Document:

<PAGE>

                                                                    EXHIBIT 10.6

        PHASE II DEVELOPMENT AND PHASE III FEASIBILITY STUDY AGREEMENT

          This DEVELOPMENT AGREEMENT ("Agreement") is effective as of
January 22, 1999, ("Effective Date") by and between Active Power, 11525
Stonehollow Drive, Suite 135, Austin, Texas 78758  ("ACTIVE POWER") and
Caterpillar Inc., 100 N.E. Adams Street, Peoria, Illinois  61629-6490
("CATERPILLAR").

          1.   DEFINITIONS
               -----------

          For purposes of this AGREEMENT, the following definitions shall apply:

               a)   "AFFILIATE" means any company, corporation, partnership or
other business entity which is more than fifty percent (50%) or more owned,
directly or indirectly, by a party to this AGREEMENT.

               b)   "BACKGROUND INTELLECTUAL PROPERTY" shall be all INTELLECTUAL
PROPERTY incorporated into the PHASE II PRODUCT other than that which is defined
as PROGRAM INTELLECTUAL PROPERTY.

               c)   "FIELD OF USE" shall mean earth-moving equipment,
construction equipment, mining equipment, forestry equipment, engines, engine
generator sets, agricultural equipment, paving equipment, components for all
such equipment and all reasonable extensions thereof which are mutually agreed
in writing by the parties hereto.

               d)   "INTELLECTUAL PROPERTY" includes, without limitation,
inventions, whether or not patentable, copyrights, computer software and
accompanying documentation, specifications, know how and original works of
authorship. INTELLECTUAL PROPERTY includes PROPRIETARY INFORMATION.

               e)   "PROGRAM INTELLECTUAL PROPERTY" means INTELLECTUAL PROPERTY
that is  created, made, conceived or reduced to practice in performance of work
under the PROGRAM with respect to UPS electronics (identified as such in Exhibit
E) or UPS packaging.

               f)   "PROGRAM" shall mean the efforts of CATERPILLAR or ACTIVE
POWER to develop PHASE II PRODUCTS.

          2.   PROGRAM
               -------

          CATERPILLAR and ACTIVE POWER have agreed to a PHASE I program under a
separate agreement governing the purchase of certain PHASE I products.  This
Agreement governs Phase II development and preliminary Phase III discussions.
Notwithstanding anything contained in this Agreement and subject to the
restrictions in the PHASE I Purchase Agreement, nothing contained herein shall
preclude ACTIVE POWER from selling or otherwise disposing of ACTIVE POWER'S
CleanSource flywheel energy storage system.

               a)   PHASE II

                    (i)  The parties shall cooperate to develop a PHASE II
PRODUCT which shall include an industrial duty uninterruptible power supply
("UPS") and a CleanSource flywheel. The PHASE II PRODUCT specification and
requirements are detailed in Exhibit A ("Specifications").

                                       1
<PAGE>

                    (ii)   The parties will cooperate with one another to
design, develop and test the PHASE II PRODUCT for possible use with CATERPILLAR
generator sets. ACTIVE POWER will make one prototype that conforms with the
Specifications. If the parties mutually agree on any changes to the
Specifications during the development process, such changes shall be
incorporated into the Specifications and be attached to,and become part of, this
Agreement. The parties will test this prototype, at a mutually, reasonably
agreed upon site, for compliance with the Specifications (except for the
Specification relating to reliability target) stated in Exhibit A. Each party
will document and report to the other party the results of such tests performed
on such prototype together with any comments concerning design changes, further
development, and the like. CATERPILLAR will accept or reject the PHASE II
PRODUCT prototype within thirty (30) calendar days after testing begins at the
site selected by CATERPILLAR (however, if CATERPILLAR fails to indicate a
testing location within sixty (60) days after ACTIVE POWER has completed
Milestone 2 (as set forth in Exhibit C), the testing site shall be ACTIVE
POWER's site in Austin Texas); failure to give notice of acceptance or rejection
will constitute acceptance. CATERPILLAR may reject the PHASE II PRODUCT only if
it fails in some respect to meet the Specifications (except for the
Specification relating to reliability target) stated in Exhibit A. If
CATERPILLAR properly rejects the PHASE II PRODUCT, ACTIVE POWER may correct the
failures and when it believes that it has made the necessary corrections and has
notified CATERPILLAR, the parties will again test the PHASE II prototype and the
acceptance/rejection/correction provisions above shall be reapplied until the
PHASE II PRODUCT is accepted; provided, however, if a correction to a
deliverable that is rejected by CATERPILLAR for failure to meet a Specification
(except for the Specification relating to reliability target) set forth in
Exhibit A is not accepted, Caterpillar may terminate this Agreement. The day on
which CATERPILLAR accepts the PHASE II PRODUCT shall be deemed the "Acceptance
Date". After the Acceptance Date, CATERPILLAR may purchase additional prototypes
at a price per prototype defined by the pricing for Phase II Product in Exhibit
B. Any prototypes shall be provided to CATERPILLAR on an "AS IS" basis.

                    (iii)  Within ninety (90) days following the Acceptance
Date, CATERPILLAR shall have the option of purchasing such PHASE II PRODUCTS
pursuant to the provisions of the Phase II Purchase Agreement Terms and
Conditions ("Phase II Purchase Option") as specified in Exhibit B hereto. In the
event of conflict between this Agreement and the Phase II Purchase Agreement
Terms and Conditions, this Agreement shall control. Caterpillar may exercise
such Phase II Purchase Option by providing written notice to Active Power of
such exercise within the aforesaid 90 day period. ACTIVE POWER will cooperate
with CATERPILLAR during reliability testing to meet the reliability targets.

               b)   PHASE III

                    (i)    CATERPILLAR and ACTIVE POWER will negotiate
reasonably and in good faith towards a PHASE III development program ("PHASE III
PROGRAM"), which presently contemplates the activities specified below in
paragraph 2(b)(iii).

                    (ii)   CATERPILLAR and ACTIVE POWER may agree to jointly
fund any PHASE III PROGRAM.

                    (iii)  The PHASE III PROGRAM development will include a
jointly completed feasibility study [****] that is based on the PHASE II PROGRAM
developments, ACTIVE POWER's flywheel technology, and CATERPILLAR's knowledge of
the generator set market. The parties will also explore other opportunities for
application of the PHASE II PRODUCT and opportunities for further joint
development efforts to expand the PHASE II PRODUCT's capabilities. The study
will identify the scope

                                       2

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**
<PAGE>

of the market opportunity, required resources, technical risk, and an initial
application. [****] It is envisioned that the feasibility study will provide
ACTIVE POWER and CATERPILLAR with necessary information to complete a long-term
[****] alliance agreement.

          3.   PHASE II COSTS
               --------------

               a)   Unless otherwise stated in this Agreement or later mutually
agreed to in writing specifically referencing this Agreement, each party will
bear its own costs incurred in the PROGRAM.

               b)   Caterpillar agrees to pay Active Power for co-ownership of
PROGRAM INTELLECTUAL PROPERTY the sum of $5,000,000 (five million dollars). The
payments shall be made in installments, each installment being due and payable
upon the objective satisfaction of each of the five milestones in the payment
schedule listed in Exhibit C ("Payment Milestones"). Other than the payments
specified above, Caterpillar shall not be responsible for any other payments or
funding, and Active Power shall bear all its costs for participating in this
Program, or any part thereof. Caterpillar shall bear its own costs for
participating in this program, or any part thereof.

               c)   Upon receipt of ACTIVE POWER'S correct itemized invoice(s)
and after objective satisfaction of each Milestone, CATERPILLAR will pay ACTIVE
POWER in accordance with such invoice.

