SATC Satcon Technology Corp. (MM)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended March 31, 2012

Commission File Number 1-11512

SATCON TECHNOLOGY CORPORATION

(Exact name of registrant as specified in its charter)

(617) 897-2400

(Registrant’s telephone number, including area code)

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

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $0.01 Par Value,

144,053,553 shares outstanding as of April 30, 2012.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SATCON TECHNOLOGY CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT AND COMPREHENSIVE LOSS

For the Three Months Ended March 31, 2012

(Unaudited)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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SATCON TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

The accompanying notes are an integral part of these unaudited consolidated financial statements.

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SATCON TECHNOLOGY CORPORATION

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2012 (“2012”) AND MARCH 31, 2011 (“2011”)

(Unaudited)

Note A. Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Satcon and its wholly owned subsidiaries (Satcon Power Systems Canada, Ltd.  and Satcon Trading (Shenzhen) Co., Ltd.) (collectively, the “Company”) as of March 31, 2012 and for the three months ended March 31, 2012 and 2011, and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All intercompany accounts and transactions have been eliminated. These unaudited consolidated financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year.

Note B. Realization of Assets and Liquidity

The Company has developed a business plan that envisions an increase in assets and revenue from the results experienced in the recent past. This plan includes announced reductions in our global workforce of approximately 35% by closing its Canada manufacturing facility and resizing its infrastructure in Europe, China and the U.S. The Company expects these reductions will be completed by June 30, 2012. The Company has also focused product design, commercial sales and marketing on its best performing markets in North America and Asia, and will be moving a significant portion of international sales and marketing to a partnership model. The Company’s cost reduction program also includes optimizing the design of its Prism Platform solutions and transferring more subassembly work to Asia. These actions reset the Company’s expense structure to much lower levels. In addition, the Company has reduced the amount of working capital held on the Company’s balance sheet by bringing down inventory and accounts receivable to more normalized levels. The Company believes that its existing plan will generate sufficient cash which, along with its existing cash on hand, will enable it to fund operations through at least March 31, 2013. Additionally, the Company has a line of credit, as modified in June 2011, in place with Silicon Valley Bank and believes that it has the ability to refinance and/or expand the availability of such asset-based financing. Such actions would likely require the consent of its existing lenders, and there can be no assurance that such consents would be given. Furthermore, there can be no assurance that the Company would be able to obtain similar or additional asset-based financing if and when sought.

The Company’s funding plans for its working capital needs and other commitments may be adversely impacted if it fails to realize its underlying assumed levels of revenues and expenses, receivables are not collected or if the Company fails to remain in compliance with the covenants of its bank line, subordinated note payable or subordinated convertible note. In addition, a default on the Company’s subordinated convertible notes, due to delisting or other trading restrictions, could cause the Company to have to make payments in cash, subject to restrictions for other debt holders. If any of these events were to occur, the Company may need to raise additional funds in order to sustain operations by selling equity or taking other actions to conserve its cash position, which could include selling certain assets, delaying capital expenditures and incurring additional indebtedness. Such actions would likely require the consent of Silicon Valley Bank, the lender of the Company’s subordinated note, and/or the holder of the Company’s subordinated convertible note, and there can be no assurance that such consents would be given. Furthermore, there can be no assurance that the Company will be able to raise such funds if they are required.

Note C. Significant Accounting Policies and Basis of Consolidation

There have been no material changes from the Significant Accounting Policies and Basis of Presentation previously disclosed in Part II, Item 8, contained within “Notes to Consolidated Financial Statements” of the Company’s Annual Report on Form 10-K for the fiscal year ending December 31, 2011 .

Basis of Consolidation

The consolidated financial statements include the accounts of Satcon and its wholly owned subsidiaries (Satcon Power Systems Canada, Ltd. and Satcon Trading (Shenzhen) Co., Ltd.).   All intercompany accounts and transactions have been eliminated in consolidation.

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Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the period reported. Management believes the most significant estimates include the net realizable value of accounts receivable and inventory, warranty provisions, the recoverability of long-lived assets, the recoverability of deferred tax assets and the fair value of equity, financial instruments and revenue. Actual results could differ from these estimates.

Revenue Recognition

The Company recognizes revenue from product sales when there is persuasive evidence of an arrangement, the fee is fixed or determinable, delivery of the product to the customer has occurred and the Company has determined that collection of the fee is probable. Title to the product passes upon shipment of the product, as the products are typically shipped FOB shipping point, unless otherwise agreed upon in advance with the customer. 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. When appropriate the Company provides for a warranty reserve at the time the product revenue is recognized. If a contract involves the provision of multiple elements and the elements qualify for separation, total estimated contract revenue is allocated to each element based on the relative selling price of each element provided. The amount of revenue allocated to each element is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue is recognized on each element as described above.

Cost of product revenue includes materials, labor, overhead, warranty and freight.

Deferred revenue primarily consists of cash received for extended product warranties, preventative maintenance plans and up-time guarantee programs. Deferred revenue also consists of payments received from customers in advance of services performed, product shipped or installation completed. When an item is deferred for revenue recognition purposes, the deferred revenue is recorded as a liability and the deferred costs are recorded as a component of inventory in the consolidated balance sheets.

Contract Losses

When the current estimates of total contract revenue for a customer order indicates a loss, a provision for the entire loss on the contract is recorded.  At March 31, 2012 and December 31, 2011, there were no amounts accrued related to contract losses. The excess costs over projected revenues are recorded as a component of both cost of sales and research and development expense.

Cash and Cash Equivalents

Cash and cash equivalents include demand deposits and highly-liquid investments with maturities of three months or less when acquired. Cash equivalents are stated at cost, which approximates market value. At March 31, 2012 and December 31, 2011, the Company had no restricted cash.

Accounts Receivable

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for uncollectible amounts is based primarily on a specific analysis of accounts in the receivable portfolio and historical write-off experience. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

Inventory

Inventory is valued at the lower of actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory, and costs are determined based on the first-in, first-out method of accounting and include material, labor and manufacturing overhead costs. A significant decrease in demand for the Company’s products could result in a short-term increase in the cost of inventory purchases and an increase of excess inventory quantities on hand. In addition, the industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, although the Company makes every effort to ensure the accuracy of its forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of the inventory and reported operating results. The Company records, as a charge to cost of product revenue, any amounts required to reduce the carrying value to net realizable value.

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Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization is computed using the straight-line method over the asset’s estimated useful life. The estimated useful lives of property and equipment are as follows:

When assets are retired or otherwise disposed of, the cost and related depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in operating expenses.

