CRGS CurAegis Technologies Inc (CE)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE A — THE COMPANY AND BASIS OF PRESENTATION

The interim information contained herein with respect to the three and nine month periods ended September 30, 2013 and 2012 and the period from September 25, 1996 (inception) through September 30, 2013 has not been audited but was prepared in conformity with generally accepted accounting principles for interim financial information and instructions for Form 10-Q. Accordingly, the condensed consolidated financial statements do not include all information and footnotes required by generally accepted accounting principles for financial statements. Included are ordinary adjustments which, in the opinion of management, are necessary for a fair presentation of the financial information for the three and nine month periods ended September 30, 2013 and 2012 and since inception. The results are not necessarily indicative of results to be expected for the entire year. Certain amounts in the prior year consolidated financial statements have been reclassified to conform to the current year presentation.

Torvec, Inc. was incorporated as a New York business corporation on September 25, 1996. Upon its incorporation, the Company acquired numerous patents, inventions and know-how created by Vernon E. Gleasman and his sons, James and Keith Gleasman, a family with more than fifty years of experience in the automotive industry. Since its inception, the Company has endeavored to design, develop, build and commercialize its technology portfolio. We have not yet had any significant revenue-producing operations and, as such, we are a development stage entity. The Company currently is focusing its commercialization strategies on the following technologies: the IsoTorque® differential and the Torvec hydraulic pump.

As used in this quarterly report, unless otherwise indicated, the terms “we”, “our”, “us” and “the Company” refer to Torvec, Inc.

NOTE B — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation : The financial statements include the accounts of the Company, our wholly-owned subsidiary Iso-Torque Corporation, and our majority-owned subsidiary, Ice Surface Development, Inc. (56% owned at September 30, 2013 and December 31, 2012). As of September 30, 2013, each of the subsidiaries is non-operational. During 2012, we dissolved Creative Performance Consultants Inc., Variable Gear LLC, and Torvec China LLC. We are intending to let Ice Surface Development, Inc. dissolve by proclamation. All material intercompany transactions and account balances have been eliminated in consolidation.

Use of Estimates: The preparation of financial statements in conformity with U.S. 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 at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Such estimates are used in valuing the useful lives of any intangible assets and the future realizable value of such assets. These estimates are subject to a high degree of judgment and potential change. Actual results could differ from those estimates.

Reclassifications : Certain reclassifications have been made to prior year balances to conform to the current year’s presentation.

Cash and Cash Equivalents : Cash and cash equivalents may include time deposits, certificates of deposit, and highly liquid debt instruments with original maturities of three months or less. We maintain cash and cash equivalents at financial institutions which periodically may exceed federally insured amounts.

Accounts Receivable : We carry our accounts receivable at invoice amount less an allowance for doubtful accounts.  On a periodic basis, we evaluate our accounts receivable and establish an allowance for doubtful accounts, based on a history of past write-offs and collections and current credit conditions.  We do not accrue interest on past due invoices.  There was $0 allowance for doubtful accounts as of September 30, 2013 and December 31, 2012, as determined by management.

Inventories : Inventories are stated at the lower of cost or market with cost determined under the first-in, first-out (FIFO) method. We record provisions for excess, obsolete or slow-moving inventory based on changes in customer demand, technology developments or other economic factors. There was $0 provision for excess, obsolete or slow-moving inventory as of September 30, 2013 and December 31, 2012, as determined by management.

Property and Equipment: Property and equipment are stated at cost. Estimated useful lives are as follows:

Depreciation and amortization are computed using the straight-line method. Betterments, renewals and extraordinary repairs that extend the life of the assets are capitalized. Other repairs and maintenance costs are expensed when incurred. When disposed, the cost and accumulated depreciation applicable to assets retired are removed from the accounts and the gain or loss on disposition is recognized in other income (expense). Depreciation and amortization expense for the three month periods ended September 30, 2013 and 2012 amounted to $31,000 and $24,000, respectively. Depreciation and amortization expense for the nine month periods ended September 30, 2013 and 2012 amounted to $92,000 and $59,000, respectively.

Whenever events or circumstances indicate, our long-lived assets, including any intangible assets with finite useful lives, are tested for impairment by using the estimated future cash flows directly associated with, and that are expected to arise as a direct result of, the use of the assets. If the carrying amount exceeds the estimated undiscounted cash flows, an impairment may be indicated. The carrying amount is then compared to the estimated discounted cash flows, and if there is an excess, such amount is recorded as an impairment. During the three and nine month periods ended September 30, 2013 and 2012, we recorded $0 in impairment charges.

Fair Value of Financial Instruments: As defined by U.S. GAAP , fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. All assets and liabilities are required to be measured and reported on a fair value basis. A hierarchy for ranking the quality and reliability of the information is used to determine fair values. Assets and liabilities carried at fair value will be classified and disclosed in one of the following three categories:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data.

Level 3: Unobservable inputs that are not corroborated by market data.

The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).

The FASB’s (Financial Accounting Standards Board) guidance for the disclosure about fair value of financial instruments requires disclosure of an estimate of the fair value of certain financial instruments. The fair value of financial instruments pursuant to FASB’s guidance for the disclosure about fair value of financial instruments approximated their carrying values at September 30, 2013 and December 31, 2012. The carrying amount of cash, accounts receivable, accounts payable, and accrued expenses approximates their fair value due to their short maturity. The carrying amount of notes payable approximates fair value because stated or implied interest rates approximate current interest rates that are available for debt with similar terms.