          4.   CONFIDENTIALITY
               ---------------

               a)   In connection with work under this Agreement, a party
("TRANSMITTING PARTY") may deliver PROPRIETARY INFORMATION relating directly to
the PHASE II or PHASE III development to the other party ("RECEIVING PARTY").
The RECEIVING PARTY may not use the PROPRIETARY INFORMATION except for work
performed according to this Agreement, will protect the confidentiality of the
PROPRIETARY INFORMATION with at least the same degree of care as it protects its
own confidential information and will not disclose any such PROPRIETARY
INFORMATION, without the express written consent of the TRANSMITTING PARTY.
"PROPRIETARY INFORMATION" includes any process, system, formula, pattern, model,
device compilation, or other information:  (i) not known by the RECEIVING PARTY
prior to this Agreement or known by the RECEIVING PARTY prior to this Agreement
but having restriction on its use or disclosure; and (ii) not generally known by
others (unless so know through some fault of the RECEIVING PARTY).  PROPRIETARY
INFORMATION does not include knowledge, skills or information which is generally
known in ACTIVE POWER's or CATERPILLAR's trade or profession.

               b)   Each party agrees that it will neither (i) disclose to the
other party or any of its employees information in confidence belonging to a
third party; nor (ii) knowingly in the performance of the work hereunder produce
anything that embodies information under confidential restriction, or is covered
by a patent, patent application, copyright, trade secret, or other intellectual
property right owned by a third party.

               c)   Nothing in this Agreement shall be construed as preventing
either party from independent development, provided that PROPRIETARY INFORMATION
is handled in accordance with paragraph 4(a).

               d)   Should the RECEIVING PARTY be required to disclose
PROPRIETARY INFORMATION by governmental or judicial order, the RECEIVING PARTY
will give the TRANSMITTING PARTY prompt notice of any such order and will comply
with any protective order imposed on such disclosure.

                                       3

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**
<PAGE>

          5.   INTELLECTUAL PROPERTY
               ---------------------

               a)   BACKGROUND INTELLECTUAL PROPERTY shall remain the property
of the party who created, made, conceived and reduced it to practice.

               b)   All PROGRAM INTELLECTUAL PROPERTY shall be jointly owned by
the parties and may be exploited and/or nonexclusively licensed by either party
without further consent or accounting to the other party.  With respect to all
rights and ownership in such PROGRAM INTELLECTUAL PROPERTY, the parties will
mutually discuss whether to obtain or maintain such rights, including without
limitation, any patents, trademarks, copyrights, trade secrets, CONFIDENTIAL
INFORMATION, and any other proprietary rights therein, and if one refuses to
take any such joint action requested by the other, the other may proceed at its
own expense; no such action will change the foregoing ownership provision.  A
party will execute all documents the other may request for such purposes and to
otherwise assist the other (at the other's expense) for such purposes.

               c)   Each of CATERPILLAR and ACTIVE POWER grant to the other
party an irrevocable, perpetual, nonexclusive, worldwide, royalty free license
(including the right to sublicense to such other party's Affiliates) to make,
have made, use, sell and otherwise exploit during and/or after the term of this
Agreement any modifications, improvements, inventions, know how, ideas or
suggestions made with respect to the other party's Proprietary Information by
such party's employees who have had access to such Proprietary Information.  If
something ceases to be considered Proprietary Information, licenses granted with
respect thereto while such information was deemed Proprietary Information, will
be unaffected.

               d)   Except as provided in this Agreement or the Exhibits,
nothing in this Agreement shall be construed as a grant of, or agreement to
grant, to either party any licenses under intellectual property rights of the
other party, regardless of whether they are dominant of or subordinate to those
provided herein.

          6.   LICENSING JOINTLY OWNED INTELLECTUAL PROPERTY
               ---------------------------------------------

               a)   Unless otherwise agreed to by the parties, all licensing
revenues generated by licensing PROGRAM INTELLECTUAL PROPERTY to third parties
shall be retained by the licensor of such PROGRAM INTELLECTUAL PROPERTY.

               b)   In the event that one party chooses to enforce PROGRAM
INTELLECTUAL PROPERTY rights against a third party, the other party shall be
given the opportunity to join in such enforcement prior to its commencement and
in the event the other party chooses to join, both parties shall equally share
all costs, including attorneys' fees and share equally all revenues generated by
the enforcement, including licensing fees, if any.  If the other party chooses
not to join such enforcement, such party shall nevertheless reasonably cooperate
with the one party in such enforcement (at the other party's expense), including
joining as a nominal party subject to indemnification by such party , but will
not be entitled to any proceeds of such enforcement activity.

          7.   NOTICES
               -------

          All notices and invoices pursuant to this Agreement shall reference
this Agreement and be given in writing to the respective party at its address
designated below or to such other address as may be substituted in writing by
that party to the other.  All notices shall be deemed to be fully given and
received if sent by registered or certified mail, postage prepaid, return
receipt requested.

                                       4

<PAGE>

     Notice to ACTIVE POWER:
     Active Power
     11525 Stonehollow Drive, Suite 135
     Austin, Texas 78758

     Notices to CATERPILLAR:                Invoices to CATERPILLAR:
     Caterpillar Inc.                       Attn:  Disbursements Div.
     Intellectual Property Department           LD235 Mailroom
     Attn:  Licensing Division              600 W. Washington Street
     100 N.E. Adams Street                  East Peoria, Illinois 61630
     Peoria, Illinois 61629-6490            Pontiac, Illinois 61764

          8.  INDEMNIFICATION
              ---------------

          Each party shall indemnify, defend and hold harmless the other party,
its directors, officers, employees and agents, from all third party (including a
party's employees) claims, demands, liabilities, loss, damage, and expense,
including costs, and reasonable litigation expenses and counsel fees incurred in
connection therewith, arising out of injury to or death of any person or damage
to property proximately caused by the indemnifying party's gross negligence or
willful acts or omissions which arise in connection with the performance of work
hereunder while the indemnifying party is on premises of the other party. Such
indemnity shall be provided subject to (a) prompt written notifications of any
and all such threats, claims, or proceedings related thereto and the other party
giving reasonable assistance to the indemnifying party in the defense thereof,
(b) the indemnifying party having sole control of the defense and all related
settlement negotiations, and (c) such indemnifications shall be limited in the
case of real or tangible property to the reduction in value or replacement cost
of such property.

          9.  WARRANTY
              --------

          Each party warrants its right to enter into this AGREEMENT.
Warranties for production units of PHASE II PRODUCTS shall be as set forth in
Exhibit B.  In addition, any hardware, software or firmware provided by ACTIVE
POWER to CATERPILLAR is warranted to accurately process properly formatted
date/time data (including, but not limited to, calculating, comparing, and
sequencing) from, into, and between the twentieth and twenty-first centuries,
and the years 1999 and 2000 and leap year calculations to the extent that other
hardware, software or firmware used in combination with the hardware, software
or firmware being provided by ACTIVE POWER, properly exchanges properly
formatted date/time data with it.

          10. TERM AND TERMINATION
              --------------------

              a)   This PROGRAM shall become effective on the Effective Date of
this Agreement and shall remain in effect unless terminated in writing by both
parties.

              b)   CATERPILLAR may terminate ACTIVE POWER's work under this
Agreement  by giving ACTIVE POWER ninety (90) days written notice in which event
ACTIVE POWER shall be (i) reimbursed only for work performed and expenses
reasonably incurred prior to receipt of such notice and (ii) entitled to
immediate payment of the amount associated with the next milestone. In no event
shall the total amount paid to ACTIVE POWER exceed the price agreed to herein.

               c)   Upon termination of this Agreement, Paragraphs 4, 5,6,7, 8,
9, 10, 11, 12, 13, and 14, of this Agreement shall survive.

               d)   If the Agreement is terminated and upon and in accordance
with the written reasonable request of either party (provided such written
request is given within a reasonable

                                       5

<PAGE>

period of time after such termination), but except for information covered by
the rights granted in Paragraph 5, the other party shall promptly return or
destroy any tangible information (including all copies thereof except as noted
below) provided under the PROGRAM by the requesting party. However the other
party's counsel may retain in a secure location one copy each of such tangible
information and use them only for ensuring compliance with the obligations of
Paragraph 5.

          11.  RELATIONSHIP
               ------------

          Nothing herein is to imply an agency, joint venture or partner
relationship between the parties.

          12.  ASSIGNMENT AND GOVERNING LAW
               ----------------------------

          Except to an entity that acquires all or substantially all the
business or assets of a party, this Agreement is not assignable by either party
without the written consent of the other party, which shall not be unreasonably
withheld, and will be governed by and construed in accordance with the laws of
the State of New York, without regard to the conflict of laws provisions
thereof.

