
environmental impacts. The patented K-Fuel Technology uses heat and pressure to
physically and chemically transform high-moisture, low-energy value coal and
other organic feedstocks into a low-moisture, high-energy solid clean fuel
("K-Fuel"). KFx plans to license K-Fuel Technology domestically and
internationally to various parties wishing to construct and operate K-Fuel
production facilities.

     In 1998, through the acquisition of a controlling interest in Pegasus, the
Company added NeuSIGHT(TM) to its solutions. NeuSIGHT is the leading combustion
optimization product for coal- fired electric utility boilers, which, in
addition to improving boiler efficiency, reduces Nox emissions. NeuSIGHT is a
neural network-based (i.e., artificial intelligence) software technology.
Pegasus developed NeuSIGHT and continues to enhance NeuSIGHT, develop related
products and market NeuSIGHT licenses and related implementation services.


SOFTWARE LICENSE AND SERVICES REVENUE

     The Company recognizes software licenses and services revenue in accordance
with the provisions of Statement of Position 97-2, "Software Revenue
Recognition." The Company derives such revenues from license fees for the
Company's NeuSIGHT software and services, including installation and
implementations, under the terms of both fixed-price and time and materials
contracts. Revenues are not recognized until persuasive evidence of an
arrangement exists, either by way of a signed contract or signed purchase order.

     Through December 31, 1999 the Company's installation services were
considered essential to the functionality of its software products because a
limited number of installations had been completed without significant
involvement of company personnel. Accordingly, software license fee and service
revenues during 1999 and 1998 were generally recognized using the
percentage-of-completion method of accounting, as prescribed by SOP 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts". The percentage of completion for each contract is determined based
on the ratio of direct labor hours incurred to total estimated direct labor
hours required to complete the contract. The Company may periodically encounter
changes in costs, estimated costs and other factors that may lead to a change in
the original estimated profitability of a fixed-price contract. In such
circumstances, adjustments


                                      F-7
<PAGE>   63

to cost and profitability estimates are made in the periods in which the
underlying factors requiring such revisions become known. If such revisions
indicate a loss on a contract, the entire loss is recorded at such time. Amounts
billed in advance of services being performed are recorded as deferred revenue
and are generally billed and collected within twelve months. Unbilled
work-in-progress represents revenue earned but not yet billed under the terms of
fixed price contracts. Deferred job costs represent up-front hardware costs
incurred that will be amortized to expense over the term of related revenue
recognition.

     Revenue from other services provided pursuant to time-and-materials
contracts is recognized as the services are performed. The Company did not
derive a significant level of revenues from maintenance contracts or training
services during 1999 and 1998.


FAIR VALUE OF FINANCIAL INSTRUMENTS

     The carrying amount of cash and cash equivalents, accounts receivable,
accounts payable, accrued liabilities and the current portion of long-term
obligations in the consolidated financial statements approximate fair value
because of the short-term maturity of the instruments. The fair value of
long-term obligations for long-term debt and the Convertible Debentures was
estimated by discounting the related future cash flows using market interest
rates and does not differ significantly from that reflected in the consolidated
financial statements.


LONG-LIVED ASSETS

     The Company evaluates long-lived assets based on estimated fair values or
estimated future undiscounted net cash flows, whichever is more readily
determinable, whenever significant events or changes in circumstances occur
which indicate the carrying amount may not be recoverable.


PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment are recorded at cost. Expenditures that
extend the useful lives of assets are capitalized. Repairs and maintenance that
do not extend the useful lives of the assets are expensed as incurred.
Depreciation expense is computed using the straight-line method over the
following estimated useful lives:

<TABLE>
<S>                                                                                      <C>
               Plant, machinery and equipment.............................               7-15 years
               Office furniture and equipment.............................                3-5 years
</TABLE>


PATENTS

     The Company holds patents to the Series "A", "B" and "C" K-Fuel
Technology. The costs of obtaining new patents are capitalized; costs of
defending and maintaining patents are expensed as incurred. Patents are
amortized over the lives of the respective patents of 17 to 20 years for
domestic patents and 5 to 20 years for foreign patents.


GOODWILL

     Goodwill, which was recorded in connection with the acquisition of Pegasus
using the purchase accounting method, is amortized on a straight-line basis over
an estimated useful life of five years from acquisition date.



                                      F-8
<PAGE>   64

DEFERRED FINANCING COSTS

     The Company capitalized issuance costs related to the convertible
debentures. These costs are amortized over the life of the debentures using the
straight-line method, the results of which are not materially different than
using the effective interest method because of the short life of the debentures.


RESEARCH AND DEVELOPMENT COSTS

     Research and development costs related to Pegasus software development are
expensed as incurred. Such costs are required to be expensed until such time as
technological feasibility of the product, process or improvement thereto is
established, after which remaining costs can be capitalized until general
availability of the product. The period of time between achieving technological
feasibility and general availability is typically short. To date, software
development costs qualifying for capitalization have been insignificant;
accordingly, the Company has not capitalized any software development costs.


STOCK BASED COMPENSATION

     The Company periodically grants qualified and non-qualified stock options
to certain executive officers, non-employee directors, other key employees and
certain consultants under three stock option plans as well as outside these
plans. Stock options granted are accounted for in accordance with Accounting
Principles Board Opinion No. 25--"Accounting for Stock Issued to Employees"
("APB25"), which generally provides that no compensation expense is recorded in
connection with the granting of stock options if the options are granted at
prices at least equal to fair value at date of grant.


NET LOSS PER COMMON SHARE

     Basic net loss per common share is based on the weighted average number of
common shares actually outstanding during each respective year. Except for
instances in which there is a net loss, the calculation of diluted net loss per
common share adds the weighted average number of potential common shares
outstanding to such number of weighted average common shares actually
outstanding. The Company's potential common shares outstanding result from
warrants to purchase the Company's common stock as described in Notes 6 and 15,
the conversion feature of the Convertible Debentures outstanding as described in
Note 12 and stock options outstanding as described in Note 14. All potential
common shares outstanding have been excluded from diluted net loss per common
share because the impact of such inclusion on a net loss would be anti-dilutive.


CASH AND CASH EQUIVALENTS

     The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At December
31, 1999 and 1998, cash and cash equivalents included commercial paper and money
market accounts of $93,384 and $5,564,992, respectively. Such amounts are
carried at amortized cost, which at December 31, 1999 and 1998 approximated fair
market value.


CONCENTRATIONS OF CREDIT RISK

         The Company's clients participate in various aspects of the electric
power generation industry and consist principally of several large electrical
utilities, Kennecott Energy and a Wyoming-based non-profit research
organization. Financial instruments which are potentially subject to
concentrations of credit risk consist principally of accounts receivable. The
Company considers the credit worthiness of its clients in negotiating contract
terms, which generally do not require collateral. At December 31, 1999 four
clients accounted for 10% or more each of consolidated receivables


                                      F-9
<PAGE>   65

(26%, 21%, 15%, and 14%). At December 31, 1998 five clients accounted for 10% or
more each of consolidated receivables (37%, 29%, 13%, 11% and 10%).


ESTIMATES

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenue and expenses during the periods
presented. Significant estimates have been made by management with respect to
the realizability of the Company's property, plant and equipment, patents,
equity investments, and prepaid royalty. Actual results could differ from these
estimates, making it possible that a change in these estimates could occur in
the near term.


RECLASSIFICATIONS

     Certain reclassifications have been made to the 1998 and 1997 financial
statements to conform to the current year presentation.


NOTE 2.   PEGASUS TECHNOLOGIES, LIMITED

     On March 23, 1998, the Company acquired a 60 percent interest in Pegasus,
an Ohio limited liability company that develops and markets computer software
products intended to optimize combustion and provide related benefits in
coal-fired electric utility power plants. The purchase price totaled $2,574,000
and consisted of a cash payment of $1,100,000, $600,000 in four-year promissory
notes, the agreement to provide an immediate capital contribution of $500,000
and certain costs related to the acquisition. The promissory notes bear interest
at 5% and require annual principal payments of $150,000 each anniversary date
until fully paid in March 2002. In addition, the Company agreed to issue to
certain Pegasus principals non-qualified stock options to purchase 75,000 shares
of KFx common stock under the Company's 1996 Stock Option and Incentive Plan at
$3.75 per share. The Company also issued 100,000 fully vested non-qualified
stock options to purchase KFx common stock under the Company's 1996 Stock Option
and Incentive Plan to a consultant who provided certain acquisition services.
Using the Black-Scholes option-pricing model, the stock options were valued at
$253,750; this amount is included in goodwill. In addition, the Company agreed
to provide Pegasus $1,400,000 in working capital guarantees secured through
lines of credit or other financing sources mutually acceptable to the Company
and Pegasus.