Revenue Recognition: Our terms provide that customers are obligated to pay for products sold to them within a specified number of days from the date that title to the products is transferred to the customers. Our standard terms are typically net 30 days. We recognize revenue when transfer of title occurs, risk of ownership passes to a customer at the time of shipment or delivery depending on the terms of the agreement with a particular customer and collection is reasonably assured. The sale price of our products is substantially fixed and determinable at the date of the sale based upon purchase orders generated by a customer and accepted by us.

We occasionally enter into prototype development contracts with customers. In such cases, revenue is recognized using either (a) the proportional effort method based on the relationship of costs incurred to date to the total estimated cost to complete a contract, or (b) where appropriate, the milestone method, if milestones are clearly identifiable and substantive.

During the first quarter of 2011, we entered into a prototype development agreement to design, build and integrate our IsoTorque differential into the product of a customer for total consideration of $120,000. Milestones include completion of design, manufacturing of a prototype, and installation / integration of the prototype. The payment required for each milestone was considered to be substantive based on the fact that performance required by us in order to achieve the milestone enhanced the value of the item delivered and is reasonable in relation to all of the deliverables. The first milestone consisted of completion and delivery of the design for the prototype, which was completed and delivered during the first quarter of 2011 and resulted in the recognition of revenue in the amount of $30,000, as well as the related costs incurred to complete this milestone. The second milestone consisted of the manufacture and delivery of two prototype differentials to our customer, which was completed in March 2012 and resulted in the recognition of revenue in the amount of an additional $60,000, as well as the related costs incurred to complete this milestone. Further revenue will be recognized, as well as related costs, upon reaching other milestones defined in the contract.

During the first quarter of 2013, we entered into a prototype development agreement with a Chinese automotive manufacturer to design, develop and manufacture an IsoTorque® differential for a specific vehicle application. Essentially, there is one performance milestone associated with the agreement, which is the delivery of our IsoTorque prototypes to the customer that they can test and evaluate. In total, the customer will pay us approximately $39,000 in two installments. We are deferring the recognition of revenue and related expenses pertaining to this development agreement until we achieve the delivery milestone. As of September 30, 2013, we have deferred approximately $20,000 in revenue and nominal expenses associated with this program.

Research and Development and Patents: Research and development costs and patent expenses are charged to operations as incurred. Research and development includes personnel-related costs, materials and supplies, depreciation, consulting services, and amortization of acquired technology. Depreciation expense for the three month periods ended September 30, 2013 and 2012 that was charged to research and development was $22,000 and $8,000, respectively. Depreciation expense for the nine month periods ended September 30, 2013 and 2012 that was charged to research and development was $42,000 and $20,000, respectively.

Patent costs for the three month periods ended September 30, 2013 and 2012 amounted to $39,000 and $63,000, respectively, and are included in general and administrative expenses. Patent costs for the nine month periods ended September 30, 2013 and 2012 amounted to $113,000 and $165,000, respectively, and are included in general and administrative expenses.

Stock-based Compensation: FASB Accounting Standards Codification (“ASC”) 718-10 requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values on the grant date. Under the modified prospective method that we adopted, awards that were granted, modified, or settled on or after January 1, 2006 are measured and accounted for in accordance with ASC 718-10. Unvested equity-classified awards that were granted prior to January 1, 2006 will continue to be accounted for in accordance with ASC 718-10, except that the grant date fair value of all awards are recognized in the results of operations over the remaining vesting periods. The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized. In addition, the realization of tax benefits in excess of amounts recognized for financial reporting purposes will be recognized as a financing activity in accordance with ASC 718-10.

No tax benefits were attributed to the stock-based compensation expense because a valuation allowance was maintained for substantially all net deferred tax assets. We elected to adopt the alternative method of calculating the historical pool of windfall tax benefits as permitted by ASC 718-10-65 (previously known as: FASB Staff Position (FSP) No. SFAS 123(R)-c, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards”). This is a simplified method to determine the pool of windfall tax benefits that is used in determining the tax effects of stock compensation in the results of operations and cash flow reporting for awards that were outstanding as of the adoption of ASC 718-10.

Income Taxes: We account for income taxes using the asset and liability method, the objective of which is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting and the tax bases of our assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. A valuation allowance related to deferred tax assets is recorded when it is more likely than not that some portion or all of the deferred tax assets will not be realized. We adopted FASB ASC 740-10 relating to “Accounting for uncertainty in income taxes” on January 1, 2008. As a result of the implementation of FASB ASC 740-10, we recognized no adjustment for uncertain tax positions. It is our policy to recognize interest and penalties related to income tax matters as general and administrative expenses. The tax years 2009 through 2012 remain open to examination by the federal and state tax jurisdictions to which we are subject.

