BCON Beacon Power Corp (MM)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x                     Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended June 30, 2011

or

o                        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: 000-31973

Beacon Power Corporation

(Exact name of registrant as specified in its charter)

(978) 694-9121

(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.   x Yes o No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).  Yes    x     No    o

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.

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

The number of shares of the Registrant’s common stock, par value $.01 per share, outstanding as of August 5, 2011 was 28,368,027.

BEACON POWER CORPORATION AND SUBSIDIARIES
Table of Contents

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PART 1 — FINANCIAL INFORMATION

Item 1. Financial Statements

BEACON POWER CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

See notes to unaudited consolidated financial statements.

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BEACON POWER CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations (Unaudited)

See notes to unaudited consolidated financial statements.

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BEACON POWER CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

See notes to unaudited consolidated financial statements.

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BEACON POWER CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity (Unaudited)

See notes to unaudited consolidated financial statements.

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BEACON POWER CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

Note 1.  Nature of Business and Operations

Nature of Business

Beacon Power Corporation (collectively the “Company,” “Beacon,” “we,” “our,” or “us”) was incorporated on May 8, 1997, as a wholly owned subsidiary of SatCon Technology Corporation.  Since our inception, we have been primarily engaged in the development of flywheel devices that store and recycle energy on a highly efficient basis.  In 2000, we completed an initial public offering of our common stock and raised approximately $49.3 million, net of offering expenses. Since our initial public offering, we have raised approximately $125.0 million as of June 30, 2011, through the sale of our stock and warrant exercises.

Prior to June 2011, we were accounted for as a development stage company under the Financial Accounting Standards Board’s Accounting Standard Codification (ASC) Topic 915 because we had not yet generated a significant amount of revenue from our principal operations.  During June 2011, our Stephentown, New York, flywheel energy storage plant reached its full 20 megawatt (MW) capacity.  Since we are now generating significant revenue from our principal operations, as of June 30, 2011, we are no longer accounted for as a development stage company.

We expect to continue to increase revenues from the commercialization our Smart Energy Matrix™ flywheel system that provides frequency regulation services to the electricity grid in North America. We also expect to sell turnkey systems outright or on a fractional basis, both within the United States and internationally, that will also be used to provide frequency regulation as well as related energy balancing services. We believe that as we expand our production capabilities and continue to lower system costs, we will be able to market other cost-effective applications for our flywheel systems that will further expand revenues.

Operations

We have experienced net losses since our inception and, as of June 30, 2011, had an accumulated deficit of approximately $245.7 million. We do not expect to have positive EBITDA (earnings before interest, taxes, depreciation and amortization) or positive cash flow from operations until we have deployed a sufficient number of merchant plants and/or sold turnkey systems. In the future, as the number of our merchant regulation facilities increases and we develop sustainable cash flows from operations and the sale of turnkey plants, we expect to fund additional plants from a combination of cash flow from operations, non-recourse project financing and project equity.

On August 6, 2010, our wholly-owned subsidiary, Stephentown Regulation Services, LLC (SRS), closed on a credit facility (the “FFB Credit Facility”) with the Federal Financing Bank (FFB), pursuant to which the FFB agreed to make loans to SRS from time to time in an aggregate principal amount of up to $43,137,019, subject to the terms and conditions set forth in the loan documents governing the FFB Credit Facility (collectively, the “FFB Loan Documents”).   The loans made to SRS by the FFB under the FFB Loan Documents are guaranteed by the U.S. Department of Energy (DOE).  Proceeds of the loans made under the FFB Loan Documents, together with $26 million of cash and in-kind assets contributed by Beacon through its wholly-owned subsidiary, Stephentown Holding LLC (“Holding”), are being applied to pay the estimated $69 million total project cost of our 20 megawatt (MW) frequency regulation plant in Stephentown, New York.  Advances under the FFB Credit Facility began in September 2010, and are based upon eligible project spending, with the last day for an advance of May 30, 2012.  Each loan disbursement is subject to the satisfaction of certain conditions.

We began earning frequency regulation revenue in January 2011 at our Stephentown plant. In June 2011, our Stephentown plan achieved its full 20-MW capacity.