          13.  ENTIRE UNDERSTANDING
               --------------------

          This Agreement and the Exhibits hereto constitute the entire agreement
and understanding between the parties with respect to the subject matters herein
and therein, and shall supersede and replace any conflicting terms and
conditions set forth in any purchase order, prior agreement, quotation,
proposal, correspondence, or oral discussion relating to the subject matter
hereof.  This Agreement may only be amended by a writing signed by both parties
which makes specific reference to the provision(s) of this Agreement being
modified.  Should any provision of this Agreement be held invalid, illegal, or
unenforceable, the validity of the remaining provisions shall not be affected by
such holding. This AGREEMENT shall be binding upon the heirs, successors, and/or
legal representatives of the parties.

          14.  Limitation of Liability
               -----------------------

          NEITHER PARTY SHALL BE LIABLE FOR (I) ANY SPECIAL, INCIDENTAL,
INDIRECT OR CONSEQUENTIAL DAMAGES ARISING OUT OF THE SUBJECT MATTER OF THIS
AGREEMENT OR (II) CATERPILLAR'S COST OF PROCUREMENT OF SUBSTITUTE GOODS OR
SERVICES.

          The parties have caused this Agreement to be signed in duplicate by
their duly authorized representatives on the Effective Date.

ACTIVE POWER, Inc.                       CATERPILLAR INC

By:      /s/                             By:       /s/
   ------------------------                 -----------------------------

Name:______________________              Name:___________________________

Title:_____________________              Title:__________________________

Date:______________________              Date:___________________________

                                       6

<PAGE>

EXHIBIT "A"

                      SPECIFICATIONS FOR PHASE II PRODUCT

     In the event that ACTIVE POWER has developed and includes a CS2 flywheel
  and associated components in the Prototype, then the Phase II Product shall
  comply with the following specification entitled CS2-UPS Specification,
  otherwise the Phase II Product shall comply with the following specification
  entitled CS1-UPS Specification.

                             CS1-UPS Specification
                                   12/14/98

                                  Definition

CS1-UPS is a line-interactive UPS that employs Active Power's first generation
DC to DC flywheel energy storage system (flywheel system described in US patent
5,731,645).

                    (i)   Ratings

  .  Maximum discharge time - 300 seconds
  .  Delivered energy - 3.0 MJ
  .  Maximum delivered power - 250KW for 12.5 seconds

                    (ii)  Input

  .  Input voltage - 480Vrms +10%/-20%
  .  Interface - 3 phase, 4 wire (3 phase plus neutral and ground)
  .  Input frequency - 45Hz - 66Hz
  .  Walk-in time - 1 second minimum, variable to up to 15 seconds

                    (iii) Output

  .  Nominal output voltage: 480Vrms, matched to utility input  +/- 5%
  .  Interface - 3 phase, 4 wire (3 phase plus neutral and ground)
  .  Output voltage regulation in Flywheel Mode:
       . +/- 5 % of input nominal, static balanced
       . +/- 5 % of input nominal, static asymmetrical
       . +/- 5 % of input nominal, within 80 ms following 100% step load
  .  Output voltage harmonic distortion:
       . 5% THD maximum and 3% any single harmonic with 100% linear load
       . 10% THD maximum with 100% non-linear load

                    (iv)  Recharge Time

  .  Recharge time - 2.5 minutes maximum
  .  Charge time from 0 RPM - 7.5 minutes maximum
  .  Adjustable to avoid overloading source
  .  Duty Cycle: 10% for 5 discharges

                    (v)    Standby Losses

         .  3% of rated power

                    (vi)   Temperature rating

     .   Start-up - 0 to +40C
     .   Operating - -20 to 40C
     .   Storage - -25 to +70C

                    (vii)  Humidity

                                       7

<PAGE>

     .   Relative humidity -  95%, non-condensing

                    (viii) Barometric Pressure

         .  Full rating to 3000  feet; reduced by 5% /1000ft above 4000ft

                    (ix)   Vibration

         .  5g  peak, 30ms pulse duration

                    (x)    Acoustical Noise

         .  70 dB, "A" weighting, at 3 feet from system

                    (xi)   Dimensions

         .  Height 79" maximum
         .  Width 43" maximum
         .  Depth 36" maximum

                    (xii)  Floor Loading

         .  325 lbs./sq. ft. maximum

                    (xiii) System Features

         .  Bi-directional Inverters
         .  Flywheel energy storage for standby power
         .  Adjustable load walk-in
         .  Internal self-diagnostics
         .  Fault event logging
         .  Preheat capability

                    (xiv)  Monitoring and Control

         .  Key switch for system control
         .  Local EPO (Emergency Power Off)
         .  LCD display - reports alarms & system state
         .  Monitor & alarms on critical components
         .  Programmable setup parameters
         .  External customer contacts (A-Type) dry contacts {six (6) input and
            six (6) output
         .  RS232 or RS485 Serial Connection
         .  Ethernet Interface

                    (xv)   System Options

         .  Automatic bypass
         .  Automatic restart following depletion of stored-energy and
            restoration of AC source
         .  Remote monitoring capability
         .  Internal modem
         .  Remote EPO (Emergency Power Off)
         .  Input voltage other than 480VAC using optional external transformer
            cabinet
         .  Output voltage other than 480VAC using optional external transformer
            cabinet

                    (xvi)  System Reliability

         The reliability target of .039 failures per 100 hours is to be met with
         a 75% confidence.

                                      8

<PAGE>

                                    [****]

                                       9

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                    [****]

                                      10

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "B"

               PURCHASE OF PHASE II PRODUCT TERMS AND CONDITIONS

          The terms and conditions of the Phase II Purchase Agreement are
attached hereto and shall be incorporated herein by reference.

                                      11

<PAGE>

             PHASE II PURCHASE AGREEMENT TERMS AND CONDITIONS
             ------------------------------------------------

     1.  Products Covered by Agreement.  This Agreement concerns the purchase
         -----------------------------
and sale of the PHASE II PRODUCT (hereinafter called "Product"), manufactured to
the Specifications.

     2.  Purchase and Sale of Product.  Subject to the terms and conditions of
         ----------------------------
this Agreement, Seller will, to the extent properly and accurately forecasted
and ordered by Buyer as provided in the next paragraph, use commercially
reasonable efforts to supply the Products to Buyer and Buyer agrees to purchase
ninety percent (90%) of Buyer's and its Affiliates ("Affiliate" means any
company of which Buyer holds a greater than fifty percent (50%) ownership
interest) requirements for an AC to AC flywheel-based UPS product for generator
set applications. Seller understands that Buyer makes no guarantee as to the
quantity of Product it will require, however, Buyer agrees that it will
undertake the Phase II activities set forth on Exhibit A ("Phase II
Activities").

      Buyer's initial forecasted annual requirements will be attached hereto as
Exhibit B as of the Effective Date of this Phase II Purchase Agreement.  Such
forecast of such requirements provided to Seller by Buyer shall be non-binding
and Seller acknowledges that it shall not be entitled to and shall not rely on
such forecasts/estimates as binding commitments unless they are expressly stated
as such by Buyer in writing.  Seller shall not be obligated to supply Buyer with
more than one hundred fifty percent (150%) of the initial projection for a
particular quarter, unless agreed to in writing.  Buyer's forecasts and orders
shall reflect its good-faith expectations of customer demand and Buyer shall act
in a commercially reasonable manner to schedule orders to avoid creating
production capacity problems for Seller.

     3.  Exclusive Caterpillar Rights.  For a period of five years from the
         ----------------------------
Effective Date of this Phase II Purchase Agreement, and provided this Phase II
Purchase Agreement has not been terminated, ACTIVE POWER agrees not to license
any PROGRAM INTELLECTUAL PROPERTY nor ACTIVE POWER's BACKGROUND INTELLECTUAL
PROPERTY that is solely developed for a PHASE II PRODUCT, to [****] Before the
end of such five-year period, ACTIVE POWER will, at CATERPILLAR's option,
discuss the possibility of a mutually agreeable extension of such FIELD OF USE
exclusivity. During such five year period, if any, and provided this Phase II
Purchase Agreement has not been terminated, ACTIVE POWER shall, at CATERPILLAR's
option and provided that CATERPILLAR [****] However, nothing contained in this
Agreement, shall restrict ACTIVE POWER with respect to making, using, selling,
marketing, licensing or exploiting its flywheel energy storage systems or
technologies.