Loss per Common Share: FASB’s ASC 260-10 (previously known as FASB Statement 128, “Earnings Per Share”) requires the presentation of basic earnings per share, which is based on weighted average common stock outstanding, and dilutive earnings per share, which gives effect to options, warrants and convertible securities in periods when they are dilutive. At September 30, 2013 and 2012, we excluded 29,115,846 and 28,961,517 potential common shares, respectively, relating to convertible preferred stock, options and warrants outstanding from the diluted net loss per common share calculation because their inclusion would be anti-dilutive. In addition, we excluded 625,000 warrants from the diluted net loss per common share calculation at September 30, 2013 and 2012 as the conditions for their vesting are not time-based.

Recent Accounting Pronouncements: There have been no accounting pronouncements issued since January 1, 2013 that have had a material impact on the reporting of the Company’s financial results.

NOTE C — RELATED PARTY TRANSACTIONS

[1] Effective January 1, 2008, the board instituted a compensation plan for James Gleasman, our chief executive officer, and Keith Gleasman, our president, each of whom were major shareholders and co-founders of the Company. The compensation plan was designed to compensate each of them for services performed, and inventions and know-how transferred to us, at the rate of $300,000 per year. Actual payment of this compensation, or any portion thereof, was conditioned upon a determination by the board that we had the requisite cash to make payment, after the complete funding of all ongoing Company projects.

We did not have the requisite cash available to pay the Gleasmans’ compensation under this arrangement from January 1, 2008 through August 17, 2009, the date on which each of the Gleasmans waived all of his rights and interest in and to the board-created compensation plan, including all of his rights and interest in and to the amount(s) under the plan accrued to such date. As a result of such waiver, of the $942,000 accrued under the plan at September 30, 2009, $900,000 was reclassified to equity as a contribution of services and $42,000 accrued under the plan for payroll taxes was recorded as a reduction to general and administrative expenses in the quarter ended September 30, 2009.

For subsequent periods, there had not been a compensation plan in place for the Gleasmans. However, due to the significance of their ownership interest at the time and their influence within the Company, we were required to record the estimated value of each of the Gleasman’s services rendered to us (estimated at $300,000 each per annum) as a contribution of services in accordance with generally accepted accounting principles, and we allocated the amount of such contribution between research and development expenses and general and administrative expenses, based upon management’s estimate of the Gleasmans’ time allocation. Effective March 14, 2010, James Gleasman retired as our chief executive officer, interim chief financial officer and as a member of the board of directors. As of October 1, 2011 following our September 2011 private placement, we reassessed the estimated value of the services we were receiving from Keith Gleasman as a result of the reduction of his overall ownership interest, and reduced the amount we were recording for his contribution for shareholder services to the equivalent of $100,000 per annum. On January 9, 2012, the board approved a base salary for Keith Gleasman of $100,000 per annum to be effective as of January 1, 2012. The board’s decision was based upon the recommendation of our chief executive officer and our Governance and Compensation Committee, composed entirely of independent directors.

Effective as of January 1, 2012, we no longer imputed an expense related to contributed shareholder services.

[2] On September 14, 2007, we moved our executive offices from Pittsford, New York to Rochester, New York, which includes both a manufacturing and executive office facility. The Rochester facility is owned by a partnership, with which Asher J. Flaum, a Company director, is associated. On April 28, 2008, our board of directors approved the terms of a lease and such lease was executed on April 29, 2008.

Effective October 24, 2012, we amended certain terms of the lease for our Rochester facility. The primary changes that were made include a two-year extension of the current lease originally set to expire as of May 31, 2013 at the same rent rate, and the addition of two three-year renewal options with a 10% rate increase at each subsequent renewal period. These renewal options replace the previous renewal options of three five-year renewal periods which had incorporated 15% rate increases at each subsequent renewal period. (See Note H[1].)

[3] On December 13, 2010, we executed a consultant agreement with a director to provide consulting services to us at a rate of $200 per hour. Pursuant to the agreement, we also agreed to pay the consultant an incentive fee equal to $10,000 or proportionate part thereof for each $1,000,000 of revenue or proportionate part thereof actually received by us for a period of five years, provided the definitive agreement with the third party results from the material efforts of the consultant. During each of the three month periods ended September 30, 2013 and 2012, we recorded an expense of $0 for services rendered in relation to this agreement. During the nine month periods ended September 30, 2013 and 2012, we recorded an expense of $0 and $2,000, respectively, for services rendered in relation to this agreement.

[4] Effective on March 27, 2012, we hired Dr. William Mark McVea as our Chief Technology Officer. Prior to joining the Company, Dr. McVea provided us with consulting services through KBE ⁺ , Inc., a group of consulting engineers engaged in the design and development of gear trains and power transmission devices, and of which Dr. McVea was the principal engineer and president. At the time Dr. McVea joined the Company in March 2012, we had an outstanding liability of $41,000 to KBE ⁺ , Inc. related to consulting services provided to the Company, which was paid in full by April 2012.

On April 30, 2012, we purchased various test equipment, office furniture, and supplies from KBE ⁺ , Inc. for a total of $162,500. We have entered into a financing agreement with KBE ⁺ , Inc., whereby we are paying KBE ⁺ , Inc. over 24 months in equal monthly installments of approximately $6,800, beginning on May 1, 2012. Based on an imputed interest rate of approximately 5%, the initial principal of the note was approximately $154,000, and as of September 30, 2013, the outstanding principal on the note was approximately $47,000. Interest expense pertaining to this note amounted to approximately $1,000 and $2,000 for the three month periods ended September 30, 2013 and 2012, respectively. Interest expense pertaining to this note amounted to approximately $3,000 and $3,000 for the nine month periods ended September 30, 2013 and 2012, respectively.

