- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

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

For the transition period from to

Commission file number: 000-51991

Basin Water, Inc.

(Exact name of registrant as specified in its charter)


Delaware		20-4736881
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

9302 Pittsburgh Avenue, Suite 210 Rancho Cucamonga, California		91730
(Address of principal executive offices)		(Zip Code)

(909) 481-6800

(Registrant’s telephone number, including area code)

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

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

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨

(Do not check if a smaller reporting company)

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: On February 2, 2009 there were 22,205,843 shares of common stock, par value $0.001, outstanding.

BASIN WATER, INC.

INDEX


			Page No.
Part I.	Financial Information:

	Item 1.	Financial Statements:

		Condensed Consolidated Balance Sheets – September 30, 2008 (unaudited) and December 31, 2007 (audited)	1

		Condensed Consolidated Statements of Operations (unaudited) – Three and nine months ended September 30, 2008 and 2007	2

		Condensed Consolidated Statement of Changes in Stockholders’ Equity (unaudited) – Nine months ended September 30, 2008	3

		Condensed Consolidated Statements of Cash Flows (unaudited) – Nine months ended September 30, 2008 and 2007	4

		Notes to Condensed Consolidated Financial Statements (unaudited)	5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30

	Item 4.	Controls and Procedures	30

Part II.	Other Information:

	Item 1.	Legal Proceedings	33

	Item 1A.	Risk Factors	33

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	33

	Item 3.	Defaults Upon Senior Securities	34

	Item 4.	Submission of Matters to a Vote of Security Holders	34

	Item 5.	Other Information	34

	Item 6.	Exhibits	35

Signatures			36

PART I – FINANCIAL INFORMATION

Item 1.

Financial Statements

BASIN WATER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)


	September 30, 2008			December 31, 2007
	(Unaudited)			Restated
ASSETS
Current assets
Cash and cash equivalents	$	16,882		$	36,038
Accounts receivable, net of $461 and $92 allowance for doubtful accounts		3,550			3,167
Unbilled receivables, net of $235 and $208 allowance for doubtful accounts		3,528			7,357
Inventory, net of $79 and $79 reserve		1,482			975
Prepaid expenses and other		682			1,163

Total current assets		26,124			48,700

Property and equipment
Property and equipment		32,510			24,885
Less: accumulated depreciation		3,106			2,235

Property and equipment, net		29,404			22,650

Other assets
Goodwill		2,773			6,323
Unbilled receivables, net of current portion		—			3,653
Intangible assets, net		2,570			2,468
Patent costs, net		3,251			2,274
Investment in affiliate		2,100			4,632
Other assets		1,662			1,667

Total other assets		12,356			21,017

Total assets	$	67,884		$	92,367

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	3,954		$	3,553
Current portion of notes payable		56			239
Current portion of capital lease obligations		10			11
Current portion of deferred revenue and advances		299			266
Current portion of contract loss reserve		1,286			2,109
Accrued expenses and other		3,740			3,131

Total current liabilities		9,345			9,309
Notes payable, net of current portion		111			113
Capital lease obligations, net of current portion		8			15
Deferred revenue, net of current portion		327			391
Deferred revenue - affiliate		797			1,456
Contract loss reserve, net of current portion		7,043			7,003
Other long-term liabilities		—			179

Total liabilities		17,631			18,466

Noncontrolling interest		342			84

Commitments and contingencies
Stockholders’ equity
Common stock, $0.001 par value - 100,000,000 shares authorized, 22,205,843 and 21,948,704 shares issued and outstanding		22			22
Additional paid-in capital		112,098			110,193
Treasury stock		(552	)		(552	)
Accumulated deficiency		(61,657	)		(35,846	)

Total stockholders’ equity		49,911			73,817

Total liabilities and stockholders’ equity	$	67,884		$	92,367

See accompanying notes to unaudited condensed consolidated financial statements.

BASIN WATER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007 Restated			2008			2007 Restated
Revenues
System sales	$	665		$	625		$	2,603		$	2,739
Contract revenues		2,182			1,781			6,202			3,631

Total revenues		2,847			2,406			8,805			6,370

Cost of revenues
Cost of system sales		878			2,471			2,708			5,303
Cost of contract revenues		2,144			8,851			5,921			10,633
Depreciation expense		205			142			603			346

Total cost of revenues		3,227			11,464			9,232			16,282

Gross loss		(380	)		(9,058	)		(427	)		(9,912	)

Research and development expense		882			152			1,101			398
Selling, general and administrative expense		11,891			3,399			22,589			8,019

Loss from operations		(13,153	)		(12,609	)		(24,117	)		(18,329	)

Other income (expense)
Interest expense		(65	)		(81	)		(210	)		(629	)
Interest income		164			683			765			2,108
Equity in loss of affiliate		(223	)		—			(703	)		—
Impairment charge - investment in affiliate		(1,277	)		—			(1,277	)		—
Other income (expense)		(8	)		100			(11	)		101

Total other income (expense)		(1,409	)		702			(1,436	)		1,580

Loss before income taxes		(14,562	)		(11,907	)		(25,553	)		(16,749	)
Income tax benefit		—			—			—			—

Loss before noncontrolling interest		(14,562	)		(11,907	)		(25,553	)		(16,749	)
Less: net income attributable to noncontrolling interest		(91	)		—			(258	)		(74	)

Net loss	$	(14,653	)	$	(11,907	)	$	(25,811	)	$	(16,823	)

Net loss per share:
Basic	$	(0.67	)	$	(0.60	)	$	(1.19	)	$	(0.85	)
Diluted	$	(0.67	)	$	(0.60	)	$	(1.19	)	$	(0.85	)
Weighted average common shares outstanding:
Basic		21,812			19,873			21,774			19,751
Diluted		21,812			19,873			21,774			19,751

See accompanying notes to unaudited condensed consolidated financial statements.

BASIN WATER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(In thousands)

(Unaudited)


	Common Stock			Additional Paid-in		Treasury			Accumulated
	Shares	Amount		Capital		Stock			Deficiency			Totals
Balance - December 31, 2007 (Restated)	21,949	$	22	$	110,193	$	(552	)	$	(35,846	)	$	73,817
Stock options exercised	29		—		25		—			—			25
Stock-based compensation expense	—		—		1,880		—			—			1,880
Deferred stock compensation	228		—		—		—			—			—
Net loss	—		—		—		—			(25,811	)		(25,811	)

Balance - September 30, 2008	22,206	$	22	$	112,098	$	(552	)	$	(61,657	)	$	49,911

See accompanying notes to unaudited condensed consolidated financial statements.

BASIN WATER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)


	Nine Months Ended September 30,
	2008			2007 Restated
	(Unaudited)
Cash flows from operating activities
Net loss	$	(25,811	)	$	(16,823	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		1,305			700
Stock-based compensation expense		1,880			1,034
Amortization of deferred compensation		119			148
Bad debt expense		562			235
Equity in loss of affiliate		703			—
Net income attributable to noncontrolling interest		258			74
Impairment of goodwill		4,952			—
Impairment of investment in affiliate		1,277			—
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		(716	)		(599	)
Unbilled receivables		2,755			3,778
Inventory		(507	)		172
Prepaid expenses and other		481			(467	)
Accounts payable		401			1,718
Deferred revenues		215			(117	)
Accrued expenses and other		559			(1,203	)
Contract loss reserve		(783	)		6,012
Other assets and other liabilities		(560	)		(795	)

Net cash used in operating activities		(12,910	)		(6,133	)

Cash flows from investing activities
Purchase of property, plant and equipment		(4,067	)		(4,489	)
Acquisition of business, net of cash acquired		(1,971	)		(6,231	)
Patent costs		(40	)		(125	)

Net cash used in investing activities		(6,078	)		(10,845	)

Cash flows from financing activities
Proceeds from stock option exercises		25			326
Proceeds from warrant exercises		—			3,088
Proceeds from notes payable		—			500
Repayments of notes payable and capital lease obligations		(193	)		(2,296	)

Net cash provided by (used in) financing activities		(168	)		1,618

Net decrease in cash and cash equivalents		(19,156	)		(15,360	)
Cash and cash equivalents, beginning of period		36,038			54,567

Cash and cash equivalents, end of period	$	16,882		$	39,207

See accompanying notes to unaudited condensed consolidated financial statements.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 1—Business Activity

Basin Water, Inc. and its subsidiaries (the Company) design, build and implement systems for the treatment of contaminated groundwater, industrial process water and air streams from municipal and industrial sources. Customers can choose between purchasing the Company’s systems and entering into long-term contracting arrangements for the Company’s systems. The Company also offers long-term contracts for the treatment of water produced from installed treatment systems as well as other water treatment-related services.

The Company markets its treatment systems and services primarily to utilities, cities, municipalities, special districts, real estate developers, and other organizations for use in treating groundwater that does not comply with federal or state drinking water regulations due to the presence of chemical contaminants. The Company markets its treatment systems and services through its direct sales force, independent contractors and strategic relationships.

On September 14, 2007, the Company completed the acquisition of Mobile Process Technology Co. (MPT), a provider of technology and services to the water and wastewater treatment and industrial process markets. This acquisition extended the Company’s capabilities including expanded technological solutions, geographic presence and customer base. Additional services the Company can now provide as a result of the acquisition include: (1) central regeneration for ion-exchange, in which the Company replaces the resin vessel on a periodic basis and regenerates the resin offsite, (2) smaller ion-exchange systems permitting the servicing of low-flow wells, and (3) technologies to treat process water and to provide resource recovery from wastewater. The Company now also has the ability to service and treat smaller capacity water systems.

In 2007, the Company entered into transactions with respect to the sale of water treatment systems to two special purpose entities (VL Capital, or VLC and Water Services Solutions, or WSS) that were to be funded by third-party financial institutions. In accordance with the provisions of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities – Deferral for Certain Interests, Revised December 2003 (FIN 46(R)), the Company has concluded that the financial statements of VLC and WSS should be consolidated with those of the Company. Accordingly, the Company’s condensed consolidated financial statements for the periods presented herein include these entities.

In September 2008, the Company acquired the bioreactor and biofilter business (Envirogen) of Shaw Environmental & Infrastructure, Inc. (Shaw) for $1,500 cash (subject to adjustment for working capital) plus the settlement of a previously disputed claim against Shaw for amounts the Company claimed to be owed by Shaw. The dispute involved an ion exchange unit purchase agreement executed by the Company and Shaw in December 2005 which was structured as a $5,000 sale of water treatment units by the Company to Shaw in two parts. In the settlement, Shaw relinquished its claims or rights under the 2005 purchase agreement generally, and in particular to the ion exchange units that were the subject of the agreement. In the transaction, the Company acquired the assets of Envirogen, which includes the design and supply of fluidized bed, membrane, and suspended carrier bioreactors for the treatment of groundwater and wastewater streams in industrial, municipal and federal applications. The business also includes the design and supply of biofilters for the treatment of air streams from municipalities and industry for the removal of odor-causing and other contaminants.

