S-1/A
As filed with the Securities and Exchange Commission on July 3, 2008
Registration No. 333-149920
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
Amendment No. 2
to
 
Form S-1
REGISTRATION STATEMENT
UNDER THE SECURITIES ACT OF 1933
 
 
MECHANICAL TECHNOLOGY, INCORPORATED
(Exact name of registrant as specified in its charter)
 
         
New York
(State of
incorporation)
  3829, 3629
(Primary Standard Industrial
Classification Code No.)
  14-1462255
(I.R.S. Employer
Identification No.)
 
 
431 New Karner Road
Albany, New York 12205
(518) 533-2200
(Address, including zip code and telephone number, including area code of registrant’s principal executive offices)
 
Cynthia A. Scheuer
Vice President, Chief Financial Officer & Secretary
431 New Karner Road
Albany, New York 12205
(518) 533-2200
(Address, including zip code and telephone number, including area code of registrant’s principal executive offices)
 
with copies to:
     
Brett Cooper, Esq.
Stuart R. Goldfarb, Esq.
Orrick, Herrington & Sutcliffe LLP
666 Fifth Avenue
New York, NY 10103-0001
(212) 506-5000
  Robert S. Kant, Esq.
Scott K. Weiss, Esq.
Greenberg Traurig, LLP
2375 E. Camelback Road
Phoenix, AZ 85016
(602) 445-8000
 
Approximate date of commencement of proposed sale to the public:  As soon as practicable after this registration statement becomes effective.
 
If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box:  o
 
If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  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. (Check one):
 
Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company þ
(Do not check if a smaller reporting company)  
 
CALCULATION OF REGISTRATION FEE
 
             
      Maximum
     
      Aggregate
     
Title of Each Class of
    Offering Price
    Registration
Securities to be Registered     (1)(2)     Fee
Units, each consisting of convertible senior notes and warrants to purchase common stock
    $13,800,000     $542
Warrants included as part of the units
    (3)     (3)
Total Registration Fee
    $13,800,000     542 (4)
             
 
 
(1) Includes the offering price of the units (consisting of convertible senior notes and warrants) that the underwriters have the option to purchase to cover over-allotments, if any.
 
(2) Estimated solely for the purpose of calculating the amount of the registration fee, pursuant to Rule 457(o) under the Securities act of 1933, as amended.
 
(3) Pursuant to Rule 457(g), no separate registration fee is required for the warrants because we are registering those securities in the same registration statement as the units.
 
(4) A filing fee of $1,179 was previously paid.
 
The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.
 


 

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.
 
Subject to Completion, Dated July 3, 2008
 
$12,000,000     % Convertible Senior Notes due      
and
Warrants to Purchase           Shares of Common Stock
 
(MTI LOGO)
 
Interest payable           15 and           15
Issue price: 100%
 
We are offering $12,000,000 principal amount of our     % convertible senior notes due           and warrants to purchase           shares of our common stock in “units.” For each unit purchased in the offering, investors will receive $1,000 principal amount of notes and warrants to purchase           shares of our common stock at an exercise price of $      per share. Upon the closing of the offering, the units will separate and the notes and warrants will be issued separately.
 
The notes will bear interest at a rate of     % per year. Interest will be payable semiannually in arrears on      15 and      15 of each year, beginning      15, 2009. The notes will mature on          .
 
Beginning     , 2008, holders may convert their notes into shares of our common stock based on a conversion rate of           shares of our common stock per $1,000 principal amount of notes, equivalent to a conversion price of approximately $      per share, subject to adjustment, at their option at any time prior to the close of business on the third scheduled trading day immediately preceding the maturity date.
 
We may not redeem any of the notes at our option prior to maturity.
 
For a more detailed description of the notes, see “Description of Notes” beginning on page 77.
 
The notes will not be listed on any securities exchange. Currently, there is no public market for the notes.
 
The warrants may be exercised at any time during the period commencing on the closing date of this offering and ending on the fifth anniversary of the closing date.
 
Our common stock is listed on The Nasdaq Global Market under the symbol “MKTY”. On July 2, 2008, the last reported sale price of our common stock on The Nasdaq Global Market was $1.60 per share.
 
 
 
 
Investing in our securities involves risks.
See “Risk Factors” beginning on page 8 of this prospectus.
 
 
 
 
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.
 
                 
    Per Unit   Total
 
Public offering price
    100 %   $    
Underwriting discounts and commissions
      %   $    
Proceeds to us (before expenses)
      %   $  
 
The public offering price set forth above does not include accrued interest, if any. Interest on the notes will accrue from the date of original issuance, expected to be          , 2008. We have granted the underwriter a 30-day option to purchase up to an additional 1,800 units (consisting of $1,800,000 principal amount of notes and           warrants) to cover over-allotments.
 
The underwriter expects to deliver the notes and warrants to purchasers on or about          , 2008.
 
Merriman Curhan Ford & Co.
 
The date of this prospectus is          , 2008


 

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You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information that is different. We are offering to sell, and seeking offers to buy, units only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of units. It is important for you to read and consider all information contained in this prospectus in making your investment decision. You should also read and consider the information in the documents we have referred you to in “Where You Can Find Additional Information” below.
 
 
TABLE OF CONTENTS
 
     
    Page
 
Prospectus Summary
  1
Risk Factors
  8
Special Note Regarding Forward-Looking Statements
  26
Use of Proceeds
  28
Price Range of Our Common Stock
  29
Dividend Policy
  29
Capitalization
  30
Ratio of Earnings to Fixed Charges
  32
Selected Consolidated Financial Data
  33
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  34
Business
  50
Management
  62
Certain Relationships and Related Transactions
  76
Description of Notes
  77
Description of Warrants
  93
Description of Our Capital Stock
  94
Principal Stockholders
  96
Material U.S. Federal Income Tax Considerations
  97
Underwriting
  105
Legal Matters
  108
Experts
  108
Where You Can Find Additional Information
  108
Index to Consolidated Financial Statements
  F-1
 
 
Unless the context requires otherwise, in this prospectus the terms “we,” “us,” and “our” refer to Mechanical Technology, Incorporated, a New York corporation, “MTI Micro” refers to MTI MicroFuel Cells Inc., a Delaware corporation and our majority owned subsidiary, and “MTI Instruments” refers to MTI Instruments, Inc., a New York corporation and our wholly owned subsidiary. We have a registered trademark in the United States for “Mobion”. Other trademarks, trade names, and service marks used in this prospectus are the property of their respective owners.


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PROSPECTUS SUMMARY
 
This summary provides an overview of selected information contained elsewhere in this prospectus and does not contain all of the information you should consider in making an investment decision. You should read carefully the entire prospectus, including the section entitled “Risk Factors,” beginning on page 8 and our financial statements and the related notes included elsewhere in this prospectus, before making an investment decision.
 
Our Company
 
We are developing and commercializing off-the-grid rechargeable portable power source products that generate electrical power, using up to 100% methanol as fuel, for consumer electronic devices. Our portable power source products, utilizing our patented, proprietary direct methanol fuel cell technology platform called Mobion, offer a compelling alternative to lithium-ion and similar rechargeable battery systems currently used by original equipment manufacturers, or OEMs, in many handheld electronic devices, such as mobile phones, digital cameras, and portable media players. We believe our rechargeable portable power source products will offer substantial advantages, such as smaller size, lower weight, longer power life, higher reliability, and greater convenience of use, without the environmental concerns of lithium-ion batteries. Our portable power solution can be implemented as three different product options: a compact external charging device, a snap-on or attached power accessory, or an embedded fuel cell power solution. We have strategic arrangements with Samsung Electronics, with Duracell, part of the Procter & Gamble Company, and with a global Japanese consumer electronics company. We intend to commercialize our first Mobion products in 2009. According to Frost and Sullivan, the global rechargeable battery market for portable electronic devices exceeds $5 billion.
 
We also design, manufacture, and sell high-performance test and measurement instruments and systems serving primarily the general dimensional gauging, semiconductor, and aviation industries. These products consist of electronic, computerized gauging instruments for position, displacement and vibration applications for the design, manufacturing and test markets; semiconductor products for wafer characterization; and engine balancing and vibration analysis systems for military and commercial aircraft.
 
Our Markets and Opportunities
 
Consumers demand portable electronics that offer an enhanced experience through expanded memory, improved display technologies, constant connectivity, robust software, and a reduced form factor. In addition, technological advances in semiconductor manufacturing, LED displays, memory costs and availability, wireless technologies, and software applications have resulted in a dramatic increase in the number of portable electronic devices, their usage, and power requirements. As a result of these consumer demands and technological advances, there are a number of handheld electronic devices that have been introduced into the market. This trend towards increased functionality in portable electronic devices has led to a “power gap,” which is the disparity between a device’s power supply, typically a rechargeable lithium-ion battery, and its power need. This power gap leads to a need for the end user to plug-in their devices to the electrical grid on a regular basis, which limits their ability to use these electronic devices where and when the need arises.
 
Improvements in rechargeable battery technology have not kept pace with the evolution of consumer electronic device performance. Over the last ten years, device performance as measured by silicon processor speed has increased by a factor of 128 times, while the energy density of lithium-ion technology has only doubled. In addition to their performance shortfalls, lithium-ion battery technology poses an environmental risk as the various heavy metals incorporated in these batteries require special disposal to prevent contamination of waste disposal sites.
 
OEMs are actively seeking improved power sources to replace existing rechargeable lithium-ion batteries and to power additional improvements to their mobile electronic devices.


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Our Solution and Strategies
 
At the core of our solution is our proprietary Mobion Chip engine, a design architecture that embodies a reduction in the size, complexity, and cost of fuel cell construction, which results in a reliable, manufacturable, and affordable power solution that we believe provides improved energy density and portability over competing rechargeable battery technologies. Our proprietary fuel cell power solution consists of two primary components integrated in an easily manufactured device: the direct methanol fuel cell power engine, which we refer to as our Mobion Chip, and the methanol replacement cartridge. Our current Mobion Chip weighs less than one ounce and is small enough to fit in the palm of one’s hand. For these reasons, we believe that our Mobion platform is ideally suited to provide a replacement for rechargeable lithium-ion batteries. Based upon our ability to provide a compact, efficient, clean, safe, and long-lasting power source for lower power applications, we intend to initially target power solutions for handheld consumer electronic applications. Our goal is to become a leading provider of portable power for handheld electronic devices. Key elements of our strategy designed to achieve this objective include the following:
 
Business Focus. We are focusing our efforts on the development and commercialization of our portable power source products. We believe this business provides a higher potential, higher growth opportunity than our test and measurement instrumentation business.
 
Design for Mass Manufacturing. Our portable power source products will be manufactured using standard processes, such as injection molding and automated test and assembly, which are broadly employed throughout the electronics manufacturing industry. In preparing Mobion for commercialization, our current Mobion Chip is injection molded and is being designed for mass manufacturing.
 
Outsource Manufacturing. We plan to outsource manufacturing to expand rapidly and diversify our production capacity. This strategy will allow us to maintain a variable cost model in which we do not incur most of our manufacturing costs until our proprietary fuel cell power solution has been shipped and billed to our customers.
 
Utilize our Technology to Provide Compelling Products. We plan to utilize our intellectual property portfolio and technological expertise to develop and offer portable power source products across multiple electronic device markets. We intend to employ our technological expertise to reduce the overall size and weight of our portable power source products while increasing their ease of manufacturing, power capacity, and power duration, and decreasing their cost.
 
Capitalize on Growth Markets. We intend to capitalize on the growth of the electronic device markets, including new products that may be brought about by the convergence of computing, communications, and entertainment devices. We believe our portable power source products will address the growing need for portability, connectivity, and functionality in the evolving electronic device markets. We plan to offer these power solutions to OEM customers to enable them to offer products that have advantages in terms of size, weight, power duration, and environmental friendliness.
 
Develop Strong Customer Relationships. We plan to develop strong and long-lasting customer relationships with leading electronic device OEMs and to provide them with power solutions for their products. We believe that our portable power source products will enable our OEM customers to deliver an enhanced user experience and to differentiate their products from those of their competitors. We will attempt to enhance the competitive position of our customers by providing them with innovative, distinctive, and high-quality portable power supply products on a timely and cost-effective basis.


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Our Competitive Strengths
 
We believe that our portable power source products will offer the following advantages:
 
•   Off-the-grid power source. Our products provide users of consumer electronic devices with extended mobility by providing power without having to attach to a wall outlet to recharge their devices.
 
•   Small size and low weight. The dimensions of our products will enable our OEM customers to reduce the overall size and weight of their products.
 
•   Power density. Our products will have power density of over 50 mW/cm2 and high energy efficiencies of 1.4 Wh/cc of methanol.
 
•   Power duration. Our products will offer longer run time than currently available portable charging systems.
 
•   Ease of manufacturing. Our products will be manufactured using traditional injection molding techniques that will easily transfer to mass manufacturing production lines.
 
•   Safety. Our products will utilize methanol fuel, which does not require storage under pressure or at low temperatures.
 
•   Environmentally friendly. Our products will utilize fully biodegradable methanol fuel.
 
Corporate Information
 
We were incorporated in New York in 1961. We operate two businesses: our new energy business that is conducted through MTI Micro, a majority owned subsidiary, and our test and measurement instrument business that is conducted through MTI Instruments, a wholly owned subsidiary. We maintain our principal executive offices at 431 New Karner Road, Albany, New York 12205, and our telephone number is (518) 533-2200. Our website is located at www.mechtech.com. The information contained in, or that can be accessed through, our website does not constitute part of this prospectus.


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The Offering
 
The following summary contains basic information about the notes and the warrants and is not intended to be complete. It does not contain all the information that is important to you. For a more complete understanding of the notes and the warrants, you should read the sections of this prospectus entitled “Description of Notes” and “Description of Warrants.”
 
Securities Offered $12,000,000 (or $13,800,000 if the underwriter exercises its over-allotment option in full) principal amount of     % convertible senior notes and warrants to purchase           shares of common stock in units. Each unit will consist of $1,000 principal amount of notes and warrants to purchase     shares of common stock.
 
          % Convertible Senior Notes $12,000,000 aggregate principal amount of     % convertible senior notes due     .
 
     Warrants Warrants to purchase     shares of common stock. The warrants will be exercisable on or after the closing date of this offering through and including the fifth anniversary of the closing date and will be exercisable at a price of $        per share of common stock.
 
     Over-allotment Option 1,800 units (consisting of $1,800,000 principal amount of notes and      warrants).
 
Terms of Notes
 
     Maturity           .
 
     Interest      %. Interest on the notes will accrue from          , 2008. Interest will be payable semiannually in arrears on      15 and      15 of each year, beginning      15, 2009.
 
     Conversion Rights Prior to     , 2008, the notes will not be convertible. On or after     , 2008, holders may convert their notes into shares of our common stock at the applicable conversion rate, in integral multiples of $1,000 principal amount, at their option, at any time prior to the close of business on the third scheduled trading day immediately preceding the maturity date.
 
      The initial conversion rate for the notes is          shares per $1,000 principal amount of notes (equivalent to a conversion price of approximately $     per share), subject to adjustment.
 
      Upon conversion, we will deliver shares of our common stock and cash in lieu of any fractional share of our common stock, based on the conversion rate then in effect. See “Description of Notes — Conversion Rights — General.”
 
      Holders will not receive any additional cash payment or additional shares representing accrued and unpaid interest and additional interest, if any, upon conversion of a note, except in limited circumstances. Instead, interest will be deemed paid by the shares of common stock issued to holders upon conversion.


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     Redemption of Notes We may not redeem any of the notes at our option prior to maturity.
 
     Covenants Neither we nor any of our subsidiaries are subject to any financial covenants under the indenture. In addition, neither we nor any of our subsidiaries are restricted under the indenture from paying dividends, incurring debt, or issuing or repurchasing our securities.
 
     Sinking Fund None.
 
     Events of Default If there is an event of default under the notes, the principal amount of the notes, plus accrued and unpaid interest, including additional interest, if any, may be declared immediately due and payable. These amounts automatically become due and payable if an event of default relating to certain events of bankruptcy, insolvency, or reorganization occurs. See “Description of Notes — Events of Default.”
 
     Ranking The notes will be our senior unsecured obligations and will rank equal in right of payment with all of our existing and future unsecured senior indebtedness and senior in right of payment to all our future subordinated indebtedness, if any. The indenture does not limit the amount of indebtedness that we or our subsidiaries may incur. The notes will effectively be subordinated to any secured indebtedness we may incur to the extent of the value of the assets securing such indebtedness. The notes will not be guaranteed by any of our subsidiaries and accordingly will be structurally subordinated to all liabilities of our subsidiaries. As of March 31, 2008, we had no outstanding indebtedness. See “Description of Notes — Ranking.”
 
     Use of Proceeds We estimate that the net proceeds from this offering will be approximately $11.1 million (or $12.8 million if the underwriter exercises its over-allotment option in full), after deducting the underwriter’s discount and commissions and estimated offering expenses. We expect to use the net proceeds from this offering for research, design, tooling and capital expenditures to support the commercialization of our Mobion portable power source products, and working capital needs and general corporate purposes.
 
     Nasdaq Global Market Symbol Our common stock is listed on The Nasdaq Global Market under the symbol “MKTY.”
 
     No Prior Market The notes and warrants are new securities, and there is currently no established market for the notes or warrants. Accordingly, we cannot assure you as to the development or liquidity of any market for the notes or warrants. The underwriter has advised us that it currently does not intend to make a market in the notes or warrants.
 
     Book-entry Form The notes will be issued in book-entry form and will be represented by permanent global


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certificates deposited with, or on behalf of, The Depository Trust Company, or DTC, and registered in the name of Cede & Co., as nominee of DTC. Beneficial interests in the notes will be shown on, and transfers will be effected only through, records maintained by DTC or its nominee, and any such interest may not be exchanged for certificated securities, except in limited circumstances. See “Description of the Notes — Book-entry, Settlement, and Clearance.”
 
      The warrants will be certificated.
 
     Risk Factors Investment in the units involves risk. You should carefully consider the information under “Risk Factors” and all other information included in this prospectus before investing in the units.


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Summary Consolidated Financial Data
 
The following table sets forth our summary consolidated financial data for the fiscal years ended December 31, 2005, 2006 and 2007, which was derived from our audited consolidated financial statements included elsewhere in this prospectus. The summary consolidated balance sheet data as of March 31, 2008 and the summary consolidated statements of operations data for each of the three months ended March 31, 2007 and 2008 have been derived from the unaudited consolidated financials that are included elsewhere in this prospectus. You should read the following summary consolidated financial data together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements (including the related notes thereto).
 
                                                 
    Years Ended December 31,     Three Months Ended March 31,        
    2005     2006     2007     2007     2008        
 
                                                 
Statement of Operations Data (in thousands except share and per share data):
                                               
Product revenue
    $6,012       $7,667       $9,028       $1,701       $1,980          
Gross profit on product revenue
    3,631       4,767       5,598       963       1,140          
Funded research and development revenue
    1,829       489       1,556       615       173          
Research and product development expenses
    9,671       12,921       11,765       3,622       2,373          
Operating loss
    (15,098 )     (17,737 )     (13,349 )     (4,500 )     (3,678 )        
Net loss
    $(15,094 )     $(13,667 )     $(9,575 )     $(3,156 )     $(3,187 )        
                                                 
Net loss per share (basic and diluted)
    $(3.93 )     $(3.46 )     $(2.01 )     $(0.66 )     $(0.67 )        
                                                 
Weighted average common shares outstanding (basic and diluted)
    3,842,201       3,952,793       4,763,547       4,754,868       4,771,861          
                                                 
 
                 
    March 31, 2008  
    Actual     As Adjusted (1)  
 
Balance Sheet Data (in thousands):
               
Cash and cash equivalents
  $ 4,560     $ 15,655  
Securities available for sale (2)
    3,537       3,537  
Working capital
    7,634       18,729  
Total assets
    14,812       25,907  
Current liabilities
    4,170       4,170  
Long-term debt
          12,000  
Other long-term liabilities
    572       572  
Total stockholders’ equity (3)
    10,045       10,045  
 
 
(1) The as adjusted column reflects the net proceeds of $11.1 million expected to be received by us from the sale of the units offered hereby (assuming the underwriter’s over-allotment option is not exercised) and the application of the net proceeds therefrom as described in “Use of Proceeds.”
 
(2) Represents shares of Plug Power Inc., or Plug Power, a Nasdaq-listed company, held for sale by us, classified as current assets, and such amount reflects the fair value of these shares. Through the sale of Plug Power shares, we generated proceeds of $6.2 million during 2006 and $5.1 million during 2007 that we have used to fund the development and commercialization of our portable power source business.
 
(3) Our ownership percentage of MTI Micro will increase as a result of this offering since proceeds from the offering will be used to make further investments in MTI Micro. Over the last three years, we have increased our ownership in MTI Micro from 89% in 2004 to 96% in 2008.


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RISK FACTORS
 
Investing in our securities involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our securities. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties of which we are unaware, or that we currently deem immaterial, also may become important factors that affect us. If any of the following risks occur, our business, financial condition, or results of operations could be materially and adversely affected. In that case, the trading price of our common stock could decline, and you may lose some or all of your investment.
 
Risks Related to Our Business and Industry
 
We have incurred recurring net losses and anticipate continued net losses as we execute our commercialization plan for our portable power source business.
 
We have incurred recurring net losses, including net losses of $15.1 million in 2005, $13.7 million in 2006, $9.6 million in 2007, and $3.2 million during the three months ended March 31, 2008, which includes a net gain of $2.5 million from the sale of securities available for sale and a net gain of $3.0 million on derivatives in 2007 and a net gain of $333,000 on derivatives during the first three months of 2008. As a result of ongoing operating losses, we had an accumulated deficit of approximately $108.3 million as of March 31, 2008. We expect to continue to make significant expenditures and incur substantial expenses as we develop and commercialize our proposed portable power source products; develop our manufacturing, sales, and distribution networks; implement internal systems and infrastructure; and hire additional personnel. As a result, we expect to continue to incur continued significant losses as we execute our plan to commercialize our portable power source business and may never achieve or maintain profitability. We will be unable to satisfy our current obligations solely from cash generated from operations or become profitable until we successfully commercialize our portable power source business. If we continue to incur substantial losses and are unable to secure additional sources of funding, we could be forced to discontinue or curtail our business operations; sell assets at unfavorable prices; or merge, consolidate, or combine with a company with greater financial resources in a transaction that may be unfavorable to us.
 
We have received a going concern report from our independent auditors.
 
Our auditors have included an explanatory paragraph in their opinion that accompanies our audited consolidated financial statements as of December 31, 2007, indicating that our recurring losses from operations, net capital deficiency, and current liquidity position raise substantial doubt about our ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
We currently derive all of our product revenue from our test and measurement instrumentation business, but our principal focus is the development and commercialization of our portable power source business.
 
We currently derive all of our product revenue from our test and measurement instrumentation business, but our principal focus is the development and commercialization of our portable power source business. Our test and measurement instrumentation business is subject to a number of risks, including the following:
 
  •   a slow down or cancellation of sales to the military as a result of a potential redeployment of governmental funding;
 
  •   a failure to expand or maintain the business as a result of competition, a lack of brand awareness, or market saturation; and


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  •   an inability to launch new products as a result of intensive competition, uncertainty of new technology development, and developmental timelines.
 
In addition, our test and measurement instrumentation products can be sold in quantity to a relatively few number of customers, resulting in a customer concentration risk. The loss of any significant portion of such customers or a material adverse change in the financial condition of any one of these customers could have a material adverse effect on our business.
 
We have not generated any product revenue from our portable power source business and currently have no portable power source commercial products.
 
We have not generated any product revenue from our portable power source business and currently have no portable power source commercial products. The successful development and commercialization of our portable power source products will depend on a number of factors, including the following:
 
  •   continuing our research and development efforts;
 
  •   finalizing the design of our portable power source products;
 
  •   securing OEM customers to incorporate our portable power source products into products sold by them;
 
  •   arranging for adequate manufacturing capabilities; and
 
  •   completing, refining, and managing our supply chain and distribution channels.
 
Additionally, our technology is new and complex, and there may be technical barriers to the development of our portable power source products. The development of our portable power source products may not succeed or may be significantly delayed. Our portable power source products will be produced through manufacturing arrangements that have not been finalized or tested on a commercial scale. If we fail to successfully develop or experience significant delays in the development of our portable power source products, or if there are significant delays in commercialization, we are unlikely to recover those losses, thus making it impossible for us to become profitable through the sales of these products. This would materially and adversely affect our business and financial condition. If adequate funds are not available, we may have to delay development or commercialization of our portable power source products or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize. Any of these factors could harm our business and financial condition.
 
Any revenue derived in the relatively near-term relating to our portable power source business likely will result from governmental contracts or other governmental funding. We can offer no assurance that we will be able to secure continued government funding. The loss of such contracts or the inability to obtain additional contracts could materially harm our business.
 
Although we believe the net proceeds of this offering will assist us in achieving certain milestones in commercializing our portable power source products, we will require additional funds to complete product commercialization and we have no commitments for additional financing.
 
Although we believe the net proceeds of this offering will assist us in achieving certain milestones in commercializing our portable power source business, we will require additional funds to complete the commercialization of our portable power source products. We have no commitments for any additional financing. If we are unable to secure any necessary additional financing or to raise funds from the sale of our test and measurement instrumentation business should we determine to do so, we may need to delay further commercialization plans. In order to conserve cash and extend operations while we pursue any additional necessary financing, we would be required to reduce operating expenses. There is no assurance that funds raised in any such financing will be sufficient,


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that the financing will be available on terms favorable to us or to existing stockholders and at such times as required, or that we will be able to obtain the additional financing required for the continued operation and growth of our business. If we raise additional funds by issuing equity securities, our stockholders will experience dilution. Debt financing, if available, may involve restrictive covenants. Any debt financing or additional equity financing may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or grant licenses on terms that are not favorable to us. If we are unable to raise adequate funds, we may have to liquidate some or all of our assets or delay, reduce the scope of or eliminate some or all of our research and development programs.
 
A primary asset of our company is the Plug Power common stock we own. As of March 31, 2008, we owned 1,137,166 shares of Plug Power common stock. Plug Power common stock is traded on The Nasdaq Global Market. The market price of our Plug Power common stock may fluctuate as a result of market conditions and other factors over which we have no control. Fluctuations in the market price of Plug Power’s common stock may result in a reduction of resources available to fund operations, which could result in our requiring additional funding sooner than anticipated.
 
If current airline and certain international regulations do not change, passengers will be unable to carry methanol in the passenger compartments of airplanes, which would adversely affect our sales and results of operations.
 
Current airline and certain international laws, regulations, and treaties limit the amount and concentration of methanol that any passenger can carry onboard passenger planes. We believe that these regulations must change for mass commercialization of Mobion technology products to be possible. There are several major markets, most notably within the European Union, that have not adopted the global regulations adopted by the International Civil Aviation Organization. If these regulations are not implemented, it would materially and adversely affect our ability to achieve mass commercialization of Mobion technology products and have a material adverse effect on our business plans, prospects, results of operations, and financial condition.
 
Our portable power source products may not be accepted by the market.
 
Any portable power source products that we develop may not achieve market acceptance. The development of a successful market for our proposed portable power source products and our ability to sell those products at favorable prices may be adversely affected by a number of factors, many of which are beyond our control, including the following:
 
  •   our failure to produce portable power source products that compete favorably against other products on the basis of price, quality, performance, and life;
 
  •   competition from conventional lithium-ion or other rechargeable battery systems;
 
  •   the ability of our technologies and product solutions to address the needs of the electronic device markets, the requirements of OEMs, and the preferences of end users;
 
  •   our ability to provide OEMs with portable power source products that provide advantages in terms of size, weight, peak power, power duration, reliability, durability, performance, and value-added features compared to alternative solutions; and
 
  •   our failure to develop and maintain successful relationships with OEMs, manufacturers, distributors, and others as well as strategic partners.
 
Target markets for our proposed portable power source products, such as those for mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, personal digital assistants, or PDAs, and global positioning systems, or GPS devices, are volatile, cyclical, and rapidly changing and could continue to utilize existing technology or adopt


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other new competing technologies. The market for certain of these products depends in part upon the development and deployment of wireless and other technologies, which may or may not address the needs of users of these new products.
 
Many manufacturers of portable electronic devices have well-established relationships with competitive suppliers. Penetrating these markets will require us to offer better performance alternatives to existing solutions at competitive costs. The failure of any of our target markets to continue to expand, or our failure to penetrate these markets to a significant extent, will impede our sales growth. We cannot predict the growth rate of these markets or the market share we will achieve in these markets in the future.
 
If our proposed portable power source products fail to gain market acceptance, it could materially and adversely affect our business and financial condition.
 
Market acceptance of our customers’ products that utilize our portable power source products may decline or may not develop and, as a result, our sales will be harmed.
 
We currently do not anticipate selling our portable power source products directly to end users. Instead, we plan to produce portable power source products that our OEM customers incorporate into their products. As a result, the success of our proposed portable power source products will depend upon the widespread market acceptance of the products of our OEM customers. We will not control or influence the manufacture, promotion, distribution, or pricing of the products that incorporate our portable power source products. Instead, we will depend on our OEM customers to manufacture and distribute products incorporating our portable power source products and to generate consumer demand through their marketing and promotional activities. Even if our technologies and products successfully meet our customers’ price and performance goals, our sales would be harmed if our OEM customers do not achieve commercial success in selling their products to consumers that incorporate our portable power source products.
 
Any lack of adoption in the use of our portable power source products by OEM customers in the electronic device markets, the reduced demand for our OEM customers’ products, or a slowdown in their markets would adversely affect our sales.
 
If we fail to build and maintain relationships with our customers and do not satisfy our customers, we may lose future sales and our revenue may stagnate or decline.
 
Because our success depends on the widespread market acceptance of our customers’ products, we must develop and maintain our relationships with leading global OEMs of electronic devices, such as mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, PDAs, and GPS devices. In addition, we must identify areas of significant growth potential in other markets, establish relationships with OEMs in those markets, and assist them in developing products that use our portable power source products and technologies. Our failure to identify potential growth opportunities, particularly in new markets, or establish and maintain relationships with OEMs in those markets, would prevent our business from growing in those markets.
 
Our ability to meet the expectations of our customers will require us to provide portable power source products for customers on a timely and cost-effective basis and to maintain customer satisfaction with our product solutions. We must match our design and production capacity with customer demand, maintain satisfactory delivery schedules, and meet specific performance goals. If we are unable to achieve these goals for any reason, our customers could reduce their purchases from us and our sales would decline or fail to develop.


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Our customer relationships also can be affected by factors affecting our customers that are unrelated to our performance. These factors can include a myriad of situations, including business reversals of customers, determinations by customers to change their product mix or abandon business segments, or mergers, consolidations, or acquisitions involving our customers.
 
We have no experience manufacturing portable power source products on a commercial scale.
 
To date, we have focused primarily on research, development, and pilot production, and we have no experience manufacturing any portable power source products on a commercial scale. Our pilot production efforts to date have been limited in scale. It is our intent to manufacture our portable power source products through OEM customers and third-party manufacturers. Failure to secure manufacturing capabilities could materially and adversely affect our business and financial condition.
 
We will rely on others for our production, and any interruptions of these arrangements could disrupt our ability to fill our customers’ orders.
 
We plan to rely on others for all of our production requirements for our portable power source products. The majority of this manufacturing is anticipated to be conducted in Asia by manufacturing subcontractors that also perform services for numerous other companies. We do not expect to have a guaranteed level of production capacity with any of our manufacturing subcontractors. Qualifying new manufacturing subcontractors is time consuming and might result in unforeseen manufacturing and operating problems. The loss of any relationships with our manufacturing subcontractors or assemblers or their inability to conduct their manufacturing and assembly services for us as anticipated in terms of cost, quality, and timeliness could adversely affect our ability to fill customer orders in accordance with required delivery, quality, and performance requirements. If this were to occur, the resulting decline in revenue would harm our business.
 
We will depend on third parties to maintain satisfactory manufacturing yields and delivery schedules, and their inability to do so could increase our costs, disrupt our supply chain, and result in our inability to deliver our portable power source products, which would adversely affect our results of operations.
 
We will depend on our manufacturing subcontractors to maintain high levels of productivity and satisfactory delivery schedules for our portable power source products from manufacturing and assembly facilities likely located primarily in Asia. We plan to provide our manufacturing subcontractors with rolling forecasts of our production requirements. We do not, however, anticipate having long-term agreements with any of our manufacturing subcontractors that guarantee production capacity, prices, lead times, or delivery schedules. Our manufacturing subcontractors will serve other customers, many of which will have greater production requirements than we do. As a result, our manufacturing subcontractors could determine to prioritize production capacity for other customers or reduce or eliminate deliveries to us on short notice. We may experience lower than anticipated manufacturing yields and lengthening of delivery schedules. Lower than expected manufacturing yields could increase our costs or disrupt our supply chain. We may encounter lower manufacturing yields and longer delivery schedules while commencing volume production of any new products. Any of these problems could result in our inability to deliver our product solutions in a timely manner and adversely affect our operating results.
 
We plan to rely on third-party suppliers for most of our manufacturing equipment.
 
We plan to rely on third-party suppliers for most of the manufacturing equipment necessary to produce our portable power source products. The failure of suppliers to supply manufacturing equipment in a timely manner or on commercially reasonable terms could delay our commercialization plans and otherwise disrupt our production schedules or increase our manufacturing costs. Further, our orders with certain of our suppliers may represent a very small portion of their total orders. As a result, they may not give priority to our business, leading to


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potential delays in or cancellation of our orders. If any single-source supplier were to fail to supply our needs on a timely basis or cease providing us with key components, we would be required to substitute suppliers. We may have difficulty identifying a substitute supplier in a timely manner and on commercially reasonable terms. If this were to occur, our business would be harmed.
 
Shortages of components and raw materials may delay or reduce our sales and increase our costs, thereby harming our results of operations.
 
The inability to obtain sufficient quantities of components and other materials, including platinum and ruthenium, necessary for the production of our portable power source products could result in reduced or delayed sales or lost orders. Any delay in or loss of sales could adversely impact our operating results. Many of the materials used in the production of our portable power source products will be available only from a limited number of foreign suppliers, particularly component suppliers located in Asia. In most cases, neither we nor our manufacturing subcontractors will have long-term supply contracts with these suppliers. As a result, we will be subject to economic instability in these Asian countries as well as to increased costs, supply interruptions, and difficulties in obtaining materials. Our customers also may encounter difficulties or increased costs in obtaining the materials necessary to produce their products into which our product solutions are incorporated.
 
From time to time, materials and components necessary for our portable power source products or in other aspects of our customers’ products may be subject to allocation because of shortages of these materials and components. Shortages in the future could cause delayed shipments, customer dissatisfaction, and lower revenue.
 
We will be subject to lengthy development periods and product acceptance cycles, which can result in development and engineering costs without any future revenue.
 
We plan to provide portable power source solutions that are incorporated by OEMs into the products they sell. OEMs will make the determination during their product development programs whether to incorporate our portable power source solutions or pursue other alternatives. This process may require us to make significant investments of time and resources in the design of portable customer-specific power source solutions well before our customers introduce their products incorporating our product solutions and before we can be sure that we will generate any significant sales to our customers or even recover our investment. During a customer’s entire product development process, we will face the risk that our portable power source products will fail to meet our customer’s technical, performance, or cost requirements or that our products will be replaced by competing products or alternative technological solutions. Even if we complete our design process in a manner satisfactory to our customer, the customer may decide to delay or terminate its product development efforts. The occurrence of any of these events could cause sales to not materialize, to be deferred, or to be cancelled, which would adversely affect our operating results.
 
We will not have long-term purchase commitments from our customers, and their ability to cancel, reduce, or delay orders could reduce our revenue and increase our costs.
 
Customers for our portable power source products will not provide us with firm, long-term volume purchase commitments, but instead will issue purchase orders to buy a specified number of units. As a result, customers may be able to cancel purchase orders or reduce or delay orders at any time. The cancellation, delay, or reduction of customer purchase orders could result in reduced revenue, excess inventory, and unabsorbed overhead. We currently have no presence in the electronic device markets. Our success in the electronic device markets will require us to establish the value added proposition of our products to OEMs that have traditionally used other portable power solutions. All of the markets we plan to serve are subject to severe competitive pressures, rapid technological change and product obsolescence, which may increase our inventory and overhead risks, resulting in increased costs.


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Variability of customer requirements resulting in cancellations, reductions, or delays may adversely affect our operating results.
 
We will be required to provide rapid product turnaround and respond to short lead times. A variety of conditions, both specific to individual customers and generally affecting the demand for OEMs’ products, may cause customers to cancel, reduce, or delay orders. Cancellations, reductions, or delays by a significant customer or by a group of customers could adversely affect our operating results. Customers may require rapid increases in production, which could strain our resources and reduce our margins.
 
If we are unable to adequately protect our intellectual property, our competitors and other third parties could produce products based on our intellectual property, which would substantially impair our ability to compete.
 
Our success and ability to compete depends in part upon our ability to maintain the proprietary nature of our technologies. We rely on a combination of patent, trade secret, copyright, and trademark law and license agreements, as well as nondisclosure agreements, to protect our intellectual property. These legal means, however, afford only limited protection and may not be adequate to protect our intellectual property rights. We cannot be certain that we were the first creator of inventions covered by pending patent applications or the first to file patent applications on these inventions. In addition, we cannot be sure that any of our pending patent applications will issue. The United States Patent and Trademark Office, or other foreign patent and trademark offices may deny or significantly narrow claims made under our patent applications and, even if issued, these patents may be successfully challenged, designed around, or may otherwise not provide us with any commercial protection.
 
We may in the future need to assert claims of infringement against third parties to protect our intellectual property. Regardless of the final outcome, any litigation to enforce our intellectual property rights in patents, copyrights, or trademarks could be highly unpredictable and result in substantial costs and diversion of resources, which could have a material and adverse effect on our business and financial condition. In the event of an adverse judgment, a court could hold that some or all of our asserted intellectual property rights are not infringed, or are invalid or unenforceable, and could award attorneys’ fees to the other party.
 
We may become subject to claims of infringement or misappropriation of the intellectual property rights of others, which could prohibit us from selling our products, require us to obtain licenses from third parties or to develop non-infringing alternatives, and subject us to substantial monetary damages and injunctive relief.
 
We may receive notices from third parties that the manufacture, use, or sale of any products we develop infringes upon one or more claims of their patents. Moreover, because patent applications can take many years to issue, there may be currently pending applications, unknown to us, which may later result in issued patents that materially and adversely affect our business. Third parties could also assert infringement or misappropriation claims against us with respect to our future product offerings, if any. Whether or not such claims are valid, we cannot be certain that we have not infringed the intellectual property rights of such third parties. Any infringement or misappropriation claim could result in significant costs, substantial damages, and our inability to manufacture, market, or sell any of our product offerings that are found to infringe. Even if we were to prevail in any such action, the litigation could result in substantial cost and diversion of resources that could materially and adversely affect our business. If a court determined, or if we independently discovered, that our product offerings violated third-party proprietary rights, there can be no assurance that we would be able to re-engineer our product offerings to avoid those rights or obtain a license under those rights on commercially reasonable terms, if at all. As a result, we could be prohibited from selling products that are found to infringe upon the rights of others. Even if obtaining a license were feasible, it may be costly and time-consuming. A court could also enter


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orders that temporarily, preliminarily, or permanently enjoin us from making, using, selling, offering to sell, or importing our portable power source products, or could enter orders mandating that we undertake certain remedial activities. Further, a court could order us to pay compensatory damages for such infringement, plus prejudgment interest, and could in addition treble the compensatory damages and award attorneys’ fees. These damages could materially and adversely affect our business and financial condition.
 
Confidentiality agreements with employees and others may not adequately prevent disclosure of our trade secrets and other proprietary information, which could limit our ability to compete.
 
We rely on trade secrets to protect our proprietary technology and processes. Trade secrets are difficult to protect. We enter into confidentiality and intellectual property assignment agreements with our employees, consultants, and other advisors. These agreements generally require that the other party keep confidential and not disclose to third parties confidential information developed by the party or made known to the party by us during the course of the party’s relationship with us. However, these agreements may not be honored and enforcing a claim that a party illegally obtained and is using our trade secrets is difficult, expensive and time-consuming, and the outcome is unpredictable. The failure to obtain and maintain trade secret protection could adversely affect our competitive position.
 
Our efforts to develop new technologies may not result in commercial success, which could cause a decline in our revenue and could harm our business.
 
Our research and development efforts with respect to our technologies may not result in customer or market acceptance. Some or all of those technologies may not successfully make the transition from the research and development lab to cost-effective production as a result of technology problems, competitive cost issues, yield problems, and other factors. Even when we successfully complete a research and development effort with respect to a particular technology, our customers may decide not to introduce or may terminate products utilizing the technology for a variety of reasons, including the following:
 
  •   difficulties with other suppliers of components for the products;
 
  •   superior technologies developed by our competitors and unfavorable comparisons of our solutions with these technologies;
 
  •   price considerations; and
 
  •   lack of anticipated or actual market demand for the products.
 
The nature of our business will require us to make continuing investments for new technologies. Significant expenses relating to one or more new technologies that ultimately prove to be unsuccessful for any reason could have a material adverse effect on us. In addition, any investments or acquisitions made to enhance our technologies may prove to be unsuccessful. If our efforts are unsuccessful, our business could be harmed.
 
We may not be able to enhance our product solutions and develop new product solutions in a timely manner.
 
Our future operating results will depend to a significant extent on our ability to provide new portable power source products that compare favorably with alternative solutions on the basis of time to introduction, cost, performance, and end-user preferences. Our success in attracting customers and developing business will depends on various factors, including the following:
 
  •   innovative development of new portable power source products for customer products;
 
  •   utilization of advances in technology;


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  •   maintenance of quality standards;
 
  •   efficient and cost-effective solutions; and
 
  •   timely completion of the design and introduction of new portable power source products.
 
Our inability to commercialize our proposed portable power source solutions and develop new product solutions on a timely basis could harm our operating results and impede our growth.
 
If we do not keep pace with technological innovations, our products may not be competitive and our revenue and operating results may suffer.
 
Technological advances, the introduction of new products, and new design techniques could adversely affect our business prospects unless we are able to adapt to the changing conditions. Technological advances could render our proposed portable power source products obsolete, and we may not be able to respond effectively to the technological requirements of evolving markets. As a result, we will be required to expend substantial funds for and commit significant resources to
 
  •   continue research and development activities on portable power source products;
 
  •   hire additional engineering and other technical personnel; and
 
  •   purchase advanced design tools and test equipment.
 
Our business could be harmed if we are unable to develop and utilize new technologies that address the needs of our customers, or our competitors do so more effectively than we do.
 
New technology solutions that achieve significant market share could harm our business.
 
New portable power source solutions could be developed. Existing electronic devices also could be modified to allow for a different power source solution. Our business could be harmed if our products become noncompetitive as a result of a technological breakthrough that allows a new power source solution to displace our solution and achieve significant market acceptance.
 
Our inability to respond to changing technologies will harm our business.
 
The electronics industry is subject to constant technological change. Our future success will depend on our ability to respond appropriately to changing technologies and changes in product function and quality. If we rely on products and technologies that are not attractive to consumers, we may not be successful in capturing or retaining any significant market share. In addition, any new technologies utilized in our portable power source products may not perform as expected or as desired, in which event our adoption of such products or technologies may harm our business.
 
International sales and manufacturing risks could adversely affect our operating results.
 
We anticipate that the manufacturing and assembly operations for our portable power source products will be conducted primarily in Asia by manufacturing subcontractors. We also believe that many of our OEM customers will be located and much of our sales and distribution operations will be conducted in Asia. These international operations will expose us to various economic, political, and other risks that could adversely affect our operations and operating results, including the following:
 
  •   difficulties and costs of staffing and managing a multi-national organization;
 
  •   unexpected changes in regulatory requirements;
 
  •   differing labor regulations;
 
  •   potentially adverse tax consequences;
 
  •   tariffs and duties and other trade barrier restrictions;


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  •   possible employee turnover or labor unrest;
 
  •   greater difficulty in collecting accounts receivable;
 
  •   the burdens and costs of compliance with a variety of foreign laws;
 
  •   potentially reduced protection for intellectual property rights; and
 
  •   political or economic instability in certain parts of the world.
 
The risks associated with international operations could negatively affect our operating results.
 
Our business may suffer if international trade is hindered, disrupted, or economically disadvantaged.
 
Political and economic conditions abroad may adversely affect the foreign production and sale of our portable power source products. Protectionist trade legislation in either the United States or foreign countries, such as a change in the current tariff structures, export or import compliance laws, or other trade policies, could adversely affect our ability to sell our portable power source products in foreign markets and to obtain materials or equipment from foreign suppliers.
 
Changes in policies by the U.S. or foreign governments resulting in, among other things, higher taxation, currency conversion limitations, restrictions on the transfer of funds, or the expropriation of private enterprises also could have a material adverse effect on us. Any actions by countries in which we conduct business to reverse policies that encourage foreign investment or foreign trade also could adversely affect our operating results. In addition, U.S. trade policies, such as “most favored nation” status and trade preferences for certain Asian nations, could affect the attractiveness of our products to our U.S. customers and adversely impact our operating results.
 
Our operating results could be adversely affected by fluctuations in the value of the U.S. dollar against foreign currencies.
 
We plan to transact our portable power source business predominantly in U.S. dollars and bill and collect our sales in U.S. dollars. A weakening of the dollar could cause our overseas vendors to require renegotiation of either the prices or currency we pay for their goods and services. In the future, customers may negotiate pricing and make payments in non-U.S. currencies.
 
If our overseas vendors or customers require us to transact business in non-U.S. currencies, fluctuations in foreign currency exchange rates could affect our cost of goods, operating expenses, and operating margins and could result in exchange losses. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results.
 
We expect that a majority of our manufacturing subcontractors will be located in Asia, increasing the risk that a natural disaster, labor strike, war, or political unrest in those countries would disrupt our operations.
 
We expect that a majority of our manufacturing subcontractors will be located in Asia. Events out of our control, such as earthquakes, fires, floods, or other natural disasters, or political unrest, war, labor strikes, or work stoppages in Asia could disrupt their operations, which would impact our business. In addition, there is political tension between Taiwan and China that could lead to hostilities. If any of these events occur, we may not be able to obtain alternative manufacturing capacity. Failure to secure alternative manufacturing capacity could cause a delay in the shipment of our products, which would cause our revenue to fluctuate or decline.


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Continuing uncertainty of the U.S. economy may have serious implications for the growth and stability of our business and may negatively affect our stock price.
 
The revenue growth and profitability of our business will depend significantly on the overall demand for electronic devices. Softening demand in these markets caused by ongoing economic uncertainty may result in decreased revenue or earnings levels or growth rates. The U.S. economy has been historically cyclical, and market conditions continue to be challenging, which has resulted in individuals and companies delaying or reducing expenditures. Further delays or reductions in spending could have a material adverse effect on demand for our products, and consequently on our business, financial condition, results of operations, prospects, and stock price.
 
The electronics industry is cyclical and may result in fluctuations in our operating results.
 
The electronics industry has experienced significant economic downturns at various times. These downturns are characterized by diminished product demand, accelerated erosion of average selling prices, and production overcapacity. In addition, the electronics industry is cyclical in nature. We will seek to reduce our exposure to industry downturns and cyclicality by providing design and production services for leading companies in rapidly expanding industry segments. We may, however, experience substantial period-to-period fluctuations in future operating results because of general industry conditions or events occurring in the general economy.
 
Our strategic alliances may not achieve their objectives, and their failure to do so could impede our growth.
 
Our prospects depends to a significant extent on our strategic alliances with Samsung and Duracell. In addition, we plan to explore additional strategic alliances designed to enhance or complement our technology or to work in conjunction with our technology; to provide necessary know-how, components, or supplies; and to develop, introduce, and distribute products utilizing our technology. Any strategic alliances may not achieve their intended objectives, may be cancelled by either party, and parties to our strategic alliances may not perform as contemplated. The failure of our current alliances or our inability to form additional alliances may impede our ability to introduce new products and enter new markets.
 
Product liability claims against us could result in adverse publicity and potentially significant monetary damages.
 
As a seller of consumer products using a flammable material such as methanol, we will face an inherent risk of exposure to product liability claims in the event that injuries result from product usage by customers. It is possible that our products could result in injury, whether by product malfunctions, defects, improper installation, or other causes. If such injuries or claims of injuries were to occur, we could incur monetary damages and our business could be adversely affected by any resulting negative publicity. The successful assertion of product liability claims against us could result in potentially significant monetary damages and, if our insurance protection is inadequate to cover these claims, could require us to make significant payments from our own resources.
 
We expect to face intense competition that could result in failing to gain market share and suffering reduced revenue from our portable power source products.
 
We plan to serve intensely competitive markets that are characterized by price erosion, rapid technological change, and competition from major domestic and international companies. This intense competition could result in pricing pressures, lower sales, reduced margins, and lower market share. Most of our competitors have greater market recognition, larger customer bases, and substantially greater financial, technical, marketing, distribution, and other resources than we possess and that afford them competitive advantages. As a result, they may be able to devote greater resources to the promotion and sale of products, to negotiate lower prices for raw materials and


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components, to deliver competitive products at lower prices, and to introduce new product solutions and respond to customer requirements more quickly than we can. Our competitive position could suffer if one or more of our customers determine not to utilize our portable power source products and instead decide to contract with our competitors or to use alternative technologies.
 
Our ability to compete successfully will depend on a number of factors, both within and outside our control. These factors include the following:
 
  •   our success in designing and introducing new portable power source products;
 
  •   our ability to predict the evolving needs of our customers and to assist them in incorporating our technologies into their new products;
 
  •   our ability to meet our customer’s requirements for small size, low weight, peak power, long power duration, ease of use, reliability, durability, and small form factor;
 
  •   the quality of our customer services;
 
  •   the rate at which customers incorporate our products into their own products;
 
  •   product or technology introductions by our competitors; and
 
  •   foreign currency fluctuations, which may cause a foreign competitor’s products to be priced significantly lower than our products.
 
We depend on key personnel who would be difficult to replace, and our business will likely be harmed if we lose their services or cannot hire additional qualified personnel.
 
Our success will depend substantially on the efforts and abilities of our senior management and key personnel. The competition for qualified management and key personnel, especially engineers, is intense. Although we maintain non-competition and non-disclosure covenants with most of our key personnel, we do not have employment agreements with most of them. The loss of services of one or more of our key employees or the inability to hire, train, and retain key personnel, especially engineers and technical support personnel, and capable sales and customer-support employees outside the United States, could delay the development and sale of our products, disrupt our business, and interfere with our ability to execute our business plan.
 
Our operating results may experience significant fluctuations.
 
In addition to the variability resulting from the short-term nature of our customers’ commitments, other factors will contribute to significant periodic and seasonal quarterly fluctuations in our results of operations. These factors include the following:
 
  •   the cyclicality of the markets we serve;
 
  •   the timing and size of orders;
 
  •   the volume of orders relative to our capacity;
 
  •   product introductions and market acceptance of new products or new generations of products;
 
  •   evolution in the life cycles of our customers’ products;
 
  •   timing of expenses in anticipation of future orders;
 
  •   changes in product mix;
 
  •   availability of manufacturing and assembly services;
 
  •   changes in cost and availability of labor and components;
 
  •   timely delivery of product solutions to customers;


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  •   pricing and availability of competitive products;
 
  •   introduction of new technologies into the markets we serve;
 
  •   pressures on reducing selling prices;
 
  •   our success in serving new markets; and
 
  •   changes in economic conditions.
 
Accordingly, you should not rely on period-to-period comparisons as an indicator of our future performance. Negative or unanticipated fluctuations in our operating results may result in a decline in the price of our stock.
 
Risks Related to this Offering
 
We may incur substantially more debt or take other actions that may affect our ability to satisfy our obligations under the notes.
 
We will not be restricted under the terms of the notes or the indenture from incurring additional indebtedness, including secured debt. In addition, the limited covenants applicable to the notes do not require us to achieve or maintain any minimum financial results relating to our financial position or results of operations. Our ability to recapitalize, incur additional debt, and take a number of other actions that are not limited by the terms of the notes could have the effect of diminishing our ability to make payments on the notes when due, and could reduce the availability of cash flow to fund our operations, working capital, and capital expenditures. In addition, we are not restricted from repurchasing common stock by the terms of the notes. From time to time we and our subsidiaries may incur additional indebtedness, including secured indebtedness, which could adversely affect our ability to pay our obligations under the notes.
 
The notes are unsecured and, therefore, will be effectively subordinated to any secured debt we may incur.
 
The notes are not secured by any of our assets or those of our subsidiaries. Although we do not currently have any secured debt, the notes will be effectively subordinated to any secured debt we may incur in the future. In any liquidation, dissolution, bankruptcy or other similar proceeding, the holders of our secured debt may assert rights against the secured assets in order to receive full payment of their debt before the assets may be used to pay the holders of the notes. In such an event, we may not have sufficient assets remaining to pay amounts due on any or all of the notes.
 