In May 2012, we purchased certain additional testing tools and supplies from KBE ⁺ , Inc. for approximately $5,700. At June 30, 2013, the outstanding payable to KBE ⁺ , Inc. related to this purchase was fully paid.

[5] Effective as of January 1, 2013, we entered into a one-year consulting agreement with SCIRE Corporation, of which one of our directors is president, to provide us with expertise and advice on hydraulic pump technology and related markets. The consulting agreement provides for a guaranteed minimum of $3,840 per month, based on 32 hours of consulting, plus travel costs. Additional hours above this minimum will be billed at a rate of $120 per hour. During the three and nine month periods ended September 30, 2013, we recorded an expense of approximately $14,000 and $39,000, respectively, for consulting services and travel costs related to this agreement.

NOTE G — STOCKHOLDERS’ EQUITY

[1] Preferred Stock

On August 30, 2000, we amended our certificate of incorporation to permit the Company to issue up to 100,000,000 shares of $.01 par value preferred stock. Under the amendment, the board of directors has the authority to allocate these shares into as many separate classes of preferred as it deems appropriate and with respect to each class, designate the number of preferred shares issuable and the relative rights, preferences, seniority with respect to other classes and to our common stock and any limitations and/or restrictions that may be applicable without obtaining shareholder approval.

(a)   Class A Preferred Stock

In March 2002, our board designated the first series of preferred shares, authorizing the issuance of up to 3,300,000 Class A Non-Voting Cumulative Convertible Preferred Shares. Each Class A Preferred Share is convertible after a one year holding period, at the holder’s election, into one share of our common stock. The conversion rate is subject to adjustment in the event of the issuance of our common stock as a dividend or distribution and in the case of the subdivision or combination of our common stock. The Class A Preferred has no voting rights, except with respect to matters directly impacting upon the rights and privileges accorded to such Class.

The holders of the Class A Preferred are entitled to receive cumulative preferential dividends in the amount of $.40 per share of Class A Preferred for each annual dividend period.

Dividends payable on the Class A Preferred will be paid in cash out of any funds legally available for the payment of dividends or, in the discretion of the board, will be paid in Class A Preferred at a rate of 1 share of Class A Preferred for each $4.00 of dividends.

If dividends are paid in shares of Class A Preferred, such dividend shares are not entitled to accumulate additional dividends and themselves may be converted into the common stock of the Company on a one for one basis. Holders of Class A Preferred are permitted to request that dividends payable in Class A Preferred be immediately converted into shares of our common stock. At times, our board may elect to settle the dividends through the issuance of common stock in lieu of cash.

Accumulated and unpaid dividends on the Class A Preferred will not bear interest. Class A Preferred shares are also entitled to participate pro rata in dividends declared and/or distributions made with respect to all classes of our outstanding equity.

We may, in the absolute discretion of our board, redeem at any time and from time to time from any source of funds legally available any and all of the outstanding Class A Preferred at the redemption price of $4.00 per Class A Preferred, plus all unpaid accumulated dividends payable with respect to each Class A Preferred Share.

Since its designation in March 2002, we have sold an aggregate 765,512 shares of Class A Preferred for proceeds of approximately $3,062,000. We sold 0 Class A Preferred shares during the nine month period ended September 30, 2013 and the year ended December 31, 2012.

Since its designation in March 2002, Class A Preferred shareholders have converted an aggregate 189,750 Class A Preferred into our common stock (on a one to one basis) through September 30, 2013. There were 0 Class A Preferred shares converted in each of the nine month periods ended September 30, 2013 and 2012.

For each of the nine month periods ended September 30, 2013 and 2012, we settled 0 Class A Preferred dividends. Since its inception in March 2002 through September 30, 2013, we have settled an aggregate Class A Preferred dividend amounting to approximately $242,000 through the issuance of 11,339 Class A Preferred shares and 100,924 common shares.

At September 30, 2013, there were 587,101 outstanding shares of Class A Preferred stock, of which 11,339 shares resulted from the settlement of dividends due to conversion, and those shares no longer accrue dividends. The value of dividends payable upon the conversion of the remaining 575,762 outstanding shares of Class A Preferred stock amounted to approximately $1,961,000 at September 30, 2013.

In the event of the liquidation, dissolution and winding up of the Company, and subject to the liquidation rights and privileges of our Class C Preferred, Class A Preferred shareholders have a liquidation preference with respect to all accumulated and unsettled dividends. The value of the Class A Preferred shareholders’ liquidation preference was approximately $1,961,000 and $1,788,000 at September 30, 2013 and December 31, 2012, respectively. In the event of a liquidation, dissolution or winding up of the Company, unpaid accumulated dividends on the Class A Preferred are payable in Class A Preferred shares at a rate of 1 share of Class A Preferred for each $4.00 of dividends.

(b)   Class B Preferred Stock

In September 2004, the board created a second series of preferred stock by authorizing the issuance of up to 300,000 Class B Non-Voting, Cumulative Convertible Preferred Shares to fund the business operations of Iso-Torque Corporation, an entity incorporated to separately commercialize our IsoTorque differential technology.