O n February 28, 2011, we announced we had signed a lease agreement with NorthWestern Corporation d/b/a NorthWestern Energy for a one-megawatt (1MW) Beacon Smart Energy Matrix flywheel energy storage system.  The system will be installed by us and operated in conjunction with the Dave Gates Generating Station (formerly known as the Mill Creek Generating Station), a gas-fired regulating reserve plant recently commissioned in Montana and owned by NorthWestern Energy.  Our system is expected to be operational by the end of 2011. The initial term of the lease will be 15 months, which can be extended up to two additional 12-month terms at NorthWestern Energy’s option. NorthWestern Energy will pay us $500,000 for the first 15-month term and $500,000 for each subsequent term should it choose to extend the lease. At any point, NorthWestern Energy can opt to purchase the 1 MW system outright for approximately $4 million.  A portion of the lease payments made under the agreement would be applied to the purchase, depending on when the purchase is made.

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In addition to the revenue we earned from our Stephentown plant, we also earned frequency regulation revenue during the first half of 2011 from approximately 1 MW of capacity operating at our Tyngsboro facility under the ISO-NE pilot program. During the first half of 2010, we had 3 MW in service at this site; however, during the third quarter of 2010 we redeployed a portion of those assets to the Stephentown plant in partial fulfillment of our equity contribution to SRS.  In April 2011, we temporarily discontinued our participation in the ISO-NE pilot program in order to prepare the remaining flywheels for shipment to NorthWestern Energy.  In July 2011, we resumed limited participation in this pilot program.

We plan to increase revenues by building and operating additional 20 MW facilities. We have been awarded a $24 million DOE Smart Grid stimulus grant to support a plant in Hazle Township, Pennsylvania, which is in the Mid-Atlantic ISO (PJM) region.  In April 2011, we were approved by the DOE to proceed to Phase II tasks, subject to final expected approval of the revised project budget.  We expect the project budget to be approved before the end of the third quarter of 2011. Once formally approved, we will be allowed to draw Phase II funds of up to 95% of the $24-million grant.  Under Phase I, we were limited to a spending cap of 4% of the grant amount.  We have site control and have filed an interconnection application and DOE has completed and approved the environmental assessment for the Hazle Township site.

We are identifying other plant locations for future merchant facilities, as well as marketing our systems to domestic and foreign utilities that lack open-bid markets with the objective of selling our plants in those markets on a turnkey basis.  Additionally, we are exploring other potential flywheel applications, including the sale of systems for wind/diesel/flywheel energy storage hybrid power systems on islands and remote grids, frequency response, as well as military applications.  In September 2010 we were awarded a two-year $2.2 million ARPA-E contract to develop the initial design of a new type of flywheel that would have the capability of delivering four times the energy as our current Gen4 flywheel.  If successful, this new flywheel design would be capable of delivering 100 kW for up to one hour.  Additional effort would be required once a design is developed before this new flywheel could be commercialized. Target applications for this device would include ramp mitigation for wind and solar generation whose power output may exceed local ramp rate limitations, demand limiting for commercial, industrial, institutional and government facilities that pay high electricity demand charges, and back-up power supply for a portion of the Uninterruptable Power Supply (UPS) market that requires extended time to achieve orderly shutdown because the customer lacks back-up generation capability.

To continue to build merchant plants, fund operations and continue as a going concern, we will require additional funding through a combination of equity, debt and/or cash proceeds from the sale of plants. Although the Stephentown plant began generating revenue in January 2011, the terms of the FFB loan require us to escrow a significant amount of the cash expected to be generated from SRS operations in 2011 and beyond to create required reserves for debt service, maintenance and ongoing operations. We estimate that we will need to raise an additional $5 to $10 million during 2011 to fund operations into the second quarter of 2012.

Note 2.  Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared using accounting principles generally accepted in the United States of America except that certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in this Form 10-Q.  We suggest that the consolidated financial statements presented herein be read in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC on March 16, 2011, respectively.  In management’s opinion, all adjustments consisting of normal recurring accruals considered necessary for a fair presentation have been included in the accompanying unaudited financial statements.  Operating results for the six months ended June 30, 2011, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2011.