The Company restated its previously reported consolidated financial statements for the years ended December 31, 2007 and 2006 and the quarterly periods therein, as well as the quarter ended March 31, 2008. See Notes 3 and 4 to the condensed consolidated financial statements included in the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2007 and Note 3 to the condensed consolidated financial statements included in the Company’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended March 31, 2008.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies

Interim Consolidated Financial Statements

The interim consolidated financial statements for the three and nine-month periods ended September 30, 2008 and 2007 have been prepared in accordance with Regulation S-X Rule 10-01 of the Securities Exchange Act of 1934 (the Exchange Act) as prescribed by the Securities and Exchange Commission (SEC). As such, certain disclosures which would substantially duplicate the disclosures contained in the Company’s latest audited consolidated financial statements have been omitted. This Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 (the September Report) should be read in concert with the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2007 (the Restated 2007 Annual Report), which contains the Company’s restated audited consolidated financial statements for the year ended December 31, 2007.

The interim financial information for the three- and nine-month periods ended September 30, 2008 and 2007 is unaudited and has been prepared on the same basis as the audited financial statements. However, the financial statements contained in the September Report do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America (US GAAP) for audited financial statements. In the opinion of management, such unaudited information includes all adjustments (consisting of normal recurring adjustments) necessary for fair presentation of the interim financial information.

Basis of Presentation and Use of Estimates

The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect certain reported amounts of assets, liabilities, revenues and expense, and related disclosures. Accordingly, actual results could differ from those estimates.

Certain reclassifications have been made to the prior year financial statement presentation to conform to the current year presentation.

Inventory

Inventory consists primarily of raw materials and supplies used in the fabrication of the Company’s groundwater treatment systems, as well as the reprocessing and conditioning of resins. Inventory items are stated at the lower of cost on a first-in, first-out (FIFO) basis or market. Inventory that is no longer usable as a system component is considered obsolete. A reserve for slow-moving inventory is maintained as appropriate.

Revenue Recognition and Fluctuation

As described in the Company’s Restated 2007 Annual Report, the Company recognizes revenues either from the sale of a system or as recurring revenues from the lease of a system. In addition, the Company also recognizes recurring revenues from long-term contracts for the treatment of the water produced from installed treatment systems or by providing other services for the processing of water and other water treatment-related services. These revenues are also referred to as service revenues.

The Company’s revenues vary from period to period, because customers may choose between purchasing groundwater treatment systems and entering into long-term contract arrangements for groundwater treatment systems. If a customer chooses to purchase a system, revenues are recognized over a much shorter period of time, generally within two or three quarters, than for the same system if the customer chooses a long-term contract arrangement. Revenues tend to be higher in periods in which sales rather than long-term lease and services contracts occur. In addition, service revenues tend to be higher in warmer, dryer weather when treated water is at a high demand. The results of operations for the first nine months of 2008 are not necessarily predictive of the remaining three months of the year. The timing and amount of revenues from system sales in a given period can be unpredictable and relatively inconsistent, and are dependent on such factors as the duration of the sales cycle (which varies from customer to customer), size and number of water treatment systems included in the sale, and whether the equipment is sold or leased.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

Recent Accounting Pronouncements

In May 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 162, The Hierarchy of Generally Accepted Accounting Principles , which identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with US GAAP. SFAS No. 162 becomes effective in the third quarter of 2009 and is not expected to have a material impact on the Company’s consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS No. 133 , which requires enhanced disclosures for derivative and hedging activities. SFAS No. 161 becomes effective in the first quarter of 2009 and is not expected to have a material impact on the Company’s consolidated financial statements.

Other than the above, there have been no recent accounting pronouncements issued which would impact the Company’s consolidated financial statements following the filing of the Company’s 2007 Restated Annual Report.

Impact of Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 . This statement permits companies to choose to measure many financial instruments and other specified items at fair value. The Company was required to adopt SFAS No. 159 for its fiscal year beginning on January 1, 2008, prospectively applied. The adoption of SFAS No. 159 did not have a material impact on the Company’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements . This statement establishes a single authoritative definition of fair value, sets out a framework for establishing fair value, and requires additional disclosures about fair value measurements. This statement applies only to fair value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements. The Company was required to adopt SFAS No. 157 for its fiscal year beginning on January 1, 2008, prospectively applied, except for the provisions of SFAS No. 157 relating to nonfinancial instruments, which will be required to be adopted by the Company for its fiscal year beginning January 1, 2009. The adoption of SFAS No. 157 did not have a material impact on the Company’s consolidated financial statements.

Note 3—Acquisitions

Mobile Process Technology

On September 14, 2007, a newly formed subsidiary of the Company acquired 100% of the business of Mobile Process Technology Co., an Arkansas corporation based in Memphis, Tennessee, through the means of a merger agreement, and upon completion of the merger and acquisition, the business was renamed Basin Water-MPT, Inc. (MPT). MPT is a provider of technology and services to the water treatment and industrial process markets.

The aggregate purchase price was approximately $12,200, consisting of approximately $6,900 of cash and 462,746 shares of Company common stock with a fair value of approximately $5,300. The fair value of the common stock issued was determined based on the average closing market price of the Company’s common stock over the period beginning five business days before and ending five business days after the terms of the acquisition were agreed upon and announced.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 3—Acquisitions (continued)

A valuation of MPT’s property and intangible assets was finalized during the second quarter of 2008. The following table presents the fair values of the assets acquired and liabilities assumed at the date of acquisition.


Current assets	$	2,585
Property, plant and equipment		2,191
Goodwill		6,323
Intangible assets		4,329

Total assets acquired		15,428

Current liabilities		(2,754	)
Long-term debt		(266	)
Other liabilities		(179	)

Total liabilities assumed		(3,199	)

Net assets acquired	$	12,229

The net assets acquired in the table above represent cash consideration of approximately $6,200 (net of cash acquired), approximately $700 of cash acquired included in current assets above and common stock consideration of approximately $5,300. The purchase price was allocated to net tangible and intangible assets acquired based on their estimated fair values, with approximately $4,200 allocated to intangible assets with a weighted-average useful life of approximately 11 years.

As of September 30, 2008, approximately $1,250 of the cash portion of the purchase price remained in an escrow account as a reserve for unidentified liabilities of the acquired business, which is included in goodwill. This balance was subsequently released in full to the former shareholders of MPT.

In addition, $750 of the cash portion of the purchase price was placed into an escrow account until the working capital of MPT at the date of acquisition was finalized. In February 2008, $326 was released from the working capital escrow account to the Company, reducing the purchase price by that amount, and the balance of the working capital escrow account was released to the former shareholders of MPT.

Acquired intangible assets consist of a covenant not to compete in the amount of $322 (three year useful life), trade name in the amount of $180 (two year useful life), service agreements and contracts in the amount of $1,355 (six year useful life), customer relationships in the amount of $569 (15 year useful life) and patents in the amount of $1,812 (17 year useful life). The excess of the net purchase price over the estimated fair value of assets acquired was approximately $6,300 which was recorded as non-tax deductible goodwill.

During the quarter ended September 30, 2008, the Company determined that the goodwill related to the MPT acquisition was impaired, and recorded a charge to earnings of $4,952 to reduce the carrying value of goodwill. See Note 6 for a further discussion of this impairment charge.

The results of MPT’s operations have been included in the Company’s consolidated financial statements included in this report since it was acquired on September 14, 2007.

Envirogen

On September 18, 2008, the Company acquired the bioreactor and biofilter businesses (Envirogen) from Shaw Environmental and Infrastructure, Inc. (Shaw) through an asset purchase agreement.

The Company previously sold to Shaw water treatment systems for a total purchase price of approximately $4,800, including installation, of which the Company recognized revenues of approximately $3,000 and approximately $1,600 during the years ended December 31, 2006 and 2005, respectively. Under the terms of the sale, Shaw made a down payment of $227 and was to pay an additional $2,048 of the total amount due not later than December 31, 2007 and the remaining balance of approximately $2,300 not later than December 31, 2008. The Company’s condensed consolidated balance sheet as of June 30, 2008 reflected a receivable of $4,357, plus accrued interest of $370, classified as long-term.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 3—Acquisitions (continued)

The aggregate purchase price for Envirogen was approximately $4,100, consisting of approximately $2,000 (including adjustments and transaction costs) of cash and the satisfaction of approximately $4,700 of accounts receivable and accrued interest owed to the Company by Shaw, less approximately $2,600 representing the fair value of the water treatment systems returned by Shaw to the Company. The fair value of the water treatment systems was determined by management through an evaluation of the current replacement cost of equivalent systems, less the cost to sell such systems.

A valuation of Envirogen’s property and intangible assets is in the process of being developed; accordingly, the allocation of the purchase price is subject to revision and adjustment. The following table presents the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.


Current assets	$	249
Property, plant and equipment		947
Goodwill		1,423
Intangible assets		1,534

Total assets acquired		4,153

Current liabilities		(51	)
Other liabilities		—

Total liabilities assumed		(51	)

Net assets acquired	$	4,102

The net assets acquired in the table above represent cash consideration of approximately $2,000 (including adjustments and transaction costs) and approximately $4,700 representing satisfaction of accounts receivable and accrued interest owed to the Company by Shaw, less approximately $2,600 representing the fair value of the water treatment systems returned by Shaw to the Company. The purchase price was allocated to net tangible and intangible assets acquired based on their estimated fair values, with approximately $1,100 allocated to intangible assets with a weighted-average useful life of approximately nine years and approximately $400 allocation to intangible assets with indefinite useful lives.

Acquired intangible assets consist of contract backlog in the amount of $83 (one year useful life), distribution network in the amount of $112 (six year useful life), patents in the amount of $966 (10 year useful life) and trade name in the amount of $363 (indefinite useful life). The excess of the net purchase price over the estimated fair value of assets acquired was approximately $1,400 which was recorded as non-tax deductible goodwill.

The results of Envirogen’s operations have been included in the consolidated financial statements since it was acquired on September 18, 2008.