The conversion rate of the notes may not be adjusted for all dilutive events.
 
The conversion rate of the notes will be subject to adjustment for certain events, including the issuance of stock dividends on our common stock; the issuance of certain rights or warrants; subdivisions; combinations; distributions of capital stock, indebtedness or assets; cash dividends; and certain issuer tender or exchange offers as described under “Description of Notes — Conversion Rights — Conversion Rate Adjustments.” However, the conversion rate will not be adjusted for other events, such as a third-party tender or exchange offer or an issuance of common stock for cash, that may adversely affect the trading price of the notes or the common stock. An event that adversely affects the value of the notes may occur, and that event may not result in an adjustment to the conversion rate.
 
If the market price of our common stock decreases, the market price of the notes may similarly decrease.
 
We expect that the market price of the notes will be significantly affected by the market price of our common stock. This may result in greater volatility in the market price of the notes than


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would be expected for debt securities. The market price of our common stock will likely continue to fluctuate in response to factors, including the factors discussed elsewhere in the sections of this prospectus titled “Risk Factors” and “Special Note Regarding Forward-Looking Statements,” many of which are beyond our control. For instance, the price of our common stock could be affected by sales of our common stock by investors who view the notes as a more attractive means of equity participation in our company than our common stock, or by other hedging or arbitrage trading activity that may develop involving our common stock. This hedging or arbitrage could, in turn, affect the trading price of the notes.
 
The notes may not have an active market and their price may be volatile. You may be unable to sell your notes at the price you desire or at all.
 
There is no existing trading market for the notes. As a result, there can be no assurance that a liquid market will develop or be maintained for the notes, that you will be able to sell any of the notes at a particular time (if at all) or that the prices you receive if or when you sell the notes will be above their initial offering price. The underwriter has advised us that it currently does not intend to make a market in the notes after this offering is completed. In addition, market making will be subject to the limits imposed by the Securities Act, and the Exchange Act, and may be limited during the pendency of any shelf registration statement or exchange offer. The liquidity of the trading market in the notes, and the market price quoted for the notes, may be adversely affected by various factors, including the following:
 
  •   changes in the overall market for debt securities;
 
  •   changes in our financial performance or prospects;
 
  •   the prospects for companies in our industry generally;
 
  •   the number of holders of the notes;
 
  •   the interest of securities dealers in making a market for the notes; and
 
  •   prevailing interest rates.
 
Conversion of the notes will dilute the ownership interest of existing shareholders, including holders who had previously converted their notes.
 
The conversion of some or all of the notes will dilute the ownership interests of existing shareholders. Any sales in the public market of the common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the notes may encourage short selling by market participants because the conversion of the notes could depress the price of our common stock.
 
If you hold notes, you will not be entitled to any rights with respect to our common stock, but you will be subject to all changes made with respect to our common stock.
 
If you hold notes, you will not be entitled to any rights with respect to our common stock (including voting rights and rights to receive any dividends or other distributions on our common stock), but if you subsequently convert your notes into common stock, you will be subject to all changes affecting the common stock. You will have rights with respect to our common stock only if and when we deliver shares of common stock to you upon conversion of your notes and, to a limited extent, under the conversion rate adjustments applicable to the notes. For example, in the event that an amendment is proposed to our certificate of incorporation or by-laws requiring stockholder approval and the record date for determining the stockholders of record entitled to vote on the amendment occurs prior to delivery of common stock to you, you will not be entitled to vote on the amendment, although you will nevertheless be subject to any changes in our common stock that result from such amendment.


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You may not be able to sell the shares of our common stock issuable upon conversion of the notes and exercise of the warrants when you want to, and, if you do, you may not be able to receive the price that you want.
 
Our common stock is currently traded on The Nasdaq Global Market. The daily trading volume of our common stock is relatively low. During the year ended December 31, 2007, the daily volume for our common stock was as low as 3,844 and as high as 155,701 and averaged 19,994 shares per day as reported by Nasdaq. Because of this limited trading volume, you may be unable to sell the shares of our common stock issuable upon conversion of the notes and exercise of the warrants.
 
Moreover, the market price of our common stock has fluctuated substantially in the past and is likely to continue to be highly volatile and subject to wide fluctuations in the future. For example, as of June 30, 2008, the 52-week high closing sales price of our common stock was $10.72 per share, which compares to a 52-week low closing sales price of our common stock of $1.25 per share. These fluctuations have occurred in the past and may occur in the future in response to various factors, many of which we cannot control, including the following:
 
  •   actual or anticipated changes in our operating results;
 
  •   variations in our quarterly results;
 
  •   changes in expectations relating to our products, plans, and strategic position or those of our competitors or customers;
 
  •   announcements of technological innovations or new products by our competitors, our customers, or us;
 
  •   market conditions within our market;
 
  •   price and volume fluctuations in the overall stock market from time to time;
 
  •   significant volatility in the market price and trading volume of technology companies in general and alternative energy companies in particular;
 
  •   changes in investor perceptions;
 
  •   the level and quality of any research analyst coverage of our common stock;
 
  •   changes in earnings estimates or investment recommendations by securities analysts or our failure to meet such estimates;
 
  •   the financial guidance we may provide to the public, any changes in such guidance, or our failure to meet such guidance;
 
  •   various market factors or perceived market factors, including rumors, whether or not correct, involving us, our customers, our subcontractors, or our competitors;
 
  •   introductions of new products or new pricing policies by us or by our competitors;
 
  •   acquisitions or strategic alliances by us or by our competitors;
 
  •   litigation involving us, our industry, or both;
 
  •   regulatory developments in the United States or abroad;
 
  •   the gain or loss of significant customers;
 
  •   the gain or loss of significant orders;


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  •   recruitment or departure of key personnel;
 
  •   developments with respect to intellectual property rights;
 
  •   market conditions in our industry, the industries of our customers, and economy as a whole;
 
  •   acquisitions or strategic alliances by us or our competitors; and
 
  •   general global economic and political instability.
 
In addition, the market prices of securities of technology companies have experienced significant price and volume fluctuations that often have been unrelated or disproportionate to their operating performance. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were the object of a securities class action litigation, it could result in substantial losses and divert management’s attention and resources from other matters. If the price of our common stock falls below the minimum price requirement of The Nasdaq Global Market, you may not be able to sell the shares issuable upon conversion of the notes and exercise of the warrants when you want to and if you do, you may not receive the price that you want.
 
Furthermore, because the notes are convertible into shares of our common stock, volatility or depressed prices of our common stock could have a similar effect on the trading price of our notes. Holders who receive common stock upon conversion also will be subject to the risk of volatility and depressed prices of our common stock. In addition, the existence of the notes may encourage short selling in our common stock by market participants because the conversion of the notes could depress the price of our common stock.
 
Sales of a significant number of shares of our common stock in the public markets, or the perception of such sales, could depress the market price of the notes and our common stock.
 
Sales of a substantial number of shares of our common stock or other equity-related securities in the public markets could depress the market price of the notes, our common stock, or both, and impair our ability to raise capital through the sale of additional equity securities. We cannot predict the effect that future sales of our common stock or other equity-related securities would have on the market price of our common stock or the value of the notes. The price of our common stock could be affected by possible sales of our common stock by investors who view the notes as a more attractive means of equity participation in our company and by hedging or arbitrage trading activity that may occur involving our common stock. This hedging or arbitrage could, in turn, affect the market price of the notes and our common stock.
 
We may not be able to refinance the notes if required or if we so desire.
 
We may need or desire to refinance all or a portion of the notes or any other future indebtedness that we incur on or before the maturity of the notes. There can be no assurance that we will be able to refinance any of our indebtedness on commercially reasonable terms, if at all.
 
The notes will initially be held in book-entry form and, therefore, you may be forced to rely on the procedures of the relevant clearing systems to exercise your rights and remedies.
 
Unless and until certificated notes are issued in exchange for book-entry interests in the notes, owners of the book-entry interests will not be considered owners or holders of notes. Instead, the depository, or its nominee, will be the sole holder of the notes. Payments of principal, interest, and other amounts owing on or in respect of the notes in global form will be made to the paying agent, which will make payments to The Depository Trust Company, or DTC. Thereafter, such payments will be credited to DTC participants’ accounts that hold book-entry interests in the notes in global form and credited by such participants to indirect participants. Unlike holders of the notes


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themselves, owners of book-entry interests will not have the direct right to act upon our solicitations for consents or requests for waivers or other actions from holders of the notes. Instead, if you own a book-entry interest, you will be permitted to act only to the extent you have received appropriate proxies to do so from DTC or, if applicable, a participant. We cannot assure you that procedures implemented for the granting of such proxies will be sufficient to enable you to vote on any requested actions on a timely basis.
 
The notes could be treated as “contingent payment debt instruments” for U.S. federal income tax purposes.  
 
It is possible that the IRS could assert that the additional interest which we would be obligated to pay in connection with an event of default relating to the failure to file any documents or reports that we are required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act, and for any failure to comply with the requirements of Section 314(a)(1) of the Trust Indenture Act or of certain covenants described herein, constitutes a “contingent payment” for U.S. federal income tax purposes. If so treated, the notes would be treated as contingent payment debt instruments and certain adverse U.S. federal income tax consequences could result (including a requirement that U.S. Holders (as defined below under “Material U.S. Federal Income Tax Considerations”) report such additional interest as OID (as defined below under “Material U.S. Federal Income Tax Considerations — Consequences to Holders of Notes — Consequences to U.S. Holders of Notes — Interest”) and the treatment of any gain from the sale of a note as ordinary income for U.S. federal income tax purposes). However, the Treasury Regulations issued by the IRS regarding debt instruments that provide for one or more contingent payments provide that, for purposes of determining whether a debt instrument is a contingent payment debt instrument, remote or incidental contingencies are ignored. We believe that the possibility of the payment of additional interest is remote and, accordingly, we do not intend to treat the notes as contingent payment debt instruments.
 
You may be subject to U.S. federal income tax if we make or fail to make certain adjustments to the conversion rate of the notes even though you do not receive a corresponding cash distribution.
 
The conversion rate of the notes is subject to adjustment in certain circumstances, including the payment of certain cash dividends. If the conversion rate is adjusted as a result of a distribution that is taxable to our common stockholders, such as a cash dividend, you may be deemed to have received a taxable dividend subject to U.S. federal income tax without the receipt of any cash. In addition, a failure to adjust (or to adjust adequately) the conversion rate after an event that increases your proportionate interest in our company could be treated as a deemed taxable dividend to you. See “Material U.S. Federal Income Tax Considerations.”
 
We have broad discretion over the use of the net proceeds from this offering and could spend the proceeds in ways with which you might not agree.
 
We have broad discretion to allocate the net proceeds of this offering, and you will be relying on the judgment of our management regarding the application of those proceeds. We currently expect to use these proceeds to conduct research and development, and the commercialization of our portable power source products. The timing and amount of our actual expenditures, however, are subject to change and will be based on many factors, including the following:
 
  •   the results of our research and development and product testing;
 
  •   manufacturing, marketing, and other costs associated with commercialization of our products; and
 
  •   the costs involved in preparing, filing, prosecuting, maintaining and enforcing patents or defending ourselves against competing technological and market developments.


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We may experience an “ownership change” in connection with this offering (or in the future), which would result in a limitation of the use of our net operating losses.
 
As of March 31, 2008, we had approximately $57 million of net operating loss, or NOL, carryforwards. Our ability to utilize these NOL carryforwards, including any future NOL carryforwards that may arise, may be limited by Section 382 of the Internal Revenue Code of 1986, as amended, if we undergo an “ownership change” as a result of subsequent changes in the ownership of our outstanding common stock pursuant to the exercise of the warrants, the conversion of the notes, or otherwise. A corporation generally undergoes an “ownership change” when the ownership of its stock, by value, changes by more than 50 percentage points over any three-year testing period. In the event of an ownership change, Section 382 imposes an annual limitation on the amount of post-ownership change taxable income a corporation may offset with pre-ownership change NOL carryforwards and certain recognized built-in losses.
 
The warrants could adversely affect our stock price and future financings.
 
We are offering senior convertible notes and warrants to purchase          shares of our common stock in “units.” We are also granting the underwriter a 30-day option to purchase up to an additional 1,800 units (consisting of $1,800,000 principal amount of notes and           warrants) to cover over-allotments. As part of its compensation, the underwriter will also receive a warrant to purchase shares of our common stock equal to 6% of the number of shares issuable upon conversion of the notes and exercise of the warrants included in the units. The existence of such warrants may adversely affect the market price of our common stock and terms on which we can obtain additional financing, and the holders of such warrants can be expected to exercise them at a time when we, in all likelihood, would be able to obtain additional capital by offering shares of our common stock on terms more favorable to us than those provided by the exercise of such warrants.


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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This prospectus contains “forward-looking statements” that are forward-looking in nature. Examples of forward-looking statements include statements regarding our belief that the fuel cell industry will continue to develop, our future financial results, operating results, business strategies, projected costs, products under development, competitive positions, and our plans and objectives for future operations. Words such as “may,” “will,” “should,” “would,” “expects,” “plans,” “anticipates,” “intends,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology, as well as statements in future tense, identify forward-looking statements. Any expectations based on these forward-looking statements are subject to risks and uncertainties and other important factors, including the “Risk Factors” discussed herein. These and many other factors could affect our future operating results and financial condition and could cause actual results to differ materially from expectations based on forward-looking statements made in this document or elsewhere by us or on our behalf.
 
Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, that performance or those results will be achieved. Forward-looking statements are based on information available at the time they are made or our good faith belief as of that time with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements. Important factors that could cause these differences include the following:
 
  •   our history of recurring net losses and the risk of continued net losses;
 
  •   our independent auditors raising substantial concern about our ability to continue as a going concern;
 
  •   sales revenue growth of our test and measurement instrumentation business may not be achieved;
 
  •   the dependence of our test and measurement instrumentation business on a small number of customers and potential loss of government funding;
 
  •   risks related to developing Mobion direct methanol fuel cells and whether we will ever successfully develop reliable and commercially viable Mobion fuel cell solutions;
 
  •   our need to raise additional financing;
 
  •   risks relating to the market price of Plug Power common stock;
 
  •   the risk that certain European Union regulations will not be changed to permit methanol to be carried onto airplanes;
 
  •   our portable power source products or our customers’ products that utilize our portable power source products may not be accepted by the market;
 
  •   our inability to build and maintain relationships with our customers;
 
  •   our limited experience in manufacturing fuel cell systems on a commercial basis;
 
  •   our dependence on others for our production requirements for our portable power source products;
 
  •   our dependence on our manufacturing subcontractors to provide high levels of productivity and satisfactory delivery schedules for our portable power source products;
 
  •   our dependence on third-party suppliers for most of the manufacturing equipment necessary to produce our portable power source products;


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  •   our inability to obtain sufficient quantities of components and other materials, including platinum and ruthenium, necessary for the production of our portable power source products;
 
  •   our dependence on OEMs integrating Mobion fuel cell systems into their devices;
 
  •   our lack of long-term purchase commitments from our customers and the ability of our customers to cancel, reduce, or delay orders for our products;
 
  •   risks related to protection and infringement of intellectual property;
 
  •   our new technologies may not result in customer or market acceptance;
 
  •   our ability to commercialize our proposed portable power source solutions and develop new product solutions on a timely basis;
 
  •   our ability to develop and utilize new technologies that address the needs of our customers;
 
  •   intense competition in the direct methanol fuel cell and instrumentation businesses;
 
  •   change in policies by U.S. or foreign governments that hinder, disrupt, or economically disadvantage international trade;
 
  •   the impact of future exchange rate fluctuations;
 
  •   uncertainty of the U.S. economy;
 
  •   the historical volatility of our stock price;
 
  •   the cyclical nature of the electronics industry;
 
  •   failure of our strategic alliances to achieve their objectives or perform as contemplated and the risk of cancellation or early termination of such alliance by either party;
 
  •   product liability or defects;
 
  •   risks related to the flammable nature of methanol as a fuel source;
 
  •   the loss of services of one or more of our key employees or the inability to hire, train, and retain key personnel;
 
  •   significant periodic and seasonal quarterly fluctuations in our results of operations; and
 
  •   other factors discussed under the headings “Risk Factors,” Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and “Business.”
 
Forward-looking statements speak only as of the date they are made. You should not put undue reliance on any forward-looking statements. We assume no obligation to update forward-looking statements to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking information, except to the extent required by applicable securities laws. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.
 


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USE OF PROCEEDS
 
We estimate that our net proceeds from the sale of units in this offering will be approximately $11.1 million (or $12.8 million if the underwriter exercises its over-allotment option in full), after deducting the underwriter’s discount and commissions and estimated offering expenses payable by us.
 
We intend to use the net proceeds from this offering as follows:
 
       
Commercialization of our portable power source products (1)
  $ 8,408,000
Capital equipment (2)
    1,487,000
General corporate purposes, including working capital
    1,200,000
       
Total
  $ 11,095,000
       
 
(1) Expected to consist of activities to commercialize our portable power source products for portable handheld electronic devices (including further enhancements to our Mobion Chip) and activities to achieve manufacturing readiness (including design for manufacturability, design for assembly, design for testability, and design for serviceability).
 
(2) Expected to consist of expenditures for equipment and tooling to support engineering design and commercialization of our Mobion portable power source products.
 
We believe the net proceeds of this offering will assist us in achieving certain milestones in commercializing our portable power source products. We will, however, require capital above the net proceeds of this offering to complete the commercialization of our portable power source business. We may raise this additional capital through one or more financings or by selling our test and measurement instrumentation business should we determine to do so.
 
The amounts and timing of our actual expenditures will depend upon numerous factors, including the amount of proceeds actually raised in this offering, cash flows from operations, and the growth of our business. We will, from time to time, evaluate these and other factors to determine if the allocation of our resources, including the proceeds of this offering, is being optimized and we must therefore retain broad discretion to allocate the net proceeds from this offering.
 
Pending use of the net proceeds as described above, we intend to invest the net proceeds of this offering in U.S. government and short-term investment grade securities.


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PRICE RANGE OF OUR COMMON STOCK
 
Our common stock trades on The Nasdaq Global Market under the symbol “MKTY.” The following table sets forth the high and low sale prices of our common stock as reported by The Nasdaq Global Market for the periods indicated (for periods prior to May 16, 2008, such prices have been derived by multiplying the actual prices by eight to reflect the reverse split of our common stock that was approved by our stockholders at a meeting held on May 15, 2008, pursuant to which every eight shares of our common stock were combined into one share of our common stock).
 
             
    High   Low
 
2006
           
First Quarter
  $ 31.20   $ 21.60
Second Quarter
    40.00     16.00
Third Quarter
    19.92     10.16
Fourth Quarter
    23.68     12.40
2007
           
First Quarter
    15.44     10.56
Second Quarter
    14.40     9.60
Third Quarter
    11.28     7.20
Fourth Quarter
    10.80     5.76
2008
           
First Quarter
    7.44     3.76
Second Quarter
    7.80     1.11
Third Quarter (through July 2, 2008)
    1.63     1.26
 
We estimate that there were approximately 540 holders of our common stock as of July 2, 2008, which does not include an indeterminate number of stockholders whose shares may be held by brokers in street name.
 
DIVIDEND POLICY
 
We have never declared or paid any dividends on our capital stock. We currently intend to retain any future earnings to fund the development and expansion of our business, and therefore do not anticipate paying cash dividends in the foreseeable future. Any future determination to pay dividends will be at the discretion of our Board of Directors and will depend on our financial condition, results of operations, capital requirements, restrictions contained in financing instruments, and other factors our Board of Directors deems relevant.


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CAPITALIZATION
 
The following table sets forth our capitalization as of March 31, 2008
 
  •   on an actual basis, which reflects our actual capitalization as of March 31, 2008 on a historical basis, giving effect to our eight-to-one reverse stock split that was approved by our stockholders at a meeting held May 15, 2008; and
 
  •   on an as adjusted basis to reflect the sale of the units (assuming the underwriter’s over-allotment option is not exercised) and the application of the net proceeds therefrom as described in “Use of Proceeds.”
 
                 
    March 31, 2008  
    Actual     As Adjusted  
    (in thousands, except share data)  
 
Cash and cash equivalents
    $4,560     $ 15,655  
Securities available for sale (1)
    3,537       3,537  
Long-term debt:
               
     % Convertible Senior Notes due          (5)
          12,000  
                 
Total long-term debt
          12,000  
Stockholders’ equity (2)(5):
               
Common stock, par value $0.01 per share, 75,000,000 shares authorized, actual and as adjusted; 5,777,578 shares issued, actual and as adjusted (3)
    58       58  
Additional paid-in capital
    132,449       132,449  
Accumulated deficit
    (108,253 )     (108,253 )
Accumulated other comprehensive income:
               
Unrealized gain on securities available for sale, net of tax
    (455 )     (455 )
Common stock in treasury, at cost, 1,005,092 shares
    (13,754 )     (13,754 )
                 
Total stockholders’ equity
    10,045       10,045  
                 
Total capitalization (4)
    $10,045     $ 22,045  
                 
 
 
(1) Represents shares of Plug Power held for sale by us, classified as current assets, and such amount reflects the fair value of these shares. Through the sale of Plug Power shares, we generated proceeds of $6.2 million during 2006 and $5.1 million during 2007 that we have used to fund the development and commercialization of our portable power source business.
 
(2) The table includes adjustments in the number of shares of our issued common stock as a result of the reverse split of our common stock that was approved by our stockholders at a meeting held May 15, 2008, pursuant to which every eight shares of our common stock were combined into one share of our common stock.
 
(3) Excludes the following as of March 31, 2008:
 
  •   136,886 shares of common stock reserved for future issuance under our equity incentive plans. As of March 31, 2008, there were 762,391 options outstanding and 625 shares of restricted stock issued under our equity incentive plans;
 
  •   378,472 shares of common stock issuable upon exercise of outstanding warrants as of March 31, 2008, with an exercise price of $18.16 per share; and
 
  •              shares of common stock that will be issued upon exercise of warrants at an exercise price of $      per share sold as part of the units in this offering and the warrants issued to the underwriter.
 
(4) Total capitalization is the sum of total long-term debt and total stockholders’ equity.
 
(5) Upon completion of the offering, the net proceeds of the units attributable to the fair value of the warrants to purchase common stock will be recorded as a permanent component of stockholders’ equity.


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Please read the capitalization table together with the sections of this prospectus entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes included elsewhere in this prospectus.


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RATIO OF EARNINGS TO FIXED CHARGES
 
Our ratio of earnings to fixed charges for each of the periods indicated is as follows:
 
                                                 
                                  Three Months Ended
 
    Year Ended December 31,     March 31,
 
    2003     2004     2005     2006     2007     2008  
 
Ratio of earnings to fixed charges (1)
                                   
 
 
(1) For the purposes of computing ratio of earnings to fixed charges, earnings consist of income (loss) before provision for income taxes plus fixed charges. Fixed charges consist of interest charges and that portion of rental payments under operating leases we believe to be representative of interest. Earnings for the years ended December 31, 2003, 2004, 2005, 2006 and 2007, were insufficient to cover fixed charges by $552, $4,191, $15,094, $13,667 and $9,575 (in thousands) respectively. Earnings for the three months ended March 31, 2008, were insufficient to cover fixed charges by $3,187 (in thousands). For this reason, no ratios are provided for these periods.


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SELECTED CONSOLIDATED FINANCIAL DATA
 
The following table sets forth our summary consolidated financial data for the fiscal years ended December 31, 2005, 2006, and 2007, which was derived from our audited consolidated financial statements included elsewhere in this prospectus. The summary consolidated balance sheet data as of March 31, 2007 and 2008 and the summary consolidated statements of operations data for each of the three months ended March 31, 2007 and 2008 have been derived from the unaudited consolidated financial statements included elsewhere in this prospectus. We derived the consolidated financial data for the years ended December 31, 2003 and 2004 from our audited consolidated financial statement that is not included in this prospectus. You should read the following summary consolidated financial data together with the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements, including the related notes thereto.
 
                                                         
    Years Ended December 31,     Three Months Ended March 31,  
    2003     2004     2005     2006     2007     2007     2008  
 
Statement of Operations Data (in thousands except share and per share data):
                                                       
Product revenue
    $5,547       $7,530       $6,012       $7,667       $9,028       $1,701       $1,980  
Gross profit on product revenue
    3,165       4,653       3,631       4,767       5,598       963       1,140  
Funded research and development revenue
    2,311       1,040       1,829       489       1,556       615       173  
Research and product development expenses
    8,348       12,960       9,671       12,921       11,765       3,622       2,373  
Operating loss
    (8,709 )     (13,592 )     (15,098 )     (17,737 )     (13,349 )     (4,500 )     (3,678 )
Net loss
    $(559 )     $(4,191 )     $(15,094 )     $(13,667 )     $(9,575 )     $(3,156 )     $(3,187 )
                                                         
Net loss per share (basic and diluted)
    $(0.16 )     $(1.15 )     $(3.93 )     $(3.46 )     $(2.01 )     $(0.66 )     $(0.67 )
                                                         
Weighted average common shares outstanding (basic and diluted)
    3,456,999       3,645,147       3,842,201       3,952,793       4,763,547       4,754,868       4,771,861  
                                                         
Balance Sheet Data (in thousands):
                                                       
Cash and cash equivalents
    $12,380       $22,545       $11,230       $14,545       $7,650       9,885       4,560  
Securities available for sale (1)
    44,031       17,678       18,947       10,075       4,492       8,184       3,537  
Working capital
    49,053       33,663       33,045       23,076       11,347       15,927       7,634  
Current ratio
    4.2:1       4.0:1       4.9:1       3.9:1       3.9:1       3.9:1       2.8:1  
Total assets
    65,838       66,830       41,267       33,811       18,716       26,310       14,812  
Total current liabilities
    16,761       8,826       8,222       7,071       3,866       5,448       4,170  
Long-term obligations
    24       1,149             3,664       904       2,883       572  
Total stockholders’ equity
    $48,266       $55,584       $32,916       $22,871       $13,803       17,839       10,045  
 
 
(1) Represents shares of Plug Power held for sale by us, classified as current assets, except for 2004 when approximately $16.5 million shares were classified as restricted shares, and such amount reflects the fair value of these shares. Through the sale of Plug Power shares, we generated proceeds of $6.2 million during 2006 and $5.1 million during 2007 that we have used to fund the development and commercialization of our portable power source business.


33


 

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements, which involve risk and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors including those discussed in “Risk Factors” and elsewhere in this prospectus.
 
Overview
 
We are developing and commercializing off-the-grid rechargeable power sources for portable electronics. We have developed a patented, proprietary direct methanol fuel cell technology platform called Mobion, which generates electrical power using up to 100% methanol as fuel. Our proprietary fuel cell power solution consists of two primary components integrated in an easily manufactured device: the direct methanol fuel cell power engine, which we refer to as our Mobion Chip, and methanol replacement cartridges. Our current Mobion Chip weighs less than one ounce and is small enough to fit in the palm of one’s hand. The methanol used by the technology is fully biodegradable. We believe we are the only micro fuel cell developer to have demonstrated power density of over 50 mW/cm2 with high energy efficiencies of 1.4 Wh/cc of methanol for handheld consumer electronic applications. For these reasons, we believe our technology offers a compelling alternative to current lithium-ion and similar rechargeable battery systems currently used by original equipment manufacturers and branded partners, or OEMs, in many handheld electronic devices, such as mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, PDAs, and GPS devices. We believe our platform will facilitate the development of numerous product advantages, including small size, environmental friendliness, and simplicity of design, all critical for commercialization in the consumer market, and can be implemented as three different product options: a compact external charging device, a snap-on or attached power accessory, or an embedded fuel cell power solution. We have strategic arrangements with Samsung Electronics, an OEM of mobile phones and mobile phone accessories, with Duracell, part of the Procter & Gamble Company, and with a global Japanese consumer electronics company. Our goal is to become a leading provider of portable power for handheld electronic devices and we intend to commercialize Mobion products beginning in 2009.
 
Our Mobion technology eliminates the need for active water recirculation pumps or the inclusion of water as a fuel dilutant. The water required for the electrochemical process is transferred internally within the Mobion Chip from the site of water generation on the air-side of the cell. This internal flow of water takes place without the need for any pumps, complicated re-circulation loops or other micro-plumbing tools. Our Mobion technology is protected by a patent portfolio that includes over 90 U.S. patent applications covering five key technologies and manufacturing areas.
 
We also design, manufacture, and sell high-performance test and measurement instruments and systems serving three markets: general dimensional gauging, semiconductor, and aviation. These products consist of: electronic, computerized gauging instruments for position, displacement and vibration applications for the design, manufacturing and test markets; semiconductor products for wafer characterization; and engine balancing and vibration analysis systems for military and commercial aircraft.


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Our cash requirements depend on numerous factors, including completion of our portable power source products development activities, our ability to commercialize our portable power source products, market acceptance of our portable power source products, and other factors. We expect to pursue the expansion of our operations through internal growth and strategic partnerships. Several key indicators of our liquidity are summarized in the following table:
 
                                         
    Years Ended December 31,     Three Months Ended March 31,  
    2005     2006     2007     2007     2008  
    (dollars in thousands)              
 
Cash and cash equivalents
    $11,230       $14,545       $7,650       9,885       4,560  
Securities available for sale
    18,947       10,075       4,492       8,184       3,537  
Working capital
    24,465       20,820       11,347       15,927       7,634  
Net loss
    (15,094 )     (13,667 )     (9,575 )     (3,156 )     (3,187 )
Net cash used in operating activities
    (12,572 )     (12,706 )     (11,683 )     (4,610 )     (2,988 )
Purchase of property, plant and equipment
    (1,004 )     (1,574 )     (414 )     (50 )     (102 )
 
From inception through March 31, 2008, we have incurred an accumulated deficit of $108.3 million and we expect to incur losses for the foreseeable future as we continue micro fuel cell product development and commercialization programs. We expect that losses will fluctuate from year to year and that such fluctuations may be substantial as a result of, among other factors, sales of securities available for sale as well as the operating results of our business.
 
Results of Operations
 
Results of Operations for the Three Months Ended March 31, 2008 Compared to the Three Months Ended March 31, 2007.
 
Product Revenue. Product revenue in our test and measurement instrumentation business increased by $279,000, or 16.4%, to $2.0 million for the three months ended March 31, 2008 from $1.7 million for the three months ended March 31, 2007. The revenue increase was primarily a result of a $220,000 increase in commercial aviation sales, coupled with smaller increases in our semiconductor and general dimensional products.
 
As a result of general global economic conditions, our test and measurement instrumentation business is currently experiencing weaker than expected demand in Japan for photolithography equipment. This weakness in demand may negatively impact OEM capacitance sales over the remainder of 2008.
 
Information regarding government contracts included in product revenue is as follows:
 
                                     
          Revenue For
        Total Contract
          the
    Revenue
  Orders
          Three Months
    Contract
  Received
          Ended
    to Date
  to Date
          March 31,     March 31,
  March 31,
Contract (1)
  Expiration     2007     2008     2008   2008
    (Dollars in thousands)
 
$2.3 million Air Force New PBS-4100 Systems
    07/28/2010 (2 )   $     $     $ 1,596   $ 1,596
$8.8 million Air Force Retrofit and Maintenance of PBS-4100 Systems
    06/19/2008 (3 )   $ 346     $ 338     $ 7,703   $ 7,703
 
 
(1) Contract values represent maximum potential values and may not be representative of actual results.
 
(2) Date represents expiration of contract, including all three potential option extensions.
 
(3) Expiration date was extended during May 2008 from May 19, 2008 to June 19, 2008.
 
Funded Research and Development Revenue. Funded research and development revenue in our new energy business during 2008 decreased by $442,000, or 71.9%, to $173,000 during the three


35


 

months ended March 31, 2008 from $615,000 during the three months ended March 31, 2007. The decrease in revenue was primarily a result of the completion of the SAFT America, Inc., or SAFT, contract during the first quarter of 2007, which accounted for $418,000 of revenue in 2007. Revenue during 2008 for the U.S. Department of Energy, or the DOE, contract, which had its funding reinstated during May 2007, increased by $170,000, while revenue recognized under the alliance agreement with Samsung Electronics Co., Ltd., or Samsung, decreased by $194,000 during 2008 over 2007 as a result of the contract’s completion in 2007.
 
Information regarding our contracts included in funded research and development revenue is as follows:
 
                                                 
          Revenue
          Revenue
          Revenue
 
          Three Months
          Three Months
          Contract to
 
          Ended
          Ended
          Date
 
          March 31,
    % of 2007
    March 31,
    % of 2008
    March 31,
 
Contract (1)
  Expiration     2007     Total     2008     Total     2008  
                (dollars in thousands)              
 
$3.0 million DOE (2)
    03/31/09     $ 3       0.5 %   $ 173       100.0 %   $ 2,019  
$1.0 million Samsung (3)
    07/31/07       194       31.5                   875  
$418,000 SAFT (4)
    12/31/06       418       68.0                   418  
                                                 
Total funded research and development revenue
          $ 615       100.0 %   $ 173       100.0 %   $ 3,312  
                                                 
 
 
(1) Dates represent expiration of contract, not date of final billing.
 
(2) The DOE contract is a cost-share contract. DOE funding for this contract was suspended during January 2006 and reinstated during May 2007. During 2007, we received notifications from the DOE of funding releases totaling $1.0 million and also received an extension of the termination date for the contract from July 31, 2007 to September 30, 2008. During 2008, we received notifications of funding releases totaling $825,000 and also received an extension of the termination date for the contract from September 30, 2008 to March 31, 2009.
 
(3) The Samsung contract is a research and prototype contract. This contract included one up-front payment of $750,000 and two milestone payments of $125,000 each for the delivery of prototypes. The contract was amended on October 22, 2007 as we agreed to issue a credit in the amount of the last invoice in recognition of our continuing collaboration with Samsung. Therefore, revenue under this contract totaled $875,000.
 
(4) The SAFT contract is a fixed-price contract. This is a subcontract with SAFT under the U.S. Army CECOM contract. The purchase order received in connection with this subcontract was revised on November 14, 2006, eliminating one milestone. As a result, the contract value was reduced from $470,000 to $418,000 and the expiration date was extended from September 30, 2006 to December 31, 2006.
 
Cost of Product Revenue. Cost of product revenue in our test and measurement instrumentation business increased by $102,000, or 7.0%, to $840,000 during the three months ended March 31, 2008 from $738,000 during the three months ended March 31, 2007. As a percentage of product revenue, the quarterly cost of product revenue declined by one percentage point as a result of a more favorable product sales mix.
 
Gross profit as a percentage of product revenue increased by 0.9% to 57.5% during the three months ended March 31, 2008 from 56.6% during the three months ended March 31, 2007.
 
Funded Research and Product Development Expenses. Funded research and product development expenses in our new energy business increased by $132,000, or 13.8%, to $356,000 during the three months ended March 31, 2008 from $224,000 during the three months ended March 31, 2007. This change was primarily a result of costs for the DOE contract increasing by $351,000, reflecting its reinstatement during 2007, while cost for the Samsung contract decreased by $194,000, as that contract was completed during July 2007.


36


 

Unfunded Research and Product Development Expense. Unfunded research and product development expenses decreased by $1.4 million, or 40.6%, to $2.0 million during the three months ended March 31, 2008 from $3.4 million during the three months ended March 31, 2007. This decrease reflects a $1.5 million decrease in development costs in our new energy business related to (a) cost savings from the decision to suspend work on our high power program during March 2007, and (b) the DOE contract that resumed during May 2007, which increased funded research and product development expense, which were partially offset by the effects of the completion of work under the Samsung alliance agreement, which increased unfunded research and product development. This decrease was also partially offset by a $129,000 increase in product development expenses for our test and measurement instrumentation business, reflecting increased staffing and external product development costs focused on the development of our photovoltaic thickness module and certain redesigns of our general gauging and aviation solutions.
 
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $162,000, or 6.6%, to $2.6 million during the three months ended March 31, 2008 from $2.5 million during the three months ended March 31, 2007. This increase was primarily a result of (a) a $715,000 increase related to decreases in liquidations to unfunded research and development costs, which was primarily due to the elimination of our high power program, partially offset by increased liquidations in connection with the DOE program, (b) a $400,000 decrease in administrative salaries and benefits as a result of our March 2007 restructuring, (c) a $266,000 decrease in severance costs, which was also attributable to the 2007 restructuring, (d) a $139,000 increase in salaries, benefits, and commissions, reflecting increased sales and marketing efforts in our test and measurement instrumentation business, (e) a $42,000 increase in non-cash equity compensation primarily related to performance grants, (f) a $78,000 decrease in depreciation costs, and (g) a $10,000 increase in other expenses, net.
 
Operating Loss. Operating loss decreased by $822,000, or 18.3%, to $3.7 million during the three months ended March 31, 2008 compared to the three months ended March 31, 2007 as a result of the factors noted above.
 
Gain on Derivatives. Our gain on derivative treatment of the freestanding warrants issued in conjunction with our December 2006 capital raise decreased by $636,000, or 65.6%, to $333,000 during the three months ended March 31, 2008 compared to $969,000 during the three months ended March 31, 2007. The decrease in derivative income was attributable to valuation changes of the underlying warrants using the Black-Scholes option-pricing model.
 
Income Tax (Expense) Benefit. Our income tax rate for both the three months ended March 31, 2007 and 2008 was 0.3%. These tax rates were primarily a result of losses generated by operations, changes in the valuation allowance, state true-ups, and permanent deductible differences for derivative valuations.
 
The valuation allowance against our deferred tax assets were $24.2 million at March 31, 2008 and $22.3 million at December 31, 2007. We determined that it was more likely than not that ultimate recognition of certain deferred tax assets would not be realized.
 
Results of Operations for the Year Ended December 31, 2007 Compared to December 31, 2006.
 
Product Revenue. Product revenue in our test and measurement instrumentation business increased by $1.4 million, or 17.8%, to $9.0 million for the fiscal year ended December 31, 2007 from $7.7 million for the fiscal year ended December 31, 2006. This performance was primarily the result of a $602,000 increase in activity by the U.S. Air Force, driven by the New PBS-4100 systems contract. Also contributing were increased purchases by our Japanese distributor (particularly OEM capacitance), as well as increased volume in semiconductor product shipments. Total product revenue for general dimensional gauging products increased $298,000, or 7.2%, to $4.5 million, while total product revenue for the segment’s semiconductor products increased by $364,000, or 71.2%, to $875,000.


37


 

In our test and measurement instrumentation business, during 2007 the U.S. Air Force accounted for $2.4 million, or 26.3%, of product revenue while during 2006, the U.S. Air Force accounted for $1.8 million, or 23.1%, of product revenue. Additionally, during 2007, Koyo Precision, our Japanese distributor, represented $2.5 million, or 27.7%, of product revenue while during 2006, Koyo Precision represented $1.8 million, or 22.9%, of product revenue.
 
Information regarding government contracts included in product revenue is as follows:
 
                     
                    Total Contract
                Revenue
  Orders
        Revenue For The
  Contract to
  Received to
        Year Ended
  Date
  Date
        December 31,   December 31,
  December 31,
Contract (1)
  Expiration   2006   2007   2007   2007
    (dollars in thousands)
 
$2.3 million Air Force New PBS-4100 Systems
  07/28/2010 (2)   $–   $1,596   $1,596   $1,596
$8.8 million Air Force Retrofit and Maintenance of PBS-4100 Systems
  06/19/2008 (3)   $1,417   $738   $7,365   $7,365
 
 
(1) Contract values represent maximum potential values and may not be representative of actual results.
 
(2) Date represents expiration of contract, including all three potential option extensions.
 
(3) Expiration date was extended during December 2007 from December 20, 2007 to May 19, 2008, and in May 2008 it was extended from May 19, 2008 to June 19, 2008.
 
Funded Research and Development Revenue. Funded research and development revenue in our new energy business during 2007 increased $1.1 million, or 218.2%, to $1.6 million for the year ended December 31, 2007 from $489,000 for the year ended December 31, 2006. The increase in revenue was primarily the result of billings under the DOE contract, which had its funding reinstated during May 2007 after it had been suspended during 2006. This DOE funding resumption contributed an additional $613,000 to revenue during 2007. Revenue during 2007 also included $418,000 from the SAFT contract, for which revenue recognition had been deferred until the delivery under the contract was accepted during the first quarter of 2007. Revenue recognized under the Samsung alliance agreement increased $21,000 during 2007 over 2006.
 
                                       
        For The Year Ended
  For The Year Ended
  Revenue
        December 31, 2006   December 31, 2007   Contract to Date
Contract
  Expiration (1)   Revenue   Percent   Revenue   Percent   December 31, 2007
        (dollars in thousands)
 
$3.0 million DOE (2)
    03/31/09   $ 62     12.7%   $ 675     43 .4%   $ 1,846
$1.0 million Samsung (3)
    07/31/07     427     87.3        448     28 .8     875
$418,000 SAFT (4)
    12/31/06         —        418     26 .9     418
$15,000 NCMS (5)
    06/30/07         —        15     0 .9     15
                                       
Total
        $ 489     100.0%   $ 1,556     100 .0%   $ 3,154
                                       
 
(1) Dates represent expiration of contract, not date of final billing.
 
(2) The DOE contract is a cost share contract. DOE funding for this contract was suspended during January 2006 and reinstated during May 2007. During 2007, we received notifications from the DOE of funding releases totaling $1.0 million and also received an extension of the termination date for the contract from July 31, 2007 to September 30, 2008. During February 2008, we received notification from the DOE of a funding release of $500,000, and during May 2008 we received notification of a funding release of $325,000.
 
(3) The Samsung contract is a research and prototype contract. This contract included one up-front payment of $750,000 and two milestone payments of $125,000 each for the delivery of


38


 

prototypes. The contract was amended on October 22, 2007 as we agreed to issue a credit in the amount of the last invoice in recognition of our continuing collaboration with Samsung. Therefore, revenue under this contract totaled $875,000.
 
(4) The SAFT contract is a fixed price contract. This is a subcontract with SAFT under the U.S. Army CECOM contract. The purchase order received in connection with this subcontract was revised on November 14, 2006 eliminating one milestone. As a result, the contract value was reduced from $470,000 to $418,000 and the expiration date was extended from September 30, 2006 to December 31, 2006.
 
(5) This contract was a cost plus catalyst research contract with the National Center for Manufacturing Sciences, or NCMS.
 
Cost of Product Revenue. Cost of product revenue in our test and measurement instrumentation business increased by $530,000, or 18.3%, to $3.4 million during the year ended December 31, 2007 from $2.9 million during the year ended December 31, 2006. As a percentage of product revenue, the annual cost of product revenue remained relatively consistent with 2006, and this increase was consistent with the higher revenue during 2007.
 
Gross profit as a percentage of product revenue decreased by 0.2% to 62.0% during the year ended December 31, 2007, remaining relatively consistent with 2006.
 
Funded Research and Product Development Expenses. Funded research and development expenses in our new energy business increased $739,000, or 64.1%, to $1.9 million for the year ended December 31, 2007 from $1.2 million for the year ended December 31, 2006. While the active contracts were relatively consistent between periods, costs for the DOE contract increased $1.3 million, reflecting its reinstatement during May 2007, while costs for the Samsung contract increased by $22,000. These increases were partially offset by a decrease in costs for the SAFT contract of $576,000, as that contract was completed during the first quarter of 2007.
 
Unfunded Research and Product Development Expenses. Unfunded research and product development expenses decreased $1.9 million, or 16.1%, to $9.9 million for the year ended December 31, 2007 from $11.8 million for the year ended December 31, 2006. This decrease reflects a $2.2 million decrease in development costs related to (a) the DOE contract that resumed during May 2007, which related increase is reflected in funded research and product development expenses, and (b) cost savings from the decision to suspend work on our high power program during March 2007. This decrease was partially offset by a $317,000 increase in product development expenses in our test and measurement instrumentation business, reflecting increased staffing and external product development costs focused on the development of the division’s new stand-alone measurement and data acquisition solution, stand-alone laser head, as well as other precision measurement solutions.
 
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased by $1.3 million, or 13.2%, to $8.7 million for the year ended December 31, 2007 from $10.1 million for the year ended December 31, 2006. This decrease was primarily the result of (a) a $387,000 decrease in non-cash stock-based compensation charges reflecting the difference between sign on and promotion grants during 2006 compared with primarily annual compensation grants during 2007 and the reversal of expense during 2007 related to certain cancelled executive stock-based performance grants where performance goals were not met, (b) a $528,000 decrease in outside services, including audit, legal, and consulting fees, (c) a $345,000 decrease in recruiting and relocation costs, (d) a $178,000 increase in severance costs attributable to employees terminated as a result of our March 2007 restructuring, (e) a $632,000 decrease in wages and benefits, which was also attributable to our March 2007 restructuring, (f) a $227,000 decrease in other operating expenses, primarily insurance and laboratory operating fees, (g) a $647,000 increase related to a decrease in allocations of expense from SG&A to funded and unfunded research and development costs for overhead and other costs allocable to research and development programs, and (h) a $40,000 savings in other expenses, net.
 
Operating Loss. Operating loss for the year ended December 31, 2007 compared with the operating loss for the year ended December 31, 2006 decreased by $4.4 million to $13.3 million, a 24.7% decrease, as a result of the factors noted above.


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Gain on Sale of Securities Available for Sale. The gain on sale of securities available for sale for the year ended December 31, 2007 was $2.5 million compared with a gain of $4.3 million for the year ended December 31, 2006. During 2007, we sold 1,452,770 shares of Plug Power common stock at a weighted average price of $3.53 per share, with gross proceeds to us of $5.1 million.
 
Gain (loss) on Derivatives. We recorded a gain on derivative accounting of $3.0 million for the year ended December 31, 2007 and a gain of $182,000 on derivative accounting for the year ended December 31, 2006. Both the 2007 and 2006 gains are the result of derivative treatment of the freestanding warrants issued to investors in conjunction with our December 2006 capital raise.
 
Income Tax (Expense) Benefit. Our income tax rate for the year ended December 31, 2007 was 33%, while the income tax rate for the year ended December 31, 2006 was 15%. These tax rates were primarily the result of losses generated by operations, changes in the valuation allowance, state true-ups upon tax return filings, permanent deductible differences for the derivative valuation, and disproportionate effects of reclassification of gains on Plug Power security sales included in operating loss.
 
The valuation allowance against our deferred tax assets at December 31, 2007 was $22.3 million and at December 31, 2006 was $18.9 million. We determined that it was more likely than not that the ultimate recognition of certain deferred tax assets would not be realized.
 
Results of Operations for the Year Ended December 31, 2006 Compared to December 31, 2005.
 
Product Revenue. Product revenue in our test and measurement instrumentation business increased by $1.7 million, or 27.5%, to $7.7 million for the year ended December 31, 2006 from $6.0 million for the year ended December 31, 2005. This performance was primarily the result of (a) an increase of $1.5 million, or 55.0%, in dimensional gauging sales, particularly direct capacitance sales through our Japanese distributor, (b) increases in semiconductor sales of $200,000, as 18 manual, one automatic, and one semi-automated metrology tool systems were sold during the year, compared to seven manual, one semi-automated, and four OEM systems during 2005, (c) commercial aviation equipment sales increases of $539,000, and (d) lower revenue from the U.S. Air Force of $611,000 as a result of fewer purchases of new equipment and reduced activity under the existing repair contract.
 
In our test and measurement instrumentation business, the U.S. Air Force accounted for $1.8 million, or 23.1%, of product revenue during the year ended December 31, 2006 compared with $2.4 million, or 39.7% of product revenue during the year ended December 31, 2005. During 2006, Koyo Precision, our Japanese distributor, represented $1.8 million, or 22.9%, of product revenue.
 
Information regarding government contracts included in product revenue is as follows:
 
                                   
                          Total
                          Contract
          Revenue
    Revenue
  Orders
          Year Ended
    Contract to
  Received to
          December 31,     Date
  Date
Contract (1)
  Expiration     2005     2006     December 31, 2006   December 31, 2006
          (dollars in thousands)
 
$8.8 million Air Force Retrofit and Maintenance of PBS-4100 Systems
    06/19/2008 (1 )   $ 1,552     $ 1,417     $6,627   $ 6,637
 
 
(1) Expiration date was extended from December 20, 2007 to May 19, 2008, and in May 2008 it was extended from May 19, 2008 to June 19, 2008.
 
Funded Research and Development Revenue. Funded research and development revenue in our new energy business decreased $1.3 million, or 73.3%, to $489,000 for the year ended December 31, 2006 from $1.8 million for the year ended December 31, 2005. The decrease in revenue was primarily


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the result of the suspension of previously approved DOE funding for 2006 and the completion of other programs that were active in 2005, including programs with the New York State Energy Research and Development Authority, the Army Research Labs, the Marine Corps, the Cabot Superior Micro Powders subcontract with the National Institute of Standards and Technology, and Harris. This decrease was partially offset by $427,000 of revenue recognized from the Samsung alliance agreement during 2006.
 
Information regarding government and private company development contracts included in funded research and development revenue is as follows:
 
                                         
                        Revenue
        For The Year Ended
  For The Year Ended
  Contract to
        December 31, 2005   December 31, 2006   Date
Contract
  Expiration (1)   Revenue   Percent   Revenue   Percent   December 31, 2006
        (dollars in thousands)
 
$3.0 million DOE (2)
    03/31/09   $ 930     50 .8%   $ 62     12 .7%   $ 1,171
$1.3 million NYSERDA (3)
    06/30/06     329     18 .0               1,135
$1.0 million Samsung (4)
    07/31/07               427     87 .3     427
$418,000 SAFT (5)
    12/31/06                        
$250,000 ARL
    09/30/05     250     13 .7               250
$210,000 NIST (6)
    06/30/05     100     5 .5               210
$150,000 Harris (7)
    06/25/04     150     8 .2               150
$70,000 Marine Corps
    03/31/05     70     3 .8               70
                                         
Total
        $ 1,829     100 .0%   $ 489     100 .0%   $ 3,413
                                         
 
 
(1) Dates represent expiration of contract, not date of final billing.
 
(2) The DOE contract is a cost-share contract. DOE funding for this contract was suspended during January 2006 and reinstated during May 2007. During 2007, we received notifications from the DOE of funding releases totaling $1.0 million and also received an extension of the termination date for the contract from July 31, 2007 to September 30, 2008. During February 2008, we received notification from the DOE of a funding release of $500,000, and during May 2008 we received notification of a funding release of $325,000.
 
(3) The total contract value for this cost shared contract is $1.3 million consisting of four Phases: Phase I for $500,000 was from March 12, 2002 through September 30, 2003; Phase II for $200,000 was from October 28, 2003 through October 31, 2004; Phase III for $348,000 was from August 23, 2004 through August 31, 2005; and Phase IV for $202,000 which commenced on December 14, 2004 and expired on June 30, 2006. Phases I, II, and III have been completed, while Phase IV expired before it was completed.
 
(4) The Samsung contract is a research and prototype contract. This contract included one up-front payment of $750,000 and two milestone payments of $125,000, each for the delivery of prototypes. The contract was amended on October 22, 2007 as we agreed to issue a credit in the amount of the last invoice in recognition of our continuing collaboration with Samsung. Therefore, revenue under this contract totaled $875,000.
 
(5) Represents a fixed price subcontract with SAFT under the U.S. Army CECOM contract. The purchase order received in connection with this subcontract was revised on November 14, 2006 eliminating one milestone. As a result, the contract value was reduced from $470,000 to $418,000 and the expiration date was extended from September 30 to December 31, 2006.
 
(6) Represents a fixed price subcontract with CSMP under NIST and includes the original contract for $200,000 and a contract amendment for $10,000.


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(7) Represents a fixed price contract that includes the original contract for $200,000, an amendment for $50,000, and a 2005 amendment reducing the contract by $100,000.
 
Cost of Product Revenue. Cost of product revenue in our test and measurement instrumentation business increased by $519,000, or 21.8%, to $2.9 million for the year ended December 31, 2006 from $2.4 million for the year ended December 31, 2005. This increase is consistent with higher product revenue during 2006 compared with 2005.
 
Gross profit as a percentage of product revenue increased by 1.8% to 62.2% for the year ended December 31, 2006. The improvement in gross margin during 2006 was primarily the result of a five point rise in average margins on capacitance product sales resulting from higher sales volume and improved pricing strategies.
 
Funded Research and Product Development Expenses. New energy funded research and development expenses decreased by $2.4 million, or 67.6%, to $1.2 million for the year ended December 31, 2006 from $3.6 million for the year ended December 31, 2005. The decreased costs were attributable to active contracts during 2005, which were no longer active during 2006. During 2006, we had active contracts with Samsung, DOE, and SAFT, while during 2005 we had active contracts with DOE, NYSERDA, SAFT, NIST, ARL, and the Marine Corps.
 