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Going Concern

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.  As shown in our consolidated financial statements, we have incurred significant losses of approximately $245.7 million since our inception including losses during the six months ending June 30, 2011, of approximately $17.0 million.  We have approximately $5.4 million of cash and cash equivalents on hand at June 30, 2011, which, in combination with the proceeds from the FFB loan and the remaining $3 million we contributed to SRS for the Stephentown project, is adequate to fund the remaining costs associated with the Stephentown facility, fund the necessary SRS reserves and finance our operations into the fourth quarter of 2011.  Since our cash needs beyond that point exceed the cash we expect to generate from operations, we may be unable to continue as a going concern.  The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should we be unable to continue as a going concern.

We recognize that our continuation as a going concern is dependent upon our ability to generate sufficient cash flow to allow us to satisfy our obligations on a timely basis.  The generation of sufficient cash flow is dependent, in the short term, on our ability to raise additional capital from a combination of equity and/or project financing; and in the long term, on the successful operation of our merchant plants and on our sales of turnkey systems. We believe that the successful achievement of these initiatives should provide us with sufficient resources to meet our long-term cash requirements.

Reclassification of prior period amounts

The Board of Directors of the Company authorized a reverse split of the Company’s common stock at a ratio of one-for-ten, effective February 25, 2011. The Company filed a Certificate of Amendment to its Sixth Amended and Restated Certificate of Incorporation (the “Amendment”) to implement the reverse stock split and to reduce the number of shares of common stock authorized under the Certificate of Incorporation from 400 million to 200 million. The number of shares authorized and all previously reported share and per share amounts have been restated in the accompanying consolidated financial statements and related notes to reflect the reverse stock split.

Certain prior period amounts have also been reclassified to be consistent with current period reporting. Deferred financing costs and other current assets have been reclassified such that the individual components (deferred financing costs, advance payments to suppliers, and other assets) are now shown separately. In addition, on the cash flow statement, purchases and manufacture of property and equipment are now shown net of related payables and accruals. Also, the components of  non-cash interest income related to the preferred stock and associated warrants  have been combined in the cash flow statement.

Consolidation

The accompanying consolidated financial statements include the accounts of Beacon Power Corporation and our subsidiaries, Beacon Power Securities Corporation, Holding and SRS.  In September 2008, we established two additional wholly-owned subsidiaries, Tyngsboro Regulation Services LLC and Tyngsboro Holding LLC, which remain inactive as of June 30, 2011. The frequency regulation service revenue and costs from the ISO-NE pilot program are accounted for as part of Beacon Power Corporation.  All significant inter-company accounts and transactions have been eliminated in consolidation.

Loss per Share — Basic and Diluted

Basic and diluted losses per share have been computed using the weighted-average number of shares of common stock outstanding during each period as adjusted retroactively for the effect of the reverse stock split that was effective February 25, 2011. Warrants, options and other securities exercisable for common shares are used in the calculation of fully diluted earnings per share (EPS) only if their conversion to common shares would decrease income or increase loss per share from continuing operations.  Since the three and six-month periods ended June 30, 2011, and 2010, reflect losses, including the potential conversion of warrants and options in the diluted EPS calculation would decrease loss per share. Accordingly, they are considered anti-dilutive and are not included in the calculation of loss per share.

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Summary of Significant Accounting Policies

Use of Estimates

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

Debt recorded at par value or stated value

The Massachusetts Development Finance Agency (MassDev) and FFB loans are recorded on our balance sheet at par value or stated value adjusted for unamortized discount or premium. Discounts and premiums for debt recorded at par value or stated value generally are capitalized and amortized over the life of the debt and are recorded in interest expense using the effective interest method. Such costs are amortized over the life of the debt and are recorded in depreciation and amortization expense.

Debt or derivative liabilities recorded at fair value

Costs related to the issuance of debt for which we have elected the fair value option are recognized in current earnings. We have elected not to mark our MassDev or FFB loan to market through the income statement. However, we have three instruments that are recorded as debt or derivatives which we have elected to mark to fair value through earnings: our mandatorily redeemable convertible preferred stock, our preferred stock warrants (which had been fully-exercised as of June 30, 2011), and the common stock warrants issued in conjunction with our preferred stock. We determine fair value for these instruments as of the end of each reporting period, and we reduce the amount outstanding for any redemptions, exercises, or conversions at the fair value determined at the end of the prior reporting period. The fair value adjustment is charged or credited to Interest expense.