The unaudited pro forma condensed combined statements of operations table below reflects the results of operations of the Company and Envirogen for the three- and nine-month periods ended September 30, 2008 and 2007 as if the acquisition had occurred at the inception of each of the periods presented. Unaudited pro forma condensed combined statements of operations are not necessarily indicative of the results that would have been achieved had the transaction been consummated as of the date indicated or had the entities been a single entity during these periods, and are not necessarily indicative of the results that may be achieved in the future.


	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
	(Unaudited pro forma)						(Unaudited pro forma)
Revenues	$	3,701		$	4,279		$	14,783		$	11,654

Net loss	$	(14,985	)	$	(12,573	)	$	(26,565	)	$	(18,740	)

Net loss per share
Basic	$	(0.68	)	$	(0.63	)	$	(1.22	)	$	(0.95	)
Diluted	$	(0.68	)	$	(0.63	)	$	(1.22	)	$	(0.95	)

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 4—Earnings Per Share

In accordance with the provisions of SFAS No. 128, Earnings Per Share , the Company reports earnings per share (EPS) by computing both basic and diluted EPS. Basic EPS measures the Company’s performance for a reporting period by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS measures the Company’s performance for a reporting period by dividing net income available to common stockholders by the weighted average number of common shares plus common stock equivalents outstanding during the period. Common stock equivalents consist of all potentially dilutive shares of common stock, such as stock options and warrants, which are convertible into shares of common stock.

The Company incurred net losses for the three- and nine-month periods ended September 30, 2008 and 2007, respectively. No stock options or warrants, but 388,000 shares of unvested stock have been excluded from the computation of diluted EPS for the three months ended September 30, 2008, and approximately 82,000 stock options, 175,000 warrants and 333,000 shares of unvested stock have been excluded from the computation of diluted EPS for the nine months ended September 30, 2008 due to the antidilutive effect of such common stock equivalents. Likewise, approximately 730,000 stock options, 279,000 shares of unvested stock and 1,355,000 warrants have been excluded from the computation of diluted EPS for the three months ended September 30, 2007, and approximately 528,000 stock options, 245,000 shares of unvested stock and 860,000 warrants have been excluded from the computation of diluted EPS for the nine months ended September 30, 2007, due to the antidilutive effect of such common stock equivalents.

In addition, approximately 1,413,000 stock options and 675,000 warrants have been excluded from the computation of diluted EPS for both the three- and nine-month periods ended September 30, 2008, and approximately 327,000 stock options and 33,000 warrants have been excluded from the computation of diluted EPS for the three- and nine-month periods ended September 30, 2007, as the exercise prices of such options and warrants were higher than the weighted average price of the Company’s common stock during those periods.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 4—Earnings Per Share (continued)

The following tables contain a reconciliation of the numerators (net loss) and denominators (weighted average shares) used in both basic and diluted EPS calculations:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
	(Unaudited)						(Unaudited)
Net loss per share

Numerator:
Net loss applicable to common shares	$	(14,653	)	$	(11,981	)	$	(25,811	)	$	(16,823	)


Denominator:
Weighted average common shares outstanding		21,812			19,873			21,774			19,751


Net loss per common share	$	(0.67	)	$	(0.60	)	$	(1.19	)	$	(0.85	)

Net loss per share - assuming dilution

Numerator:
Net loss applicable to common shares	$	(14,655	)	$	(11,981	)	$	(25,811	)	$	(16,823	)


Denominator:
Weighted average common shares outstanding		21,812			19,873			21,774			19,751

Net loss per common share - diluted	$	(0.67	)	$	(0.60	)	$	(1.19	)	$	(0.85	)

The Company incurred net losses in the three- and nine-month periods ended September 30, 2008 and 2007. The impact of common stock equivalents has been excluded from the computation of diluted EPS because the effect on net loss per share is anti-dilutive.

Note 5—Stock-Based Compensation

2006 Equity Incentive Award Plan

In May 2006, the Company adopted the Basin Water 2006 Equity Incentive Award Plan, or 2006 Equity Plan. The 2006 Equity Plan became effective immediately prior to the completion of the initial public offering in May 2006. Under the 2006 Equity Plan, 2,500,000 shares of the Company’s common stock were initially reserved for issuance. In addition, the 2006 Plan contains an evergreen provision that allows for an annual increase in the number of shares available for issuance under the plan on January 1 of each year during the ten-year term of the 2006 Plan, beginning on January 1, 2007. Under this evergreen provision, the annual increase in the number of shares shall be equal to the least of:

•

5.0% of the Company’s outstanding capital stock on the first day of the relevant fiscal year;

•

1,000,000 shares; and

•

an amount determined by the Company’s board of directors.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 5—Stock-Based Compensation (continued)

In no event shall the number of shares of the Company’s common stock that may be issued or transferred pursuant to awards under the 2006 Plan exceed an aggregate of 12,500,000 shares. The number of total shares of common stock that may be issued under the 2006 Plan automatically increased to 4,495,383 and 3,495,383 shares as of January 1, 2008 and 2007, respectively.

Options under the plan are issued with an exercise price equal to the closing price of the Company’s stock on the date of the grant. Option grants generally vest over three years, with one-third of the shares subject to the option vesting on each of the first, second and third anniversaries of the grant date and expire 10 years from the date of grant. Options granted to directors generally vest on the first anniversary of the grant date.

Cheap Stock Amortization

Prior to becoming a publicly traded company in May 2006, the Company granted stock options with exercise prices equal to the estimated fair value of its common stock. However, to the extent that the deemed fair value of the common stock exceeded the exercise price of stock options on the grant date the Company recorded deferred stock-based compensation expense and amortizes the expense over the vesting period of the options. The fair value of the Company’s common stock was determined by the Board. In the absence of a public trading market for the Company’s common stock, the Board considered both objective and subjective factors in determining the fair value of the Company’s common stock and related stock options. Consistent with the guidance provided by the American Institute of Certified Public Accountants in its Technical Practice Aid (TPA) entitled The Valuation of Privately Held Company Equity Securities Issued as Compensation, such considerations included, but were not limited to, the following factors:

•

The liquidation preference, anti-dilution and redemption rights of the preferred stock and the lack of such rights for the common stock;

•

The per share price for concurrent or recent sales of common stock and redeemable convertible preferred stock;

•

Historical performance and operating results at the time of the grant;

•

Expected future earnings performance;

•

Liquidity and future capital requirements;

•

Stage of development and business strategy;

•

Marketplace developments and major competition;

•

Market barriers to entry;

•

Strategic relationships with third parties;

•

Size of workforce and related skills;

•

The illiquidity of the common stock; and

•

The likelihood of achieving a liquidity event for the shares of common stock, such as an initial public offering or a sale.

In connection with the Company’s initial public offering, the Company re-evaluated the historical fair value of its common stock. As a result of this re-evaluation, the Company recorded deferred stock-based compensation which represents the difference between the exercise price of stock options granted in the first quarter of 2006 and in the fourth quarter of 2005 and the revised fair value of the common stock underlying such options on the date of grant.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 5—Stock-Based Compensation (continued)

Pursuant to FASB Interpretation (FIN) No. 28, the Company is amortizing these deferred compensation amounts using the straight-line attribution method over the vesting period of the options, which is generally three years. As a result of the amortization of the deferred compensation amounts, the Company recorded $119 and $148 of non-cash stock-based compensation expense for the nine-month periods ended September 30, 2008 and 2007, respectively.

Method of Accounting for Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with the provisions set forth in SFAS No. 123(R), Share-Based Payment (SFAS No. 123(R)). Under the provisions of SFAS No.123(R), stock-based compensation cost is measured at the date of grant, based on the calculated fair value of the stock-based award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the award).

The Company estimates the fair value of stock options granted using the Black-Scholes method. Key assumptions used to estimate the fair value of stock options include the exercise price of the award, the fair value of the Company’s stock on the date of grant, the expected option term, the risk free interest rate at the date of grant, the expected volatility of the Company’s stock over the expected option term, and the expected annual dividend yield on the Company’s stock.

The fair value of each option grant during the three- and nine-month periods ended September 30, 2008 and 2007 was estimated on the date of grant using the following assumptions:


	Three Months Ended September 30,		Nine Months Ended September 30,
	2008	2007	2008	2007
Expected option term in years	—	6.5 to 7.0	5.5 to 6.5	5.0 to 7.0
Risk free interest rate	—	4.5%	4.5%	4.5% to 4.8%
Expected volatility	—	26.9%	28.4%	26.9% to 29.5%
Expected dividend yield	—	0.0%	0.0%	0.0%

The estimated forfeiture rates for stock option grants during the three- and nine-month periods ended September 30, 2008 and 2007 were 9.0% and 8.0%, respectively.

No options were granted during the quarter ended September 30, 2008.

The expected option term in years was calculated using an average of the vesting period and the option term, in accordance with the “simplified method” for “plain vanilla” stock options allowed under Staff Accounting Bulletin (SAB) No. 110.

The risk free interest rate is the rate on a zero-coupon U.S. Treasury bond with a remaining term equal to the expected option term. The expected volatility was derived from an industry-based index, in accordance with the calculated value method allowed under SFAS No. 123(R).

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 5—Stock-Based Compensation (continued)

Stock Option Activity

A summary of stock option activity for the nine months ended September 30, 2008 is as follows:


(In thousands, except exercise prices)	Number of Shares		Weighted Average Exercise Price
Options outstanding at December 31, 2007	1,710		$	5.85
Granted	518			4.71
Exercised	(29	)		0.83
Forfeited	(26	)		4.81

Options outstanding at September 30, 2008	2,173		$	5.75

The following table summarizes information about stock options outstanding and exercisable as of September 30, 2008:


(In thousands, except exercise prices and years)	Outstanding		Exercisable
Number of shares		2,173		953
Weighted average remaining contractual life in years		7.6		5.8
Weighted average exercise price per share	$	5.75	$	4.31
Aggregate intrinsic value (at Sept. 30, 2008 closing price of $1.84 per share)	$	178	$	178

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the Company’s closing price as of September 30, 2008 and the exercise price multiplied by the number of shares) that would have been received by the option holders had all options holders exercised their options on September 30, 2008. This amount will vary as the Company’s stock price varies.

The weighted average grant-date fair value of options granted by the Company during the nine months ended September 30, 2008 was $1.81 per share.

Compensation expense arising from grants of stock options was $812 and $453 during the nine months ended September 30, 2008 and 2007, respectively. Such expense was classified as selling, general and administrative expense.