Impairment of Long-Lived Assets

The Company reviews its long-lived assets whenever events or changes in circumstances indicate that a carrying amount of the asset may not be recoverable. The Company determines the fair value of certain of the long-lived assets based on a discounted cash flow income approach. The income approach indicates the fair value of a long-lived assets based on the discounted value of the cash flows that the long-lived asset can be expected to generate in the future over the life of the long-lived asset. This analysis is based upon projections prepared by the Company. These projections represent management’s best estimate of future results. In making these projections, the Company considers the markets it is addressing, the competitive environment and the Company’s advantages. There will usually be differences between estimated and actual results as events and circumstances frequently do not occur as expected, and those differences may be material. In addition, the Company performs a macro assessment of the overall likelihood that we would achieve the projected cash flows and performed sensitivity analysis using historical data as the basis for projected cash flows.

Warranty

The Company offers warranty coverage for our products for period of 5 years after shipment. The Company estimates the anticipated costs of repairing products under warranty based on the historical or expected cost of the repairs and expected failure rates. The assumptions used to estimate warranty accruals are re-evaluated quarterly, at a minimum, in light of actual experience and, when appropriate, the accruals or the accrual percentage is adjusted based on specific estimates of project repair costs and quantity of product returns. The Company’s determination of the appropriate level of warranty accrual is based on estimates of the percentage of units affected and the repair costs. Estimated warranty costs are recorded at the time of sale of the related product, and are recorded within cost of sales in the consolidated statements of operations.

Foreign Currency Translation

As of April 1, 2010, the Company determined that the functional currency of its foreign subsidiaries was the US dollar.  As the functional currency changed from the foreign currency to the reporting currency, the translation adjustments as of April 1, 2010 remains as a component of accumulated other comprehensive income (loss).  Prior to this determination, the functional currency was the local currency, assets and liabilities were translated at the rates in effect at the balance sheet dates, while stockholders’ equity (deficit) including the long-term portion of intercompany advances was translated at historical rates. Statements of operations and cash flow amounts were translated at the average rate for the period. Translation adjustments were included as a component of accumulated other comprehensive income (loss). The Company records the impact from foreign currency transactions as a component of other income (expense).  Foreign currency gains and losses were a gain of $53,130 and a loss of $28,000 for the three months ended March 31, 2012 and March 31, 2011, respectively.  All foreign currency transaction gains and losses were recorded as a component of other income (loss), net.

Foreign Currency Hedges

The Company uses foreign currency contracts to manage its exposure to changes in foreign currency exchange rates associated with our foreign currency denominated receivables. The Company primarily hedges foreign currency exposure to the Euro. The Company does not engage in trading, market making or speculative activities in the derivatives markets. The foreign currency contracts utilized by the Company do not qualify for hedge accounting treatment, and as a result, any fluctuations in the value of these foreign currency contracts are recognized in other income (expense),net in our consolidated statements of operations as incurred. The fluctuations in the value of these foreign currency contracts do, however, largely offset the impact of changes in the value of the underlying risk that they are intended to economically hedge. As of March 31, 2011, the Company had foreign currency contracts with a net notional value equivalent to $2.2 million, which matured on April 18, 2011.  On April 18, 2011, the Company entered into a foreign currency hedge with a bank with a notional amount of approximately $1.6 million, and a term of 90 days. For the three months ended March 31, 2012, the Company has no foreign currency contracts.

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The following table shows the changes in the fair value of our foreign currency contract recorded in net loss during the three month period ended March 31, 2011:

(a)                    The Company recorded transaction losses associated with the re-measurement of its foreign denominated assets of $27,775 in the three months ended March 31, 2011. Transaction losses were included in Other income (expense), net in the consolidated statements of operations. The net impact of transaction (losses) gains associated with the re-measurement of the foreign denominated assets and the losses incurred on the foreign currency hedges was a net loss of $158,185.

Income Taxes

The Company accounts for income taxes utilizing the asset and liability method for accounting and reporting for income taxes. Under this method, deferred tax assets and deferred tax liabilities are recognized based on temporary differences between the financial reporting and income tax basis of assets and liabilities using statutory rates. In addition, the Company is required to establish a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

The Company is allowed to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities. The amount recognized is the amount that represents the largest amount of tax benefit that is greater than 50% likely of being ultimately realized. A liability is recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalties (if applicable) on that excess. In addition, the Company is required to provide a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to the accrued interest and penalties for unrecognized tax benefits. Discussion is also required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next twelve months.

As of December 31, 2011, the Company had federal and state net operating loss (“NOL”) carry forwards and federal and state R&D credit carry forwards, which may be available to offset future federal and state income tax liabilities which expire at various dates through 2032. Utilization of the NOL and R&D credit carry forwards may be subject to a substantial annual limitation due to ownership change limitations that have occurred previously or that could occur in the future provided by Sections 382 or 383 of the Internal Revenue Code of 1986, as well as similar state and foreign provisions. These ownership changes may limit the amount of NOL and R&D credit carry forwards that can be utilized annually to offset future taxable income and tax, respectively. In general, an ownership change, as defined by Section 382, results from transactions increasing the ownership of certain shareholders or public groups in the stock of a corporation by more than 50 percentage points over a rolling three-year period. Since the Company’s formation, the Company has raised capital through the issuance of capital stock on several occasions (both pre and post initial public offering) which, combined with the purchasing shareholders’ subsequent disposition of those shares, may have resulted in a change of control, as defined by Section 382, or could result in a change of control in the future upon subsequent disposition.

The Company commissioned a study to determine whether Sections 382 or 383 could limit the use of our carryforwards in this manner. After completing this study, the Company has concluded that the limitation will not have a material impact on its ability to utilize its net operating loss or credit carryforwards.

The tax years 1996 through 2011 remain open to examination by major taxing jurisdictions to which the Company is subject, which are primarily in the United States, as carryforward attributes generated in years past may still be adjusted upon examination by the Internal Revenue Service or state tax authorities if they are or will be used in a future period. The Company is currently not under examination by the Internal Revenue Service or any other jurisdiction for any tax years. The Company did not recognize any interest and penalties associated with unrecognized tax benefits in the accompanying financial statements. The Company would record any such interest and penalties as a component of interest expense. The Company does not expect any material changes to the unrecognized benefits within 12 months of the reporting date.

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Accounting for Stock-based Compensation

The Company has several stock-based employee compensation plans, as well as stock options issued outside of such plans as an inducement to engage new executives. Stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the service period.