     Approximately $2,436,000 of the total purchase price was allocated to
goodwill, since the fair value of the underlying net assets of Pegasus at date
of acquisition was negative and there were no significant identifiable
intangible assets or research and development in process. Goodwill is being
amortized over five years and amortization expense totaled $531,515 and $369,364
in 1999 and 1998, respectively. The balance sheets of Pegasus at December 31,
1999 and 1998 and its results of operations for the year ended December 31, 1999
and the period March 24, 1998 to December 31, 1998 are included in the
consolidated financial statements of the Company.

     During August 1999, the Company issued 527,000 shares of its common stock
in exchange for an additional 15% interest in Pegasus. This transaction was
recorded based on the average price of KFx common stock shortly before the
transaction was completed, which approximated $1.45 per share. Accordingly, the
additional investment in Pegasus was recorded at approximately $763,000, all of
which has been allocated to goodwill, which will be amortized over five years.


                                      F-10
<PAGE>   66

     Unaudited pro forma operating results as if both purchases of equity in
Pegasus had occurred as of January 1, 1997 are summarized as follows:

<TABLE>
<CAPTION>
                                                           1999                1998                1997
                                                        -----------         -----------         -----------
                                                                            (UNAUDITED)
<S>                                                    <C>                 <C>                 <C>
Operating revenues .............................       $  2,851,000         $ 2,266,000         $ 1,891,000
Net loss .......................................        (12,832,000)         (7,284,000)         (6,026,000)
Basic net loss per common share ................               (.53)               (.30)               (.25)
</TABLE>


NOTE 3.   PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment consisted of the following:

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                           ---------------------------------
                                               1999                 1998
                                           ------------         ------------
<S>                                        <C>                  <C>
Demonstration plant ...............        $ 10,854,375         $ 10,854,375
Office and computer equipment .....             488,904              382,485
Other .............................             348,896              344,220
                                           ------------         ------------
                                             11,692,175           11,581,080
Less accumulated depreciation .....          (9,433,749)          (8,337,268)
                                           ------------         ------------
                                           $  2,258,426         $  3,243,812
                                           ============         ============
</TABLE>

     Depreciation expense was $1,096,481, $1,109,928, and $1,016,670 in 1999,
1998, and 1997, respectively.

     In order to facilitate the development of the production facility discussed
in Note 5, in 1995 the Company acquired certain coal mining and surface
properties near Gillette, Wyoming. The consideration paid for the properties is
in the form of a royalty share agreement whereby the Company is required to pay
Fort Union an amount equal to 20 percent of the royalty income received by the
Company from all North American applications of the K-Fuel process until the
earlier of such time as (1) Fort Union has received royalty share payments in
the amount of $1,500,000, or (2) September 15, 2015. Additionally, the Company
was required to assume the reclamation liabilities related to the acquired
properties. During 1998, this property was sold to KFP in exchange for KFP's
assumption of the mine reclamation liability, resulting in a gain of $700,500.

NOTE 4.   PATENTS

     Patents consisted of the following:

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                     ---------------------------------
                                                         1999                 1998
                                                     ------------         ------------
<S>                                                  <C>                  <C>
Series "A"  and "B"  patents ................        $  8,800,000         $  8,800,000
Series "C"  patents .........................           1,335,134            1,335,134
Foreign patents--granted ....................             323,066              212,922
Domestic and foreign patents--pending .......             458,643              401,604
Other .......................................              90,000               50,000
                                                     ------------         ------------
                                                       11,006,843           10,799,660
Less accumulated amortization ...............          (8,709,135)          (8,077,591)
                                                     ------------         ------------
                                                     $  2,297,708         $  2,722,069
                                                     ============         ============
</TABLE>


     Patents amortization expense, including abandoned patents, was $631,544,
$634,799, and $637,765 in 1999, 1998, and 1997, respectively.


                                      F-11
<PAGE>   67
NOTE 5. INVESTMENT IN KFX FUEL PARTNERS, L.P.

     In 1995, the Company acquired a 5 percent general and limited partnership
interest in KFP. Thermo Ecotek Corporation ("TCK") holds the remaining 95
percent general and limited partnership interest in KFP. In 1995, KFP began
construction of a 500,000 tons-per-year K-Fuel production facility near
Gillette, Wyoming, which was completed in 1998 at a total construction cost
approximating $66.5 million.

     TCK, the operating partner and 95% owner of KFP began reporting operating
results from the KFP Facility in April 1998. Although the KFP Facility has
operated and produced commercially salable product, TCK encountered difficulties
in achieving optimal and sustained operations. On May 24, 1999, TCK announced
its decision to hold for sale its investment in the KFP Facility and that it
would record related restructuring and other charges. Further, TCK in June 1999
suspended operations at the KFP Facility and K-Fuel is not currently being
produced. The Company's share of the losses of KFP were $452,364, $410,155, and
$-0- for 1999, 1998, and 1997, respectively. The Company's investment in KFP
approximated $3,327,000 at December 31, 1999.

     The Company is unable to predict with certainty the effect (including the
recoverability of the Company's $3.4 million investment related to the KFP
Facility) if any, of these actions of TCK on KFx. Management of KFx is actively
assisting in soliciting offers to purchase the KFP Facility and TCK is in active
negotiations with various parties. [Update for Black Hills transaction, etc
consistent with language in MD&A section of 10-K] No assurance can be given,
however, as to when or if the KFP Facility will be sold or when, if ever, it
will resume operations.

     In addition to its 5 percent interest in KFP, the Company receives a
royalty of 3 percent of the net sales of the KFP facility. The Company also
performed $197,273, $519,501 and $395,679 of technical services for KFP in 1999,
1998 and 1997, respectively; these amounts are included in contract revenues for
the periods.

NOTE 6. THERMO ECOTEK CORPORATION STOCK PURCHASE AGREEMENT

     In 1995, the Company and TCK entered into a stock purchase agreement (the
"Stock Purchase Agreement") whereby TCK acquired 1,500,000 shares of the
Company's common stock for $3 million, and the right to purchase up to an
additional 2,750,000 shares of the Company's common stock at the same price per
share. In December 1995, TCK purchased an additional 1,500,000 shares for $3.0
million. Additionally, TCK purchased the remaining 1,250,000 shares of common
stock in January 1997 for $2.5 million, increasing its ownership in the Company
to approximately 18 percent.

     In addition, as part of the Stock Purchase Agreement, the Company issued
two common stock purchase warrants to TCK. The first warrant ("Warrant A") is
for 7,750,000 shares of common stock of the Company at an exercise price of
$3.65 per share (subject to certain adjustments), and is exercisable, in whole
or in part, commencing on January 1, 2000 and expiring on July 31, 2001. The
second warrant ("Warrant B") gives TCK the right to purchase additional shares
of common stock that would be sufficient to give TCK ownership of 51 percent of
the outstanding shares of common stock of the Company, on a fully diluted basis,
on the exercise date. Warrant B is exercisable, in whole or in part, commencing
on January 1, 2000 and expiring on July 31, 2001, provided, however, that
Warrant B may not be exercised unless TCK has fully exercised Warrant A. The
exercise price of Warrant B will be the average daily closing price of the
common stock for the 40 trading days immediately preceding the exercise date. In
connection with efforts to sell the KFP Facility discussed in Notes, TCK is also
seeking to sell the common shares of KFx that it owns and is expected to cancel
Warrant A and Warrant B. [update for agreement with Black Hills and TCK]

NOTE 7. INVESTMENT IN K-FUEL, L.L.C.