Each Class B Preferred Share is convertible after a one year holding period, at the holder’s election, into one share of our common stock or one share of the common stock of IsoTorque Corporation. The conversion rate is subject to adjustment in the event of the issuance of the Company’s or IsoTorque Corporation’s common stock as a dividend or distribution and in the case of the subdivision or combination of such common stock. The Class B Preferred has no voting rights, except with respect to matters directly impacting upon the rights and privileges accorded to such Class.

Subject to the dividend rights and privileges of our Class A Preferred, the holders of the Class B Preferred are entitled to receive cumulative preferential dividends in the amount of $.50 per share of Class B Preferred for each annual dividend period.

Dividends payable on the Class B Preferred will be paid in cash out of any funds legally available for the payment of dividends or, in the discretion of the board, will be paid in Class B Preferred at a rate of 1 share of Class B Preferred for each $5.00 of dividends.

If dividends are paid in shares of Class B Preferred, such dividend shares are not entitled to accumulate additional dividends and themselves may be converted into the common stock of the Company on a one for one basis. Holders of Class B Preferred are permitted to request that dividends payable in Class B Preferred be immediately converted into shares of our common stock.

Accumulated and unpaid dividends on the Class B Preferred will not bear interest. Class B Preferred shares are also entitled to participate pro rata in dividends declared and/or distributions made with respect to all classes of our outstanding equity.

We may, in the absolute discretion of our board, redeem at any time and from time to time from any source of funds legally available any and all of the outstanding Class B Preferred at the redemption price of $5.00 per Class B Preferred, plus all unpaid accumulated dividends payable with respect to each Class B Preferred Share.

Since its designation in September 2004, we have sold an aggregate 97,500 Class B Preferred in a number of private placements for proceeds of approximately $487,500. We sold 0 Class B Preferred shares during the nine month period ended September 30, 2013 and the year ended December 31, 2012.

Since its designation, Class B Preferred shareholders have converted an aggregate 30,000 Class B Preferred into our common stock (on a one to one basis) through September 30, 2013. Through September 30, 2013, we have issued 0 Class B Preferred shares to converting Class B Preferred shareholders as a dividend.

Depending upon our cash position, from time to time we may request that a converting preferred shareholder receiving dividends in cash consent to receive shares of restricted common stock in lieu thereof. During the nine month period ended September 30, 2013, we issued 0 shares of restricted common stock in payment of Class B dividends. During the three and nine month periods ended September 30, 2012, we issued 0 and 5,328 shares of restricted common stock in payment of Class B dividends amounting to approximately $0 and $27,000, respectively. Cumulatively through September 30, 2013, we have issued 35,431 restricted common shares in payment of Class B dividends amounting to approximately $51,000.

At September 30, 2013, dividends payable upon the conversion of 67,500 outstanding shares of Class B Preferred amounted to approximately $277,000. In the event of the liquidation, dissolution and winding up of the Company, and subject to the liquidation rights and privileges of our Class C Preferred and our Class A Preferred, Class B Preferred shareholders have a liquidation preference with respect to all accumulated and unsettled dividends. The value of the Class B Preferred shareholders’ liquidation preference was $277,000 and $251,000 at September 30, 2013 and December 31, 2012, respectively. In the event of a liquidation, dissolution or winding up of the Company, unpaid accumulated dividends on the Class B Preferred are payable in Class B Preferred shares at a rate of 1 share of Class B Preferred for each $5.00 of dividends.

(c)   Class C Preferred Stock

In September 2011, the board of directors authorized, and Class A Preferred and Class B Preferred shareholders approved, a third series of preferred stock, namely 16,250,000 shares of Class C Voting Convertible Preferred Stock. On September 23, 2011, we sold and issued a total of 16,250,000 shares of Series C Voting Convertible Preferred Stock and warrants to purchase 1,625,000 shares of our common stock in a private placement transaction, generating gross proceeds of $6,500,000. Direct expenses of approximately $106,000 pertaining to the transaction, consisting of primarily external legal costs, were incurred, resulting in net proceeds of approximately $6,394,000.

Each Class C Preferred share is convertible, at the holder’s election, into one share of our common stock. The conversion rate is subject to adjustment in the event of the issuance of common stock as a dividend or distribution, and the subdivision or combination of the outstanding common stock.

The Class C Preferred shares have a liquidation preference at their stated value per share of $0.40 that is senior to our common stock, and the Company’s Class A Non-Voting Cumulative Convertible Preferred Shares and Class B Non-Voting Cumulative Convertible Preferred Shares. The liquidation preference is payable upon a liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, or upon a deemed liquidation of the Company.

The Class C Preferred shares have no right to receive dividends and have no redemption right. The Class C Preferred shares vote with the common stock on an as-converted basis. Class C Preferred is also entitled to participate pro rata in dividends declared and distributions made with respect to all classes of our outstanding equity.