                                    [****]

     4.  Price Containment.  Both Seller and Buyer are committed to controlling
         -----------------
and reducing costs, and both recognize that effective cost control is of the
essence to this Agreement, While this Agreement is in effect, Seller will
maintain a cost control and reduction program with respect to Product,

                                      B-1

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

and will review costs on a regular basis for progress toward the objective of
maintaining or reducing Seller's prices to Buyer. A constant interaction between
Buyer's and Seller's engineering personnel is essential. All documented mutually
agreed cost savings, through the efforts of Buyer or Seller, will be shared on a
50-50 basis. Any cost savings gained without the efforts of Buyer and not
mutually agreed to in writing will be owned by Seller. Any cost increases must
be documented and approved by Buyer.

     5.  Product Prices.  Prices are as shown in Exhibit E.  After eighteen
         ---------------
months from the Effective date of this Agreement, Exhibit E may be modified from
time to time upon sixty (60) days written notice from the Seller; provided,
however, that Buyer may terminate this Agreement within thirty(30) days after
receipt of notice of such price increase if such increase is unacceptable to
Buyer.  Seller agrees and acknowledges that should such prices exceed the lowest
Product prices provided to any other customer of Seller purchasing Product at
similar (or reduced) volume levels and making only similar or reduced
commitments (including, but not limited to time commitments), such prices to
Buyer shall be automatically adjusted to reflect any lower pricing provided to
such other customers.

     6.  Product Training and Support.
         ----------------------------

         a.  In order to provide sufficient warranty support for the Product,
Buyer's service training personnel will successfully complete Seller's certified
training course in order to become competent to a level equivalent to Seller's
certified service technicians. Seller shall provide such training for up to five
(5) scheduled classes and for a maximum of ten (10) students per class. Such
training shall be given at Seller's facilities free of charge for the first five
scheduled classes of the term of this Agreement and at Seller's published prices
for any remaining training. Buyer shall be responsible for its own travel
expenses as incurred for such training at Seller's facilities.

         b.  Seller will provide sales and marketing support to Buyer's key
dealers, as requested and identified by Buyer. Except as provided below, Seller
agrees to provide such support free of charge for three (3) man days per
identified dealer up to a maximum amount of thirty (30) man days which shall be
the cumulative total available for such dealers. Any dealer support services
requested beyond the thirty (30) day limit shall be charged to Buyer at a rate
of $1000 per man day. Buyer shall reimburse Seller for any travel expenses for
dealer support services requested outside of North America or such expenses
beyond the initial thirty (30) man days.

     7.  Term.  The initial term of this Agreement shall be Five (5) years,
         -----
commencing as of the date of completion of performance tests on Products and
shipment of first reliability test machines (the "Effective Date").  This
Agreement shall automatically be extended for additional terms of six (6) months
each unless either party gives written notice to terminate at least three (3)
months prior to the end of the initial term or any additional term, or unless
otherwise terminated pursuant to the provisions hereof.

     8.  Warranty.
         --------

         a.   Seller warrants that each Product shall be in conformity with
the Specifications and shall be free from defects in material and workmanship.
In addition, any hardware, software or firmware provided by Seller to Buyer is
warranted to accurately process properly formatted date/time data (including,
but not limited to, calculating, comparing, and sequencing) from, into, and
between the twentieth and twenty-first centuries, and the years 1999 and 2000
and leap year calculations to the extent that other hardware, software or
firmware used in combination with the hardware, software or firmware being
provided by Seller, properly exchanges properly formatted date/time data with
it.

         b.   Except as provided below, Seller will provide Buyer with the
same warranty, under the same terms and conditions (including without
limitation, disclaimers), as Buyer provides to its customers procuring electric
power generation products (as attached as Exhibit G); provided, however,

                                      B-2

<PAGE>

that Seller's warranty to Buyer shall be for a one year period from the date of
delivery to the end-user, notwithstanding any longer warranty period in Buyer's
warranty.  If Buyer performs travel labor (up to four hours), Seller shall
reimburse such documented, customary and reasonable expenses incurred by Buyer
on behalf of the Product provided such labor is performed by an employee of
Buyer or one of its dealers that has been competently trained with respect to
the Product.  A monthly written statement of Buyer's actual costs for providing
warranty services to its customers, including notice of specific Product
failures, and summary information on the causes of such failure, will be sent by
Buyer to Seller.

         c.   Within twelve (12) months from the Effective Date of this
Agreement, Buyer shall inventory and maintain appropriate spares to provide its
standard level of service.

         d.   Claims for Buyer's "Product Improvement Programs" (PIP), "Product
Support Programs" (PSP), "Extended Warranty" and other policy actions are to be
negotiated on a case-by-case basis by both parties and documented in writing as
signed by both parties. Participation in these programs will be based on an
amount mutually agreed to by Seller and Buyer.

     THE FOREGOING WARRANTIES SHALL BE SELLER'S SOLE LIABILITY WITH REGARD TO
THE PRODUCTS.

     9.  Indemnification.  Except to the extent covered by the indemnity from
         ---------------
Buyer below, Seller agrees to indemnify, defend, and hold Buyer harmless against
and from all claims, demands, liabilities, loss, damage, cost, and expense, of
whatsoever nature paid to a third party or incurred in the defense (i) arising
from a claim that the Product infringes an intellectual property right of a
third party or (ii) arising from the injury or death of any person or loss or
damage to property directly due to, any defect of design, material, or
workmanship of Product  or failure of Product to conform with the
Specifications, provided Seller is promptly notified of any and all such
threats, claims or proceedings related thereto and given reasonable assistance
and the opportunity to assume sole control over defense and settlement; Seller
shall not be responsible for any settlement it does not approve of in writing.
The indemnity provided in this Section shall be Buyer's sole and exclusive
remedy for any claim of infringement related to the Product. Buyer agrees to
indemnify, defend, and hold Seller harmless against and from all claims,
demands, liabilities, loss, damage, cost, and expense, of whatsoever nature paid
to a third party or incurred in the defense of a claim arising on account of
Buyer's (i) misrepresentation of the Product or providing unauthorized
representations or warranties to its customers, (ii) modifications to the
Product or (iii) negligence or other fault of products or services of Buyer.

     10.  Indemnity Restrictions.  SELLER MAKES NO WARRANTY OR REPRESENTATION
          ----------------------
WITH RESPECT TO, (a) determining whether the Product will achieve the results
desired by Buyer or any third person, (b) selecting, procuring, installing,
operating and maintaining complementary equipment to insure correct operation of
the Product, and (c) ensuring the accuracy of any configuration design or
implementation that utilizes the Product.  In the event of any alteration or
attachment to the Product not authorized by Seller, Seller shall have no
liability or responsibility to Buyer for:  (a) any hardware, software,
equipment, or services provided by any persons other than Seller; (b) the proper
functioning of the Product if the alteration or attachment is the cause of the
malfunction; or (c) damage caused by any alteration or attachment to  the
Product.

     11.  Insurance.  Seller agrees to keep in full force and effect, at its
          ----------
sole expense, during the term of this Agreement and for a period of ten (10)
years thereafter, at least the insurance coverage described below with insurance
companies acceptable to Buyer.  The limits set forth are minimum limits and
shall not be construed to limit Seller's liability.  All cost and deductible
amounts shall be for the sole account of Seller.  All policies required by Buyer
pursuant to this Agreement shall name Buyer as an additional insured (per ISO
Endorsement #CG 2026 or its equivalent) and waive subrogation rights in favor of
Caterpillar.  All policies required shall also be designated as primary coverage
to any similar coverage carried by Caterpillar.

                                      B-3

<PAGE>

     Seller shall not provide Product hereunder until all insurance as required
hereunder has been obtained, and certificates have been submitted to and
accepted by Buyer.

     The required coverage shall be:  Commercial General Liability Insurance
(Occurrence Coverage) including products, completed operations, contractual
liability coverage of indemnities contained in this contract, with a minimum
combined single limit of liability of $5,000,000 for each occurrence for bodily
injury and property damage.  Such policy shall contain provisions that provide
at least thirty (30) days prior written notice of any cancellation, non-renewal,
or reduction in coverage to Buyer.  Seller shall deliver Certificates of
Insurance in a form satisfactory to Buyer evidencing the existence of such
policy.