Unfunded Research and Product Development Expenses. Unfunded research and product development expenses increased by $5.7 million, or 92.4%, to $11.8 million for the year ended December 31, 2006 from $6.1 million for the year ended December 31, 2005. This increase reflected a $5.4 million increase in our new energy business related to increased internal costs for the development of micro fuel cell systems and costs in connection with developing prototypes and product intent prototypes, including a $512,000 non-cash charge for share-based compensation resulting from the adoption of SFAS No. 123R, which requires that the fair value of share-based compensation be expensed. This increase also included a $208,000 increase in product development expenses in our test and measurement instrumentation business for projects related to the development of a glass thickness gauge, improvements to the portable engine vibration and balancing system, and updated industrial balancing software.
 
Selling, General and Administrative Expense. Selling, general and administrative expenses decreased by $815,000, or 7.5%, to $10.1 million for the year ended December 31, 2006 from $10.9 million for the year ended December 31, 2005. This decrease was primarily the result of (a) an $892,000 increase in non-cash equity compensation charges resulting from the adoption of SFAS No. 123R, which required that the fair value of share-based compensation be expensed, (b) a $1.1 million decrease in salaries and engineering management costs, partially a result of an increase in costs directly charged to research and product development and the elimination of the government systems group during the second quarter of 2005, (c) a $640,000 decrease related to increases in liquidations to unfunded research and development costs, which was a result of having charged more time to internal development projects for low power and high power technology platform developments, the development of prototypes for Samsung, and the development of the Mobion 30M product, (d) a $259,000 decrease in the Los Alamos National Laboratory license fees as a result of an amendment of the license agreement, which resulted in reduced minimum annual license payments, (e) a $152,000 decrease in depreciation costs primarily related to the renewal of the lease on our main office, (f) a $104,000 increase in commission costs at MTI Instruments, (g) a $131,000 increase in incentive compensation primarily related to new executive employment agreements, (h) a $261,000 increase in marketing costs as MTI Micro raised its emphasis on marketing and business development and MTI Instruments underwent a major rebranding campaign during 2006, and (i) a $39,000 decrease in other expenses, net.
 
Operating Loss. Operating loss increased by $2.6 million, or 17.5%, to $17.7 million for the year ended December 31, 2006 compared with the year ended December 31, 2005 as a result of the factors noted above.


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Gain on Sale of Securities Available for Sale. The gain on sale of securities available for sale for the year ended December 31, 2006 was $4.3 million compared with $10.1 million for the year ended December 31, 2005. During the year ended December 31, 2006, we sold 1,103,500 shares of Plug Power common stock at a weighted average price of $5.66 per share, with gross proceeds to us of $6.2 million.
 
On June 24, 2005, Fletcher International Ltd., or Fletcher, notified us of its election to exercise in full its right to purchase from us an amount of common stock of Plug Power. As a result of this election, Fletcher purchased 1,799,791 shares of Plug Power common stock from us at a price of $0.7226 per share, with proceeds to us of $1.3 million. In connection with this exercise, we recognized a loss on this embedded derivative immediately prior to exercise of $7.2 million and a gain on the sale of Plug Power common shares of $9.6 million.
 
Gain (loss) on Derivatives. We recorded a gain on derivative accounting of $182,000 for the year ended December 31, 2006 and a loss of $10.4 million on derivative accounting for the year ended December 31, 2005. The 2006 gain was the result of derivative treatment of the freestanding warrants issued in conjunction with our December 2006 capital raise, while the 2005 result related to an embedded derivative for the purchase of Plug Power common stock, which was issued as part of the 2004 private placement transaction. The warrant derivative was valued using the Black-Scholes Pricing model, as was the embedded derivative prior to its exercise on June 24, 2005. Upon exercise, the embedded derivative was valued at its intrinsic value.
 
Income Tax (Expense) Benefit. Our income tax expense rate for the year ended December 31, 2006 was 15%, while the income tax expense rate for the year ended December 31, 2005 was 11%. These tax rates were primarily the result of losses generated by operations, changes in the valuation allowance, and disproportionate effects of reclassification of gains on Plug Power security sales included in operating loss.
 
The valuation allowance against our deferred tax assets at December 31, 2006 was $18.8 million and at December 31, 2005 was $10.9 million. We determined that it was more likely than not that the ultimate recognition of certain deferred tax assets would not be realized.


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Quarterly Results of Operations
 
The following table presents unaudited quarterly financial information for each of the 12 quarters ended March 31, 2008. We believe this information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation. The quarterly operating results are not necessarily indicative of results for any future periods. Quarter-to-quarter comparisons should not be relied upon as indicators of future performance. Our operating results are subject to quarterly fluctuations as a result of a number of factors.
 
                                                                                                 
    2005     2006     2007     2008  
    June 30     Sep. 30     Dec. 31     Mar. 31     June 30     Sep. 30     Dec. 31     Mar. 31     June 30     Sep. 30     Dec. 31     Mar. 31  
    (dollars in thousands, except per share data)  
 
Operating Data:
                                                                                               
Product revenue
    $1,285       $1,428       $1,896       $1,513       $1,700       $1,693       $2,761       $1,701       $2,275       $2,196       $2,856       1,980  
Gross profit on product revenue
    768       865       1,197       974       974       1,043       1,776       963       1,348       1,348       1,828       1,140  
Funded research and development revenue
    380       792       333       45       93       173       178       615       353       357       231       173  
Research and development expenses
    2,913       2,093       2,005       2,560       3,252       3,557       3,552       3,622       2,872       2,677       2,594       2,373  
Operating loss
    (4,273 )     (2,623 )     (3,633 )     (4,601 )     (4,961 )     (4,200 )     (3,975 )     (4,500 )     (3,500 )     (2,688 )     (2,661 )     (3,678 )
Net loss
    $(2,793 )     $(1,909 )     $(4,338 )     $(3,431 )     $(3,222 )     $(3,678 )     $(3,336 )     $(3,156 )     $(2,487 )     $(2,481 )     $(1,451 )     (3,187 )
                                                                                                 
Loss per share
                                                                                               
Basic and diluted loss per share
    $(0.73 )     $(0.50 )     $(1.12 )     $(0.89 )     $(0.82 )     $(0.93 )     $(0.82 )     $(0.66 )     $(0.52 )     $(0.52 )     $(0.30 )     (0.67 )
                                                                                                 
 
Liquidity and Capital Resources
 
We have incurred significant losses as we continue to fund the development and commercialization of our portable power source business. We expect that losses will fluctuate from year-to-year and that such fluctuations may be substantial as a result of, among other factors, sales of securities available for sale, our operating results, the availability of equity financing, including warrants issued in connection with the December 2006 capital raise, and the ability to attract government funding resources to offset research and development costs. As of March 31, 2008, we had an accumulated deficit of $108.3 million. During the three months ended March 31, 2008, our results of operations resulted in a net loss of $3.2 million and cash used in operating activities totaling $3.0 million. This cash use in 2008 was funded primarily by cash and cash equivalents on hand as of December 31, 2007 of $7.7 million. We expect to continue to incur losses as we seek to develop and commercialize our portable power source products. We expect to continue funding our operations from current cash and cash equivalents, the sales of securities available for sale, proceeds, if any, from equity financings, including warrants issued in connection with the December 2006 capital raise, and government funding. We expect to spend approximately $11.7 million on research and development of Mobion technology and $1.8 million in research and development on our test and measurement instrumentation products during 2008.
 
Additional financing may not be available to us on acceptable terms, if at all. Cash used to support operations is expected to total approximately $11.8 million, and cash used for capital expenditures is expected to total approximately $1.1 million. Capital expenditures will consist of purchases of manufacturing and laboratory equipment, software, computer equipment, and furniture. Proceeds from our sale of securities available for sale are subject to fluctuations in the market value of Plug Power Inc., or Plug Power. We may also seek to supplement our resources through additional equity offerings, sales of assets (including MTI Instruments). Additional government revenue could also provide more resources.


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As of March 31, 2008, we owned 1,137,166 shares of Plug Power common stock. Potential future sales of Plug Power securities will generate taxable income or loss, which is different from book income or loss, as a result of the tax bases in these assets being significantly different from their book bases. Book and tax bases as of March 31, 2008 were as follows:
 
                   
        Average Book
  Average Tax
Security
  Shares Held   Cost Basis   Cost Basis
 
Plug Power
    1,137,166   $ 1.78   $ 0.96
 
Plug Power stock is currently traded on The Nasdaq Global Market and is therefore subject to stock market conditions. When acquired, these securities were unregistered. Our Plug Power securities are considered “restricted securities” as defined under the securities laws and may not be sold in the future without registration under the Securities Act of 1933, as amended, unless in compliance with an available exemption from registration. While our Plug Power shares remain “restricted securities,” these shares are now freely transferable in accordance with Rule 144(d) under the Securities Act of 1933, subject to the limitations associated with such rule.
 
Working capital was $7.6 million at March 31, 2008, a $3.7 million decrease from $11.3 million at December 31, 2007. This decrease was primarily a result of the use of cash in operations and a decline in the value of our Plug Power common stock.
 
At March 31, 2008, our order backlog was $1.9 million compared to $445,000 at December 31, 2007.
 
Our inventory turnover ratios and accounts receivable days sales outstanding for the trailing 12-month periods and their changes at March 31, 2007 and 2008 were as follows:
 
                     
    2007   2008   Change  
 
Inventory turnover
    2.5     2.3     (0.2 )
Average accounts receivable days sales outstanding
    47     57     10  
 
The decline in inventory turnover stemmed from a 15% higher inventory balance needed at March 31, 2008, compared to March 31, 2007, to support new product initiatives as these products gain acceptance in their targeted markets, as well as to build higher stock levels to facilitate delivery upon our increased order backlog.
 
The increase in average accounts receivable days sales outstanding in 2008 compared to 2007 was primarily attributable to our decision to grant our largest commercial customer 90-day payment terms during 2007.
 
Cash used by operating activities was $3.0 million for the three months ended March 31, 2008 compared to $4.6 million in 2007. This cash use decrease of $1.6 million reflects a net decrease in cash expenditures to fund operations of $743,000, coupled with net balance sheet changes, which decreased cash expenditures by $879,000, reflecting the timing of cash payments and receipts, particularly recognition of deferred revenue and the accrual of certain accrued liabilities.
 
Capital expenditures were $102,000 during the three months ended March 31, 2008, an increase of $52,000 from the comparable period in prior year. Capital expenditures in 2008 included manufacturing, laboratory and demonstration equipment. Outstanding commitments for capital expenditures as of March 31, 2008 totaled $5,000 and included commitments for laboratory equipment. We expect to finance these expenditures with current cash and cash equivalents, the sale of securities available for sale, equity financing and other sources, as appropriate and to the extent available.
 
Cash flow used by operating activities was $11.7 million during 2007 compared with $12.7 million during 2006. This cash use decrease of $1.0 million reflected a net decrease of


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$3.5 million in cash expenditures to fund operations coupled with net balance sheet changes, which increased cash expenditures by $2.5 million, reflecting the timing of cash receipts and payments, particularly recognition of deferred revenue and payment of certain accrued liabilities.
 
Capital expenditures were $414,000 during 2007, a decrease of $1.2 million from the prior year. Capital expenditures during 2007 included computer equipment, software, and manufacturing and laboratory equipment. Outstanding commitments for capital expenditures as of December 31, 2007 totaled $35,000 and included expenditures for laboratory and computer equipment. We expect to finance these expenditures and other capital expenditures during 2008 with current cash and cash equivalents, the sale of securities available for sale, equity financing, and other sources, as appropriate and to the extent available.
 
During 2007, we sold 1,452,770 shares of Plug Power common stock with proceeds totaling $5.1 million and gains totaling $2.5 million. These proceeds reflect our previously announced strategy to raise additional capital through the sale of Plug Power stock to fund our micro fuel cell operations. We expect the net gains to be offset by our operating losses for purposes of computing taxable income. We estimate that as of December 31, 2007, our remaining net operating loss carry forwards were approximately $54 million.
 
Off-Balance Sheet Arrangements
 
Pursuant to a financing transaction between us and certain investors on December 15, 2006, we issued warrants to purchase up to an aggregate 378,472 shares of our common stock exercisable at any time until December 19, 2011 at an exercise price per share of $18.16. The shares issuable upon exercise of these warrants would be issued under a shelf registration statement covering the resale of such shares. The terms of the warrant agreement permit a cash settlement with the holders of the warrants if we are acquired by, or merge with, a private company. Because of the possibility of such a settlement, we have classified this agreement as an asset/liability derivative in accordance with SFAS No. 133 and EITF 00-19.
 
Critical Accounting Policies and Significant Judgments and Estimates
 
The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. Note 2 to the consolidated audited financial statements includes a summary of our most significant accounting policies. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, inventories, securities available for sale, income taxes, share-based compensation and derivatives. We base our estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Periodically, we review our critical accounting estimates with the Audit Committee of our Board of Directors.
 
The significant accounting policies that we believe are most critical to aid in fully understanding and evaluating our financial statements include the following:
 
Revenue Recognition. We recognize revenue from development contracts based upon the relationship of actual costs to estimated costs to complete the contract. These types of contracts typically provide development services to achieve a specific scientific result relating to direct methanol fuel cell technology. Some of these contracts require us to contribute to the development effort. The customers for these contracts are commercial customers and various state and federal government agencies. While government agencies are providing revenue, we do not expect the


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government to be a significant end user of the resulting products. Therefore, we do not reduce funded research and product development expense by the funding received. When it appears probable that estimated costs will exceed available funding on fixed price contracts and we are not successful in securing additional funding, we record the estimated additional expense before it is incurred.
 
We apply the guidance in SAB No. 104, Revenue Recognition, in the evaluation of commercially funded fuel cell research and prototype agreements to determine when to properly recognize income. Payments received in connection with commercial research and prototype agreements are deferred and recognized on a straight-line basis over the term of the agreement for service-related payments. For milestone and prototype delivery payments, if and when achieved, revenue is deferred and recognized on a straight-line basis over the remaining term of the agreement. When revenue qualifies for recognition it will be recorded as funded research and development revenue. The costs associated with research and prototype-producing activities are expensed as incurred. Expenses in an amount equal to revenue recognized are reclassified from unfunded research and product development to funded research and product development.
 
We also recognize revenue from product sales in accordance with SAB No. 104. We recognize product revenue when there is persuasive evidence of an arrangement, delivery of the product to the customer or distributor has occurred, at which time title generally is passed to the customer or distributor, and we have determined that collection of a fixed fee is probable, all of which occur upon shipment of the product. If the product requires installation to be performed by us, all revenue related to the product is deferred and recognized upon the completion of the installation.
 
Inventory. Inventory is valued at the lower of cost or the current estimated market value of the inventory. We periodically review inventory quantities on hand and record a provision for excess or obsolete inventory based primarily on our estimated forecast of product demand, as well as based on historical usage. Demand and usage for products and materials can fluctuate significantly. A significant decrease in demand for our products could result in a short-term increase in the cost of inventory purchases and an increase of excess inventory quantities on hand. Therefore, although we make every effort to assure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our reported operating results.
 
Share-Based Payments. We grant options to purchase our common stock and award restricted stock to our employees and directors under our equity incentive plans. The benefits provided under these plans are share-based payments subject to the provisions of SFAS No. 123R, Share-Based Payment, and SEC Staff Accounting Bulletin 107, Share-Based Payments. Effective January 1, 2006, we use the fair value method to apply the provisions of FAS 123R with the modified prospective application, which provides for certain changes to the method for valuing share-based compensation. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified. Under the modified prospective application, prior periods are not revised for comparative purposes. Share-based compensation expense recognized under FAS 123R for the three months ended March 31, 2008 was $389,000 and for the year ended December 31, 2007 was $1.6 million. At March 31, 2008, total unrecognized estimated compensation expense related to non-vested awards granted prior to that date was $1.3 million, which is expected to be recognized over a weighted average period of 1.27 years.
 
Upon adoption of FAS 123R, we began estimating the value of share-based awards on the date of grant using a Black-Scholes option-pricing model. Prior to the adoption of FAS 123R, the value of each share-based award was estimated on the date of grant using the Black-Scholes model for the pro forma information required to be disclosed under FAS 123. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected


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by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate, and expected dividends.
 
If factors change and we employ different assumptions in the application of FAS 123R during future periods, the compensation expense that we record under FAS 123R may differ significantly from what we have recorded in the current period. Therefore, we believe it is important for investors to be aware of the high degree of subjectivity involved when using option-pricing models to estimate share-based compensation under FAS 123R. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions, are fully transferable and do not cause dilution. Because our share-based payments have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect our estimates of fair values, in our opinion, existing valuation models, including the Black-Scholes Option Pricing model, may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may bear little resemblance to the intrinsic values realized upon the exercise, expiration, cancellation, or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and expensed in our financial statements. Alternatively, value may be realized from these instruments that are significantly in excess of the fair values originally estimated on the grant date and expensed in our financial statements. There currently is neither a market-based mechanism nor other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor a way to compare and adjust the estimates to actual values. Although the fair value of employee share-based awards is determined in accordance with FAS 123R and SAB 107 using a qualified option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction. Estimates of share-based compensation expenses are significant to our financial statements, but these expenses are based on the aforementioned option valuation model and will never result in the payment of cash by us.
 
The guidance in FAS 123R and SAB 107 is still relatively new, and best practices are not well established. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of share-based payments. It may also result in a lack of comparability with other companies that use different models, methods, and assumptions.
 
Theoretical valuation models and market-based methods are evolving and may result in lower or higher fair value estimates for share-based compensation. The timing, readiness, adoption, general acceptance, reliability, and testing of these methods is uncertain. Sophisticated mathematical models may require voluminous historical information, modeling expertise, financial analyses, correlation analyses, integrated software and databases, consulting fees, customization, and testing for adequacy of internal controls.
 
For purposes of estimating the fair value of stock options granted during the three months ended March 31, 2008 and the year ended December 31, 2007 using the Black-Scholes model, we used the historical volatility of our stock for the expected volatility assumption input to the Black-Scholes model, consistent with the guidance in FAS 123R and SAB 107. The risk-free interest rate is based on the risk-free zero-coupon rate for a period consistent with the expected option term at the time of grant. We do not currently pay nor do we anticipate paying dividends, but we are required to assume a dividend yield as an input to the Black-Scholes model. As such, we use a zero dividend rate. The expected option term is estimated using both historical term measures and projected termination estimates.


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Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves the estimation of our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Included in this assessment is the determination of net operating loss carry forwards. These differences result in a net deferred tax asset. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent that we believe that recovery is not likely, we must establish a valuation allowance.
 
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance as a result of uncertainties in our ability to realize certain net deferred tax assets, primarily consisting of net operating losses being carried forward. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust the recorded valuation allowance, which could materially impact our financial position and results of operations. We have recorded a full valuation allowance against our net deferred tax assets of $22.3 million as of December 31, 2007. In the event actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust our valuation allowance which could materially impact our financial position and results of operations.
 
During June 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 or FIN 48, which became effective for us beginning in fiscal 2007. FIN 48 addresses the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The impact of our reassessment of our tax positions in accordance with FIN 48 did not have a material impact on our results of operations, financial condition, or liquidity.
 
Derivative Instruments. We account for derivative instruments and embedded derivative instruments in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The amended standard requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure these instruments at fair value. Fair value is estimated using the Black-Scholes Pricing model. We also follow EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to and Potentially Settled in, a Company’s Own Stock, which requires freestanding contracts that are settled in a company’s own stock, including common stock warrants, to be designated as an equity instrument, asset or a liability. Under the provisions of EITF Issue No. 00-19, a contract designated as an asset or a liability must be carried at fair value, with any changes in fair value recorded in the results of operations. A contract designated as an equity instrument can be included in equity, with no fair value adjustments are required.
 
The asset/liability derivatives are valued on a quarterly basis using the Black-Scholes Pricing model. Significant assumptions used in the valuation included exercise dates, closing prices for our common stock, volatility of our common stock, and a proxy risk-free interest rate. Gains (losses) on derivatives are included in “Gain (loss) on derivatives” in our consolidated statement of operations.


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BUSINESS
 
We are developing and commercializing off-the-grid rechargeable power sources for portable electronics. We have developed a patented, proprietary direct methanol fuel cell technology platform called Mobion, which generates electrical power using up to 100% methanol as fuel. Our proprietary fuel cell power solution consists of two primary components integrated in an easily manufactured device: the direct methanol fuel cell power engine, which we refer to as our Mobion Chip, and methanol replacement cartridges. Our current Mobion Chip weighs less than one ounce and is small enough to fit in the palm of one’s hand. The methanol used by the technology is fully biodegradable. We believe we are the only micro fuel cell developer to have demonstrated power density of over 50 mW/cm2 with high energy efficiencies of 1.4 Wh/cc of methanol for handheld consumer electronic applications. For these reasons, we believe our technology offers a compelling alternative to current lithium-ion and similar rechargeable battery systems currently used by original equipment manufacturers and branded partners, or OEMs, in many handheld electronic devices, such as mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, PDAs, and GPS devices. We believe our platform will facilitate the development of numerous product advantages, including small size, environmental friendliness, and simplicity of design, all critical for commercialization in the consumer market, and can be implemented as three different product options: a compact external charging device, a snap-on or attached power accessory, or an embedded fuel cell power solution. We have strategic arrangements with Samsung Electronics, an OEM of mobile phones and mobile phone accessories, with Duracell, part of the Procter & Gamble Company, and with a global Japanese consumer electronics company. Our goal is to become a leading provider of portable power for handheld electronic devices and we intend to commercialize Mobion products beginning in 2009.
 
Our Mobion technology eliminates the need for active water recirculation pumps or the inclusion of water as a fuel dilutant. The water required for the electrochemical process is transferred internally within the Mobion Chip from the site of water generation on the air-side of the cell. This internal flow of water takes place without the need for any pumps, complicated re-circulation loops or other micro-plumbing tools. Our Mobion technology is protected by a patent portfolio that includes over 90 U.S. patent applications covering five key technologies and manufacturing areas.
 
We also design, manufacture, and sell high-performance test and measurement instruments and systems serving three markets: general dimensional gauging, semiconductor, and aviation. These products consist of: electronic, computerized gauging instruments for position, displacement and vibration applications for the design, manufacturing and test markets; semiconductor products for wafer characterization; and engine balancing and vibration analysis systems for military and commercial aircraft.
 
The Portable Power Source Industry
 
Industry Background
 
Consumers demand portable electronics that offer an enhanced experience through expanded memory, improved display technologies, constant connectivity, robust software, and a reduced form factor. In addition, technological advances in semiconductor manufacturing, LED displays, memory costs and availability, wireless technologies, and software applications have resulted in a dramatic increase in the number of portable electronic devices, their usage, and power requirements. As a result of these consumer demands and technological advances, there are a number of handheld electronic devices, such as mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, PDAs, and GPS devices, that have been introduced into the market. Many of these devices provide consumers and mobile professionals with the ability to communicate any time, anywhere and have effectively enabled the creation of an “always-on” environment independent of the end user’s location. This trend towards increased


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functionality in portable electronic devices has led to a “power gap” in which the disparity between a device’s power supply, typically a rechargeable lithium-ion battery, and its power need are not being met. This power gap leads to a need for the end user to plug-in their devices to the electrical grid on a regular basis, which limits their ability to use these electronic devices where and when the need arises.
 
The Power Source Bottleneck
 
Improvements in rechargeable battery technology have not kept pace with the evolution of consumer electronic device performance. Over the last ten years, device performance as measured by silicon processor speed has increased by a factor of 128 times, while the energy density of lithium-ion technology has only doubled. We believe that further gains in lithium-ion technology for portable electronics will be incremental at best, as any achievable benefits may be outweighed by the decreasing stability, availability, integrity, and relative safety of these higher energy output batteries. In addition to their performance shortfalls, lithium-ion battery technology poses an environmental risk as the various heavy metals incorporated in these batteries require special disposal to prevent contamination of waste disposal sites.
 
According to Frost and Sullivan, an independent research firm, the global battery market was approximately $14.3 billion in 2006 and is projected to increase to roughly $21.4 billion by 2012. The market for batteries can be divided into three segments: consumer, industrial, and military. Consumer battery sales represented approximately 81% of this market and are projected to represent an overwhelming majority of sales through at least 2012. The same study estimates that rechargeable batteries accounted for approximately $5.4 billion of this market in 2006.
 
OEMs are actively seeking improved power sources to replace existing rechargeable lithium-ion batteries and to power additional improvements to their mobile electronic devices. The development of new products using technologies that already exist, such as radio frequency technologies and 4G wireless capabilities, but cannot be effectively commercialized on mobile devices, will result from the availability of portable, compact, economical, rechargeable/replaceable higher energy density power sources, including micro fuel cells.
 
Our Solution
 
At the core of our solution is our proprietary Mobion Chip engine, a design architecture that embodies a reduction in the size, complexity, and cost of fuel cell construction, which results in a reliable, manufacturable, and affordable power solution that we believe provides improved energy density and portability over competing rechargeable battery technologies. Our proprietary fuel cell power solution consists of two primary components integrated in an easily manufactured device: the direct methanol fuel cell power engine, which we refer to as our Mobion Chip, and methanol replacement cartridges. Our Mobion Chip weighs less than one ounce and is small enough to fit in the palm of one’s hand. For these reasons, we believe that our Mobion platform is ideally suited to provide a replacement for rechargeable lithium-ion batteries. Based upon our ability to provide a compact, efficient, clean, safe, and long-lasting power source for lower power applications, we intend to initially target power solutions for applications, such as mobile phones (including smart phones) and mobile phone accessories, digital cameras, portable media players, PDAs, and GPS devices.
 
For handheld consumer electronic applications, we believe we are the only micro fuel cell developer to have demonstrated power density of over 50 mW/cm2 with energy efficiencies of 1.4 Wh/cc of fuel, which is a direct result of our Mobion platform’s ability to use 100% methanol – a widely available, environmentally friendly, inexpensive, and biodegradable fuel. These advantages result in higher energy density and reduced size, cost, and complexity of our power solution offering consumers portable on-demand power, independence from power outlets, and freedom from the need to constantly recharge their devices.


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Our Strategy
 
Our goal is to become a leading provider of portable power for handheld electronic devices. Key elements of our strategy designed to achieve this objective include the following:
 
Business Focus. We are focusing our efforts on the development and commercialization of our portable power source products. We believe this business provides a higher potential, higher growth opportunity than our test and measurement instrumentation business. We will continue to evaluate our test and measurement instrumentation business, which contributes positive operating results and cash flows, but may consider its eventual sale or other disposition.
 
Design for Mass Manufacturing. Our portable power source products will be manufactured using standard processes, such as injection molding and automated test and assembly, which are broadly employed throughout the electronics manufacturing industry. In preparing Mobion for commercialization, our current Mobion Chip is injection molded and is being designed for mass manufacturing. In addition, we have continued integrating more functionality into our Mobion Chip while reducing its part count to one molded piece. Our current Mobion Chip is 9cc in size, which is small enough to fit in the palm of a hand.
 
Outsource Manufacturing. We plan to outsource manufacturing to expand rapidly and diversify our production capacity. This strategy will allow us to maintain a variable cost model in which we do not incur most of our manufacturing costs until our proprietary fuel cell power solution has been shipped and billed to our customers. We intend to concentrate on our core competencies of research and development and product design. This approach should reduce our fixed capital expenditures and allow us to efficiently scale production.
 
Utilize our Technology to Provide Compelling Products. We plan to utilize our intellectual property portfolio and technological expertise to develop and offer portable power source products across multiple electronic device markets. We intend to employ our technological expertise to reduce the overall size and weight of our portable power source products while increasing their ease of manufacturing, power capacity, and power duration and decreasing their cost. We believe that these efforts will enable us to meet customer expectations and to achieve our goal of supplying on a timely and cost-effective basis the most environmentally friendly portable power source products to our target markets. We believe our products will offer advantages in terms of performance, functionality, size, weight, and ease of use. We plan to continue enhancing our customers’ industrial design alternatives and device functionality through innovative product development based on our existing capabilities and technological advances.
 
Capitalize on Growth Markets. We intend to capitalize on the growth of the electronic device markets, including new products that may be brought about by the convergence of computing, communications, and entertainment devices. We believe our portable power source products will address the growing need for portability, connectivity, and functionality in the evolving electronic device markets. We plan to offer these power solutions to OEM customers to enable them to offer products that have advantages in terms of size, weight, power duration, and environmental friendliness. We plan to utilize our existing technologies, as well as aggressively pursue new technologies and evolving markets that demand enhanced power solutions.
 
Develop Strong Customer Relationships. We plan to develop strong and long-lasting customer relationships with leading electronic device OEMs and to provide them with power solutions for their products. We believe that our portable power source products will enable our OEM customers to deliver a more positive user experience and to differentiate their products from those of their competitors. We will attempt to enhance the competitive position of our customers by providing them with innovative, distinctive, and high-quality portable power supply products on a timely and cost-effective basis. We will work continually to improve our portable power source products, to reduce costs, and to speed the delivery of our products. We will endeavor to streamline our designs


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and delivery processes through ongoing design, engineering, and production improvement efforts. We will also devote considerable effort to support our customers after the purchase of our portable power source products.
 
Pursue Strategic Relationships. We intend to develop and expand strategic relationships to enhance our ability to offer value-added customer solutions, penetrate new markets, and strengthen the technological leadership of our portable power source products.
 
Products
 
Portable Power Source Products
 
We are developing three product categories of our Mobion technology: (i) external power charger products, (ii) snap-on or attached power source products, and (iii) embedded power source products. In addition, we are working with our strategic partners and suppliers to develop disposable methanol cartridges that will be used to fuel our portable power source products. Through our alliance with Duracell, we are developing fuel cartridges that will be designed and branded for mass market commercialization. Duracell has experience in the sale and distribution of portable power through its battery products, as well as in the development, distribution, and sale of liquid products with similar safety and packaging requirements as the 100% methanol cartridges.
 
External Power Charger: Our design for an external power charger is a standalone device that uses a standard and widely used universal serial bus, or USB, interface as a power output connector that can be used to recharge handheld mobile devices. Our current design for the device is roughly the size of two decks of playing cards (see photo below) and employs a 100% methanol fuel cartridge, which occupies the same volume as a pack of chewing gum. Our current prototype external power charger provides up to one month of power for the typical mobile phone. It can also be designed to enable a professional photographer to take over 5,000 pictures using a high end digital camera from a single fuel tank. Our device is designed to provide 2.5 watts of power from its USB interface and also offer fast charge, ultra-long run time and self-charging modes.
 
CHARGER PROTOTYPE
 
Mobion external power charger prototypes
 
Snap-on or Attached Power Source Products: Similar to aftermarket battery attachments, our snap-on direct methanol fuel cell power solution is an attached power supply that is compatible with existing portable electronic devices and offers users extended run-time power. In this category, we envision a number of product applications, including attachments for digital cameras, portable media players, GPS devices, and other consumer and electronic products. Our initial design is a direct methanol fuel cell camera-grip (see photo below) that replaces comparable rechargeable lithium-ion battery-pack grips and is designed to provide twice as much energy as similar


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rechargeable lithium-ion battery-based products. Our Mobion direct methanol fuel cell camera grip allows photographers the benefits of extended usage plus the freedom to refill using a methanol cartridge rather than by plugging into a wall outlet.
 
CAMERA GRIP
 
Sample Mobion attached power
source camera-grip prototype
 
Embedded power source products: Our goal is to produce direct methanol fuel cells that can be embedded into portable electronic devices in order to increase their run time and to provide fast charge capability by hot-swapping 100% methanol cartridges. We have developed an embedded fuel cell prototype for a GPS unit that we believe will generate three times as much usage time as GPS devices powered by conventional disposable AA batteries (see photos below.)
 
We have also developed an embedded fuel cell concept model designed for a smart phone (see photos below) and believe that this concept model highlights the anticipated future product direction for our portable power source products in the consumer market.
 
SMART PHONE
 
Prototype of a GPS unit with an
embedded Mobion power source
SMART PHONE
 
Concept model of a smart phone with an
embedded Mobion power source
 
Advantages of our Portable Power Source Products
 
We believe that our portable power source products will offer the following advantages:
 
  •   Off-the-grid power source. Our products provide users of consumer electronic devices with extended mobility by providing power without having to attach to a wall outlet to recharge their devices.
 
  •   Small size and low weight. The dimensions of our products will enable our OEM customers to reduce the overall size and weight of their products.
 
  •   Power density. Our products will have power density of over 50 mW/cm2 and high energy efficiencies of 1.4 Wh/cc of methanol.
 
  •   Power duration. Our products will offer longer run time than currently available portable charging systems.
 
  •   Ease of manufacturing. Our products will be manufactured using traditional injection molding techniques that will easily transfer to mass-manufacturing production lines.


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  •   Safety. Our products will utilize methanol fuel, which does not require storage under pressure or at low temperatures.
 
  •   Environmentally friendly. Our products will utilize fully biodegradable methanol fuel.
 
Codes and Standards
 
In 2004, we became the world’s first company to obtain micro fuel cell safety compliance certifications for a fuel cell product from Underwriter’s Laboratory and CSA International. In addition, we received United Nations packaging certification and our methanol cartridges were deemed compliant by the U.S. Department of Transportation for worldwide cargo shipment. Certification is required for every commercial product prior to its shipment. Based upon our previous experiences with these regulatory agencies, we do not anticipate delays associated with seeking Underwriter’s Laboratory and CSA International product certifications for our commercial products, which are anticipated to begin shipping in 2009.
 
Also, we helped to develop a proposal adopted by the United Nations to provide methanol fuel cartridges a separate classification and we worked with other micro fuel cell companies, and the appropriate regulatory bodies, to generate the first draft of the international standards for methanol safety and use related to transport on commercial airplanes.
 
As a result of our industry coalition efforts, the International Civil Aviation Organization technical instructions and the International Air Transport Association Dangerous Goods Regulations now permit airline passengers and crew to carry on and use certain fuel cell power systems and fuel cell cartridges containing methanol. On April 30, 2008, the U.S. Department of Transportation issued a final ruling adopting the International Civil Aviation Organization, or ICAO, regulations permitting commercial aircraft passengers and crew to bring in their carry-on baggage methanol fuel cell cartridges and fuel cell systems designed for portable electronic devices. The effective date of this ruling is October 1, 2008, although voluntary compliance with this ruling may begin as soon as May 30, 2008.
 
Test and Measurement Instrumentation Products
 
We are a global supplier of computerized gauging instruments, metrology systems for semiconductor wafers, and jet engine balancing systems.
 
General Dimensional Gauging: Our gauging instruments employ fiber optic, laser, and capacitance technologies to make precision measurements in product design, production, and quality related processes. Our gauging instruments include capacitance gauging systems offering ultra-high precision measurement, a fiber-optic based vibration sensor system with extremely high frequency response, a high-speed laser sensor system utilizing the latest complementary metal-oxide semiconductor/charge-coupled device technology, and a stand-alone data acquisition system that incorporates multiple sensor technologies. These products are targeted towards the data storage, semiconductor, and automotive industries.
 
Semiconductor: Our family of wafer metrology systems range from manually operated units to fully automated systems, which test key wafer characteristics critical to producing high-quality chips used in the semiconductor industry. These units are used as quality control tools delivering highly precise measurements for thickness variations, bow, warp, resistivity, and flatness. These systems can be used on substrates varying widely in size and materials. Our wafer metrology systems include an automated wafer characterization system, a semi-automated, full wafer surface scanning system, and a device that provides for manual, non-contact measurements.
 
Jet Engine Balancing Systems: Our portable and test cell balance systems automatically collect and record aircraft engine vibration data, identify vibration or balance issues in an engine, and calculate a solution to the problem. These units are used by major aircraft engine manufacturers, the U.S. Air Force, other military and commercial airlines and gas turbine manufacturers.


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Technology
 
A fuel cell is an electrochemical energy conversion device, which is similar to a battery, that produces electricity from a liquid or gaseous fuel, such as methanol, and an oxidant, such as oxygen. Fuel cells are different from batteries in that they consume a reactant, which must be replenished, while batteries store electrical energy chemically in a closed system. Generally, the reactants flow in and reaction products flow out of the fuel cell. While the electrodes within a battery react and change as a battery is charged or discharged, a fuel cell’s electrodes are catalytic and relatively stable.
 
The direct methanol fuel cell relies upon the reaction of water with methanol at the catalytic anode layer to release protons and electrons, and form carbon dioxide. The electrons pass through a circuit and generate electricity that can be used to power external devices. The protons generated through this reaction pass through the proton exchange membrane to the cathode, where they combine to form water. The anode and cathode layers of a direct methanol fuel cell are usually made of platinum particles and platinum ruthenium particles embedded on either side of a proton exchange membrane.
 
Methanol fuel cells need water at the anode and therefore pure methanol cannot be used without the provision of water via either active transport, such as the pumping of water generated at the cathode back to the anode layer (see Chart A), or a passive recirculation mechanism that incorporates pressurized internal ducts or piping. Without either an active or a passive recirculation mechanism, a direct methanol fuel cell would require the inclusion of water as a dilutant in the methanol fuel, which limits the energy content of the diluted fuel (see Chart B).
 
Direct Methanol Fuel Cell with Active Water Transport (Chart A)
 
CHART A


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Methanol Fuel Cell With Water As A Fuel Dilutant (Chart B)
 
CHART B
 
Our Mobion technology eliminates the need for active water recirculation pumps or the inclusion of water as a fuel dilutant. The water required for reaction at the anode is transferred internally within the Mobion Chip from the site of water generation on the air-side of the cell through a proprietary, passive design that eliminates the need for water movement by external pumps, complicated re-circulation loops or other micro-plumbing tools (see Chart C).
 
Our Mobion Technology with 100% Methanol and Passive Water Recirculation (Chart C)
 
CHART C
 
Our Mobion solution contains a passive water recirculation sub-system that allows for the consumption of 100% methanol, results in a reduced parts count design and offers the advantage of higher energy density than competing fuel cell technologies for portable electronic devices.


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Strategic Agreements
 
On April 28, 2008, we entered into a development agreement with a global Japanese consumer electronics company to evaluate the feasibility, development, and production of our Mobion products. This agreement will enable us and this developer to collaborate in evaluating and adopting our Mobion technology for use in various precision imaging applications, including digital cameras. On May 12, 2008, we announced that we delivered a Mobion prototype to this company for their evaluation.
 
On May 16, 2006, we entered into an alliance with Samsung Electronics Co., Ltd., or Samsung, to develop next-generation fuel cell prototypes for Samsung’s mobile phone business. We developed, and together with Samsung we jointly tested and evaluated, our Mobion technology for several Samsung mobile phone applications. We are continuing to work with Samsung on a non-exclusive collaboration under which we continue to refine our Mobion baseline product design. We will share development updates with Samsung and loan them prototypes for evaluation. Samsung may also request changes to product specifications until December 2008 and may purchase commercial samples as soon as they become available.
 
On September 19, 2003, we entered into a strategic alliance agreement with Duracell, now part of the Procter & Gamble Company, under which we agreed to work with Duracell to develop and commercialize complementary methanol fuel cell products to power mass market, high-volume portable consumer devices. The agreement provides for a multi-year partnership for the design, development, and commercialization of a low power direct methanol fuel cell power system and a compatible fuel refill system. The arrangement provides for us to receive a percentage of net revenues related to Duracell’s sale of fuel refills for methanol fuel cells. The agreement gives Duracell the ability to make equity investments in MTI Micro. Duracell has made an initial $1.0 million investment in MTI Micro common stock and may make additional investments of up to $4.0 million, subject to agreed upon milestones related to technical and marketing progress. Any further investment by Duracell in MTI Micro will effectively dilute our ownership interest in MTI Micro, although we do not believe that such dilution will be substantial.
 
On August 1, 2004, we entered into a $6.1 million cost-shared development contract with the U.S. Department of Energy, or the DOE, for the development of manufacturing techniques and the optimization of our Mobion product solutions. Through May 2008, the DOE has authorized $6.1 million of spending on a cost-shared basis.
 
On December 13, 2007, we entered into an agreement with Trident Systems, Inc. to pursue opportunities to leverage our consumer market platform into low-power military markets. Teaming opportunities include demonstrations of unattended ground sensor prototypes powered by Mobion and evaluations and potential submissions of proposals for military programs.
 
Manufacturing
 
We plan to outsource manufacturing of our portable power source products through third-party relationship contract manufacturers. We believe this strategy will provide us with a business model that allows us to concentrate on our core competencies of research and development and technological know-how and reduce our capital expenditures. In addition, this strategy will significantly reduce our working capital requirements for inventory because we will not incur most of our manufacturing costs until we have actually shipped our portable power source products to our customers and billed those customers for those products. To date, we have established an internal developmental pilot production line to test our design and engineering capabilities and a representative office in Shanghai to facilitate our efforts to develop relationships with manufacturers and low cost component suppliers in China. Although we have developed an internal developmental pilot production line, we intend to rely upon third parties to forecast production requirements and have established the basic design, function, and performance of our in-house engineering capabilities to foster the successful commercialization of our products.


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The commercialization of our Mobion power solution will depend upon our ability to reduce the costs of our portable power source products, as they are currently more expensive than existing rechargeable battery technologies. In addition, we continue to work on enhancing our Mobion power source, including our injection molded Mobion Chip, design to ensure its manufacturability (including engineering, verification and product testing), design for assembly, design for testability, and design for serviceability, all of which are critical to successful high-volume production.
 
We assemble and test our test and instrumentation measurement products at our facilities located in Albany, New York. We believe that our existing assembly and test capacity is sufficient to meet our current needs and short-term future requirements. We believe that most of the raw materials used in our test and measurement products are readily available from a variety of vendors.
 
Sales and Marketing
 
We plan to sell our portable power source products for incorporation into the products of our OEM customers or to be sold as accessories through them. We plan to generate sales to OEM customers through direct sales employees as well as outside sales representatives and distributors. We have recently established sales representatives in South Korea and Japan.
 
We build awareness in our target markets through a series of targeted campaigns, which include our website, e-mails, conferences, tradeshows, and other standard marketing efforts. In addition, we monitor developments in the portable power industry through subscriptions with well known firms such as Frost and Sullivan, a wide array of publications, active public relations, updates with industry analysts and the investment community, and speaking engagements.
 
We market our test and measurement instrumentation products through a combination of direct sales personnel and domestic and international distributors.
 
Customers
 
We expect that our customers for our portable power source products will include a number of the world’s largest electronic device OEMs.
 
Revenue from our test and measurement instrumentation products to Koyo, our Japanese distributor, and the U.S. Air Force accounted for 20.1% and 18.3%, respectively, of product revenue for the three months ended March 31, 2008. In 2007, sales to Koyo and the U.S. Air Force accounted for 26.4% and 27.8%, respectively, of product revenue. In 2006, sales to Koyo and the U.S. Air Force accounted for 22.9% and 23.1%, respectively, of product revenue. No other single customer accounted for greater than 10% of product revenue in 2006, 2007 or 2008.
 
Competition
 
We expect that the primary competitive factor in our portable power source business will be market acceptance of our portable power source products as an alternative power source to conventional lithium-ion and other rechargeable batteries. Market acceptance of our portable power source products will depend on a wide variety of factors, including the compatibility of direct methanol fuel cell power sources with portable electronic devices and the market’s assessment of the advantages offered by our products in terms of size, weight, power density and duration, safety, reliability, and environmental friendliness when measured against price disadvantages. We anticipate direct competition from large Asian-based companies and some of our potential OEM customers.
 
Competition in the sale of our measurement and instrumentation products is based on product quality, performance, price, and timely delivery. Our competitors for test and measurement instrumentation products include National Instruments, KLA-Tencor, Capacitec, Sigma Tech, Corning Tropel, Chadwick-Helmuth, ACES Systems, Micro-Epsilon, and Keyence.


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Product Development
 
Over the past two years, we have developed and built a number of engineering prototypes used to validate our technology and to generate discussions with potential customers about the inclusion of our technology in new products. During the same period, we have created three generations of external power charger prototypes, each of which has shown a dramatic size reduction over the previous generation. Our latest external power charger prototype achieved a 60% reduction in volume over our first generation prototype.
 
We have improved the capabilities of our Mobion Chip technology during the last two years, which we expect will continue to evolve as we integrate greater functionality into our designs. This continuous iterative integration process is intended to reduce the size, simplify the design and construction, and reduce assembly complexity of our technology. We continue to improve the product design of the Mobion Chip and believe that future product generations will deliver performance improvements in terms of energy density, size, weight, and power duration and should be able to power wireless electronic devices for longer periods of time than rechargeable lithium-ion batteries.
 
Intellectual Property and Proprietary Rights
 
We rely on a combination of patent (both national and international), trade secret, trademark, and copyright protection to protect our intellectual property. Our strategy is to apply for patent protection for all significant design requirements. Additionally, we systematically analyze the existing intellectual property landscape for direct methanol fuel cells to determine where the greatest opportunities for developing intellectual property exist. We also enter into standard confidentiality agreements with our employees, consultants, vendors, partners and potential customers and seek to control access to and distribution of our proprietary information.
 
As of December 31, 2007, we had filed over 90 U.S. patent applications, 43 of which have been awarded. Of the awarded patents, 34 are assigned to us and 9 are assigned to Duracell as part of our strategic alliance agreement with them. We have filed 22 Patent Cooperation Treaty Applications and have filed for National Phase Patent Protection for 12 pieces of intellectual property in multiple countries, including Japan, the European Union, and South Korea. We have developed a portfolio of patent applications in areas including fuel cell systems, components, controls, manufacturing processes, and system packaging.
 
Research and Development
 
Our research and development team is responsible for advanced research, product planning, design and development, and quality assurance. Through our supply chain, we are also working with subcontractors in developing specific components of our technologies.
 
The primary objective of our research and development program is to advance the development of our direct methanol fuel cell technology to enhance the commercial value of our products and technology, as well as to develop next generation fuel cell products.
 
We have incurred research and development costs of approximately $9.7 million, $12.9 million and $11.8 million for the years ended December 31, 2005, 2006, and 2007, respectively. We incurred research and development costs of approximately $2.4 million for the three months ended March 31, 2008. We expect to continue to invest in research and development in the future.
 
Employees
 
As of March 31, 2008, we had 106 employees. Of these employees, 45 were involved in our portable power source business (including 24 scientists and engineers, of whom 18 had advanced degrees) and 46 were involved in our test and measurement instrumentation business. Fifteen of our employees are involved in corporate functions.


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Properties
 
We presently lease two premises, one located at 325 Washington Avenue Extension, Albany, New York and the other at 431 New Karner Road, Albany, New York. Both leases expire at the end of 2009. The 325 Washington Avenue Extension premise consists of approximately 20,700 useable square feet of space, and the 431 New Karner Road consists of approximately 23,500 useable square feet of space. Together, the premises are adequate for our current and foreseeable needs.
 
Legal Proceedings
 
We are not currently involved in any legal proceeding that we believe would have a material adverse effect on our business or financial condition.


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MANAGEMENT
 
The following table sets forth information regarding our executive officers and directors.
 
             
Name
 
Age
 
Position or Capacity
 
Peng K. Lim
    45     Chairman and Chief Executive Officer
Cynthia A. Scheuer
    47     Vice President, Chief Financial Officer and Secretary
Robert J. Kot
    57     Vice President and General Manager, MTI Instruments
James K. Prueitt
    51     Vice President of Engineering and Operations, MTI Micro
Thomas J. Marusak
    57     Director
E. Dennis O’Connor
    68     Director
William P. Phelan
    52     Director
Dr. Walter L. Robb
    80     Director
 
Peng K. Lim was elected as our Chairman on May 15, 2008 and has served as our Chief Executive Officer since December 2006. Between May 2006 and December 2006, Mr. Lim served as the President and Chief Executive Officer of MTI Micro. From July 2005 to April 2006, Mr. Lim served on numerous boards of private and public companies. From 2001 to 2005, Mr. Lim served as the President and Chief Executive Officer of Tapwave, Inc., a handheld and entertainment platform company. Mr. Lim served as Vice President, Worldwide Product Development of Palm, Inc., a handheld and wireless computer company, from April 1999 until May 2001. Mr. Lim served as Vice President of Engineering of Fujitsu Personal Systems, a pen-based and wireless computer company and a wholly-owned subsidiary of Fujitsu Limited, from June 1997 until March 1999. From July 1996 to June 1997, Mr. Lim was an Engineering Platform Director for Texas Instruments, a semiconductor company. Mr. Lim holds a B.S. and an M.S. in Electrical Engineering from University of Windsor (Ontario, Canada) and a Master of Engineering Management from Northwestern University. Mr. Lim is an alumnus of the Stanford Executive Program for Growing Companies at Stanford University.
 
Cynthia A. Scheuer has served as our Vice President and Chief Financial Officer since November 1997 and as our Secretary since March 2005. From June 1983 to October 1997, Ms. Scheuer served as a Senior Business Assurance Manager at PricewaterhouseCoopers LLP where she was responsible for the planning and delivery of audit and financial consulting services to a diverse group of clients in manufacturing, high technology, retail, and government. Ms. Scheuer holds a B.A. in Accounting and Economics from Ohio Wesleyan University and is a Certified Public Accountant.
 
Robert J. Kot has served as a Vice President of MTI Instruments since March 2007 and has served as General Manager in that division since December 2005. Mr. Kot previously served as MTI Instruments’ Vice President of Marketing and Sales from August 2005 to December 2005. From June 2001 to July 2005, Mr. Kot served as Vice President of Sales for Sierra Monitor Corporation, a company with independent business units serving the industrial, building automation, and telecommunications industries. During 1998, Mr. Kot founded OnCuity, a software company that marketed advanced alarm management systems for the process controls, building, and security markets. Mr. Kot served as Chief Executive Officer of OnCuity from 1998 to 2001. Prior to that time, Mr. Kot served in various capacities with Honeywell, EMC Controls, Azonix, and several venture capital backed technology companies focused upon rapid growth within the process, measurement, and building automation markets.
 
James K. Prueitt has served as Vice President of Engineering and Operations of MTI Micro since November 2007 and served as MTI Micro’s Senior Director of Engineering between April 2006 and November 2007. Mr. Prueitt manages research and development, purchasing, quality, operations and program management. Prior to joining our company, Mr. Prueitt spent 20 years at Polaroid Corporation where he served most recently as Divisional Vice President of Hardware and Software research and development. Mr. Prueitt also holds an M.B.A. from the University of West Florida and an M.S. in Mechanical Engineering from the University of Kentucky.


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Thomas J. Marusak has served as a director since December 2004. Since 1986, Mr. Marusak has served as President of Comfortex Corporation, an internationally recognized manufacturer of window blinds and specialty shades. Mr. Marusak served with New York’s Capital Region Center for Economic Growth as Chairman of the Technology Council from June 2001 to July 2004 and Chairman of the Board of Directors from July 2004 until December 2005. Mr. Marusak has served as a director for the New York State Energy and Development Authority since September 1999. Mr. Marusak also represented the interests of small- and medium- sized manufacturing businesses of New York as a delegate at the White House in 1995. He was previously a member of the Advisory Board of Directors for Key Bank of New York from 1996 through 2004, and served on the Advisory Boards of Dynabil Industries Inc. and Clough Harbour Associates Technology Services Company of Albany from 2000 through 2005. Mr. Marusak received a B.S. in Engineering from Pennsylvania State University, and an M.S. in Engineering from Stanford University.
 
E. Dennis O’Connor has served as a director since 1993, and is a retired attorney specializing in intellectual property. From 1984 until his retirement in June 2000, Mr. O’Connor served as the Director of New Products and Technology for Masco Corporation, a diversified manufacturer of building, home improvement, and other specialty products for the home and family. Mr. O’Connor holds a J.D. degree from George Washington University and a B.S. in Mechanical Engineering from Notre Dame University.
 
William P. Phelan has served as a director since December 2004. Mr. Phelan is the co-founder and Chief Executive Officer of Bright Hub, Inc., a software company founded in 2006, which focuses on the development of online commerce for software. Since May 2004, Mr. Phelan has acted as Chairman and CEO of Chatham Capital Management, Inc. In May 1999, Mr. Phelan founded OneMade, Inc., an electronic commerce marketplace technology systems and tools provider. Mr. Phelan served as Chief Executive Officer of OneMade, Inc. from May 1999 to May 2004. OneMade, Inc. was sold to America Online in May 2003. Mr. Phelan also serves on the Board of Trustees, and Chairman of the Audit Committee, of the Paradigm mutual fund family. In addition, Mr. Phelan served as a member of the Board of Directors of Florists’ Transworld Delivery, the largest floral services organization in the world, from January 1995 through December 1999. He has also held numerous executive positions at Fleet Equity Partners, Cowen & Company, and UHY Advisors Inc., formerly Urbach Kahn & Werlin, PC. Mr. Phelan has a B.A. in Accounting and Finance from Siena College, an M.S. in Taxation from City College of New York, and is a Certified Public Accountant.
 