     In April 1996, the Company and a wholly-owned subsidiary of Kennecott
Energy Company (Kennecott Energy), formed K-Fuel, LLC. Pursuant to the Limited
Liability Company Agreement (the "Agreement"), K-Fuel, LLC is




                                      F-12
<PAGE>   68


intended to be the vehicle for further technical advancement and the
commercialization of business opportunities arising out of the K-Fuel
Technology, including research and development, sublicensing, marketing and
consulting, but not including any actual construction of plants or facilities to
produce K-Fuel products on a commercial basis ("Commercial Projects"). Any
Commercial Projects will be constructed by separate entities in which Kennecott
Energy, the Company or both may have an equity interest and which will receive a
sublicense from K-Fuel, LLC for the K-Fuel Technology.

        Initially, the Company has a 51 percent interest in K-Fuel, LLC and
Kennecott Energy has a 49 percent interest, except to the extent of certain
research and development and amortization expenses, which by written agreement
are allocated 100 percent to Kennecott Energy. At such time as entities in which
Kennecott Energy has an equity interest have placed into service Commercial
Projects with a collective design capacity equal to or in excess of 3 million
tons of K-Fuel product per annum, Kennecott Energy will have a 51 percent
interest in K-Fuel, LLC and the Company will have a 49 percent interest. In
connection with an amendment to the Agreement executed in June, 1999 Kennecott
Energy paid to KFx a $1,000,000 K-Fuel license fee and an additional $1,000,000
that, in accordance with the amendment, was invested in K-Fuel LLC to fund
future development activities associated with the next phase of K-Fuel
commercialization. Kennecott Energy incurred research and development costs
totaling approximately $141,000, $51,000, and $879,000 in 1999, 1998, and 1997
respectively, and an additional $209,000, $327,000 and $371,000, for certain
administrative, marketing and project development activities in the United
States and Indonesia for the same periods. The Company contributed $1,000,000,
$99,000, and $334,000 to K-Fuel, LLC in 1999, 1998, and 1997 respectively, for
certain administrative, marketing and project development activities in the
United States and Indonesia. As of December 31, 1999, K-Fuel, LLC was not
committed to fund or construct any Commercial Projects.

     The activities and financial results of K-Fuel, LLC are accounted for by
the Company using the equity method, rather than as a consolidated subsidiary,
since the Company does not have the authority to control K-Fuel, LLC. The
Company recognized income of $11,618 and expense of $162,925, and $267,977 for
its equity share of the marketing, general and administrative expenses of
K-Fuel, LLC for 1999, 1998, and 1997 respectively. The Company's investment in
K-Fuel, LLC at December 31, 1999 was approximately $1,172,000.

         In connection with the Agreement, the Company granted K-Fuel, LLC an
exclusive, worldwide, fully-paid, royalty-free right and license (including the
right to grant sublicenses) to and under the K-Fuel Technology, except to the
extent that it pertains to the beneficiation or restructuring of coal or coal-
related feedstocks covered under the HFC License (as defined below) (the "KFx
License"). In addition, Heartland Fuels Corporation, an 85 percent owned
subsidiary of the Company, granted K-Fuel, LLC an exclusive, worldwide,
fully-paid, royalty-free right and license (including the right to grant
sublicenses) to and under the Series "A" and Series "B" K-Fuel Technology, as
it pertains to the beneficiation or restructuring of coal or coal-related
feedstocks (the "HFC License"). Both the KFx License and the HFC License
specify minimum terms and provisions for any sublicenses granted by K-Fuel, LLC
to third parties.

NOTE 8. CHARCO REDONDO, L.L.C.

     In December 1997, the Company purchased a 12.6 percent interest in Charco
Redondo, LLC, a Texas limited liability company, ("Charco") for $540,000, which
was funded during 1998. The Company has made additional investments
approximating $89,000 pursuant to cash calls made by Charco through December 31,
1998. During 1998, Charco successfully completed a pilot tertiary oil recovery
project.

NOTE 9. PREPAID ROYALTY

     In 1996, the Company entered into a royalty amendment agreement with Edward
Koppelman, the inventor of the K-Fuel Technology. As a result of the agreement,
Mr. Koppelman's royalty is now 25 percent of the Company's worldwide royalty and
license fee revenue, computed after a State of Wyoming royalty. The royalty to
Mr. Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. Mr. Koppelman is now deceased and his estate holds
all royalty rights.



                                      F-13
<PAGE>   69

     As consideration for the royalty amendment agreement, the Company paid Mr.
Koppelman $300,000 in cash and issued a promissory note for $200,000, which was
paid in full in 1997. The $500,000 prepaid royalty will be amortized based on
the difference between what royalty payments to Mr. Koppelman would have been on
the original royalty agreement and the amended royalty agreement reached in
1996.


NOTE 10.   DUE TO RELATED PARTIES

     Due to related parties consisted of the following:


<TABLE>
<CAPTION>

                                                                      DECEMBER 31,
                                                                -----------------------
                                                                    1999         1998
                                                                ----------   ----------
<S>                                                             <C>          <C>
Due to KFx Fuel Partners, L.P. ..............................   $       --   $  267,446
Due to K-Fuel, L.L.C ........................................                   204,058
                                                                ----------   ----------
     Total related party liabilities ........................   $       --   $  471,504
                                                                ==========   ==========
</TABLE>

     During 1999, 1998 and 1997, the Company wrote off $204,058, $95,653 and
$237,438, respectively, in net trade and related party payables since such
amounts were forgiven or otherwise determined to be no longer due.

NOTE 11. LONG-TERM DEBT

     Long-term debt consisted of the following:

<TABLE>
<CAPTION>

                                                                                                         DECEMBER 31,
                                                                                               ----------------------------
                                                                                                   1999            1998
                                                                                               ------------    ------------
<S>                                                                                            <C>             <C>
Unsecured promissory note, interest at 6.5 percent and payable February 29, 2000 ...........   $    500,000    $    500,000
Unsecured promissory note, interest at 8.0 percent and payable July 31, 2000 ...............        245,000         260,000
Unsecured promissory note, interest at 6.0 percent, payable in $10,000 quarterly
installments beginning March 2001 with the balance due December 2002 .......................        170,000         170,000
Unsecured promissory note, interest at 5.0 percent due with principal payments in four
annual payments approximating $150,000 each beginning March 1999 ...........................        460,792         600,000
Other ......................................................................................             --          65,000
                                                                                               ------------    ------------
                                                                                                  1,375,792       1,595,000
Less current maturities ....................................................................       (891,167)       (704,207)
                                                                                               ------------    ------------
                                                                                               $    484,625    $    890,793
                                                                                               ============    ============
</TABLE>


     Scheduled maturities of long-term debt at December 31, 1999 are as follows:
$, $891,167 in 2000, $213,475 in 2001, and $17,271,150 (including the
Convertible Debentures) in 2002.

NOTE 12. CONVERTIBLE DEBENTURES

     On July 31, 1997, the Company completed a private placement of unsecured
convertible debentures (the "Debentures") totaling $17.0 million. The
Debentures mature in July 2002 at 112% of principal amount, and have an annual
interest rate of 6.0 percent, payable semi-annually on January 31 and July 31.
The Debentures became convertible into shares of the Company's common stock at a
conversion price of $3.75 per share, beginning on October 30, 1997. On November
1, 1999, the conversion price changed to $3.65 per share in accordance with
provisions of the Debentures. The Debentures are callable by the Company at 130%
of principal amount after July 31, 1999. The Debentures contain covenants
related to investments, payment of dividends, additional indebtedness and
certain other matters. Management believes that the Company has complied with
the Debentures' covenants in all material respects. In connection with the sale
of the Debentures, the Company issued warrants to purchase 453,333 shares of
common stock to the placement





                                      F-14
<PAGE>   70
agents. See Note 15. In connection with the placement of the Debentures, the
Company incurred costs totaling $2,435,565, which were recorded as debt issue
costs and are being amortized over the life of the Debentures. Related
amortization expense was $492,000, $492,000 and $205,000 in 1999, 1998 and 1997,
respectively.

     The Debentures were offered, sold and delivered only to non-United States
persons outside of the United States pursuant to Regulation S of the Securities
Act of 1933, as amended.