· Mandatorily Redeemable Convertible Preferred Stock

The certificate of designations governing the rights and preferences of the preferred stock contains several embedded features that would be required to be considered for bifurcation. The preferred stock is mandatorily redeemable and therefore has to be recorded as a liability. We have elected the fair value option, and as such, will value the host preferred stock certificate of designations and embedded features as one instrument. Changes in the fair value of the preferred stock will be recorded as Non-cash interest on the Statement of Operations.

·                   Redemptions

We expect to redeem the balance of our preferred stock by issuing common stock. The difference between the fair value of the preferred stock and the fair value of the common stock on the date the common stock issued is charged or credited to Non-cash interest income (expense).

·                   Conversions

Investors in the preferred stock can voluntarily convert their preferred shares to common stock at a conversion price defined in the preferred stock certificate of designations. The difference between the fair value of the preferred stock and the fair value of the common stock given in conversion is recognized as a non-cash gain or loss on the extinguishment of debt.

·                   Dividends

Dividends paid with scheduled redemptions are expected to be paid in stock. However, when an investor voluntarily converts its preferred shares, we are required to pay the investor for the dividends that would have been earned had the shares been held to maturity. The portion of those dividends that have not been accrued must be paid in cash, and are referred to as “make whole” payments. Dividends paid in cash are charged to Interest expense. Dividends paid in stock are valued at the fair value of the common stock as of the date of issuance, and are charged to Non-cash interest.

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· Preferred Stock Warrants

We accounted for freestanding warrants to purchase shares of our mandatorily redeemable convertible preferred stock as liabilities on the consolidated balance sheets at fair value upon issuance. The preferred stock warrants were recorded as a liability because the underlying shares of convertible preferred stock were mandatorily redeemable, which obligated us to transfer assets at some point in the future. (See Note 11.) The warrants were subject to re-measurement to fair value at each balance sheet date and any changes in fair value were recognized in Non-cash interest, net, on the consolidated statements of operations. As the warrants were exercised, the warrant liability was reclassified to preferred stock. The difference between the fair value of the preferred warrant and of the preferred stock as of the date of exercise was charged or credited to Non-cash interest.  As of June 30, 2011, there were no preferred stock warrants outstanding.

· Common Stock Warrants

We have issued common stock warrants in connection with the December 2010 preferred stock offering. (See Note 13.) Because this warrant has terms that adjust the exercise price in certain circumstances, the warrant cannot be considered indexed to our own stock and is therefore accounted for as a derivative liability at fair value. Changes in fair value of derivative liabilities are recorded in the consolidated statements of operations as Non-cash interest. The fair value of the warrant liability is determined using the Black-Scholes option pricing model. The fair value of the warrants is subject to significant fluctuation based on changes in our stock price, expected volatility, remaining contractual life and the risk free interest rate. Upon exercise, the difference between the fair value of the common stock and the common stock warrant is charged or credited to Non-cash interest.

Lease Obligation and Deferred Rent

In July 2007, we signed a seven-year operating lease with escalating payments on a 103,000 square foot facility in Tyngsboro, Massachusetts. As part of this lease agreement, we issued to the landlord 15,000 shares of our common stock and a warrant exercisable for 50,000 shares of our common stock in return for lower cash payments under the lease. (See Note 8.)  Additionally, the landlord has reimbursed us for certain leasehold improvements we have made. In accordance with the Financial Accounting Standards Board’s (FASB’s) Accounting Standards Codification (ASC) Topic 840, “ Leases, ” these reimbursements have been credited to “Deferred Rent,” and we have recorded rent expense on a straight-line basis. The current portion of the deferred rent is included in current liabilities, and the remainder is shown on the balance sheet as “Deferred rent — long term.”

Property and Equipment

Property and equipment in service is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Property and equipment are defined as tangible items with unit costs exceeding our capitalization threshold that are used in the operation of the business, are not intended for resale and which have a useful life of one year or more. The cost of fixed assets is defined as the purchase price of the item, as well as all of the costs necessary to bring it to the condition and location necessary for its intended use.  These costs include labor, overhead, capitalized interest and, if applicable, exit costs. Exit costs for which we are obligated are accounted for in accordance with ASC Topic 410, “ Asset Retirement and Environmental Obligations .”  No overhead is generally applied for internally-constructed projects not directly related to our core business (e.g., leasehold improvements). Interest costs incurred during the construction of major construction projects (such as the construction of our frequency regulation plants) are capitalized in accordance with ASC Topic 835, Subtopic 20, “ Interest — Capitalization of Interest .”  The interest is capitalized until the underlying asset is ready for its intended use, and is considered an integral part of the total cost of acquiring a qualifying asset.  Thus, the capitalized interest costs are included in the calculation of depreciation expense once the constructed assets are in service. Repair and maintenance costs are expensed as incurred.  Materials used in our development efforts are considered research and development materials, and are expensed as incurred in accordance with ASC Topic 730, “Research and Development.”