Dr. Walter L. Robb has served as a director since 1997. Dr. Robb has served as President of Vantage Management, Inc., a management consulting company, since 1993. Prior to that time, Dr. Robb served in various executive positions with General Electric Company. Dr. Robb served as Senior Vice President for Corporate Research and Development with General Electric from 1986 until his retirement in December 1992, directing the General Electric Research and Development Center, one of the world’s largest and most diversified industrial laboratories, while also serving on its Corporate Executive Council. Dr. Robb served on the Board of Directors of Plug Power Inc., from 1997 through October 2002, and currently serves on the board of directors of Celgene Corporation, a publicly held integrated biopharmaceutical company, and a number of privately held companies.
 
Classification of our Board of Directors
 
Our certificate of incorporation provides for a Board of Directors consisting of three classes serving three-year staggered terms. Messrs. Lim, and Robb serve as our Class I directors, with the term of office of the Class I directors expiring at the annual meeting of stockholders in fiscal 2010. The Class II directors consist of Messrs. Marusak and O’Connor, with the term of office of the Class II directors expiring at the annual meeting of stockholders in fiscal 2011. The Class III director is Mr. Phelan, with the term of office of the Class III director expiring at the annual meeting of stockholders in 2009. Officers serve at the pleasure of the Board of Directors.


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Information Relating to Corporate Governance and the Board of Directors
 
Our Board of Directors has determined, after considering all the relevant facts and circumstances, that Messrs. Marusak, O’Connor and Phelan, and Dr. Robb are independent directors, as “independence” is defined by the listing standards of Nasdaq Stock Market and the SEC, because they have no relationship with us that would interfere with their exercise of independent judgment in carrying out their responsibilities as a director.
 
Our bylaws authorize our Board of Directors to appoint among its members one or more committees, each consisting of one or more directors. Our Board of Directors has established two standing committees: an Audit Committee and a Governance, Nominating and Compensation Committee, each consisting entirely of independent directors.
 
The Audit Committee
 
The primary purpose of the Audit Committee is to select the independent registered public accounting firm to conduct the independent audit of the financial statements of our company; review the annual financial statements, any significant accounting issues, and the scope of the audit with the independent registered public accounting firm; and discuss with such firm any other audit-related matters that may arise during the year. The Audit Committee currently consists of Messrs. Phelan and O’Connor and Dr. Robb, each of whom is an independent director of our company under The Nasdaq Stock Market Inc. as well as under rules adopted by the SEC.
 
The Governance, Nominating, and Compensation Committee
 
The Governance, Nominating, and Compensation Committee reviews and acts on matters relating to compensation levels and benefit plans for our key executives; assists our Board of Directors in fulfilling its responsibility to nominate and approve qualified new members to our Board of Directors in accordance with our certificate of incorporation and bylaws; develops and recommends to our Board of Directors a set of corporate governance principles; and oversees the selection and compensation of committees of our Board of Directors. The Compensation Committee currently consists of Messrs Marusak and O’Connor and Dr. Robb, with Mr. O’Connor serving as Chairman.
 
Executive Compensation
 
Compensation Philosophy
 
The primary objectives of our compensation policies are to attract, retain, motivate, develop, and reward our management team for executing our strategic business plan thereby enhancing stockholder value, while recognizing and rewarding individual and company performance. These compensation policies include (i) an overall management compensation program that is competitive with national and regional companies of similar size or within our industry; and (ii) long-term incentive compensation in the form of stock-based compensation that will encourage management to continue to focus on stockholder return. Our executive compensation program ties a substantial portion of each executive’s overall compensation to key strategic, financial, and operational goals, including establishing and maintaining customer relationships, signing OEM agreements; meeting revenue targets and profit and expense targets; introducing new products; progressing products towards manufacturing; and improving operational efficiency.
 
We believe that potential equity ownership in our company is important to provide executive officers with incentives to build value for our stockholders. We believe that equity awards provide executives with a strong link to our short- and long-term performance, while creating an ownership culture to maintain the alignment of interests between our executives and our stockholders. When implemented responsibly, we also believe these equity incentives can function as a powerful executive retention tool.


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Our Governance, Compensation, and Nominating Committee consists entirely of independent directors, administers our compensation plans and policies, including the establishment of policies that govern base salary as well as short- and long-term incentives for our executive management team.
 
Summary of Cash and Other Compensation
 
The following table sets forth the total compensation received for services rendered in all capacities to our company during the fiscal years ended December 31, 2006 and 2007 by our three “named executive officers,” namely our Chief Executive Officer and our other two most highly compensated executive officers during fiscal 2007.
 
SUMMARY COMPENSATION TABLE
 
                                                   
                        Non-Equity
       
                        Incentive
       
                Stock
  Option
  Plan
  All Other
   
Name and Principal Position
  Year   Salary   Bonus (3)   Awards (4)   Awards (5)   Compensation (6)   Compensation (7)   Total
 
Peng K. Lim     2007   $ 300,000   $ 21,041   $ 67,000     $ 509,750   $ 120,000   $ 10,769   $ 1,028,560
Chief Executive
    2006     196,154     38,959           610,448     60,000     143,243     1,048,804
Officer (1)
                                                 
                                                   
                                                   
Cynthia A. Scheuer
    2007     210,000         (7,001 )     92,485     10,500     8,400     314,384
Vice President,
    2006     207,500     20,000     10,447       116,310         8,300     362,557
Chief Financial Officer and Secretary
                                                 
                                                   
                                                   
James K. Prueitt
    2007     184,975               54,645         46,909     286,529
Vice President of Engineering and Operations, MTI Micro (2)
                                                 
 
 
(1) Mr. Lim commenced employment as the Chief Executive Officer of MTI Micro on May 8, 2006, becoming our Chief Executive Officer on December 1, 2006.
 
(2) Mr. Prueitt did not become a named executive officer until 2007.
 
(3) Mr. Lim received a $60,000 guaranteed bonus in 2007 at the conclusion of his first year of employment. The bonus amount for 2006 reflects the proportionate amount of his bonus accrued through December 31, 2006 and the amount for 2007 reflects the remainder of the bonus accrued and then paid in 2007.
 
(4) Valuations based upon the dollar amount of stock awards recognized for financial statement reporting purposes pursuant to FAS 123R. During 2007, Ms. Scheuer forfeited a 625 restricted stock grant that did not vest, which resulted in compensation expense recovery of $10,493, and was awarded a 625 restricted stock grant that will vest upon successful completion of a financing objective by June 30, 2008, which resulted in compensation expense of $3,492.
 
(5) Valuations based upon the dollar amount of option grants recognized for financial statement reporting purposes pursuant to FAS 123R with respect to 2006 and 2007. The assumptions we use in calculating these amounts are discussed in Note 13 to our consolidated financial statements for the year ended December 31, 2007.
 
(6) Mr. Lim received a $60,000 bonus in 2007 based upon successful completion of performance objectives, and we have accrued, as of December 31, 2007, a $120,000 bonus related to his successful completion of performance objectives established for 2007-2008. We have accrued for Ms. Scheuer, as of December 31, 2007, a $10,500 bonus related to successful completion of certain of her 2007-2008 performance objectives.
 
(7) The following is a recap of the major categories included in ‘All Other Compensation’:
 


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    2007 All Other Compensation
                      Total –
    401(k)
                All Other
    Matching     Relocation     Other     Compensation
 
Peng K. Lim
    $10,385       $–       $384       $10,769
Cynthia A. Scheuer
    8,400                   8,400
James K. Prueitt
    6,240       40,669             46,909
 
Base Salary and Cash Incentives of the Chief Executive Officer
 
Mr. Lim joined our company during May 2006 as President and Chief Executive Officer of MTI Micro at an annual salary of $300,000 and was promoted to our Chief Executive Officer during December 2006, receiving no base salary change. During our annual Chief Executive Officer compensation review during 2007, we engaged Radford to review the compensation package of our Chief Executive Officer based upon competitive market data. After consideration of the analysis and information provided by and the recommendations from Radford, we determined that no base salary adjustment was required for Mr. Lim during 2007.
 
Mr. Lim participates in an annual cash incentive compensation plan with a bonus targeted at 40% of base salary as prescribed in his current employment agreement.
 
During May 2007, Mr. Lim was awarded his first year bonus payouts: a cash bonus of $60,000 in connection with his first year guaranteed bonus and a cash bonus of $60,000 in connection with the completion of performance objectives for his first year of employment as established during 2006 by our Board of Directors.
 
In concert with our milestones, we included the following objectives in Mr. Lim’s 2007-08 performance plan:
 
  •   completion of low-power prototypes to Samsung;
 
  •   introduction of the next generation of MTI Instruments’ precision instrumentation products;
 
  •   addition of at least one OEM agreement for our low power platform;
 
  •   at least a 15% increase in MTI Instruments annual revenue during fiscal year 2007 compared with fiscal year 2006; and
 
  •   maintenance of key affiliate relationships, among other individual goals.
 
The Governance, Compensation, and Nominating Committee has determined that Mr. Lim met these performance objectives for fiscal 2007 and has approved a $120,000 bonus to be paid during 2008. Any future bonus compensation to Mr. Lim will be contingent solely upon the determination of the Governance, Compensation, and Nominating Committee that set objectives for Mr. Lim have been satisfied.
 
Base Salary and Cash Incentives of Other Named Executive Officers
 
We evaluated other named executive officer base salaries during 2007. We maintained current base salary levels for most of our named executive officers, but adjustments to the following executives’ base salaries were made to recognize either high performance or an increase in responsibility.
 
On October 8, 2007, James Prueitt was promoted to Vice President of Engineering and Operations at MTI Micro. Mr. Prueitt had received a base salary increase from $175,000 to $188,300 during April 2007 when he was appointed the acting leader of engineering and operations. We believed that Mr. Prueitt’s total compensation package required a greater emphasis on equity

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participation in congruence with compensation packages offered by other early stage technology companies. Thus, Mr. Prueitt’s base salary was not changed at his promotion date and he received additional equity incentive awards.
 
The base salary of Cynthia Scheuer, Vice President, Chief Financial Officer and Secretary, has not increased since April 2006 and remains at $210,000.
 
In addition to base salary compensation, we consider short-term cash incentives to be an important tool in motivating and rewarding near-term performance against established short-term goals. We do not utilize a specific formula, but executive management is eligible for cash awards contingent upon achievement of individual, financial, or company-wide performance criteria. The criteria are established to ensure that a reasonable portion of an executive’s total annual compensation is performance based.
 
We believe that the higher an executive’s level of responsibility, the greater the portion of that executive’s total earnings potential should be tied to the achievement of critical technological, operational and financial goals. Our Chief Executive Officer generally is eligible for annual cash incentive awards of up to 40% of his base salary, with other named executive officer eligibility between 5% and 10% of base salary. We believe this strategy places the desired proportionate level of risk and reward on performance by the Chief Executive Officer and other named executive officers.
 
During June 2007, our Board of Directors initiated individual executive cash incentive programs for Ms. Scheuer. Ms. Scheuer became eligible for a bonus of up to 10% of her annual base salary based upon achievement of certain operating expense and administrative goals to be achieved by May 2008. The Governance, Compensation, and Nominating Committee has determined that Ms. Scheuer met these goals by May 2008, and has approved a $21,000 bonus to be paid during 2008. In connection with his promotion to Vice President, Mr. Prueitt became eligible for a bonus of 5% of his annual salary based upon certain commercial prototype technical advances to be achieved by May 2008.
 
While performance targets are established at levels that are intended to be achievable, we believe that we have structured these incentives so that maximum bonus payouts would require a substantial level of both individual and company performance.
 
Long-Term Equity Incentive Compensation
 
Equity awards typically take the form of stock option and restricted stock grants. Authority to make equity awards to executive officers rests with our Governance, Compensation and Nominating Committee. In determining the size of awards for new or current executives, we consider the competitive market, strategic plan performance, contribution to future initiatives, benchmarking of comparative equity ownership for executives in comparable positions at similar companies, individual option history, recommendations of our Chairman and Chief Executive Officer.
 
We generally base our criteria for performance-based equity awards on one or more of the following long-term measurements:
 
  •   procurement and maintenance of OEM alliance/strategic agreements;
 
  •   manufacturing readiness;
 
  •   financing targets;
 
  •   gross revenue and profit goals;
 
  •   operating expense improvements; and
 
  •   product launches, new product introductions or improvements to existing products or product-intent prototypes.


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These performance measurements support various initiatives identified by our Board of Directors as critical to our future success, and are either expressed as absolute in terms of success or failure, or will be measured in more qualitative terms.
 
The timing of all equity awards for our Chief Executive Officer and our Chief Financial Officer in the past have generally coincided with either employment anniversary dates or the annual meeting dates. Other executive officer equity awards have occurred in conjunction with completion or assignment of objectives, promotions, commencement of employment, or coincide with our annual meeting date. We do not time option grants to our executives in coordination with the release of material non-public information, nor do we impose any equity ownership guidelines on our executives.
 
The following table sets forth certain information regarding the options held and value of each such officer’s unexercised options as of December 31, 2007.
 
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END 2007
 
                                           
    Option Awards   Stock Awards
            Equity
          Equity
  Equity
            Incentive
          Incentive
  Incentive
            Plan
          Plan
  Plan
            Awards:
          Awards:
  Awards:
            Number of
          Number of
  Market Value
            Securities
          Shares or
  of Shares
    Number of
  Underlying
          Units of
  or Units
    Securities Underlying
  Unexercised
  Option
  Option
  Stock That
  of Stock
    Unexercised Options (#)   Unearned
  Exercise
  Expiration
  Have Not
  That Have
Name
  Exercisable   Unexercisable   Options (#)   Price ($)   Date   Vested (#)   Not Vested ($)
 
P. Lim     20,313             35.44     5/7/2013        
      15,235     25,390(1)         35.44     5/7/2013        
              20,313     35.44     5/7/2013        
      8,750             10.72     6/17/2014        
          28,438(5)         10.72     6/17/2014        
      6,563             10.72     6/17/2014        
              12,500     10.72     6/17/2014        
C. Scheuer
    3,594             14.08     12/17/2008        
      2,500             23.04     12/14/2010        
      3,125             15.28     3/31/2013        
      625             49.36     6/19/2010        
      1,875             49.36     3/29/2010        
      7,500             49.36     6/22/2014        
      5,000             19.92     8/17/2015        
      625             22.40     7/16/2012        
      1,042             22.40     3/31/2013        
      2,552     1,823(2)         32.40     5/17/2013        
      3,281             10.72     6/17/2014        
          6,094(5)         10.72     6/17/2014        
                            625     3,750
J. Prueitt
    2,188     2,187(3)         10.72     3/16/2014        
              6,250     9.84     10/7/2014        
          18,750(6)         9.84     10/7/2014        
              1,875     35.04     4/18/2016        
      782     2,343(4)         35.04     4/18/2016        
 
 
(1) The options vest at a rate of 6.25% per quarter, becoming fully exercisable on May 8, 2010.
 
(2) The options vest at a rate of 8.33% per quarter, becoming fully exercisable on February 18, 2009.
 
(3) The options vested 50% immediately on the grant date, with the remaining options vesting at a rate of 25% annually, becoming fully exercisable on March 17, 2009.
 
(4) The options vest at a rate of 25% annually, becoming fully exercisable on April 19, 2010.


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(5) The options vest at a rate of 6.25% per quarter, starting January 1, 2008, becoming fully exercisable on October 1, 2011.
 
(6) The options vest at a rate of 25% at the first anniversary of the grants date and 6.25% on each quarterly anniversary thereafter, becoming fully exercisable on October 8, 2011 unless performance targets for accelerated vesting of this grant are achieved.
 
Equity Awards to Officers
 
Chief Executive Officer. On May 21, 2008, we awarded Mr. Lim the following:
 
  •   options to purchase 57,500 shares of common stock that will vest upon attainment of a commercial shipment volume goal by December 31, 2009, and if such goal is not met, the options will be cancelled; and
 
  •   options to purchase 57,500 shares of common stock (which was subsequently reduced to 37,500 due to limitations on share reserves under our active equity compensation plans) that will vest annually over a two-year period, with the first vesting event on May 21, 2009.
 
During June 2007, we awarded Mr. Lim the following:
 
  •   6,250 shares of restricted stock that vested immediately;
 
  •   options to purchase 8,750 shares of common stock that vested immediately;
 
  •   options to purchase 6,563 shares of common stock that will vest upon achievement of all of our 2007 publicly disclosed milestones, as well as maintenance of existing relationships with our strategic alliance partners;
 
  •   options to purchase 12,500 shares of common stock that will vest upon attainment of our financing goal during 2008, and if such goals are not achieved by June 30, 2008, the options will be cancelled; and
 
  •   options to purchase 28,438 shares of common stock that will vest quarterly over a four-year period, with the first vesting event on January 1, 2008.
 
All stock options awarded to Mr. Lim during 2007 have a seven-year term.
 
Other Named Executive Officers. On May 21, 2008, we awarded Mr. Prueitt the following:
 
  •   options to purchase 27,500 shares of common stock that will vest upon attainment of a commercial shipment volume goal by December 31, 2009, and if such goal is not met, the options will be cancelled; and
 
  •   options to purchase 27,500 shares of common stock (which was subsequently reduced to 17,500 due to limitations on share reserves under our active equity compensation plans) that will vest annually over a two-year period, with the first vesting event on May 21, 2009.
 
During October 2007, in recognition of his promotion to Vice President of Engineering and Operations, Mr. Prueitt was awarded the following performance-based stock options:
 
  •   options to purchase 6,250 shares of common stock options that will vest upon attainment of a commercialization shipment volume goal to be achieved by March 31, 2010, and if the goals are not met, the options will be cancelled; and
 
  •   options to purchase 18,750 shares of common stock that will vest 25% on the first anniversary of the grant date and 6.25% on each quarterly anniversary thereafter; this grant will accelerate vest upon the achievement of a specific unit shipment target.


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During March 2007, as part of a non-executive retention initiative following suspension of our high power program, Mr. Prueitt was granted options to purchase 4,375 shares of common stock that vest as follows: 2,188 vested immediately; while 1,094 will vest during March 2008 and 1,093 during March 2009.
 
The awards to Mr. Prueitt reflect his performance and increasing responsibility through the year, as well as our expectations of future performance and retention needs for early stage organizations where significant equity awards take the place of cash compensation.
 
During June 2007, Ms. Scheuer was awarded the following:
 
  •   options to purchase 1,875 shares of common stock that vested immediately;
 
  •   options to purchase 1,406 shares of common stock that will vest upon achievement of all our 2007 publicly disclosed milestones, as well as maintenance of existing relationships with our strategic alliance partners; and
 
  •   options to purchase 6,094 shares of common stock that will vest quarterly over a four-year period, with the first vesting event on January 1, 2008.
 
Concurrently, Ms. Scheuer was awarded 625 shares of restricted stock that will vest upon attainment of certain financing goals during 2008. If such goals are not achieved by June 30, 2008, the stock will be forfeited. On July 31, 2007, Ms. Scheuer forfeited a separate award of 625 shares of restricted stock, which would have vested upon achievement of certain financing goals by that date.
 
We believe the size of the awards to Ms. Scheuer is appropriate and necessary to retain and motivate her to meet these challenging but obtainable short and longer term objectives.
 
All 2007 option grants to Mr. Prueitt and Ms. Scheuer have a seven-year term.
 
Equity Incentive Plans
 
As of December 31, 2007, we have three equity compensation plans: 1) 1996 Stock Incentive Plan; 2) 1999 Employee Stock Incentive Plan; and 3) 2006 Equity Incentive Plan.
 
The Governance, Compensation, and Nominating Committee administers all equity compensation plans, and has the authority to determine the terms and conditions of the awards granted under the 1996 Stock Incentive Plan and the 1999 Employee Stock Incentive Plan.
 
1996 Stock Incentive Plan. The 1996 Stock Incentive Plan, or 1996 Plan, was approved by our stockholders during December 1996. Under the 1996 Plan, our Board of Directors was authorized to award stock options, stock appreciation rights, restricted stock, and other stock-based incentives to our officers, employees and others. As of December 31, 2007, there were 166,202 options outstanding under the 1996 Plan, of which 155,444 were exercisable. No additional shares are available for future grants.
 
1999 Employee Stock Incentive Plan. The 1999 Employee Stock Incentive Plan, or 1999 Plan, was approved by our stockholders during March 1999. Under the 1999 Plan, our Board of Directors is authorized to award stock options and restricted stock to our officers, employees and others. The 1999 Plan expires on March 18, 2009. As of December 31, 2007, options to purchase 454,180 shares of our common stock were outstanding under the 1999 Plan, of which 372,110 were exercisable with an additional 41,293 shares reserved for future grants.
 
Options issued under both the 1996 Plan and 1999 Plan terminate between seven and ten years after the date of grant. Stock option grants or restricted stock awards under these plans can be issued to vest immediately, vest over a certain period, vest based upon successful completion of a performance measure specified by our Governance, Compensation, and Nominating Committee, or a prescribed combination of performance and time vesting (i.e. a time vesting option accelerated by achievement of a performance objective or a performance vesting option that will vest at a certain date in the future).


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The 1996 Plan and 1999 Plan provide that in the event of a change of control all unexercised and outstanding options and restricted stock shall become fully vested and exercisable as of the date of the change of control, provided the optionee is employed by us at the date of the change. This is commonly referred to as a single trigger acceleration of option vesting.
 
2006 Equity Incentive Plan. The 2006 Equity Incentive Plan, or 2006 Plan, was approved by our stockholders during May 2006. Up to 250,000 shares of our common stock may be issued under the 2006 Plan to our employees, officers, directors, consultants and advisors. As of December 31, 2007, 156,938 options to purchase our common stock were outstanding under the 2006 Plan, of which 51,052 were exercisable with an additional 86,813 shares reserved for future grants.
 
The 2006 Plan provides for the grant of incentive stock options intended to qualify under Section 422 of the Internal Revenue Code of 1986, nonqualified stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards.
 
Our Governance, Compensation, and Nominating Committee selects the recipients of awards and determines (i) the number of shares of common stock covered by options and the dates upon which such options become exercisable, (ii) the exercise price of options (which may not be less than 100% of fair market value of the common stock), (iii) the duration of options (which may not exceed seven years), and (iv) the number of shares of common stock subject to any stock appreciation rights, restricted stock award, restricted stock unit award or other stock-based awards and the terms and conditions of such awards, including conditions for forfeiture, repurchase, issue price and repurchase price, if any.
 
Upon a “Substantial Corporate Change,” as such term is defined in the 2006 Plan, the 2006 Plan and any unexercised or forfeitable awards will terminate unless either (i) an award agreement with a participant provides otherwise or (ii) provision is made in writing in connection with such transaction for the assumption or continuation of outstanding awards, or the substitution for such awards with awards covering the stock or securities of a successor employer entity, or a parent or subsidiary of such successor. If an award would otherwise terminate under the preceding sentence, we will either provide that optionees or holders of stock appreciation rights or other exercisable awards will have the right, at such time before the completion of the transaction causing such termination as we reasonably designate, to exercise any unexercised portions of the options or stock appreciation rights or other exercisable awards, including portions of such awards not already exercisable, or for any awards including the foregoing, cause us, or agree to allow the successor, to cancel each award after payment to the participant of an amount, if any, in cash, cash equivalents, or successor equity interests substantially equal to the fair market value of the consideration (as valued by the administrator) paid for our shares, under the transaction minus, for options and stock appreciation rights or other exercisable awards, the exercise price for the shares covered by such awards (and, for any awards, where we determine it is appropriate, any required tax withholdings), and with such allocation among cash, cash equivalents, and successor equity interests as we determine or approve.
 
Perquisites and Other Benefits
 
Our executive officers are eligible to participate in similar benefit plans available to all our other employees including medical, dental, vision, group life, disability, accidental death and dismemberment, paid time off, and 401(k) plan benefits. In addition, we pay 100% of Mr. Lim’s group term life insurance premiums, representing an additional cost in 2007 of $384.
 
We also maintain a standard directors and officers liability insurance policy with coverage similar to the coverage typically provided by other small publicly held technology companies.
 
As prescribed in his employment agreement, Mr. Lim was reimbursed for his relocation, associated tax gross-ups and certain legal fees in connection with joining our company during 2006. These amounts totaled $133,063 in relocation, $16,637 in tax gross-ups and $10,000 in legal fees.


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We reimbursed Mr. Prueitt his relocation costs and associated tax gross-ups in connection with joining our company during 2006. These amounts totaled $31,103 in relocation and $8,463 in tax gross-ups.
 
Severance, Change in Control and Non-Compete Agreements
 
Most of the our executive officers are entitled to receive severance payments equal to a specified number of months of base salary and benefits in the event their employment is terminated “without cause” or in Mr. Lim’s case, if he is terminated “without cause” or if he terminates his employment with us for “good reason.” Mr. Lim’s stock options are also subject to acceleration or a continuation of vesting should we terminate his employment without cause or if he terminates\ his employment with us for good reason.
 
A change in control will accelerate the vesting of outstanding stock options issued under the 1996 and 1999 Stock Incentive Plans; however options outstanding under the 2006 Equity Plan will not automatically accelerate vesting unless provided in an employment agreement. See “Employment Agreements.”
 
We believe these severance and change in control arrangements are reasonable and mitigate some of the risk that exists for executives working in small technology companies by maintaining employee engagement and encouraging retention in an environment with substantial challenges and changes. This is especially true considering each executive officer has signed a Non-Competition and Non-Solicitation Agreement limiting future opportunities in the event the executive’s employment is terminated for any reason. These agreements specify that the executive will not compete with our businesses for a period of one year following such termination.
 
Employment Agreements
 
Peng K. Lim. We entered into an employment agreement Mr. Lim effective May 8, 2006, that provides he will serve as the President and Chief Executive Officer of MTI Micro for an initial term of two years at an annual salary of $300,000. In December 2006, Mr. Lim was promoted to our Chief Executive Officer, receiving no salary change. Following his initial term, the agreement will be automatically renewed for successive one year terms, subject to our right, or his right, not to renew the agreement upon at least ninety (90) days’ written notice prior to the expiration of the initial two year term or any one year renewal term thereafter. Mr. Lim participates in an annual cash incentive compensation plan with a bonus targeted at 40% of base salary as prescribed in his current employment agreement. During May 2007, Mr. Lim was awarded his first year bonus payouts: a cash bonus of $60,000 in connection with his first year guaranteed bonus and a cash bonus of $60,000 in connection with the completion of performance objectives for his first year of employment as established during 2006 by our Board of Directors. In concert with our milestones, we included the following objectives in Mr. Lim’s 2007-08 performance plan:
 
  •   completion of low-power prototypes to Samsung;
 
  •   introduction of the next generation of MTI Instruments’ precision instrumentation products;
 
  •   addition of at least one OEM agreement for our low power platform;
 
  •   at least a 15% increase in MTI Instruments annual revenue during fiscal year 2007 compared with fiscal year 2006; and
 
  •   maintenance of key affiliate relationships, among other individual goals.
 
The Governance, Compensation, and Nominating Committee has certified that Mr. Lim met these performance objectives for fiscal 2007, and has approved a $120,000 bonus to be paid during 2008. Any future bonus compensation to Mr. Lim will be contingent solely upon the determination of the Governance, Compensation, and Nominating Committee that set objectives for Mr. Lim have been satisfied.


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In connection with our hiring of Mr. Lim, we also granted to Mr. Lim options to purchase 81,250 shares of common stock at an exercise price of $35.44 that vest as follows: a) options to purchase 20,313 shares vested immediately; b) options to purchase 40,625 shares vest in equal quarterly amounts over a four-year period at the rate of 6.25% per quarter; and c) options to purchase 20,313 shares vest upon the earlier of the determination by our Board of Directors or a committee of the Board of Directors, that the performance milestones for the grant with respect to 2007 had been satisfied or December 31, 2008. All of such options will vest immediately upon a “change of control” as defined in the agreement.
 
The agreement also provides that if we terminate Mr. Lim’s employment without cause or if Mr. Lim terminates his employment for good reason he will receive 1) his accrued salary, business expenses, and earned bonus through the date of termination; 2) 100% of his regular base salary and target bonus (in monthly installments) for 12 months, and certain other benefits for one year from the date of termination; 3) the first year premium for converting his group life insurance coverage to an individual policy; and 4) continued vesting of his outstanding options at the rate described in the each respective option agreement (including the full acceleration of the vesting of the performance-based options) for one year from the date of termination, with continued exercisability for all vested options for 90 days following the period ending one year after the date of termination.
 
If Mr. Lim’s employment is terminated for “cause,” Mr. Lim will receive his accrued salary, business expenses, and earned bonus through the date of termination. If Mr. Lim’s employment is terminated by reason of death or disability, in addition to these accrued entitlements, Mr. Lim will receive a pro-rata bonus, continuation of vesting of outstanding time-based options for one additional quarter, vesting of performance-based options as of the date of termination (if such date is after September 30, 2008), and all vested options will remain exercisable for one year.
 
For purposes of this agreement, “cause” means gross misconduct, gross negligence, theft, dishonesty, fraud, or gross dereliction of duties; or indictment on any felony charge or misdemeanor charge involving theft, moral turpitude; or a violation of the federal securities laws whether or not related to his conduct at work. “Good reason” means our failure to renew the agreement at substantially equivalent or greater salary and target bonus; a significant diminution of Mr. Lim’s job title, responsibilities or reporting relationship; or relocation of the job to a location outside a 50 mile radius of MTI Micro’s office location on the commencement date.
 
Other Named Executive Officers. We have employment agreements with our other named executive officers. Those employment agreements continue unless modified or terminated, with severance benefits where noted, provided employment terminations are without cause.
 
Our employment agreement with Ms. Scheuer provides her a current base annual salary of $210,000. If we terminate Ms. Scheuer’s employment without cause, she will continue to receive her base salary and benefits for a six-month period. During June 2007, our Board of Directors initiated an individual executive cash incentive program for Ms. Scheuer. Ms. Scheuer became eligible for a bonus of up to 10% of her annual base salary based upon achievement of certain operating expense and administrative goals to be achieved by May 2008. The Governance, Compensation, and Nominating Committee has determined that Ms. Scheuer met these goals by May 2008, and has approved a $21,000 bonus to be paid during 2008.
 
Our employment agreement with Mr. Prueitt provides him a current base salary of $188,300. Mr. Prueitt had received a base salary increase from $175,000 to $188,300 during April 2007 when he was appointed the acting leader of engineering and operations. In connection with his promotion to Vice President, Mr. Prueitt became eligible for a bonus of 5% of his annual salary based upon certain commercial prototype technical advances to be achieved by May 2008. During his first two years with us, a period ending on April 18, 2008, Mr. Prueitt will receive three months of base salary and benefits as a severance benefit. During this period, if Mr. Prueitt’s employment is terminated within 90 days following a change in control of our company, he will receive his base salary and benefits for six months as a severance benefit.


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Potential Payments upon Termination
 
The following table sets forth a breakdown of termination payments and the net realizable value of stock and stock options if the employment of any of our named executive officers had been terminated as of December 31, 2007. The information assumes a price of $6.00 per share of our common stock as December 31, 2007. Severance payments are made either on a salary continuation basis paid over the severance period or on a lump sum basis payable upon a fixed date subsequent to termination of employment.
 
                                     
                    Intrinsic
     
                Health & Life
  Value of
     
            Guaranteed
  Insurance
  Stock Options
     
Name
  Severance Term   Salary   Bonus   Continuation   at Separation   Total  
 
Peng K. Lim
  One year salary and                                
    benefits     $300,000     $120,000     $11,512     $–   $ 431,512  
Cynthia A. Scheuer
  Six months salary                                
    and benefits     105,000         3,673         108,673  
James K. Prueitt (1)
  Three months salary                                
    and benefits     47,075         2,696         49,771  
 
 
(1) Pursuant to Mr. Prueitt’s employment agreement, beginning April 19, 2006, for the first two years of employment, we will provide three months of base salary and benefits as a severance benefit in the event his employment is terminated without cause. During this period, if Mr. Prueitt’s employment is terminated within 90 days following a change in control of our company, he will receive his base salary and benefits for six months as a severance benefit.
 
Directors’ Compensation
 
On April 20, 2007, our Board of Directors adopted a new compensation plan for non-management directors that eliminated the quarterly cash retainer compensation of $12,000 per year, after reducing it from $16,000 per year, on March 13, 2007. Beginning in 2007, non-employee directors annually receive the following: 1) options to purchase 6,250 shares of our common stock, 2) the Chairman of the Audit Committee, the Chairman of the Governance, Compensation,and Nominating Committee and the Chairman of the Technical Committee of our MTI Micro subsidiary each receive additional options to purchase 938 shares of our common stock, and 3) members of the Audit Committee, the Governance, Compensation, and Nominating Committee and the Technical Committee of our MTI Micro subsidiary each receive additional options to purchase 625 shares of our common stock. Future compensation will be issued on an annual basis thereafter on the third Monday of each March. These options are priced based on the closing price of our common stock on The Nasdaq Global Market System on the date of grant, vest immediately and have a seven-year term. Each non-employee director is also reimbursed for reasonable travel and related expenses incurred on our behalf.
 
On March 12, 2008, the Board of Directors of the Company approved the deferral of the issuance of annual stock option compensation for the Company’s non-management directors until a later date in 2008. Under the Company’s current compensation plan for its non-management directors, annual option compensation was scheduled to be issued on March 17, 2008.


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DIRECTOR COMPENSATION FOR FISCAL YEAR 2007
 
                                 
    Fees Earned or
    Option
    All Other
       
Name
  Paid in Cash      Awards(1)     Compensation     Total   
 
Steven N. Fischer (2)
  $ 100,000       $9,403     $ 4,000     $ 113,403  
Thomas J. Marusak (3)
    7,000       51,558             58,558  
E. Dennis O’Connor (4)
    7,000       53,706             60,706  
William P. Phelan (5)
    7,000       49,410             56,410  
Dr. Walter Robb (6)
    7,000       55,855             62,855  
 
 
(1) Valuations are based upon the dollar amount of option grants recognized for financial statement purposes pursuant to FAS 123R with respect to 2007. The assumptions and methodologies were utilized in calculating these amounts are discussed in Note 13 to the financial statements for the year ended December 31, 2007.
 
(2) Mr. Fischer retired from our Board of Directors on May 15, 2008. As of December 31, 2007, Mr. Fischer had 55,980 options outstanding and exercisable. During 2007, Mr. Fischer was paid $100,000 in cash and received $4,000 in 401(k) matching contributions related to his executive position, forfeited 12,500 performance based stock options that did not vest and was granted 12,500 performance based stock options that will vest upon attainment of certain financing goals during 2008. If such goals are not achieved by June 30, 2008, the options will be forfeited.
 
(3) As of December 31, 2007, Mr. Marusak had 16,147 options outstanding and exercisable.
 
(4) As of December 31, 2007, Mr. O’Connor had 41,262 options outstanding and exercisable.
 
(5) As of December 31, 2007, Mr. Phelan had 18,127 options outstanding and exercisable.
 
(6) As of December 31, 2007, Dr. Robb had 40,857 options outstanding and exercisable.


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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
Review, Approval or Ratification of Transactions with Related Persons
 
In early 2007, we formalized the process by which we review and approve transactions in which we or one or more related persons participate. Although we have always had procedures in place, we strengthened our current procedures by adopting a written policy requiring that all related person transactions, be reported to our Chief Financial Officer and approved or ratified by the Governance, Compensation and Nominating Committee of the Board of Directors. In completing our review of proposed related person transactions, the Governance, Compensation, and Nominating Committee considers the aggregate value of the transaction, whether the transaction was undertaken in the ordinary course of business, the nature of the relationships involved, and whether the transaction is on terms comparable to those that could be obtained in arm’s length dealings with an unrelated third party.
 
We believe transactions among related parties are as fair to us as those obtainable from unaffiliated third parties. During our December 2006 capital raise, Sidney V. Gold, a stockholder in MTI Micro purchased 5,000 units consisting of 62,500 shares our common stock and warrants exercisable for five years to purchase an additional 31,250 shares of our common stock at an exercise price of $18.16 per share. The purchase price per unit was $180.00.


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DESCRIPTION OF NOTES
 
We will issue the notes under an indenture to be dated as of          , 2008 between us and American Stock Transfer & Trust Company, as trustee. The terms of the notes include those expressly set forth in the indenture and the notes and those made part of the indenture by reference to the Trust Indenture Act of 1939, as amended.
 
You may request a copy of the indenture from us as described under “Where You Can Find Additional Information.”
 
The following description is a summary of the material provisions of the notes and the indenture, and does not purport to be complete. This summary is subject to and is qualified by reference to all of the provisions of the notes and the indenture, including the definitions of certain terms used in the indenture. We urge you to read these documents because they, and not this description, define your rights as a holder of the notes.
 
General
 
The notes
 
  •   will be our general unsecured, senior obligations;
 
  •   will initially be limited to an aggregate principal amount of $12.0 million (or $13.8 million if the underwriter’s over-allotment option is exercised in full);
 
  •   will be junior to any secured indebtedness we may incur to the extent of the value of the assets securing such indebtedness;
 
  •   will be structurally subordinated to all of our liabilities;
 
  •   will bear cash interest from          , 2008 at an annual rate of     % payable semi-annually on           and           of each year, beginning on          , 2009;
 
  •   will mature on          , 20           unless earlier converted;
 
  •   will be issued in denominations of $1,000 and integral multiples of $1,000; and
 
  •   will be represented by one or more registered notes in global form, but in certain limited circumstances may be represented by notes in certificated form. See “Book-Entry, Settlement, and Clearance.”
 
Subject to the fulfillment of certain conditions and during the periods described below, the notes may be converted initially at a conversion rate of          shares of common stock per $1,000 principal amount of notes (equivalent to a conversion price of approximately $      per share of common stock). The conversion rate is subject to adjustment if certain events occur as described below under “Conversion rights — Conversion Rate Adjustments.” Upon conversion of a note, we will deliver shares of our common stock and cash in lieu of any fractional share of our common stock based on the conversion rate then in effect. You will not receive any separate cash payment for interest or additional interest, if any, accrued and unpaid to the conversion date except under the limited circumstances described below.
 
The indenture does not limit the amount of debt that may be issued by us or our subsidiaries under the indenture or otherwise. The indenture does not contain any financial covenants and does not restrict us from paying dividends or issuing or repurchasing our other securities. The indenture does not contain any covenants or other provisions designed to afford holders of the notes protection in the event of a highly leveraged transaction involving us or in the event of a decline in our credit rating as the result of a takeover, recapitalization, highly leveraged transaction, or similar restructuring involving us that could adversely affect such holders.
 
We may, without the consent of the holders, issue additional notes under the indenture with the same terms and with the same CUSIP numbers as the notes offered hereby in an unlimited aggregate principal amount, provided that such additional notes must be part of the same issue as


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the notes offered hereby for U.S. federal income tax purposes. We may also from time to time repurchase notes in open market purchases or negotiated transactions without prior notice to holders.
 
We do not intend to list the notes on a national securities exchange or interdealer quotation system.
 
We use the term “note” in this prospectus to refer to each $1,000 principal amount of notes. We use the term “common stock” in this prospectus to refer to our common stock, $0.01 par value.
 
Payments on the Notes; Paying Agent and Registrar; Transfer and Exchange
 
We will pay principal of and interest (including additional interest, if any) on notes in global form registered in the name of or held by The Depository Trust Company, or DTC, or its nominee in immediately available funds to DTC or its nominee, as the case may be, as the registered holder of such global note. We will pay principal of certificated notes at an office or agency designated by us for that purpose. We have initially designated the trustee as our paying agent and registrar and its agency in New York, New York as a place where notes may be presented for payment or for registration of transfer. We may, however, change the paying agent or registrar without prior notice to the holders of the notes, and we may act as paying agent or registrar. Interest (including additional interest, if any) on certificated notes will be payable (i) to holders having an aggregate principal amount of $      or less, by check mailed to the holders of these notes and (ii) to holders having an aggregate principal amount of more than $     , either by check mailed to each holder or, upon application by a holder to the registrar not later than the relevant record date, by wire transfer in immediately available funds to that holder’s account within the United States, which application shall remain in effect until the holder notifies the registrar to the contrary in writing.
 
A holder of notes may transfer or exchange notes at the office of the registrar in accordance with the indenture. The registrar and the trustee may require a holder, among other things, to furnish appropriate endorsements and transfer documents, including signature guarantees. No service charge will be imposed by us, the trustee, or the registrar for any registration of transfer or exchange of notes, but we may require a holder to pay a sum sufficient to cover any transfer tax or other similar governmental charge required by law or permitted by the indenture. We are not required to transfer or exchange any note surrendered for conversion. The registered holder of a note will be treated as the owner of it for all purposes.
 
Interest
 
The notes will bear interest at a rate of     % per year until maturity. Interest on the notes will accrue from          , 2008 or from the most recent date on which interest has been paid or duly provided for. Interest will be payable semi-annually in arrears on           and           of each year, beginning on          , 2009. We will pay reporting additional interest on the notes under the circumstances described under “— Events of Default.”
 
Interest will be paid to the person in whose name a note is registered at the close of business on           or          , as the case may be, immediately preceding the relevant interest payment date. Interest on the notes will be computed on the basis of a 360-day year composed of twelve 30-day months.
 
If any interest payment date (other than an interest payment date coinciding with the stated maturity date) of a note falls on a day that is not a business day, such interest payment date will be postponed to the next succeeding business day. If the stated maturity date would fall on a day that is not a business day, the required payment of interest, if any (including additional interest, if any), and principal will be made on the next succeeding business day and no interest on such payment will accrue for the period from and after the stated maturity date to such next succeeding business day. The term “business day” means, with respect to any note, any day other than a Saturday, a Sunday, or a day on which the Federal Reserve Bank of New York is closed.


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Ranking
 
The notes will be our general unsecured obligations and will rank senior in right of payment to all future indebtedness that is expressly subordinated in right of payment to the notes. The notes will rank equally in right of payment with all of our existing and future liabilities that are not so subordinated. The notes will effectively rank junior to any secured indebtedness we may incur to the extent of the value of the assets securing such indebtedness. In the event of our bankruptcy, liquidation, reorganization, or other winding up, our assets that secure such secured indebtedness will be available to pay obligations on the notes only after all such secured indebtedness has been repaid in full from such assets. We advise you that there may not be sufficient assets remaining to pay amounts due on any or all of the notes then outstanding.
 
As of March 31, 2008, we had no indebtedness. After giving pro forma effect to the sale of the notes (assuming no exercise of the underwriter’s over-allotment option) and the use of proceeds therefrom, our total consolidated indebtedness would have been $12 million.
 
No Optional Redemption
 
We may not redeem any of the notes at our option prior to maturity. No sinking fund is provided for the notes.
 
Conversion Rights
 
General
 
Prior to          , 2008, the notes will not be convertible. On or after          , 2008, holders may convert each of their notes at the applicable conversion rate at any time prior to the close of business on the third scheduled trading day immediately preceding the maturity date. The conversion rate will initially be           shares of common stock per $1,000 principal amount of notes (equivalent to a conversion price of approximately $      per share of common stock), and will be subject to adjustment as provided below. Upon conversion of a note, we will issue shares of our common stock based on the applicable conversion rate, as further described below under “— Payment Upon Conversion.” The trustee will initially act as the conversion agent.
 
The conversion rate and the equivalent conversion price in effect at any given time are referred to as the “applicable conversion rate” and the “applicable conversion price,” respectively, and will be subject to adjustment as described below. A holder may convert fewer than all of such holder’s notes so long as the notes converted are a multiple of $1,000 principal amount.
 
Upon conversion, you will not receive any separate cash payment for accrued and unpaid interest and additional interest, if any, unless such conversion occurs between a record date and the interest payment date to which it relates and you were the holder of record on such record date. We will not issue fractional shares of our common stock upon conversion of notes. Instead, we will pay cash in lieu of fractional shares based on the closing sale price of our common stock on the trading day immediately preceding the date of conversion. Our delivery to you of shares of our common stock, together with any cash payment for any fractional share, into which a note is convertible, will be deemed to satisfy in full our obligation to pay:
 
  •   the principal amount of the note; and
 
  •   accrued and unpaid interest and additional interest, if any, to, but not including, the conversion date.
 
As a result, accrued and unpaid interest and additional interest, if any, to, but not including, the conversion date will be deemed to be paid in full rather than cancelled, extinguished, or forfeited.
 
Notwithstanding the preceding paragraph, if notes are converted after 5:00 p.m., New York City time, on a regular record date for the payment of interest, holders of such notes at 5:00 p.m., New York City time, on such record date will receive the interest and additional interest, if any, payable on such notes on the corresponding interest payment date notwithstanding the conversion.


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Notes, upon surrender for conversion during the period from 5:00 p.m., New York City time, on any regular record date to 9:00 a.m., New York City time, on the immediately following interest payment date, must be accompanied by funds equal to the amount of interest and additional interest, if any, payable on the notes so converted; provided that no such payment need be made:
 
  •   for conversions following the record date immediately preceding the maturity date; or
 
  •   to the extent of any overdue interest, if any overdue interest exists at the time of conversion with respect to such note.
 
If a holder converts notes, we will pay any documentary, stamp, or similar issue or transfer tax due on the issue of any shares of our common stock upon the conversion, unless the tax is due because the holder requests any shares to be issued in a name other than the holder’s name, in which case the holder will pay that tax.
 
Notice Upon Specified Corporate Transactions
 
In order to provide holders of the notes an opportunity to convert the notes in advance of certain corporate events, if we elect to
 
  •   issue to all or substantially all holders of our common stock certain rights entitling them to purchase, for a period expiring within 60 days after the date of the distribution, shares of our common stock at less than the average of the last reported sale prices of a share of our common stock for the 10 consecutive trading day period ending on the trading day preceding the announcement of such issuance;
 
  •   distribute to all or substantially all holders of our common stock our assets, debt securities, or certain rights to purchase our securities, which distribution has a per share value, as reasonably determined by our board of directors, exceeding     % of the last reported sale price of our common stock on the trading day immediately preceding the declaration date for such distribution; or
 
  •   effect a “fundamental change,” which will be deemed to have occurred at the time after the notes are originally issued that any of the following occurs:
 
(1) a “person” or “group” within the meaning of Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) other than us, our subsidiaries, or our or their employee benefit plans, has become the direct or indirect “beneficial owner,” as defined in Rule 13d-3 under the Exchange Act, of our common equity representing more than 50% of the voting power of our common equity;
 
(2) consummation of (A) any recapitalization, reclassification, or change of our common stock (other than changes resulting from a subdivision or combination) as a result of which our common stock will be converted into, or exchanged for, stock, other securities, other property, or assets or (B) any share exchange, consolidation, or merger of us pursuant to which our common stock will be converted into cash, securities, or other property or any sale, lease or other transfer in one transaction or a series of transactions of all or substantially all of the consolidated assets of us and our subsidiaries, taken as a whole, to any person other than one of our subsidiaries; provided, however, that a share exchange, consolidation, or merger transaction where the holders of more than 50% of all classes of our common equity immediately prior to such transaction own, directly or indirectly, more than 50% of all classes of common equity of the continuing or surviving corporation or transferee or the parent thereof immediately after such event will not constitute a fundamental change;
 
(3) our stockholders approve any plan or proposal for the liquidation or dissolution of us; or
 
(4) our common stock (or other common stock into which the notes are then convertible) ceases to be listed or quoted on a U.S. national securities exchange or an established automated over-the-counter trading market in the United States.


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we must notify the holders of the notes at least 65 scheduled trading days prior to the ex-dividend date for such distribution or proposed effective date of a fundamental change or, if based on the nature of the transaction we are unable to provide at least 65 scheduled trading days’ notice, then the number of scheduled trading days as is reasonably practicable under the circumstances. The “ex-dividend date” is the first date upon which a sale of our common stock does not automatically transfer the right to receive the relevant dividend from the seller of our common stock to its buyer.
 
Conversion Procedures
 
If you hold a beneficial interest in a global note, to convert you must comply with DTC’s procedures for converting a beneficial interest in a global note and, if required, pay funds equal to the interest payable on the next interest payment date and all taxes and duties that may be applicable to such conversion.
 
If you hold a certificated note, to convert you must:
 
  •   complete and manually sign the conversion notice on the back of the note, or a facsimile of the conversion notice;
 
  •   deliver the conversion notice, which is irrevocable, and the note to the conversion agent;
 
  •   if required, furnish appropriate endorsements and transfer documents;
 
  •   if required, pay all taxes and duties that may be applicable to such conversion; and
 
  •   if required, pay funds equal to the interest payable on the next interest payment date.
 
The date you comply with these requirements is the conversion date under the indenture.
 
Payment Upon Conversion
 
Upon conversion, we will deliver to holders in respect of each $1,000 principal amount of notes being converted a number of fully paid and nonassessable shares of common stock equal to the product of (a) the applicable conversion rate in effect on the date of conversion times (b) the quotient of the principal amount of the note or portion of the note surrendered for conversion divided by $1,000.00.
 
For the purposes of determining payment upon conversion only, “trading day” means a day on which (i) there is no market disruption event (as defined below) and (ii) trading in securities generally occurs on The Nasdaq Stock Market or, if our common stock is not then listed on The Nasdaq Stock Market, on the principal other U.S. national or regional securities exchange on which our common stock is then listed or, if our common stock is not then listed on a U.S. national or regional securities exchange, in the principal other market on which our common stock is then traded. If our common stock (or other security for which a trading price must be determined) is not so listed or quoted, “trading day” means a “business day.”
 
“Scheduled trading day” means a day that is scheduled to be a trading day on the primary United States national or regional securities exchange or market on which our common stock is listed or admitted for trading. If our common stock is not so listed or admitted for trading, “scheduled trading day” means a business day.
 
For the purposes of determining payment upon conversion, “market disruption event” means (i) a failure by the primary United States national or regional securities exchange or market on which our common stock is listed or admitted to trading to open for trading during its regular trading session or (ii) the occurrence or existence prior to 1:00 p.m., New York City time, on any


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trading day for our common stock for an aggregate one half hour period of any suspension or limitation imposed on trading (by reason of movements in price exceeding limits permitted by the stock exchange or otherwise) in our common stock or in any options, contracts, or future contracts relating to our common stock.
 
We will deliver the shares of common stock, as well as cash payable for any fraction of a share of common stock, to converting holders on the fifth scheduled trading day immediately following the first business day upon which we receive the applicable conversion notice and all conditions to conversion set forth in the indenture have been satisfied. The person in whose name any shares of our common stock shall be issuable upon such conversion will become the holder of record of such shares as of the close of business on the trading day on which we receive the applicable conversion notice and all conditions to conversion set forth in the indenture have been satisfied; provided, however, that in case of any conversion on any date when our stock transfer books are closed, the person or persons in whose name the certificates for common stock are to be issued will be deemed to have become a record holder for all purposes on the next day on which our stock transfer books are open, but the conversion shall be effected at the applicable conversion rate in effect on the trading day upon which the conditions to conversion set forth in the indenture have been satisfied.
 
Conversion Rate Adjustments
 
The conversion rate will be adjusted as described below, except that we will not make any adjustments to the conversion rate if holders of the notes participate, as a result of holding the notes, in any of the transactions described below without having to convert their notes.
 
(1) If we issue shares of our common stock as a dividend or distribution on shares of our common stock and such dividend or distribution consists exclusively of shares of our common stock, or if we effect a share split or share combination, the conversion rate will be adjusted based on the following formula:
 
                     
CR1
  =   CR0   x   OS1
OS0
   
 
where,
 
         
CR0
  =   the conversion rate in effect immediately prior to the ex-dividend date of such dividend or distribution, or the effective date of such share split or combination, as applicable;
CR1
  =   the conversion rate in effect immediately after the opening of business on such ex-dividend date or effective date;
OS0
  =   the number of shares of our common stock outstanding immediately prior to such ex-dividend date or effective date; and
OS1
  =   the number of shares of our common stock outstanding immediately after the opening of business on such ex-dividend date or effective date after giving effect to such dividend, distribution, share split or share combination.
 
(2) If we issue to all or substantially all holders of our common stock any rights or warrants entitling them for a period of not more than 60 calendar days to subscribe for or purchase shares of our common stock, at a price per share less than the average of the last reported sale prices of our common stock for the 10 consecutive trading day period ending on the trading day immediately preceding the date of announcement of such issuance, the conversion rate will be adjusted based on the following formula (provided that the conversion rate will be readjusted to the extent that such rights or warrants are not exercised prior to their expiration):
 
                     
CR1
  =   CR0   x   OS0 + X
OS0 + Y
   


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where,
 
         
CR0
  =   the conversion rate in effect immediately prior to the ex-dividend date for such issuance;
CR1
  =   the conversion rate in effect immediately after the opening of business on such ex-dividend date;
OS0
  =   the number of shares of our common stock outstanding immediately prior to such ex-dividend date;
X
  =   the total number of shares of our common stock issuable pursuant to such rights or warrants; and
Y
  =   the number of shares of our common stock equal to the aggregate price payable to exercise such rights or warrants divided by the average of the last reported sale prices of our common stock over the 10 consecutive trading day period ending on the trading day immediately preceding the date of announcement of the issuance of such rights or warrants.
 