The associated warrants have a ten (10) year term and are immediately exercisable for 1,625,000 shares of common stock. The warrants are exercisable, at the holder’s election, for shares of the Company’s common stock in either a cash or cashless exercise. The warrants have an exercise price equal to the greater of (i) $0.01 or (ii) eighty percent (80%) of the volume weighted average sale price per share of our common stock during the ten (10) consecutive trading days immediately preceding the notice of exercise. The number of warrants and exercise price are subject to adjustment in the event of the issuance of common stock as a dividend or distribution, and the subdivision or combination of the outstanding common stock. At the time of issuance, we estimated a value of $.50 per warrant, or a total of approximately $812,000, using a weighted average of assigned probabilities for various gain scenarios at certain price points based on expected volatility. As a result of the combined issuance of the Class C Preferred stock with the associated warrants, we reflected a non-cash distribution on the Class C Preferred shares for the warrants issued in our consolidated statements of operations for 2011. (See Note G[3](o).)

In conjunction with the issuance of the 16,250,000 shares of Class C Preferred stock, we computed the value of the non-cash beneficial conversion feature associated with the right to convert the shares into common stock on a one-for-one basis. We compared the fair value of our common stock on the date of issuance with the effective conversion price after allocation of the proceeds to the related warrants, and determined that the value of the non-cash beneficial conversion feature is approximately $5,582,000, which was reflected in our consolidated statements of operations for the year ended December 31, 2011 as an adjustment to arrive at the net loss attributable to common stockholders.

Cumulatively through September 30, 2013, Class C Preferred shareholders have converted 0 shares of Class C Preferred into common stock. At September 30, 2013, there were 16,250,000 shares of Preferred C stock outstanding. The value of the Class C Preferred shareholders’ liquidation preference was $6,500,000 at September 30, 2013.

[2] Stock Options

(a)   1998 Stock Option Plan

In December 1997, our board approved a Stock Option Plan (the “1998 Plan”) which provided for the granting of up to 2,000,000 shares of common stock, pursuant to which officers, directors, key employees and key consultants/advisors are eligible to receive incentive, nonqualified or reload stock options which plan was ratified by the shareholders on May 28, 1998. Options granted under the 1998 Plan are exercisable for a period of up to 10 years from date of grant at an exercise price which is not less than the fair value on date of grant, except that the exercise period of options granted to a stockholder owning more than 10% of the outstanding capital stock may not exceed five years and their exercise price may not be less than 110% of the fair value of the common stock at date of grant. Options may vest over five years.

By its terms, our 1998 Plan terminated as to the grant of future options on May 27, 2008. Consequently, no additional stock options will be granted under the 1998 Plan, although outstanding options remain available for exercise in accordance with their terms. There were 0 options exercised under the 1998 Plan during each of the nine month periods ended September 30, 2013 and 2012.

Through September 30, 2013, a total of 1,823,895 stock options had been granted under the 1998 Plan and 0 stock options had been exercised. During the three and nine month periods ended September 30, 2013, 0 and 50,000 stock options expired, respectively. During the nine month period ended September 30, 2012, 0 stock options expired. Since the plan’s inception, a total of 1,332,047 stock options have expired. As of September 30, 2013, there were 491,848 outstanding stock options under the 1998 Plan, all of which were fully vested. The following table summarizes information relating to stock options outstanding under the 1998 Plan at September 30, 2013:

As of September 30, 2013, we had $0 unrecognized stock compensation related to unvested awards under the 1998 Plan.

(b)   2011 Stock Option Plan

On November 3, 2010, the board adopted, and on January 27, 2011 the shareholders approved, the 2011 Stock Option Plan (“2011 Plan”) which provides for the grant of up to 3,000,000 common stock options to provide equity incentives to directors, officers, employees and consultants. Two types of options may be granted under the 2011 Plan: non-qualified options and incentive options.

Non-qualified options may be granted to our officers, directors, employees and outside consultants. Incentive options may be granted only to our employees, including officers and directors who are also employees. In the case of non-qualified options, the exercise price may be less than the fair market value of our stock on the date of grant. In the case of incentive options, the exercise price may not be less than such fair market value and in the case of an employee who owns more than 10% of our common stock, the exercise price may not be less than 110% of such market price. Options generally are exercisable for ten years from the date of grant, except that the exercise period for an incentive option granted to an employee who owns more than 10% of our stock may not be greater than five years.

Effective January 28, 2011, our board of directors appointed Wesley K. Clark as a member of the board of directors. Our board voted to grant Gen. Clark a non-qualified stock option for 250,000 common shares under the 2011 Plan, effective January 28, 2011 and exercisable at $.90 per share. The option is conditioned upon Gen. Clark serving as a director and vests in four tranches of 25% of the total granted shares on each of the four annual anniversary dates of January 28, 2011. The original terms of the option required the optionee to exercise each tranche within two and one-half months following the calendar year in which the tranche vests or lose the tranche. However, on March 20, 2012, the board approved a modification of these options to provide for a 10 year term with an expiration date of January 28, 2021, and this modification was subsequently approved by shareholders at the Company’s annual meeting on June 14, 2012. We used the Black-Scholes option-pricing model to value the cost of this modification at approximately $56,000, which is being recognized ratably over the vesting periods of the respective tranches.

In March 2012, we granted an incentive stock option to our new chief technology officer to acquire 250,000 common shares at an exercise price of $.82 per share, exercisable for 10 years. The option vests in four tranches of 25% of the total granted shares on each of the four annual anniversary dates from the initial date of grant.