     12.  Termination by Buyer.  Buyer may terminate this Agreement at any time,
          --------------------
in the event:

          a.  Quality - Products consistently and materially fail to meet the
Specifications as defined herein or as hereafter agreed to by Buyer and Seller,
or fails to achieve status as a Caterpillar certified supplier within twenty-
four (24) months of the Effective Date of this Agreement.

          b.  Delivery - Seller is substantially and continuously failing to
meet Buyer's Firm Orders with respect to mutually agreed shipment dates.  Seller
shall provide to Buyer a written schedule of Seller's standard lead times for
delivery of Products from the date Orders are accepted by Seller.  Such schedule
for lead times shall be updated by Seller on a regular basis to reflect any
modifications thereto.

          c.  Competitiveness - Seller fails to be responsive to the market
place or fails to remain competitive on a world-wide basis with other
manufacturers of comparable parts in terms of price.

          d.  Default Generally - Material default by Seller in any material
obligation hereunder owed by Seller to Buyer.

     Notwithstanding the above, Buyer may terminate pursuant to Subsections (a),
(b), (c) or (d) above only if Seller has failed to cure such default within
sixty (60) days after written notice thereof has been received by Seller.

     13.  Termination by Seller.  Seller may terminate this Agreement at any
          ---------------------
time in the event Buyer breaches the Agreement and fails to cure such breach
within sixty (60) (or ten days in the case of non-payment) after written notice
thereof has been received by Buyer.

     14.  Licenses.  As between the parties, Seller shall own all right, title
          --------
and interest in and to the Product except as otherwise provided in the "Phase II
Development and Phase III Feasibility Study Agreement.".  In the event that this
Agreement is terminated by Buyer pursuant to Section 12(b) and only while Buyer
remains in full compliance with the provisions of this Agreement prior to
termination and following termination as such surviving provisions shall apply,
Seller hereby grants to Buyer, effective as of such termination date, a
nonexclusive, worldwide, royalty bearing license (including the right to
sublicense to Buyer's Affiliates) to make, have made, use and/or sell Product.
The foregoing license shall only be effective for the 18 months beginning  with
the date of termination and Buyer shall pay a royalty of one thousand  two
hundred fifty  dollars ( $1,250) per delivered megajoule per published rating by
Seller for each Product.

     Each of Buyer and Seller grant to the other party an irrevocable,
perpetual, nonexclusive, worldwide, royalty free license (including the right to
sublicense to such other party's Affiliates) to make, have made, use, sell and
otherwise exploit during and/or after the term of this Agreement any
modifications, improvements, inventions, know how, ideas or suggestions made
with respect to the other party's Confidential Information by such party's
employees who have had access to such Confidential Information.  If something
ceases to be considered Confidential Information, licenses granted with respect
thereto while such information was deemed Confidential Information, will be
unaffected.

                                      B-4
<PAGE>

     15.  Parts Support.  During the term of this Agreement or following any
          -------------
termination hereof, other than termination by Seller due to a breach by Buyer,
Seller shall provide, or at its option cause to be provided, such quantities of
parts to Buyer as Buyer may request from time to time for a period of five (5)
years from the date of the last customer shipment made by Seller under this
Agreement of the applicable Product release, at a price not to exceed Seller's
then-current prices provided to other customers under similar terms and
conditions, provided such parts are reasonably and commercially available to
Seller.  If for any reason Seller is unable to provide parts to Buyer pursuant
to its obligations under this section 14, Seller grants to Buyer a nonexclusive,
perpetual, worldwide royalty bearing license to make, have made, use and/or sell
such parts utilizing Seller's proprietary designs.  The foregoing license is
subject to a royalty of 6% of the applicable price set forth in Seller's most
current Catalog Spares Pricing list.

     16.  Use of Other Supply Sources.  Nothing in this Agreement shall prevent
          ---------------------------
Buyer from seeking other sources for alternatives to the Product to the extent
Seller's production capacity continuously and substantially fails to meet
Buyer's Firm Orders.

     17.  Change in Ownership and Control.  During the life of this Agreement,
          -------------------------------
if there is a change in the ownership and control of either party, the other
party shall have the option of terminating this Agreement immediately by giving
written notice thereof within ten days of being notified of the occurrence of
such change of control; provided that if a party provides advance notice of a
bona fide proposed change of control (including the identity of the principal
owners after such change of control occurs) the other party will within ten days
provide written notification to the first party as to whether it will exercise
such termination right if the change of control occurs. For purposes of this
Section 17, a change in the ownership and control of either Buyer or Seller or a
parent company of either party shall be deemed to have occurred if and only if
and when any one or more persons (excluding existing investors) acting in
concert individually or jointly is or becomes a beneficial owner, directly or
indirectly, of securities representing more than fifty percent (50%) of the
combined voting power of all then outstanding securities of Seller or Buyer or
the parent company of either party.

     18.  Shipping Instructions/Terms and Conditions.  Orders will be placed
          ------------------------------------------
under Buyer's blanket purchase order(s).  This agreement shall supersede Buyers
standard purchase order terms (other than the terms under the following
sections:  "Work on Buyer's Premises" and "Property Furnished to Seller by
Buyer", which terms shall be deemed to be incorporated herein by reference and
made a part hereof) or any terms stated in any acknowledgment forms or other
forms utilized by Seller or Buyer.  Such orders shall specify the quantity, part
number and description, unit price, requested ship date, destination, and
Buyer's freight carrier and account number with the carrier.  Orders shall be
subject to acceptance by Seller ("Firm Orders").  No modification to this
Agreement will be stated on an order.  All Products shall be shipped F.O.B.
Seller's facility in Austin, Texas.  Title and risk of loss to Product shall
pass to Buyer upon delivery to the carrier at the F.O.B. point.  Buyer shall
designate a carrier.  Any special freight charges shall be Seller's
responsibility if necessary to meet not more than 115% of Buyer's projected
quarterly requirements.

     19.  Inspection.  Product is subject to Buyer's inspection, testing and
          ----------
approval.  Buyer, at its option, may reject or refuse to accept any Product
which does not meet the requirements of the warranty set forth herein.  Buyer's
right to reject shall expire one (1) year after the date of shipment.  Prior to
returning any Product, Buyer shall notify Seller of its intent to reject, and
Seller may within thirty (30) days correct any such defect.  Items rejected by
Buyer will be returned to Seller at Seller's expense, and Seller agrees to
refund to Buyer any payments (including but not limited to shipment expense)
made by Buyer for such Product.  Payment by Buyer for any Product shall not be
deemed an acceptance thereof.  Acceptance of any Product shall not relieve
Seller from any of its obligations, representations or warranties hereunder or
with respect thereto.

     20.  Prices and Payments.  Prices set forth in Exhibit E do not include
          -------------------
installation, freight and handling charges, or applicable taxes, and Buyer shall
be responsible for all such charges and taxes with respect to the Products and
the shipment thereof. All payments shall be made by Buyer in accordance

                                      B-5

<PAGE>

with the terms of Buyer's then-current standard settlement schedule. All
payments due hereunder shall be paid to Seller in United States dollars in the
United States. Unless Buyer furnishes a proper exemption certificate, Buyer
shall be charged for all taxes, however, designated, levied or based on this
Agreement or the Product.

     21.  Force Majeure.  Neither Buyer nor Seller shall be liable for any delay
          -------------
in or failure of performance of their respective obligations hereunder if such
performance is rendered impossible or impracticable by reason of fire,
explosion, earthquake, accident, breakdown, strike, drought, embargo, war, riot,
act of God or public enemy, an act of governmental authority, agency or entity,
shortage of raw materials, or other contingency, delay, failure or cause, beyond
the reasonable control of the part whose performance is affected, irrespective
of whether such contingency is specified herein or is presently occurring or
anticipated by either party.  Upon the occurrence of any event covered by this
provision, Seller and Buyer shall make every effort to continue to maintain as
much as possible the supplier-customer relationship established under this
Agreement. However, in the event Buyer or Seller is unable to meet its
obligations hereunder because of the conditions described above and such
inability continued for a period of two (2) months, the other party shall have
the right to terminate this Agreement upon thirty (30) days prior written
notice.

     22.  Assignment/Applicable Law.  Except to an entity that acquires all or
          -------------------------
substantially all the business or assets of a party, this Agreement is not
assignable by either party without the written consent of the other party and
will be governed by and construed in accordance with the laws of the State of
New York without regard to the conflict of laws provisions thereof.