(3) If we distribute shares of our capital stock, evidences of our indebtedness or other assets or property of ours to all or substantially all holders of our common stock, excluding
 
  •   dividends or distributions and rights or warrants referred to in clause (1) or (2) above;
 
  •   dividends or distributions paid exclusively in cash; and
 
  •   spin-offs to which the provisions set forth below in this clause (3) shall apply;
 
then the conversion rate will be adjusted based on the following formula:
 
                     
CR1
  =   CR0   x   SP0
SP0 - FMV
   
 
where,
 
         
CR0
  =   the conversion rate in effect immediately prior to the ex-dividend date for such distribution;
CR1
  =   the conversion rate in effect immediately after the opening of business on such ex-dividend date;
SP0
  =   the average of the last reported sale prices of our common stock over the 10 consecutive trading day period ending on the trading day immediately preceding the ex-dividend date for such distribution; and
FMV
  =   the fair market value (as determined by our board of directors) of the shares of capital stock, evidences of indebtedness, assets, or property distributed with respect to each outstanding share of our common stock on the ex-dividend date for such distribution.
 
With respect to an adjustment pursuant to this clause (3) where there has been a payment of a dividend or other distribution on our common stock of shares of capital stock of any class or series, or similar equity interest, of or relating to a subsidiary or other business unit, which we refer to as a “spin-off,” the conversion rate in effect immediately before 5:00 p.m., New York City time, on the effective date of the spin-off will be increased based on the following formula:
 
                     
CR1
  =   CR0   x   FMV0 + MP0
MP0
   
 
where,
 


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CR0
  =   the conversion rate in effect immediately prior to the end of the valuation period (as defined below);
CR1
  =   the conversion rate in effect immediately after the end of the valuation period;
FMV0
  =   the average of the last reported sale prices of the capital stock or similar equity interest distributed to holders of our common stock applicable to one share of our common stock over the first 10 consecutive trading day period after, and including, the effective date of the spin-off (the “valuation period”); and
MP0
  =   the average of the last reported sale prices of our common stock over the valuation period.
 
The adjustment to the conversion rate under the preceding paragraph will occur on the last day of the valuation period; provided that in respect of any conversion during the valuation period, references with respect to 10 trading days shall be deemed replaced with such lesser number of trading days as have elapsed between the effective date of such spin-off and the conversion date in determining the applicable conversion rate.
 
(4) If any cash dividend or distribution is made to all or substantially all holders of our common stock, the conversion rate will be adjusted based on the following formula:
 
                     
CR1
  =   CR0   x   SP0
SP0 - C
   
 
where,
 
         
CR0
  =   the conversion rate in effect immediately prior to the ex-dividend date for such dividend or distribution;
CR1
  =   the conversion rate in effect immediately after the opening of business on the ex-dividend date for such dividend or distribution;
SP0
  =   the last reported sale price of our common stock on the trading day immediately preceding the ex-dividend date for such dividend or distribution; and
C
  =   the amount in cash per share we distribute to holders of our common stock.
 
(5) If we or any of our subsidiaries make a payment in respect of a tender offer or exchange offer for our common stock, to the extent that the cash and value of any other consideration included in the payment per share of common stock exceeds the last reported sale price of our common stock on the trading day next succeeding the last date on which tenders or exchanges may be made pursuant to such tender or exchange offer, the conversion rate will be increased based on the following formula:
 
                     
CR1
  =   CR0   x   AC + (SP1 x OS1)
OS0 x SP1
   
 
where,
 
         
CR0
  =   the conversion rate in effect immediately prior to the effective date of the adjustment;
CR1
  =   the conversion rate in effect immediately after the effective date of the adjustment;

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AC
  =   the aggregate value of all cash and any other consideration (as determined by our board of directors) paid or payable for shares purchased in such tender or exchange offer;
OS0
  =   the number of shares of our common stock outstanding immediately prior to the date such tender or exchange offer expires;
OS1
  =   the number of shares of our common stock outstanding immediately after the date such tender or exchange offer expires; and
SP1
  =   the average of the last reported sale prices of our common stock over the 10 consecutive trading day period commencing on the trading day next succeeding the date such tender or exchange offer expires.
 
The adjustment to the conversion rate under the preceding paragraph will occur at the close of business on the tenth trading day from, and including, the trading day next succeeding the date such tender or exchange offer expires; provided that in respect of any conversion within 10 trading days immediately following, and including, the expiration date of any tender or exchange offer, references with respect to 10 trading days shall be deemed replaced with such lesser number of trading days as have elapsed between the expiration date of such tender or exchange offer and the conversion date in determining the applicable conversion rate.
 
Except as stated herein, we will not adjust the conversion rate for the issuance of shares of our common stock or any securities convertible into or exchangeable for shares of our common stock or the right to purchase shares of our common stock or such convertible or exchangeable securities.
 
If, however, the application of the foregoing formulas would result in a decrease in the conversion rate, no adjustment to the conversion rate will be made (other than as a result of a share split or share combination).
 
As used in this section, “ex-dividend date” means the first date on which the shares of our common stock trade on the applicable exchange or in the applicable market, regular way, without the right to receive the issuance or distribution in question.
 
We are permitted to increase the conversion rate of the notes by any amount for a period of at least 20 business days if our board of directors determines that such increase would be in our best interest. We may also (but are not required to) increase the conversion rate to avoid or diminish income tax to holders of our common stock or rights to purchase shares of our common stock in connection with a dividend or distribution of shares (or rights to acquire shares) or similar event.
 
A holder may, in some circumstances, including the distribution of cash dividends to holders of our shares of common stock, be deemed to have received a distribution or dividend subject to U.S. federal income tax as a result of an adjustment or the nonoccurrence of an adjustment to the conversion rate. For a discussion of the U.S. federal income tax treatment of an adjustment to the conversion rate, see “Material U.S. Federal Income Tax Considerations.”
 
We do not currently have a preferred stock rights plan. To the extent that we have a rights plan in effect upon a conversion of the notes in which you receive common stock, you will receive, in addition to the common stock, the rights under the rights plan, unless prior to any conversion, the rights have separated from the common stock, in which case, and only in such case, the conversion rate will be adjusted at the time of separation as if we distributed to all holders of our common stock, shares of our capital stock, evidences of indebtedness, or assets as described in clause (3) above, subject to readjustment in the event of the expiration, termination, or redemption of such rights.

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Notwithstanding any of the foregoing, the applicable conversion rate will not be adjusted:
 
  •   upon the issuance of any shares of our common stock pursuant to any present or future plan providing for the reinvestment of dividends or interest payable on our securities and the investment of additional optional amounts in shares of our common stock under any plan;
 
  •   upon the issuance of any shares of our common stock or restricted stock units or options or rights to purchase those shares pursuant to any present or future employee, director, or consultant benefit plan or program of or assumed by us or any of our subsidiaries;
 
  •   upon the issuance of any shares of our common stock pursuant to any option, warrant, right, or exercisable, exchangeable, or convertible security not described in the preceding bullet and outstanding as of the date the notes were first issued;
 
  •   for a change in the par value of our common stock; or
 
  •   for accrued and unpaid interest and additional interest, if any.
 
Adjustments to the applicable conversion rate will be calculated to the nearest 1/10,000th of a share. Except as described above in this section, we will not adjust the conversion rate.
 
Recapitalizations, Reclassifications, and Changes of our Common Stock
 
In the case of any recapitalization, reclassification, or change of our common stock (other than changes resulting from a subdivision or combination), a consolidation, merger, or combination involving us, a sale, lease, or other transfer to a third party of our and our subsidiaries’ consolidated assets substantially as an entirety, or any statutory share exchange, in each case as a result of which our common stock would be converted into, or exchanged for, stock, other securities, other property, or assets (including cash or any combination thereof), then, at the effective time of the transaction, the right to convert a note will be changed into a right to convert it into the kind and amount of shares of stock, other securities, or other property or assets (including cash or any combination thereof) that a holder of a number of shares of common stock equal to the conversion rate immediately prior to such transaction would have owned or been entitled to receive (the “reference property”) upon such transaction. If the transaction causes our common stock to be converted into the right to receive more than a single type of consideration (determined based in part upon any form of stockholder election), the reference property into which the notes will be convertible will be deemed to be the weighted average of the types and amounts of consideration received by the holders of our common stock that affirmatively make such an election. However, at and after the effective time of the transaction, any amount otherwise payable in cash upon conversion of the notes will continue to be payable in cash, and the daily conversion value will be calculated based on the value of the reference property. We will agree in the indenture not to become a party to any such transaction unless its terms are consistent with the foregoing.
 
Consolidation, Merger, and Sale of Assets
 
The indenture provides that we may not consolidate with or merge with or into, or convey, transfer, or lease all or substantially all of our properties and assets (other than the stock or assets of MTI Instruments, Inc.) to, another person, unless (i) the resulting, surviving, or transferee person (if not us) is a person organized and existing under the laws of the United States of America, any state thereof, or the District of Columbia, and such entity (if not us) expressly assumes by supplemental indenture all of our obligations under the notes and the indenture; and (ii) immediately after giving effect to such transaction, no default has occurred and is continuing under the indenture. Upon any such consolidation, merger, or transfer, the resulting, surviving, or transferee person shall succeed to, and may exercise every right and power of, us under the indenture.


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Reports
 
The indenture governing the notes provides that any document or report that we are required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act will be filed with the trustee within 30 days after such document or report is required to be filed with the SEC. Such requirement to file with the trustee shall be met if we file the applicable document or report with the SEC via the EDGAR system.
 
In addition, we agree that, if at any time we are not required to file with the SEC the reports required by the preceding paragraph, we will furnish to the holders of notes or any shares of our common stock issued upon conversion thereof the information required to be delivered pursuant to Rule 144A(d)(4) under the Securities Act and take such further action as any such holder may reasonably request, all to the extent required from time to time to enable such holder to sell its notes or common stock without registration under the Securities Act within the limitation of the exemption provided by Rule 144A, as such rule may be amended from time to time.
 
Events of Default
 
Each of the following is an event of default:
 
(1) default in any payment of interest, including additional interest, if any, on any note when due and payable and such default continues for a period of 30 days;
 
(2) default in the payment of principal of any note when due and payable at its stated maturity, upon acceleration, or otherwise;
 
(3) our failure to comply with our obligation to convert the notes in accordance with the indenture upon exercise of a holder’s conversion right, and such failure continues for a period of five trading days;
 
(4) our failure to give notice of a specified corporate transaction as described under “— Notice Upon Specified Corporate Transactions,” in each case when due;
 
(5) our failure to comply with our obligations under “Consolidation, Merger, and Sale of Assets;”
 
(6) our failure to comply with any of our other agreements contained in the notes or the indenture for 60 days after we receive written notice from the trustee or the holders of at least     % in principal amount of the notes then outstanding;
 
(7) default by us or any of our subsidiaries with respect to any mortgage, agreement or other instrument under which there may be outstanding, or by which there may be secured or evidenced, any indebtedness for money borrowed in excess of $      in the aggregate of us or any of our subsidiaries, whether such indebtedness now exists or shall hereafter be created (i) resulting in such indebtedness becoming or being declared due and payable or (ii) constituting a failure to pay the principal or interest of any such debt when due and payable (by the end of the applicable grace period, if any) at its stated maturity, upon declaration, or otherwise;
 
(8) certain events of bankruptcy, insolvency, or reorganization involving us or any of our significant subsidiaries (as defined in Regulation S-X under the Exchange Act); or
 
(9) a final judgment for the payment of $      or more (excluding any amounts covered by insurance) rendered against us or any of our subsidiaries, which judgment is not discharged or stayed within 60 days after (i) the date on which the right to appeal thereof has expired if no such appeal has commenced, or (ii) the date on which all rights to appeal have been extinguished.
 
If an event of default occurs and is continuing, the trustee by notice to us, or the holders of at least     % in principal amount of the outstanding notes by notice to us and the trustee, may, and the trustee at the request of such holders shall, declare 100% of the principal of and accrued and


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unpaid interest, including additional interest, if any, on all the notes to be due and payable. In case of certain events of bankruptcy, insolvency, or reorganization, involving us or a significant subsidiary, 100% of the principal of and accrued and unpaid interest on the notes will automatically become due and payable. Upon such a declaration, such principal and accrued and unpaid interest, including additional interest, if any, will be due and payable immediately.
 
Notwithstanding the foregoing, the indenture provides that, if we so elect, the sole remedy for an event of default relating to the failure to file any documents or reports that we are required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act and for any failure to comply with the requirements of Section 314(a)(1) of the Trust Indenture Act or of the covenant described above in “— Reports,” will for the first 365 days after the occurrence of such an event of default consist exclusively of the right to receive additional interest on the notes at an annual rate equal to     % of the principal amount of the notes during the first 180 days after the occurrence of such an event of default and     % of the principal amount of the notes from the 181st day until the 365th day following the occurrence of such an event of default. If we so elect, such additional interest will be payable on all outstanding notes from and including the date on which such event of default first occurs to but not including the 365th day thereafter (or such earlier date on which the event of default relating to a failure to comply with such requirements has been cured or waived). On the 365th day after such event of default (or earlier, if the event of default is cured or waived prior to such 365th day), additional interest will cease to accrue and the notes will be subject to acceleration as provided above. The provisions of the indenture described in this paragraph will not affect the rights of holders of notes in the event of the occurrence of any other event of default. In the event we do not elect to pay additional interest upon an event of default in accordance with this paragraph, the notes will be subject to acceleration as provided above.
 
In order to elect to pay additional interest as the sole remedy during the first 365 days after the occurrence of an event of default relating to the failure to comply with the reporting obligations in accordance with the immediately preceding paragraph, we must notify all holders of notes and the trustee and paying agent of such election prior to the tenth business day following the date on which such event of default occurs. If we fail to timely give such notice, the notes will be immediately subject to acceleration as provided above.
 
The holders of a majority in principal amount of the outstanding notes may waive all past defaults (except with respect to nonpayment of principal or interest, including any additional interest) and rescind any such acceleration with respect to the notes and its consequences if (1) rescission would not conflict with any judgment or decree of a court of competent jurisdiction and (2) all existing events of default, other than the nonpayment of the principal of and interest, including additional interest, if any, on the notes that have become due solely by such declaration of acceleration, have been cured or waived.
 
Subject to the provisions of the indenture relating to the duties of the trustee, if an event of default occurs and is continuing, the trustee will be under no obligation to exercise any of the rights or powers under the indenture at the request or direction of any of the holders unless such holders have offered to the trustee indemnity or security reasonably satisfactory to it against any loss, liability or expense. Except to enforce the right to receive payment of principal or interest, including additional interest, if any, when due, no holder may pursue any remedy with respect to the indenture or the notes unless:
 
(1) such holder has previously given the trustee notice that an event of default is continuing;
 
(2) holders of at least     % in principal amount of the outstanding notes have requested the trustee to pursue the remedy;
 
(3) such holders have offered the trustee security or indemnity reasonably satisfactory to it against any loss, liability, or expense;


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(4) the trustee has not complied with such request within 60 days after the receipt of the request and the offer of security or indemnity; and
 
(5) the holders of a majority in principal amount of the outstanding notes have not given the trustee a direction that, in the opinion of the trustee, is inconsistent with such request within such 60-day period.
 
Subject to certain restrictions, the holders of a majority in principal amount of the outstanding notes are given the right to direct the time, method, and place of conducting any proceeding for any remedy available to the trustee or of exercising any trust or power conferred on the trustee.
 
The indenture provides that if an event of default has occurred and is continuing, the trustee will be required in the exercise of its powers to use the degree of care that a prudent person would use in the conduct of its own affairs. The trustee, however, may refuse to follow any direction that conflicts with law or the indenture or that the trustee determines is unduly prejudicial to the rights of any other holder or that would involve the trustee in personal liability. Prior to taking any action under the indenture, the trustee will be entitled to indemnification satisfactory to it in its sole discretion against all losses and expenses caused by taking or not taking such action.
 
The indenture provides that if a default occurs and is continuing and is known to the trustee, the trustee must mail to each holder notice of the default within 90 days after it occurs. Except in the case of a default in the payment of principal of or interest (including additional interest, if any) on any note, the trustee may withhold notice if and so long as a committee of trust officers of the trustee in good faith determines that withholding notice is in the interests of the holders. In addition, we are required to deliver to the trustee, within 120 days after the end of each fiscal year, a certificate indicating whether the signers thereof know of any default that occurred during the previous year. We are also required to deliver to the trustee, within 30 days after the occurrence thereof, written notice of any events which would constitute certain defaults, their status, and what action we are taking or propose to take in respect thereof.
 
Modification and Amendment
 
Subject to certain exceptions, the indenture or the notes may be amended with the consent of the holders of at least a majority in principal amount of the notes then outstanding (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, notes) and, subject to certain exceptions, any past default or compliance with any provisions may be waived with the consent of the holders of a majority in principal amount of the notes then outstanding (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, notes). However, without the consent of each holder of an outstanding note affected, no amendment may, among other things:
 
(1) reduce the amount of notes whose holders must consent to an amendment;
 
(2) reduce the rate of or extend the stated time for payment of interest, including additional interest, if any, on any note;
 
(3) reduce the principal of or extend the stated maturity of any note;
 
(4) make any change that impairs or adversely affects the right of a holder to convert any note or the conversion rate thereof;
 
(5) make any note payable in currency other than that stated in the note;
 
(6) change the ranking of the notes in a manner adverse to holders of the notes;
 
(7) impair the right of any holder to receive payment of principal and interest, including additional interest, if any, on such holder’s notes on or alter the due dates therefore or to institute suit for the enforcement of any payment on or with respect to such holder’s notes; or


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(8) make any change in the amendment provisions of the indenture which require each holder’s consent or in the waiver provisions.
 
Without the consent of any holder, we and the trustee may amend the indenture to:
 
(1) cure any ambiguity or correct any omission, defect, or inconsistency in the indenture, so long as such action will not adversely affect the interests of holders of the notes; provided that any such amendment made solely to conform the provisions of the indenture to this prospectus will be deemed not to adversely affect the interests of holders of the notes;
 
(2) provide for the assumption by a successor corporation, partnership, trust, or limited liability company of our obligations under the indenture;
 
(3) add guarantees with respect to the notes;
 
(4) secure the notes;
 
(5) add to our covenants for the benefit of the holders or surrender any right or power conferred upon us;
 
(6) make any change that does not materially adversely affect the rights of any holder; or
 
(7) comply with any requirement of the SEC in connection with the qualification of the indenture under the Trust Indenture Act.
 
The consent of the holders is not necessary under the indenture to approve the particular form of any proposed amendment. It is sufficient if such consent approves the substance of the proposed amendment. After an amendment under the indenture becomes effective, we are required to mail to the holders a notice briefly describing such amendment. However, the failure to give such notice to all the holders, or any defect in the notice, will not impair or affect the validity of the amendment.
 
Discharge
 
We may satisfy and discharge our obligations under the indenture by delivering to the securities registrar for cancellation all outstanding notes or by depositing with the trustee or delivering to the holders, as applicable, after the notes have become due and payable, whether at stated maturity or upon conversion or otherwise, cash or shares of common stock sufficient to pay all of the outstanding notes and paying all other sums payable under the indenture by us. Such discharge is subject to terms contained in the indenture.
 
Calculations in Respect of Notes
 
Except as otherwise provided above, we will be responsible for making all calculations called for under the notes. These calculations include, but are not limited to, determinations of the last reported sale prices of our common stock, accrued interest payable on the notes, and the conversion rate of the notes. We will make all these calculations in good faith and, absent manifest error, our calculations will be final and binding on holders of notes. We will provide a schedule of our calculations to each of the trustee and the conversion agent, and each of the trustee and the conversion agent is entitled to rely conclusively upon the accuracy of our calculations without independent verification. The trustee will forward our calculations to any holder of notes upon the request of that holder.
 
Trustee
 
American Stock Transfer & Trust Company is the trustee, security registrar, paying agent, and conversion agent. American Stock Transfer & Trust Company, in each of its capacities, including without limitation as trustee, security registrar, paying agent, and conversion agent, assumes no responsibility for the accuracy or completeness of the information concerning us or our affiliates or


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any other party contained in this document or the related documents or for any failure by us or any other party to disclose events that may have occurred and may affect the significance or accuracy of such information.
 
Governing Law
 
The indenture provides that it and the notes will be governed by, and construed in accordance with, the laws of the State of New York.
 
Book-entry, Settlement, and Clearance
 
The Global Notes
 
The notes will be initially issued in the form of one or more registered notes in global form, without interest coupons (the “global notes”). Upon issuance, each of the global notes will be deposited with the trustee as custodian for DTC and registered in the name of Cede & Co., as nominee of DTC.
 
Ownership of beneficial interests in a global note will be limited to persons who have accounts with DTC (“DTC participants”) or persons who hold interests through DTC participants. We expect that under procedures established by DTC:
 
  •   upon deposit of a global note with DTC’s custodian, DTC will credit portions of the principal amount of the global note to the accounts of the DTC participants designated by the underwriter; and
 
  •   ownership of beneficial interests in a global note will be shown on, and transfer of ownership of those interests will be effected only through, records maintained by DTC (with respect to interests of DTC participants) and the records of DTC participants (with respect to other owners of beneficial interests in the global note).
 
Beneficial interests in global notes may not be exchanged for notes in physical, certificated form except in the limited circumstances described below.
 
The global notes and beneficial interests in the global notes will be subject to certain restrictions on transfer in accordance with procedures established by DTC.
 
Book-entry Procedures for the Global Notes
 
All interests in the global notes will be subject to the operations and procedures of DTC. We provide the following summary of those operations and procedures solely for the convenience of investors. The operations and procedures of DTC are controlled by that settlement system and may be changed at any time. Neither we nor the underwriter are responsible for those operations or procedures.
 
DTC has advised us that it is
 
  •   a limited purpose trust company organized under the laws of the State of New York;
 
  •   a “banking organization” within the meaning of the New York State banking law;
 
  •   a member of the Federal Reserve System;
 
  •   a “clearing corporation” within the meaning of the Uniform Commercial Code; and
 
  •   a “clearing agency” registered under Section 17A of the Exchange Act.
 
DTC was created to hold securities for its participants and to facilitate the clearance and settlement of securities transactions between its participants through electronic book-entry changes to the accounts of its participants. DTC’s participants include securities brokers and dealers, including the underwriter; banks and trust companies; clearing corporations; and other


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organizations. Indirect access to DTC’s system is also available to others such as banks, brokers, dealers, and trust companies; these indirect participants clear through or maintain a custodial relationship with a DTC participant, either directly or indirectly. Investors who are not DTC participants may beneficially own securities held by or on behalf of DTC only through DTC participants or indirect participants in DTC.
 
So long as DTC’s nominee is the registered owner of a global note, that nominee will be considered the sole owner or holder of the notes represented by that global note for all purposes under the indenture. Except as provided below, owners of beneficial interests in a global note
 
  •   will not be entitled to have notes represented by the global note registered in their names;
 
  •   will not receive or be entitled to receive physical, certificated notes; and
 
  •   will not be considered the owners or holders of the notes under the indenture for any purpose, including with respect to the giving of any direction, instruction, or approval to the trustee under the indenture.
 
As a result, each investor who owns a beneficial interest in a global note must rely on the procedures of DTC to exercise any rights of a holder of notes under the indenture (and, if the investor is not a participant or an indirect participant in DTC, on the procedures of the DTC participant through which the investor owns its interest).
 
Payments of principal and interest (including any additional interest) with respect to the notes represented by a global note will be made by the trustee to DTC’s nominee as the registered holder of the global note. Neither we nor the trustee will have any responsibility or liability for the payment of amounts to owners of beneficial interests in a global note, for any aspect of the records relating to or payments made on account of those interests by DTC, or for maintaining, supervising, or reviewing any records of DTC relating to those interests.
 
Payments by participants and indirect participants in DTC to the owners of beneficial interests in a global note will be governed by standing instructions and customary industry practice and will be the responsibility of those participants or indirect participants and DTC.
 
Transfers between participants in DTC will be effected under DTC’s procedures and will be settled in same-day funds.
 
Certificated Notes
 
Notes in registered physical, certificated form will be issued and delivered to each person that DTC identifies as a beneficial owner of the related notes only if
 
  •   DTC notifies us at any time that it is unwilling or unable to continue as depositary for the global notes and a successor depositary is not appointed within 90 days;
 
  •   DTC ceases to be registered as a clearing agency under the Exchange Act and a successor depositary is not appointed within 90 days;
 
  •   we, at our option, notify the trustee that we elect to cause the issuance of certificated notes, subject to DTC’s procedures; or
 
  •   certain other events provided in the indenture should occur.


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DESCRIPTION OF WARRANTS
 
In connection with this offering, we will issue warrants to purchase           shares of common stock, including warrants issued as underwriter’s compensation. Each warrant entitles the holder to purchase at any time for a period of five years, a specified number of shares of common stock at an exercise price of $      per share. After the expiration of the exercise period, unit warrant holders will have no further rights to exercise such unit warrants.
 
The unit warrants may be exercised only for full shares of common stock, and may be exercised on a “cashless” basis. We will not issue fractional shares of common stock or cash in lieu of fractional shares of common stock. Unit warrant holders do not have any voting or other rights as a stockholder of our company. The exercise price and the number of shares of common stock purchasable upon the exercise of each unit warrant are subject to adjustment upon the happening of certain events, such as stock dividends, distributions, and splits. No adjustment in the exercise price will be required unless cumulative adjustments require an adjustment of at least $0.01. Notwithstanding the foregoing, in case of any consolidation, merger, or sale of all or substantially all of the assets of our company, the holder of each of the unit warrants will have only the right, upon the subsequent exercise thereof, to receive the kind and amount of shares and other securities and property, including cash, that the holder would have been entitled to receive by virus of such transaction had the unit warrants been exercised immediately prior to such transaction.


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DESCRIPTION OF OUR CAPITAL STOCK
 
The following is a description of the material provisions of our capital stock, as well as other material terms of our certificate of incorporation and bylaws as they will be in effect as of the consummation of the offering. The following description is intended to be a summary and does not describe all provisions of our certificate of incorporation or bylaws or New York law applicable to us. For a more thorough understanding of the terms of our securities, you should read the following together with our certificate of incorporation and bylaws, which are filed as exhibits to the registration statement of which this prospectus forms a part.
 
General
 
As of March 31, 2008, our total authorized capital stock consisted of 75,000,000 shares of common stock, par value $0.01 per share. As of March 31, 2008, 4,771,861 shares of common stock were issued and outstanding. As of March 31, 2008, options to purchase 762,391 shares of common stock and warrants to purchase 378,472 shares of common stock were outstanding.
 
Common Stock
 
The holders of outstanding shares of our common stock are entitled to receive dividends out of assets legally available therefore at such time and in such amounts as our Board of Directors may from time to time determine subject to the prior rights of the holders of any preferred stock. The holders of our common stock have no preemptive or subscription rights to purchase any of our securities. Upon our liquidation, dissolution or winding up, the holders of common stock are entitled to receive, pro rata, our assets which are legally available for distribution, after payment of all debts and other liabilities and subject to the rights of any holders of preferred stock. Each outstanding share of common stock is entitled to one vote on all matters submitted to a vote of stockholders. There is no cumulative voting with respect to any shares of capital stock.
 
Our common stock is quoted on The Nasdaq Global Market under the symbol “MKTY.”
 
Warrants
 
Warrants for the issuance of 378,472 shares of our common stock are outstanding, all of which are exercisable at a price of $18.16 per share. These warrants became exercisable on June 20, 2007 and are exercisable through December 19, 2011.
 
The descriptions of the warrants are only a summary and are qualified in their entirety by the provisions of the forms of the warrant, which are attached or referenced to the registration statement of which this prospectus forms a part.
 
Limitation of Liability and Indemnification of Officers and Directors
 
Pursuant to the statutes of the State of New York, a director or officer of a corporation is entitled, under specified circumstances, to indemnification by our company against reasonable expenses, including attorney’s fees, incurred by him/her in connection with the defense of a civil or criminal proceeding to which he/she has been made, or threatened to be made, a party by reason of the fact that he/she was such director or officer. In certain circumstances, indemnity is provided against judgments, fines, and amounts paid in settlement. In general, indemnification is available where the director or officer acted in good faith, for a purpose he/she reasonably believed to be in the best interests of the corporation. Specific court approval is required in some cases. The foregoing statement is subject to the detailed provisions of Sections 715, 717 and 721-725 of the New York Business Corporation Law.
 
Under provisions of our certificate of incorporation, we will indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending, or completed action, proceeding or suit (including one by or in the right of us to procure a judgment in its favor), whether civil or criminal, by reason of the fact that he, his testator or intestate is or was one of our directors or officers, or is or was serving any other corporation, partnership, joint venture, trust, employee benefit


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plan, or other enterprise in any capacity at our request, against judgments, fines, amounts paid in settlement, and expenses, including attorneys’ fees, actually incurred as a result of or in connection with any such action, proceeding or suit, or any appeal therefrom, if such director or officer acted in good faith for a purpose which he reasonably believed to be in or not opposed to our best interests, and, in criminal actions or proceedings, in which he had no reasonable cause to believe that his conduct was unlawful. No indemnification will be made, however, to or on behalf of any director or officer if a judgment or other final adjudication adverse to the director or officer establishes that his/her acts were committed in bad faith or were the result of active and deliberate dishonesty and were material to the cause of action so adjudicated, or that he/she personally gained a financial profit or other advantage to which he/she was not legally entitled.
 
Our directors and officers are covered by insurance policies indemnifying against certain liabilities, including certain liabilities arising under the Securities Act that might be incurred by them in such capacities.
 
Our certificate of incorporation further provides that directors of our company will not be personally liable to us or our stockholders for any breach of duty in such capacity, however, such provision will not operation to eliminate or limit the liability of any director if a judgment or other final adjudication adverse to such director establishes that the director’s acts or omissions were in bad faith or involved intentional misconduct or a knowing violation of law or that the director personally gained in fact a financial profit or other advantage to which the director was not legally entitled or that the director’s acts violated certain provisions of the New York Business Corporation Law.
 
Indemnification for Securities Act Liabilities
 
Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers or persons controlling our company pursuant to the foregoing provisions, we have been informed that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.
 
Transfer Agent and Registrar
 
The transfer agent and registrar for our common stock and warrants placed through this offering is American Stock Transfer & Trust Company, located at 59 Maiden Lane, Plaza Level, New York, NY 10038.


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PRINCIPAL STOCKHOLDERS
 
The following table sets forth information regarding the beneficial ownership of our common stock as of June 30, 2008 by each of our directors and named executive officers and all of our executive officers and directors as a group. We are not aware of any stockholders that beneficially own more than 5% of our common stock.
 
           
    Shares
   
    Beneficially
   
Name (1)
  Owned (2)   Percent of Class
 
Robert J. Kot (3)
  9,182     *
Peng K. Lim (4)
  95,515     2.0%
Thomas J. Marusak (5)
  17,022     *
E. Dennis O’Connor (6)
  60,824     1.3%
William P. Phelan (7)
  18,127     *
James K. Prueitt (8)
  6,096     *
Dr. Walter L. Robb (9)
  97,107     2.0%
Cynthia A. Scheuer (10)
  38,179     *
All present directors and officers as a group (8 persons) (11)
  342,052     6.8%
 
 
Less than 1%.
 
(1) Unless otherwise indicated, each of the stockholders has sole voting and investment power with respect to the shares of common stock beneficially owned by the stockholder. The address of all listed stockholders is c/o Mechanical Technology, Incorporated, 431 New Karner Road, Albany, New York 12205.
 
(2) The number of shares beneficially owned by each stockholder is determined under rules promulgated by the SEC and includes voting or investment power with respect to securities. Under these rules, beneficial ownership includes any shares as to which the individual or entity has sole or shared voting power or investment power and includes any shares as to which the individual or entity has the right to acquire beneficial ownership within 60 days after June 30, 2008, through the exercise of any warrant, stock option or other right. The inclusion in this schedule of such shares, however, does not constitute an admission that the named stockholder is a direct or indirect beneficial owner of such shares. The number of shares of common stock outstanding used in calculating the percentage for each listed person includes the shares of common stock underlying options held by such person, which are exercisable within 60 days of June 30, 2008, but excludes shares of common stock underlying options held by any other person. Percentage of beneficial ownership is based on 4,771,658 shares of common stock outstanding as of June 30, 2008.
 
(3) Includes 9,182 shares of common stock issuable upon exercise of stock options.
 
(4) Includes 84,128 shares of common stock issuable upon exercise of stock options.
 
(5) Includes 16,147 shares of common stock issuable upon exercise of stock options.
 
(6) Includes 41,262 shares of common stock issuable upon exercise of stock options.
 
(7) Includes 18,127 shares of common stock issuable upon exercise of stock options.
 
(8) Includes 4,846 shares of common stock issuable upon exercise of stock options.
 
(9) Includes 40,857 shares of common stock issuable upon exercise of stock options.
 
(10) Includes 33,961 shares of common stock issuable upon exercise of stock options.
 
(11) Includes 248,510 shares of common stock issuable upon exercise of stock options.


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MATERIAL U.S. FEDERAL
INCOME TAX CONSIDERATIONS
 
The following is a summary of the material U.S. federal income tax consequences of acquiring, owning and disposing of (i) the notes, (ii) the warrants and (iii) the common stock issuable upon a conversion of the notes or an exercise of the warrants. This summary only applies to notes, warrants or common stock held as capital assets and does not address, except as set forth below, aspects of U.S. federal income taxation that may be applicable to holders that are subject to special tax rules, such as:
 
  •   financial institutions or insurance companies;
 
  •   real estate investment trusts, regulated investment companies or grantor trusts;
 
  •   tax-exempt organizations;
 
  •   dealers or traders in securities or currencies;
 
  •   persons that will hold a note or warrant as part of a position in a straddle or as part of a hedging, conversion or integrated transaction for U.S. federal income tax purposes; and
 
  •   persons that have a functional currency other than the U.S. dollar.
 
Moreover, except as set forth below, this summary does not address the U.S. federal estate and gift or alternative minimum tax consequences of the acquisition, ownership or retirement of notes, warrants or common stock and does not address the U.S. federal income tax treatment of persons that do not acquire notes as part of the initial distribution at their initial issue price. Each prospective purchaser should consult its tax advisor with respect to the U.S. federal, state, local and foreign tax consequences of acquiring, holding and disposing of notes, warrants or common stock.
 
This summary is based on the Internal Revenue Code of 1986, as amended, existing and proposed Treasury Regulations, administrative pronouncements and judicial decisions, each as available and in effect on the date hereof. All of the foregoing are subject to change, possibly with retroactive effect, or differing interpretations which could affect the tax consequences described herein.
 
For purposes of this summary, a U.S. Holder is a beneficial owner of notes, warrants or common stock, as the case may be, who for U.S. federal income tax purposes is:
 
  •   a citizen or resident of the United States;
 
  •   a corporation or partnership organized in or under the laws of the United States or any State thereof, including the District of Columbia;
 
  •   an estate the income of which is subject to U.S. federal income taxation regardless of its source;
 
  •   a trust (1) that validly elects to be treated as a United States person for U.S. federal income tax purposes or (2)(a) the administration over which a U.S. court can exercise primary supervision and (b) all of the substantial decisions of which one or more United States persons have the authority to control; or
 
  •   subject to U.S. federal income taxation on a net income basis with respect to payments under the notes or warrants.
 
If a partnership (or any other entity treated as a partnership for U.S. federal income tax purposes) holds notes, warrants or common stock, the tax treatment of such partnership and a partner in such partnership will generally depend on the status of the partner and the activities of the partnership. Such partnerships and partners of such partnerships should consult their own tax advisors as to its consequences.


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A Non-U.S. Holder is a beneficial owner of notes, warrants or common stock, as the case may be, other than a U.S. Holder.
 
Consequences to Holders of Notes
 
The Company intends to treat the notes as debt of the Company for U.S. federal income tax purposes. The remainder of this summary assumes that the notes will be so treated.
 
Allocation of the Issue Price between a Note and a Warrant
 
Each unit is comprised of a note and a warrant. The “issue price” of a unit for U.S. federal income tax purposes will be the initial offering price of a substantial amount of units to investors (other than persons acting in their capacity as underwriters, placement agents or wholesalers). The issue price will be allocated between the note and warrant based on their respective fair market values at the time of issuance, and a U.S. Holder’s initial tax basis in each will be equal to the amount so allocated. Based upon its estimate of the fair market value of a warrant, the Company intends to treat $      of the issue price of a unit as allocable to the note (which amount the Company will therefore treat as its “issue price” for U.S. federal income tax purposes) and $      as allocable to the warrant. The Company intends to file information returns with the U.S. Internal Revenue Service (the “IRS”) based on such allocation.
 
The Company’s allocation of the issue price is binding on a U.S. Holder for U.S. federal income tax purposes unless the holder discloses the use of a different allocation in its U.S. federal income tax return for the year in which the unit was acquired. However, the Company’s allocation is not binding on the IRS, and there can be no assurance that the IRS will not challenge such allocation.
 
Consequences to U.S. Holders of Notes
 
Interest
 
Generally, interest paid on a note will be includible in a U.S. Holder’s gross income as ordinary interest income in accordance with the U.S. Holder’s usual method of tax accounting.
 
Prospective U.S. Holders of notes should note that the allocation of the issue price of a unit between the note and the warrant may cause the note to be treated as issued with original issue discount (“OID”) for U.S. federal income tax purposes. For U.S. federal income tax purposes, OID is the excess of the “stated redemption price at maturity” of a debt instrument over its “issue price,” if that excess equals or exceeds 1/4 of 1% of the debt instrument’s stated redemption price at maturity multiplied by the number of complete years from its issue date to its maturity or weighted average maturity in the case of installment obligations (the “OID de minimis amount”). The “stated redemption price at maturity” of a debt instrument, such as the notes, is the sum of all payments required to be made on the notes other than “qualified stated interest” payments. The “issue price” of a note generally is the first offering price to the public at which a substantial amount of the debt instrument is sold. The term “qualified stated interest” generally means stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer), or that is treated as constructively received, at least annually at a single fixed rate or, under certain conditions discussed below, at a variable rate.
 
If a U.S. Holder holds a note that is issued with OID (an “OID Note”), such U.S. Holder may be required to include OID in income before receipt of the associated cash payment, regardless of the U.S. Holder’s accounting method for U.S. federal income tax purposes. If the U.S. Holder is an initial purchaser of an OID Note, the amount of the OID includible in income is the sum of the daily accruals of the OID for the note for each day during the taxable year (or portion of the taxable year) in which such U.S. Holder held the OID Note. The daily portion is determined by allocating the OID for each day of the accrual period. An accrual period may be of any length and the accrual periods may even vary in length over the term of the OID Note, provided that each accrual period is no


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longer than one year and each scheduled payment of principal or interest occurs either on the first day of an accrual period or on the final day of an accrual period. The amount of OID allocable to an accrual period is equal to the difference between: (a) the product of the “adjusted issue price” of the OID Note at the beginning of the accrual period and its yield to maturity (computed generally on a constant yield method and compounded at the end of each accrual period, taking into account the length of the particular accrual period); and (b) the amount of any qualified stated interest allocable to the accrual period. The “adjusted issue price” of an OID Note at the beginning of any accrual period is the sum of the issue price of the OID Note plus the amount of OID allocable to all prior accrual periods reduced by any payments the U.S. Holder received on the OID Note that were not qualified stated interest. Under these rules, the U.S. Holder generally will have to include in income increasingly greater amounts of OID in successive accrual periods.
 
It is possible that the IRS could assert that the additional interest which we would be obligated to pay in connection with an event of default relating to the failure to file any documents or reports that we are required to file with the SEC pursuant to Section 13 or 15(d) of the Exchange Act, and for any failure to comply with the requirements of Section 314(a)(1) of the Trust Indenture Act or of certain covenants described herein, constitutes a “contingent payment” for U.S. federal income tax purposes. If so treated, the notes would be treated as contingent payment debt instruments and certain adverse U.S. federal income tax consequences could result (including the U.S. Holder reporting such additional interest as OID and the treatment of any gain from the sale of a note as ordinary income for U.S. federal income tax purposes). However, the Treasury Regulations issued by the IRS regarding debt instruments that provide for one or more contingent payments provide that, for purposes of determining whether a debt instrument is a contingent payment debt instrument, remote or incidental contingencies are ignored. The Company believes that the possibility of the payment of additional interest is remote and, accordingly, does not intend to treat the notes as contingent payment debt instruments. The remainder of this summary assumes that the notes will not be treated as contingent payment debt instruments.
 
Sale, Exchange or Retirement
 
Upon the sale, exchange or retirement of a note, a U.S. Holder will recognize taxable gain or loss equal to the difference, if any, between the amount realized on the sale, exchange or retirement, other than accrued but unpaid interest which will be taxable as such, and such U.S. Holder’s adjusted tax basis in the note. A U.S. Holder’s adjusted tax basis in a note generally will equal such holder’s initial tax basis in the note (as determined above under “Consequences to Holders of Notes — Allocation of the Issue Price Between a Note and a Warrant”) increased by the amount of any OID accrued and reduced by any payments other than payments of qualified stated interest under such note. Any such gain or loss will be capital gain or loss. In the case of a noncorporate U.S. Holder, the maximum marginal U.S. federal income tax rate applicable to the gain will be lower than the maximum marginal U.S. federal income tax rate applicable to ordinary income if such U.S. Holder’s holding period for the notes exceeds one year. The deductibility of capital losses is subject to limitations.
 
Conversion of Notes
 
A U.S. Holder’s conversion of notes into shares of our common stock generally will not be a taxable event (except to the extent attributable to accrued but unpaid interest or to cash received in lieu of fractional common shares) for U.S. federal income tax purposes. A U.S. Holder’s tax basis in common shares received upon conversion will generally be the same as the U.S. Holder’s tax basis (exclusive of any tax basis allocable to a fractional share) in the notes converted.
 
Adjustment of Conversion Price
 
The conversion rate of the notes is subject to adjustment in certain circumstances. Under the Code, adjustments of the conversion rate that increase a holder’s proportionate share of our assets


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and earnings will be considered a constructive distribution to such holder, resulting in ordinary income to U.S. persons to the extent of our current and accumulated earnings and profits, as determined under U.S. federal income tax principles. It is unclear whether any such constructive distribution would be eligible for the preferential rates of U.S. federal income tax applicable to certain dividends received by noncorporate holders or whether corporate holders would be entitled to claim the dividends-received deduction with respect to such constructive distribution. Further, a failure to adjust the conversion ratio to reflect certain events can in some circumstances give rise to a constructive distribution to U.S. Holders. Prospective purchasers should consult their own tax advisors concerning the consequences of any adjustments to the conversion rate.
 
Consequences to Non-U.S. Holders of Notes
 
Subject to the discussion below under the heading “U.S. Backup Withholding Tax and Information Reporting,” payments of principal of, and interest on, any note to a Non-U.S. Holder, other than (1) a controlled foreign corporation, as such term is defined in the Internal Revenue Code, which is related to us through stock ownership, (2) a person owning, actually or constructively, securities representing at least 10% of the total combined outstanding voting power of all classes of our voting stock and (3) banks which acquire such note in consideration of an extension of credit made pursuant to a loan agreement entered into in the ordinary course of business, will not be subject to any U.S. withholding tax provided that the beneficial owner of the note provides certification completed in compliance with applicable statutory and regulatory requirements, which requirements are discussed below under the heading “U.S. Backup Withholding Tax and Information Reporting,” or an exemption is otherwise established.
 
Subject to the discussion below under the heading “U.S. Backup Withholding Tax and Information Reporting,” any gain realized by a Non-U.S. Holder upon the sale, exchange or retirement of a note generally will not be subject to U.S. federal income tax, unless (i) such gain is effectively connected with the conduct by such Non-U.S. Holder of a trade or business in the United States; or (ii) in the case of any gain realized by an individual Non-U.S. Holder, such holder is present in the United States for 183 days or more in the taxable year of such sale, exchange or retirement and certain other conditions are met.
 
A Non-U.S. Holder’s conversion of notes into shares of our common stock generally will not be a taxable event (except to the extent attributable to accrued but unpaid interest (which would be treated in the manner described above regarding payments of interest on the notes) or to cash received in lieu of fractional common shares (which would be treated in the manner described above regarding the sale, exchange or retirement of a note)) for U.S. federal income tax purposes.
 
U.S. Federal Estate Taxes
 
A note that is held by an individual who at the time of death is not a citizen or resident of the United States will not be subject to U.S. federal estate tax as a result of such individual’s death, provided that such individual is not a shareholder owning actually or constructively 10% or more of the total combined voting power of all classes of our stock that is entitled to vote and, at the time of such individual’s death, payments of interest with respect to such notes would not have been effectively connected with the conduct by such individual of a trade or business in the United States.
 
Consequences to Holders of Warrants
 
Consequences to U.S. Holders of Warrants
 
Sale, Exchange or Other Disposition
 
The sale or exchange of a warrant (other than through its exercise) will result in the recognition of gain or loss to a U.S. Holder in an amount equal to the difference between the amount realized and such holder’s adjusted tax basis in such warrant. Any such gain or loss will be capital


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gain or loss. In the case of a noncorporate U.S. Holder, the maximum marginal U.S. federal income tax rate applicable to the gain will be lower than the maximum marginal U.S. federal income tax rate applicable to ordinary income if such U.S. Holder’s holding period for the warrant exceeds one year. The deductibility of capital losses is subject to limitations.
 
Exercise
 
No gain or loss will be recognized to a U.S. Holder of warrants on such holder’s purchase of shares of our common stock for cash upon the exercise of the warrants. The initial tax basis of the shares of our common stock so acquired would be equal to the adjusted tax basis of the exercised warrants plus the exercise price. For U.S. federal income tax purposes, the holding period of shares of our common stock acquired upon the exercise of warrants will begin on the date of exercise.
 
Adjustments to Exercise Price
 
The exercise price of the warrants is subject to adjustment in certain circumstances. Under the Code, adjustments of the exercise price of the warrants that increase a holder’s proportionate share of our assets and earnings will be considered a constructive distribution to such holder, resulting in ordinary income to U.S. persons to the extent of our current and accumulated earnings and profits, as determined under U.S. federal income tax principles. It is unclear whether any such constructive distribution would be eligible for the preferential rates of U.S. federal income tax applicable to certain dividends received by noncorporate holders or whether corporate holders would be entitled to claim the dividends-received deduction with respect to such constructive distribution. Further, a failure to adjust the exercise price of the warrants to reflect certain events can in some circumstances give rise to a constructive distribution to U.S. Holders. Prospective purchasers should consult their own tax advisors concerning the consequences of any adjustments to the exercise price of the warrants.
 
Lapse
 
If the warrants are not exercised and are allowed to expire, the warrants will be deemed to have been sold or exchanged on the expiration date resulting in a loss equal to the U.S. Holder’s adjusted tax basis in the warrants. Any loss to the U.S. Holder of warrants will be a capital loss, and the classifications of the loss as long-term or short-term will depend upon the date the warrants were acquired and the length of time the warrants were held. The deductibility of any capital losses is subject to limitations.
 
Consequences to Non-U.S. Holders of Warrants
 
Subject to the discussion below under “U.S. Backup Withholding and Information Reporting,” any gain realized by a Non-U.S. Holder upon the sale or exchange of warrants generally will not be subject to U.S. federal income or withholding tax, unless (i) such gain is effectively connected with the conduct by such Non-U.S. Holder of a trade or business in the United States; or (ii) in the case of any gain realized by an individual Non-U.S. Holder, such holder is present in the United States for 183 days or more in the taxable year of such sale, exchange or retirement and certain other conditions are met or (iii) we are or have been a “U.S. real property holding corporation” during the applicable statutory period.
 
Consequences to Holders of Common Stock
 
Consequences to U.S. Holders of Common Stock
 
Dividends
 
A distribution in respect of our common stock generally will be treated as a dividend to the extent paid from our current or accumulated earnings and profits (as determined for U.S. federal


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income tax purposes). If the distribution exceeds our current and accumulated earnings and profits, the excess will be treated as a nontaxable return of capital reducing the U.S. holder’s tax basis in the holder’s common stock to the extent of the U.S. holder’s tax basis in that stock. Any remaining excess will be treated as capital gain. Dividends received by noncorporate U.S. holders generally will be subject to a reduced maximum tax rate of 15% through December 31, 2010, after which the rate applicable to dividends is scheduled to return to the tax rate generally applicable to ordinary income. The rate reduction will not apply to dividends received to the extent that the U.S. holder elects to treat dividends as “investment income,” which may be offset by investment interest expense. Furthermore, the rate reduction also will not apply to dividends that are paid to a U.S. holder with respect to shares of our common stock that are held by such holder for less than 61 days during the 121-day period beginning on the date that is 60 days before the date on which the shares of our common stock became ex-dividend with respect to such dividend. If a holder is a U.S. corporation, it will be able to claim the deduction allowed to U.S. corporations in respect of dividends received from other U.S. corporations equal to a portion of any dividends received, subject to generally applicable limitations on that deduction. In general, a dividend to a corporate holder may qualify for the 70% dividends received deduction if the holder owns less than 20% of the voting power and value of our stock.
 
U.S. holders are urged to consult their tax advisors regarding the holding period and other requirements that must be satisfied in order to qualify for the dividends-received deduction for corporate holders and the reduced maximum tax rate on dividends for non-corporate holders.
 
Sale, Exchange or Other Disposition
 
A U.S. holder generally will recognize capital gain or loss on a sale or other disposition of our common stock. The holder’s gain or loss will equal the difference between the amount realized by the holder and the holder’s tax basis in the stock. The amount realized by the holder will include the amount of any cash and the fair market value of any other property received for the stock. Any such gain or loss will be capital gain or loss. In the case of a noncorporate U.S. Holder, the maximum marginal U.S. federal income tax rate applicable to the gain will be lower than the maximum marginal U.S. federal income tax rate applicable to ordinary income if such U.S. Holder’s holding period for the common stock exceeds one year. The deductibility of capital losses is subject to limitations.
 
Consequences to Non-U.S. Holders of Common Stock
 
Dividends
 
Any dividends paid with respect to our common stock (and any deemed dividends resulting from certain adjustments, or failure to make adjustments, to the conversion rate (as discussed above under “Adjustment of Conversion Price”)) will be subject to withholding tax at a 30% rate or such lower rate as specified by an applicable income tax treaty. However, dividends that are effectively connected with the conduct of a trade or business within the United States and, if a treaty applies, such dividends are attributable to a U.S. permanent establishment of such holders, are not subject to the withholding tax, but are subject to U.S. federal income tax on a net income basis at applicable graduated individual or corporate rates. Certain certification and disclosure requirements must be complied with in order for a non-U.S. holder’s effectively connected income to be exempt from withholding. Any such effectively connected dividends received by a foreign corporation may, under certain circumstances, be subject to an additional branch profits tax at a 30% rate or such lower rate as specified by an applicable income tax treaty.
 
A non-U.S. holder of shares of common stock who wishes to claim the benefit of an applicable treaty rate is required to satisfy applicable certification and other requirements. If a


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non-U.S. holder is eligible for a reduced rate of U.S. withholding tax pursuant to an income tax treaty, the holder may obtain a refund of any excess amounts withheld by timely filing an appropriate claim for refund with the IRS.
 
Sale, Exchange or Other Disposition
 
Any gain realized by a non-U.S. holder upon the sale, exchange, redemption or other taxable disposition of shares of common stock will not be subject to U.S. federal income tax unless (i) such gain is effectively connected with the conduct by such Non-U.S. Holder of a trade or business in the United States; (ii) in the case of any gain realized by an individual Non-U.S. Holder, such holder is present in the United States for 183 days or more in the taxable year of such sale, exchange or retirement and certain other conditions are met; or (iii) we are or have been a “U.S. real property holding corporation” during the applicable statutory period.
 
U.S. Federal Estate Taxes
 
A share of common stock that is held by an individual who at the time of death is not a citizen or resident of the United States will be subject to U.S. federal estate tax as a result of such individual’s death.
 