Capital assets are classified as “Construction in Progress” (CIP) when initially acquired, and reclassified to the appropriate asset account when placed into service, with the exception of land, which is capitalized upon purchase. Depreciation expense is not recorded on assets not yet placed into service.

Materials purchased to build flywheels, power electronics and other components used in our frequency regulation installations are classified as CIP, along with the related labor and overhead costs. Some components of the Smart Energy

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Matrix™, such as the flywheels and power electronics, are considered “fungible” in that they can be moved and redeployed at a different location.  Non-fungible costs are costs which would not be recovered if we redeployed the matrix or portions thereof.  In some cases, we may elect to deploy a Smart Energy Matrix™ system at a location for the purpose of demonstrating our technology or gaining experience operating in that particular market.  In these instances, the costs of the fungible components are capitalized, and the remaining costs, which may include such costs as site preparation, interconnection costs, capitalized interest and estimated exit costs, are expensed.

Deferred financing costs

Deferred financing costs represent legal, due diligence and other direct costs incurred to raise capital or obtain debt.  Direct costs include only “out-of-pocket” or incremental costs directly related to the effort, such as a finder’s fee and fees paid to outside consultants for accounting, legal or engineering investigations or for appraisals.  These costs will be capitalized if the efforts are successful, or expensed when unsuccessful.  Indirect costs are expensed as incurred. Deferred financing costs related to debt are amortized over the life of the debt. Deferred financing costs related to issuing equity are charged to Paid in Capital.  See Debt or derivative liabilities recorded at fair value for treatment of issuance costs on liability for which we have elected the fair value option.

Advance payments to suppliers

Advance payments to suppliers represent payments made in advance of receipt for services or custom materials used in the manufacture of our flywheels or frequency regulation facilities. Advance payments are relieved when the materials or services are received. The advance payments are for the construction of our merchant plants, and therefore they are recorded as non-current assets.

Loss on Contract Commitments

Our contracts have been primarily for the development of demonstration units of new products, design of a frequency regulation plant, design of a flywheel for use by the Navy in their electric ships, and other work that supports our core research and development efforts.  Most of these contracts have been structured on a cost-share basis for which the expected cost share has been recorded as a contract loss.  The “cost” basis allowable on these contracts is based on government-allowable overhead rates, which differ from overhead rates required by GAAP.  In particular, most of our stock compensation expense is not an allowable cost for the purposes of calculating government-allowable rates.  As a consequence, we may incur losses on our financial statements even for contracts granted on a cost-plus-fixed fee basis.  We establish reserves for anticipated losses on contract commitments if, based on our cost estimates to complete the commitment, we determine that the cost to complete the contract will exceed the total expected contract revenue.  Each quarter, we perform an estimate-to-complete analysis, and any increases to our reserve for contract losses are recognized in the period in which they are determined.

Stock-Based Compensation

We account for stock-based compensation for employees in accordance with ASC Topic 718, “ Compensation-Stock Compensation .” Under the fair value recognition provision of ASC Topic 718, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense as it is earned over the requisite service period, which is the vesting period. The fair value of the options on their grant date is measured using the Black-Scholes option pricing model, which we believe yields a reasonable estimate of the fair value of the grants made. The valuation provisions of ASC Topic 718 apply to grants issued since January 1, 2006, (the effective date) and to grants that were outstanding as of that date that are subsequently modified. Estimated compensation expense for grants that were outstanding as of the effective date will be recognized over the remaining vesting period.

Non-employee stock-based compensation is accounted for in accordance with ASC Topic 505, “ Equity-based payments to Non-Employees .”  In accordance with this topic, cost recognized for non-employee share-based payment transactions is determined by the fair value of whichever is more reliably measurable:  (a) the goods or services received; or (b) the equity instruments issued.