     23.  Entire Agreement.  This Agreement and the Exhibits hereto constitute
          ----------------
the entire agreement and understanding between the parties with respect to the
subject matters herein and therein, and supersede and replace any prior
agreements and understandings whether oral or written, between them with respect
to such matters.  Any additional or different terms of any related purchase
order, confirmation, acknowledgment, shipping instruction form or similar form
of Buyer or Seller even if signed by the parties after the date hereof, shall
have no force or effect.

     24.  Waiver.  The provisions of this Agreement may waived, altered,
          ------
amended, or repealed in whole or in part upon the written consent of all parties
to this Agreement The waiver by party of any breach of this Agreement shall not
be deemed or construed as a waiver of any other breach, whether prior,
subsequent or contemporaneous, of this Agreement.

     25.  Severability.  Invalidation of any of the provisions contained herein,
          ------------
or the application of such invalidation of thereof to any person, by
legislation, judgment or court order shall in no way affect any of the other
provisions hereof or the application thereof to any other person, and the same
shall remain in full force and effect, unless enforcement as so modified would
be unreasonable or grossly inequitable under all the circumstances or would
frustrate the purposes hereof.

     26.  Counterparts.  Section headings contained herein are for ease of
          ------------
reference only and shall not be given substantive effect.  This Agreement may be
signed in one or more counterparts, each to be effective as an original.

     27.  Limitation of Liability.  NEITHER PARTY SHALL BE LIABLE FOR ANY
          -----------------------
SPECIAL, INCIDENTAL, INDIRECT OR CONSEQUENTIAL DAMAGES ARISING OUT OF THE
SUBJECT MATTER OF THIS AGREEMENT, OR BUYER'S COST OF PROCUREMENT OF SUBSTITUTE
GOODS OR SERVICES.

     28.  Confidential Information.
          ------------------------

                                      B-6

<PAGE>

          a.  In connection with work under this Agreement, a party
("TRANSMITTING PARTY") may deliver PROPRIETARY INFORMATION relating directly to
the business or technology of the other party ("RECEIVING PARTY").  The
RECEIVING PARTY may not use the PROPRIETARY INFORMATION except as necessary to
perform its obligations under this Agreement, will protect the confidentiality
of the PROPRIETARY INFORMATION with at least the same degree of care as it
protects its own confidential information and will not disclose any such
PROPRIETARY INFORMATION, without the express written consent of the TRANSMITTING
PARTY.  "PROPRIETARY INFORMATION" includes any process, system, formula,
pattern, model, device compilation, or other information:  (i) not known by the
RECEIVING PARTY prior to this Agreement or known by the RECEIVING PARTY prior to
this Agreement but having restriction on its use or disclosure; and (ii) not
generally known by others (unless so know through some fault of the RECEIVING
PARTY).  PROPRIETARY INFORMATION does not include knowledge, skills or
information which is generally known in Seller's or Buyer's trade or profession.

          b.  Each party agrees that it will neither (i) disclose to the other
party or any of its employees information in confidence belonging to a third
party; nor (ii) knowingly in the performance of the work hereunder produce
anything that embodies information under confidential restriction, or is covered
by a patent, patent application, copyright, trade secret, or other intellectual
property right owned by a third party.

          c.  Nothing in this Agreement shall be construed as preventing either
party from independent development, provided that PROPRIETARY INFORMATION is
handled in accordance with paragraph 28(a).

          d.  Should the RECEIVING PARTY be required to disclose PROPRIETARY
INFORMATION by governmental or judicial order, the RECEIVING PARTY will give the
TRANSMITTING PARTY prompt notice of any such order and will comply with any
protective order imposed on such disclosure.

     29.  Compliance with Laws.  Both parties represent that they have complied,
          --------------------
and during the performance of this Agreement will continue to comply, with the
provisions of all applicable laws and regulations from which liability may
accrue to the other party for any violation thereof.

     30.  Confidentiality.  Except with respect to potential investors and/or
          ----------------
acquirers, the terms of this Agreement as well as its existence shall be kept
confidential and not disclosed by either party without the express written
consent of the other party.

                                      B-7
<PAGE>

                                  Exhibit "A"

                         PHASE II MARKETING ACTIVITIES

 .  Buyer will conduct a product launch with appropriate marketing subsidiaries
   and dealers.
 .  Buyer will create appropriate sales binder for above training or launch.
 .  Buyer will effect pricing and price list literature for the program for all
   appropriate worldwide marketing subsidiaries and dealers.
 .  Buyer will announce product to dealers.
 .  Buyer will effect a Caterpillar Product News announcement.
 .  Buyer will create product brochures for product promotion.
 .  Buyer will create product specification sheets.
 .  Buyer will enter appropriate performance and specifications into its online
   Technical Marketing Information (TMI) systems.
 .  Buyer will make adequate technical drawings available to its dealers.
 .  Buyer will effect a public product announcement of the phase II product that
   will include reference to the new Caterpillar UPS product and its use of the
   Active Power flywheel energy storage system.
 .  Buyer will create a product promotional video.
 .  Buyer will include the product where appropriate in its
   marketing/specification software.
 .  Buyer will promote the product internally to its worldwide marketing
   subsidiaries.
 .  Buyer will effect the above in all languages deemed appropriate by Buyer.

   Implementation of the foregoing Marketing Activities is dependent upon Buyer
   receiving adequate product and technical information from Seller

                                      B-8
<PAGE>

                                   EXHIBIT B

               Forecast (to be provided as of the Effective Date)

                                      B-9

<PAGE>

                                  EXHIBIT "C"

                                    [****]

                                     B-10

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "D"

                                    [****]

                                     B-11

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "E"
                                  -----------

 . Prices:
  ------
                                    [****]

                                     B-12

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "C"

                              PAYMENT MILESTONES

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------
               MILESTONE                                     PAYMENT                     ESTIMATED
               ---------                                     -------                     ---------
                                                                                         COMPLETION
                                                                                         ----------
                                                                                            DATE
                                                                                            ----
---------------------------------------------------------------------------------------------------------
<S>                                                      <C>                        <C>
1.  Phase II agreement signed                                  $ .5 million                  4Q98

---------------------------------------------------------------------------------------------------------
1.  CS-UPS bench demo at Active Power's
    Austin facility that meets following                       $1.0 million                  1Q99
    performance objectives:

 . 30 second discharge at 50 kW
 . flywheel recharges in less than 20 minutes
 . less than 15% THD on input & output
 . output voltage regulation plus or minus 10%
---------------------------------------------------------------------------------------------------------
3.  CS-UPS bench demo at Active Power's                        $1.5 million                  1Q99
    Austin facility that meets following
    performance objectives:

 . 20 second discharge at 100 kW
 . flywheel recharges in less than 10 minutes
 . less than 10% THD on input & output
 . output voltage regulation plus or minus 5%
---------------------------------------------------------------------------------------------------------
4.  CS-UPS bench demo at Active Power's                        $1   million                  2Q99
    Austin facility that meets following
    performance objectives:

 . will use production components
 . single board controller for flywheel & UPS
 . static switch & contactors operational
 . 12.5 second discharge at 250 kW
 . flywheel recharges in less than 5 minutes
 . less than 5% THD on input & output
 . output voltage regulation plus or minus 2%
---------------------------------------------------------------------------------------------------------
5.  Phase II product meets Exhibit A                            $1  million                  3Q99
    specifications and first Phase II unit
    shipped, along with associated production
    drawings, to Caterpillar.
---------------------------------------------------------------------------------------------------------
</TABLE>

<PAGE>

                                  EXHIBIT "D"

                                    [****]

**Confidential treatment has been requested for the portions of this agreement
marked by asterisks. Omitted material for which confidential treatment has been
requested has been filed separately with the Securities and Exchange
Commission.**

<PAGE>

                                  EXHIBIT "E"

            PICTORIAL DESCRIPTION OF PROGRAM INTELLECTUAL PROPERTY

                              PHASE II SCHEMATIC

                            [Graphic of Schematic]

[Description of graphic: The schematic depicts the elements of each party's
intellectual property divided between "flywheel and flywheel electronics" and
"UPS electronics."]