In December 2012, we granted a non-qualified stock option to a new director to acquire 250,000 common shares at an exercise price of $.70 per share, exercisable for 10 years. The option vests in four tranches of 25% of the total granted shares on each of the four annual anniversary dates from the initial date of grant.

During the three month period ended September 30, 2013, we granted 25,000 stock options under the 2011 Plan, 0 options became vested, and 0 options expired or were exercised. During the three month period ended September 30, 2012, we granted 0 stock options under the 2011 Plan, 0 options became vested, and 0 options expired or were exercised. During the nine month period ended September 30, 2013, we granted 25,000 stock options under the 2011 Plan, 125,500 options became vested, and 0 options expired or were exercised. During the nine month period ended September 30, 2012, we granted 251,000 stock options under the 2011 Plan, 62,750 options became vested, and 0 options expired or were exercised. As of September 30, 2013, there were 1,207,000 stock options outstanding under the 2011 Plan, 348,248 of which were vested. At September 30, 2013, there were 1,793,000 options remaining available for future grant under the 2011 Plan.

(c)   Non-Plan Options

During the first quarter of 2011, we granted a total of 1,350,000 non-plan stock options. On January 27, 2011, our shareholders approved the issuance of stock options to 5 directors each for 250,000 common shares, and the issuance of stock options to a consultant acting in the capacity as a special advisor to the board for 100,000 common shares, exercisable at $.90 per common share. Each option is conditioned upon the optionee serving as a director or consultant and vests in four tranches of 25% of the total granted shares on each of the four annual anniversary dates of January 27, 2011. The original terms of the options required the optionee to exercise each tranche within two and one-half months following the calendar year in which the tranche vests or lose the tranche. However, on March 20, 2012, the board approved a modification of these options to provide for a 10 year term with a uniform expiration date of January 27, 2021, and this modification was subsequently approved by shareholders at the Company’s annual meeting on June 14, 2012. We used the Black-Scholes option-pricing model to value the cost of this modification at approximately $304,000, which is being recognized ratably over the vesting periods of the respective tranches.

As of September 30, 2013, there were a total of 7,161,668 non-plan options outstanding, of which 4,274,168 were fully vested. During each of the three month periods ended September 30, 2013 and 2012, we granted 0 non-plan stock options, 0 options became vested, and 0 options were exercised or cancelled. During each of the nine month periods ended September 30, 2013 and 2012, we granted 0 non-plan stock options, 337,500 options became vested, and 0 options were exercised or cancelled.

(d)   Summary

For the three month periods ended September 30, 2013 and 2012, compensation cost related to all stock options amounted to $179,000 and $303,000, respectively. For the nine month periods ended September 30, 2013 and 2012, compensation cost related to all stock options amounted to $587,000 and $1,068,000, respectively. As of September 30, 2013, there was $778,000 of total unrecognized compensation costs related to outstanding stock options, which are expected to be recognized over the next 3.9 years.

During each of the three and nine month periods ended September 30, 2013, we granted 25,000 stock options with a weighted average grant-date fair value of $.40. The weighted average grant-date fair value of all stock options granted during the nine month period ended September 30, 2012 was $.74 per share. The total grant date fair value of all stock options vested during the nine month periods ended September 30, 2013 and 2012 was approximately $680,000 and $605,000, respectively.

The fair value of each option granted during the nine month periods ended September 30, 2013 and 2012 was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

The average risk-free interest rate is based on the U.S. treasury security rate in effect as of the grant date. We determined expected volatility using the historical closing stock price. The expected term was generally determined using the simplified method as we do not believe we have sufficient historical stock option exercise experience on which to base the expected term.

The following summarizes the activity of all of our outstanding stock options for the nine month period ended September 30, 2013:

Note (A) – Figures include the impact of 405,000 options that were granted in 2011 to replace options / warrants previously granted to certain engineering personnel. The previously issued options / warrants will expire as the newer options vest on a one-to-one basis. During the fourth quarter of 2012, 134,998 of these options vested, and 98,332 previously issued options and 36,666 previously issued warrants were cancelled concurrently in conjunction with the vesting of the 2011 options, leaving 270,002 options remaining to vest.

As of September 30, 2013, the exercise prices of all outstanding stock options, as well as all vested stock options, ranged from $.36 per share to $5.00 per share.

[3] Warrants

As of September 30, 2013, outstanding warrants to acquire shares of our common stock are as follows:

The following summarizes the activity of our outstanding warrants for the nine month period ended September 30, 2013:

NOTE H — COMMITMENTS AND OTHER MATTERS

 [1] Leases

We lease a facility from a related party (see Note C[2]) located at 1999 Mount Read Blvd., Rochester, New York. On April 29, 2008, we executed a five and one-half year lease for the premises (with a December 1, 2007 lease commencement date), providing for rent to be paid at a rate of $5,687 per month ($68,244 per annum) and in addition, for the payment of our proportionate share of yearly real estate taxes and yearly common area operating costs. Under the lease, monthly rental payments commenced June 1, 2008 and were to continue through May 2013. The lease contained three 5-year renewal options and grants us an option to lease additional adjacent manufacturing and assembly space.

Effective October 24, 2012, we amended certain terms of the lease. The primary changes that were made include a two-year extension of the current lease originally set to expire as of May 31, 2013 at the same rent rate, and the addition of two three-year renewal options with a 10% rate increase at each subsequent renewal period. These renewal options replace the previous renewal options of three 5-year renewal periods which had incorporated 15% rate increases at each subsequent renewal period.