NOTE 13. STOCKHOLDERS' EQUITY

     In September 1999, the Company issued 527,000 shares of its common stock in
exchange for an additional 15% interest in Pegasus. This transaction was
recorded at approximately $763,000 based on the average price of KFx common
stock shortly before the transaction was completed, which approximated $1.45 per
share.

     In July 1999, the Company issued 3,500 shares of the Company's Common Stock
for certain professional services at a value of $13,124.

     In 1998, the Company granted warrants and options to purchase 230,000
shares of the Company's common stock at an exercise price of $3.75-$4.38 per
share in exchange for certain professional services. Using the Black-Scholes
option-pricing model, the warrants were valued at $196,000; this amount is
included in marketing, general and administrative expenses for 1998.

     In 1998, the Company granted purchase options for 175,000 shares of the
Company's common stock under the Company's 1996 Stock Option and Incentive Plan
in connection with the Company's acquisition of a 60 percent interest in Pegasus
Technologies, LLC. Using the Black-Scholes option-pricing model, the stock
options were valued at $253,750; this amount is included in goodwill and
acquisition costs related to the acquisition of Pegasus Technologies, LLC.

     During 1998, the Company issued 25,700 shares of its common stock at $3.75
per share in exchange for consulting services; $96,375 of related expense is
included in marketing, general and administrative expenses.

     During 1997, the Company issued 1,250,000 shares of common stock for
$2,500,000 as part of the Stock Purchase Agreement.

     In connection with the sale of the Debentures, the Company issued to the
placement agents warrants to purchase 453,333 shares of common stock at an
exercise price of $5.00 per share, expiring in July 2002. The warrants were
valued at $567,000 using the Black-Scholes option-pricing model and are included
in the debt issue costs.

NOTE 14. STOCK OPTION PLANS

KFx

     The Company has three employee stock option plans--the Amended and Restated
Stock Option Plan (the "1992 Plan"), the 1996 Stock Option and Incentive Plan
(the "1996 Plan"), and the 1999 Stock Incentive Plan (the "1999 Plan"). These
plans are administered by the Compensation Committee of the Board of Directors
("Committee"), which subject to certain restrictions of the Internal Revenue
Code regarding incentive stock options ("ISO"), has the authority to determine
the specific terms of awards under these plans, including grant price, vesting
and term.

     The 1992 Plan provides for the award to the Company's executive officers,
non-employee directors, other key employees and consultants and others of
non-qualified stock options ("NSO") and ISOs. Stock options granted under the
1992 Plan generally vest 20 percent on the date of grant, with an additional 20
percent vesting on each anniversary date thereof until fully vested. The
Committee can accelerate the vesting of an outstanding option at its sole
discretion, and is required to accelerate the vesting of all outstanding options
outstanding under the 1992 Plan in the event of a



                                      F-15
<PAGE>   71


change in control of the Company, as defined (which includes a change in
ownership of 15% or more). As a result of TCK's investment in the Company on
January 31, 1997, increasing its ownership in the Company to in excess of 15
percent, all options outstanding under the 1992 Plan at that date became fully
vested at that time. Stock options granted under the 1992 Plan generally expire
not more than ten years from the date of grant. The Company has reserved
1,000,000 shares of common stock for issuance under the 1992 Plan, of which
178,000 options remain available for grant as of December 31, 1999.

     The 1996 Plan provides for the award to the Company's executive officers,
non-employee directors, other key employees and consultants and others of NSOs,
ISOs, stock appreciation rights ("SAR") and restricted stock. Stock options
granted under the 1996 Plan generally vest 20 percent on the first anniversary
date of the grant, and an additional 20 percent each anniversary date thereafter
until fully vested. The Committee has similar authority to accelerate the
vesting of any outstanding option as described above under the 1992 Plan, except
there are no specific change in control vesting requirements. Stock options
granted under the 1996 Plan generally expire not more than ten years from the
date of grant. The Company has reserved 1,500,000 shares of common stock for
issuance under the 1996 Plan, of which 20,666 options remain available for grant
at December 31, 1999. During 1999, 158,334 SARs were granted under the 1996
Plan; see further discussion of these SAR grants below.

         The 1999 Plan provides for the award to the Company's executive
officers, non employee directors, other key employees and consultants and others
of various forms of equity based compensation including, ISOs, NSOs, SARs, or
restricted stock. The Committee has similar authority to accelerate the vesting
of any outstanding option as described above under the 1992 Plan, except that
changes in control are generally transactions involving in excess of 50% of the
Company's common stock. The Company has reserved 2,000,000 shares of common
stock for issuance under the 1999 Plan, of which 1,270,000 options remain
available for grant at December 31, 1999. During 1999 730,000 SARs were granted
under the 1999 Plan; see further discussion of 1999 SAR grants later in this
footnote.

     In addition to the 1992 Plan, the 1996 Plan, and the 1999 Plan, the Company
has issued non-qualified stock options and restricted stock related to various
compensation and fee agreements with directors and employees of and consultants
to the Company.

     The following table summarizes the Company's stock option activity for the
three-year period ending December 31, 1999:

<TABLE>
<CAPTION>

                                                                       OPTION ACTIVITY
                                                                 ---------------------------
                                                                                   WEIGHTED                 WEIGHTED
                                                                                    AVERAGE                  AVERAGE
                                                                                   EXERCISE      OPTIONS     EXERCISE
                                                                    TOTAL          PRICE PER   EXERCISABLE  PRICE PER
                                                                   OPTIONS           SHARE     AT YEAR END    SHARE
                                                                 -----------       ---------   -----------  ----------

<S>                                                              <C>               <C>         <C>          <C>
Balance 12-31-96...........................................       2,365,500        $  5.28
Granted....................................................         885,000        $  4.01
Expired and cancelled......................................        (388,000)       $  5.92
                                                                 ----------
Balance 12-31-97...........................................       2,862,500        $  4.80     1,637,100    $    4.67
Granted....................................................       1,310,000        $  4.05
Expired and cancelled......................................        (300,500)       $  6.87
                                                                 ----------
Balance 12-31-98...........................................       3,872,000        $  4.38     2,273,000    $    4.42
Granted....................................................          71,000        $  3.75
Expired and cancelled......................................        (380,000)       $  4.31
                                                                 ----------
Balance 12-31-99...........................................       3,563,000        $  4.23     2,606,000    $    4.32
</TABLE>

     The range of exercise prices for stock options outstanding and exercisable
at December 31, 1999 was $2.50 per share to $7.39 per share. The weighted
average estimated grant date fair value of options granted in 1999, 1998 and
1997 was $.26 per share, $.95 per share and $2.12 per share, respectively. . All
stock options granted during each of the three years ended December 31, 1999
were at exercise prices that were not below the fair market value of the
Company's




                                      F-16
<PAGE>   72


common stock on the date of grant. Generally such grants were at the greater of
fair market value of the Company's common stock on the date of grant or $3.75
per share, due to restrictions imposed under the Convertible Debentures and the
TCK Stock Purchase Agreement.

Pegasus

     The Company's Pegasus subsidiary has adopted a separate stock option plan
(the "Pegasus Plan") that provides for the award to Pegasus' executive officers,
non employee directors, other key employees and consultants of various forms of
equity based compensation, including ISOs, NSOs, SARs, andr restricted stock.
The board of directors of Pegasus administers the Pegasus Plan and has similar
authority to the Committee to accelerate the vesting of any outstanding option
as described above under the 1992 Plan, except that changes in control are
generally transactions involving in excess of 50% of Pegasus' common stock.
Pegasus has reserved 2,500,000 shares of common stock for issuance under the
Pegasus Plan, which approximates 17.7% of the outstanding common stock of
Pegasus at December 31, 1999. During 1999, the board of directors of Pegasus
granted options to purchase 1,026,000 shares of Pegasus common stock at a
weighted average price of $1.01 per share. During 1998 options were granted to
purchase 742,421 options at a price of $.31 per share. Option prices are
equivalent to estimated market values at the dates of grant. The weighted
average estimated grant date fair value of options granted in 1999 was $.63 per
share. Vesting of options granted under the plan is generally at 2% per month,
with one grant vesting at 25% per year, and the options generally expire seven
years from date of grant. At December 31, 1999, options to purchase 1,768,421
shares included 742,421 options at a price of $.31 per share with a remaining
contractual life of 5.8 years and 1,026,000 of options at a weighted average
price of $1.01 per share, a price range of $1.00 to $1.10 per share, and a
weighted average remaining contractual life of 5.9 years. At December 31, 1999
options to purchase 447,565 shares of Pegasus common at a weighted average price
of $.73 per share stock were vested.