For the avoidance of doubt, PROGRAM INTELLECTUAL PROPERTY does not include
INTELLECTUAL PROPERTY with respect to the fly wheel, fly wheel electronics or
flywheel packaging.<PAGE>

                                                                    Exhibit 10.7

Imperial Bank
Member FDIC

226 Airport Parkway
San Jose, CA  95110

Subject:  Credit Terms and Conditions ("Agreement")

Gentlemen:

     To induce you to make loans to the undersigned (herein called "Borrower"),
and in consideration of any loan or loans you, in your sole discretion, may make
to Borrower, Borrower warrants and agrees as follows:

A.   Borrower represents and warrants that:
     1.   Existence and Rights.
              Borrower is a Texas corporation.    Borrower: Active Power, Inc.

Borrower is duly organized and existing and in good standing under the laws of
the State of Texas and is authorized and in good standing to do business in the
State of Texas. Borrower has powers and adequate authority, rights and
franchises to own its property and to carry on its business as now conducted,
and is duly qualified and in good standing in each State in which the character
of the properties owned by it therein or the conduct of its business makes such
qualification necessary, and Borrower has the power and adequate authority to
make and carry out this Agreement. Borrower has no investment in any other
business entity.
     2.   Agreement Authorized. The execution, delivery and performance of this
Agreement are duly authorized and do not require the consent or approval of any
governmental body or other regulatory authority; are not in contravention of or
in conflict with any law or regulation or any term or provision of Borrower's
articles of incorporation, by-laws, or Articles of Association, as the case may
be, and this Agreement is the valid, binding and legally enforceable obligation
of Borrower in accordance with its terms.
     3.   No Conflict. The execution, delivery and performance of this Agreement
are not in contravention of or in conflict with any agreement, indenture or
undertaking to which Borrower is a party or by which it or any of its property
may be bound or affected, and do not cause any lien, charge or other encumbrance
to be created or imposed upon any such property by reason thereof.
     4.   Litigation. There is no litigation or other proceeding pending or
threatened against or affecting Borrower, and Borrower is not in default with
respect to any order, writ, injunction, decree or demand of any court or other
governmental or regulatory authority.
     5.   Financial Condition. The balance sheet of Borrower as of May 31, 1999
and the related profit and loss statement for the one month ended on that date,
a copy of which has heretofore been delivered to you by Borrower, and all other
statements and data submitted in writing by Borrower to you in connection with
this request for credit are true and correct, and said balance sheet and profit
and loss statement truly present the financial condition of Borrower as of the
date thereof and the results of the operations of Borrower for the period
covered thereby, and have been prepared in accordance with generally accepted
accounting principles on a basis consistently maintained. Since such date there
have been no materially adverse changes in the financial condition or business
of Borrower. Borrower has no knowledge of any liabilities, contingent or
otherwise, at such date not reflected in said balance sheet, and Borrower has
not entered into any special commitments or substantial contracts which are not
reflected in said balance sheet, other than in the ordinary and normal course of
its business, which may have a materially adverse effect upon its financial
condition, operations or business as now conducted.
     6.   Title to Assets. Borrower has good title to its assets, and the same
are not subject to any liens or encumbrances other than those permitted by
Section C.3 hereof.
     7.   Tax Status. Borrower has no liability for any delinquent state, local
or federal taxes, and if Borrower has contracted with any government agency,
Borrower has no liability for renegotiation of profits.
     8.   Trademarks, Patents. Borrower, as of the date hereof, possesses all
necessary trademarks, trade names, copyrights, patents, patent rights, and
licenses to conduct its business as now operated, without any known conflict
with the valid trademarks, trade names, copyrights, patents and license rights
of others.
<PAGE>

August 3, 1999
Borrower:           Active Power, Inc.

     9.   Regulation U. The proceeds of this loan shall not be used to purchase
or carry margin stock (as defined with Regulation U of the Board of Governors of
the Federal Reserve system).
     10.  Year 2000 Compliance. Borrower has reviewed the areas within their
operations and business which could be adversely affected by, and have developed
or are developing a program to address on a timely basis, the Year 2000 Problem
and have made related appropriate inquiry of material suppliers and vendors, and
based on such review and program, the Year 2000 Problem will not have a material
adverse effect upon its financial condition, operations or business as now
conducted. "Year 2000 Problem" means the risk that any computer applications
used by Borrower may be unable to recognize and properly perform date-sensitive
functions involving certain dates prior to and any dates one or after December
31, 1999.
B.  Borrower agrees that so long as it is indebted to you, or so long as Bank
has any obligation to extend credit to Borrower it will, unless you shall
otherwise consent in writing:
     1.   Rights and Facilities. Maintain and preserve all rights, franchises
and other authority adequate for the conduct of its business; maintain its
properties, equipment and facilities in good order and repair; conduct its
business in an orderly manner without voluntary interruption and, if a
corporation or partnership, maintain and preserve its existence.
     2.   Insurance. Maintain public liability, property damage and workers'
compensation insurance and insurance on all its insurable property against fire
and other hazards with responsible insurance carriers to the extent usually
maintained by similar businesses.
     3.   Taxes and Other Liabilities. Pay and discharge, before the same become
delinquent and before penalties accrue thereon, all taxes, assessments and
governmental charges upon or against it or any of its properties, and all its
other liabilities at any time existing, except to the extent and so long as:
(a) The same are being contested in good faith and by appropriate proceedings in
such manners as not to cause any materially adverse effect upon its financial
condition or the loss of any right of redemption from any sale thereunder, and
(b) it shall have set aside on its books reserves (segregated to the extent
required by generally accepted accounting practice) deemed by it adequate with
respect thereto.
     4.   Records and Reports. Maintain a standard and modern system of
accounting in accordance with generally accepted accounting principles on a
basis consistently maintained; permit your representatives to have access to,
and to examine its properties, books and records at all reasonable times and,
except at any time while an event of default has occurred and is continuing,
upon reasonable prior written notice; and furnish you:
(a) As soon as available, and in any event within 30 days after the close of
each month of each fiscal year of Borrower, commencing with the month next
ending, a balance sheet, profit and loss statement and reconciliation of
Borrower's capital accounts as of the close of such period and covering
operations for the portion of Borrower's fiscal year ending on the last day of
such period, all in reasonable detail, prepared in accordance with generally
accepted accounting principles on a basis consistently maintained by Borrower
and certified by an appropriate officer of Borrower, subject, however, to
year-end audit adjustments;
(b) As soon as available, and in any event within 90 days after the close of
each fiscal year of Borrower, a report of annual statements of Company as of the
close of and for such fiscal year, all in reasonable detail and stating in
comparative form the figures as of the close of and for the previous fiscal
year, with the unqualified opinion of accountants reasonably satisfactory to
you.
(c) Within 30 days after the close of each month and of each fiscal year of
Borrower, a certificate by chief financial officer or partner of Borrower,
stating that Borrower has performed and observed each and every covenant
contained in this Agreement to be performed by it and that, to the best of
Borrower's knowledge, no event has occurred and no condition then exists which
constitutes an event of default hereunder or would constitute such an event of
default upon the lapse of time or upon the giving of notice and the lapse of
time specified herein, or, if any such event has occurred or any such condition
exists, specifying the nature thereof;
(d) Promptly after the receipt thereof by Borrower, copies of any detailed audit
reports submitted to Borrower by independent accountants in connection with each
annual or interim audit of the accounts of Borrower made by such accountants;
<PAGE>

(e) Promptly after the same are available, copies of all such proxy statements,
financial statements and reports as Borrower shall send to its stockholders, if
any, and copies of all reports which Borrower may file with the Securities and
Exchange Commission or any governmental authority at any time substituted
therefor; and
(f) Such other information relating to the affairs of Borrower as you reasonably
may request from time to time.
(g) Notice of Default. Promptly notify the Bank in writing of the occurrence of
any event of default hereunder or any event which, to the best of Borrower's
knowledge, upon notice and lapse of time would be an event of default.
     5.   Year 2000 Compliance. Borrower shall perform all acts reasonably
necessary to ensure that Borrower and any business in which Borrower holds a
substantial interest become Year 2000 Compliant in a timely manner. Such acts
shall include, without limitation, performing a comprehensive review and
assessment of all Borrower's systems and adopting a detailed plan, with itemized
budget, for the remediation, monitoring and testing of such systems. Borrower
shall also take reasonably necessary steps to ensure that it will not be
materially adversely affected as a result of any customer, supplier or vendor's
failure to become Year 2000 compliant. As used in this paragraph, "Year 2000
Compliant" shall mean, in regard to any entity, that all software, hardware,
firmware, equipment, goods or systems utilized by or material to the business
operations or financial condition of such entity, will properly perform date
sensitive functions before, during and after the year 2000. Borrower shall,
immediately upon request, provide to Bank such certifications or other evidence
of Borrower's compliance with the terms of this paragraph as Bank may from time
to time require.