U.S. Backup Withholding Tax and Information Reporting
 
A backup withholding tax and information reporting requirements apply to certain payments on a note, warrant, or share of common stock and to proceeds of the sale, exchange, redemption or other disposition of a note, warrant, or share of common stock, to certain noncorporate holders of notes, warrants or shares of common stock that are United States persons. Under current U.S. Treasury Regulations, payments on a note, warrant, or share of common stock to a holder that is not a United States person will not be subject to any backup withholding tax requirements if the beneficial owner of the note, warrant, or share of common stock or a financial institution holding the note, warrant, or share of common stock on behalf of the beneficial owner in the ordinary course of its trade or business provides an appropriate certification to the payor and the payor does not have actual knowledge or a reason to know, that the certification is incorrect. If a beneficial owner provides the certification, the certification must give the name and address of such owner, state that such owner is not a United States person, or, in the case of an individual, that such owner is neither a citizen nor a resident of the United States, and the owner must sign the certificate under penalties of perjury. If a financial institution, other than a financial institution that is a qualified intermediary, provides the certification, the certification must state that the financial institution has received from the beneficial owner the certification set forth in the preceding sentence, set forth the information contained in such certification, and include a copy of such certification, and an authorized representative of the financial institution must sign the certificate under penalties of perjury. A financial institution generally will not be required to furnish to the Internal Revenue Service the names of the beneficial owners of notes, warrants or shares of common stock that are not United States persons and copies of such beneficial owners’ certifications where the financial institution is a qualified intermediary that has entered into a withholding agreement with the Internal Revenue Service pursuant to applicable U.S. Treasury Regulations. The backup withholding tax rate currently is 28%.
 
In addition, if the foreign office of a foreign “broker,” as defined in applicable U.S. Treasury Regulations, pays the proceeds of the sale of a note, warrant, or share of common stock to the seller of the note, warrant or share of common stock, backup withholding and information reporting requirements will not apply to such payment provided that such broker derives less than 50% of its gross income for certain specified periods from the conduct of a trade or business in the United States, is not a controlled foreign corporation for U.S. tax purposes, and is not a foreign partnership (1) one or more of the partners of which, at any time during its tax year, are U.S. persons (as defined in U.S. Treasury Regulations Section 1.1441-1(c)(2)) who, in the aggregate


103


 

hold more than 50% of the income or capital interest in the partnership or (2) which, at any time during its tax year, is engaged in the conduct of a trade or business in the United States. Moreover, the payment by a foreign office of other brokers of the proceeds of the sale of a note, warrant, or share of common stock will not be subject to backup withholding, unless the payor has actual knowledge or a reason to know that the payee is a U.S. person. Payments on a note, warrant or share of common stock by the U.S. office of a custodian, nominee or agent, or the payment by the U.S. office of a broker of the proceeds of a sale of a note, warrant, or share of common stock, are subject to backup withholding requirements unless the beneficial owner provides the nominee, custodian, agent or broker with an appropriate certification as to its non-U.S. status under penalties of perjury or otherwise establishes an exemption.
 
The above summary is not intended to constitute a complete analysis of all tax consequences relating to the ownership of notes, warrants or common stock. Prospective purchasers of notes, warrants or common stock should consult their own tax advisors concerning the tax consequences of their particular situations.


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UNDERWRITING
 
Merriman Curhan Ford & Co. is acting as our underwriter. We and Merriman Curhan Ford & Co. intend to enter into an underwriting agreement with respect to the units being offered by this prospectus. In connection with this offering and subject to certain conditions, Merriman Curhan Ford & Co. has agreed to purchase, and we have agreed to sell, the units set forth on the cover page of this prospectus.
 
The underwriting agreement is subject to a number of terms and conditions and provides that Merriman Curhan Ford & Co. must buy all of the units if they buy any of them (other than those units covered by the over-allotment option described below).
 
Merriman Curhan Ford & Co. has advised us that its does not intend to confirm sales of the units to any account over which it exercises discretionary authority in an aggregate amount in excess of 15% of the total securities offered by this prospectus.
 
We have granted to Merriman Curhan Ford & Co. an option, exercisable as provided in the underwriting agreement and expiring 30 days after the effective date of this offering, to purchase up to an additional 1,800 units at the public offering price set forth on the cover page of this prospectus, less underwriting discounts and commissions. Merriman Curhan Ford & Co. may exercise this option only to cover over-allotments made in connection with the sale of units offered by this prospectus, if any. We will be obligated, pursuant to the option, to sell these additional units to Merriman Curhan Ford & Co. to the extent the option is exercised. If any additional units are so purchased, Merriman Curhan Ford & Co. will offer the additional units on the same terms as those on which the units are being offered.
 
We have paid Merriman Curhan Ford & Co. $20,000 related to its expenses in connection with this offering. We have agreed to reimburse Merriman Curhan Ford & Co. for up to $125,000 of its legal fees incurred in connection with this offering if the offering is not completed.
 
Merriman Curhan Ford & Co. proposes initially to offer the units to the public at the public offering price set forth on the cover page of this prospectus and to the dealers at that price less a concession not in excess of $      per unit. Merriman Curhan Ford & Co. may allow, and the dealers may reallow, a discount not in excess of $      per unit to other dealers. After the public offering, the public offering price, concession and discount may be changed.
 
Our common stock trades on The Nasdaq Global Market under the symbol “MKTY.”
 
The underwriting discounts and commission per unit are equal to the public offering price per unit less the amount paid by Merriman Curhan Ford & Co. to us per unit. The underwriting discounts and commission are     % of the public offering price. We have agreed to pay Merriman Curhan Ford & Co. the following discounts and commissions, assuming either no exercise or full exercise by Merriman Curhan Ford & Co. of its over-allotment option:
 
                         
          With Full Exercise
    Without Exercise
 
    Fees Per
    of Over-Allotment
    of Over-
 
    Unit     Option     Allotment Option  
 
Discounts and commissions paid by us
  $                $                     $                  
 
In addition, we have agreed to grant Merriman Curhan Ford & Co. five-year warrants to purchase a number shares of our common stock equal to 6% of the total number of common share equivalents issuable upon conversion of the notes and exercisable pursuant to the warrants. The exercise price of the underwriter’s warrants will be equal to $     , which is equal to the exercise price of the warrants contained in the units. The warrants may not be sold during the offering or sold, transferred, assigned, pledged, or hypothecated, or be the subject of any hedging, short sale, derivative, put, or call transaction that would result in the effective disposition of the securities by any person for a period of 120 days immediately following the effective date of this


105


 

except to any member participating in the offering and the officers or partners thereof, or as otherwise permitted under 2710(g)(2) of the FINRA’s Corporate Financing Rule and only if the warrants so transferred remain subject to the 120-day lock-up restriction.
 
We estimate that our share of the total expenses of this offering, excluding underwriting discounts and commissions, will be approximately $305,000.
 
Each of our directors and executive officers have agreed with Merriman Curhan Ford & Co. not to offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant to purchase, lend, or otherwise transfer or dispose of, directly or indirectly, any shares of our common stock or any securities convertible into or exercisable or exchangeable for shares of our common stock, or enter into any swap or other arrangement that transfers to another, in whole or in part, any of the economic consequences of ownership of shares of our common stock, for a period of at least 180 days after the date of the final prospectus relating to this public offering, without the prior written consent of Merriman Curhan Ford & Co. This consent may be given at any time without public notice. In addition, if we issue an earnings release or material news or a material event relating to us occurs during the last 17 days of the 180-day lock-up period or if prior to the expiration of the 180-day lock-up period, we announce that we will release earnings results during the 16-day period beginning on the last day of the 180-day lock-up period, the restrictions imposed by the underwriter’s lock-up agreements will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release or the occurrence of the material news or material event, as applicable, unless Merriman Curhan Ford & Co. waives, in writing, such extension. The lock-up agreements do not apply to the exercise of options or warrants or the conversion of a security outstanding on the date of this prospectus and which is described in this prospectus, nor do they apply to transfers or dispositions of shares made (i) as a bona fide gift or gifts, provided that the donee or donees thereof agree to be bound by the restrictions set forth in the lock-up agreements, (ii) to any trust for the direct or indirect benefit of a signatory to a lock-up agreement or the immediate lock-up agreements, (iii) by will or intestate succession provided the transferee agrees to be bound by the restrictions set forth in the lock-up agreements, or (iv) to Merriman Curhan Ford & Co. pursuant to the underwriting agreement. There are not agreements between Merriman Curhan Ford & Co. and any of our stockholders or affiliates releasing them from these lock-up agreements prior to the expiration of the 180-day period. In addition, we have agreed with Merriman Curhan Ford & Co. not to make certain issuances or sales of our securities for a period of at least 180 days after the date of the final prospectus relating to this public offering, without the prior written consent of Merriman Curhan Ford & Co.
 
The underwriting agreement provides that we will indemnify Merriman Curhan Ford & Co. against specified liabilities, including liabilities under the Securities Act. We have been advised that, in the opinion of the Securities and Exchange Commission, indemnification for liabilities under the Securities Act is against public policy as expressed in the Securities Act and is therefore unenforceable.
 
A prospectus in electronic format may be available on Internet sites or through other online services maintained by Merriman Curhan Ford & Co. or selling group members participating in this offering, or by their affiliates. In those cases, prospective investors may view offering terms online and, depending on the particular selling group member, prospective investors may be allowed to place orders online. Merriman Curhan Ford & Co. may agree with us to allocate a specific number of units for sale to online brokerage account holders. Any such allocation for online distributions will be made by Merriman Curhan Ford & Co. on the same basis as other allocations.
 
From time to time, Merriman Curhan Ford & Co. and its affiliates may in the future provide investment banking, commercial banking, and financial advisory services to us, for which it may in the future receive, customary fees. We have also entered into a six-month exclusive agreement with Merriman Curhan Ford & Co., pursuant to which Merriman Curhan Ford & Co. will act as our


106


 

financial advisor in connection with the potential sale or other disposition of certain of our assets. Other than the foregoing, Merriman Curhan Ford & Co. does not have any material relationship with us or any of our officers, directors or controlling persons, except with respect to their contractual relationship with us entered into in connection with this offering.
 
The notes and warrants comprising the units are new issues of securities, and there is currently no established trading market for the notes or warrants. We do not intend to apply for the notes or warrants to be listed on any securities exchange or to arrange for the notes or warrants to be quoted on any quotation system. Merriman Curhan Ford & Co. has advised us that they do not intend to make a market in the notes or warrants. Accordingly, we cannot assure you that a liquid trading market will develop for the notes or warrants. If an active trading market for the notes or warrants does not develop, the market price and liquidity of the notes or warrants may be adversely affected. If the notes or warrants are traded, they may trade at a discount from their initial offering price, depending on prevailing interest rates, the market for similar securities, or performance, and other factors.


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LEGAL MATTERS
 
Our legal counsel, Orrick, Herrington & Sutcliffe LLP, New York, New York has passed upon the notes and warrants as our legal and binding obligations. Certain legal matters in connection with this offering will be passed upon for the underwriter by Greenberg Traurig, LLP, Phoenix, Arizona.
 
EXPERTS
 
The consolidated financial statements as of December 31, 2006 and December 31, 2007 and for each of the three years in the period ended December 31, 2007 included in this prospectus have been so included in reliance on the report (which contains an explanatory paragraph relating to our ability to continue as a going concern as described in Note 1 to the financial statements) of PricewaterhouseCoopers LLP, an independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.
 
WHERE YOU CAN FIND ADDITIONAL INFORMATION
 
We file annual, quarterly, current and special reports, proxy statements and other information with the Securities and Exchange Commission, or SEC, under the Securities Exchange Act of 1934, as amended. You may read and copy this information at the following location of the SEC:
 
Public Reference Room
100 F Street, NE
Washington, D.C. 20549
 
You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
 
The SEC also maintains an Internet web site that contains reports, proxy and information statements and other information about issuers that file electronically with the SEC. The address of that site is www.sec.gov.
 
We have filed a registration statement on Form S-1 with the SEC that covers the sale of the units offered by this prospectus. This prospectus is a part of the registration statement, but the prospectus does not include all of the information included in the registration statement. You should refer to the registration statement for additional information about us and the units being offered in this prospectus. Statements that we make in this prospectus relating to any documents filed as an exhibit to the registration statement may not be complete and you should review the referenced document itself for a complete understanding of its terms.
 
This prospectus contains market data and industry forecasts that were obtained from industry publications, third-party market research and publicly available information. These publications generally state that the information contained therein has been obtained from sources believed to be reliable, but the accuracy and completeness of such information is not guaranteed. While we believe that the information from these publications is reliable, we have not independently verified and make no representation as to the accuracy of such information.


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MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
         
   
Page
 
Audited Consolidated Financial Statements:
       
Reports of Independent Registered Public Accounting Firm
    F-2  
Consolidated Financial Statements:
       
Balance Sheets as of December 31, 2006 and 2007
    F-3  
Statements of Operations for the Years Ended December 31, 2005, 2006, and 2007
    F-4  
Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2005, 2006, and 2007
    F-5  
Statements of Cash Flows for the Years Ended December 31, 2005, 2006, and 2007
    F-6  
Notes to Consolidated Financial Statements
    F-7 to F-47  
       
Unaudited Condensed Consolidated Financial Statements:
       
Condensed Consolidated Balance Sheets — December 31, 2007 and March 31, 2008 (Unaudited)
    F-48  
Condensed Consolidated Statements of Operations — Three months ended March 31, 2007 and 2008 (Unaudited)
    F-49  
Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Loss — Three months ended March 31, 2007 and 2008 (Unaudited)
    F-50  
Condensed Consolidated Statements of Cash Flows — Three months ended March 31, 2007 and 2008 (Unaudited)
    F-51  
Notes to Condensed Consolidated Financial Statements (Unaudited)
    F-52 to F-64  


F-1


 

 
Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Stockholders of
Mechanical Technology, Incorporated:
 
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and of cash flows present fairly, in all material respects, the financial position of Mechanical Technology, Incorporated and its subsidiaries at December 31, 2006 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
/s/ PricewaterhouseCoopers LLP
 
Buffalo, New York
February 28, 2008, except for the effects of the reverse stock split discussed in Note 20 to the consolidated financial statements, as to which the date is May 15, 2008.


F-2


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

December 31, 2006 and 2007
 
                 
    December 31,  
    2006     2007  
    (dollars in thousands)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
    $14,545       $7,650  
Securities available for sale
    10,075       4,492  
Accounts receivable
    1,613       1,369  
Inventories, net
    1,216       1,373  
Prepaid expenses and other current assets
    442       329  
                 
Total current assets
    27,891       15,213  
Property, plant and equipment, net
    2,926       2,159  
Deferred income taxes
    2,994       1,344  
                 
Total assets
    $33,811       $18,716  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
    $651       $273  
Accrued liabilities
    2,470       2,121  
Deferred revenue
    866       117  
Income taxes payable
    90       11  
Deferred income taxes
    2,994       1,344  
                 
Total Current Liabilities
    7,071       3,866  
Long-term liabilities:
               
Uncertain tax position liability
          208  
Derivative liability
    3,664       696  
                 
Total Long-Term-Liabilities
    3,664       904  
                 
Total Liabilities
    10,735       4,770  
                 
Commitments and contingencies
               
Minority interests
    205       143  
                 
Stockholders’ equity:
               
Common stock, par value $0.01 per share, authorized 75,000,000; 5,760,585 issued in 2006 and 5,777,578 issued in 2007
    58       58  
Paid-in-capital
    130,968       132,065  
Accumulated deficit
    (95,385 )     (105,066 )
Accumulated other comprehensive income:
               
Unrealized gain on securities available for sale, net of tax
    984       500  
Common stock in treasury, at cost, 1,005,092 shares in 2006 and 2007
    (13,754 )     (13,754 )
                 
Total stockholders’ equity
    22,871       13,803  
                 
Total liabilities and stockholders’ equity
    $33,811       $18,716  
                 
 
The accompanying notes are an integral part of the consolidated financial statements.


F-3


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2005, 2006, and 2007
 
                         
    Years Ended December 31,  
    2005     2006     2007  
    (dollars in thousands, except per share)  
 
Product revenue
    $6,012       $7,667       $9,028  
Funded research and development revenue
    1,829       489       1,556  
                         
Total revenue
    7,841       8,156       10,584  
Operating costs and expenses:
                       
Cost of product revenue
    2,381       2,900       3,430  
Research and product development expenses:
                       
Funded research and product development
    3,555       1,152       1,891  
Unfunded research and product development
    6,116       11,769       9,874  
                         
Total research and product development expenses
    9,671       12,921       11,765  
Selling, general and administrative expenses
    10,887       10,072       8,738  
                         
Operating loss
    (15,098 )     (17,737 )     (13,349 )
Gain (loss) on derivatives
    (10,407 )     182       2,967  
Gain on sale of securities available for sale
    10,125       4,289       2,549  
Other income, net
    431       286       224  
                         
Loss before income taxes and minority interests
    (14,949 )     (12,980 )     (7,609 )
                         
Income tax (expense)
    (1,587 )     (1,895 )     (2,548 )
Minority interests in losses of consolidated subsidiary
    1,442       1,208       582  
                         
Net loss
    $(15,094 )     $(13,667 )     $(9,575 )
                         
Loss per Share (Basic and Diluted):
                       
Loss per share
    $(3.93 )     $(3.46 )     $(2.01 )
                         
 
The accompanying notes are an integral part of the consolidated financial statements.


F-4


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)
For the Years Ended December 31, 2005, 2006, and 2007
 
                         
    Years Ended December 31,  
    2005     2006     2007  
    (dollars in thousands)  
 
Common stock
                       
Balance, beginning
    $48       $49       $58  
Issuance of shares — capital
          8        
Issuance of shares — stock options
    1       1        
                         
Balance, ending
    $49       $58       $58  
                         
Paid-in capital
                       
Balance, beginning
    $121,371       $122,436       $130,968  
Private placement, net of expenses
    (45 )            
Capital raise and warrant issuance, net of expenses
          6,303        
Issuance of shares — stock options
    328       1,187       60  
Share-based compensation
    1,083       2,406       1,558  
MTI MicroFuel Cell investment
    (301 )     (1,284 )     (521 )
Elimination of unearned compensation due to change in accounting principle
          (80 )      
                         
Balance, ending
    $122,436       $130,968       $132,065  
                         
Accumulated deficit
                       
Balance, beginning
    $(66,624 )     $(81,718 )     $(95,385 )
Cumulative effect of adoption of FIN 48
                (106 )
Net loss
    (15,094 )     (13,667 )     (9,575 )
                         
Balance, ending
    $(81,718 )     $(95,385 )     $(105,066 )
                         
Accumulated other comprehensive income (loss):
                       
Unrealized Gain (loss) on Securities Available for Sale, Net of Taxes
                       
Balance, beginning
    $14,542       $5,983       $984  
Change in unrealized (loss) gain on securities available for sale (net of taxes of $0 in 2005, 2006, and 2007)
    (3,620 )     (3,212 )     68  
Less reclassification adjustment for gains included in net income (net of taxes of $3,293 in 2005, $1,913 in 2006 and $2,518 in 2007)
    (4,939 )     (1,787 )     (552 )
                         
Balance, ending
    $5,983       $984       $500  
                         
Restricted stock grants — unearned compensation
                       
Balance, beginning
          (80 )      
Elimination of unearned compensation due to change in accounting principle
          80        
Issuance of shares
    (125 )            
Grants amortization
    45              
                         
Balance, ending
    $(80 )     $—       $—  
                         
Treasury stock
                       
Balance, beginning
    $(13,754 )     $(13,754 )     $(13,754 )
                         
Balance, ending
    $(13,754 )     $(13,754 )     $(13,754 )
                         
Total stockholders’ equity
    $32,916       $22,871       $13,803  
                         
Total comprehensive (loss):
                       
Net loss
    $(15,094 )     $(13,667 )     $(9,575 )
Other comprehensive (loss):
                       
Classification adjustment for gains included in net income, net of taxes
    (4,939 )     (1,787 )     (552 )
Change in unrealized (loss) gain on securities available for sale, net of taxes
    (3,620 )     (3,212 )     68  
                         
Total comprehensive (loss)
    $(23,653 )     $(18,666 )     $(10,059 )
                         
 
The accompanying notes are an integral part of the consolidated financial statements.


F-5


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2005, 2006, and 2007
 
                         
    Years Ended December 31,  
    2005     2006     2007  
    (dollars in thousands)  
 
Operating activities
                       
Net loss
    $(15,094 )     $(13,667 )     $(9,575 )
Adjustments to reconcile net loss to net cash used by operating activities:
                       
(Gain) loss on derivatives
    10,407       (182 )     (2,967 )
Gain on sale of securities available for sale
    (10,125 )     (4,289 )     (2,549 )
Depreciation and amortization
    1,253       1,101       1,129  
Minority interests in losses of consolidated subsidiary
    (1,442 )     (1,208 )     (582 )
Allowance for bad debts
    (58 )     (1 )      
Loss on disposal of fixed assets
    130       40       39  
Deferred income taxes
    1,617       1,890       2,518  
Stock based compensation
    1,003       2,406       1,558  
Changes in operating assets and liabilities:
                       
Accounts receivable
    832       (614 )     244  
Other receivables — related parties
          3        
Inventories
    78       (158 )     (157 )
Prepaid expenses and other current assets
    53       9       113  
Accounts payable
    362       277       (379 )
Income taxes payable
    25       25       23  
Deferred revenue
    (359 )     746       (749 )
Accrued liabilities — related parties
    2       (2 )      
Accrued liabilities
    (1,256 )     918       (349 )
                         
Net cash used by operating activities
    (12,572 )     (12,706 )     (11,683 )
                         
Investing activities
                       
Purchases of property, plant and equipment
    (1,004 )     (1,574 )     (414 )
Proceeds from sale of property, plant and equipment
    10       2       12  
Proceeds from sale of securities available for sale
    1,969       6,249       5,130  
                         
Net cash provided by investing activities
    975       4,677       4,728  
                         
Financing activities
                       
Gross proceeds from capital raise and warrants issued
          10,900        
Costs of private placement
    (45 )            
Cost of capital raise
          (744 )      
Proceeds from stock option exercises
    327       1,188       60  
                         
Net cash provided by financing activities
    282       11,344       60  
                         
(Decrease) increase in cash and cash equivalents
    (11,315 )     3,315       (6,895 )
Cash and cash equivalents — beginning of year
    22,545       11,230       14,545  
                         
Cash and cash equivalents — end of year
    $11,230       $14,545       $7,650  
                         
 
The accompanying notes are an integral part of the consolidated financial statements.


F-6


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. Nature of Operations
 
Description of Business
 
Mechanical Technology, Incorporated, (“MTI” or the “Company”), a New York corporation, was incorporated in 1961. MTI operates in two segments, the New Energy segment which is conducted through MTI MicroFuel Cells Inc. (“MTI Micro”), a majority owned subsidiary, and the Test and Measurement Instrumentation segment, which is conducted through MTI Instruments, Inc. (“MTI Instruments”), a wholly owned subsidiary.
 
At its MTI Micro subsidiary, the Company’s Mobion® cord-free power packs are being developed to replace current lithium ion and similar rechargeable battery systems in many handheld electronic devices for the military and consumer markets. Mobion® power packs are based on direct methanol fuel cell technology which has been recognized as enabling technology for advanced portable power sources by the scientific community and industry analysts. As the need for advancements in portable power increases, MTI Micro is developing Mobion® cord-free rechargeable power pack technology as a superior solution for powering the multi-billion dollar portable electronics market.
 
At its MTI Instruments subsidiary, the Company continues to be a worldwide supplier of precision non-contact physical measurement solutions, condition based monitoring systems, portable balancing equipment and semiconductor wafer inspection tools. MTI Instruments’ products use a comprehensive array of technologies to solve complex real world applications in numerous industries including manufacturing, semiconductor, commercial/military aviation, automotive and data storage. The Company’s products consist of electronic gauging instruments for position, displacement and vibration applications within the design, manufacturing/production, test and research markets; semiconductor products for wafer characterization of semi-insulating and semi-conducting wafers within the semiconductor industry; and engine balancing and vibration analysis systems for both military and commercial aircraft.
 
Liquidity and Going Concern
 
The Company has incurred significant losses as it continues to fund MTI Micro’s direct methanol fuel cell product development and commercialization programs, and has an accumulated deficit of $105,066 thousand and working capital of $11,347 thousand at December 31, 2007. Because of these losses, limited current cash, cash equivalents and securities available for sale, negative cash flows and accumulated deficit, the report of the Company’s independent registered public accounting firm for the year ended December 31, 2007 expressed substantial doubt about the Company’s ability to continue as a going concern.
 
During 2007, the Company sold 1,452,770 shares of Plug Power Inc. (“Plug Power”) common stock with proceeds totaling $5,130 thousand and gains totaling $2,549 thousand. These proceeds reflect the Company’s previously announced strategy to raise additional capital through the sale of Plug Power stock in order to fund MTI Micro operations.
 
Based on the Company’s projected cash requirements for operations and capital expenditures for 2008 and its current cash, cash equivalents and marketable securities of $12,142 thousand at December 31, 2007, management believes it will have adequate resources to fund operations and capital expenditures for the next twelve months based on current cash and cash equivalents, current cash flow requirements, revenue and expense projections and the potential sale of securities available for sale at current market values.


F-7


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
1. Nature of Operations — (Continued)
 
However, the Company may need to do one or more of the following to raise additional resources, or reduce its cash requirements:
 
  •  reduce its current expenditure run-rate;
 
  •  sell additional shares of Plug Power;
 
  •  obtain additional government or private funding of the Company’s direct methanol fuel cell research, development, manufacturing readiness and commercialization;
 
  •  sell operating divisions of the Company; or
 
  •  secure additional equity financing.
 
There is no guarantee that such resources will be available to the Company on terms acceptable to it, or at all, or that such resources will be received in a timely manner, if at all, or that the Company will be able to reduce its expenditure run-rate without materially and adversely affecting its business.
 
2. Accounting Policies
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant inter-company transactions are eliminated in consolidation.
 
Minority interest in subsidiaries consists of equity securities issued by a subsidiary of the Company. No gain or loss was recognized as a result of the issuance of these securities, and the Company owned a majority of the voting equity of the subsidiary both before and after the transactions. The Company reflects the impact of the equity securities issuances in its investment in subsidiary and additional paid-in-capital accounts for the dilution or anti-dilution of its ownership interest in the subsidiary.
 
Use of Estimates
 
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) which 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.
 
Fair Value of Financial Instruments
 
The Company’s financial instruments consist of cash and cash equivalents, marketable securities, accounts receivable, unbilled contract costs and fees, derivatives and accounts payable. The estimated fair values of these financial instruments approximate their carrying values at December 31, 2006 and 2007. The estimated fair values have been determined through information obtained from market sources, where available, or Black-Scholes Option Pricing model valuations.


F-8


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
Accounting for Derivative Instruments
 
The Company accounts for derivative instruments and embedded derivative instruments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The amended standard requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure these instruments at fair value. Fair value is estimated using the Black-Scholes Option Pricing model. The Company also follows Emerging Issues Task Force (“EITF”) Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to and Potentially Settled in, a Company’s Own Stock, which requires freestanding contracts that are settled in a company’s own stock, including common stock warrants, to be designated as an equity instrument, asset or a liability. Under the provisions of EITF Issue No. 00-19, a contract designated as an asset or a liability must be carried at fair value, with any changes in fair value recorded in the results of operations. A contract designated as an equity instrument can be included in equity, with no fair value adjustments are required.
 
The asset/liability derivatives are valued on a quarterly basis using the Black-Scholes Option Pricing model. Significant assumptions used in the valuation include exercise dates, closing market prices for the Company’s common stock, volatility of the Company’s common stock, and proxy risk-free interest rates. Gains (losses) on derivatives are included in “Gain (loss) on derivatives” in the Consolidated Statement of Operations.
 
Accounts Receivable and Allowance for Doubtful Accounts
 
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. An allowance for doubtful accounts, if necessary, represents the Company’s best estimate of the amount of probable credit losses in its existing accounts receivable. The Company determines the allowance based on historical write-off experience and current exposures identified. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectability. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when the Company believes it is probable the receivable will not be recovered. The Company does not have any off-balance-sheet credit exposure related to its customers.
 
Inventories
 
Inventories are valued at the lower of cost (first-in, first-out) or market. The Company provides estimated inventory allowances for excess, slow moving and obsolete inventory as well as inventory whose carrying value is in excess of net realizable value.
 
Property, Plant, and Equipment
 
Property, plant and equipment are stated at cost and depreciated using primarily the straight-line method over their estimated useful lives:
 
     
Leasehold improvements
  Lesser of the life of the lease or the useful life of the improvement
Computers and related software
  3 to 5 years
Machinery and equipment
  3 to 10 years
Office furniture, equipment and fixtures
  2 to 10 years


F-9


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
Significant additions or improvements extending assets’ useful lives are capitalized; normal maintenance and repair costs are expensed as incurred. The costs of fully depreciated assets remaining in use are included in the respective asset and accumulated depreciation accounts. When items are sold or retired, related gains or losses are included in net (loss) income.
 
Income Taxes
 
The Company accounts for taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”), which requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable for future years to differences between financial statement and tax bases of existing assets and liabilities. Under SFAS No. 109, the effect of tax rate changes on deferred taxes is recognized in the income tax provision in the period that includes the enactment date. The provision for taxes is reduced by investment and other tax credits in the years such credits become available. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not those assets will be realized.
 
Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions (tax contingencies) accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes.
 
Revenue Recognition
 
The Company applies the guidance within SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition (“SAB No. 104”) in the evaluation of its contracts to determine when to properly recognize revenue. Under SAB No. 104, revenue is recognized when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, the fee is fixed or determinable, delivery has occurred or services have been rendered, the sales price is determinable, and collectability is reasonably assured.
 
Product Revenue
 
Product revenue is recognized when there is persuasive evidence of an arrangement, the collection of a fixed fee is probable or determinable, delivery of the product to the customer or distributor has occurred, at which time title generally is passed to the customer or distributor, all of which generally occur upon shipment of the product. If the product requires installation to be performed by the Company, all revenue related to the product is deferred and recognized upon the completion of the installation. If the product requires specific customer acceptance, revenue is deferred until customer acceptance occurs or the acceptance provisions lapse, unless the Company can objectively and reliably demonstrate that the criteria specified in the acceptance provisions are satisfied.


F-10


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
MTI Instruments currently has distributor agreements in place for the international sale of general instrument and semiconductor products in certain global regions. Such agreements grant a distributor the right of first refusal to act as distributor for such products in the distributor’s territory. In return, the distributor agrees to not market other products which are considered by MTI Instruments to be in direct competition with MTI Instruments’ products. The distributor is allowed to purchase MTI Instruments’ equipment at a price which is discounted off the published domestic/international list prices. Such list prices can be adjusted by MTI Instruments during the term of the distributor agreement, but MTI Instruments must provide advance notice at least 90 days before the price adjustment goes into effect. Generally, payment terms with the distributor are standard net 30 days; however, on occasion, extended payment terms have been granted. Title and risk of loss of the product passes to the distributor upon delivery to the independent carrier (standard “free-on-board” factory), and the distributor is responsible for any required training and/or service with the end-user. The sale (and subsequent payment) between MTI Instruments and the distributor is not contingent upon the successful resale of the product by the distributor. Distributor sales are covered by MTI Instruments’ standard one-year warranty and there are no special return policies for distributors.
 
Some of MTI Instruments’ direct sales, particularly sales of semi-automatic and fully-automated semiconductor metrology equipment, or rack-mounted vibration systems, involve on-site customer acceptance and/or installation. In those instances, revenue recognition does not take place at time of shipment. Instead, MTI Instruments recognizes the sale after the unit is installed and/or an on-site acceptance is given by the customer. Agreed-upon acceptance terms and conditions, if any, are negotiated at the time of purchase.
 
Funded Research and Development Revenue
 
The Company performs funded research and development for government agencies under both cost reimbursement and fixed-price contracts. Cost reimbursement contracts provide for the reimbursement of allowable costs. On fixed-price contracts, revenue is generally recognized on the percentage of completion method based upon the proportion of costs incurred to the total estimated costs for the contract. Revenue from reimbursement contracts is recognized as the services are performed. In each type of contract, the Company generally receives periodic progress payments or payments upon reaching interim milestones. When the current estimates of total contract revenue for commercial development contracts indicate a loss, a provision for the entire loss on the contract is recorded. Any losses incurred in performing funded research and development projects are recognized as research and development expense as incurred. When government agencies are providing funding they do not expect the government to be the only significant end user of the resulting products. These contracts do not require delivery of products that meet defined performance specifications, but are best efforts arrangements to achieve overall research and development objectives. Included in accounts receivable are billed and unbilled work-in-progress on contracts. Billings in excess of contract revenues earned are recorded as deferred revenue. While the Company’s accounting for government contract costs is subject to audit by the sponsoring entity, in the opinion of management, no material adjustments are expected as a result of such audits. Adjustments are recognized in the period made.


F-11


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
Commercial Research and Prototype Agreement Income
 
The Company also applies the guidance in SAB No. 104 in the evaluation of commercially funded fuel cell research and prototype agreements in order to determine when to properly recognize income. Payments received in connection with commercial research and prototype agreements are deferred and recognized on a straight-line basis over the term of the agreement for service-related payments, and for milestone and prototype delivery payments, if and when achieved, revenue is deferred and recognized on a straight-line basis over the remaining term of the agreement. Under this policy, when revenue qualifies for recognition it will be recorded in the Consolidated Statements of Operations in the line “Funded research and development revenue.” The costs associated with research and prototype-producing activities are expensed as incurred. Expenses in an amount equal to revenues recognized are reclassified from “Unfunded research and product development” to “Funded research and product development” in the Consolidated Statements of Operations.
 
Information regarding MTI Micro’s government and commercial funded research and development contracts is as follows:
 
     
Contract Name   Expiration (1)
 
$3,000 thousand DOE (2)
  09/30/08
$1,250 thousand NYSERDA (3)
  06/30/06
$1,000 thousand Samsung (4)
  07/31/07
$418 thousand SAFT (5)
  12/31/06
$250 thousand ARL
  09/30/05
$210 thousand NIST (6)
  06/30/05
$150 thousand Harris (7)
  06/25/04
$70 thousand Marine Corps
  03/31/05
$15 thousand NCMS (8)
  06/30/07
 
 
(1) Dates represent expiration of contract, not date of final billing.
 
(2) The DOE contract is a cost share contract. DOE funding for this contract was suspended during January 2006 and reinstated during May 2007. During 2007, the Company received notifications from the DOE of funding releases totaling $1.0 million and also received an extension of the termination date for the contract from July 31, 2007 to September 30, 2008.
 
(3) The total contract value for this cost shared contract is $1.3 million consisting of four Phases: Phase I for $500,000 was from March 12, 2002 through September 30, 2003; Phase II for $200,000 was from October 28, 2003 through October 31, 2004; Phase III for $348,000 was from August 23, 2004 through August 31, 2005; and Phase IV for $202,000 which commenced on December 14, 2004 and expired on June 30, 2006. Phases I, II, and III have been completed, while. Phase IV expired before it was completed.
 
(4) The Samsung contract is a research and prototype contract. This contract included one up-front payment of $750,000 and two milestone payments of $125,000 each for the delivery of prototypes. The contract was amended on October 22, 2007 as MTI Micro agreed to issue a credit in the amount of the last invoice in recognition of the Company’s continuing collaboration with Samsung. Therefore, revenue under this contract totaled $875,000.
 
(5) The SAFT contract is a fixed price contract. This is a subcontract with SAFT under the U.S. Army CECOM contract. The purchase order received in connection with this subcontract was revised


F-12


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
on November 14, 2006 eliminating one milestone. As a result, the contract value was reduced from $470,000 to $418,000 and the expiration date was extended from September 30, 2006 to December 31, 2006.
 
(6) Represents a fixed price subcontract with CSMP under NIST and includes the original contract for $200,000 and a contract amendment for $10,000.
 
(7) Represents a fixed price contract that includes the original contract for $200,000, an amendment for $50,000, and a 2005 amendment reducing the contract by $100,000.
 
(8) This contract was a cost plus catalyst research contract with the National Center for Manufacturing Sciences (“NCMS”).
 
The Company’s cost-shared contracts require that MTI Micro conduct research, deliver direct methanol fuel cell prototypes, and other deliverables pursuant to predefined work plans and schedules. For cost-shared contracts spanning multiple years, the following table summarizes as of December 31, 2007 the total expenditures incurred or expected to be incurred by MTI Micro along with the related funded research and development revenue received or expected to be received:
 
         
    Total Contract Value
Contract   Funded Expense   Funded Revenue
    (dollars in thousands)
 
DOE
  $6,144   $3,000
NYSERDA
  2,702   1,250
 
MTI Micro retains ownership of the intellectual property (“IP”) generated by MTI Micro under each of its federal government contract and under the contract with Samsung. Each federal government agency retains a government use license and march-in rights if MTI Micro fails to commercialize technology generated under the contract. In addition, under the New York State Energy Research and Development Authority (“NYSERDA”) contract, MTI Micro has the right to elect to retain any invention made under the NYSERDA contract within six months of invention. NYSERDA also retains rights to a government use license for New York State and its political subdivisions for any inventions made under the contract. Additionally, MTI Micro agreed to pay NYSERDA a royalty of 5.0% of the sales price of any product sold incorporating IP developed pursuant to the NYSERDA contract. If the product is manufactured by a New York State manufacturer, this royalty is reduced to 1.5%. Total royalties are subject to a cap equal to two times the total contract funds paid by NYSERDA to MTI Micro, and may potentially be reduced to reflect any New York State jobs created by MTI Micro.
 
Cost of Product Revenue
 
Cost of product revenue includes material, labor and overhead. Costs incurred in connection with funded research and development arrangements are included in funded research and product development expenses.
 
Deferred Revenue
 
Deferred revenue consists of payments received from customers in advance of services performed, completed installation or customer acceptance.


F-13


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
Warranty
 
The Company records a warranty reserve at the time product revenue is recorded based on a historical rate. The reserve is reviewed during the year and is adjusted, if appropriate, to reflect new product offerings or changes in experience. Actual warranty claims are tracked by product line.
 
Accounting for Goodwill and Other Intangible Assets
 
Intangible assets include patents and trade names. Goodwill and other intangible assets are accounted for in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Intangible assets with finite useful lives are amortized over those periods. Indefinite life intangible assets are tested for impairment annually, and will be tested for impairment between annual tests if an event occurs or circumstances change that would indicate that the carrying amount may be impaired. Definite life assets are tested for impairment whenever events or circumstances indicate that a carrying amount of an asset may not be recoverable. An impairment loss would be recognized when the carrying amount of an asset exceeds the estimated undiscounted cash flows used in determining the fair value of the asset. The amount of the impairment loss to be recorded is calculated by the excess of the assets carrying value over its fair value. Fair value is generally determined using a discounted cash flow analysis. Costs related to internally-developed intangible assets are expensed as incurred.
 
Accounting for Impairment or Disposal of Long-Lived Assets
 
The Company accounts for impairment or disposal of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets and specifies how impairment will be measured and how impaired assets will be classified in the consolidated financial statements. On a quarterly basis, the Company analyzes the status of its long-lived assets at each subsidiary for potential impairment. As of December 31, 2007, the Company does not believe that any of its long-lived assets have suffered any type of impairment that would require an adjustment to that asset’s recorded value.
 
Cash and Cash Equivalents
 
Cash and cash equivalents consist of cash and highly liquid short-term investments with original maturities of less than three months.
 
Securities Available for Sale
 
Management determines the appropriate classification of its investments in marketable securities at the time of purchase and reevaluates such determinations at each balance sheet date. Marketable securities for which the Company does not have the intent or ability to hold to maturity are classified as available for sale. Securities available for sale are carried at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of stockholders’ equity. The Company has had no investments that qualify as trading or held to maturity. Realized gains and losses are included in the caption “Gain (loss) on sale of securities available for sale” in the Consolidated Statements of Operations. The cost of securities sold is based on the specific identification method.


F-14


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
Net (Loss) Income per Common Share
 
The Company reports net (loss) income per basic and diluted common share in accordance with SFAS No. 128, Earnings Per Share, which establishes standards for computing and presenting (loss) income per share. Basic earnings (loss) per common share are computed by dividing net (loss) income by the weighted average number of common shares outstanding during the reporting period. Diluted (loss) income per share reflects the potential dilution, if any, computed by dividing net (loss) income by the combination of dilutive common share equivalents, comprised of shares issuable under outstanding investment rights, warrants and the Company’s share-based compensation plans, and the weighted average number of common shares outstanding during the reporting period. Dilutive common share equivalents include the dilutive effect of in-the-money stock options, which are calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of a stock option, the amount of compensation cost, if any, for future service that the Company has not yet recognized, and the amount of windfall tax benefits that would be recorded in additional paid-in capital, if any, when the stock option is exercised are assumed to be used to repurchase shares in the current period.
 
Share-Based Payments
 
The Company has three share-based employee compensation plans and MTI Micro has one share-based employee compensation plan, all of which are described more fully in Note 13, Stock Based Compensation.
 
In December 2004, the Financial Accounting Standards Board (“FASB”) revised SFAS No. 123 (“FAS 123R”), Share-Based Payment, which establishes accounting for share-based awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period. The accounting provisions of FAS 123R were adopted by the Company as of January 1, 2006. In March 2005, the SEC issued SAB 107, Share-Based Payment (“SAB 107”) to assist filers by simplifying some of the implementation challenges of FAS 123R. In particular, SAB 107 provides supplemental implementation guidance on FAS 123R, including guidance on valuation methods, classification of compensation expense, inventory capitalization of share-based compensation cost, income tax effects, disclosures in Management’s Discussion and Analysis and several other issues. The Company applied the principles of SAB 107 in conjunction with its adoption of FAS 123R.
 
Under FAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. The Company has awards with performance conditions, but no awards with market conditions. The Company adopted the provisions of FAS 123R on January 1, 2006, the first day of the Company’s fiscal year, using the modified prospective application, which provided for certain changes to the method for valuing share-based compensation. Under the modified prospective application, prior periods were not revised for comparative purposes. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under the original FASB Statement No. 123, Accounting for Stock-Based Compensation (“FAS 123”).
 
In November 2005, the FASB issued Staff Position No. FAS 123(R)-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company elected to adopt the


F-15


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to FAS 123R. This method included a simplified method to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of FAS 123R.
 
Prior to the adoption of FAS 123R, the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations as permitted under FAS 123. Under the intrinsic value method, stock-based compensation was typically only recognized by the Company due to modifications in option provisions, since the exercise price of the Company’s and MTI Micro’s common stock options granted to employees and directors generally equaled the fair market value of the underlying stock at the date of grant.
 
Stock-based compensation represents the cost related to stock-based awards granted to employees and directors. The Company measures stock-based compensation cost at grant date based on the estimated fair value of the award, and recognizes the cost as expense on a straight-line basis (net of estimated forfeitures) over the option’s requisite service period. The Company estimates the fair value of stock-based awards using a Black Scholes valuation model. Stock-based compensation expense is recorded in “Selling, general and administrative expenses” and “Unfunded research and product development expenses” in the Consolidated Statements of Operations based on the employees’ respective functions.
 
The Company records deferred tax assets for awards that potentially can result in deductions on the Company’s income tax returns based on the amount of compensation cost recognized and the Company’s statutory tax rate. Differences between the deferred tax assets recognized for financial reporting purposes and the actual tax deduction reported on the Company’s income tax return are recorded in Additional Paid-In Capital (if the tax deduction exceeds the deferred tax asset) or in the Consolidated Statement of Operations (if the deferred tax asset exceeds the tax deduction and no historical pool of windfall tax benefits exists). Since the adoption of FAS 123R, no tax benefits have been recognized related to share-based compensation since the Company has incurred net operating losses and has established a full valuation allowanced to offset all potential tax benefits associated with these deferred tax assets. The Company continues to record the fair market value of stock options and warrants granted to non-employees and non-directors in exchange for services in accordance with EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, in the Consolidated Statements of Operations.
 
Advertising
 
The costs of advertising are expensed as incurred. Advertising expense was approximately $45, $110, and $102 thousand for the years ended December 31, 2005, 2006, and 2007, respectively.
 
Concentration of Credit Risk
 
Financial instruments that subject the Company to concentrations of credit risk principally consist of cash equivalents, marketable securities, trade accounts receivable and unbilled contract costs.


F-16


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
The Company’s trade accounts receivable and unbilled contract costs and fees are primarily from sales to commercial customers, the U.S. government and state agencies. The Company does not require collateral and has not historically experienced significant credit losses related to receivables or unbilled contract costs and fees from individual customers or groups of customers in any particular industry or geographic area.
 
The Company deposits its cash and invests in marketable securities primarily through commercial banks and investment companies. Credit exposure to any one entity is limited by Company policy.
 
Research and Development Costs
 
The Company expenses research and development costs as incurred.
 
Comprehensive (Loss) Income
 
Comprehensive (loss) income includes net (loss) income, as well as changes in stockholders’ equity, other than those resulting from investments by stockholders (i.e., issuance or repurchase of common shares and dividends).
 
Effect of Recent Accounting Pronouncements
 
In December 2007, the FASB issued SFAS No. 141R, Business Combinations — a replacement of FASB Statement No. 141 (“SFAS No. 141R”), which significantly changes the principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective prospectively, except for certain retrospective adjustments to deferred tax balances, for fiscal years beginning after December 15, 2008. This statement will be effective for the Company for fiscal year 2009. The Company has not yet determined the impact, if any, of this statement on its Consolidated Financial Statements.
 
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendments of ARB No. 51 (“SFAS No. 160”). SFAS No. 160 requires that accounting and reporting for minority interests will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS No. 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. This statement is effective as of the beginning of an entity’s first fiscal year beginning after December 15, 2008. This statement will be effective for the Company for its


F-17


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
2. Accounting Policies — (Continued)
 
fiscal year beginning January 1, 2009. Based upon the December 31, 2007 balance sheet, the impact of adopting SFAS No. 160 would be to reclassify from $143 thousand minority interests in consolidated subsidiaries to stockholders’ equity as a separate component of stockholders’ equity.
 
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). SFAS No. 159 provides companies with an option to report selected financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. SFAS No. 159 is effective beginning January 1, 2008. The adoption of the provisions of SFAS No. 159 is not expected to have a material effect on the Company’s Consolidated Financial Statements.
 
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 establishes a common definition for fair value to be applied to United States generally accepted accounting principles guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. This Statement is effective for fiscal years beginning after November 15, 2007. This statement will be effective for the Company for its fiscal year beginning January 1, 2008. The adoption of the provisions of SFAS No. 157 is not expected to have a material effect on the Company’s Consolidated Financial Statements.
 
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS No. 158”). Among other items, SFAS No. 158 requires recognition of the over-funded or under-funded status of an entity’s defined benefit postretirement plan as an asset or liability in the financial statements, requires the measurement of defined benefit postretirement plan assets and obligations as of the end of the employer’s fiscal year, and requires recognition of the funded status of defined benefit postretirement plans in other comprehensive income. This Statement is effective for fiscal years ending after December 15, 2006. Since the Company does not maintain any defined benefit or other postretirement plans, the adoption of this Statement for fiscal year 2007 did not have a material effect on the Company’s Consolidated Financial Statements.
 
In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140 (“SFAS No. 156”) that provides guidance on accounting for separately recognized servicing assets and servicing liabilities. In accordance with the provisions of SFAS No. 156, separately recognized servicing assets and servicing liabilities must be initially measured at fair value, if practicable. Subsequent to initial recognition, the Company may use either the amortization method or the fair value measurement method to account for servicing assets and servicing liabilities within the scope of this Statement. The adoption of this Statement by the Company in fiscal year 2007 did not have a material effect on the Company’s Consolidated Financial Statements.
 
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140 (“SFAS No. 155”), to permit fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation in accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The adoption of this Statement by the Company in fiscal year 2007 did not have a material effect on the Company’s Consolidated Financial Statements.


F-18


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
3. Accounts Receivable and Allowance for Doubtful Accounts
 
Receivables consist of the following at December 31:
 
         
    2006   2007
    (dollars in thousands)
 
U.S. and State Government:
       
Amount billable
  $194   $0
Amount billed
  9   79
         
Total U.S. and State Government
  203   79
Commercial
  1,410   1,290
         
Total
  $1,613   $1,369
         
 
As of December 31, 2006 and 2007, the Company concluded that a reserve for doubtful trade accounts receivable was not considered necessary.
 
4. Issuance of Stock by Subsidiary
 
MTI Micro was formed on March 26, 2001 and as of December 31, 2007, the Company owns approximately 96% of MTI Micro’s outstanding common stock.
 
On December 31, 2005, as a result of an option exchange between the Company and MTI Micro, MTI Micro issued 105,701 shares of its common stock at a price of $2.22 per share to the Company as compensation for minority stockholder benefit in connection with the transaction. Additionally, on December 31, 2005, MTI Micro issued 1,103,604 shares of its common stock at a price of $2.22 per share to the Company in connection with the conversion of its $2,450 thousand loan receivable to equity.
 
On December 31, 2006, MTI Micro issued 3,772,727 shares of its common stock at a price of $1.10 per share to the Company in connection with the conversion of its $4,150 thousand loan receivable to equity; on December 1, 2006, MTI Micro issued 739 shares of its common stock at a price of $1.61 per share to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; on November 11, 2006, MTI Micro issued 1,960,506 shares of its common stock at a price of $1.06 per share to the Company in connection with the transfer of $2,070 thousand worth of Plug Power common stock to MTI Micro; on September 30, 2006, MTI Micro issued 2,574,627 shares of its common stock at a price of $1.34 per share to the Company in connection with the conversion of its $3,450 thousand loan receivable to equity; on September 1, 2006, MTI Micro issued 56,055 shares of its common stock at a price of $3.10 per share to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; on May 27, 2006, MTI Micro issued 50,158 shares of its common stock at a price of $2.32 to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; between April 11 and April 18, 2006, MTI Micro issued 1,662,400 shares of its common stock at a price of $2.50 per share to the Company in connection with the transfer of $4,156 thousand worth of Plug Power common stock to MTI Micro; and on March 31, 2006, MTI Micro issued 1,400,000 shares of its common stock at a price of $2.50 per share to the Company in connection with the conversion of its $3,500 thousand loan receivable to equity.


F-19


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
4. Issuance of Stock by Subsidiary — (Continued)
 
Between October 10 and October 25, 2007, MTI Micro issued 4,050,488 shares of its common stock at a price between $0.37 and $0.41 per share to the Company in connection with the transfer of $2,808 thousand worth of Plug Power common stock to MTI Micro; on November 16, 2007, MTI Micro issued 1,630,339 shares of its common stock at a price of $0.33 per share to the Company in connection with the transfer of $1,113 thousand worth of Plug Power common stock to MTI Micro; on September 1, 2007, MTI Micro issued 35,625 shares of its common stock at a price of $0.62 per share to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; on September 30, 2007, MTI Micro issued 2,740,715 shares of its common stock at a price of $0.69 per share to the Company in connection with the conversion of its $1,900 thousand loan receivable to equity; on June 1, 2007, MTI Micro issued 8,653 shares of its common stock at a price of $0.94 per share to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; on June 30, 2007, MTI Micro issued 6,083,334 shares of its common stock at a price of $0.60 per share to the Company in connection with the conversion of its $3,650 thousand loan receivable to equity; on March 1, 2007, MTI Micro issued 682 shares of its common stock at a price of $0.98 per share to the Company as compensation for the minority stockholder benefit in connection with the Company issuing Company options to MTI Micro employees; and on March 31, 2007, MTI Micro issued 4,243,721 shares of its common stock at a price of $0.84 per share to the Company in connection with the conversion of its $3,550 thousand loan receivable to equity.
 
The decrease in the Company’s paid-in-capital of $301, $1,284, and $521 thousand in 2005, 2006, and 2007, respectively, represents the changes in the Company’s equity investment in MTI Micro, which resulted from the anti-dilutive impact of the Company’s investments into and third-party stock transactions in MTI Micro stock.
 
5.  Inventories
 
Inventories, net consist of the following at December 31:
 
             
    2006   2007
    (dollars in thousands)
 
Finished goods
    $279     $467
Work in process
    238     168
Raw materials, net
    699     738
             
      $1,216     $1,373
             


F-20


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
6.  Property, Plant and Equipment
 
Property, plant and equipment consist of the following at December 31:
 
             
    2006   2007
    (dollars in thousands)
 
Leasehold improvements
    $1,213     $1,213
Computers and related software
    2,186     2,241
Machinery and equipment
    3,625     3,895
Office furniture and fixtures
    303     303
             
      7,327     7,652
Less accumulated depreciation
    4,401     5,493
             
      $2,926     $2,159
             
 
Depreciation expense was $1,253, $1,101, and $1,129 thousand for 2005, 2006, and 2007, respectively. Repairs and maintenance expense was $105, $75, and $82 thousand for 2005, 2006, and 2007, respectively.
 
7.  Securities Available for Sale
 
Securities available for sale are classified as current assets and accumulated net unrealized gains (losses) are charged to other comprehensive income (loss).
 