As of September 30, 2008, approximately $1,700 of unrecognized compensation expense related to stock options is expected to be recognized over a weighted average period of 1.1 years. The total fair value of options vested during the nine months ended September 30, 2008 and 2007 was $398 and $152, respectively, which was included in selling, general and administrative expense.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 5—Stock-Based Compensation (continued)

Stock options outstanding and exercisable at September 30, 2008, and the related exercise price and remaining contractual life are as follows:


	Options Outstanding				Options Exercisable
Exercise Price	Number of Options Outstanding	Weighted Average Exercise Price		Weighted Average Remaining Contractual Life of Options Outstanding	Number of Options Exercisable	Weighted Average Exercise Price
$0.83 - $1.33	218	$	1.03	2.9 yrs	218	$	1.03
$4.00 - $4.29	455	$	4.04	7.0 yrs	308	$	4.00
$5.00	677	$	5.00	8.3 yrs	286	$	5.00
$6.79 - $9.00	718	$	7.88	8.5 yrs	107	$	7.82
$9.87 - $12.29	105	$	11.33	8.9 yrs	34	$	11.34

	2,173	$	5.75	7.6 yrs	953	$	4.31

The total intrinsic value of stock options exercised during the nine months ended September 30, 2008 and 2007 was $99 and $541, respectively.

Non-vested Stock

Under the 2006 Equity Plan, the Company has granted non-vested stock to management, officers and directors, which is subject only to a service condition. In general, such non-vested stock vests over three years for management and officers, and one year for directors. The total cumulative number of shares of non-vested stock granted under the 2006 Equity Plan through September 30, 2008 is 510,514, of which 122,123 shares had vested as of September 30, 2008.

The fair value of non-vested stock is measured at the date of grant based upon the closing price of the Company’s common stock on that date, and such fair value is recognized as stock-based compensation expense over the requisite vesting period. Compensation expense arising from grants of non-vested stock during the nine months ended September 30, 2008 and 2007 was $1,016 and $624, respectively, which was included in selling, general and administrative expense. As of September 30, 2008, approximately $1,600 of unrecognized compensation expense related to non-vested stock grants is expected to be recognized over a weighted average period of 1.1 years.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 6 —Goodwill and Intangible Assets

During the third quarter of 2008, the Company recorded a charge to earnings of approximately $ 5,000 to reduce the carrying value of the goodwill related to the MPT acquisition, which was included in selling, general and administrative expense. The primary factors impacting management’s assessment of value included slower-than-anticipated growth rates and a decline in the customer base of MPT, both of which have resulted in a significant decline in MPT’s future revenues and cash flows since its acquisition in September 2007. The Company’s goodwill at September 30, 2008 increased due to the acquisition of Envirogen, as discussed in Note 3.

Goodwill represents the excess of the cost of an acquired entity over the net fair value of identifiable assets acquired and liabilities assumed. The following table presents the changes in the carrying amounts of goodwill for the nine months ended September 30, 2008:


Balance at December 31, 2007	$	6,323
Acquisition of Envirogen business during the period		1,423
Adjustments to MPT goodwill		(21	)
Impairment of MPT goodwill		(4,952	)

Balance at September 30, 2008	$	2,773

Net intangible assets are as shown in the following table as of the dates indicated:


	September 30, 2008			December 31, 2007
Deferred stock based compensation	$	37		$	157
Service agreements and contracts		1,438			1,355
Customer relationships		691			569
Covenant not to compete		322			322
Trade name		543			180
Accumulated amortization		(461	)		(115	)

Intangible assets, net	$	2,570		$	2,468

Note 7—Notes Payable

In June 2007, the Company sold 10 of its water treatment systems to a special purpose entity, VL Capital (VLC). The total sales price was $3,853, consisting of $500 in cash to be paid to the Company plus a secured note payable in 72 monthly installments of $56 beginning April 2008, with a net present value of $3,353, calculated using an imputed interest rate of 5.0% per annum.

VLC, in turn, received a loan of $500 from a finance company to fund the cash payment to the Company. This non-interest bearing loan is due in nine monthly installments of $63 plus 71 monthly installments of $7 beginning August 2008.

The Company has determined that, in accordance with the provisions of FIN 46(R), the financial statements of VLC should be included in the consolidated financial statements of the Company. Accordingly, both the sale of equipment to VLC and the notes receivable from VLC have been eliminated in consolidation, and the Company has now included in its consolidated financial statements the notes payable by VLC to the finance company. Notes payable by VLC to a finance company consisted of the following:


	September 30, 2008			December 31, 2007
Note payable to a financing company, non-interest bearing, imputed interest rate of 68.9% per annum, payable in 80 monthly installments beginning on August 1, 2008 and ending on March 1, 2014	$	167		$	352
Less: current portion of notes payable		(56	)		(239	)

Notes payable, net of current portion	$	111		$	113

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 8—Contract Loss Reserve

During the latter half of 2006 and 2007, the Company analyzed operating results for each water service agreement (WSA) and determined that certain, generally older contracts were operating at net cash flow losses. Under the WSAs, the Company provides to its customers operations and maintenance services for water treatment units previously sold or leased to those customers. These contracts have sustained increasing operating costs such as waste disposal and salt purchase costs as the direct result of higher fuel, salt and other third-party costs.

These contracts did not allow management to renegotiate terms to recover such increased costs. Management determined that these contracts would continue to generate net operating cash flow losses through the end of the contract period. Accordingly, the Company recorded a reserve for future contract losses in the amount of approximately $3,700 in the quarter ended December 31, 2006. This amount represented management’s estimate of the losses the Company expected to incur during the remaining term of the initial period of these contracts excluding renewal periods, if any, related to such contracts.

During 2007, additional older legacy contracts became operational and were operated during the busy, higher volume summer months. Based on the new operating history, especially during the third quarter of 2007, the Company determined that the original reserve was not adequate. Management reviewed each contract’s financial performance and identified the future expected losses for these contracts, resulting in an approximate $6,800 (as restated; see following paragraph) increase to the reserve which was charged to cost of contract revenues in the quarter ended September 30, 2007.

Also, as discussed in Note 3 to the Company’s restated consolidated financial statements included in its Annual Report on Form 10-K/A for the year ended December 31, 2007, the Company subsequently determined that an error was made in the calculation of the reserve for contract losses at September 30, 2007. Specifically, with regard to one of its service contracts, it was assumed that a possible facility expansion would result in higher service fees to the customer, thus eliminating estimated operating losses on this contract beyond 2008. As a result, the Company increased the reserve for contract losses (and the related cost of contract revenues) by approximately $1,800 million in the quarter ended September 30, 2007 to correct this error.

Actual losses on the underlying contracts are being charged against the reserve as incurred. Such charges against the reserve totaled approximately $800 during each of the nine-month periods ended September 30, 2008 and 2007, respectively. The reserve for contract losses included in the condensed consolidated balance sheet, both short- and long-term, as of September 30, 2008 was $8,329. The changes in the reserve are as follows:


	Nine Months Ended September 30,
	2008			2007
Beginning balance	$	9,112		$	3,725
Additions to contract loss reserve		40			6,777
Actual contract losses charged against the reserve		(823	)		(765	)

Ending balance	$	8,329		$	9,737

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 9— Investment in Empire Water Corporation (Empire)

In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold to Empire its rights to purchase certain collective assets from unrelated parties including (a) a canal located in San Bernardino and Riverside counties in Southern California that is approximately 18 miles in length, (b) rights to pump water from the San Bernardino Basin, and (c) other equipment and tangible and intangible personal property of the sellers. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007 and September 30, 2008.

The Company accounted for the December 2007 transaction under the equity method; therefore under EITF 01-2 the Company recorded a partial gain of approximately $3,100 on the transaction. The Company determined the gain by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company’s ownership interest in Empire. This reduction of approximately $1,500 was recorded as deferred revenue—affiliate on the balance sheet of the Company at December 31, 2007 and September 30, 2008.

In addition, the Company has concluded that the assets sold under the agreement did not constitute the sale of a business as contemplated by EITF 98-3, as the rights conveyed to Empire were not an integrated set of activities and assets conducted and managed for the purpose of providing a return or other economic benefits. The Company also does not believe the transaction was covered under SAB Topic 5.U., as 1) Empire is not a highly leveraged entity, 2) the underlying assets sold to Empire have historically produced cash flows, 3) substantial capital has been raised by Empire from outside investors and 4) the Company does not have any actual or implied commitment to support Empire. According to Empire’s Annual Report on Form 10-K for the year ended June 30, 2008, Empire raised a total of $4,750 in financing through June 2008 and had $1,300 in cash as of June 30, 2008. Empire also disclosed that it intends to raise an additional $16,000 or joint venture its assets with a municipal or financial partner to fully implement its plan of operation. The Company is not aware of any parties obliged to provide Empire with financial support in the future.

During the quarter ended September 30, 2008, the Company assessed its investment in an affiliate, Empire. Based upon current market conditions, Empire’s financial condition, and the Company’s understanding of Empire’s business prospects, the Company determined that the carrying value of its investment in Empire should be reduced by approximately $1,900 at September 30, 2008. As part of this assessment, the Company determined that a portion of the impairment is attributable to the deferred revenue recorded at the date that the Company sold assets to Empire, as the Company has evaluated the underlying assets associated with the deferred revenue and concluded that such assets are impaired to the extent of the Company’s 32% ownership interest in Empire. Accordingly, the Company has reduced deferred revenue-affiliate by $659 at September 30, 2008. The difference between the $1,936 impairment to investment in affiliate and the $659 reduction of deferred revenue-affiliate is included as other expense of $1,277 in the statements of operations for the three- and nine-month periods ended September 30, 2008.

As of September 30, 2008, the Company has recorded its investment in Empire at approximately $2,100, while the amount of underlying equity in the net assets of Empire is approximately $2,900. The difference of approximately $800 represents the excess of the Company’s 32% interest in the net assets of Empire over the market value of the Company’s investment in Empire. As required under the equity method of accounting, the Company has also recorded approximately $200 and $700 of other expense during the three months and nine months ended September 30, 2008, respectively which represents the Company’s 32% interest in Empire’s loss for such periods.

The quoted market price for Empire’s common stock as of September 26, 2008 was $2.40 per share. To the Company’s knowledge, there have been no significant intervening events relating to Empire since its last available financial statements.