     The Company measures compensation expense under Accounting Principles Board
("APB") Opinion No. 25, which uses an intrinsic value approach to measurement,
i.e., compensation expense is generally recognized only when the exercise price
of an employee stock option or similar equity instrument is below the fair
market value of the underlying common stock on the date of grant.

     The following table summarizes the pro forma effects on net loss, and the
related assumptions under the Black-Scholes option pricing model, for the three
most recent fiscal years as if the Company had elected to implement the fair
value approach of accounting for stock options as provided by Statement of
Financial Accounting Standards No. 123 ("Accounting for Stock-Based
Compensation") issued in 1995:

<TABLE>
<CAPTION>

                                                     YEAR ENDED DECEMBER 31,
                                           -------------------------------------------------
                                                1999              1998              1997
                                           -------------     -------------     -------------

<S>                                        <C>               <C>               <C>
Net loss--pro forma ....................   $ (13,850,000)    $  (7,778,000)    $  (5,985,000)
Net loss per share--pro forma ..........   $        (.57)    $        (.33)    $        (.25)
Weighted average
     Risk free interest rate ...........            6.33%             4.86%             6.48%
     Expected option life (years) ......             5.9               5.9               6.7
     Expected volatility ...............            60.6%             50.6%             50.4%
     Expected dividends ................              NA                NA                NA
</TABLE>

         During the second half of 1999, the Company's Board of Directors
adopted a policy of granting stock-based compensation to directors in lieu of
directors' fees. Accordingly, SARs for 475,000 shares at a price of $1.00 per
share were granted to directors. The Company also granted SARs at a price of
$1.50 per share for 255,000 shares to certain employees, in lieu of cash
bonuses, and for approximately 158,000 shares to certain consultants, in lieu of
cash fee payments. The Company's closing stock price on the dates of grant was
$1.00 and the SARs were generally fully vested at date of grant, but cannot be
exercised until (a) the Company's Debentures are converted, redeemed or mature
and (b) Warrant A and Warrant B held by Thermo Ecotek Corporation are cancelled
(see Note 6). SARs granted to directors expire in ten years and consultants
generally expire five years from date of grant, in December 2004. The SARs
granted to employees expire upon the later of one year from date of grant, in
December 2000, or 30 days after the conditions precedent to exercisability have
been satisfied. Upon exercise of any of the SARs, the Company has the option of
(a)








                                      F-17
<PAGE>   73


paying the stock appreciation in excess of the grant price in cash, (b)
converting the SAR to a non-qualified stock option for the same number of shares
as covered by the SAR at the SAR grant price, or (c) granting common stock of
the Company with a value at the date of exercise equivalent to the amount of
stock appreciation at the date of exercise. Since the conditions precedent to
exercisability had not been satisfied at December 31, 1999, no expense
associated with these SAR grants was recognized in 1999.

NOTE 15. WARRANTS TO PURCHASE COMMON STOCK

     See Note 6 regarding the warrants held by TCK to acquire up to 51% of the
shares of the Company's common stock beginning in January 2000.

     Associated with various financing transactions and professional service
agreements, the Company has issued transferable warrants to purchase common
stock. The following table summarizes the outstanding warrants as of December
31, 1999, all of which are fully exercisable as of that date:

<TABLE>
<CAPTION>

                                                                   NUMBER      EXERCISE
                                                    TYPE OF          OF         PRICE
                                                  TRANSACTION      SHARES      PER SHARE     EXPIRATION
                                                  -----------     --------    -----------   ----------

<S>                                               <C>              <C>        <C>           <C>
Granted in 1997...............................      Services       453,333    $      5.00        2002
Granted in 1998...............................      Services       230,000    $3.75-$4.38        2001
                                                                  --------
                                                                   683,333
                                                                  ========
</TABLE>

     Warrants granted in 1997 related to the placement of the Convertible
Debentures. Warrants granted in 1998 related to certain professional service
expenses totaling $196,000.

NOTE 16. COMMITMENTS AND CONTINGENT LIABILITIES

     On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden ("Sanden")
filed a complaint against the Company in US District Court for the District of
Colorado. The complaint alleges that KFx, Link, Kobel and Sanden had entered
into an agreement requiring KFx to acquire Link and that KFx breached such
agreement. The complaint seeks damages in excess of $5.3 million. Although this
matter is still in discovery and its ultimate resolution cannot be predicted
with certainty, based on a preliminary review of the underlying facts and
discussion with counsel, management believes that this complaint is without
merit. KFx intends to contest this complaint vigorously. Accordingly, management
does not believe that this matter will have a material impact on the results of
operation or financial position of the Company.

     The Company is obligated for noncancelable operating leases with initial
terms exceeding one year relating to office space and certain equipment and
vehicle leases. Rent expense in 1999, 1998, and 1997 was $246,494, $204,847, and



                                      F-18
<PAGE>   74


$182,005, respectively. The lease agreements require future minimum lease
payments as follows:

<TABLE>
<CAPTION>

                                                                                             AMOUNT
                             YEAR ENDING DECEMBER 31,                                        PAYABLE
                             ------------------------                                        -------

<S>                                                                                        <C>
2000..............................................................................         $   275,000
2001..............................................................................             302,000
2002..............................................................................             309,000
2003..............................................................................             280,000
2004..............................................................................             189,000
</TABLE>

     As part of the restructured bond agreement with the State of Wyoming
(Wyoming) in 1994, Energy Brothers Holding, Inc., an affiliate of the Company,
and an officer and director of the Company executed a promissory note to Wyoming
for $819,000, with annual interest at 6 percent. The Company has agreed to
indemnify both Energy Brothers Holding, Inc. and the officer and director of the
Company to the extent that payments are made to Wyoming under the agreement. In
addition, the Company entered into a royalty agreement with Wyoming, which
requires the Company to pay Wyoming 12 percent of its domestic K-Fuel license
and royalty revenue. The rate decreases to 6 percent when cumulative payments
under the royalty agreement total $5 million.

     The Company is contingently liable to Ohio Valley Electric Corporation
("OVEC") for an overriding royalty of 0.5 percent to OVEC on the gross revenues
generated by the sale of fuel produced from any production plant (other than the
current facility owned by KFP) located in the United States in which the
feedstock is coal and which uses the Company's proprietary Series "C" K-Fuel
technology to produce fuel. The Company is contingently liable to Fort Union for
20 percent of the Company's North American royalty proceeds.

     Pegasus is contingently liable to certain of its founding stockholders for
a royalty equivalent to 2% of the license fee revenues derived from the sale its
NeuSIGHT product through November 30, 2004. This obligation is limited to the
extent of pretax income without regard to such royalty, subject to a maximum of
$2.5 million and subject to certain other limitations.

     Pursuant to an Indemnity Agreement dated August 18, 1995 between the
Company and TCK, the parties agreed, among other things, that (i) neither party,
nor any affiliate thereof may build, construct or operate, or have any interest
in a plant or facility, except as contemplated by the OVEC Fuel Option Agreement
and the I&M Fuel Option Agreement that would compete, directly or indirectly,
with the Project until the earlier of (a) five years after the date the KFP
Project commences commercial operation, (b) the date on which KFP has entered
into contracts for the sale of a minimum of 70 percent of the output of the KFP
Project for a term of at least five years, and (c) the date on which the
combined KFP interests of the Company and TCK total less than 50.1 percent;
provided, however, that such limitation shall not apply to the operations or
activities of the parties with respect to international (excluding Canada and
Mexico) business ventures and activities; and (ii) the Company shall guarantee
any loan created pursuant to the Partnership Agreement relating to a capital
call for the license to mine coal.