The principal components of the Company’s securities available for sale consist of the following at:
 
                                     
                Quoted
       
            Recorded
  Market
       
    Book
  Unrealized
  Fair
  Price
       
Security   Basis   Gain   Value   Per NASDAQ   Ownership   Shares
    (dollars in thousands, except stock price and share data)
 
December 31, 2006
                                   
Plug Power
    $4,602     $5,473     $10,075     $3.89     2.99%     2,589,936
                                     
December 31, 2007
                                   
Plug Power
    $2,021     $2,471     $4,492     $3.95     1.29%     1,137,166
                                     
 
The book basis roll forward of Plug Power securities as of December 31 is as follows:
 
                 
    2006     2007  
    (dollars in thousands)  
 
Securities available for sale, beginning of period
    $6,562       $10,075  
Sale of shares
    (1,960 )     (8,054 )
                 
Securities book basis
    4,602       2,021  
Unrealized gain on securities available for sale
    5,473       2,471  
                 
Securities available for sale, end of period
    $10,075       $4,492  
                 


F-21


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
7.  Securities Available for Sale — (Continued)
 
Accumulated unrealized gains related to securities available for sale for each of the years ended December 31 are as follows:
 
                 
    2006     2007  
    (dollars in thousands)  
 
Accumulated unrealized gains
    $5,473       $2,471  
Accumulated deferred tax expense on unrealized gains
    (4,489 )     (1,971 )
                 
Accumulated net unrealized gains
    $984       $500  
                 
 
Realized gains related to Plug Power securities available for sale sold during each of the years ended December 31 are as follows:
 
             
    2006   2007
    (dollars in thousands, except shares)
 
Shares sold
    1,103,500     1,452,770
Proceeds
    $6,249     $5,130
Total net gain on sales
    $4,289     $2,549
 
The Company regularly reviews its securities available for sale to determine if any declines in value of those securities available for sale are other than temporary. The Company assesses whether declines in the value of its securities in publicly traded companies, measured by comparison of the current market price of the securities to the carrying value of the Company’s securities, are considered to be other than temporary based on factors that include the length of time carrying value exceeds fair market value, the Company’s assessment of the financial condition and the near term prospects of the companies and the Company’s intent with respect to the securities.
 
8.  Income Taxes
 
Income tax (expense) benefit for each of the years ended December 31 consists of the following:
 
                         
    2005     2006     2007  
    (dollars in thousands)  
 
Operations before minority interest
                       
Federal
    $—       $—       $—  
State
    54       (5 )     (30 )
Deferred
    (1,641 )     (1,890 )     (2,518 )
                         
Total
    $(1,587 )     $(1,895 )     $(2,548 )
                         


F-22


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
8.  Income Taxes — (Continued)
 
Income tax benefit (expense) allocated directly to stockholders’ equity for each of the years ended December 31 is as follows:
 
                         
    2005     2006     2007  
    (dollars in thousands)  
 
Change in unrealized (gain) loss on securities available for sale:
                       
Deferred tax benefit (expense)
    $1,448       $1,285       $(27 )
Valuation allowance (expense)
    (1,448 )     (1,285 )     27  
Tax effect of reclassification adjustment for gains included in
net income (loss)
    3,293       1,913       2,518  
Expenses for employee stock options recognized differently for financial reporting/tax purposes:
                       
Federal tax benefit
    87              
Valuation allowance (expense)
    (87 )            
                         
      $3,293       $1,913       $2,518  
                         
 
The significant components of deferred income tax (expense) benefit from operations before minority interest for each of the years ended December 31 consists of the following:
 
                         
    2005     2006     2007  
    (dollars in thousands)  
 
Deferred tax benefit (expense)
    $238       $1,158       $1,181  
Net operating loss carry forward
    5,673       3,983       3,069  
Valuation allowance
    (4,259 )     (5,118 )     (4,250 )
Disproportionate tax effect of reclassification adjustment for gains included in net income (loss)
    (3,293 )     (1,913 )     (2,518 )
                         
      $(1,641 )     $(1,890 )     $(2,518 )
                         
 
The Company’s effective income tax rate from operations before minority interest differed from the Federal statutory rate for each of the years ended December 31 is as follows:
 
                         
    2005     2006     2007  
 
Federal statutory tax rate
    34  %     34  %     34  %
State taxes, net of federal tax effect
    3       3       1  
Change in valuation allowance
    (29 )     (37 )     (56 )
Disproportionate tax effect of reclassification
                       
adjustment for gains included in net income (loss)
    (19 )     (13 )     (28 )
Permanent tax difference on derivative valuation
                16  
Other, net
          (2 )      
                         
Tax Rate
    (11 )%     (15 )%     (33 )%
                         


F-23


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
8.  Income Taxes — (Continued)
 
Pre-tax loss before minority interests was $14,949, $12,980, and $7,609 thousand for 2005, 2006, and 2007, respectively. The deferred tax assets and liabilities as of December 31 consist of the following tax effects relating to temporary differences and carry forwards:
 
                 
    2006     2007  
    (dollars in thousands)  
 
Current deferred tax (liabilities) assets:
               
Inventory valuation
    $60       $73  
Inventory capitalization
    14       13  
Securities available for sale
    (3,039 )     (1,362 )
Vacation pay
    161       147  
Warranty and other sale obligations
    8       29  
Other reserves and accruals
    58       56  
                 
      (2,738 )     (1,044 )
Valuation allowance
    (256 )     (300 )
                 
Net current deferred tax liabilities
    $(2,994 )     $(1,344 )
                 
Noncurrent deferred tax assets (liabilities):
               
Net operating loss
    $19,661       $21,037  
Property, plant and equipment
    (239 )     27  
Stock options
    1,379       1,800  
Other
    239        
Research and development tax credit
    459       459  
Alternative minimum tax credit
    54       54  
                 
      21,553       23,377  
Valuation allowance
    (18,559 )     (22,033 )
                 
Non-current net deferred tax assets
    $2,994       $1,344  
                 
 
The valuation allowance at December 31, 2006 and 2007 was $18,815 and $22,333 thousand, respectively. The net change in the valuation allowance was $7,892 thousand in 2006 and $3,518 thousand in 2007. The valuation allowance at December 31, 2006 and 2007 reflects the estimate that it is more likely than not that the net deferred tax assets may not be realized. In addition to changes in valuation allowance of $4,250 thousand reflected in continuing operations, the valuation allowance was increased by $1,201 thousand reflected in stockholders’ equity and decreased by $1,933 thousand as a result of the adoption of FIN 48.
 
At December 31, 2007, the Company has unused Federal net operating loss carry forwards of approximately $53,918 thousand. Of these carry forwards, $1,325 thousand represents windfall tax benefits from stock option transactions, the tax effect of which are not included in the Company’s net deferred tax assets. The Federal net operating loss carry forwards, if unused, will begin to expire in 2010. As of December 31, 2007, the Company has approximately $459 thousand of research and development tax credit carry forwards, which begin to expire in 2018, and approximately $54


F-24


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
8.  Income Taxes — (Continued)
 
thousand of alternative minimum tax credit carry forwards, which have no expiration date. Deferred tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates.
 
The Company adopted the provisions of FIN 48 on January 1, 2007, the first day of its 2007 fiscal year. As a result of the implementation of FIN 48, the Company recorded a $106 thousand increase in the net liability for uncertain tax positions, which was recorded as an adjustment to the Company’s opening balance of retained earnings on January 1, 2007. Additionally, the same tax position that triggered the Company’s FIN 48 adoption charge caused the Company to reclassify $80 thousand from current income taxes payable to non-current liabilities for uncertain tax positions.
 
A reconciliation of the beginning and ending amount of unrecognized tax benefits for 2007 is as follows:
 
         
    (dollars in thousands)  
 
Balance as of January 1, 2007
    $2,024  
Additions for tax positions related to the current year
     
Additions for tax positions of prior years
    20  
Reductions for tax positions of prior years
     
Settlements
     
         
Balance as of December 31, 2007
    $2,044  
         
 
In future periods, if $1,836 thousand of these unrecognized benefits become supportable, the Company may not recognize a change in its effective rate as long as it remains in a full valuation allowance position, $208 thousand of these unrecognized tax benefits would affect the Company’s effective tax rate if recognized. Included in the balance of unrecognized tax benefits at January 1, 2007 is $239 thousand related to tax positions for which it is reasonably possible that the total amounts could significantly change during the next twelve months. This amount represents unrecognized tax benefits comprising potential recognition for tax purposes of losses in a partnership in which the Company held a minority stake. In accordance with the Company’s accounting policy, it recognizes interest and penalties related to uncertain tax positions as a component of tax expense. This policy did not change as a result of the adoption of FIN 48. As of January 1, 2007, accrued interest included in Uncertain Tax Position Liability totaled $34 thousand. During the year ended December 31, 2007, the Company recognized $15 thousand in potential interest expense on uncertain tax positions, and the Company’s Consolidated Balance Sheet as of that date includes total interest of $49 thousand associated with these positions.
 
The Company files income tax returns, including returns for its subsidiaries, with federal and state jurisdictions. The Company is no longer subject to IRS examination for its federal returns for any periods prior to 2003, although carryforward attributes that were generated prior to 2004 may still be adjusted upon examination by the IRS if they either have been or will be used in a future period. The Company has an ongoing tax examination by New York State for the years 2002 through 2004. The Company does not believe that the net outcome of this examination will have a material impact on its financial statements.


F-25


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
9.  Accrued Liabilities
 
Accrued liabilities consist of the following at December 31:
 
             
    2006   2007
    (dollars in thousands)
 
Salaries, wages and related expenses
    $781     $937
Acquisition and disposition costs
    363     363
Legal and professional fees
    311     230
Warranty and other sale obligations
    19     72
Commissions
    139     95
Other
    857     424
             
      $2,470     $2,121
             
 
10.  Stockholders’ Equity
 
Common Shares
 
Changes in common shares are as follows for the years ended December 31:
 
                     
    2005   2006   2007  
 
Balance, beginning
    4,831,369     4,870,742     5,760,585  
Issuance of shares for stock option exercises
    18,571     89,974     10,743  
Issuance of shares for private placement shares
    8,302          
Issuance of shares for restricted and unrestricted stock grants
    12,500     9,510     6,875  
Issuance of shares for capital raise
        756,956      
Issuance of shares for anti-dilution penalty
        33,414      
Forfeiture of restricted stock grants
            (625 )
                     
Balance, ending
    4,870,742     5,760,585     5,777,578  
                     
 
Treasury Stock
 
Changes in treasury stock are as follows for the years ended December 31:
 
                   
    2005   2006   2007
 
Balance, beginning
    1,005,092     1,005,092     1,005,092
                   
Balance, ending
    1,005,092     1,005,092     1,005,092
                   


F-26


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
10.  Stockholders’ Equity — (Continued)
 
Sale of Common Stock
 
Capital Raise: On December 15, 2006, the Company entered into agreements with certain investors to sell 756,944 shares of common stock and warrants to purchase 378,472 shares of common stock for an aggregate purchase price of $10,900 thousand. The common stock and warrants were sold in units, with each unit consisting of 12.5 shares of common stock and a warrant to purchase 6.25 shares of common stock, at an exercise price of $18.16 per share. Each non-certificated unit was sold at a negotiated price of $180.00. The shares of common stock and warrants are immediately separable and were issued separately (see Warrants Issued below). The common stock, the warrants and shares issuable upon exercise of the warrants are registered with the SEC on the Company’s filed and effective registration statement.
 
In connection with the 2006 capital raise, in December 2006, the Company paid Rodman & Renshaw, LLC placement fees, recorded in equity against the proceeds of the capital raise, of $570 thousand.
 
Private Placement: The Company entered into a financing transaction with Fletcher on January 29, 2004 and amended the terms of such transaction on May 4, 2004. Fletcher purchased 335,084 shares of the Company’s common stock for $18,000 thousand pursuant to such financing transaction — 177,355 shares at $56.384 per share and 157,729 shares at $50.72 per share. In addition, Fletcher had the right to purchase an additional $20,000 thousand of the Company’s common stock, on one or more occasions, at a price of $48.184 (adjusted from $50.72) per share at any time prior to December 31, 2006. Fletcher had the right to receive Company shares without payment upon the occurrence of certain events, including but not limited to, failing to register for resale with the SEC shares purchased by Fletcher on the agreed upon time table, a restatement of the Company’s financial statements, change of control of the Company and issuance of securities at a price below Fletcher’s purchase price. The Company has filed registration statements covering all of the shares purchased by Fletcher.
 
The Company filed a registration statement on January 6, 2005 covering the resale of 157,729 shares of the Company’s common stock purchased by Fletcher on December 22, 2004. The Company failed to meet its contractual obligation with Fletcher to have such registration statement declared effective by March 22, 2005 and therefore under the terms of the Fletcher agreement the Company was required to issue additional shares of common stock to Fletcher and the exercise price for the Fletcher additional investment rights has been reduced to $48.184 per share. The Company was required to issue a number of shares of common stock that resulted in Fletcher having effectively made its December 2004 investment at a price per share that was lower than the actual price paid. The Company refers to this reduced exercise price as the “deemed exercise price.” More specifically, for each month during which the Company failed to satisfy the registration requirement, the deemed exercise price was reduced by $2.536 per share. As a consequence, on April 20, 2005 the Company issued 8,302 shares of common stock to Fletcher without any additional payment required by Fletcher, representing a deemed exercise price for Fletcher’s December 2004 investment of $48.184 per share. In addition, since the Company was required to file a registration statement covering the resale of any such additional shares issued to Fletcher, the Company amended the registration statement initially filed in January 2005 to include the additional 8,302 shares of common stock. That registration statement, covering the resale of 166,030 shares of common stock, was declared effective by the SEC on April 21, 2005.
 
Dilutive Issuances: If, after December 31, 2004 and ending December 31, 2006, the Company issued any equity securities at a price below $56.384 as it relates to the initial $10,000 thousand


F-27


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
10.  Stockholders’ Equity — (Continued)
 
investment and $50.72 as it relates to any additional investments which have been made, the exercise price for the additional investment rights would have been adjusted to provide Fletcher “weighted average” anti-dilution protection and the Company would have had to issue to Fletcher a number of additional shares such that all prior investments would have been effectively made at such adjusted exercise price.
 
On December 7, 2006, Fletcher agreed to lower the dilutive issuance provision by 25% of the original calculation for the remainder of the provision’s original term and in connection with the issuance of common stock in the Company’s December 2006 capital raise, the Company issued Fletcher 33,414 of its common shares. Through a release dated January 5, 2007, between the Company and Fletcher, the Company is not required to register these shares with the SEC since these shares may be sold by Fletcher pursuant to Rule 144(k) under the Securities Act of 1933, as amended.
 
The Company does not presently have any outstanding agreements with Fletcher concerning additional investment rights or dilutive stock issuance.
 
Warrants Issued
 
On December 20, 2006, the Company issued warrants to investors to purchase 378,472 shares of the Company’s common stock at an exercise price of $18.16 per share. These warrants will be fair valued by the Company until expiration or exercise of the warrants. The warrants became exercisable on June 20, 2007 and expire on December 19, 2011.
 
Reservation of Shares
 
The Company has reserved common shares for future issuance as follows as of December 31, 2007:
 
       
Stock options outstanding
    776,696
Stock options available for issuance
    128,105
Warrants outstanding
    378,474
       
Number of common shares reserved
    1,283,275
       
 
Completion of Option Exchange with MTI Micro Option Holders
 
On December 30, 2005, the Company issued options to acquire 127,652 shares of MTI common stock, par value $0.01 per share, to certain employees, officers and directors of MTI and MTI Micro who previously held MTI Micro options (the “Optionees”). The options have an exercise price per share of $22.40 (the closing price of the Company’s common stock on December 30, 2005). The Company issued the options pursuant to a November 28, 2005 stock option exchange offer. MTI Micro options outstanding for a purchase of a total of 2,392,947 shares of MTI Micro common stock, par value $0.01 per share, were tendered by the Optionees and then cancelled by MTI Micro as a result of this exchange. Each option is exercisable for one share of MTI common stock. The exchange rate was 0.125 options for each two MTI Micro options, rounded down to the nearest whole option, or if an individual had an MTI Micro option balance in excess of 150,000 options, then at a rate of 0.125 options for each four MTI Micro options in excess of 150,000 options. The exchange was accounted for in accordance with EITF 00-23 Issue 1, Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44 and no compensation expense was recorded.


F-28


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
11.  Retirement Plan
 
The Company maintains a voluntary savings and retirement plan under Internal Revenue Code Section 401(k) covering substantially all employees. Employees must complete six months of service and have attained the age of twenty-one prior to becoming eligible for participation in the plan. The Company plan allows eligible employees to contribute a percentage of their compensation on a pre-tax basis and the Company matches employee contributions dollar for dollar up to a discretionary amount, currently 4%, of the employee’s salary, subject to annual tax deduction limitations. Company matching contributions vest at a rate of 25% annually for each year of service completed. Company matching contributions were $272, $269, and $283 thousand for 2005, 2006, and 2007, respectively. The Company may also make additional discretionary contributions in amounts as determined by management and the Board of Directors. There were no additional discretionary contributions by the Company for the years 2005, 2006, or 2007.
 
12.  Earnings per Share
 
The following table sets forth the reconciliation of the numerators and denominators of the basic and diluted per share computations for continuing operations for the years ended December 31:
 
                         
    2005     2006     2007  
    (dollars in thousands, except shares)  
 
Numerator:
                       
Net loss
    $(15,094 )     $(13,667 )     $(9,575 )
                         
Denominator:
                       
Basic EPS:
                       
Common shares outstanding, beginning of period
    3,826,277       3,865,650       4,755,493  
Weighted average common shares issued during the period
    15,924       87,533       9,111  
Weighted average restricted shares forfeited during the period
                (360 )
Less Weighted average non-vested restricted stock
          (390 )     (697 )
                         
Denominator for basic earnings per common shares — Weighted average common shares
    3,842,201       3,952,793       4,763,547  
                         
Diluted EPS:
                       
Common shares outstanding, beginning of period
    3,826,277       3,865,650       4,755,493  
Weighted average common shares issued during the period
    15,924       87,533       9,111  
Weighted average restricted shares forfeited during the period
                (360 )
Less Weighted average non-vested restricted stock due to
anti-dilutive effect
          (390 )     (697 )
                         
Denominator for diluted earnings per common shares — Weighted average common shares
    3,842,201       3,952,793       4,763,547  
                         
 
Not included in the computation of earnings per share-assuming dilution for the year ended December 31, 2005 were options to purchase 630,155 shares of the Company’s common stock, additional investment rights to purchase approximately 415,076 shares of the Company’s common stock, warrants to purchase 3,547 shares of the Company’s common stock and options to purchase


F-29


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
12.  Earnings per Share — (Continued)
 
78,461 shares of MTI Micro’s common stock. These potentially dilutive items were excluded because the Company incurred a loss for this period and their inclusion would be anti-dilutive. The additional investment rights expired on December 31, 2006.
 
Not included in the computation of earnings per share-assuming dilution for the year ended December 31, 2006 were options to purchase 688,649 shares of the Company’s common stock, 625 unvested restricted shares of the Company’s common stock and options to purchase 33,668 shares of MTI Micro’s common stock. These potentially dilutive items were excluded because the Company incurred a loss for this period and their inclusion would be anti-dilutive. The MTI options expire between January 4, 2007 and November 9, 2016, while the MTI Micro options expire between September 29, 2012 and September 18, 2015. The Company also has 378,472 warrants outstanding as of December 31, 2006; however, these were excluded in the computation earnings per share because they were not eligible to be exercised until June 20, 2007.
 
Not included in the computation of earnings per share-assuming dilution for the year ended December 31, 2007 were options to purchase 776,696 shares of the Company’s common stock, warrants to purchase 378,472 shares of the Company’s stock, 625 unvested restricted shares of the Company’s common stock and options to purchase 22,668 shares of MTI Micro’s common stock. These potentially dilutive items were excluded because the Company incurred a loss for this period and their inclusion would be anti-dilutive.
 
13.  Stock Based Compensation
 
MTI Option Plans
 
Stock-based incentive awards are provided to employees and directors under the terms of the Company’s 1996 Stock Incentive Plan (“1996 Plan”), 1999 Employee Stock Incentive Plan (“1999 Plan”) and 2006 Equity Incentive Plan (“2006 Plan”), the (collectively, the “Plans”). Awards under the Plans have generally included at-the-money options and restricted stock grants. MTI Micro also issued awards under the MTI MicroFuel Cells Inc. 2001 Employee, Director and Consultant Stock Option Plan (“2001 MTI Micro Plan”). During 2005, MTI Micro ceased making grants under the 2001 MTI Micro Plan and determined that it would make no new awards under this plan in the future.
 
The 1996 Plan was approved by stockholders during December 1996 and expired during October 2006. The 1996 Plan provided an initial aggregate number of 500,000 shares of common stock to be awarded or issued. The number of shares available to be awarded under the 1996 Plan and awards outstanding were adjusted for stock splits and rights offerings. The total number of shares which may be awarded under the 1996 Plan was 468,352 during 2005. Under the 1996 Plan, the Board of Directors was authorized to issue stock options, stock appreciation rights, restricted stock, and other stock-based incentives to officers, employees and others.
 
The 1999 Plan was adopted by the Company’s Board of Directors and approved by stockholders on March 18, 1999. The 1999 Plan provides that an initial aggregate number of 1,000,000 shares of common stock may be awarded or issued. The number of shares which may be awarded under the 1999 Plan and awards outstanding have been adjusted for stock splits, and during 2005, 2006, and 2007, the total number of shares which may be awarded under the 1999 Plan was 562,500 shares. Under the 1999 Plan, the Board of Directors is authorized to issue stock-based awards to officers, employees and others.


F-30


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The 2006 Plan was adopted by the Company’s Board of Directors on March 16, 2006 and approved by stockholders on May 18, 2006. The 2006 Plan provides that an initial aggregate number of 2,000,000 shares of common stock may be awarded or issued. The number of shares which may be awarded under the 2006 Plan and awards outstanding have been adjusted for stock splits and other similar events. Under the 2006 Plan, the Board of Directors is authorized to issue stock options, stock appreciation rights, restricted stock, and other stock-based incentives to officers, employees and others.
 
Stock-based compensation expense for the year ended December 31, 2007 was generated from stock options and restricted stock grants. Stock options are awards which allow holders to purchase shares of the Company’s common stock at a fixed price. Stock options issued to employees generally vest 25% per year beginning one year after grant. Options issued to non-employee members of the MTI Board of Directors generally vest upon grant. Certain options granted may be fully or partially exercisable immediately, may vest on other than a four year schedule or vest upon attainment of specific performance criteria. Restricted stock awards generally vest one year after the date of grant; however, certain awards may vest immediately or vest upon attainment of specific performance criteria. Option exercise prices are generally equivalent to the closing market value price of the Company’s common stock on the date of grant. Unexercised options generally terminate either seven or ten years after date of grant.
 
Share-Based Compensation Information under FAS 123 and APB 25
 
Prior to January 1, 2006, the Company had elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”) and related Interpretations in accounting for employee stock-based compensation and to provide the disclosures required under FAS 123. APB Opinion No. 25 requires no recognition of compensation expense for most of the stock-based compensation arrangements provided by the Company, namely, broad-based employee option grants where the exercise price is equal to market value at the date of grant. However, APB Opinion No. 25 requires recognition of compensation expense for variable award plans over the vesting periods of such plans, based upon the then-current market values of the underlying stock. In contrast, FAS 123 requires recognition of compensation expense for grants of stock, stock options, and other equity instruments, over the vesting periods of such grants, based on the estimated grant-date fair values of those grants. Under the intrinsic-value-based method, compensation cost is the excess, if any, of the market value of the stock at grant over the amount an employee must pay to acquire the stock.
 
During 2005, the Company awarded 6,250 shares each of common stock and restricted common stock which vested over a one-year period. Presented below is a summary of compensation expense related to the intrinsic value of performance-based, time-based and unrestricted awards, which is included in the summary of the Company’s compensation expense under all share-based awards, for the Plans which was recorded in the financial statement line “Selling, general and administrative expenses” for the year ended December 31:
 
         
    2005  
    (dollars in thousands)  
 
Stock
  $ 124  
Restricted stock
    45  
Stock options
    633  
         
Total stock-based compensation expense
  $ 802  
         


F-31


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The 2005 stock-based compensation expense included $438 thousand of stock-based compensation expense recorded as a result of accelerating the vesting and/or extending the time to exercise options after termination but not in excess of the original contractual life of the options. These changes were made in connection with employment, termination and change in status (employee to consultant) arrangements.
 
Pro Forma Information under FAS 123 for Periods Prior to Fiscal 2006
 
Prior to adopting the provisions of FAS 123R, the Company recorded estimated compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to APB Opinion No. 25 and provided the required pro forma disclosures of FAS 123. Because the Company generally established the exercise price based on the fair market value of the Company’s stock at the date of grant, the stock options generally had no intrinsic value upon grant, and therefore compensation expense was recorded primarily for grant modifications prior to adopting FAS 123R. Each accounting period, the Company reported the potential dilutive impact of stock options in its diluted earnings per common share using the treasury-stock method. Out-of-the-money stock options (i.e., the average stock price during the period was below the strike price of the stock option) were not included in diluted earnings per common share as their effect was anti-dilutive.
 
For purposes of pro forma disclosures under FAS 123 for the year ended December 31, 2005, the estimated fair value of the stock options was assumed to be amortized to expense over the stock options’ vesting periods. The pro forma effects of recognizing estimated compensation expense under the fair value method on net (loss) and (loss) per common share for the year ended December 31 was as follows:
 
         
    2005  
    (dollars in thousands,
 
    except per share data)  
 
Net loss, as reported
    $(15,094 )
Add: Total stock-based employee compensation expense already recorded in financial statements, net of related tax effects
    1,003  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (2,963 )
         
Pro forma net loss
    $(17,054 )
         
Loss per Share:
       
Basic and diluted — as reported
    $(3.93 )
         
Basic and diluted — pro forma
    $(4.44 )
         
 
       
    2005
 
Fair value of each option granted
    $22.80
Number of options granted
    183,485
Fair value of all options granted
    $4,187,301


F-32


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The fair value of options granted, which is amortized to expense over the option vesting period in determining the pro forma impact, is estimated on the date of grant using the Black-Scholes Option Pricing model with the following weighted average assumptions for each of the year ended December 31:
 
         
    2005  
 
Expected life of option
    5 years  
Risk-free interest rate
    4.28%  
Expected volatility of the Company’s stock
    77.3%  
Expected dividend yield on the Company’s stock
    0%  
 
The weighted average grant-date fair value of stock awarded and vested for each of the year ended December 31 is as follows:
 
         
    2005  
 
Fair value of each share granted
    $19.92  
Number of shares granted
    6,250  
Fair value of all shares granted
    $124,500  
 
The weighted average grant-date fair value of restricted stock awarded for each of the year ended December 31 is as follows:
 
         
    2005  
 
Fair value of each restricted share granted
    $19.92  
Number of restricted shares granted
    6,250  
Fair value of all restricted shares granted
    $124,500  
 
Share-Based Compensation Information under FAS 123R
 
As discussed in Note 2 “Significant Accounting Policies,” effective January 1, 2006, the Company adopted the fair value recognition provisions for stock-based awards granted to employees using the modified prospective application method provided by FAS 123R. Stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the employee requisite service period.
 
The Company estimates the fair value of stock options using a Black Scholes valuation model consistent with the provisions of FAS 123R and SAB 107. Key inputs and assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the Company’s stock, an appropriate risk-free rate, and the Company’s dividend yield. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company.


F-33


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The fair value of each stock option grant was estimated at the date of grant using a Black-Scholes Option Pricing model. The following table presents the weighted-average assumptions used for options granted:
 
                 
    2006     2007  
 
Option term (years) A
    4.26       3.61  
Volatility B
    73.14 %     72.76 %
Risk-free interest rate range C
    4.60 - 5.29 %     3.23 - 5.04 %
Dividend yield D
    0 %     0 %
Weighted-average fair value per option granted
    $22.08       $6.16  
 
 
A The option term is the number of years that the Company estimates, based upon historical experience and the full contractual term of the options outstanding, those options will be outstanding prior to exercise.
 
B The expected stock price volatility as of the grant date is based on the historical volatility of the Company’s common stock price over a period corresponding to the expected term of the option, adjusted for activity that is not expected to occur in the future.
 
C The risk-free interest rate is the implied yield on U.S. Treasury zero coupon issues with a remaining term equal to the expected term used as the assumption in the model.
 
D The dividend yield assumption is based on the Company’s history and expectation of future dividend payouts, which may be subject to substantial change in the future.
 
Share-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, therefore, awards are reduced for estimated forfeitures. FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
 
Stock-Based Compensation Expense — All Accounting Treatments
 
Total share-based compensation expense, related to all of the Company’s share-based awards, recognized for the years ended December 31, was comprised as follows:
 
                         
    2005     2006     2007  
    (dollars in thousands, except eps)  
 
Unfunded research and product development
    $—       $512       $216  
Selling, general and administrative-B
    1,003       1,894       1,342  
                         
Share-based compensation expense before taxes
    1,003       2,406       1,558  
Related income tax benefits-A
                 
                         
Share-based compensation expense, net of taxes
    $1,003       $2,406       $1,558  
                         
Impact on basic and diluted EPS
            $(0.61 )     $(0.33 )
                         
 
 
A Income tax effect is zero due to the Company maintaining a full valuation allowance.
 
B Compensation expense for the year ended December 31, 2005 was calculated under APB 25.


F-34


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
 
As of January 1, 2006, the adoption of FAS 123R resulted in the elimination of unearned compensation related to restricted stock (contra equity account) against additional paid-in capital totaling approximately $80 thousand. Total unrecognized compensation costs related to non-vested awards as of December 31, 2007 is $1,595 thousand and is expected to be recognized over a weighted-average vesting period of approximately 1.31 years.
 
Presented below is a summary of the Company’s stock option plans’ activity for the years ended December 31:
 
                         
    2005     2006     2007  
 
Shares under option, beginning
    469,008       630,155       688,649  
Granted
    183,485       195,594       231,731  
Exercised
    (18,572 )     (89,974 )     (10,743 )
Canceled/Forfeited
    (1,266 )     (21,887 )     (65,115 )
Expired
    (2,500 )     (25,239 )     (67,814 )
                         
Shares under option, ending
    630,155       688,649       776,696  
                         
Options exercisable
    524,629       506,661       578,544  
                         
Remaining shares available for granting of options
    170,402       262,020       128,105  
                         
 
The weighted average exercise price is as follows for each of the years ended December 31:
 
                         
    2005     2006     2007  
 
Shares under option, beginning
    32.48       30.08       32.32  
Granted
    22.80       32.32       10.96  
Exercised
    17.60       13.20       5.60  
Canceled/Forfeited
    34.08       34.32       28.40  
Expired
    49.36       42.40       41.04  
Shares under option, ending
    30.08       32.32       25.92  
Options exercisable, ending
    30.80       32.96       28.40  
 
The following table summarizes information for options outstanding and exercisable at December 31, 2007:
 
                               
Outstanding Options   Options Exercisable
        Weighted Average
  Weighted
      Weighted
Exercise
      Remaining
  Average
      Average
Price Range
  Number   Contractual Life   Exercise Price   Number   Exercise Price
 
$6.08 - $9.04
    19,250     4.9     $7.04     9,375     $7.36
$9.84 - $14.24
    247,837     5.6     $11.20     129,478     $11.68
$15.28 - $22.64
    145,400     4.8     $20.64     139,157     $20.64
$22.88 - $33.36
    163,583     4.9     $29.04     151,768     $29.04
$34.40 - $50.24
    175,313     4.9     $41.60     123,453     $44.16
$74.00 - $103.76
    25,313     2.1     $84.40     25,313     $84.40
                               
      776,969     5.0     $25.92     578,544     $28.40
                               


F-35


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The aggregate intrinsic value (i.e. the difference between the closing stock price and the price to be paid by the option holder to exercise the option) is zero for both the Company’s outstanding and exercisable options as of December 31, 2007. The amounts are based on the Company’s closing stock price of $0.75 as of December 31, 2007.
 
The total intrinsic value of options exercised during the years ended December 31, 2005, 2006, and 2007 was $217, $1,307, and $44 thousand, respectively. The total cash received by the Company as a result of stock option exercises for the year ended December 31, 2007 was approximately $60 thousand. In connection with these exercises, there was no tax benefit or expense realized by the Company for the year ended December 31, 2007. The Company settles employee stock option exercises with newly issued shares of Company common stock.
 
The number and weighted average grant-date fair value of unvested restricted stock for the period ended December 31, 2007 is as follows:
 
               
          Weighted Average
          Grant-Date
    Number     Fair Value
 
Unvested restricted stock, beginning
    625       $32.40
Granted
    6,875       10.72
Forfeited
    (625 )     32.40
Vested
    (6,250 )     10.72
               
Unvested restricted stock, ending
    625       $10.72
               
 
The aggregate intrinsic value of restricted stock vested during the year ended December 31, 2007 was $67 thousand.
 
MTI Micro Option Plan
 
The 2001 MTI Micro Plan was approved by MTI Micro’s stockholders in 2001 and provided an initial aggregate number of 1,766,000 shares of MTI Micro common stock to be awarded. The number of shares which may be awarded under the 2001 MTI Micro Plan and awards outstanding have been adjusted for a 2004 reverse stock split, and during 2005, 2006, and 2007, the total number of shares which may be awarded under the 2001 MTI Micro Plan were 3,416,667 shares. Under the 2001 MTI Micro Plan, the MTI Micro Board of Directors was authorized to award stock options to officers, directors, employees and consultants. No further grants will be made under this plan.
 
Options issued to employees generally vest 25% per year beginning one year after grant. Option exercise prices were determined by MTI Micro’s Board of Directors. Unexercised options generally terminate ten years after date of grant. Up until January 1, 2006, MTI Micro followed APB Opinion No. 25 and related Interpretations, in accounting for employee stock-based compensation and to provide the disclosures required under SFAS No. 123. APB Opinion No. 25 requires no recognition of compensation expense for most of the stock-based compensation arrangements provided by MTI Micro, namely, broad-based employee stock purchase plans and option grants where the exercise price is equal to or not less than the market value at the date of grant. However, APB Opinion No. 25 requires recognition of compensation expense for variable award plans over the vesting periods of such plans, based upon the then-current market values of the underlying stock. As of January 1, 2006, MTI Micro is accounting for employee stock-based compensation under FAS 123R.


F-36


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
Presented below is a summary of compensation expense, which is included in the summary of the Company’s compensation expense under all share-based awards above, for the MTI Micro plan:
 
                   
    2005   2006   2007
    (dollars in thousands)
 
Stock options
  $ 201   $ 25   $ 12
                   
Total stock-based compensation expense
  $ 201   $ 25   $ 12
                   
 
Presented below is a summary of the 2001 MTI Micro stock option plans activity for the years ended December 31:
 
                         
    2005     2006     2007  
 
Shares under option, beginning
    2,876,881       78,461       33,668  
Granted
    358,000              
Exercised
    (10 )            
Canceled/Forfeited
    (3,156,410 )     (44,793 )     (11,000 )
                         
Shares under option, ending
    78,461       33,668       22,668  
                         
Options exercisable
    35,752       17,003       18,626  
                         
Remaining shares available for granting of options
    3,280,403       3,325,196       3,336,196  
                         
 
The weighted average exercise price for MTI Micro options is as follows for each of the years ended December 31:
 
                         
    2005     2006     2007  
 
Shares under option, beginning
  $ 3.00     $ 3.22     $ 3.61  
Granted
    3.68              
Exercised
    2.55              
Canceled/Forfeited
    3.12       2.93       3.42  
Shares under option, ending
    3.22       3.61       3.70  
Options exercisable, ending
    2.93       3.57       3.63  
 
The fair value of MTI Micro options granted in 2005, which is amortized to expense over the option vesting period in determining the pro forma impact, was estimated on the date of grant using the Black-Scholes Option Pricing model with the following weighted average assumptions for the year ended December 31:
 
         
    2005  
 
Expected life of option
    5 years  
Risk-free interest rate
    4.28%  
Expected volatility of the MTI Micro’s stock
    77.3%  
Expected dividend yield on MTI Micro’s stock
    0%  


F-37


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
13.  Stock Based Compensation — (Continued)
 
The weighted average fair value of MTI Micro options granted for the year ended December 31 is as follows:
 
         
    2005  
 
Fair value of each option granted
    $3.68  
Fair value of all options granted
    $930,890  
 
In accordance with SFAS No. 123, the weighted average fair value of stock options granted is required to be based on a theoretical statistical model using the preceding Black-Scholes Option Pricing model assumptions.
 
                               
Outstanding Options   Options Exercisable
        Weighted Average
           
Exercise
      Remaining
  Weighted Average
      Weighted Average
Price Range
  Number   Contractual Life   Exercise Price   Number   Exercise Price
 
$2.39 - $2.55
    6,500     6.4   $ 2.44     5,375   $ 2.45
$2.76 - $3.80
    4,501     5.7   $ 3.03     4,501   $ 3.03
$4.06 - $4.66
    11,667     6.2   $ 4.66     8,750   $ 4.66
                               
      22,668     6.2   $ 3.70     18,626   $ 3.63
                               
 
Based upon an estimated common stock price of $0.51 at December 31, 2007, the intrinsic value of all MTI Micro’s outstanding and exercisable options are zero, since all exercise prices are above the estimated common stock fair value price.
 
On December 30, 2005, the Company granted options to acquire 1,021,213 shares of MTI common stock, par value $0.01 per share, to certain Optionees. The options have an exercise price per share of $2.80 (the closing price of the Company’s common stock on December 30, 2005). The Company issued the options pursuant to a November 28, 2005 stock option exchange offer. MTI Micro options outstanding for a purchase of a total of 2,392,947 shares of MTI Micro common stock, par value $0.01 per share, were tendered by the Optionees and then cancelled by MTI Micro as a result of this exchange. Each option is exercisable for one share of MTI common stock. The exchange rate was 0.125 options for each two MTI Micro options, rounded down to the nearest whole option, or if an individual had an MTI Micro option balance in excess of 150,000 options, then at a rate of 0.125 options for each four MTI Micro options in excess of 150,000 options. The exchange was accounted for in accordance with EITF 00-23 Issue 1 and no compensation expense was recorded.
 
14.  Cash Flows — Supplemental Information
 
                         
    Years Ended December 31,  
    2005     2006     2007  
    (dollars in thousands)  
 
Non-Cash Investing and Financing Activities:
                       
Change in investment and paid-in capital resulting from other investors’ activity in MTI Micro stock
  $ (301 )   $ (1,284 )   $ (521 )
Cash Payments:
                       
Taxes paid (tax refunds), net
    37       3       (10 )


F-38


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
14.  Cash Flows — Supplemental Information — (Continued)
 
15.  Derivatives
 
The Company held or has outstanding as of December 31, the following derivative financial instruments:
 
             
    2006   2007   Expiration
 
Derivatives issued:
           
Warrants, exercisable beginning June 20, 2007, to purchase the Company’s common stock issued to three investors at a purchase price of $18.16 per share
  378,474   378,474   12/19/2011
 
Plug Power Investment Right Derivative:  The Company placed 2,700,000 shares of Plug Power common stock in escrow that was available for purchase by Fletcher in certain instances. Fletcher could, on one or multiple occasions, from June 1, 2005 to December 31, 2006, exercise its right to purchase from the Company a number of shares of Plug Power common stock totaling $10,000 thousand divided by the prevailing price (as defined below) per share of Plug Power common stock, but only to the extent of the number of shares remaining in escrow. Commencing immediately after the SEC declared effective on May 20, 2004 the registration statement relating to shares of the Company’s common stock owned by Fletcher, the Company had the right to have 250,000 of such shares released from escrow to the Company, on a monthly basis, in the event that on any day during such month, the prevailing price of the Company’s common stock exceeds $50.744 (which price may have been adjusted to reflect stock splits, recombinations, stock dividends or the like).
 
The exercise price for the Plug Power investment right was $10,000 thousand less the positive difference between $18,000 thousand and the product of the sum of 335,084 shares multiplied by the prevailing price per share of the Company’s common stock on the date Fletcher elected to exercise such right, all divided by the quotient obtained by dividing $10,000 thousand by the prevailing price of Plug Power common stock on the date.
 
Fletcher elected to exercise such right. As used herein, a prevailing price is the average of the daily volume-weighted average price per share of common stock during the sixty-business-day period ending three days prior to the date Fletcher elects to exercise such right, provided however that the price may not exceed the average of the daily volume-weighted average prices for any ten business days within such sixty-business day period.
 
On June 24, 2005, Fletcher notified the Company of their election to exercise in full its right to purchase from the Company certain shares of common stock of Plug Power. As a result of this election, Fletcher purchased 1,799,791 shares of Plug Power common stock from the Company at a price of $0.7226 per share, with proceeds to the Company of $1,301 thousand. This transaction closed on June 28, 2005 and, in connection with this exercise, the Company recognized a loss based on the intrinsic value of the derivative immediately prior to exercise of $7,173 thousand and a gain on the sale based on the fair value of the underlying Plug Power common shares of $9,635 thousand.
 
Warrant Derivative to Purchase MTI Common Stock:  The warrants issued during the Company’s December 2006 capital raise were legally freestanding, detachable and transferable by the holders. The features of the warrant allowed both straight cash exercises as well as cashless exercises. Due primarily to a stipulation in the warrant agreement which allowed a potential cash settlement with the holders if the Company was acquired by, or merged with a private company, these warrants were classified as an asset/liability derivative in accordance with SFAS No. 133 (paragraph 11) and EITF 00-19.


F-39


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
15.  Derivatives — (Continued)
 
The estimated fair value of this warrant at the date issued was $10.16 per share, using a Black-Scholes Option Pricing model and assumptions similar to those used for valuing the Company’s employee share-based compensation. The fair value of the derivative is recorded in the “Derivative Liability” line on its financial statements, and is valued quarterly using the Black-Scholes Option Pricing Model. The assumptions used for the valuations as of December 31 were as follows:
 
         
    2006   2007
 
Expected life of option (days)
  1,815   1,450
Risk-free interest rate
  4.70%   3.45%
Expected volatility of stock
  80.34%   73.46%
Expected dividend yield
  None   None
 
The Company recognizes changes in fair value in its Consolidated Statements of Operations in the line titled “Gain on derivatives.”
 
16.  Commitments and Contingencies
 
Lawrence Litigation
 
On September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc. (“Lawrence”) and certain other Lawrence-related entities (“Plaintiffs”) initially filed suit in the United States Bankruptcy Court for the Northern District of New York (“Bankruptcy Court”) and the United States District Court for the Northern District of New York (“District Court”), which were subsequently consolidated in the District Court, against First Albany Corporation, now known as Broadpoint Capital, Inc. (“BCI”), the Company, Dale Church, Edward Dohring, Beno Sternlicht, Alan Goldberg and George McNamee (Church, Dohring, Sternlicht, Goldberg and McNamee are former Directors of the Company), Marty Mastroianni (former President and Chief Operating Officer of the Company) and 33 other individuals (“Defendants”) who purchased a total of 820,909 shares (307,841 post-split) of the Company’s stock from the Plaintiffs. The case concerns the Defendants’ 1997 purchase of the Company’s common stock from the Plaintiffs at the price of $2.25 per share ($6.00 per share post split). BCI acted as Placement Agent in connection with the negotiation and sale of the shares, including in proceedings before the Bankruptcy Court, which approved the sale in September 1997.
 
Plaintiffs claim that the Defendants failed to disclose material inside information to the Plaintiffs in connection with the sale and that the $2.25 per share ($6.00 per share post split) purchase price was unfair. Plaintiffs are seeking damages of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion to dismiss the amended complaint, which was denied by the Bankruptcy Court. On appeal in October 2000, Plaintiffs’ claims were dismissed by the District Court. In November 2000, Plaintiffs filed an appeal of that dismissal with the United States Court of Appeals for the Second Circuit. In June 2002, the Second Circuit Court of Appeals reversed the District Court decision in part and remanded the case for further consideration of the Plaintiffs’ claims as motions to modify the Bankruptcy Court sale order. The Plaintiffs’ claims have now been referred back to Bankruptcy Court for such consideration. By order and decision dated September 30, 2003, the Bankruptcy Court allowed certain limited discovery to proceed, and this process is still underway.


F-40


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
16.  Commitments and Contingencies — (Continued)
 
The Company believes the claims have no merit and intends to defend them vigorously. The Company cannot predict the outcome of the claims nor reasonably estimate a range of possible loss given the current status of the litigation. Accordingly, no amounts have been reserved for this matter.
 
Leases
 
The Company and its subsidiaries lease certain manufacturing, laboratory and office facilities. The leases generally provide for the Company to pay either an increase over a base year level for taxes, maintenance, insurance and other costs of the leased properties or the Company’s allocated share of insurance, taxes, maintenance and other costs of leased properties. The leases contain renewal provisions.
 
Future minimum rental payments required under non-cancelable operating leases are (dollars in thousands): $694 in 2008, $659 in 2009, $1 in 2010 and $0 in 2011 and 2012. Rent expense under all leases was $746, $748, and $687 thousand for 2005, 2006, and 2007, respectively. Contingent rent included in the rent expense was $11, $3, and $3 thousand for 2005, 2006, and 2007, respectively.
 
Warranties
 
Below is a reconciliation of changes in product warranty liabilities at December 31:
 
                 
    2006     2007  
    (dollars in thousands)  
 
Balance, beginning of period
    $20       $19  
Accruals for warranties issued
    25       126  
Accruals related to pre-existing warranties (including changes in estimates)
    (12 )      
Settlements made (in cash or in kind)
    (14 )     (73 )
                 
Balance, end of period
    $19       $72  
                 
 
Licenses
 
On January 24, 2008, the Company cancelled its non-exclusive licensing agreement with Los Alamos National Laboratory (“LANL”) covering certain direct methanol fuel cell technology. This agreement, which was last amended on May 17, 2006, prescribed annual license fees ranging from $35,000 in 2008 to $100,000 in 2019. The Company paid a one-time fee of $50,000 to cancel the agreement, and no future royalties will be paid. The Company cancelled this agreement because it no longer considers the direct methanol fuel cell technology licensed from LANL to be applicable to its future products.


F-41


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
16.  Commitments and Contingencies — (Continued)
 
Under the NYSERDA contract, MTI Micro agreed to pay NYSERDA a royalty of 5.0% of the sales price of any product sold incorporating IP developed pursuant to the NYSERDA contract. If the product is manufactured by a New York State manufacturer, this royalty is reduced to 1.5%. Total royalties are subject to a cap equal to two times the total contract funds paid by NYSERDA to MTI Micro, and may be reduced to reflect any New York State jobs created by MTI Micro.
 
Employment Agreements
 
The Company has employment agreements with certain employees that provide severance payments, certain other payments, accelerated vesting and exercise extension periods of certain options upon termination of employment under certain circumstances, as defined in the applicable agreements. As of December 31, 2007, the Company’s potential minimum obligation to these employees was approximately $753 thousand.
 
Contract Losses
 
During 2005, MTI Micro entered into a fixed price contract with Saft America, Inc. (“SAFT”) under the U.S. Army CECOM contract. The total fixed price to be paid at the completion was amended on November 14, 2006 from $470 thousand to $418 thousand, in recognition of the elimination of Milestone 4. As of December 31, 2006, MTI Micro forecasted costs in excess of this revised contract value of $66 thousand, and accrued this amount for the anticipated cost overrun for this project. The project was completed during February 2007.
 
17.  Related Party Transactions
 
Management believes transactions among related parties are as fair to the Company as obtainable from unaffiliated third parties.
 
The Company purchases materials from E.I. du Pont de Nemours and Company (“DuPont”), a stockholder in MTI Micro. Such purchases totaled $130 for the year ended December 31, 2005.
 
During the Company’s December 2006 capital raise, Sidney V. Gold, a stockholder in MTI Micro, purchased 5,000 units consisting of 62,500 shares of the Company’s common stock and warrants exercisable for five years to purchase an additional 31,250 shares of the Company’s common stock at an exercise price of $18.16 per share. The purchase price per unit was $180.00.


F-42


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
18.  Geographic and Segment Information
 
The Company sells its products on a worldwide basis with its principal markets listed in the table below where information on product revenue and funded research and development revenue is summarized by geographic area for the Company as a whole for each of the years ended December 31:
 
             
    2005   2006   2007
    (dollars in thousands)
 
Product revenue:
           
United States
  $4,751   $4,737   $5,453
Japan
  628   1,762   2,516
Singapore
  31   355   286
Other Pacific Rim
  202   279   307
Europe
  96   175   161
Rest of World
  304   359   305
             
Total product revenue
  $6,012   $7,667   $9,028
             
Funded research and development revenue:
           
South Korea
  $—   $427   $448
United States
  1,829   62   1,108
             
Total funded research and development revenue
  $1,829   $489   $1,556
             
Total revenue
  $7,841   $8,156   $10,584
             
 
Revenues are attributed to regions based on the location of customers.
 
The Company operates in two business segments, New Energy and Test and Measurement Instrumentation. The New Energy segment is focused on commercializing DMFCs. The Test and Measurement Instrumentation segment designs, manufactures, markets and services computer-based balancing systems for aircraft engines, high performance test and measurement instruments and systems, and wafer characterization tools for the semiconductor industry. The Company’s principal operations are located in North America.
 
The accounting policies of the New Energy and Test and Measurement Instrumentation segments are similar to those described in the summary of significant accounting policies (See Note 2). The Company evaluates performance based on profit or loss from operations before income taxes, accounting changes, items management does not deem relevant to segment performance, and interest income and expense. Inter-segment sales are not significant.


F-43


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
18.  Geographic and Segment Information — (Continued)
 
Total product revenues contributed by the Test and Measurement Instrumentation products segment and their percentage of total product revenues for each of the years ended December 31 are shown below:
 
                                           
    2005     2006     2007  
    Sales   %     Sales   %     Sales   %  
    (dollars in thousands)  
 
Aviation
    $3,013     50.12 %     $2,990     39.00 %     $3,664     40.58 %
General Gauging
    2,688     44.71       4,165     54.32       4,489     49.72  
Semiconductor
    311     5.17       512     6.68       875     9.70  
                                           
Total
    $6,012     100.00 %     $7,667     100.00 %     $9,028     100.00 %
                                           
Total Foreign-Based Revenue
    $1,261     20.97 %     $2,930     38.22 %     $3,557     39.40 %
                                           
 
In the Test and Measurement Instrumentation segment, the U.S. Air Force accounted for $2,385 thousand or 30.4% of total revenue in 2005, $1,774 thousand or 23.1% of total product revenue in 2006, and $2,375 thousand or 26.3% of total product revenue in 2007. Sales to a Japanese distributor accounted for $1,757 thousand or 22.9% of total product revenue in 2006, and $2,501 thousand or 27.7% of total product revenue in 2007.
 
In the New Energy segment, the DOE accounted for $930 thousand or 11.9% of total funded research and development revenue in 2005, $63 thousand or 12.8% of total funded research and development revenue in 2006, and $675 thousand or 43.4% of total funded research and development revenue in 2007. Samsung accounted for $426 thousand or 87.2% of total funded research and development revenue in 2006 and $448 thousand or 28.9% of total funded research and development revenue in 2007, while SAFT accounted for $418 thousand or 26.8% of total funded research and development revenue in 2007.
 
Summarized financial information concerning the Company’s reportable segments is shown in the following table. The “Other” column includes corporate related items and items such as income taxes or unusual items, which are not allocated to reportable segments. The “Reconciling Items” column includes minority interests in a consolidated subsidiary. In addition, segments’ non-cash items include any depreciation and amortization in reported profit or loss. The New Energy


F-44


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
18.  Geographic and Segment Information — (Continued)
 
segment figures include the Company’s direct micro fuel cell operations, equity securities of Plug Power, gains on the sale of these securities, and (losses) gains related to the embedded derivative for the purchase of Plug Power common stock.
 