The Company uses the Black-Scholes valuation model for valuing options. This model incorporates several assumptions, including volatility, expected life and discount rate. The Company uses historical volatility as it believes it is more reflective of market conditions and a better indicator of volatility. The Company uses historical information in the calculation of expected life for its “plain-vanilla” option grants. If the Company determines that another method used to estimate expected volatility is more reasonable than the Company’s current methods, or if another method for calculating these input assumptions is prescribed by authoritative guidance, the fair value calculated for share-based awards could change significantly. Higher volatility and longer expected lives would result in an increase to share-based compensation determined at the date of grant.

The Company recognized the full impact of its share-based compensation plans in the consolidated financial statements for the three months ended March 31, 2012 and 2011 and did not capitalize any such costs on the consolidated balance sheets, as such costs that qualified for capitalization were not material.  The following table presents stock-based compensation expense, included in the Company’s consolidated statement of operations:

Compensation expense associated with the granting of stock options to employees is being recognized on a straight line basis over the service period of the option. In instances where the actual compensation expense would be greater than that calculated using the straight line method, the actual compensation expense is recorded in that period.

Included in the 2012 and 2011 stock-based compensation expense above are amounts related to employee participation in the Employee Stock Purchase Plan (“ESPP”) of approximately $103,000 and $134,000, respectively. See Note R, Employee Benefit Plan .

At March 31, 2012 approximately $7.1 million in unrecognized compensation expense remains to be recognized over a weighted average period of 1.3 years.  The table below summarizes the recognition of the deferred compensation expense associated with employee stock options over the next four years as follows:

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The weighted average grant date fair value of options granted during the three months ended March 31, 2012 and 2011 were $0.48 and $4.40, respectively, per option.  The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option-pricing model with the following range of assumptions:

(1)           The option life was determined using actual option experience. Prior to March 31, 2010, the option life was determined using the simplified method for estimating expected option life, which qualify as “plain vanilla” options.

(2)           The stock volatility for each grant is measured using the weighted average of historical daily price changes of the Company’s common stock over the most recent period equal to the expected option life of the grant, the historical short term trend of the option and other factors, such as expected changes in volatility arising from planned changes in the Company’s business operations.

(3)           The risk-free interest rate for each grant is equal to the U.S. Treasury yield curve in effect at the time of grant for instruments with a similar expected life.

(4)           The estimated forfeiture rate for each option grant is between 0% - 6.25%.    The Company periodically reviews the estimated forfeiture rate, in light of actual experience.

Net Loss per Basic and Diluted Common Share

The Company reports net loss per basic and diluted common share in accordance with standards established for computing and presenting earnings per share. Basic earnings per share excludes dilution and is computed by dividing income attributable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company, except when the effect would be anti-dilutive. See Note E, Loss Per Share , for more information related to options, warrants and Convertible Subordinated Note which would be considered anti-dilutive.

Concentration of Credit Risk

Financial instruments that subject the Company to concentrations of credit risk principally consist of cash equivalents, trade accounts receivable, unbilled contract costs and deposits in bank accounts.   The Company deposits its cash and invests in short-term investments primarily through a national commercial bank. Deposits in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) are exposed to loss in the event of nonperformance by the institution.

The Company’s trade accounts receivable and fees are primarily from sales to commercial customers. The Company does not require collateral and has not historically experienced significant credit losses related to receivables, letters of credit or unbilled contract costs and fees from individual customers or groups of customers in any particular industry or geographic area.

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Significant customers are defined as those customers that account for 10% or more of total net revenue in a fiscal year or 10% or more of accounts receivable at the end of a fiscal period.  The table below details out customers that were considered significant, greater than 10%, as it pertains to both revenues for the three months ended March 31, 2012 and 2011 and accounts receivable as of March 31, 2012 and December 31, 2011.

* The accounts receivable associated with this customer were backed by irrevocable letters of credit at December 31, 2011.

Significant suppliers are defined as those suppliers that account for 10% or more of total purchases in a fiscal year or 10% or more of accounts payable at the end of a fiscal period. At March 31, 2012, there was one supplier, Perfect Galaxy, which made up approximately 39.5% of the Company’s gross accounts payable.  Purchases from this supplier for the first quarter of 2012 were approximately $11.2 million.  At December 31, 2011, there was one supplier, Perfect Galaxy, which made up approximately 66% of the Company’s gross accounts payable at December 31, 2011. The Company’s non-exclusive contract manufacturing agreement with Perfect Galaxy was extended for 5 years in February 2012.

Research and Development Costs

The Company expenses research and development costs as incurred. Cost of research and development and other revenue includes costs incurred in connection with both funded research and development and other revenue arrangements and unfunded research and development activities.

Comprehensive Income (Loss)

Comprehensive income (loss) includes net loss and foreign currency translation adjustments prior to the changing of the functional currency in Canada to the US dollar.  Pursuant to ASC 220, as amended, the Company is required to present the components of net income (loss) and other comprehensive income (loss) either as one continuous statement or as two separate but consecutive statements.  The Company, since the change in the functional currency of its Canadian subsidiary in April 2010, does not have any other comprehensive income (loss) activity for the three months ended March 31, 2012, and therefore will not be presenting this information in tabular format as required.

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Fair Value of Financial Instruments

The Company’s financial instruments consist of cash equivalents, accounts receivable, warrants to purchase shares of common stock, accounts payable, foreign currency hedge, subordinated note payable and the line of credit. The estimated fair values have been determined through information obtained from market sources and management estimates.  The Company’s warrant liability and foreign currency hedge is recorded at fair value.  See “Fair Value Measurements” below.  The carrying value of the subordinated notes payable, as of March 31, 2012, is not materially different from the fair value of the notes. The estimated fair values of the remaining financial instruments approximate their carrying values at March 31, 2012 and December 31, 2011.

Fair Value Measurements

The fair value of the Company’s financial assets and liabilities are measured using inputs from the three levels of fair value hierarchy which are as follows:

The amounts outstanding under our Loan Agreement and subordinated notes payable are not measured at fair value in our accompanying consolidated balance sheets. We determine the fair value of the amount outstanding under our Loan Agreement and subordinate notes payable using a discounted cashlow approach based on current market interest rates for debt issues with similar remaining years to maturity. Our Loan Agreement and subordinated notes payable are valued using level 2 inputs.

The following table sets forth the fair value of certain of our liabilities as of March 31, 2012 by level within the fair value hierarchy are as follows:

Transfers in and out of Level 3 of the fair value hierarchy consist of settlements of the convertible note and adjustments to the fair value of the convertible note:

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There were no assets measured at fair value on a recurring basis as of December 31, 2011. Liabilities measured at fair value on a recurring basis as of December 31, 2011 are as follows:

Transfers in and out of Level 3 of the fair value hierarchy consist of the issuance of the subordinated convertible note in June 2011, and the subsequent modification in December 2011 (for details of the change in fair value related activity see Note I, Commitments and Contingencies - Subordinated Convertible Note).

The following table rolls forward the Level 3 balance as it relates to the subordinated convertible note:

(1)           The Company’s Level 2 financial liabilities consist of long term investor warrant liabilities comprised of the Warrant As, Warrant Cs, the warrants issued to the investors in connection with the 2007 preferred stock financing (the “2007 Financing Warrants”) and the placement agent warrants.  The fair value of the Warrant As and Warrant Cs is being estimated using a binomial lattice model and the fair value of the placement agent warrants and the 2007 Financing Warrants is being estimated using the Black-Scholes option pricing model. (See Note K. Warrant Liabilities-Valuation — Methodology and Significant Assumptions ; Note L - Redeemable Convertible Series B and Series C Preferred Stock; and “Warrant Liabilities”).

(2)           The Company’s Level 3 financial liabilities consist of a subordinated convertible notes. (See Note I. Commitments and Contingencies.) The valuation of this instrument utilizes a continuous-variable stochastic process in the form of a Monte-Carlo Simulation and includes unobservable inputs supported by little or no market activity such as discount rate applicable to the instrument’s debt-like feature, probabilities of debt-like and equity-like positions, and various probabilities of occurrences of certain future events. The analysis also includes the contractual terms of instrument in the form of interest rate, timing and extent of principal and interest payments, and time to maturity.

The estimated fair value of certain financial instruments including cash, accounts receivable and accounts payable, approximate carrying value due to their short maturity.

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Subordinated Convertible Note

The Company has elected to account for the Subordinated Convertible Note (“Convertible Note”) as an instrument that has the characteristics of a debt host contract containing several embedded derivative features that would require bifurcation and separate accounting as a derivative instrument pursuant to the provisions of ASC 815. The Company has identified all of the derivatives associated with the June 30, 2011 financing; however, several of the derivatives cannot be reliably measured nor reliably associated with another derivative that can be reliably measured. As such, the Company has appropriately valued these derivatives as a single contract together with the Convertible Note. As permitted under ASC 825-10-10, the Company has elected as of the issuance date to measure the Convertible Note in its entirety at fair value with changes in fair value recognized as either gain or loss until the notes are settled. This election was made by the Company after determining that the fair value of the Convertible Note to be more meaningful in the context of the Company’s financial statements than if separate fair values were assigned to each of the multiple embedded instruments contained in such Convertible Note.

Warrant Liabilities

Upon issuance, the Warrant As, Warrant Bs and Warrant Cs, along with the Placement Agent Warrants (together the “Warrants”), did not meet the requirements for equity classification, because such warrants (a) must be settled in registered shares, (b) are subject to substantial liquidated damages if the Company is unable to maintain the effectiveness of the resale registration of the shares and (c) provide a cash-out election using a Black-Scholes valuation under various circumstances.  Therefore these Warrants are required to be accounted for as freestanding derivative instruments.  Changes in fair value are recognized as either a gain or loss in the consolidated statement of operations under the caption “Change in fair value of warrant liabilities.”

The Company determined the fair value of the investor warrants (the Warrant As and Warrant Cs) and placement agent warrants using valuation models it considers to be appropriate. The Company’s stock price has the most significant influence on the fair value of its warrants. An increase in the Company’s common stock price would cause the fair values of the warrants to increase, because the exercise price of the warrants is fixed at $1.815 per share, and result in a charge to the Company’s statement of operations. A decrease in the Company’s stock price would likewise cause the fair value of the warrants to decrease and result in a credit to the Company’s statement of operations. See Note K. Warrant Liabilities for valuation discussion.

Note D.  Shareholders Rights Agreement

On January 6, 2011, the Company entered into a stockholder rights agreement (the “Rights Agreement”).  The Rights Agreement provides for a dividend distribution of one preferred stock purchase right for each outstanding share of the Company’s common stock.  Each right entitles the registered holder to purchase from the Company one-thousandth of a share of the Company’s Series A Junior Participating Preferred Stock.  The Company’s board of directors adopted the Rights Agreement to protect the Company’s ability to use its net operating losses and certain other tax attributes (“NOLs”) for federal and state income tax purposes.  Under the Internal Revenue Code of 1986, as amended (the “Code”), the Company may utilize the NOLs in certain circumstances to offset current and future earnings and thus reduce its federal income tax liability, subject to certain requirements and restrictions.  If the Company experiences an “ownership change,” as defined in Section 382 of the Code, its ability to use the NOLs could be substantially limited or lost altogether.  In general terms, the Rights Agreement is intended to act as a deterrent to any person or group that acquires 4.99% or more of the Company’s common stock without approval of the Company’s board of directors by allowing other stockholders to acquire equity securities of the Company at half of their fair value.  The Rights Plan will continue in effect until January 6, 2014, unless it is terminated or redeemed earlier by the Company’s board of directors.

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Note E. Loss Per Share

The following is the reconciliation of the numerators and denominators of the basic and diluted loss per share computations:

As of March 31, 2012 and 2011, shares of common stock issuable upon the exercise of options and warrants and upon the conversion of the convertible note were excluded from the diluted average common shares outstanding, as their effect would have been antidilutive.  Basic earnings per share excludes dilution and is computed by dividing income attributable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company, except when the effect would be antidilutive.

The table below summarizes the actual number of shares of common stock issuable upon the exercise of options and warrants and upon the conversion of the convertible note that were excluded from the calculation above due to their effect being antidilutive:

(1)           This amount represents the number of shares issuable using the conversion price of $0.8381 per share, without considering the volume weighted average price of the Company’s common stock, at March 31, 2012. See Note I. Commitments and Contingencies for discussion of the conversion price. The Company has registered for resale 34,557,281 shares related to the subordinated convertible note, of which 19,672,909 remain unissued as of March 31, 2012.

The table below details out shares of common stock underlying securities for which the securities would have been considered dilutive at March 31, 2012 and 2011, had the Company not been in a loss position:

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Note F. Inventory

Inventory components at the end of each period were as follows:

During December of 2011, the Company reorganized its operations focusing commercial sales, marketing and product development on its fastest growing markets in North America and Asia. As a result of this reorganization, the Company recorded a provision for excess and obsolete inventory of $16 million relating primarily to its Solstice product line and its European inventory and other inventory considered excess or obsolete.  During the period ended March 31, 2012, the Company sold approximately $0.9 million of the inventory that was fully reserved.

Note G. Property and Equipment

Property and equipment consisted of the following:

Depreciation and amortization expense relating to property and equipment for the three months ended March 31, 2012 and 2011 was approximately $0.6 million and approximately $0.5 million, respectively.

Note H. Legal Matters

From time to time, the Company is a party to routine litigation and proceedings in the ordinary course of business.  Except as described below, the Company is not aware of any current or pending litigation in which the Company is or may be a party that it believes could materially adversely affect the results of operations or financial condition.

In the normal course of the Company’s business, the Company is party to various claims and suits pending for alleged damages to persons and property, alleged violations of certain laws and alleged liabilities arising out of matters occurring during the normal operation of its business.

In accordance with ASC 450-20, the Company accrues for legal proceedings when losses become probable and reasonably estimable. As of the end of each applicable reporting period, the Company reviews each of its legal proceedings to determine whether it is probable, reasonably possible or remote that a liability has been incurred and, if it is at least reasonably possible, whether a range of loss can be reasonably estimated under the provisions of ASC 450-20-25-2. In instances where the Company determines that a loss is probable and the Company can reasonably estimate a range of losses the Company may incur with respect to such a matter, the Company records an accrual for the amount within the range that constitutes its best estimate of the possible loss. If the Company is able to reasonably estimate a range but no amount within the range appears to be a better estimate than any other, the Company records an accrual in the amount that is the low end of such range. When a loss is reasonably possible but not probable the Company will not record an accrual but it will disclose its estimate of the possible range of loss where such estimate can be made in accordance with ASC 450-20-25-3. During 2011, the Company had accrued approximately $0.7 million related to the FuelCell Energy Arbitration and $0.5 million related the SynQor dispute noted below. During the Quarter ended March 31, 2012, the Company accrued an additional $0.3 million related to the SynQor dispute.

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The Company offers no prediction of the outcome of any of the proceedings or negotiations described below. The Company is vigorously defending each of these lawsuits and claims. However, there can be no guarantee the Company will prevail or that any judgments against it, if sustained on appeal, will not have a material adverse effect on our business, financial condition, results of operations or cash flows.

FuelCell Arbitration.   On February 17, 2011, FuelCell Energy, Inc. (“FuelCell Energy”) filed a Demand for Arbitration with the American Arbitration Association seeking recovery of damages related to allegedly defective transformers that the Company procured for them. In its Demand for Arbitration, FuelCell Energy asserts that it is entitled to recovery of approximately $2.8 million from the Company. On October 27, 2011, the Company and FuelCell Energy reached a settlement in regards to these claims. The Company, among other considerations, paid FuelCell Energy approximately $225,000. In addition, the Company guaranteed discounts on future purchases of approximately $160,000. These amounts have been included in the Company’s result of operations for the year ended December 31, 2011.

Class Action Litigation.   In July 2011, two purported securities class action complaints were filed against us, our Chief Executive Officer and our former Chief Financial Officer by the following plaintiffs, individually and on behalf of all others similarly situated, in the U.S. District Court, District of Massachusetts: Allan Edwards (filed July 19, 2011) and Larry Ziegler (filed July 21, 2011). The virtually identical complaints are purportedly brought on behalf of persons who acquired our common stock during the period of March 4, 2010 through July 5, 2011, and allege claims against all defendants for violations under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, as well as claims against the individual defendants for violations of Section 20(a) of the Exchange Act. Putative plaintiffs claim that the defendants caused our common stock to trade at artificially inflated prices through false and misleading statements and/or omissions related to our business. The complaints seek compensatory damages for all damages sustained as a result of the defendants’ actions, including reasonable costs and expenses, and other relief as the court may deem just and proper. The Company believe these allegations are baseless and the Company intends to defend against them vigorously. At this time, the Company believes a loss is neither probable or estimable.

Shareholder Derivative Litigation.   On August 2, 2011, a shareholder derivative action was brought by plaintiff purportedly on behalf of our company against several of our senior officers and directors, in the U.S. District Court, District of Massachusetts. The complaint alleges that the officer and director defendants breached their fiduciary duties by providing allegedly misleading and inaccurate information regarding our business. The shareholder derivative action generally seeks compensatory damages for all alleged losses sustained as a result of the individual defendants’ actions, including reasonable costs and expenses, and other relief as the court may deem just and proper. The Company believe that these allegations are baseless and the Company intends to defend against them vigorously. At this time, the Company believes a loss is neither probable or estimable.

SynQor, Inc.   On August 23, 2011, SynQor, Inc. instituted suit against the Company seeking approximately $5,000,000 in damages arising out of the Company’s alleged failure to pay SynQor for products supplied to the Company and for allegedly inducing SynQor to purchase raw materials on the Company’s behalf. Subsequent to the filing of the suit the Company has paid SynQor for all open invoices for goods that SynQor has supplied to the Company. The Company does not believe that the Company has any liability to SynQor for inducing them to buy raw materials on the Company’s behalf and the Company intends to defend this matter vigorously. SynQor and the Company agreed to submit this matter to non-binding mediation and a mediation session which took place in March 2012. Following the mediation session, the Company and SynQor have continued to discuss the possibility of settling the case.  The parties have tentatively proposed, subject to the negotiation of formal settlement documents, settling the matter for a payment by the Company of $0.8 million.  The Company initially expensed $0.5 million during the year ended December 31, 2011.  For the period ended March 31, 2012 the Company expensed the additional $0.3 million.  The settlement is to be paid out in 12 monthly installments beginning in July 2012.

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Note I. Commitments and Contingencies

Operating Leases

The Company leases its facilities under various operating leases that expire through October 2016.

Future minimum annual rentals under lease agreements at March 31, 2012 are as follows:

Purchase Order Liability

At December 31, 2011, the Company had non-cancellable purchase commitments with several of its key suppliers. At December 31, 2011, the Company evaluated these purchase commitments and determined that approximately $8.1 million of the outstanding purchase commitment related to excess and obsolete inventory and would result in a loss. As a result, the Company recorded a liability of $8.1 million and expensed the cost of these materials in the statement of operations for the year ended December 31, 2011.   As of March 31, 2012, the Company had a non-cancellable purchase order liability of approximately $17.4 million, for which there remains a $5.2 million liability for excess and obsolete inventory.

Letters of Credit:

The Company utilizes a standby letter of credit to satisfy a security deposit requirement. Outstanding standby letters of credit as of March 31, 2012 and December 31, 2011 were $0.3 million and $0.3 million, respectively. The Company may be required to pledge cash as collateral on these outstanding letters of credit. As of March 31, 2012 and December 31, 2011, there was not any cash pledged as collateral for these letters of credit.

Employment Agreements

The Company’s employment arrangements with each of its current Chief Executive Officer, Chief Financial Officer, Chief Technology Officer, Executive Vice President of Sales and Marketing, Vice President of Global Operations, Vice President of Quality and Vice President, Administration & Secretary provide that, if such officer’s employment is terminated by the Company without cause or is constructively terminated, his salary and medical benefits will be continued for one year thereafter subject to his execution of a release agreement with the Company. In May 2011, the Company terminated the employment of its then Chief Financial Officer. Accordingly, the Company has recorded a severance accrual of approximately $0.3 million. As of March 31, 2012, approximately $72,000 remains to be paid.

Line of Credit

On February 26, 2008, the Company entered into a Loan and Security Agreement (the “Loan Agreement”) with Silicon Valley Bank (the “Bank”). Under the terms of the Loan Agreement, the Bank agreed to provide the Company with a credit line up to $10.0 million. The Company’s obligations under the Loan Agreement are secured by substantially all of the assets of the Company and advances under the Loan Agreement were limited to 80% of eligible receivables and the lesser of 25% of the value of the Company’s eligible inventory, as defined, or $1.0 million. Interest on outstanding borrowings accrued at a rate (per annum) equal to the Prime Rate plus one percent (1.0%), as defined, or the LIBOR Rate plus three and three quarter percent (3.75%). The Loan Agreement contained certain financial covenants relating to tangible net worth, as defined, which the Company had to satisfy in order to borrow under the agreement. In addition, the Company agreed to pay to the Bank a collateral monitoring fee of $750 per month and agreed to the following additional terms: (i) $50,000 commitment fee, $25,000 to be paid at signing of the Loan Agreement and $25,000 to be paid on the one year anniversary of the Loan Agreement; (ii) an unused line fee in the amount of 0.5% per annum of the average unused portion of the revolving line; and (iii) an early termination fee of 0.5% of the total credit line if the Company terminated the Loan Agreement prior to 12 months from the Loan Agreement’s effective date.

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During 2011 and 2010, the Company entered into several amendments to the Loan Agreement. On April 22, 2011, the Company and certain of its subsidiaries entered into an Amended and Restated Credit Agreement (as amended to date, the “Amended Loan Agreement”) with the Bank, as administrative agent, issuing lender and swingline lender, and such other lenders as set forth from time to time in the Amended Loan Agreement. The Amended Loan Agreement amended and restated the Company’s prior Loan Agreement, and provides for a senior secured revolving credit facility of up to $35 million. In addition, the Company may make a one-time request for an additional $15 million to increase the credit facility to an aggregate of $50 million, subject to the approval of the lending group.

Total outstanding debt under the Amended Loan Agreement may not exceed (a) the sum of (1) 80% of the book value of eligible receivables (other than those accounts denominated in Euros or Canadian dollars), plus (2) 70% of the book value of eligible receivable in Euros or Canadian dollars, plus (3) 80% of the eligible foreign receivables, plus (4) 70% of the eligible Chinese receivables, plus (5) the lesser of (i) 60% of the cost of eligible inventory or (ii) the net orderly liquidation value of eligible inventory, as adjusted pursuant to the Amended Loan Agreement, less (b) the amount of any reserves established by the Bank.

The amount available to borrow by the Company is reduced to the extent that the Company has letters of credit backed by the Amended Loan Agreement. At March 31, 2012 the Company had approximately $0.3 million outstanding on letters of credit.

The Amended Loan Agreement contains restrictions regarding the incurrence of additional indebtedness by the Company or its subsidiaries, the ability to enter into various fundamental changes (such as mergers and acquisitions), the ability to make certain payments or investments, and other limitations customary in senior secured credit facilities. In addition, the Company must comply with certain financial conditions if its liquidity (defined as cash on deposit with the Bank plus availability under the Amended Loan Agreement) is less than $15 million.

Borrowings under the Amended Loan Agreement are permitted to be used for refinancing the amounts outstanding under the existing loan agreement with the Bank, to repay certain fees and expenses, and for ongoing working capital and general corporate purposes. Interest on outstanding indebtedness under the Amended Loan Agreement will accrue at an annual rate equal to (a) the higher of (i) the prime rate and (ii) the federal funds effective rate plus one-half of one percent (0.5%) plus (b) the applicable margin. The initial applicable margin is 0.75%, and is subject to adjustment based on the Company’s liquidity in each fiscal quarter such that, if the Company’s liquidity is above $35 million, then the applicable margin is reduced to 0.25%.

The obligations of the Company and its subsidiaries under the Amended Loan Agreement are secured under various collateral documents by first priority liens on substantially all of the assets of the Company and certain of its subsidiaries.

The Amended Loan Agreement provides that events of default will exist in certain circumstances, including failure to make payment of principal or interest on the loans when required, failure to perform obligations under the Amended Loan Agreement and related documents, defaults on other indebtedness in excess of $200,000, the occurrence of a change of control of the Company, and certain other events. Upon an event of default, the Bank may accelerate maturity of the loans and enforce remedies under the Amended Loan Agreement and related documents.

The Amended Loan Agreement, if not sooner terminated in accordance with its terms, originally was to expire on April 23, 2014. On June 30, 2011, in conjunction with the Company’s subordinated convertible note financing, the Amended Loan Agreement was amended to expire on April 23, 2013.

At March 31, 2012 and December 31, 2011, the Company had $20.5 million and $34.7 million outstanding under the Loan Agreement and the Bank’s prime rate was 4%. The rate used was the Bank’s prime rate of 4.0% plus 0.50% (or 4.5% at March 31, 2012 and December 31, 2011). As of March 31, 2012, the Company had approximately $1.3 million available under the line of credit.

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Subordinated Convertible Note

On June 29, 2011, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the purchaser named therein (the “Purchaser”) in connection with the private placement (the “Private Placement”) of $16.0 million principal amount of an unsecured, subordinated convertible note (the “Convertible Note”). The Private Placement closed on June 30, 2011. 34,557,281 shares that may be issued upon conversion of the Convertible Note, or as payment of principal or interest on the Convertible Notes in lieu of cash, were registered for resale under the Securities Act.

Among other terms, the Purchase Agreement provides that the Company will not redeem or declare or pay any dividends on, any of its securities without consent of the Purchaser.

The Company also entered into a Registration Rights Agreement with the Purchaser pursuant to which the Company agreed to register the common stock issuable upon conversion of, or the payment of interest on, the Convertible Note, as further described below. The Company agreed to file a registration statement under the Securities Act within 20 days of the closing of the Private Placement to register the resale of the shares of common stock issuable upon conversion of the Convertible Note and as payment of interest on the Convertible Note, which it did. The Company agreed to use its best efforts to cause the registration statement to be declared effective within 70 days following the closing of the Private Placement (or 90 days of the registration statement is reviewed by the Securities and Exchange Commission) and to keep the registration statement effective until the earlier of (1) the date all of the securities covered by the registration statement have been sold, (2) the date all of the securities covered by the registration statement may be sold without restriction under Rule 144 promulgated under the Securities Act of 1933, as amended (the “Securities Act”). If the Company fails to comply with these or certain other provisions, then the Company shall be required to pay liquidated damages of 1% of the outstanding principal amount of the Convertible Note for the initial occurrence of such failure and for each subsequent 30 day period in which the failure continues. The net proceeds of the sale of the Convertible Note were approximately $14.9 million, after deducting placement fees and other offering-related expenses. The initial Registration Statement covering 11,403,988 shares of common stock was declared effective on July 27, 2011. Following the automatic reset of the conversion price on the Adjustment Date (as defined below), a subsequent registration statement covering an additional 23,153,293 shares of common stock was filed and was declared effective on December 21, 2011.

The Convertible Note had a principal amount of $16.0 million and was initially convertible into shares of the Company’s common stock at a conversion price of $2.92, subject to adjustment. The conversion price adjusted on the eleventh trading day following the public announcement of the Company’s financial results for the quarter ending September 30, 2011 (the “Adjustment Date”), to the lower of (i) the then effective conversion price and (ii) 110% of the arithmetic average of the volume weighted average price of the Company’s common stock for the ten consecutive trading days ending on the trading day immediately preceding the Adjustment Date, or $0.8381 per share. Accordingly, on the Adjustment Date, the conversion price was adjusted to $0.8381. On December 1, 2011, the Convertible Note was amended to provide that the conversion price of the Convertible Note on the applicable conversion date is the lower of (1) the conversion price then in effect and (2) with respect to a total of ten separate conversions, a price equal to 92% of the closing bid price of our common stock on the trading day immediately preceding the applicable conversion date.  On April 20, 2012, the Company and the Purchaser entered into an agreement regarding the Convertible Note (the “April 2012 Agreement”), which among other things, lowered the conversion price to $0.40 while still allowing for ten separate conversions of the Convertible Note at a price equal to 92% of the closing bid price of the Company’s common stock on the trading day immediately preceding the applicable conversion date. The April 2012 Agreement is further described below.

The Convertible Note matures on July 1, 2013, and bears an interest at a rate of 7.0% per annum. Interest is payable monthly, beginning on November 1, 2011. Principal and interest (each, an “installment amount”) are payable monthly (which commenced on November 1, 2011), and may be made in cash or, at the option of the Company if certain equity conditions are satisfied, in shares of its common stock. If all or any portion of an installment amount is paid in shares of common stock, the price per share (the “Company Conversion Price”) will be at the lower of (i) the then current conversion price and (ii) 82% of the arithmetic average of the volume weighted average price of the Company’s common stock for the ten consecutive trading days ending on the trading day immediately preceding the payment date (but in no event greater than the dollar volume weighted average price of our common stock on the trading day immediately preceding the payment date). In addition, the holder may, at its option, during the ten trading days immediately following each installment date, deliver one or more written notices electing to have up to two additional installment amounts converted into common stock at a conversion price equal to the Company Conversion Price in effect for the immediately preceding installment payment date. The holder may also, at its option, elect to have the payment of all or any portion of an installment amount payable on an installment date deferred until any later installment date selected by the holder. Any amounts so deferred by the holder are added to, and become part of, such later installment amount and continue to accrue interest under the Convertible Note.

If the closing sale price of Company common stock exceeds 175% of the conversion price for 30 consecutive trading days, then, if certain equity conditions are satisfied, the Company may require the holder of the Convertible Note to convert all or any part

of the outstanding principal into shares of common stock at the then applicable conversion price, provided that the Company may only

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make a one-time election to force conversion. The Convertible Note contains certain limitations on optional and mandatory conversion, including that, absent stockholder approval of the transaction, the Company will not issue shares of common stock under the Convertible to the extent such issuances equal or exceed 20.0% of the Company’s outstanding shares on the closing date. In the event that the Company is prohibited from issuing any shares of common stock due to this cap, the Company must pay cash in exchange for cancelling such excess shares at a price equal to the product of (i) such number of excess shares and (ii) the closing bid price on the trading day immediately preceding the date such excess shares would otherwise be required to be delivered to the noteholder.In addition, a provision of the Convertible Note does not allow the holder of the note to own more than 4.99% of the Company’s common stock at any one time.

The Convertible Note contains certain covenants and restrictions, including, among others, that, for so long as the Convertible Note is outstanding, the Company will not incur any indebtedness that is senior to, or on parity with, the Convertible Note in right of payment, subject to limited exceptions for existing indebtedness. Events of default under the Convertible Note include, among others, payments defaults, cross-defaults, the Company’s common stock is suspended from trading for a period of time or no longer listed on an eligible trading market, and certain bankruptcy-type events involving the Company or any subsidiary. Upon an event of default, the holder may elect to require the Company to redeem all or any portion of the outstanding principal amount of the Convertible Note for a price equal to the greater of 120% of (i) the amount to be redeemed (as calculated through the redemption date) and (ii) the product of (A) the conversion rate with respect to such amount in effect at such time as the holder deliver a redemption notice and (B) the greatest closing sale price of the Company’s common stock on any trading day during the period starting on the date immediately preceding the event of default and ending on the trading day immediately prior to the date the Company is required to pay the redemption amount. The holder may elect to require the Company to redeem for cash all or any portion of the outstanding principal on the Convertible Note in connection with a change of control of the Company.

In addition, the Company may redeem all (but not less than all) of the then outstanding amount of the Convertible Note in cash at a price equal to the greater of 125% of (i) the amount to be redeemed (as calculated through the redemption date) and (ii) the product of (A) the conversion rate with respect to such amount in effect at such time as the Company delivers a redemption notice and (B) the greatest closing sale price of the Company’s common stock on any trading day during the period starting on the date notice of redemption is given and ending on the date immediately prior to the redemption, provided that the Company may only deliver one such redemption notice.

Upon issuance of the Convertible Note the Company determined the initial carrying value of the Convertible Note to be $16.0 million. On December 1, 2011, certain of the provisions of the Convertible Note were modified. In accordance with ASC 470, the modifications resulted in the Convertible Note being deemed to be substantially different post modification because a substantive embedded conversion option was added to the Convertible Note. The modification resulted in the extinguishment of the Convertible Note on December 1, 2011, the modification date, and the establishment of a modified Convertible Note. On the date of modification the Company recorded a charge to loss on extinguishment of convertible note in the statement of operations of approximately $2.8 million. The change in fair value related to the Convertible Note is recorded as change in fair value of note and warrants in the statement of operations for the year ended December 31, 2011. Due to the Convertible Note being carried at fair value in accordance with ASC 825, financing costs associated with obtaining the Convertible Note were immediately expensed. The Company paid approximately $1.1 million in related transaction costs, which was recorded as interest expense in the statement of operations for the year ended December 31, 2011.

The holder of the Convertible Note deferred principal payments, in whole or in part, due on November 1, 2011($761,905), December 1, 2011 ($238,095), January 1, 2012 ($111,904), February 1, 2012 ($359,250) and March 1, 2012 ($761,905). In addition, during the three months ended March 31, 2012, the holder converted approximately $5.2 million of principal which has either been previously deferred or was due from the Company in future periods.  As a result of the election to defer principal payments at March 31, 2012 approximately $3.1 million of principal originally due has been deferred to later periods. The holder of the Convertible Note elected to have the interest payments due on the Convertible Note paid in cash, which was approximately $0.2 million for the quarter ended March 31, 2012. These amounts are recorded as interest expense in the statement of operations for the quarter ended March 31, 2012.

On April 20, 2012, the Company and the Holder entered into an amendment (The April 2012 Agreement).  Among other things, the April 2012 Agreement requires the Company to seek approval from its stockholders at its next annual meeting of stockholders, scheduled for June 20, 2012, to issue up to 25,000,000 additional shares of the Company’s common stock to the Holder upon conversion of, or as a payment of principal and interest on, the convertible Note.  In addition, the April 2012 Agreement requires the Holder, in the absence of an event of default or a change of control of the Company, to refrain from exercising its conversion rights under the Convertible Note or demanding payments (other than interest payments) until October 1, 2012.  As a result of the April 2012 Agreement, the principal installment due on October 1, 2012 will be approximately $6.3 million.  The April 2012 Agreement also amends the conversion price under the Convertible Note to $0.40.

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A summary of changes in the Convertible Note is as follows:

(1)                                  Amounts included in change in fair value of note and warrants on consolidated statement of operations.

(2)                                  On December 1, 2011, subsequent to the modification, the holder of the Convertible Note elected to convert a portion of the principal payment due on December 1, 2011. As a result of the conversion the Company issued 858,704 shares of common stock. The stock was issued at $0.61when the fair market value of the stock was $0.73 per share. On December 15, 2011, the holder of the Convertible Note elected to convert $500,000 of principal on the Convertible Note. As a result the Company issued 970,497 shares of common stock. The stock was issued at $0.5152 (92% of the prior day closing bid price of $0.56) per share when the fair market value of the stock on the date of conversion was $0.60 per share.

(3)                                  During the three months ended March 31, 2012, the holder of the Convertible Note elected to convert principal payments due of $923,809 into shares of the Company’s common stock.  As a result of the conversion of the principal payments the Company issued 1,989,469 shares of common stock.  In addition, during the three months ended March 31, 2012, the holder of the Convertible Note elected to accelerate conversion of approximately $5,186,905 of principal and $3,267 of accrued interest into shares of the Company’s common stock.  As a result of the accelerated conversions the Company issued to the Convertible Note holder 11,065,702 shares of common stock.

Valuation—Methodology and Significant Assumptions

The process of analyzing/valuing financial and derivative instruments utilizes facts and circumstances as of the measurement date as well as certain inputs, assumptions, and judgment calls that may affect the estimated fair value of the instruments. The estimated fair value of the Convertible Note is based on a utilization of certain valuation models that consider current and expected stock prices, expected volatility, expected interest rates, scheduled principal and interest payments, expected rate of returns and discount rates, probabilities of occurrences of certain future events, and expected liquidation horizons. Such inputs and assumptions as well as the conclusions of values are subject to significant estimates and actual results may differ. The methods, inputs, and significant assumptions utilized in estimating the fair value of the Convertible Note are summarized in the following sections.

Methods

A continuous-variable stochastic process in the form of a Monte-Carlo Simulation was utilized to estimate the fair value of the Convertible Note as of the Issuance Date. Monte Carlo simulation, a process of randomly generating values for uncertain variables, is meant to imitate a real-life system especially when other analyses are too mathematically complex or too difficult to reproduce. This method was used to simulate future expected stock prices, variable strike prices, and the behavior of each of the instrument’s significant features, as discussed above, as well as the respective outcomes at each particular time in the future—bi-weekly time steps were utilized throughout the maturity of the Convertible Note as well as daily time steps for purposes of estimating the adjustment to the Conversion price as discussed above. Other valuation methods were considered, such as the Black-Scholes-Merton option-pricing model and a binomial lattice model, but the simulation model was found as most appropriate in the analysis of the Convertible Note due to the potential variability of the conversion price (and its path dependency on stock prices during a period of 10 consecutive trading days prior to the potential adjustment day) and the Company’s ability to force conversion should certain condition are met in the future (as discussed above).

The simulation model was first utilized to continuously simulate the expected prices of the Company’s common stock at each time step and throughout the remaining life of the instrument. Secondly, an analysis of each of the instrument’s significant features was conducted at each time step for purposes of determining the respective value of each feature and its effect on the price market participants would be willing to pay for the Convertible Note. Based on the simulated stock prices, the value of each of the features at each time step, the greater of (or lower of—in the case of the options at the Company’s hands) the conversion positions, redemption positions, or holding positions (i.e. fair value as of each respective future time step discounted using the applicable effective discount rate) was conducted relative to each time step and from the

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perspective of the Holders, until a final fair value of the instrument is determined at the time step representing the measurement date. This model requires the following key inputs with respect to the Company and/or instrument:

Inputs