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Restructuring and Asset Impairment Charges

In accordance with ASC Topic 360, “ Property, Plant and Equipment ,” long-lived assets to be held and used are periodically reviewed to determine whether any events or changes in circumstances indicate that the carrying value of the asset may not be recoverable.  The conditions considered include whether or not the asset is in service, has become obsolete, or whether external market circumstances indicate that the carrying amount may not be recoverable.  We recognize a loss for the difference between the estimated fair value of the asset and the carrying amount. The fair value of the asset is measured using either available market prices or estimated discounted cash flows.

In certain instances, we may determine that it is in the best interest of the Company to move and redeploy all or part of a Smart Energy Matrix™ system installed at a given location.  When such a decision is made, we will determine which costs are associated with the movable (fungible) components, and which costs are non-fungible. We will record a period expense for the net book value associated with the non-fungible components.

No asset impairment charges were considered necessary for the three or six months ended June 30, 2011, or 2010.  However, should regulation pricing in the New York Independent Service Operator (NYISO) market decline and not be offset by performance-based pricing, or should we experience significant unexpected  cost increases, our Stephentown plant may become impaired in the future.

Revenue Recognition

We earn revenue from several sources, which are accounted for as follows:

·       Frequency Regulation Revenue

Revenue from frequency regulation is recognized when it has been earned and is realized or realizable. Revenue from services is earned either as the services are performed or when they are complete and is considered realizable once the customer has committed to pay for the services and the customer’s ability to pay is not in doubt.  Frequency regulation revenue is calculated on an hourly basis as services are provided, based on formulas specific to the tariffs in effect at the applicable ISO, at bid award rates that are published by the ISO.  Frequency regulation service revenue is calculated using the applicable rates and formulas as services are provided.

·       Research and Development Contract Revenue Recognized on the Percentage-of-Completion Method

We recognize contract revenue using the percentage-of-completion method. We use labor hours as the basis for the percentage of completion calculation, which is measured principally by the percentage of labor hours incurred to date for each contract to the estimated total labor hours for each contract at completion. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to contract costs and revenue.  Revenues recognized in excess of amounts billed are classified as current assets, and included in “Unbilled costs on contracts in progress” in our balance sheets.  Amounts billed to clients in excess of revenues recognized to date are classified as current liabilities under “Advance billings on contracts.”  Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to contract costs and revenue.

Our research and development contracts are subject to cost review by the respective contracting agencies. Our reported results from these contracts could change as a result of these reviews.

·       Sale of Alternative Renewable Energy Credits

Under the Massachusetts Alternative Energy Portfolio Standard (APS) program, our flywheel energy storage frequency regulation assets operating within the Commonwealth of Massachusetts are credited with producing a type of Renewable Energy Credit (REC) known as an Alternative Renewable Energy Credit.  These have a market value, and we recognize revenue on the sale of such credits as revenue when sold on the open market.

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·       Inverter Sales

Generally, revenue on inverter and related product sales is recognized on transfer of title, typically when products are shipped and all related costs are estimable.  For sales to distributors, we make an adjustment to defer revenue until the products are subsequently sold by distributors to their customers.

·       Grants

Grants that relate to revenues are recognized in the same period as the related revenues are reflected. Grants that relate to current expenses are reflected as reductions of the related expenses in the period in which they are reported. Grants that relate to depreciable property and equipment are reflected in income over the useful lives of the related assets, and those related to land are amortized over the life of the depreciable facilities constructed on it. A given grant may be parsed into various components, each of which may be treated either as current revenue, reduction of current expenses, or as deferred revenue to be amortized over the life of a fixed asset, as appropriate given the structure and nature of the grant. Grants to be recognized as current revenue will be recognized on a percentage of completion basis.

Cost of Goods Sold

For frequency regulation services, cost of goods sold represents the cost of energy. Cost of goods sold for our research and development contracts is calculated on a percentage-of-completion basis, using the same percentage of contract costs (up to the total contract revenue amount) as is used to calculate revenue. In the event that expected costs exceed the total contract revenue amount, the excess costs are charged to contract loss. We value our products at the lower of cost or market.  Costs in excess of this measurement are expensed in the period in which they are incurred.