C.  Borrower agrees that so long as it is indebted to you, or so long as Bank
has any obligation to extend credit to Borrower it will not, without your
written consent:
     1.   Type of Business; Management. Make any substantial change in the
character of its business; or make any substantial change in its executive
management.
     2.   Outside Indebtedness. Except for purchase money indebtedness, create,
incur, assume or permit to exist any indebtedness for borrowed moneys other than
loans from you except obligations now existing as shown in financial statement
dated July 1999 and extensions and modifications (but not increases) thereof,
excluding those being refinanced by your bank; or sell or transfer, either with
or without recourse, any accounts or notes receivable or any moneys due to
become due.
     3.   Liens and Encumbrances. Except for (i) purchase money liens, inchoate
liens securing claims or demands of materialmen, mechanics, carriers,
warehousemen, landlords and other like persons imposed without actions of such
parties, provided, that payment thereof is not yet required, (iii) liens
         --------
incurred or deposits made in the ordinary course of Borrower's business in
connection with worker's compensation, unemployment insurance, social security
and other like laws, and (iv) leases, subleases, licenses and sublicenses
granted to others in the ordinary course of business not interfering in any
material respect with the conduct or operation of Borrower's business, and any
interest or titles of a lessor, sublessor, licensor, or sublicensor under any
such lease, sublease, license, or sublicense, create, incur, or assume any
mortgage, pledge encumbrance, lien or charge of any kind (including the charge
upon property at any time purchased or acquired under conditional sale or other
title retention agreement) upon any asset now owned or hereafter acquired by it
including but not limited to intellectual property, other than liens for taxes
not delinquent and liens in your favor.
     4.   Loans, Investments, Secondary Liabilities. Make any loans or advances
to any person or other entity other than in the ordinary and normal course of
its business as now conducted or make any investment in securities other than
United States Government Treasuries or Agencies, Imperial Bank sponsored paper,
or the Monarch Money Market Funds provided, however, Borrower shall be permitted
                                  --------  -------
to invest up to twenty-five percent (25%) of its average liquid assets for the
preceding month in mutual funds and/or certificates of deposit or deposit
accounts with any United States based bank with capital in excess of One Hundred
Million Dollars ($100,000,000); or guarantee or otherwise become liable upon the
obligation of any person or other entity, except by endorsement of negotiable
instruments for deposit or collection in the ordinary and normal course of its
business.
     5.   Acquisition or Sale of Business; Merger or Consolidation. Purchase or
otherwise acquire the assets or business of any person or other entity; or
liquidate, dissolve, merge (except solely to reincorporate Borrower as a
Delaware corporation in which case the new corporation shall be required to
execute such documentation related to such reincorporation as the bank may
reasonably require) or consolidate, or commence any proceedings therefor; or
sell any assets except in the ordinary and normal course of its business as now
conducted; or sell, lease, assign, or transfer any substantial part of its
business or fixed assets, or any property or other assets necessary for the
continuance of its business as now conducted including without limitation the
selling of any property or other asset, except in connection with sale-leaseback
transactions up to $25,000 in each instance and up to $100,000 in the aggregate,
accompanied by the leasing back of the same.
<PAGE>

     6.   Dividends, Stock Payments. If a corporation, declare or pay any
dividend (other than dividends payable in common stock of Borrower) or make any
other distribution on any of its capital stock now outstanding or hereafter
issued or purchase, redeem or retire any of such stock except for stock
repurchases pursuant to Borrower's 1993 Stock Option Plan.

D. The occurrence of any one of the following events of default shall, at your
option, terminate your commitment to lend and make all sums of principal and
interest then remaining unpaid on all Borrower's indebtedness to you immediately
due and payable, all without demand, presentment or notice, all of which are
hereby expressly waived.
     1.   Failure to Pay. Failure to pay any installment of principal or of
interest on any indebtedness of Borrower to you provided such failure remains
uncured for five (5) days.
     2.   Breach of Covenant. Failure of Borrower to perform any other terms or
conditions of this Agreement or any other agreement between Borrower and Bank
binding upon Borrower provided such failure remains uncured for ten (10) days
after notice to Borrower thereof provided such failure remains uncured for ten
(10) days after notice to Borrower thereof.
     3.   Breach of Warranty. Any of Borrower's representations or warranties
made herein or any statement or certificate at any time given in writing
pursuant hereto or in connection herewith shall be false or misleading in any
material respect.
     4.   Insolvency; Receiver or Trustee. Borrower shall become insolvent; or
admit its inability to pay its debts as they mature; or make an assignment for
the benefit of creditors; or apply for or consent to the appointment of a
receiver or trustee for it or for a substantial part of its property or
business.
     5.   Judgments, Attachments. Any money judgment, writ or warrant of
attachment, or similar process shall be entered or filed against Borrower or any
of its assets and shall remain unvacated unbonded or unstayed for a period of 10
days or in any event later than five days prior to the date of any proposed sale
thereunder.
     6.   Bankruptcy. Bankruptcy, insolvency, reorganization or liquidation
proceedings or other proceedings for relief under any bankruptcy law or any law
for the relief of debtors shall be instituted by or against Borrower and, if
instituted against it, shall be consented to.

E.  Miscellaneous Provisions.
     1.   Failure or Indulgence Not Waiver. No failure or delay on the part of
your Bank or any holder of Notes issued hereunder, in the exercise of any power,
right or privilege hereunder shall operate as a waiver thereof, nor shall any
single or partial exercise of any such power, right or privilege preclude other
or further exercise thereof or of any other right, power or privilege. All
rights and remedies existing under this agreement or any note issued in
connection with a loan that your Bank may make hereunder, are cumulative to, and
not exclusive of, any rights or remedies otherwise available.
     2.   Applicable Law. This Agreement and all other agreements and
instruments required by Bank in connection therewith shall be governed by and
construed according to the laws of the state of California, to the jurisdiction
of whose courts the parties hereby agree to submit.
     3.   Waiver of Jury Trial. TO THE EXTENT NOT PROHIBITED BY APPLICABLE LAW
WHICH CANNOT BE WAIVED, THE BANK AND THE BORROWER EACH HEREBY WAIVES AND
COVENANTS THAT IT WILL NOT ASSERT (WHETHER AS PLAINTIFF, DEFENDANT OR OTHERWISE)
ANY RIGHT TO TRIAL BY JURY IN ANY FORUM IN RESPECT OF ANY ISSUE, CLAIM, DEMAND,
ACTION OR CAUSE OF ACTION ARISING OUT OF OR BASED UPON THIS AGREEMENT OR ANY
OTHER LOAN DOCUMENT OR THE SUBJECT MATTER HEREOF OR THEREOF OR ANY OBLIGATION OR
IN ANY WAY CONNECTED WITH OR RELATED OR INCIDENTAL TO THE DEALINGS OF THE BANK
OR THE BORROWER IN CONNECTION WITH ANY OF THE ABOVE, IN EACH CASE WHETHER NOW
EXISTING OR HEREAFTER ARISING AND WHETHER IN CONTRACT OR TORT OR OTHERWISE
     The Commitment Letter July 21, 1999, and all amends thereto and
replacements therefore, and certain riders are attached hereto and incorporated
herein by this reference for additional terms. In the event of a conflict
between this Agreement and the Letter, the terms in the Letter shall take
precedence.

ACTIVE POWER, INC.

By: /s/
    ----------------------------------------
Name: ______________________________________
Title: _____________________________________
<PAGE>

IMPERIAL BANK

By: /s/
    ----------------------------------------
Name: ______________________________________
Title: _____________________________________

Source: [{"source": "alea-institute/alea-institute/kl3m-data-edgar-agreements/train-00009-of-00352.parquet"}, [{"source": "alea-institute/alea-institute/kl3m-data-edgar-agreements/train-00009-of-00352.parquet"}]]