         On March 9, 1998, Fidelity and Deposit of Maryland (F&D), as subrogee
of Walsh Construction Company (Walsh), a division of Guy F. Atkinson Company,
filed a construction lien against KFP with respect to the construction of the
KFP Facility in the amount of approximately $5.9 million. It is not possible at
this time to evaluate the merits of the claim or the range of potential loss.
However, the Company believes that the ultimate resolution of this action will
not have a material adverse impact on the Company's financial position or
results of operations. In connection with this action, KFP has filed a
counterclaim in excess of $29 million against F&D, the surety company for Walsh.
The counterclaim asserts various claims of faulty construction performed by
Walsh at the KFP Facility. The counterclaim is in discovery and it is not
possible to predict the outcome of this action; however, the Company believes
that the counterclaim will not have a material impact on the Company's financial
position or results of operations.





                                      F-19
<PAGE>   75



NOTE 17. INCOME TAXES

     All of the Company's operations are currently domestic, with income taxable
at the federal statutory rate of 34 percent plus applicable state rates.
Deferred tax assets (liabilities) were comprised of the following:

<TABLE>
<CAPTION>

                                                                                         1999            1998
                                                                                     ------------    ------------
<S>                                                                                  <C>             <C>
Gross deferred tax assets:
     Loss (NOL) carryforwards ....................................................   $ 13,550,000    $ 10,712,000
     Depreciation and amortization ...............................................        956,000         632,000
     Deferred compensation .......................................................        473,000         482,000
     Accrued liabilities .........................................................        821,000
     Other .......................................................................        716,000          64,000
                                                                                     ------------    ------------
          Gross deferred tax assets ..............................................     16,516,000      11,890,000
          Deferred tax assets valuation allowance ................................    (16,516,000)    (11,890,000)
                                                                                     ------------    ------------
               Net deferred tax assets ...........................................   $         --    $         --
                                                                                     ============    ============
</TABLE>

     No net deferred tax asset has been recorded for NOL carryforwards or other
deferred tax assets because there is no assurance that such benefits will be
realized. The Company's tax return basis loss carryforwards of approximately
$36,400,000 expire in various amounts through 2014 as follows:

<TABLE>
<CAPTION>

     Five year period ending

<S>                                       <C>
     December 31, 2004                     $ 4,100,000
     December 31, 2009                     $ 6,600,000
     December 31, 2014                     $25,700,000
</TABLE>

     The Internal Revenue Code places certain limitations on the annual amount
of NOL carryforwards that can be used to offset taxable income in instances in
which certain significant changes in the Company's ownership have occurred over
a three year period. The Company does not believe that its NOL carryforward is
currently subject to such limitations but future ownership changes may trigger
such limitations.

     The Company's total provision for income taxes in 1999, 1998 and 1997 were
different from the amount expected by applying the statutory federal income tax
rate to the net loss. The approximate differences are as follows:

<TABLE>
<CAPTION>

                                                             1999             1998             1997
                                                       -------------    -------------    -------------

<S>                                                    <C>              <C>              <C>
Expected tax benefit on loss before income taxes ...   $  (4,328,000)   $  (2,306,000)   $  (1,732,000)
Expected state tax benefit, net ....................        (420,000)        (220,000)        (166,000)
Non-deductible items ...............................          40,000           42,000           27,000
Increase in valuation allowance ....................       4,626,000        2,507,000        1,704,000
Other ..............................................          82,000          (23,000)         167,000
                                                       -------------    -------------    -------------
     Total income tax benefit ......................   $          --    $          --    $          --
                                                       =============    =============    =============
</TABLE>


NOTE 18. SEGMENT INFORMATION

     KFx's reportable segments are based on its principal products and services,
which are optimization software and related services, through its Pegasus
subsidiary ("Pegasus" segment), and clean fuels technology, through certain
activities of KFx and certain of its subsidiaries ("K-Fuel" segment). Prior to
the acquisition of Pegasus in 1998 the Company had only the K-Fuel segment. The
accounting policies of these segments are the same as those described in Note 1.
In addition, the goodwill and related amortization resulting from the
acquisition of 60% of Pegasus in 1998 and the acquisition of an additional 15%
in 1999 is included in the Pegasus segment, using push-down accounting. KFx
evaluates the performance of its segments and allocates resources to them
primarily based on net income (loss) and operating cash flow. There are no
intersegment revenues; however, KFx's corporate office charges management and
related fees to the Pegasus segment.




                                      F-20
<PAGE>   76

         The tables below present information about revenues, certain income and
expense categories, net income (loss), cash used in operating activities,
segment assets and certain other information used by KFx's Chairman and CEO, its
chief operating decision maker, as of December 31, 1999 and 1998 and for the
years then ended:



                                      F-21
<PAGE>   77

<TABLE>
<CAPTION>


                                                                            Reconciling Items
1999                                        Pegasus            K-Fuel              (a)            Consolidated
----                                   ---------------    ---------------   -----------------   ---------------

<S>                                    <C>                <C>                <C>                <C>
Operating Revenues                     $     1,536,884    $     1,313,916                       $     2,850,800
                                       ---------------    ---------------    ---------------    ---------------

Operating Costs
   Cost of sales                             1,181,321                                                1,181,321
   Marketing, general and                    2,669,818             77,098    $     2,648,054          5,394,970
administrative
   Depreciation and amortization               616,563          1,627,657            507,319          2,751,539
   Other                                       335,766            664,246                             1,000,012
                                       ---------------    ---------------    ---------------    ---------------
Total Operating Costs                        4,803,468          2,369,001          3,155,373         10,327,842
                                       ---------------    ---------------    ---------------    ---------------
Operating Income                            (3,266,584)        (1,055,085)        (3,155,373)        (7,477,042)
Interest expense                              (259,097)                             (901,001)        (1,160,098)
Equity in loss of affiliates                                     (440,746)                             (440,746)
Loss in impairment of investment
  in KFx Fuel Partners, L.P.                                   (4,000,000)                           (4,000,000)
Interest income                                                                      124,402            124,402
Other income (expense)                                                               223,057            223,057
                                       ---------------    ---------------    ---------------    ---------------
Net Loss                                    (3,525,681)        (5,495,831)        (3,708,915)       (12,730,427)
                                       ---------------    ---------------    ---------------    ---------------
Cash Used in Operating Activities           (1,951,640)         1,495,898         (3,002,335)        (3,458,077)
                                       ---------------    ---------------    ---------------    ---------------
Capital Expenditures                           (96,365)           (14,730)                             (111,095)
                                       ---------------    ---------------    ---------------    ---------------
Investment in Equity Method
Subsidiaries                                                    5,127,871                             5,127,871
                                       ---------------    ---------------    ---------------    ---------------
Total Assets                                 3,457,574          9,052,687          1,757,734         14,267,995
                                       ---------------    ---------------    ---------------    ---------------
</TABLE>


<TABLE>
<CAPTION>

                                                                            Reconciling Items
1998                                       Pegasus             K-Fuel              (a)           Consolidated
----                                   ---------------    ---------------   -----------------   ---------------

<S>                                    <C>                <C>                <C>                <C>
Operating Revenues                     $     1,328,491    $       892,094                       $     2,220,585
                                       ---------------    ---------------    ---------------    ---------------
Operating Costs
   Cost of sales                               755,281                                                  755,281
   Marketing, general and                    1,224,910             50,312    $     2,871,575          4,146,797
administrative
   Depreciation and amortization               444,003          1,627,267            639,300          2,710,570
   Other                                       138,335            888,616                             1,026,951
                                       ---------------    ---------------    ---------------    ---------------
Total Operating Costs                        2,562,529          2,566,195          3,510,875          8,639,599
                                       ---------------    ---------------    ---------------    ---------------
Operating Income                            (1,234,038)        (1,674,101)        (3,510,875)        (6,419,014)
Interest expense                               (22,401)                           (1,137,524)        (1,159,925)
Equity in loss of affiliates                                     (573,080)                             (573,080)
Interest income                                                                      495,967            495,967
Other income (expense)                                            872,235                               872,235
                                       ---------------    ---------------    ---------------    ---------------
Net Loss                                    (1,256,439)        (1,374,946)        (4,152,432)        (6,783,817)
                                       ---------------    ---------------    ---------------    ---------------
Cash Used in Operating Activities           (1,693,259)           (22,059)        (2,926,740)        (4,642,058)
                                       ---------------    ---------------    ---------------    ---------------
Capital Expenditures                          (115,955)          (186,120)                             (302,075)
                                       ---------------    ---------------    ---------------    ---------------
Investment in Equity Method
Subsidiaries                                                    4,568,617                             4,568,617
                                       ---------------    ---------------    ---------------    ---------------
Total Assets                                 3,230,954         11,843,799          7,597,536         22,672,289
                                       ---------------    ---------------    ---------------    ---------------
</TABLE>

(a)  consists primarily of KFx corporate office activities and consolidating
     entries.