Rent expense for the three month periods ended September 30, 2013 and 2012 was approximately $17,000 and $15,000, respectively. Rent expense for the nine month periods ended September 30, 2013 and 2012 was approximately $51,000 and $44,000, respectively. Rent payments required under the amended lease for the full years ending December 31, 2013, 2014 and 2015, excluding consideration for any renewal option periods, amount to approximately $68,000, $68,000 and $28,000, respectively.

[2] Employment Agreements

Effective October 4, 2010, we appointed a new chief executive officer and executed a five year employment agreement pursuant to which we will pay base compensation of $50,000 per annum, which compensation increases to $200,000 per annum on the first day of the calendar year immediately following the calendar year in which we have adjusted EBITDA of at least $300,000 (earnings before interest, taxes, depreciation and amortization, but excluding all non-cash expenses associated with stock options). Under the agreement, the executive is entitled to a performance bonus based upon financial targets established each year in good faith by the Governance and Compensation Committee and the achievement of individual management objectives established annually by such committee. The executive is entitled to participate in all employee benefit plans as are provided from time to time for senior executives. If we terminate the executive, remove him as CEO, or a change in control of the Company occurs, the executive is entitled to three years’ severance pay, consisting of base pay and any incentive compensation.

Effective October 18, 2010, we engaged a new chief financial officer under a letter agreement dated October 18, 2010. If we terminate the executive, remove him as CFO, or a change in control of the company occurs, the executive is entitled to 12 months’ severance pay.

[3] Consulting Agreements

Effective July 1, 2010, in two separate agreements, we engaged the services of a consulting firm to provide expertise with business development initiatives, strategic planning and general funding opportunities. We agreed to pay the consultant an annual retainer of $82,500 for both agreements combined, to be paid in quarterly installments. We also agreed to pay the consultant a commission equal to 4% of the value received by us from third parties introduced by or through the auspices of the consultant for a period of a minimum of 4 years beyond the initial term of the agreement. The agreements were for one and two year terms. On March 31, 2011, we signed a modification agreement pursuant to which, in exchange for a one-time payment of $17,250, all of the cash obligations under these two agreements were cancelled. The obligation to pay a 4% commission with respect to the generation of business from efforts initiated by the consultant remains in effect through January 1, 2017.

On December 13, 2010, we executed a consultant agreement with a director to provide consulting services to us at a rate of $200 per hour. Pursuant to the agreement, we also agreed to pay the consultant an incentive fee equal to $10,000 or proportionate part thereof for each $1,000,000 of revenue or proportionate part thereof actually received by us for a period of five years, provided the definitive agreement with the third party results from the material efforts of the consultant. During each of the three month periods ended September 30, 2013 and 2012, we recorded an expense of $0 for consulting services under the agreement. During the nine month periods ended September 30, 2013 and 2012, we recorded an expense of $0 and $2,000, respectively, for consulting services under the agreement. Cumulatively, through September 30, 2013, we have recorded approximately $2,000 of expense for services rendered in relation to this agreement.

Effective as of January 1, 2013, we entered into a one-year consulting agreement with SCIRE Corporation, of which one of our directors is president, to provide us with expertise and advice on hydraulic pump technology and related markets. The consulting agreement provides for a guaranteed minimum of $3,840 per month, based on 32 hours of consulting, plus travel costs. Additional hours above this minimum will be billed at a rate of $120 per hour. During the three and nine month periods ended September 30, 2013, we recorded an expense of approximately $14,000 and $39,000, respectively, for consulting services and travel costs related to this agreement.

[4] Prototype Development Agreements

On January 28, 2011, we announced that we entered into a contract with a West Virginia remanufacturer of components for the mining and associated industrial equipment industry to develop, evaluate, manufacture and sell our IsoTorque® differential technology in mining shuttle cars. The contract calls for us to design and build a prototype IsoTorque® unit for installation in a 21 SC model mining shuttle car. The remanufacturer will pay us $120,000 for the initial development. Upon successful completion of the prototype phase, the parties have agreed that we will sell 100% of the differential requirements for all 21 SC model mining shuttle cars remanufactured by the remanufacturer on an exclusive basis. Minimum purchase requirements were to be established after the first anniversary of the agreement. During the first quarter of 2012, we recorded $60,000 in revenue upon the completion of the second milestone. In the nine month period ended September 30, 2013, we recorded $0 in revenue related to this contract. Through September 30, 2013, we have recorded a total of $90,000 in revenue associated with this agreement.

In December 2012, we entered into a development agreement with Chinese automotive manufacturer, BAIC Motor Co., Ltd. Under the agreement, BAIC Motor Co., Ltd. will pay us approximately $39,000 in two installments to manufacture a number of prototypes of our IsoTorque® differential for one of BAIC's anticipated future car models. We will supply BAIC with these prototypes for their evaluation and testing. In the three and nine month periods ended September 30, 2013, we received approximately $20,000 as the initial deposit related to this contract, and it has been recorded as deferred revenue on the condensed consolidated balance sheet. Revenue and related expenses associated with this development agreement will be recognized when the prototypes are completed and shipped to the customer.