The following tables present summarized information as to the assets, liabilities and results of operations for Empire for the periods indicated:


	September 30, 2008
	(Unaudited)
Current assets	$	619
Land and water rights		3,870
Property and equipment, net		4,372
Other assets		557

Total assets	$	9,418

Current liabilities	$	167
Other liabilities		—
Shareholders’ equity		9,251

Total liabilities and shareholders’ equity	$	9,418

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 9—Investment in Empire Water Corporation (Empire) (continued)


	Year Ended June 30, 2008			Three Months Ended September 30, 2008
	(Unaudited)			(Unaudited)
Revenues	$	33		$	25
Production costs		49			32

Gross loss		(16	)		(7	)

General and administrative expenses		1,500			696
Depreciation expense		1			1

Loss from operations		(1,517	)		(704	)

Other income		7			5

Net loss	$	(1,510	)	$	(699	)

Note 10—Consolidated Statements of Cash Flows

The following information supplements the Company’s consolidated statements of cash flows:


	Nine Months Ended September 30,
	2008			2007 Restated
	(Unaudited)
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	210		$	147

Income taxes	$	—		$	—

Cash paid for acquisitions:
Fair value of assets acquired	$	2,021		$	9,431
Liabilities assumed		(50	)		(3,200	)

Cash paid for acquisition (net of cash acquired)	$	1,971		$	6,231

Non-cash investing and financing activities:
Common stock issued for acquisition	$	—		$	5,266

Receivables satisfied for acquisition	$	4,727		$	—

Property returned from seller	$	(2,596	)	$	—

Note 11—Bion Impairment

During the third quarter of 2008, the Company recorded a charge to earnings of $740, classified in the accompanying condensed consolidated statement of operations as research and development expense, to write off certain assets related to the development of the Company’s proprietary Bion Exchange technology. Management determined this impairment charge was required due to uncertainties regarding the future commercial viability of the technology which were, in part, due to the economics of competing technologies with respect to biological processes intended to reduce the costs of treatment of contaminated water.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands, except share and per share data)

Note 12—Litigation

On October 26, 2007, Veolia Water North America Operating Services, LLC and certain other related parties filed a lawsuit in the United States District Court of the Middle District of Florida, Tampa Division, naming as defendants Basin Water-MPT, Inc. (a wholly owned subsidiary of Basin Water, Inc.) and two of its employees, one of whom is the son of the Company’s President and Chief Executive Officer. Subsequently, the plaintiffs amended their complaint to add as defendants Basin Water, Inc. and Michael M. Stark, the Company’s President and Chief Executive Officer, to the lawsuit. The lawsuit alleges, among other things, certain claims related to trade secrets and unfair trade practices relating to treatment of by-products produced as a result of the phosphate mining industry. In December 2008, this litigation and the underlying disputes were resolved by agreement, resulting in a payment by the Company of $230 with the remainder of the settlement being paid by the Company’s insurer.

On December 27, 2007 and January 2, 2008, two purported securities class action complaints were filed in the United States District Court for the Central District of California against Basin Water, Inc., Peter L. Jensen, Michael M. Stark and Thomas C. Tekulve (collectively referred to as the Basin defendants) for violations of the Exchange Act. These lawsuits, which contain similar allegations, are captioned Poulos v. Basin Water, et al ., Case No. CV 07-8359 GW (FFMx) and Nofer v. Basin Water, et al ., Case No. CV 08-0002 SGL (JCRx). The lawsuits were subsequently consolidated, and on October 3, 2008 a Consolidated Amended Complaint (CAC) was filed which alleges that the Company deliberately understated the reserves it took for certain unprofitable contracts, and committed various intentional violations of GAAP during a putative class period between November 14, 2006 and August 8, 2008 (the Federal Lawsuit.) The suit does not state a specific amount of damages.

On January 31, 2008, Loren Charif, a purported stockholder of the Company, filed a shareholder derivative lawsuit in the Superior Court of the State of California, County of San Bernardino, against certain of the Company’s executive officers and its current directors. The complaint assumes the truth of the aforementioned allegations in the federal securities class action lawsuits and in connection with those allegations alleges, among other things, breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of California Corporations Code pertaining to allegations of improper selling. On November 12, 2008, the Company obtained an order staying this action until a final determination occurs in the Federal Lawsuit. The suit does not state a specific amount of damages.

From time to time, the Company is involved in legal and administrative disputes and proceedings arising in the ordinary course of business, which management believes are not material to the conduct of the Company’s business. With respect to these ordinary matters, management believes that the Company has adequate accruals for expected costs, and the Company may also have effective legal defenses.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act (the Exchange Act) of 1934, as amended, which are subject to the “Safe Harbor” created by those sections. Any such forward-looking statements would be contained principally in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, industry environment, potential growth opportunities and the effects of regulation. Forward-looking statements include all statements that are not historical facts and can be identified by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” or similar expressions.

Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. We discuss many of these risks in greater detail in Part I, Item 1A of our Annual Report on Form 10-K/A for the year ended December 31, 2007 and our other filings with the SEC. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q along with our Annual Report on Form 10-K/A for the year ended December 31, 2007 completely and with the understanding that our actual future results may be materially different from what we expect.

We assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

The following discussion and analysis should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

In 2007 and the first nine months of 2008, we derived most of our revenues from designing, assembling and servicing our proprietary ion-exchange systems for the treatment of contaminated groundwater for use as drinking water. Also, in 2007, we launched major initiatives, both external and internal, to facilitate our transformation into a water services company focused on development of our technology+services business model. Using this model, we seek opportunities to combine proprietary or specialized technologies with long-term relationships built through performance-based service agreements to meet groundwater treatment, industrial water and wastewater treatment and resource recovery needs. By expanding the array of technologies we offer through our technology+services model beyond our proprietary ion-exchange technology, we believe we can expand the potential pool of customers, markets and geographic areas for our services.

While we have commenced a number of new initiatives in 2007 and 2008, we continue to derive a significant part of our revenues from selling and servicing our proprietary, ion-exchange, onsite regenerable treatment system. That system reduces groundwater contaminant levels in what we believe is an efficient, flexible and cost-effective manner. Our system produces what we believe are very low waste rates, can meet a wide range of volume requirements and is capable of removing multiple chemical contaminants at a single site. These systems regenerate the resin by using a salt brine solution to remove the contaminants from the resin so that it can be used again in the ion-exchange process. We market these systems to utilities, cities, municipalities, special districts, real estate developers, investor-owned utilities and other organizations for use in treating groundwater that does not comply with federal or state drinking water regulations due to the presence of chemical contaminants.

Building on our success in the market for treating groundwater to be used for drinking water, we are taking steps to become a next generation water services company that succeeds by combining the strengths of our existing businesses and employees with the offering of cutting edge technology and site-tailored solutions. We plan to employ this model across a broad range of treatment scenarios in municipal and industrial water markets.

The Company restated its previously reported consolidated financial statements for the years ended December 31, 2007 and 2006 and the quarterly periods therein, as well as the quarterly period ended March 31, 2008. See Notes 3 and 4 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K/A for the fiscal year ended December 31, 2007 and Note 3 to the condensed consolidated financial statements included in the Company’s Quarterly Report on Form 10-Q/A for the fiscal quarter ended March 31, 2008.

We make available free of charge through our internet website our press releases, our Annual Report on Form 10-K/A, Quarterly Reports on Form 10-Q (including this Quarterly Report on Form 10-Q), Current Reports on Form 8-K and all other required filings with the Securities and Exchange Commission (SEC) and amendments thereto as soon as reasonably practical after they are electronically filed with, or furnished to, the SEC. Our principal executive offices are located at 9302 Pittsburgh Avenue, Suite 210, Rancho Cucamonga, California 91730, and our telephone number is (888) 481-6811. Our website address is www.basinwater.com . The information on our website is neither part of nor incorporated by reference into this Quarterly Report on Form 10-Q.

Results of Operations

The following table sets forth key components of our results of operations for the periods indicated, both in thousands of dollars and as a percentage of revenues:


	Three Months Ended September 30,										Nine Months Ended September 30,
	2008			% of Revenues		2007 Restated			% of Revenues		2008			% of Revenues		2007 Restated			% of Revenues
	(dollars in thousands)										(dollars in thousands)
Revenues
System sales	$	665		23	%	$	625		26	%	$	2,603		30	%	$	2,739		43	%
Contract revenues		2,182		77	%		1,781		74	%		6,202		70	%		3,631		57	%

Total revenues		2,847		100	%		2,406		100	%		8,805		100	%		6,370		100	%

Cost of revenues
Cost of system sales		878		31	%		2,471		103	%		2,708		31	%		5,303		83	%
Cost of contract revenues		2,144		75	%		8,851		367	%		5,921		67	%		10,633		167	%
Depreciation expense		205		7	%		142		6	%		603		7	%		346		6	%

Total cost of revenues		3,227		113	%		11,464		476	%		9,232		105	%		16,282		256	%

Gross loss		(380	)	-13	%		(9,058	)	-376	%		(427	)	-5	%		(9,912	)	-156	%
Research and development expense		882		31	%		152		7	%		1,101		13	%		398		6	%
Selling, general and administrative expense		11,891		418	%		3,399		141	%		22,589		257	%		8,019		126	%

Loss from operations		(13,153	)	-462	%		(12,609	)	-524	%		(24,117	)	-274	%		(18,329	)	-288	%
Other income (loss)		(1,409	)	-49	%		702		29	%		(1,436	)	-16	%		1,580		25	%

Loss before income taxes		(14,562	)	-511	%		(11,907	)	-495	%		(25,553	)	-290	%		(16,749	)	-263	%
Income tax benefit		—					—					—					—

Loss before noncontrolling interest		(14,562	)	-511	%		(11,907	)	-495	%		(25,553	)	-290	%		(16,749	)	-263	%
Less: net income attributable to noncontrolling interest		(91	)	-3	%		—		0	%		(258	)	-3	%		(74	)	-1	%

Net loss	$	(14,653	)	-514	%	$	(11,907	)	-495	%	$	(25,811	)	-293	%	$	(16,823	)	-264	%

Three Months Ended September 30, 2008 and 2007

The following table summarizes the significant components of revenues, cost of revenues and gross profit or loss for the three months ended September 30, 2008 compared to the same period in the prior year:


	Three Months Ended September 30,						Increase (Decrease)
	2008			2007			Increase (Decrease)
	(In thousands)
Revenues:
Large system sales	$	—		$	132		$	(132	)
Standard system sales		665			493			172
Contract operations		2,182			1,781			401

Total Revenues		2,847			2,406			441

Cost of Revenues:
Large system sales		—			1,921			(1,921	)
Standard system sales		878			550			328
Contract operations		2,271			2,427			(156	)
Net change in contract loss reserve		(127	)		6,424			(6,551	)
Depreciation expense		205			142			63

Total Cost of Revenues		3,227			11,464			(8,237	)

Gross Profit (Loss):
Large system sales		—			(1,789	)		1,789
Standard system sales		(213	)		(57	)		(156	)
Contract operations		(294	)		(788	)		494
Net change in contract loss reserve		127			(6,424	)		6,551

Total Gross Loss	$	(380	)	$	(9,058	)	$	8,678

Revenues

Revenues were $2.8 million and $2.4 million during the three months ended September 30, 2008 and 2007, respectively. Revenues from system sales remained unchanged at $0.6 million in the third quarter of 2008 when compared to the same period in 2007. Contract revenues increased from $1.8 million during the third quarter of 2007 to $2.2 million during the same period of 2008, an increase of $0.4 million, or 22% as two large systems were placed in service with customers during late 2007. In addition, we acquired MPT in September 2007, which contributed $0.2 million of system sales and $0.5 million of contract operations revenues for the third quarter of 2008.