                                       
          Test and
                 
          Measurement
          Reconciling
  Consolidated
 
    New Energy     Instrumentation     Other     Items   Totals  
    (dollars in thousands)  
 
Year Ended December 31, 2005
                                     
Product revenue
    $—       $6,012       $—       $—     $6,012  
Funded research and development revenue
    1,829                       1,829  
Research and product development expenses
    8,546       1,125                 9,671  
Selling, general and administrative expenses
    3,772       2,188       4,927           10,887  
Gain on securities available for sale
    10,125                       10,125  
Loss on derivatives
    (10,407 )                     (10,407 )
Segment (loss) profit from continuing operations before income taxes, equity in holdings’ losses and minority interests
    (13,708 )     (74 )     (1,167 )         (14,949 )
Segment (loss) profit
    (13,708 )     (74 )     (2,754 )     1,442     (15,094 )
Total assets
    20,996       1,962       18,309           41,267  
Securities available for sale
    18,947                       18,947  
Capital expenditures
    783       123       98           1,004  
Depreciation and amortization
    576       69       608           1,253  
                                       
Year Ended December 31, 2006
                                     
Product revenue
    $—       $7,667       $—       $—     $7,667  
Funded research and development revenue
    489                         489  
Research and product development expenses
    11,588       1,333                   12,921  
Selling, general and administrative expenses
    2,733       2,457       4,882           10,072  
Gain on securities available for sale
    4,289                       4,289  
Segment (loss) profit from continuing operations before income taxes, equity in holdings’ losses and minority interests
    (12,847 )     662       (795 )         (12,980 )
Segment (loss) profit
    (12,847 )     662       (2,690 )     1,208     (13,667 )
Total assets
    15,565       2,782       15,464           33,811  
Securities available for sale
    10,075                         10,075  
Capital expenditures
    1,284       200       90           1,574  
Depreciation and amortization
    604       94       403           1,101  
 


F-45


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
18.  Geographic and Segment Information — (Continued)
 
                                   
          Test and
             
          Measurement
      Reconciling
  Consolidated
 
    New Energy     Instrumentation   Other   Items   Totals  
    (dollars in thousands)  
 
Year Ended December 31, 2007
                                 
Product revenue
    $—       $9,028     $—     $—     $9,028  
Funded research and development revenue
    1,556                   1,556  
Research and product development expenses
    10,115       1,650             11,765  
Selling, general and administrative expenses
    1,921       2,650     4,167         8,738  
Gain on securities available for sale
    2,549                   2,549  
Segment (loss) profit from continuing operations before income taxes, equity in holdings’ losses and minority interests
    (11,189 )     789     2,791         (7,609 )
Segment (loss) profit
    (11,189 )     789     243     582     (9,575 )
Total assets
    8,128       3,018     7,570         18,716  
Securities available for sale
    4,492                   4,492  
Capital expenditures
    212       177     25         414  
Depreciation and amortization
    715       117     297         1,129  
 
The following table presents the details of “Other” segment (loss) profit for each of the years ended December 31:
 
                         
    2005     2006     2007  
    (dollars in thousands)  
 
Corporate and other (expenses) income:
                       
Depreciation and amortization
    $(608 )     $(403 )     $(297 )
Interest income
    309       486       413  
Gain on derivatives
          182       2,967  
Income tax (expense) benefit
    (1,587 )     (1,895 )     (2,548 )
Other expense, net
    (868 )     (1,060 )     (292 )
                         
Total (expense) income
    $(2,754 )     $(2,690 )     $243  
                         
 
19.  Restructuring
 
In March 2007, the Company announced the suspension of MTI Micro’s high power direct methanol fuel cell program in response to decreased funding and sales opportunities in the military market. In connection with this action, the Company accrued restructuring charges of $344 thousand pre-tax, consisting primarily of cash-based employee severance and benefit costs related to the reduction of 23 positions within its New Energy segment and Corporate staff. Restructuring expenses were classified as selling, general and administrative expenses within the Company’s Consolidated Statements of Operations for the period. As of December 31, 2007, all employees participating in this reduction in force had been terminated. For the year ended December 31, 2007,

F-46


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
19.  Restructuring — (Continued)
 
the Company paid $330 thousand in employee severance, benefits and job placement assistance costs. The remaining accrual at December 31, 2007 was $10 thousand, reflecting a $3 thousand reduction in estimated remaining liability from the Company’s original restructuring accrual due to benefit elections made by employees participating in this action. This remaining liability is expected to be paid by the end of the first quarter of 2008.
 
20.  Subsequent Events
 
On March 27, 2008, the Company filed a registration statement on Form S-1 with the SEC for a proposed underwritten public offering, with proceeds of up to $30 million, of units consisting of shares of the Company’s common stock and warrants to purchase shares of the Company’s common stock.
 
On April 8, 2008, the Company filed a definitive proxy statement seeking stockholder approval for a reverse split of its issued and outstanding common stock at a rate of 1-for-8. On May 15, 2008, the Company’s stockholders approved the reverse split, which became effective on May 16, 2008. All share and per share amounts have been retroactively restated in the consolidated financial statements and those accompanying notes for all fiscal periods presented.


F-47


 

 
MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
As of December 31, 2007 and March 31, 2008 (Unaudited)
 
                 
    December 31,
    March 31,
 
    2007     2008  
    (dollars in thousands)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 7,650     $ 4,560  
Securities available for sale
    4,492       3,537  
Accounts receivable
    1,369       1,382  
Inventories, net
    1,373       1,460  
Prepaid expenses and other current assets
    329       865  
                 
Total current assets
    15,213       11,804  
Property, plant and equipment, net
    2,159       2,040  
Deferred income taxes
    1,344       968  
                 
Total assets
  $ 18,716     $ 14,812  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
  $ 273     $ 518  
Accrued liabilities
    2,121       2,615  
Deferred revenue
    117       56  
Income taxes payable
    11       13  
Deferred income taxes
    1,344       968  
                 
Total Current Liabilities
    3,866       4,170  
Long-term liabilities:
               
Uncertain tax position liability
    208       209  
Derivative liability
    696       363  
                 
Total Long-Term-Liabilities
    904       572  
                 
Total Liabilities
    4,770       4,742  
                 
Commitments and contingencies
               
Minority interests
    143       25  
                 
Stockholders’ equity:
               
Common stock, par value $0.01 per share, authorized 75,000,000; 5,777,578 issued in both 2007 and 2008
    58       58  
Paid-in-capital
    132,065       132,449  
Accumulated deficit
    (105,066 )     (108,253 )
Accumulated other comprehensive income:
               
Unrealized gain on securities available for sale, net of tax
    500       (455 )
Common stock in treasury, at cost, 1,005,092 shares in both 2007 and 2008
    (13,754 )     (13,754 )
                 
Total stockholders’ equity
    13,803       10,045  
                 
Total liabilities and stockholders’ equity
  $ 18,716     $ 14,812  
                 
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


F-48


 

MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
For the Three Months Ended March 31, 2007 and 2008
 
                 
    Three Months Ended March 31,  
    2007     2008  
    (dollars in thousands, except per share)  
 
Product revenue
  $ 1,701     $ 1,980  
Funded research and development revenue
    615       173  
                 
Total revenue
    2,316       2,153  
Operating costs and expenses:
               
Cost of product revenue
    738       840  
Research and product development expenses:
               
Funded research and product development
    224       356  
Unfunded research and product development
    3,398       2,017  
                 
Total research and product development expenses
    3,622       2,373  
Selling, general and administrative expenses
    2,456       2,618  
                 
Operating loss
    (4,500 )     (3,678 )
Gain on derivatives
    969       333  
Other income, net
    141       42  
                 
Loss before income taxes and minority interests
    (3,390 )     (3,303 )
                 
Income tax expense
    (11 )     (8 )
Minority interests in losses of consolidated subsidiary
    245       124  
                 
Net loss
  $ (3,156 )   $ (3,187 )
                 
Loss per Share (Basic and Diluted):
               
Loss per share
  $ (0.66 )   $ (0.67 )
                 
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


F-49


 

MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE LOSS (Unaudited)
For the Three Months Ended March 31, 2007 and 2008
 
                 
    Three Months Ended March 31,  
    2007     2008  
    (dollars in thousands)  
 
Common stock
               
Balance, beginning
  $ 58     $ 58  
                 
Balance, ending
  $ 58     $ 58  
                 
Paid-in capital
               
Balance, beginning
  $ 130,968     $ 132,065  
Stock-based compensation
    300       389  
MTI MicroFuel Cell investment
    (180 )     (5 )
                 
Balance, ending
  $ 131,088     $ 132,449  
                 
Accumulated deficit
               
Balance, beginning
  $ (95,385 )   $ (105,066 )
Cumulative effect of adoption of FIN 48
    (106 )      
Net loss
    (3,156 )     (3,187 )
                 
Balance, ending
  $ (98,647 )   $ (108,253 )
                 
Accumulated other comprehensive income (loss):
               
Unrealized gain (loss) on securities available for sale, net of taxes
               
Balance, beginning
  $ 984     $ 500  
Change in unrealized (loss) gain on securities available for sale (net of taxes of $0 in 2007 and 2008)
    (1,890 )     (955 )
                 
Balance, ending
  $ (906 )   $ (455 )
Treasury stock
               
Balance, beginning
  $ (13,754 )   $ (13,754 )
                 
Balance, ending
  $ (13,754 )   $ (13,754 )
                 
Total stockholders’ equity
               
Balance, ending
  $ 17,839     $ 10,045  
                 
Total comprehensive (loss):
               
Net loss
  $ (3,156 )   $ (3,187 )
Other comprehensive (loss):
               
Change in unrealized (loss) gain on securities available for sale, net of taxes
    (1,890 )     (955 )
                 
Total comprehensive (loss)
  $ (5,046 )   $ (4,142 )
                 
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


F-50


 

MECHANICAL TECHNOLOGY, INCORPORATED AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
For the Three Months Ended March 31, 2007 and 2008
 
                 
    Three Months Ended March 31,  
    2007     2008  
    (Dollars in thousands)  
 
Operating activities
               
Net loss
  $ (3,156 )   $ (3,187 )
Adjustments to reconcile net loss to net cash used by operating activities:
               
Gain on derivatives
    (969 )     (333 )
Depreciation and amortization
    293       221  
Minority interests in losses of consolidated subsidiary
    (245 )     (124 )
Stock based compensation
    300       389  
Changes in operating assets and liabilities:
               
Accounts receivable
    285       (13 )
Inventories
    13       (87 )
Prepaid expenses and other current assets
    (333 )     (536 )
Accounts payable
    (188 )     245  
Income taxes payable
    6       3  
Deferred revenue
    (612 )     (61 )
Accrued liabilities
    (4 )     495  
                 
Net cash used by operating activities
    (4,610 )     (2,988 )
                 
Investing activities
               
Purchases of property, plant and equipment
    (50 )     (102 )
                 
Net cash used by investing activities
    (50 )     (102 )
                 
Financing activities
               
Net cash provided by financing activities
           
                 
Decrease in cash and cash equivalents
    (4,660 )     (3,090 )
Cash and cash equivalents — beginning of period
    14,545       7,650  
                 
Cash and cash equivalents — end of period
  $ 9,885     $ 4,560  
                 
 
The accompanying notes are an integral part of the condensed consolidated financial statements.


F-51


 

MECHANICAL TECHNOLOGY, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
1. Nature of Operations
 
In the opinion of management of Mechanical Technology, Incorporated (the “Company”), the accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”) and contain all adjustments, consisting of normal, recurring adjustments, necessary for a fair statement of results for such periods. The results of operations for the interim periods presented are not necessarily indicative of results for the full year.
 
Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
 
The information presented in the accompanying condensed consolidated balance sheet as of December 31, 2007 has been derived from the Company’s audited consolidated financial statements but does not include all disclosures required by U.S. GAAP. All other information has been derived from the Company’s unaudited condensed consolidated financial statements for the periods as of and for the three months ended March 31, 2007 and 2008.
 
Liquidity and Going Concern
 
The Company incurred significant losses as it continued to fund the direct methanol fuel cell product development and commercialization programs of its majority owned subsidiary, MTI MicroFuel Cells Inc. (“MTI Micro”), and had an accumulated deficit of $108,253 thousand and working capital of $7,634 thousand at March 31, 2008. Because of these losses, limited current cash, cash equivalents and securities available for sale, negative cash flows and accumulated deficit, the report of the Company’s independent registered public accounting firm for the year ended December 31, 2007 expressed substantial doubt about the Company’s ability to continue as a going concern.
 
During 2007, the Company sold 1,452,770 shares of Plug Power Inc. (“Plug Power”) common stock with proceeds totaling $5,130 thousand and gains totaling $2,549 thousand. These proceeds reflect the Company’s previously announced strategy to raise additional capital through the sale of Plug Power common stock in order to fund MTI Micro operations.
 
Based on the Company’s projected cash requirements for operations and capital expenditures for 2008 and its current cash, cash equivalents and marketable securities of $8,097 thousand at March 31, 2008, management believes it will have adequate resources to fund operations and capital expenditures through October 2008 based on current cash and cash equivalents, current cash flow requirements, revenue and expense projections and the potential sale of securities available for sale at current market values.
 
However, the Company may need to do one or more of the following to raise additional resources, or reduce its cash requirements:
 
  •  reduce its current expenditure run-rate;
 
  •  sell additional shares of Plug Power;
 
  •  obtain additional government or private funding of the Company’s direct methanol fuel cell research, development, manufacturing readiness and commercialization;


F-52


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
1. Nature of Operations — (Continued)
 
 
  •  sell operating divisions of the Company; or
 
  •  secure additional equity financing.
 
There is no guarantee that such resources will be available to the Company on terms acceptable to it, or at all, or that such resources will be received in a timely manner, if at all, or that the Company will be able to reduce its expenditure run-rate without materially and adversely affecting its business.
 
2.  Accounting Policies
 
Changes in significant accounting policies since December 31, 2007 are as follows:
 
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). SFAS No. 159 provides companies with an option to report selected financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The adoption of this statement on January 1, 2008 did not have a material effect on the Company’s Consolidated Financial Statements as the Company did not elect to implement the fair value option for its marketable equity securities.
 
On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 applies to all financial instruments that are being measured and reported on a fair value basis. This includes financial assets including “Securities available for sale” (see Note 5) and financial liabilities including “Derivative liability” (see Note 16) on the balance sheet. As defined in SFAS No. 157, “fair value” is the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on the observability of the inputs used in the valuation methods, the Company is required to provide the following information according to the fair value hierarchy as specified by SFAS No. 157. This hierarchy ranks the quality and reliability of the information used to determine fair values.
 
Financial assets and liabilities are classified and disclosed in one of the following three categories:
 
Level 1:   Quoted market prices in active markets for identical assets or liabilities, which includes listed equities.
 
Level 2:   Observable market based inputs or unobservable inputs that are corroborated by market data. These items are typically priced using models or other valuation techniques. These models are primarily financial industry-standard models that consider various assumptions, including the time value of money, yield curves, volatility factors, as well as other relevant economic measures.
 
Level 3:   These use unobservable inputs that are not corroborated by market data. These values are generally estimated based upon methodologies utilizing significant inputs that are generally less observable from objective sources.


F-53


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
2.  Accounting Policies — (Continued)
 
 
In determining the appropriate levels, the Company performs a detailed analysis of financial assets and liabilities that are subject to SFAS No. 157. At each reporting period, all assets and liabilities for which the fair value measurements are based upon significant unobservable inputs are classified as Level 3.
 
The following is a summary of the Company’s fair value instruments categorized by their associated fair value input level:
 
                 
                Balance at
Balance Sheet Classification   Level 1   Level 2   Level 3   Mar. 31, 2008
    (dollars in thousands)
 
Financial Assets:
               
Securities available for sale
  $3,537   $–   $–   $3,537
                 
Total fair value of assets
  $3,537   $–   $–   $3,537
                 
Financial Liabilities:
               
Derivative liability
  $–   $–   $363   $363
                 
Total fair value of liabilities
  $–   $–   $363   $363
                 
 
The following is a rollforward of Level 3 fair value instruments for the three months ended March 31, 2008:
 
                 
        Total Gains /
  Purchases,
   
    Beginning
  (Losses)
  Issuances,
  Ending
    Balance as of
  Realized and
  Sales and
  Balance as of
Instrument   Jan. 1, 2008   Unrealized   Settlements   Mar. 31, 2008
    (dollars in thousands)
 
Derivative liability
  $696   $(333)   $–   $363
                 
Total Level 3 instruments
  $696   $(333)   $–   $363
                 
 
3.  Accounts Receivable
 
Receivable balances consist of the following at:
 
         
    Dec. 31,
  March 31,
    2007   2008
    (dollars in thousands)
 
U.S. and State Government
  $79   $449
Commercial
  1,290   933
         
Total
  $1,369   $1,382
         
 
For the three months ended March 31, 2007 and 2008, a single commercial customer represented 31.9% and 20.1%, respectively, and a U.S. governmental agency represented 21.4% and 18.3%, respectively, of the Company’s instrumentation segment product revenue. As of December 31,


F-54


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
3.  Accounts Receivable and Allowance for Doubtful Accounts — (Continued)
 
2007 and March 31, 2008, this commercial customer represented 46.8% and 29.0%, respectively, and U.S. governmental agency represented 0.2% and 27.2%, respectively, of the Company’s instrumentation segment accounts receivable.
 
4.  Inventories, net
 
Inventories, net consist of the following at:
 
         
    Dec. 31,
  March 31,
    2007   2008
    (dollars in thousands)
 
Finished goods
  $467   $421
Work in process
  168   280
Raw materials, net
  738   759
         
    $1,373   $1,460
         
 
5.   Securities Available for Sale
 
Securities available for sale are classified as current assets and accumulated net unrealized gains (losses) are charged to other comprehensive income (loss).
 
The principal components of the Company’s securities available for sale consist of the following at:
 
                                       
                Quoted Market Price
         
Security
  Cost Basis   Unrealized Gain   Recorded Fair Value   Per NASDAQ   Ownership     Shares
    (dollars in thousands, except market price and share data)
 
December 31, 2007
                                     
Plug Power
  $ 2,021   $ 2,471   $ 4,492   $ 3.95     1.29 %     1,137,166
                                       
March 31, 2008
                                     
Plug Power
  $ 2,021   $ 1,516   $ 3,537   $ 3.11     1.29 %     1,137,166
                                       
 
The book basis roll forward of Plug Power securities is as follows:
 
               
    Dec. 31,
    March 31,
    2007     2008
    (dollars in thousands)
 
Securities available for sale, beginning of period
  $ 4,602     $ 2,021
Sale of shares
    (2,581 )    
               
Securities cost basis
    2,021       2,021
Unrealized gain on securities available for sale, net of taxes
    2,471       1,516
               
Securities available for sale, end of period
  $ 4,492     $ 3,537
               


F-55


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
5.   Securities Available for Sale — (Continued)
 
Accumulated unrealized gains related to Plug Power securities available for sale are as follows:
 
                 
    Dec. 31,
    March 31,
 
    2007     2008  
    (dollars in thousands)  
 
Accumulated unrealized gains
  $ 2,471     $ 1,516  
Accumulated deferred tax expense on unrealized gains
    (1,971 )     (1,971 )
                 
Accumulated net unrealized gains
  $ 500     $ (455 )
                 
 
The accumulated deferred tax expense on unrealized gains includes allocated taxes for the disproportionate effect of unrealized gains recorded prior to the Company recording a full valuation allowance against its deferred tax assets during 2006.
 
6.   Income Taxes
 
The Company’s effective income tax (expense) rate from operations differed from the Federal statutory rate for each of the three months ended March 31 as follows:
 
                 
    2007     2008  
    (dollars in thousands)  
 
Federal statutory tax rate
    34.00 %     34.00 %
State taxes, net of federal tax effect
    5.79       5.84  
Change in valuation allowance
    (51.43 )     (44.03 )
Permanent tax difference on derivative valuation
    11.43       4.03  
Other, net
    (0.12 )     (0.09 )
                 
Tax Rate
    (0.33 )%     (0.25 )%
                 
 
Income tax (expense) benefit for the three months ended March 31 consists of the following:
 
                 
    2007     2008  
    (dollars in thousands)  
 
Operations before minority interest
               
State
    (11 )     (8 )
                 
Total
  $ (11 )   $ (8 )
                 
 
The valuation allowance at December 31, 2007 and March 31, 2008 was $22,333 thousand and $24,170 thousand, respectively, and represents a full valuation allowance. The valuation allowance reflects the estimate that it is more likely than not that the net deferred tax assets in excess of deferred tax liabilities may not be realized.


F-56


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
7.   Stockholders’ Equity
 
Changes in common shares issued and treasury stock outstanding are as follows:
 
         
    Year Ended
  Three Months Ended
    Dec. 31, 2007   March 31, 2008
 
Common Shares
       
Balance, beginning
  5,760,585   5,777,578
Issuance of shares for stock option exercises
  10,743  
Issuance of shares for restricted and unrestricted stock grants
  6,875  
Forfeiture of restricted stock grant
  (625)  
         
Balance, ending
  5,777,578   5,777,578
         
 
Warrants
 
On December 20, 2006, the Company issued warrants to investors to purchase 378,472 shares of the Company’s common stock at an exercise price of $18.16 per share. These warrants will be fair valued by the Company until expiration or exercise of the warrants. The warrants became exercisable on June 30, 2007 and expire on December 19, 2011.
 
Reservation of Shares
 
The Company has reserved common shares for future issuance as of March 31, 2008 as follows:
 
     
Stock options outstanding
  762,391
Stock options available for issuance
  136,886
Warrants outstanding
  378,472
     
Number of common shares reserved
  1,277,749
     


F-57


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
8.   Loss per Share
 
The following table sets forth the reconciliation of the numerators and denominators of the basic and diluted per share computations for the three months ended March 31:
 
                 
    2007     2008  
    (dollars in thousands, except shares)  
 
Numerator:
               
Net loss
  $ (3,156 )   $ (3,187 )
                 
Denominator:
               
Basic EPS:
               
Common shares outstanding, beginning of period
    4,755,493       4,772,486  
Less weighted average non-vested restricted stock
    (625 )     (625 )
                 
Denominator for basic earnings per common shares —
               
Weighted average common shares
    4,754,868       4,771,861  
                 
Diluted EPS:
               
Common shares outstanding, beginning of period
    4,755,493       4,772,486  
Less weighted average non-vested restricted stock due to anti-dilutive effect
    (625 )     (625 )
                 
Denominator for diluted earnings per common shares —
               
Weighted average common shares
    4,754,868       4,771,861  
                 
 
Not included in the computation of earnings per share-assuming dilution for the three months ended March 31, 2007 were options to purchase 697,092 shares of the Company’s common stock, warrants to purchase 378,472 shares of the Company’s stock, 625 unvested restricted shares of the Company’s common stock and options to purchase 29,168 shares of MTI Micro’s common stock. These potentially dilutive items were excluded because the Company incurred a loss for this period and their inclusion would be anti-dilutive.
 
Not included in the computation of earnings per share-assuming dilution for the three months ended March 31, 2008 were options to purchase 762,391 shares of the Company’s common stock, warrants to purchase 378,472 shares of the Company’s stock, 625 unvested restricted shares of the Company’s common stock and options to purchase 22,668 shares of MTI Micro’s common stock. These potentially dilutive items were excluded because the Company incurred a loss for this period and their inclusion would be anti-dilutive.
 
9.   Stock-Based Compensation
 
During the three month period ended March 31, 2008, the Company granted approximately 563 stock options with a weighted average fair value per share of $3.68. The total number of outstanding non-vested restricted stock awards was 625 at both December 31, 2007 and March 31, 2008.


F-58


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
9.   Stock-Based Compensation — (Continued)
 
Total stock-based compensation expense related to all of the Company’s stock-based awards, recognized for the three months ended March 31, 2007 and 2008, was comprised as follows:
 
                 
    2007     2008  
    (dollars in thousands)  
 
Unfunded research and product development B
  $ (6 )   $ 42  
Selling, general and administrative
    306       347  
                 
Stock-based compensation expense before taxes
    300       389  
Related income tax benefits A
           
                 
Stock-based compensation expense, net of taxes
  $ 300     $ 389  
                 
 
 
A Income tax effect is zero due to the Company maintaining a full valuation allowance.
 
B Expense was negative for period due to the impact of option forfeiture expense reversals for unvested options exceeding the recurring expense for the period.
 
Unrecognized compensation costs related to non-vested awards as of March 31, 2008 is $1,252 thousand for stock options and $2 thousand for restricted stock, and is expected to be recognized over a weighted average vesting period of approximately 1.27 years.
 
The fair value of stock option awards is estimated on the date of grant using a Black-Scholes Pricing Model with the following weighted average assumptions for the three months ended March 31:
 
                 
    2007     2008  
 
Expected life of options (years)
    3.51       5.38  
Risk free interest rate range
    4.50-4.51 %     2.58-3.13 %
Expected volatility of stock
    75.23 %     76.00 %
Expected dividend yield
    None       None  
 
The fair value of restricted stock awards is determined using the intrinsic value of the award on the date of grant.
 
10.   Cash Flows — Supplemental Information
 
                 
    Three Months Ended
 
    March 31,  
    2007     2008  
    (dollars in thousands)  
 
Non-cash Operating, Investing and Financing Activities:
               
Change in investment and paid-in-capital resulting from other investors’ activity in MTI Micro stock
  $ (180 )   $ (5 )
                 
 
11.   Segment Information
 
The Company operates in two business segments, New Energy and Test and Measurement Instrumentation. The New Energy segment is focused on commercializing direct methanol fuel cells. The Test and Measurement Instrumentation segment designs, manufactures, markets and services


F-59


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
11.   Segment Information — (Continued)
 
computer-based balancing systems for aircraft engines, high performance test and measurement instruments and systems, and wafer characterization tools for the semiconductor industry. The Company’s principal operations are located in North America.
 
The accounting policies of the New Energy and Test and Measurement Instrumentation segments are similar to those described in the summary of significant accounting policies in the Company’s Annual Report on Form 10-K. The Company evaluates performance based on profit or loss from operations before income taxes, accounting changes, items management does not deem relevant to segment performance, and interest income and expense. Inter-segment sales and expenses are not significant.
 
Summarized financial information concerning the Company’s reportable segments is shown in the following table. The “Other” column includes corporate related items and items such as income taxes or unusual items, which are not allocated to reportable segments. The “Reconciling Items” column includes minority interests in a consolidated subsidiary. In addition, segments’ non-cash items include any depreciation and amortization in reported profit or loss. The New Energy segment figures include the Company’s equity securities of Plug Power and gains on the sale of these securities.
 
                                         
          Test and
                Condensed
 
          Measurement
          Reconciling
    Consolidated
 
    New Energy     Instrumentation     Other     Items     Totals  
    (dollars in thousands)  
 
Three months ended March 31, 2007
                                       
Product revenue
  $     $ 1,701     $     $     $ 1,701  
Funded research and development revenue
    615                         615  
Research and product development expenses
    3,269       353                   3,622  
Selling, general and administrative expenses
    618       631       1,207             2,456  
Segment loss from operations before income taxes and minority interests
    (4,058 )     (148 )     816             (3,390 )
Segment (loss) profit
    (4,058 )     (148 )     805       245       (3,156 )
Total assets
    10,833       2,752       12,725             26,310  
Securities available for sale
    8,184                         8,184  
Capital expenditures
    31       2       17             50  
Depreciation and amortization
    183       27       83             293  
                                         
Three months ended March 31, 2008
                                       
Product revenue
  $     $ 1,980     $     $     $ 1,980  
Funded research and development revenue
    173                         173  
Research and product development expenses
    1,891       482                   2,373  
Selling, general and administrative expenses
    928       757       933             2,618  
Segment loss from operations before income taxes and minority interests
    (3,394 )     (232 )     323             (3,303 )
Segment (loss) profit
    (3,394 )     (232 )     315       124       (3,187 )
Total assets
    6,406       3,076       5,330             14,812  
Securities available for sale
    3,537                         3,537  
Capital expenditures
    52       50                   102  
Depreciation and amortization
    167       33       21             221  


F-60


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
11.   Segment Information — (Continued)
 
The following table presents the details of “Other” segment (loss) profit:
 
                 
    Three Months Ended
 
    March 31,  
    2007     2008  
    (dollars in thousands)  
 
Corporate and other (expenses) income:
               
Depreciation and amortization
  $ (83 )   $ (21 )
Interest income
    138       43  
Gain on derivatives
    969       333  
Income tax (expense) benefit
    (11 )     (8 )
Other expense, net
    (208 )     (32 )
                 
Total income (expense)
  $ 805     $ 315  
                 
 
12.   Restructuring
 
In March 2007, the Company announced the suspension of MTI Micro’s high power direct methanol fuel cell program in response to decreased funding and sales opportunities in the military market. In connection with this action, the Company accrued and paid restructuring charges of $340 thousand pre-tax, consisting primarily of cash-based employee severance and benefit costs related to the reduction of 23 positions within its New Energy segment and corporate staff. Restructuring expenses were classified as selling, general and administrative expenses within the Company’s Condensed Consolidated Statements of Operations for the period.
 
13.   Effect of Recent Accounting Pronouncements
 
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (“SFAS No. 161”). SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedging items are accounted for under SFAS No. 133 and its related interpretations, and (c) how derivative instruments and related hedging items affect an entity’s financial position, financial performance, and cash flows. This statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2008. This statement will be effective for the Company for its fiscal year beginning January 1, 2009. The Company has not yet determined the impact, if any, of this statement on its Consolidated Financial Statements.
 
In December 2007, the FASB issued SFAS No. 141R, Business Combinations — a replacement of FASB Statement No. 141 (“SFAS No. 141R”), which significantly changes the principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective prospectively, except for certain retrospective adjustments to deferred tax


F-61


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
13.   Effect of Recent Accounting Pronouncements — (Continued)
 
balances, for fiscal years beginning after December 15, 2008. This statement will be effective for the Company for its fiscal year beginning January 1, 2009. The Company has not yet determined the impact, if any, of this statement on its Consolidated Financial Statements.
 
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51 (“SFAS No. 160”). SFAS No. 160 requires that accounting and reporting for minority interests will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS No. 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. This statement is effective as of the beginning of an entity’s first fiscal year beginning after December 15, 2008. This statement will be effective for the Company for its fiscal year beginning January 1, 2009. Based upon the March 31, 2008 balance sheet, the impact of adopting SFAS No. 160 would be to reclassify $25 thousand from minority interests in consolidated subsidiaries to the Company’s stockholders’ equity section as a separate component of stockholders’ equity.
 
14.   Commitments and Contingencies
 
Lawrence Litigation
 
On September 9, 1998, Barbara Lawrence, the Lawrence Group, Inc. (“Lawrence”) and certain other Lawrence-related entities (“Plaintiffs”) initially filed suit in the United States Bankruptcy Court for the Northern District of New York (“Bankruptcy Court”) and the United States District Court for the Northern District of New York (“District Court”), which were subsequently consolidated in the District Court, against First Albany Corporation, now known as Broadpoint Capital, Inc. (“BCI”), the Company, Dale Church, Edward Dohring, Beno Sternlicht, Alan Goldberg and George McNamee (Church, Dohring, Sternlicht, Goldberg and McNamee are former Directors of the Company), Marty Mastroianni (former President and Chief Operating Officer of the Company) and 33 other individuals (“Defendants”) who purchased a total of 820,909 shares (307,841 post-split) of the Company’s stock from the Plaintiffs. The case concerns the Defendants’ 1997 purchase of the Company’s common stock from the Plaintiffs at the price of $2.25 per share ($6.00 per share post split). BCI acted as Placement Agent in connection with the negotiation and sale of the shares, including in proceedings before the Bankruptcy Court, which approved the sale in September 1997.
 
Plaintiffs claim that the Defendants failed to disclose material inside information to the Plaintiffs in connection with the sale and that the $2.25 per share ($6.00 per share post split) purchase price was unfair. Plaintiffs are seeking damages of $5 million plus punitive damages and costs. In April 1999, Defendants filed a motion to dismiss the amended complaint, which was denied by the Bankruptcy Court. On appeal in October 2000, Plaintiffs’ claims were dismissed by the District Court. In November 2000, Plaintiffs filed an appeal of that dismissal with the United States Court of Appeals for the Second Circuit. In June 2002, the Second Circuit Court of Appeals reversed the District Court decision in part and remanded the case for further consideration of the Plaintiffs’ claims as motions to modify the Bankruptcy Court sale order. The Plaintiffs’ claims have now been


F-62


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
14.   Commitments and Contingencies — (Continued)
 
referred back to Bankruptcy Court for such consideration. By order and decision dated September 30, 2003, the Bankruptcy Court allowed certain limited discovery to proceed, and this process is still underway.
 
The Company believes the claims have no merit and intends to defend them vigorously. The Company cannot predict the outcome of the claims nor reasonably estimate a range of possible loss given the current status of the litigation. Accordingly, no amounts have been reserved for this matter.
 
Leases
 
The Company’s future minimum rental payments required under non-cancelable operating leases are (dollars in thousands): $537 remaining in 2008, $652 in 2009, $1 in 2010 and $0 in years 2011 through 2013.
 
Warranties
 
Below is a reconciliation of changes in product warranty liabilities:
 
                 
    Three Months Ended
 
    March 31,  
    2007     2008  
    (Dollars in thousands)  
 
Balance, January 1
  $ 19     $ 72  
Accruals for warranties issued
    17       15  
Settlements made (in cash or in kind)
    (24 )     (10 )
                 
Balance, end of period
  $ 12     $ 77  
                 
 
Licenses
 
On January 24, 2008, the Company cancelled its non-exclusive licensing agreement with Los Alamos National Laboratory (“LANL”) covering certain direct methanol fuel cell technology. This agreement, which was last amended on May 17, 2006, prescribed annual license fees ranging from $35,000 in 2008 to $100,000 in 2019. The Company paid and recognized a one-time expense of $50,000 to cancel the agreement, and no future license fees or royalties will be owed to LANL. The Company cancelled this agreement because it no longer considers the direct methanol fuel cell technology licensed from LANL to be applicable to its future products.
 
Employment Agreements
 
The Company has employment agreements with certain employees that provide severance payments, certain other payments, accelerated vesting and exercise extension periods of certain options upon termination of employment under certain circumstances, as defined in the applicable agreements. As of March 31, 2008, the Company’s potential minimum cash obligation to these employees was approximately $810 thousand.


F-63


 

 
MECHANICAL TECHNOLOGY, INCORPORATED
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) — (Continued)
 
15.   Issuance of Stock by Subsidiary
 
MTI Micro was formed on March 26, 2001 and as of March 31, 2008, the Company owns approximately 96% of MTI Micro’s outstanding common stock.
 
On March 1, 2008, MTI Micro issued 8,653 shares of its common stock at a price of $0.68 per share to the Company as compensation for the minority shareholder benefit in connection with the Company issuing its options to MTI Micro employees.
 
The decrease in the Company’s paid-in-capital of $180 thousand and $5 thousand in 2007 and 2008, respectively, represents the changes in the Company’s equity investment in MTI Micro, which resulted from the anti-dilutive impact of the Company’s investments into and any third-party stock transactions in MTI Micro stock.
 
16.   Derivatives
 
The Company held or has outstanding the following derivative financial instruments:
 
                         
    Dec. 31,
    March 31,
       
    2007     2008     Expiration  
 
Derivatives issued:
                       
Warrants, exercisable beginning June 20, 2007, to purchase the Company’s common stock issued to three investors at a purchase price of $18.16 per share
    378,472       378,472       12/19/2011  
 
The estimated fair value of this warrant at the date issued was $10.16 per share, using a Black-Scholes Option Pricing model and assumptions similar to those used for valuing the Company’s employee stock-based compensation. The fair value of the derivative is recorded in the “Derivative Liability” line on its financial statements, and is valued quarterly using the Black-Scholes Option Pricing Model. The assumptions used for the valuations were as follows:
 
                 
    Dec. 31,
    March 31,
 
    2007     2008  
 
Expected life of option (number of days)
    1,450       1,359  
Risk-free interest rate
    3.45 %     2.46 %
Expected volatility of stock
    73.46 %     74.86 %
Expected dividend yield
    None       None  
 
The Company recognizes changes in fair value in its Consolidated Statements of Operations in the line titled “Gain on derivatives.”
 
17.   Subsequent Events
 
From April 1 through May 9, 2008, the Company sold securities available for sale as follows:
 
                 
    Number of
  Proceeds
Security
 
Shares Sold
 
from Sales
        (dollars in thousands)
 
Plug Power     427,209     $ 1,437  


F-64


 

(MICROFUEL CELLS)


 

 
 
$12,000,000
% Convertible Senior Notes due          
and
Warrants to Purchase           Shares of Common Stock
 
 
Mechanical Technology, Incorporated
 
 
 
(MTI LOGO)
 
 
 
Merriman Curhan Ford & Co.
 
          , 2008
 


 

PART II. INFORMATION NOT REQUIRED IN PROSPECTUS
 
Item 13.  Other expenses of issuance and distribution.
 
The following table sets forth all expenses payable by us in connection with the offering of the units being registered, other than underwriting discounts and commissions. All of the amounts shown are estimates except the Securities and Exchange Commission registration fee.
 
     
SEC registration fee
  $542
FINRA filing fee
  $3,500
Printing and engraving
  $60,000
Legal fees and expenses
  $155,000
Accounting fees and expenses
  $75,000
Trustee, transfer agent and registrar fees
  $3,500
Miscellaneous
  $7,458
     
Total
  $305,000
     
 
Item 14.  Indemnification of directors and officers.
 
Pursuant to the statutes of the State of New York, a director or officer of a corporation is entitled, under specified circumstances, to indemnification by the corporation against reasonable expenses, including attorney’s fees, incurred by him/her in connection with the defense of a civil or criminal proceeding to which he/she has been made, or threatened to be made, a party by reason of the fact that he/she was such director or officer. In certain circumstances, indemnity is provided against judgments, fines and amounts paid in settlement. In general, indemnification is available where the director or officer acted in good faith, for a purpose he/she reasonably believed to be in the best interests of the corporation. Specific court approval is required in some cases. The foregoing statement is subject to the detailed provisions of Sections 715, 717 and 721-725 of the New York Business Corporation Law.
 
Under provisions of our certificate of incorporation, MTI shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, proceeding or suit (including one by or in the right of MTI to procure a judgment in its favor), whether civil or criminal, by reason of the fact that he, his testator or interstate is or was a director or officer of MTI, or is or was serving any other corporation, partnership, joint venture, trust, employee benefit plan or other enterprise in any capacity at the request of MTI, against judgments, fines, amounts paid in settlement and expenses, including attorneys’ fees, actually incurred as a result of or in connection with any such action, proceeding or suit, or any appeal therefrom, if such director or officer acted in good faith for a purpose which he reasonably believed to be in or not opposed to the best interests of MTI, and, in criminal actions or proceedings, in which he had no reasonable cause to believe that his conduct was unlawful; provided, however, that no indemnification shall be made to or on behalf of any director or officer if a judgment or other final adjudication adverse to the director or officer establishes that his acts were committed in bad faith or were the result of active and deliberate dishonesty and were material to the cause of action so adjudicated, or that he personally gained a financial profit or other advantage to which he was not legally entitled.
 
The directors and officers of MTI are covered by insurance policies indemnifying against certain liabilities, including certain liabilities arising under the Securities Act that might be incurred by them in such capacities.


II-1


 

Item 15.  Recent sales of unregistered securities.
 
In connection with provisions of a private placement agreement entered into with Fletcher International, Ltd. or Fletcher, in 2004, we were required to issue shares of our common stock without payment to Fletcher upon the occurrence of certain events, including subsequent dilutive equity issuances. Pursuant to a letter agreement dated as of December 7, 2006, the dilutive issuance provision of Fletcher’s private placement agreement was amended to reduce by 25% the number of shares to be issued under any subsequent dilutive issuances. The capital raise that occurred in December 2006 was considered a dilutive issuance under the Fletcher agreement, so we issued 33,414 shares of our common stock to Fletcher. We issued these shares of common stock to Fletcher in reliance upon Section 4(2) of the Securities Act of 1933 as a transaction by an issuer not involving a public offering. We did not pay or give, directly or indirectly, any commission or other remuneration, including underwriting discounts or commissions, in connection with any of the issuances of the shares listed above. In addition, each of the share certificates issued in the transaction listed above at the time of issuance bore a restrictive legend permitting the transfer thereof only in compliance with applicable securities laws. The recipients of securities in each of these transactions listed above represented to us their intention to acquire the securities for investment only and not with view to or for sale in connection with any distribution thereof. All recipients had adequate access, through their relationship with us or through other access to information provided by us, to information about our company.
 
Item 16.  Exhibits and Financial Statement Schedules.
 
The following exhibits are filed herewith or incorporated by reference:
 
         
Exhibit
   
Number  
Description
 
  1 .1   Form of Underwriting Agreement.**
  3 .1   Certificate of Incorporation of the registrant, as amended. (22)(23)
  3 .3   By-Laws of the registrant, as amended and restated. (21)
  4 .1   Form of Common Stock Purchase Warrant (December 2006 offering). (17)
  4 .2   Form of Common Stock Purchase Warrant.
  4 .3   Form of Indenture.**
  5 .1   Opinion of Orrick, Herrington & Sutcliffe LLP.**
  10 .14   Mechanical Technology, Incorporated 1996 Stock Incentive Plan. (1)
  10 .30   Mechanical Technology, Incorporated 1999 Employee Stock Incentive Plan. (2)
  10 .38   Lease dated August 10, 1999 between Carl E. Touhey and Mechanical Technology, Inc. (3)
  10 .43   Lease dated April 2, 2001 between Kingfisher LLC and Mechanical Technology, Inc. (4)
  10 .44   First Amendment to lease dated March 13, 2003 between Kingfisher LLC and Mechanical Technology, Inc. (5)
  10 .119†   Strategic Alliance Agreement, dated as of September 19, 2003, between The Gillette Company and MTI MicroFuel Cells Inc. (6)
  10 .123   Amendment to the Strategic Alliance Agreement between The Gillette Company and MTI MicroFuel Cells Inc. dated August 18, 2004. (8)
  10 .131   Amendment No. 2 to the Strategic Alliance Agreement between The Gillette Company and MTI MicroFuel Cells Inc. dated June 20, 2005. (9)
  10 .132   Second Amendment to lease dated December 12, 2005 between Kingfisher, LLC and Mechanical Technology, Incorporated. (10)
  10 .136   Employment Agreement dated September 25, 2002 between Cynthia A. Scheuer and Mechanical Technology, Incorporated and MTI MicroFuel Cells Inc. (11)


II-2


 

         
Exhibit
   
Number  
Description
 
  10 .139   Employment Agreement dated May 4, 2006 between Peng K. Lim and MTI MicroFuel Cells Inc. (13)
  10 .140   Form of Restricted Stock Agreement for the 1996 and 1999 Mechanical Technology, Incorporated Stock Incentive Plans. (14)
  10 .141†   Alliance Agreement dated May 16, 2006 between MTI MicroFuel Cells Inc. and Samsung Electronics Co., Ltd. (15)
  10 .142   Third Amendment to lease dated August 7, 2006 between Kingfisher, LLC and Mechanical Technology, Incorporated. (15)
  10 .143†   Amendment No. 3 to the Strategic Alliance Agreement dated September 13, 2006, between MTI MicroFuel Cells Inc. and The Gillette Company. (16)
  10 .145   Mechanical Technology, Incorporated 2006 Equity Incentive Plan. (12)
  10 .146   Separation Agreement dated March 20, 2007 between Russel Marvin and MTI MicroFuel Cells Inc. (18)
  10 .148   Fourth Amendment to lease dated August 6, 2007 between Kingfisher LLC and Mechanical Technology, Incorporated. (19)
  10 .150   Future Collaboration Agreement dated October 22, 2007 between MTI MicroFuel Cells Inc. and Samsung Electronics Co., Ltd. (20)
  10 .151   Employment Agreement dated April 3, 2006 between James K. Prueitt and MTI MicroFuel Cells Inc. (22)
  10 .152   Warrant Agent Agreement dated June 10, 2008 between Mechanical Technology, Incorporated and American Stock Transfer and Trust Company, as Warrant Agent.
  12 .1   Statement Regarding Computation of Ratio of Earnings to Fixed Charges.
  21     Subsidiaries of the Registrant. (7)
  23 .1   Consent of Orrick, Herrington & Sutcliffe LLP (contained in Exhibit 5.1).**
  23 .2   Consent of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP.
  24     Power of attorney (contained on Signature Page to this Registration Statement).*
  25 .1   Form T-1: Statement of Eligibility of Trustee.**
 
 
*  Previously filed.
 
** To be filed by amendment.
 
†   Certain portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission.
 
Certain exhibits were previously filed (as indicated below) and are incorporated herein by reference. All other exhibits for which no other filing information is given are filed herewith.
 
  (1)  Filed as Appendix A to the registrant’s Definitive Proxy Statement Schedule 14A filed November 19, 1996.
 
  (2)  Filed as an Exhibit to the registrant’s Proxy Statement, Schedule 14A, dated February 13, 1999.
 
  (3)  Filed as an Exhibit to the registrant’s Form 10-K Report for the fiscal year ended September 30, 1999.
 
  (4)  Filed as an Exhibit to the registrant’s Form 10-K Report for the fiscal year ended September 30, 2001.
 
  (5)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2002.
 
  (6)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its fiscal quarter ended September 30, 2003.
 
  (7)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2003.

II-3


 

 
  (8)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended September 30, 2004.
 
  (9)  Filed as an Exhibit to the registrant’s Form 8-K Report dated June 20, 2005.
 
(10)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 12, 2005.
 
(11)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2005.
 
(12)  Filed as an Exhibit to the registrant’s Proxy Statement, Schedule 14A, dated April 3, 2006.
 
(13)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 4, 2006.
 
(14)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 18, 2006.
 
(15)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended June 30, 2006.
 
(16)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended September 30, 2006.
 
(17)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 15, 2006.
 
(18)  Filed as an Exhibit to the registrant’s Form 8-K Report dated March 22, 2007.
 
(19)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended June 30, 2007.
 
(20)  Filed as an Exhibit to the registrant’s Form 8-K Report dated October 25, 2007.
 
(21)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 14, 2007.
 
(22)  Filed as an Exhibit to the registrant’s Form 10-K for the year ended December 31, 2007.
 
(23)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 15, 2008.
 
Item 17.   Undertakings.
 
Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue.
 
The undersigned Registrant hereby undertakes the following:
 
(1)  for purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in the form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective; and
 
(2)  for the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.


II-4


 

SIGNATURES
 
Pursuant to the requirements of the Securities Act of 1933, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Albany, state of New York, on July 3, 2008.
 
     
Date: July 3, 2008
  MECHANICAL TECHNOLOGY, INCORPORATED
     
   
By: 
/s/  Peng K. Lim

Peng K. Lim
Chairman and Chief Executive Officer
 
Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed by the following persons in the capacities and on the dates indicated.
 
             
Signature
 
Title
 
Date
 
         
/s/  Peng K. Lim

Peng K. Lim
  Chairman and Chief Executive Officer
(Principal Executive Officer)
  July 3, 2008
         
/s/  Cynthia A. Scheuer

Cynthia A. Scheuer
  Vice President, Chief Financial Officer, and Secretary (Principal Financial and Accounting Officer)   July 3, 2008
         
/s/  Thomas J. Marusak*

Thomas J. Marusak
  Director   July 3, 2008
         
/s/  William P. Phelan*

William P. Phelan
  Director   July 3, 2008
         
/s/  E. Dennis O’Connor*

E. Dennis O’Connor
  Director   July 3, 2008
         
/s/  Walter L. Robb*

Dr. Walter L. Robb
  Director   July 3, 2008
 
     
*by: 
/s/  Cynthia A. Scheuer

Cynthia A. Scheuer, Attorney-in-fact
   


II-5


 

EXHIBIT INDEX
 
         
Exhibit
   
Number  
Description
 
  1 .1   Form of Underwriting Agreement.**
  3 .1   Certificate of Incorporation of the registrant, as amended. (22)(23)
  3 .3   By-Laws of the registrant, as amended and restated. (21)
  4 .1   Form of Common Stock Purchase Warrant (December 2006 offering). (17)
  4 .2   Form of Common Stock Purchase Warrant.
  4 .3   Form of Indenture.**
  5 .1   Opinion of Orrick, Herrington & Sutcliffe LLP.**
  10 .14   Mechanical Technology, Incorporated 1996 Stock Incentive Plan. (1)
  10 .30   Mechanical Technology, Incorporated 1999 Employee Stock Incentive Plan. (2)
  10 .38   Lease dated August 10, 1999 between Carl E. Touhey and Mechanical Technology, Inc. (3)
  10 .43   Lease dated April 2, 2001 between Kingfisher LLC and Mechanical Technology, Inc. (4)
  10 .44   First Amendment to lease dated March 13, 2003 between Kingfisher LLC and Mechanical Technology, Inc. (5)
  10 .119†   Strategic Alliance Agreement, dated as of September 19, 2003, between The Gillette Company and MTI MicroFuel Cells Inc. (6)
  10 .123   Amendment to the Strategic Alliance Agreement between The Gillette Company and MTI MicroFuel Cells Inc. dated August 18, 2004. (8)
  10 .131   Amendment No. 2 to the Strategic Alliance Agreement between The Gillette Company and MTI MicroFuel Cells Inc. dated June 20, 2005. (9)
  10 .132   Second Amendment to lease dated December 12, 2005 between Kingfisher, LLC and Mechanical Technology, Incorporated. (10)
  10 .136   Employment Agreement dated September 25, 2002 between Cynthia A. Scheuer and Mechanical Technology, Incorporated and MTI MicroFuel Cells Inc. (11)
  10 .139   Employment Agreement dated May 4, 2006 between Peng K. Lim and MTI MicroFuel Cells Inc. (13)
  10 .140   Form of Restricted Stock Agreement for the 1996 and 1999 Mechanical Technology, Incorporated Stock Incentive Plans. (14)
  10 .141†   Alliance Agreement dated May 16, 2006 between MTI MicroFuel Cells Inc. and Samsung Electronics Co., Ltd. (15)
  10 .142   Third Amendment to lease dated August 7, 2006 between Kingfisher, LLC and Mechanical Technology, Incorporated. (15)
  10 .143†   Amendment No. 3 to the Strategic Alliance Agreement dated September 13, 2006, between MTI MicroFuel Cells Inc. and The Gillette Company. (16)
  10 .145   Mechanical Technology, Incorporated 2006 Equity Incentive Plan. (12)
  10 .146   Separation Agreement dated March 20, 2007 between Russel Marvin and MTI MicroFuel Cells Inc. (18)
  10 .148   Fourth Amendment to lease dated August 6, 2007 between Kingfisher LLC and Mechanical Technology, Incorporated. (19)
  10 .150   Future Collaboration Agreement dated October 22, 2007 between MTI MicroFuel Cells Inc. and Samsung Electronics Co., Ltd. (20)
  10 .151   Employment Agreement dated April 3, 2006 between James K. Prueitt and MTI MicroFuel Cells Inc. (22)


 

         
Exhibit
   
Number  
Description
 
  10 .152   Warrant Agent Agreement dated June 10, 2008 between Mechanical Technology, Incorporated and American Stock Transfer and Trust Company, as Warrant Agent.
  12 .1   Statement Regarding Computation of Ratio of Earnings to Fixed Charges.
  21     Subsidiaries of the Registrant. (7)
  23 .1   Consent of Orrick, Herrington & Sutcliffe LLP (contained in Exhibit 5.1).**
  23 .2   Consent of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP.
  24     Power of attorney (contained on Signature Page to this Registration Statement).*
  25 .1   Form T-1: Statement of Eligibility of Trustee.**
 
 
*  Previously filed.
 
** To be filed by amendment.
 
†   Certain portions of this exhibit have been omitted pursuant to a request for confidential treatment filed with the Securities and Exchange Commission.
 
Certain exhibits were previously filed (as indicated below) and are incorporated herein by reference. All other exhibits for which no other filing information is given are filed herewith.
 
  (1)  Filed as Appendix A to the registrant’s Definitive Proxy Statement Schedule 14A filed November 19, 1996.
 
  (2)  Filed as an Exhibit to the registrant’s Proxy Statement, Schedule 14A, dated February 13, 1999.
 
  (3)  Filed as an Exhibit to the registrant’s Form 10-K Report for the fiscal year ended September 30, 1999.
 
  (4)  Filed as an Exhibit to the registrant’s Form 10-K Report for the fiscal year ended September 30, 2001.
 
  (5)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2002.
 
  (6)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its fiscal quarter ended September 30, 2003.
 
  (7)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2003.
 
  (8)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended September 30, 2004.
 
  (9)  Filed as an Exhibit to the registrant’s Form 8-K Report dated June 20, 2005.
 
(10)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 12, 2005.
 
(11)  Filed as an Exhibit to the registrant’s Form 10-K Report for the year ended December 31, 2005.
 
(12)  Filed as an Exhibit to the registrant’s Proxy Statement, Schedule 14A, dated April 3, 2006.
 
(13)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 4, 2006.
 
(14)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 18, 2006.
 
(15)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended June 30, 2006.
 
(16)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended September 30, 2006.
 
(17)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 15, 2006.
 
(18)  Filed as an Exhibit to the registrant’s Form 8-K Report dated March 22, 2007.
 
(19)  Filed as an Exhibit to the registrant’s Form 10-Q Report for its quarter ended June 30, 2007.
 
(20)  Filed as an Exhibit to the registrant’s Form 8-K Report dated October 25, 2007.
 
(21)  Filed as an Exhibit to the registrant’s Form 8-K Report dated December 14, 2007.
 
(22)  Filed as an Exhibit to the registrant’s Form 10-K for the year ended December 31, 2007.
 
(23)  Filed as an Exhibit to the registrant’s Form 8-K Report dated May 15, 2008.