                                      F-22
<PAGE>   78

     Since its acquisition in 1998 only the Pegasus segment has derived any
significant revenue from outside the United States, which approximated $224,000
in 1999 and $166,000 in 1998. Such non-US revenues were derived from Pegasus
license and related installation service agreements with a customer in Canada,
pursuant to which Pegasus is paid in US dollars. Neither segment has any
significant assets outside of the United States.

         During 1999, two individual Pegasus clients accounted for greater than
10%, each, of consolidated revenues (19% and 11%). During 1998, three individual
Pegasus clients accounted for greater than 10%, each, of consolidated revenues
(22%, 13%, and 10%). During 1999 K-Fuel derived its revenues principally from
the K-Fuel license fee (35% of consolidated revenues). During 1998 K-Fuel
derived its revenue principally from two parties (25% of consolidated revenues
for services related to the KFP Facility and 15% of consolidated revenues from a
K-Fuel research and development contract).

NOTE 19. SUBSEQUENT EVENTS

         Through April 14, 2000, holder of Debentures with a face value of
$1,650,000 have exercised their conversions rights, resulting in the issuance of
452,049 shares of the Company's common stock, a reduction of stockholders'
deficit of $1,650,000 and a corresponding reduction in the balance of
Debentures.

     On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott
Energy resulting in (a) the sale of 4% of the common stock of Pegasus held by
KFx ("Pegasus Common Stock") to Kennecott Energy for $1,000,000, (b) the
issuance by Pegasus to Kennecott Energy, in exchange for $500,000, of newly
authorized 6% cumulative convertible preferred stock ("Pegasus Preferred Stock")
equivalent to an additional 2% interest in Pegasus on an as converted basis, (c)
the joint development by KFx, Pegasus and Kennecott Energy of a work plan for
enhancements to NeuSIGHT, new product development and the completion of other
tasks designed to improve the performance of Pegasus and trigger additional
purchases of Pegasus Preferred Stock by Kennecott Energy at its discretion of up
to $3,500,000, for an additional interest in Pegasus up to 14%, on an as
converted basis, by December 31, 2004 or earlier and (d) the conversion of
secured debt owed by Pegasus to KFx, totaling $3,630,000, into Pegasus Preferred
Stock, at the same price as provided to Kennecott Energy. As a result of this
transaction, at April 14, 2000, the ownership of Pegasus is approximately as
follows: KFx--74%, Pegasus management--20% and Kennecott Energy--6%. Kennecott
has the right to sell the Pegasus Common Stock back to KFx at any time before
March 3, 2001 at a price equal to the greater of $1,000,000 or fair market
value.

     On April 12, 2000 the Company executed agreements with various parties that
initiate the redevelopment of the KFP Facility. Pursuant to the agreements, if
all conditions to closing are met, (a) a subsidiary of Black Hills Corporation
(BHK) will purchase the KFP Facility and receive 2 million shares of KFx common
stock previously held by TCK in exchange for the assumption of the reclamation
liability associated with the KFP Facility, (b) BHK will be given the right to
one seat of KFx's board of directors and KFx will grant BHK a warrant to
purchase 1.3 million shares of KFx common stock at $3.65 per share, subject to
certain adjustments, (c) KFx will relinquish its 5% interest in KFP and provide
certain releases in exchange for cash proceeds estimated at $___ million, will
retain royalty right and certain real and personal property and has negotiated a
revenue-based service fee, (d) TCK will sell the remaining 2.25 million common
shares of KFx it owns to private investors and cancel the warrants it holds to
purchase a control position in KFx's common stock. KFx and BHK are proceeding to
finalize plans and secure the necessary capital to rectify certain design flaws
in the balance-of-plant systems, including the addition of an incinerator to
eliminate certain process waste streams, and to modify the plant to replace
natural gas with waste coal as the facility's energy source. The cost to
implement these plans is estimated at $10 million to $12 million. If efforts to
finalize plant modification plans and secure related capital are not successful
by August 2000, BHK has the options to salvage the equipment and reclaim the
site. The terms of the agreements provide for closing of these transactions not
later than April 28, 2000. The carrying value of the Company's investment in KFP
has been written down effective December 31, 1999 by $1.5 million, to the $1.8
million near term cash proceeds expected if these transactions close.

[Restructuring of St of Wyo notes]

     Principal and interest under the promissory note (Note) to the State of
Wyoming (Wyoming) in the amount of $500,000 was due February 29, 2000, but not
paid.  The Company initiated discussions with Wyoming in advance of the maturity
date and paid the interest due under the Note on April 10, 2000.  On April 12,
2000, Wyoming granted the Company an extension until May 5, 2000 to renegotiate
definitive repayment terms.  Although Wyoming never issued a notice of default
to the Company, non payment of the principal and interest under the Note may
constitute a technical default under the Note, which if considered to be a
material default, could be considered an event of default under the Debentures.
Based on the opinion of Wyoming counsel, however, the Company believes that
since Wyoming did not issue a notice of default on the Note and Wyoming
subsequently granted an extension of the Note, that any default that may be
deemed to have occurred is not material and would not therefore constitute an
event of default under the Debentures.  The Company is continuing its
discussions with Wyoming and is seeking an extension of principal payments on
the Note through April 30, 2001 or later.  There can be no assurance that such
an extension will be granted by Wyoming.

     Circumstances substantially identical to those in the preceeding paragraph
arose relative to promissory notes due Wyoming by KFx's Chairman and one of his
affiliates.  The Company agreed in 1994 to indemnify its Chairman and his
affiliate for any payments due under such note.  The Company's Chairman and his
affiliate have agreed that if any principal payments are required before April
30, 2001, that they will waive their rights under the indemnity until after
April 30, 2001.

                                      F-23
<PAGE>   79

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>

EXHIBIT
  NO.                           DESCRIPTION
-------                         -----------

<S>          <C>
3.1(1)       Restated Certificate of Incorporation of the Company

3.2(1)       Certificate of Amendment to Certificate of Incorporation of the
             Company

3.3(5)       Second Amended and Restated Bylaws of the Company

4.1(5)       Sample Common Stock Certificate

4.2(9)       Indenture dated July 25, 1997 by and between the Company and
             Colorado National Bank

4.3          See item 10.18 below
             [4.4-4.12 below]

10.1(1)      Amendments to Agreements between Theodore Venners, S.A. Wilson,
             Koppelman Fuel Development Company, and the Koppelman Group dated
             December 29, 1992

10.2(1)      Assignment of U.S. Patents by K-Fuel Limited Partnership to the
             Company dated July 23, 1993

10.3(1)      Assignment of U.S. Trademark Registration by K-Fuel Limited
             Partnership to the Company dated July 23, 1993

10.4(1)      Royalty Agreement dated December 29, 1992 between the Company and
             the Koppelman Group

10.5(1)      Agreement dated December 19, 1991 among K-Fuel Partnership, Edward
             Koppelman, K-Fuel Limited Partnership and KSA Inc.

10.8(5)      Fourth Amendment to Office Lease dated August 17, 1995 between 1999
             Broadway Partnership and the Company

10.9(1)      Restricted Stock Plan for Directors and Selected Officers dated
             December 16, 1993

10.10(4)     Restricted Stock Plan for Selected Independent Contractors dated
             February 16, 1994

10.11(1)     Stock Option Plan dated December 16, 1993

10.12(1)     Settlement Agreement dated December 14, 1992

10.13(1)     Stock Exchange Agreement Dated December 14, 1992

10.14(1)     Stipulation and Agreement dated February 28, 1994 between Energy
             Brothers Technology, Inc., State of Wyoming, the Company, Theodore
             Venners, Edward Koppelman and Energy Brothers Holding, Inc.

10.15(4)     Internal Revenue Service Private Letter ruling dated March 20, 1995
</TABLE>





<PAGE>   80



<TABLE>
<CAPTION>

EXHIBIT
  NO.                           DESCRIPTION
-------                         -----------

<S>          <C>
10.16(4)     Extension of Stock Forfeiture Agreement between Theodore Venners
             and Rudolph G. Swenson; Joyce M. Goldman; David Bretzlauf; Joseph
             M. Butler; R.C. Whitner; Hillari Koppelman; Thomas D. Smart and
             Susan M. Thevenet; Charles F. Vance

10.17(2)     Stock Purchase Agreement dated August 18, 1995 between the Company
             and Thermo Ecotek Corporation

10.18(2)     Stock Purchase Warrants dated August 18, 1995 between the Company
             and Thermo Ecotek Corporation

10.19(2)     Stockholders' Voting and Co-Sale Agreement dated August 18, 1995
             among the Company, Thermo Ecotek Corporation and Theodore Venners

10.20(2)     Registration Rights Agreement dated August 18, 1995 between the
             Company and Thermo Ecotek Corporation

10.21(3)     Limited Partnership Agreement of KFX Fuel Partners, L.P. dated
             August 18, 1995

10.22(3)     Letter Agreement dated August 18, 1995 between Eco Fuels, Inc. and
             KFX Wyoming, Inc. regarding the Management, Operations and
             Maintenance Agreement

10.23(3)     Gross Royalty Share Agreement dated August 17, 1995 between the
             Company and Fort Union, Ltd.

10.24(3)     Indemnity Agreement dated August 18, 1995 between the Company and
             Thermo Ecotek Corporation

10.25(3)     Letter of Agreement dated August 15, 1995 between the Company and
             Edward Koppelman

10.26(3)     Assignment dated August 29, 1995 executed by Edward Koppelman in
             favor of the Company

10.28(3)     Patent and Technology License dated August 17, 1995 between Edward
             Koppelman and KFX Fuel Partners, L.P.

10.29(3)     Notice of Termination dated August 16, 1995 between Edward
             Koppelman and Energy Brothers Holding, Inc.

10.30(5)     Letter Agreement dated February 28, 1995 between RCD Development
             and the Company

10.31(6)     Limited Liability Company Agreement of K-Fuel, L.L.C. dated April
             19, 1996

10.32(6)     Pledge Agreement executed by Theodore Venners in favor of Kennecott
             Energy and Coal Company dated April 19, 1996

10.33(6)     Letter Agreement between Theodore Venners and Kennecott Energy and
             Coal Company dated April 22, 1996

10.34(6)     Amended and Restated Heartland License Agreement between Heartland
             Fuels Corporation and the Company dated April 19, 1996

10.35(7)     Royalty Amendment Agreement dated June 3, 1996 between the Company,
             Edward Koppelman and Theodore Venners

10.37(8)     Design-Build Agreement between the Company and Yanke Energy dated
             December 30, 1996

10.38(8)     Amendment to Agreement between the Company and RCD Development
             dated January 16, 1997
</TABLE>


<PAGE>   81

<TABLE>

<S>          <C>

10.39(9)     Purchase Agreement dated March 23, 1998 among the Company and
             Pegasus Technologies, Ltd. and the Lucier Group and The Radl Group

10.40(9)     Amended and Restated Operating Agreement of Pegasus Technologies
             dated March 23, 1998

10.41(10)    1998 Directors Nonqualified Stock Option Plan

10.42(10)    1998 Advisory Committee Nonqualified Stock Option Plan

10.43(10)    Non-qualified Stock Option Agreement dated October 1, 1998 between
             the Company and Seth L. Patterson
             [10.44-10.52 below]

21.1*        Subsidiaries

23.1*        Consent of Independent Accountants

27.1*        Financial Data Schedule

4.4(11)      Common Stock Purchase Warrant dated January 30, 1998 between the
             Company and George D. Crowley, Jr.

4.5(11)      Common Stock Purchase Warrant dated January 15, 1996 between the
             Company and Richard C. Whitner

4.6(11)      Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and Richard C. Whitner

4.7(11)      Company Stock Purchase Warrant dated January 30, 1998 between the
             Company and John F. Reim

4.8(11)      Company Stock Purchase Warrant dated June 19, 1997 and Amendment
             No. 2 dated August 3, 1998 between the Company and Peter G. Martin

4.9(11)      Common Stock Purchase Warrant dated August 2, 1995 and Amendment
             No. 1 dated August 3, 1998 between the Company and Peter G. Martin

4.10(11)     Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and Dawson Mathis

4.11(11)     Common Stock Purchase Warrant dated November 15, 1996 and Amendment
             No. 1 dated August 3, 1998 between the Company and Innovative
             Research Associates, Inc.

4.12(11)     Common Stock Purchase Warrant dated January 15, 1997 between the
             Company and John P. Venners

10.44(11)    Stock Purchase Agreement dated March 26, 1997 between the Company
             and Theodore Venners

10.45(11)**  Professional Installation Services Master Agreement dated March 5,
             1999, between Net Power Solutions, a subsidiary of the Company, and
             the Energy Systems Group of Science Applications International
             Corporation

10.46(12)    1999 Stock Incentive Plan

10.47(13)**  First Amended Limited Liability Company Agreement of K-Fuel, L.L.C.
             dated June 29, 1999

</TABLE>


<PAGE>   82

<TABLE>

<S>          <C>
10.48(14)**  Common Stock and Series A Preferred Stock Purchase Agreement among
             Pegasus Technologies, Inc., KFx Inc. and Kennecott Energy Company
             dated March 3, 2000

10.49(14)    Statement Respecting Rights of Series A Preferred Stock of Pegasus
             Technologies, Inc.

10.50(14)    Pegasus Technologies, Inc. Stockholders and Voting Agreement dated
             March 3, 2000

10.51(14)    Put Agreement dated March 3, 2000 between KFx Inc. and Kennecott
             Energy Company

10.52(14)    Marketing Services Agreement dated March 3, 2000 among Pegasus
             Technologies, Inc., Net Power Solutions, LLC, KFuel LLC, KFx Inc.
             and Kennecott Energy Company
</TABLE>


*         Filed herewith.

**        Certain portions of this Exhibit were omitted based upon a request for
          confidential treatment. The omitted portions were separately filed
          with the Securities and Exchange Commission.

(1)       Document previously filed with the U.S. Securities and Exchange
          Commission on March 1, 1994 as an exhibit to the Company's Form 10-SB
          and incorporated herein by reference.

(2)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Current Report on Form 8-K dated August
          18, 1995 and incorporated herein by reference.

(3)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Registration Statement on Form SB-2
          (File No. 33-97418) and incorporated herein by reference.

(4)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Registration Statement on Form SB-2
          (File No. 33-90128) and incorporated herein by reference.

(5)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-KSB, as
          amended, for the year ended December 31, 1995 and incorporated herein
          by reference.

(6)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Current Report on Form 8-K dated April
          19, 1996 and incorporated herein by reference.

(7)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Quarterly Report on Form 10-Q for the
          quarter ended June 30, 1996 and incorporated herein by reference.

(8)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1996 and incorporated herein by reference.




<PAGE>   83

(9)       Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1997 and incorporated herein by reference.

(10)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Annual Report on Form 10-K for the year
          ended December 31, 1998 and incorporated herein by reference.

(11)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Company's Quarterly Report on Form 10-Q for the
          quarter ended March 31, 1999 and incorporated herein by reference.

(12)      Document previously filed with the U.S. Securities and Exchange
          Commission on May 4, 1999 as Annex A-1 of the Company's Proxy
          Statement on Schedule 14A and incorporated herein by reference.

(13)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Registrant's Current Report on Form 8-K dated June
          29, 1999 and incorporated herein by reference.

(14)      Document previously filed with the U.S. Securities and Exchange
          Commission with the Registrant's Current Report on Form 8-K dated
          March __, 2000 and incorporated herein by reference.