Cost of Revenues

Cost of revenues decreased by $8.2 million, or 72% to $3.2 million during the third quarter of 2008 compared to $11.4 million during the same period in 2007 due to a provision of $6.8 million to increase the reserve for contract losses in the 2007 third quarter. Cost of system sales decreased $1.6 million in the third quarter of 2008 when compared to the same period in 2007 as there were no large system sales in the third quarter of 2008.

The aforementioned decrease in the cost of system sales was accompanied by a decrease of $0.1 million in the cost of contract revenues from $2.4 million in the third quarter of 2007 to $2.3 million in the third quarter of 2008. The acquisition of MPT contributed $0.3 million to the cost of contract revenues in the third quarter of 2008.

Operating costs include salt, waste disposal and field service labor expense. The 2008 increase in cost is reflective of two large systems that were placed in service in late 2007, as well as the general increases in costs for labor and supplies. Operating costs for the third quarter of 2008 and 2007 were partially offset by $0.1 million and $0.4 million, respectively, of charges against the related reserves for operating losses.

Gross Profit (Loss)

We recorded gross loss of $0.4 million during the third quarter of 2008 compared to a gross loss of $9.1 million during the third quarter of 2007. Our system sales gross loss decreased by $1.6 million in the third quarter of 2008 from $1.8 million gross loss in the third quarter of 2007 to a $0.2 million gross loss for the same period in 2008. Meanwhile, our contract operations gross loss decreased to $0.3 million in the third quarter of 2008 compared to $0.8 million in the comparable period of 2007. Our contract operations gross loss was impacted by higher volume-related contract operating costs, increased field service labor, and engineering expense, in addition to the increases in cost of revenues as described above.

Research and Development Expense

Research and development expense was approximately $0.9 million and $0.2 million for the three months-ended September 30, 2008 and 2007, respectively. We incurred research and development costs for outside consultant expenses, research material costs and personnel costs. In addition, as discussed in Note 11 to the condensed consolidated financial statements, during the quarter ended September 30, 2008, we recorded a $0.7 million charge to write off certain assets related to the development of our Bion technology.

Selling, General and Administrative Expense

The following table summarizes the significant components of selling, general and administrative (SG&A) expense for the three months ended September 30, 2008 compared to the same period in the prior year.


	Three Months Ended September 30,				Increase (Decrease)
	2008		2007		Increase (Decrease)
	(In thousands)
Compensation and benefits	$	1,767	$	996	$	771
Professional fees		2,315		542		1,773
Travel and entertainment		292		147		145
Goodwill impairment		4,952		—		4,952
Stock-based compensation expense		223		213		10
Restricted stock expense		455		233		222
Depreciation and amortization		403		42		361
Directors’ fees and public company costs		659		226		433
Bad debt expense		344		164		180
Outside selling, marketing & promotion		110		354		(244	)
Facility costs		215		250		(35	)
Insurance		84		64		20
Other SG&A expense		72		168		(96	)

Total SG&A Expense	$	11,891	$	3,399	$	8,492

SG&A expense increased by $8.5 million, or 250%, to $11.9 million during the third quarter of 2008 from $3.4 million during the same period of 2007. The increase was primarily due to a charge to reduce the carrying value of goodwill in the amount of $5.0 million, as well as higher compensation, benefits, and travel costs reflective of the increase in personnel supporting our operations, including $0.5 million relating to MPT. Additionally, we had increased professional fees in the third quarter of 2008 when compared to the year-ago period, primarily for legal fees resulting from shareholder litigation and related investigations. Stock-based compensation, including restricted stock expense, was recorded in accordance with the provisions of SFAS No. 123(R) and increased in the third quarter of 2008 compared to 2007 because of stock options granted at the end of 2007 and early 2008, and restricted stock and stock options granted to our directors in May, 2008. The above increases in SG&A expense were partially offset by a decrease in our outside sales, marketing and promotion expense. In the prior year, we relied primarily on outside sales and marketing consultants. In late 2007, we expanded our sales force and, in the third quarter of 2008, we terminated outside sales and marketing consultants. As a result, our external marketing expense decreased. SG&A expense in the quarter ended September 30, 2008 included approximately $0.8 million as a result of our acquisition of MPT. MPT also accounted for most of the $0.1 million increase in our amortization and depreciation expense.

Other Income (Expense)

The following table summarizes the significant components of other income and expense for the quarter ended September 30, 2008 compared to the same period in the prior year.


	Three Months Ended September 30,						Expense (Increase) Decrease
	2008			2007			Expense (Increase) Decrease
	(In thousands)
Interest income	$	164		$	683		$	(519	)
Interest expense		(65	)		(81	)		16
Equity in loss of affiliate		(223	)		—			(223	)
Impairment charge - investment in affiliate		(1,277	)		—			(1,277	)
Other income (expense)		(8	)		100			(108	)

Total Other Income (Expense)	$	(1,409	)	$	702		$	(2,111	)

Other expense was approximately $1.4 million during the third quarter of 2008 compared to $0.7 million of other income in the third quarter of 2007. The principal factor affecting other expense in the 2008 quarter is the charge to earnings of approximately $1.3 million to write down the carrying value of our investment in Empire, of which we hold an approximate 32% interest. Based upon current market conditions, Empire’s financial condition, and our understanding of Empire’s business prospects, we determined that the carrying value of our investment in Empire should be reduced by approximately $1.9 million, offset by a reduction of approximately $0.6 million in deferred revenue-affiliate. Equity in loss of affiliate in the 2008 quarter represents our share of the net loss of Empire, an affiliate in which we own an approximate 32% interest.

Since receiving the net proceeds of our initial public offering in mid-May, 2006, we have earned interest income on our invested cash balances. Interest income decreased due to both lower cash balances as we used cash for our operations and lower interest rates on money market funds during the third quarter of 2008 compared to the same period in 2007.

Nine Months Ended September 30, 2008 and 2007

The following table summarizes the significant components of revenues, cost of revenues and gross profit or loss for the nine months ended September 30, 2008 compared to the same period in the prior year:


	Nine Months Ended September 30,						Increase (Decrease)
	2008			2007			Increase (Decrease)
	(In thousands)
Revenues:
Large system sales	$	—		$	1,907		$	(1,907	)
Standard system sales		2,603			832			1,771
Contract operations		6,202			3,631			2,571

Total Revenues		8,805			6,370			2,435

Cost of Revenues:
Large system sales		—			4,399			(4,399	)
Standard system sales		2,708			904			1,804
Contract operations		6,704			4,621			2,083
Net change in contract loss reserve		(783	)		6,012			(6,795	)
Depreciation expense		603			346			257

Total Cost of Revenues		9,232			16,282			(7,050	)

Gross Profit (Loss):
Large system sales		—			(2,492	)		2,492
Standard system sales		(105	)		(72	)		(33	)
Contract operations		(1,105	)		(1,336	)		231
Net change in contract loss reserve		783			(6,012	)		6,795

Total Gross Loss	$	(427	)	$	(9,912	)	$	9,485

Revenues

Revenues were $8.8 million and $6.4 million during the nine months ended September 30, 2008 and 2007, respectively. Revenues from system sales decreased $0.1 million, or 4% to $2.6 million in the nine months ended September 30, 2008 when compared to the same period in 2007. Contract revenues increased from $3.6 million during the first nine months of 2007 to $6.2 million during the same period of 2008, an increase of $2.6 million, or 72% primarily as the result of two large systems placed in service with customers during late 2007. In addition, we acquired MPT in September 2007, which contributed $1.7 million to contract revenues for the first nine months of 2008.

Cost of Revenues

Cost of revenues decreased by $7.1 million, or 44% to $9.2 million during the nine months ended September 30, 2008 compared to $16.3 million during the same period in 2007. Cost of systems sold decreased by $2.6 million from $5.3 million in the first nine months of 2007 compared to $2.7 million in the same period of 2008. The decrease reflects the reduction in the number of systems sold in the first nine months of 2008 when compared to the same period in 2007, primarily from our large system sales. The decrease in number of systems sold was partially offset by approximately $0.2 million of one-time start up costs for one of our construction projects. We also incurred approximately $0.7 million of under-absorbed overhead, as our production facilities operated at less than capacity.

The aforementioned decrease in the cost of system sales was offset by an increase of $2.1 million, or 46% in the cost of contract revenues from $4.6 million in the first nine months of 2007 to $6.7 million in the same period of 2008. During the first nine months of 2008, we recorded expense of $0.4 million for damages to an installed system which resulted from an accident. We had more systems in operation during the first nine months of 2008 when compared to same period in 2007, and we also placed two large systems into service in late 2007, which contributed to the increase in operating costs. Additionally, we acquired MPT in mid-September 2007, which contributed $1.0 million of operating expense during 2008.

Operating costs include salt, waste disposal and field service labor expense. The increase in cost is reflective of additional systems in service in 2008 when compared to 2007, as well as the impact of the acquisition of MPT in September, 2007. We also experienced general increases in costs for labor and supplies. Contract revenue operating costs for the nine-month period ended September 30, 2008 were partially offset by $0.8 million of charges against the contract loss reserve for operating losses which had been recorded in prior periods. In the third quarter of 2007, we increased the reserve for contract losses by $6.8 million, which was partially offset by $0.8 million of losses applied against the reserve during the first nine months of 2008.

Gross Profit (Loss)

We recorded a gross loss of $0.4 million during the nine-month period ended September 30, 2008 compared to a $9.9 million gross loss during the same period of 2007. Our system sales gross loss decreased by $2.5 million to $0.1 million in the first nine months of 2008 from a gross loss of $2.6 million in the same period of 2007. Meanwhile, our contract operations gross loss decreased to $1.1 million in the first nine months of 2008 from $1.3 million in the same period of 2007. Our contract operations gross loss was impacted by higher volume-related contract operating costs, increased field service labor, and engineering expense in addition to the increases in cost of revenues as described above.

Research and Development Expense

Research and development expense was approximately $1.1 million and $0.4 million for the nine months ended September 30, 2008 and 2007, respectively. We incurred research and development costs for outside consultant expenses, research material costs and personnel costs. In addition, during the quarter ended September 30, 2008, we recorded a $0.7 million charge to write off certain assets related to the development of our Bion technology. See Note 11 to the condensed consolidated financial statements for further discussion.

Selling, General and Administrative Expense

The following table summarizes the significant components of selling, general and administrative (SG&A) expense for the nine months ended September 30, 2008 compared to the same period in the prior year.


	Nine Months Ended September 30,				Increase (Decrease)
	2008		2007		Increase (Decrease)
	(In thousands)
Compensation and benefits	$	5,895	$	2,691	$	3,204
Severance, consulting and stock-based compensation - former Chairman and CEO		983		—		983
Professional fees		3,797		1,160		2,637
Travel and entertainment		921		423		498
Goodwill impairment		4,952		—		4,952
Stock-based compensation expense		784		607		177
Restricted stock expense		972		624		348
Depreciation and amortization		703		63		640
Directors’ fees and public company costs		1,260		604		656
Bad debt expense		562		199		363
Outside selling, marketing & promotion		626		886		(260	)
Facility costs		628		307		321
Insurance		254		147		107
Other SG&A expense		252		308		(56	)

Total SG&A Expense	$	22,589	$	8,019	$	14,570

SG&A expense increased by $14.6 million, or 183%, to $22.6 million during the first nine months of 2008 from $8.0 million during the same period of 2007. The increase was largely attributable to goodwill impairment charge totaling $5.0 million related to our MPT business, as well as higher compensation, benefits, and travel costs reflective of the increase in personnel supporting our operations. We took an impairment charge for our MPT assets based on slower growth rates, and a decline in our MPT customer base, which we believe will have a permanent effect on MPT’s future revenues and cash flows. SG&A expense also increased due to costs associated with the resignation of our former Chairman and CEO totaling $1.0 million, which included a cash severance payment, stock-based compensation expense associated with options awarded in prior periods and consulting payments to be made over a two-year period. Professional fees increased by $2.6 million in the first nine months of 2008 when compared to 2007, primarily for legal fees related to shareholder litigation and related investigations. Our facility costs were higher as a result of an expansion of our office facilities and equipment to accommodate our increased staffing, as well as, the effects of our acquisition of MPT. Public company expense increased primarily due to higher director fees in 2008. Stock-based compensation including restricted stock expense was recorded in accordance with the provisions of SFAS No. 123(R) and increased in the first nine months of 2008 when compared to the same period in 2007. The increases were primarily due to stock options granted at the end of 2007 and early 2008, and restricted stock and stock options granted to our directors in May 2008. SG&A expense included approximately $2.4 million, excluding the effect of the impairment charges, during the first nine months of 2008 as a result of our acquisition of MPT in September 2007. The MPT acquisition accounted for approximately $1.4 million of the increase in compensation and benefits, as well as most of the $0.2 million increase in our amortization and depreciation expense.

Other Income (Expense)

The following table summarizes the significant components of other income and expense for the nine months ended September 30, 2008 compared to the same period in the prior year.


	Nine Months Ended September 30,						Expense (Increase) Decrease
	2008			2007			Expense (Increase) Decrease
	(In thousands)
Interest income	$	765		$	2,108		$	(1,343	)
Interest expense		(210	)		(180	)		(30	)
Amortization - fair value of warrants		—			(449	)		449
Equity in loss of affiliate		(703	)		—			(703	)
Impairment of investment in affiliate		(1,277	)		—			(1,277	)
Other income (expense)		(11	)		101			(112	)

Total Other Income (Expense)	$	(1,436	)	$	1,580		$	(3,016	)

Other expense was approximately $1.4 million during the first nine months of 2008 compared to other income of approximately $1.6 million in the same period of 2007. Since receiving the net proceeds of our initial public offering in mid-May, 2006, we have earned interest income on our invested cash balances. Interest income decreased due to both lower cash balances as we used cash for our operations and lower interest rates on money market funds during the first nine months of 2008 compared to the same period in 2007. Equity in loss of affiliate in the nine-month period ending September 30, 2008 represents our 32% share of the net loss of Empire for the nine months ended September 30, 2008. We also recorded a change to earnings of approximately $1.3 million to write down the carrying value of our investment in Empire. Based upon current market conditions, Empire’s financial condition and our understanding of Empire’s business prospects, we determined that the carrying value of our investment in Empire should be reduced by approximately $1.9 million, offset by a reduction of approximately $0.6 million in deferred revenue-affiliate, in the quarter ended September 30, 2008.

Liquidity and Capital Resources

At September 30, 2008, we had approximately $16.9 million in cash and cash equivalents, including $ 0.4 million resulting from the consolidation of VL Capital, which funds of VL Capital are not available to us to support our liquidity needs. We have invested substantially all of our available cash balances in money market funds placed with reputable institutions for which credit loss is not anticipated. The following table summarizes our primary sources and uses of cash in the periods presented.


	Nine Months Ended September 30,
	2008			2007
	(in thousands)
Net cash provided by (used) in:
Operating activities	$	(12,910	)	$	(6,133	)
Investing activities		(6,078	)		(10,845	)
Financing activities		(168	)		1,618

Net decrease in cash and cash equivalents	$	(19,156	)	$	(15,360	)

Operating Activities

Net cash used in operating activities was approximately $12.9 million for the first nine months of 2008 compared to net cash used in operating activities of $6.1 million for the comparable period of 2007. In addition to our net loss of $25.8 million, which included $11.1 million of non-cash expenses, cash used in operating activities during the first nine months of 2008 was negatively impacted by a $0.7 million increase in accounts receivable, a $0.5 million increase in inventory, a $0.8 million decrease in contract loss reserve and a $0.6 million increase in net other assets and liabilities. These uses of cash were offset by a $2.8 million decrease in unbilled receivables, a $0.5 million decrease in prepaid expenses, a $0.4 million increase in accounts payable and a $0.6 million increase in accrued expenses. For the first nine months of 2007, net cash used in operating activities was $6.1 million. In addition to our net loss of $16.8 million, including non-cash expenses of $2.7 million, cash used in operating activities during the first nine months of 2007 reflects an increase in accounts receivable of $0.8 million, a $0.5 million increase in prepaid expenses, a $1.2 million decrease in accrued expenses and a $0.8 million increase in other assets and liabilities, all of which were offset by a $4.0 million decrease in unbilled receivables, a $1.7 million increases in accounts payable and a $6.0 million increase in contract loss reserve.

Investing Activities

Net cash used in investing activities was approximately $6.1 million for the first nine months of 2008, compared to net cash used in investing activities of $10.8 million during the same period in 2007. Cash used in investing activities for the first nine months of 2008 and 2007 includes capital expenditures for building water treatment systems for sale or lease to customers in the amount of $4.1 million and $4.5 million, respectively. Beginning in the 2007 fourth quarter, we began investing in the construction of water treatment units for specific customers for which sales have not yet materialized. We expect to sell or lease these water treatment units in the future.

Financing Activities

Net cash used in financing activities was approximately $0.2 million for the first nine months of 2008 compared to net cash provided by financing activities of $1.6 million in the same period of 2007. Net cash provided by financing activities for the first nine months of 2007 reflects $3.1 million in net proceeds from the exercise of warrants, offset in part by $2.3 million in repayments of notes payable and capital leases.

Liquidity and Capital Resources

Our future capital requirements will depend on many factors, including our level of revenues, the expansion and success of our sales and marketing activities, the success of our strategic relationships in the marketing of our treatment systems, our ability to sell existing systems or place them under long-term contracts and provide service under our long-term contracts and the continued market acceptance of our systems and services.

We anticipate that we may need additional capital to finance our operations over the next 12 months. In such an event, we would seek to raise additional capital through a combination of bank credit facilities, issuance of long-term debt and private or public debt or equity offerings.

The U.S. credit markets have recently experienced significant dislocations and liquidity disruptions which have caused spreads on prospective debt financings to widen considerably. These circumstances have materially impacted liquidity in the debt markets, making financing terms for borrowers less attractive, and in certain cases have resulted in the unavailability of certain types of debt financing. These events in the credit markets, as well as deteriorating market conditions, have also had an adverse effect on other financial markets in the United States, including the equity markets, which may make it more difficult or costly for us to raise capital through the issuance of common stock or other equity securities. If we were unable to obtain additional capital through one or more of these sources, our ability to continue our operations and grow our revenues may be adversely impacted.

Outstanding Indebtedness

At September 30, 2008, we had no outstanding indebtedness except for approximately $0.2 million of notes payable to a finance company in connection with the consolidation of VLC. See Note 7 to our condensed consolidated financial statements for further discussion.

Contractual Obligations

The following table summarizes our known contractual obligations to make future cash payments as of September 30, 2008 as well as an estimate of the periods during which these payments are expected to be made.


Payments Due by Period	Less than 1 Year (2008-2009)		1 to 3 Years (2009-2011)		3 to 5 Years (2012-2013)		More than 5 Years (After 2013)		Total
	(In thousands)
Long-term debt obligations	$	56	$	13	$	52	$	46	$	167
Capital lease obligations		10		8		—		—		18
Operating lease obligations		724		1,336		413		—		2,473
Capital commitments (1)		392		—		—		—		392
Purchase commitments (2)		—		—		—		—		—

Totals	$	1,182	$	1,357	$	465	$	46	$	3,050

(1)-Represents estimated costs to complete groundwater treatment systems under current contracts with customers

(2)-There are no minimum purchase arrangements with vendors

Capital Expenditures

Capital expenditures totaled $4.1 million in the first nine months of 2008 compared to $4.5 million for the comparable period of 2007. Our capital expenditures are primarily for groundwater treatment systems that we build and then contract to customers under long-term contracts. Our future capital expenditures will fluctuate depending on the number of our systems we place with customers under long-term contracts. In the third quarter of 2008, we scaled back our manufacturing operations. We intend to outsource these operations in the future.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At September 30, 2008, other than the non-interest bearing notes payable by VL Capital to a financing company (see Note 7 to the condensed consolidated financial statements), we had no outstanding indebtedness. The amount of our outstanding debt at any time may fluctuate and we may from time to time be subject to refinancing risk. A hypothetical 100 basis point increase in interest rates would not have a material effect on our annual interest expense, our results of operations or financial condition. We derive substantially all of our revenues from sales within the United States. Since transactions in foreign currencies are immaterial to us as a whole, we do not consider it necessary to hedge against currency risk.

Item 4.

Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer (CEO) and chief financial officer (CFO), as appropriate to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Management, with participation by our CEO and CFO, has designed the Company’s disclosure controls and procedures to provide reasonable assurance of achieving the desired objectives. As required by SEC Rule 13a-15(b), in connection with filing this Quarterly Report on Form 10-Q, management conducted an evaluation, with the participation of our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act, as of September 30, 2008, the end of the period covered by this report.

Based upon that evaluation as of September 30, 2008 and the evaluation conducted by management in connection with the audit of the Company’s Restated financial statements for the years ended December 31, 2007 and 2006, we identified material weaknesses in our internal control over financial reporting that still existed as of September 30, 2008. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.

As a result of these material weaknesses, our CEO and CFO concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of September 30, 2008.

(b) Management’s Evaluation of Internal Control over Financial Reporting (Restated).

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Internal control over financial reporting refers to a process

designed by, or under the supervision of, our CEO and CFO, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles (GAAP) and includes those policies and procedures that: (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect our transactions and disposition of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Our management performed an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2007 based upon the Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, management concluded that our internal control over financial reporting was not effective as of December 31, 2007 as a result of the material weaknesses described below.

The ineffectiveness of internal control over financial reporting as of December 31, 2007 stemmed from several significant factors. The organization structure was changing as we hired additional management, and we were establishing new accounting information systems. This placed additional stress on the organization and our internal controls as these new structures were being instituted within the Company. Additionally, the acquisition of MPT in the third quarter of 2007 caused additional changes to our organization structure and accounting systems. These changes in our management, reporting structure and our accounting information systems resulted in a material weakness in our internal control over financial reporting.

In connection with the restatement of our consolidated financial statements, we have identified the following additional material weaknesses in our internal control over financial reporting that existed as of December 31, 2007:

•

A lack of sufficient personnel with appropriate knowledge, experience and training in applying GAAP to transactions and the correct application of revenue recognition principles required under GAAP;

•

A lack of effective checks and balances between the former CFO and accounting and legal functions with respect to the negotiation, structuring and accounting for transactions, including water treatment unit sales and water service agreements;

•

A failure to maintain adequately organized business records and complete documentation for sales contracts, many of which lacked execution dates, signatures by Company or counterparty representatives; the use of draft or non-standard arrangements; and the lack of adequate written agreements to memorialize significant transactions;

•

Insufficient information systems and processes to accumulate information to timely identify and address business and accounting issues;

•

A lack of sufficiently detailed written accounting policies and procedures with respect to the timing and recognition of sales transactions and an insufficient process at the time of the transactions to monitor compliance with such policies and procedures; and

•

A failure to maintain an effective internal audit function.

We believe that these material weaknesses still existed as of September 30, 2008. In light of these material weaknesses, we performed additional analyses and procedures in order to conclude that our consolidated financial statements for the three-months and nine-months ended September 30, 2008 included in this Quarterly Report on Form 10-Q were fairly presented in accordance with GAAP. Accordingly, management believes that despite our material weaknesses, our financial statements for the three months and nine months ended September 30, 2008 are fairly presented in accordance with GAAP.

Based on our remediation efforts described below, we expect to enhance our internal control over financial reporting with the goal of remediating the foregoing material weaknesses by December 31, 2009. The effectiveness of the measures we implement in this regard will be subject to ongoing management review supported by confirmation and testing by management and by our internal auditors, as well as audit committee oversight. As a result, we expect that additional changes could be made to our internal control over financial reporting and our disclosure controls and procedures. In addition, we may in the future identify additional material weaknesses in our internal control over financial reporting that we have not identified as of the date of this report.

(c) Plan for Remediation of Material Weaknesses

We have implemented a number of changes designed to improve our internal control over financial reporting such as:

•

We hired a new CFO in June 2008;

•

We retained an experienced consultant to assist us in our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002;

•

We have developed and are implementing our accounting policies and procedures with enhanced controls surrounding expenditures, cutoff dates and payroll processing and procedures;

•

With respect to revenue recognition, we now require the CFO and either the General Counsel or the CEO to provide written or electronic approval of all sales contracts;

•

We have developed procedures and internal documentation to reduce the risks associated with non-routine transaction documents;

•

We have developed policies and procedures designed to ensure that the appropriate authorized officers receive information regarding proposed transactions on a timely basis prior to execution and approval of such transactions;

•

With respect to non-routine transactions, we have adopted additional procedures designed to ensure the correct accounting treatment of such transactions including, where appropriate, retention of outside accounting specialists where additional expertise is determined to be advisable based upon the nature of the transaction; and

•

We have implemented new financial systems designed to enhance our financial reporting process.

We intend to take the following additional remediation efforts:

•

increase our accounting and finance resources and/or the accounting qualifications of current personnel;

•

conduct additional employee training relating to existing and newly implemented policies and procedures;

•

realign our internal audit review and internal reporting function in a manner designed to ensure compliance with written accounting and revenue recognition procedures;

•

adopt additional procedures with respect to monitoring and internal communication within the organization; and

•

implement new policies and procedures designed to improve cutoff, reporting and processing functions.

We believe these remediation efforts will continue to improve our internal control over financial reporting.

We have incurred, and expect to continue to incur, substantial expenses relating to the remediation of the material weaknesses in our internal control over financial reporting. The effectiveness of our internal control over financial reporting may in the future be limited by:

•

failure of the effectiveness of our policies, procedures and information systems and processes;

•

delays in upgrading financial software systems; and

•

the possibility that enhancements to our disclosure controls and procedures or internal control over financial reporting may not adequately assure timely and accurate financial information.

(d) Changes in Internal Control over Financial Reporting

Other than as described above, there were no changes in our internal control over financial reporting during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II Other Information

Item 1.

Legal Proceedings

On October 26, 2007, Veolia Water North America Operating Services, LLC and certain other related parties filed a lawsuit in the United States District Court of the Middle District of Florida, Tampa Division, naming as defendants Basin Water-MPT, Inc. (a wholly owned subsidiary of Basin Water, Inc.) and two of its employees, one of whom is the son of our President and Chief Executive Officer. Subsequently, the plaintiffs amended their complaint to add as defendants Basin Water, Inc. and Michael M. Stark, our President and Chief Executive Officer, to the lawsuit. The lawsuit alleges, among other things, certain claims related to trade secrets and unfair trade practices relating to treatment of by-products produced as a result of the phosphate mining industry. In December 2008, this litigation and the underlying disputes were resolved by agreement, resulting in a payment by us of $230,000 with the remainder of the settlement being paid by our insurer.

On December 27, 2007 and January 2, 2008, two purported securities class action complaints were filed in the United States District Court for the Central District of California against the Company, Peter L. Jensen, Michael M. Stark and Thomas C. Tekulve (collectively referred to as the Basin defendants) for violations of the Exchange Act. These lawsuits, which contain similar allegations, are captioned Poulos v. Basin Water, et al ., Case No. CV 07-8359 GW (FFMx) and Nofer v. Basin Water, et al ., Case No. CV 08-0002 SGL (JCRx). The lawsuits were subsequently consolidated, and on October 3, 2008 a Consolidated Amended Complaint (CAC) was filed which alleges that the Company deliberately understated the reserves it took for certain unprofitable contracts, and committed various intentional violations of GAAP during a putative class period between November 14, 2006 and August 8, 2008 (the Federal Lawsuit.) The suit does not state a specific amount of damages.

On January 31, 2008, Loren Charif, a purported stockholder of our company, filed a shareholder derivative lawsuit in the Superior Court of the State of California, County of San Bernardino, against certain of our executive officers and our current directors. The complaint assumes the truth of the aforementioned allegations in the federal securities class action lawsuits and in connection with those allegations alleges, among other things, breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of California Corporations Code pertaining to allegations of improper selling. On November 12, 2008, we obtained an order staying this action until a final determination occurs in the Federal Lawsuit. The suit does not state a specific amount of damages.

From time to time, we are involved in legal and administrative disputes and proceedings arising in the ordinary course of business, which we believe are not material to the conduct of our business. With respect to these ordinary matters, management believes that the Company has adequate accruals for expected costs, and the Company may also have effective legal defenses.

Item 1A.

Risk Factors

A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” of our recently filed Annual Report on Form 10-K/A for the year ended December 31, 2007. These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission. There have been no material changes in our risk factors from those disclosed in our Annual Report on Form 10-K/A for the year ended December 31, 2007. You should carefully consider the risk factors discussed in our Annual Report on Form 10-K/A, as well as the other information in this report, before deciding whether to invest in shares of our common stock. The occurrence of any of the risks discussed in our Annual Report on Form 10-K/A could harm our business, financial condition, results of operations or growth prospects.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

There have been no repurchases of our common stock during the nine months ended September 30, 2008 under the stock repurchase program authorized by our Board of Directors in May 2007 that allowed us to repurchase up to $10 million of our common stock. The shares could be repurchased at times and prices as determined by management, and may be completed through open market or privately negotiated transactions. The repurchase program provides that repurchases must be made in accordance with the terms and subject to the restrictions of Rule 10b-18 under the Exchange Act, as amended.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

Submission of Matters to a Vote of Security Holders

None.

Item 5.

Other Information

None.

Item 6.

Exhibits


2.2†		Asset Purchase Agreement, dated as of September 18, 2008, by and among Shaw Environmental & Infrastructure, Inc., Shaw Environmental, Inc., Envirogen, Inc. and Registrant (1)

10.39		Settlement Agreement, dated as of September 18, 2008, by and among Shaw Environmental & Infrastructure, Inc., Shaw Environmental, Inc. and Registrant (1)

10.40†		Biological Materials Sales Agreement, dated as of September 18, 2008, by and between Shaw Environmental, Inc. and Registrant (1)

10.41		Resignation Letter Agreement, dated October 13, 2008, between the Registrant and Thomas C. Tekulve (2)

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.

32.1*		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1)	Filed with the Registrant’s Current Report on Form 8-K on September 22, 2008

(2)	Filed with the Registrant’s Current Report on Form 8-K on October 14, 2008

These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Exchange Act and are not to be incorporated by reference into any filing of Basin Water, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

†	Confidential treatment has been requested for portions of this exhibit.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.