Concentration of Credit Risk

Financial instruments that potentially subject us to significant concentration of credit risk consist primarily of cash and cash equivalents.   We keep our cash investments with high-credit-quality financial institutions or Treasury funds.  At June 30, 2011, substantially all of our cash and cash equivalents were held in interest bearing accounts at financial institutions earning interest at varying rates from 0.02% to 0.36%.  At June 30, 2011, we had approximately $1,648,000 of cash equivalents that were held in non-interest bearing checking accounts.  Also at June 30, 2011, we had approximately $6,932,000 of cash equivalents (including approximately $3,203,000 in cash equivalents shown on our balance sheet as “Restricted Cash”) that were held in interest-bearing money market accounts at high-quality financial institutions, some of which are invested in off-shore securities. The fair value of these investments approximates their cost. A 10% change in interest rates would change the investment income realized on an annual basis by an immaterial amount.  The funds invested in money market accounts may not be covered under FDIC Insurance, and therefore may be at some risk of loss. However, the money market accounts are invested primarily in government funds, such as Treasury Bills.  Approximately $3.6 million of our cash on hand at June 30, 2011, was invested in mutual funds at a brokerage firm that has purchased supplementary insurance through Lloyd’s of London. This insurance coverage provides protection above the Securities Investor Protection Corporation (SIPC) coverage in the event that the broker becomes insolvent.  SIPC protects against the loss of securities up to a total of $500,000 (of which $100,000 may be in cash) per client.  The supplemental insurance provided by the broker would cover investments at that brokerage firm up to a maximum of $1 billion, including up to $1.9 million per client for the cash portion of any remaining shortfall.  SIPC and the supplemental insurance do not cover market losses; however, management believes the risk of substantial market losses is low because our funds are invested primarily in government funds.

At June 30, 2011, one of our third-party suppliers represented approximately 17% of the outstanding balance of our accounts payable and accrued liabilities. Excluding the limited revenue earned in our ISO-NE pilot program, we have one customer for our regulation services, NYISO, who is also the supplier for the cost of goods sold related to those services, e.g., the cost of energy.  The market rates for both energy and frequency regulation can fluctuate significantly from hour to hour, and we have limited control over both rates.

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Recently Issued or Adopted Accounting Pronouncements and Regulations

In May 2011, the FASB issued ASU 2011-04 which was issued to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and IFRS. ASU 2011-04 changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements.  This guidance is effective for the Company beginning on January 1, 2012.  We do not expect the adoption of ASU 2011-04 to significantly impact our consolidated financial statements.

Note 3.  Fair Value of Financial Instruments

Accounting for fair value measurements involves a single definition of fair value, along with a conceptual framework to measure fair value, with fair value defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The fair value measurement hierarchy consists of three levels:

·                   Level one—quoted market prices in active markets for identical assets or liabilities

·                   Level two—inputs other than level one inputs that are either directly or indirectly observable, and

·                   Level three—unobservable inputs developed using estimates and assumptions which are developed by the reporting entity and reflect those assumptions that a market participant would use.

We apply valuation techniques that (1) place greater reliance on observable inputs and less reliance on unobservable inputs and (2) are consistent with the market approach, the income approach and/or the cost approach, and include enhanced disclosures of fair value measurements in our financial statements.

The carrying values of cash and cash equivalents, accounts receivable, other current assets, accounts payable, accrued expenses, and other current liabilities approximate their fair values due to the short maturity of these instruments.  See Note 10 for debt fair value, which also approximates carrying value. See Note 11 for preferred stock and preferred stock warrants, and Note 13 for common stock warrants.

The following tables show information regarding assets and liabilities measured at fair value on a recurring basis as of June 30, 2011, and December 31, 2010:

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There were no significant transfers between levels in the periods ended June 30, 2011, or December 31, 2010.

Financial assets or liabilities are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.  The following table provides a summary of the changes in fair value of our financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and six months ended June 30, 2011:

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The warrant liabilities are marked-to-market each reporting period with the change in fair value recorded as a gain or loss within Non-cash interest in our consolidated statement of operations until they are exercised, expire or other facts and circumstances lead the liability to be reclassified as an equity instrument.  The fair value of the warrant liabilities are determined each reporting period by utilizing a third-party valuation completed using a Black-Scholes option pricing model that takes into account volatility as well as estimated probabilities of possible outcomes provided by us and the valuation analyst (unobservable inputs).

The preferred stock is recorded at fair value with changes in fair value recorded as gains or losses within Non-cash-interest.  The fair value of the preferred stock is determined at each reporting period by utilizing a third-party valuation completed using a Black-Scholes option pricing model that takes into account volatility as well as estimated probabilities of possible outcomes provided by us and the valuation analyst (unobservable inputs.)

Valuation—Methodology and Significant Assumptions

The estimate of the fair value of the securities noted above as of the valuation date is based on the rights and privileges afforded to each class of equity.  The valuation of derivative instruments utilized certain estimates and judgments that affect the fair value of the instruments.  Fair values for our derivatives are estimated by utilizing valuation models that consider current and expected stock prices, volatility, dividends, forward yield curves and discount rates.  Such amounts and the recognition of such amounts are subject to significant estimates which may change in the future.

In estimating the fair value of the preferred stock and warrants, the following methods and significant input assumptions were applied:

Methods

A Black-Scholes option pricing model was utilized to estimate the fair value of the mandatorily redeemable convertible preferred stock, preferred stock warrants and common stock warrants on June 30, 2011, and December 31, 2010.  The option pricing model relies on financial theory to allocate value among different classes of stock based upon a future “claim” on value.  The equity claim of the securities is equivalent to a series of call options at various breakpoints, which are determined by the necessary equity required for the diluted common stock price to reach the exercise price of the different equity instruments.  The change in option values represents the equity that is to be allocated among the different classes of stocks.  In estimating the fair value of the preferred stock, preferred stock warrants and common stock warrants, the following significant inputs and assumptions were applied as of June 30, 2011, and December 31, 2010:

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Significant Assumptions

·                   Due to the difficult nature of accurately estimating a potential exit event, we calculated the fair value using both a 3-year and a 5-year model. The fair values used are an average of value calculated using these two maturities.

·                   Stock volatility was estimated by annualizing the daily volatility of our stock price during the historical period preceding the valuation date and measured over a period corresponding to the remaining life of the instruments.  Historic stock prices were used to estimate volatility as we did not have trade options as of the valuation dates.

·                   Based on our historical operations and management expectations for the near future, our stock was assumed to be a non-dividend paying stock.

·                   The quoted market price of our stock was utilized in the valuations because the derivative guidance requires the use of quoted market prices without considerations of blockage discounts, i.e., an amount or percentage deducted from the current market price of a publicly traded security to reflect the decrease in the per share value of a block of those securities that is of a size that could not be sold in a reasonable period of time given normal trading volume.

The quoted market price of our stock as of the measurement dates and expected future stock prices were assumed to reflect the dilution upon conversion of the instruments to shares of common stock.

Note 4.  Accounts Receivable

Our accounts receivable include amounts due from customers and are reported net of a reserve for uncollectible accounts as follows:

There was no allowance for doubtful accounts as of June 30, 2011, or December 31, 2010.  All accounts are expected to be collected.

Some of our research and development contracts contain holdback provisions that allow our customers to withhold 10% from each invoice payment. As of June 30, 2011, and December 31, 2010, our accounts receivable balance included holdbacks of approximately $48,000 and $19,000, respectively.

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Note 5.  Property and Equipment

Details of our property and equipment follow:

The “Land” shown in the schedule above represents the cost of land for our Stephentown, New York frequency regulation plant. The Smart Energy 25 flywheels shown above represent the cost of the flywheels and electronic control modules in service. Smart Energy Matrix™ installations, otherwise referred to as “balance of plant,” represent the ancillary equipment required to operate our systems; construction costs charged by the contractor; equipment installation, testing and commissioning expenses; and capitalizable soft costs, such as permits, interconnection costs and capitalized interest.  The balance of plant costs are separated between those that are considered “fungible” and those that are “non-fungible.”  Fungible equipment is equipment that can be relocated to other sites, whereas non-fungible costs represent either equipment that cannot be moved, or “soft” costs such as capitalized interest.  The Smart Energy Matrix™ costs shown above also relate to equipment and costs in Stephentown or Tyngsboro.

The components of “Construction in progress” (CIP), which represent costs related to assets that have not yet been placed into service and for which no depreciation expense has been taken, were as follows: