UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K10-K/A

(Amendment No. 1)

 

 

(Mark One)

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

For the fiscal year ended December 31, 20072008

OR

 

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

For the transition period from            to        

Commission file number: 000-51991

 

 

Basin Water, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware 20-4736881

(State or other jurisdiction of


incorporation or organization)

 

(I.R.S. Employer


Identification No.)

8731 Prestige Court9302 Pittsburgh Avenue, Suite 210

Rancho Cucamonga, California

 91730
(Address of principal executive offices) (Zip Code)

(909) 481-6800

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

  

Name of exchange on which registered

Common Stock, $0.001 par value

  The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-knowwell-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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  ¨x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x¨

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

 

Large accelerated filer              ¨

 Accelerated filer            x x

Non-accelerated filer                ¨

(Do    (Do not check if a smaller reporting company)

 Smaller reporting company            ¨

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

The aggregate market value of the voting and non votingnon-voting common equity held by non-affiliates of the registrant was approximately $131.8$93.4 million based upon the closing price of the Registrant’s common stock on the NASDAQ Global Market on June 29, 2007.30, 2008. On March 14, 2008,April 28, 2009, there were 21,948,70422,205,843 shares of common stock, par value $0.001, outstanding.

Documents Incorporated by Reference

Portions of the Proxy Statement to be delivered to stockholders in connection with the Registrant’s 2008 Annual Meeting of Stockholders to be filed on or before 120 days after the end of the Registrant’s fiscal year end are incorporated by reference into Part III of this Annual Report on Form 10-K. With the exception of those portions that are specifically incorporated in this Annual Report on Form 10-K, such Proxy Statement shall not be deemed filed as part of this Report or incorporated by reference herein.None.

 

 

 


TABLE OF CONTENTS

 

   Page

Explanatory Note

1

Part I

  

Item 1.

Business

2

Item 1A.

Risk Factors

13

Item 1B.

Unresolved Staff Comments

  342

Item 2.

Properties

35

Item 3.

Legal Proceedings

35

Item 4.

Submission of Matters to a Vote of Security Holders

36

Part II

  

Item  5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities37

Item 6.

  

Selected Financial Data

393

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

40

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

59

Item 8.

Financial Statements and Supplementary Data

59

Item 9.

Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

59

Item 9A.

Controls and Procedures

59

Item 9B.

Other Information

61

Part III

  

Item 10.

Directors, Executive Officers and Corporate Governance

  625

Item 11.

Executive Compensation

  6312

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters63

Item 13.

  31

Item 13. Certain Relationships and Related Transactions, and Director Independence

  6333

Item 14.

Principal Accounting Fees and Services

  6335

Part IV

  

Item 15.

Exhibits and Financial Statement Schedules

  6436

Signatures

  6839

Index to Consolidated Financial Statements and Financial Statement Schedules

  F-1

1


EXPLANATORY NOTE

This Amendment No. 1 to our Annual Report on Form 10-K/A (the Form 10-K/A) amends the Annual Report on Form 10-K for the year ended December 31, 2008, as originally filed with the Securities and Exchange Commission (the SEC) on March 31, 2009 (the “Original Form 10-K”). As permitted by General Instruction G(3) of Form 10-K, we did not include the information required by Part III of Form 10-K in the Original Form 10-K. In accordance with General Instruction G(3) of Form 10-K, this Form 10-K/A is being filed to include the information required by Part III of Form 10-K. We have also updated Item 1B of Part I to update the unresolved SEC Staff comments to our filings.

There are no changes to the disclosures in the Original Form 10-K, except that this Form 10-K/A amends and restates, in their entirety, Item 1B of Part I, Item 5 of Part II, Items 10-14 of Part III and Item 15 of Part IV of the Original Form 10-K. This Form 10-K/A continues to speak as of the date of the Original Form 10-K, and we have not updated the disclosure herein to reflect any events that occurred at a later date.

1


FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K10-K/A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “Safe harbor”Harbor” created by those sections. Any such forward-looking statements would be contained principally in “Business”, “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, industry environment, potential growth opportunities and the effects of regulation. Forward-looking statements include all statements that are not historical facts and can be identified by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” or similar expressions.

Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. We discuss many of these risks in greater detail in “Item 1A. Risk Factors.”Factors”. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of thisthe Annual Report on Form 10-K filed on March 31, 2009.You should read this Annual Report on Form 10-K10-K/A completely and with the understanding that our actual future results may be materially different from what we expect.

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


PART I

 

ITEM 1.1B.    UNRESOLVEDBUSINESSSTAFF COMMENTS

Overview

Basin Water, Inc. is a providerOn October 23, 2008, we received comments from the Staff of reliable, long-term process solutions for a rangethe Division of customers, which include designing, building, implementing,Corporation Finance (the Staff) of the Securities and servicing systemsExchange Commission (the SEC) with respect to our Annual Report on Form 10-K for the treatmentyear ended December 31, 2007 (the 2007 Form 10-K), our Form NT 10-Q for the period ended June 30, 2008 and our Form 8-K dated August 11, 2008. We provided responses to these comments on November 6, 2008 and January 23, 2009. On February 10, 2009, we filed our Annual Report on Form 10-K/A for the year ended December 31, 2007 (the 2007 Form 10-K/A), our Quarterly Report on Form 10-Q/A for the period ended March 31, 2008, our Quarterly Report on Form 10-Q for the period ended June 30, 2008 and our Quarterly Report on Form 10-Q for the period ended September 30, 2008, which filings included disclosure to address the Staff’s comments in its October 23, 2008 letter.

On March 6, 2009, we received additional comments from the Staff with respect to our 2007 Form 10-K/A and our Quarterly Report on Form 10-Q/A for the period ended March 31, 2008. On March 30, 2009, we sent a letter to the Staff responding to these comments. On March 31, 2009, we filed our Annual Report on Form 10-K for the year ended December 31, 2008 (the 2008 Form 10-K), which included disclosures to address the Staff’s comments. On April 14, 2009, we received further comments from the Staff relating to our responses submitted on March 30, 2009 and our disclosures in the 2008 Form 10-K. The Staff’s unresolved comments relate primarily to the following:

additional disclosure to comply with paragraphs 8 and 9 of contaminated groundwater,FSP FAS 140-4 and FIN 46(R);

disclosure regarding the treatment of wastewater, waste reduction and resource recovery.

In 2007, we derived mostterms of our revenues from designing, assemblingcontract to purchase the assets that were assigned to Empire; and servicing

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

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

We are defining our municipal market opportunities in each of five geographic regions and our industrial market opportunities on a national basis. In the West, our company’s historic base, rapid population growth and decreasing drinking water supplies continue to provide opportunities for our technology and services. In addition, we believe that concerns over specific contaminants throughout the country will also provide opportunities for our technology and services, such as for treatmentaspects of the chemical contaminants.Empire transaction.

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

We make available free of charge through our internet website our press releases, this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all10-K/A or our other required filings, with the Securities and Exchange Commission (SEC) and amendments thereto as soon as reasonably practical after they are electronically filed with, or furnishedwhich may require us to the SEC. Our internet website also contains our Code of Ethics. Our principal executive offices are located at 8731 Prestige Court, Rancho Cucamonga, California 91730, and our telephone number is (909) 481-6800. Our website address iswww.basinwater.com. The information on our website is neither part of nor incorporated by reference intofurther amend this Annual Report on Form 10-K.

Company History

Originally incorporated in California in 1999, Basin Water reincorporated in Delaware in connection with our initial public offering which was completed in May 2006. Our operations from 1999 until 2001 consisted

primarily of research and development activities, as we developed our proprietary ion-exchange process. Our proprietary process was conceived by Peter L. Jensen, our founder and former Chief Executive Officer, and the late Dr. Gerald Guter, who served as our Chief Scientific Officer. Also during this time, we developed a groundwater treatment system for commercialization of our proprietary process and increased our personnel to include additional engineers and sales and marketing personnel. We successfully completed a prototype for our groundwater treatment system in May 2002, and shortly thereafter, we assisted one of our customers in submitting an application with the California Department of Health Services (DHS) for a permit to operate our system for treatment of nitrate. In June 2002, our customer received the first permit from DHS for operation of our system to treat groundwater. We also received our first revenues in 2002 from sales of our groundwater treatment system and operations.

From 2002 through 2006, we focused on developing systems that could treat10-K/A or other contaminants, increasing our engineering workforce, developing our sales and marketing force, obtaining patents, and improving our internal finance and accounting capabilities.

Beginning in the last quarter of 2006, and continuing throughout 2007, we have focused on becoming a more diversified and predictable growth company by developing our technology+services business model and also implementing internal and external initiatives.

Our internal initiatives included:filings.

 

Recruiting top personnel with an emphasis on people with experience in the water and wastewater industries or in combining technology with performance-based service agreements;

Expanding beyond our base of municipal customers (such as utilities, special districts, municipalities and other similar organizations) to include potential customers in the industrial marketplace (such as oil and gas, power, mining and chemical companies);

Installing business and financial systems to accommodate our growth and new system and service initiatives;

Developing regional sales, process engineering and field service groups aligned with both our municipal and industrial marketplace customers; and

Developing our technology+services offering to include the treatment of a variety of organic and inorganic contaminants.

Our external initiatives included the Mobile Process Technology, Co. acquisition, and entering into a strategic alliance with Rohm and Haas Chemicals LLC, among others.

Market Opportunity

Demand for drinking water treatment technologies and services. Population growth has resulted in increased demand for drinking water in much of the United States. This is a problem throughout the United States but is particularly acute in California and other states in the southwest United States, which we refer to as the arid West, where population growth and chronic shortages of drinking water have resulted in rapidly increasing demand for drinking water.

Though we believe groundwater is a cost-effective and advantageous source of water supply, it is at substantial risk of contamination from a number of chemical contaminants; such as arsenic, nitrate, perchlorate, radium, chromium VI, uranium and radionuclides, as well as organic contaminants, such as methyl tertiary-butyl ether (MTBE), trichloroethylene (TCE) and perchloroethylene (PCE), which have been linked to various cancers, diseases, metabolic disorders and other health problems. Because of these health concerns, the Environmental Protection Agency, or EPA, and state regulatory agencies have been active in establishing and lowering2

maximum containment levels, or MCLs, for contaminants in drinking water to ensure that the public has access to a safe drinking water supply. In addition, improvements in water testing and treatment technologies have allowed the EPA and state regulatory agencies to lower the MCL for certain contaminants.

We believe that a large market opportunity exists in providing a solution for treatment of groundwater for drinking water. There are few economically attractive alternatives for treating groundwater at the wellhead. Customarily, water providers either shut down a contaminated well or blend the water with non-contaminated water to meet an MCL. Ion-exchange technology is acknowledged as a leading technology for groundwater treatment, including being designated by the DHS and EPA as a “best available technology” for treating groundwater for removal of contaminants. As compared to our ion-exchange technology, many existing contaminant treatment technologies are costly, produce large amounts of waste, or are generally designed for large industrial installations rather than for wellhead treatment. We believe there is significant demand for cost-effective groundwater treatment using our ion-exchange technology. We are actively pursuing opportunities to introduce our groundwater treatments systems across the United States where the opportunity exists to provide our technology+services offerings.

Demand for technology+services costs.We believe our technology+services offerings can be valuable to municipal and industrial customers. We believe there is demand by our customers for an offering that includes our technology combined with a long-term services agreement to provide services and maintenance with our performance guarantee for the life of the agreement.

Demand for wastewater treatment, water reuse and the recovery of valuable commodities. We also believe there is demand for industrial wastewater treatment, water reuse and metals and commodities recovery systems and services. Many industrial facilities face increasingly stringent discharge requirements for industrial wastewater, driving demand for technological solutions like ours for wastewater treatment. We also believe that demand exists for applications through which our customers can reuse and recycle wastewater for process water needed for manufacturing or other industrial uses. Furthermore, in light of the high cost of metals and other materials, we believe there is demand for technologies that are able to recover valuable commodities from wastewater streams.

Our Solution and Strengths

Basin Water onsite regenerable ion-exchange. Our proprietary onsite regenerable ion-exchange system is designed to treat groundwater contamination at the wellhead. We believe our multiple-bed system provides a safe, reliable and sustainable source of drinking water to our customers. Our system effectively treats water resulting in low waste rates, can be scaled to meet a customer’s requirements and has a small footprint. These systems are designed using the Basin Water IX Program and are installed with telemetry to allow independent functionality. Approximately 95% of our revenues in 2007 were derived from sales and service related to these systems.

Our expanded technologies. We have made concerted efforts to expand our technology portfolio beyond proprietary onsite regenerable ion-exchange technology. While our ion-exchange technology continues to have great potential in a variety of applications in the groundwater treatment market, we believe that additional opportunities exist for ion-exchange and absorptive media systems utilizing alternative methods of regeneration or media handling, and also technologies that can remove organic contaminants from water. Therefore, during 2007 we sought out and acquired the rights to ion-exchange technologies and other technologies that would enable us to address these opportunities through our September 2007 acquisition of Mobile Process Technology Co., which we refer to as MPT (see Note 3 to our consolidated financial statements), our November 2007 strategic alliance with a wholly owned subsidiary of Rohm and Haas Company named Rohm and Haas Chemicals, LLC, which we refer to as Rohm and Haas, and our 2007 agreement with Purifics ES Inc., which we refer to as Purifics, a licensed engineering firm headquartered in London, Ontario, Canada. In addition, we have developed a proprietary process, which we refer to as the BIONExchange process, for biologically removing

and destroying the perchlorate loading from exhausted ion-exchange resins. This process can also be used to remove and destroy perchlorate from brine resulting from regeneration of the ion-exchange resins.

We believe these expanded technologies will enable us to address a large market of potential customers.

Our experienced management team. One of our developing strengths is our management team. Beginning in late 2006 and continuing throughout 2007, we bolstered our existing management team by hiring veterans from the water industry as well as other leading industries that have experience with technology and service offering business models. Most notably, our President and Chief Executive Officer joined Basin Water in October 2006 and brought the knowledge and experience to develop our business model. In addition, we hired four senior managers all of whom had past experience in the water, wastewater and other related industries. We believe the management team we have assembled has significantly strengthened our ability to achieve our goal to develop and implement our technology+services business model.

Our Strategy

Next generation water services company.In our view, water treatment companies who are able to profitably offer predictable, competitive life-cycle costs will become the “next generation” of water treatment companies.Our goal is to define, test and then implement the strategies necessary to become a “next generation” water services company. To do that we believe we must develop offerings and select opportunities that will generally involve pairing a proprietary or specialized technology with a service agreement to meet a defined set of customer needs. To date we have made significant progress as a leading provider of groundwater treatment systems and services to our customers throughout the United States, with an initial focus on the arid West. We expect to continue to expand our business and achieve these goals through the following strategies:

Develop and implement our technology+services model. We have developed and will now implement our technology+services business model that combines proprietary or specialized technologies with long-term relationships built through performance-based service agreements to meet groundwater treatment, industrial water and wastewater treatment, and resource recovery needs.

Extend our business and geographic reach throughout the United States. We intend to expand our business reach beyond the arid West into all areas of the United States. Our expansion plans include the creation of five regions (West, Southwest, Southeast, Great Lakes and Northeast) encompassing all of the continental United States to serve as our marketing, sales and technical services platforms for municipal customers within each of those regions. Marketing to municipal customers typically requires a local presence within the customer’s geographic region. In 2007, we began an internal organizational change and expansion through the assignment of dedicated management, sales, marketing, and technical support to certain of these regions. In addition to our West regional office in Rancho Cucamonga, we now have a footprint in the Southeast with our facility in Memphis, and will have a new Southwest regional office in Houston by mid-2008. We currently have a sales presence in the Great Lakes and the Northeast and are developing plans to open regional offices there in 2008 and 2009. We believe sales and marketing teams at the local level will be more effective because of their knowledge of and relationships with the municipalities within their region. We expect marketing to industrial customers to be more effective on a nationwide basis from one central location. Thus, for our industrial customers, we have a national sales and marketing team supported by our Memphis facility.

Expand our business by continuing to develop strategic relationships with companies serving and supplying the water industry on a national basis. We have identified and will continue to identify companies servicing and supplying the water industry on a national basis that can provide strategic benefits to the marketing of our groundwater treatment system. As part of this strategy, we have entered into a strategic alliance agreement with Rohm and Haas. We believe that by partnering with companies like Rohm and Haas, we can efficiently leverage their existing infrastructure to provide our technology+services offering in new markets.

Our Technology and Services

Our ion-exchange treatment systems. Our groundwater treatment services generally utilize our ion-exchange technology. To treat contaminated groundwater, the water is pumped from the wellhead into our system which contains a bed of ion-exchange resin. Through the ion-exchange process, the contaminants remain on the resin while the clean water exits the system and enters the drinking water distribution system. This process continues until the resin inside the bed is saturated with contaminants. We offer our customers three types of ion-exchange treatment systems—onsite regenerable systems, offsite regeneration systems, and disposable resin systems. The primary difference among these three types of system is how resin is used in the treatment process. For our onsite regenerable system, once the resin bed is saturated with contaminants, sometimes referred to as being spent or exhausted, a saturated salt brine solution is pumped into the tank which regenerates the resin onsite. For our offsite regeneration systems, we remove the spent resin to be regenerated offsite, and replenish the system with regenerated resin. The spent resin is transported for processing, such as at our Memphis central regeneration facility. There the resin is regenerated to be returned to service at the customer’s site. For some contaminants, such as radionuclides, regeneration is not feasible. In those situations we use a disposable resin system whereby we dispose of the resin in accordance with the particular regulation applicable to the contaminant being removed.

We manufacture our ion-exchange treatment systems on a build-to-order basis using raw materials from suppliers typically located in the United States and from predominantly “off-the-shelf” components for which there are generally multiple suppliers. We manufacture our onsite regenerable and disposable ion-exchange treatment systems at our facility in Rancho Cucamonga, California and our offsite regenerable systems at our facility in Memphis, Tennessee. As of December 31, 2007, eight onsite regenerable ion exchange treatment systems were in process at our Rancho Cucamonga location, and no systems were in process at our Memphis location.

Our customers must obtain a license and/or a permit from the applicable state regulatory agency in order to operate each system that we install at their wellheads. We work with our customers to secure required licenses and permits from state regulatory agencies, including assisting with the completion of the license or permit application and responding to inquiries or requests from these regulators regarding our system.

Our onsite regenerable, and certain disposable media treatment systems, use a multiple-bed system design, providing flexibility to meet different volume requirements. These systems allow resin beds to be sequenced in and out of service to optimize performance and offer users a wide range of production rates up to 12,000 gpm.

Typically our systems are installed adjacent to a wellhead. The systems use the well pump’s pressure to move water through the ion-exchange process. Our onsite regenerable systems require at least one waste brine tank to be placed onsite. The brine tank is connected to a waste line that allows for a contracted waste removal company to remove the brine without entering the well site. For our offsite regenerable systems, which service low flow wells, there is no onsite brine tank. Instead, we remove the resin vessel from the customer’s site for regeneration at our facility.

During the course of the groundwater treatment process, we do not take ownership of the water or title to the waste generated from the treatment of water, with the potential exception for recovery of valuable materials from the waste generated which we may then sell to third parties.

All of our onsite regenerable systems and some of our offsite regenerable systems and disposable resin systems are fully automatic and use a Program Logic Controller, or PLC, that runs advanced control programs to maximize treatment system performance and reliability while also minimizing waste products.

Our technology+services offering. The exact technology+services offering we use in a given situation is dependent upon the customer’s needs. Our most frequently offered technology to date is our onsite regenerable

ion-exchange system, which we incorporate into our offering by combining our treatment system with an ongoing services agreement. This agreement incorporates a variety of services requested by our customers. For our offsite regenerable systems and disposable resin systems, our service component might include such services as replacing media, conducting vessel exchanges on a periodic basis as the resin becomes exhausted, performing regeneration services at our central facility in Memphis, periodic testing of the system and ongoing support as required to optimize system operations.

We anticipate that service contracts for our expanded technology portfolio may include services similar to those listed above, and may also include the management of site-based operations involving a treatment system.

Customers

Historically, we have marketed our ion-exchange treatment systems and services to groundwater customers that included utilities, municipalities, cities and other organizations that supply drinking water. By enhancing our technology+services offerings to include smaller ion-exchange treatment systems, offsite regeneration and organic removal capabilities, we believe we have significantly expanded our potential customer base in the municipal market.

This expansion of our offerings also addresses industrial customers’ needs for wastewater treatment, water reuse and the recovery of valuable commodities from wastewater streams including for oil and gas, power, mining and chemical companies.

As of December 31, 2007, we had a total of 79 systems on order or under contract with 25 different customers (not including approximately 200 small customers from our Memphis facility), of which 48 systems are installed, permitted and can process water. Five systems are awaiting regulatory permits with the remaining 26 systems in various stages of contracting or manufacturing. These 79 systems on order or under contract nationwide represent an aggregate installed capacity of approximately 113,000 acre-feet per year, or approximately 36.9 billion gallons per year.

The following customers accounted for more than 10% of our revenues in the periods indicated:

   Year Ended December 31, 
   2007  2006  2005 

VL Capital, LLC

  26% *  * 

Water Services Solutions, LLC

  14% *  * 

Baldy Mesa Water District (Victorville)

  13% 30% * 

Shaw Environmental, Inc.  

  *  17% 11%

Arizona American Water Company

  *  *  12%

Del Valle Capital Corp.  

  *  *  14%

Coachella Valley Water District(1)

  *  *  34%
          

Totals

  53% 47% 71%
          

*Indicates a less than 10% customer during such period.
(1)We are parties to an arrangement pursuant to which Shaw provided site work, bonding and other services to Coachella Valley Water District.

As of December 31, 2007, our revenues backlog was $73.0 million, a decrease of $5.9 million, or 7%, compared to our revenues backlog of $78.9 million at December 31, 2006.

Competition

We believe successful competition in our industry and markets is dependent on the following factors: (1) superior technology and (2) customer relationships.

Superior technology is an important factor for competition in our industry. The EPA has reviewed and accepted certain well-established technologies for use in drinking water applications and designated them as “best available technology”. Ion-exchange technology has already been designated as a “best available technology” by the EPA and by many state regulatory agencies. Ion-exchange technology is also frequently sought for industrial applications. We believe our rights to proprietary technologies provide us a competitive advantage in the municipal and industrial markets.

There are significant competitive challenges even for companies relying on superior and cost-effective technologies. There are a large number of established and well-capitalized companies that already implement cost-effective technologies such as ion exchange in their solutions, and many of these large companies have strong and longstanding relationships with customers in the marketplace. We believe these relationships are critical in establishing credibility and in maintaining steady business. This is particularly true in the municipal market where a local presence and knowledge of the region contributes to a company’s ability to effectively market its services to municipalities. We are developing relationships with municipal customers on a local basis by implementing our regional structure.

We believe our geographic expansion plans, placing our marketing and sales force closer to our customer locations, coupled with the ongoing interactions between our field service force and customers, also provide us with a competitive advantage. Having regional offices will enable our marketing teams to develop closer ties with those existing and prospective customers within the region. For those existing customers, our field services staff is often our onsite ambassadors who are able to spot and kindle future opportunities to increase the number of systems, or expand on our existing services at an existing customer site.

Finally, many of our current and potential competitors have significantly stronger financial resources, larger marketing and service organizations and significantly greater market expertise than we have. However, we believe that we compete favorably based on the efficacy of our proprietary technology, our newly acquired technological expertise, our technology+services business model, and our significant relationships with our customers. In addition, we believe we also compete favorably based on lower operational costs, lower waste production, range of contaminants that can be treated, smaller system footprint and enhanced customer service.

Sales and Marketing

We market our technology+services offerings through a direct sales force, independent contractors and strategic relationships. In addition, members of our management team leverage their numerous business contacts to capitalize on opportunities to sell our technology+services offerings. Regulatory changes also trigger sales opportunities. For example, in 2006 and 2007, changes in MCLs, especially arsenic and radium, have caused customers to seek solutions such as ours to assist in their efforts to keep their groundwater supplies in compliance with regulatory standards. As a result, we periodically receive inquiries and are asked for referrals about our systems and services. Finally, our existing client base refers our services to other water providers. We also secure business through a procurement bid process in which we compete with others in qualification and proposal processes.

We are in the process of expanding our sales and marketing efforts beyond the arid West into all areas of the United States. Our expansion plans include the creation of five geographic regions (West, Southwest, Southeast, Great Lakes and Northeast) encompassing all of the continental United States to serve as our marketing, sales and technical services platforms for municipal customers within each of those regions. This expansion should assist our marketing efforts, because marketing to municipal customers typically requires a local presence within

the customer’s geographic region. In 2007, we made organizational changes to assign dedicated management, sales and service, marketing, and technical support to certain of these regions. In addition to our West regional office in Rancho Cucamonga, we now have a footprint in the Southeast with our facility in Memphis, and we expect to have a new Southwest regional office in Houston by mid 2008. We currently have a sales presence in the Great Lakes and the Northeast, and plan to open regional offices there in 2008 and 2009. We believe sales and marketing teams at the local level will be more effective because of their knowledge of and relationships with the municipalities within their region. We expect marketing to industrial customers to be more effective on a nationwide basis from one central location. Thus, for our industrial customers, we have a national sales and marketing team supported out of our Memphis facility.

We have expanded our sales and marketing efforts through strategic relationships, including the Rohm and Haas alliance and the agreement with Purifics. Our sales team plans to use Rohm and Haas’ expertise and contacts in the water treatment industry to develop and manage our relationships with customers and our strategic relationships.

Rohm and Haas Alliance

Rohm and Haas Company is a global company that develops advanced materials for customers around the world. Its business spans the world: North America, Latin America, Europe, Middle East, Africa, and Asia-Pacific, with more than 100 manufacturing, technical research and customer service sites in 27 countries. It had annual sales of approximately US $9 billion in 2007. It is a publicly owned company whose stock is traded under the “ROH” symbol on the New York Stock Exchange.

On November 14, 2007, we entered into an exclusive alliance with Rohm and Haas to provide technology solutions and service offerings in both the drinking water market and certain areas of the industrial market. We expect the alliance to also develop new technology to address other groundwater treatment issues, such as produced water from oil and gas operations and emerging water recovery applications. Each member of the alliance will contribute its respective core strengths to the alliance: Rohm and Haas its research and development capabilities, global infrastructure and ion exchange resins and our company its systems designs, channels to market and service capabilities. We expect the alliance to initially market offerings in the United States and Canada using our technology+services business model to provide guaranteed performance and guaranteed costs over the lifetime of a project. As part of the alliance, we have exclusive access to Rohm and Haas ion-exchange resin technology for certain selected markets.

The initial term of the alliance is five years. The parties agreed to renew the alliance agreement if at the end of the initial term the alliance has met projected budget, earnings and growth projections.

Shaw Agreement

Our agreement with Shaw Environmental Inc., or Shaw, expired on December 9, 2007. We continue to work with Shaw on various projects on a case-by-case basis, but as a result of the expiration of the agreement with Shaw we have now reacquired rights to market our arsenic treating systems in all territories to which Shaw had previously been granted exclusive rights.

Government Regulation

Our customers are subject to extensive environmental laws and regulations concerning emissions to the air, discharges to waterways and the generation, handling, storage, transportation, treatment and disposal of waste materials and also are subject to other federal and state laws regarding health and safety matters. Under the contracts with our customers, we assist them in meeting these regulations and obtaining any required permits and/or licenses in order to implement our system. These laws and regulations are constantly evolving, and it is difficult to predict the effect these laws and regulations may have on us or our customers in the future.

In the United States, many different federal, state and local laws and regulations govern the treatment and distribution of contaminated groundwater and disposal of attendant wastes. Changes in such laws and regulations could have a material adverse effect on our business. The increased interest in the treatment of contaminated groundwater due to increased attention on the adverse health effects from contaminated drinking water may result in intervention by governmental regulatory agencies in the United States or elsewhere under existing or newly enacted legislation and in the imposition of restrictions, fees or charges on users and providers of products and services in this area. Conversely, the failure of the EPA or state regulatory agencies to act on a timely basis to set interim or permanent standards for pollutants, or to delay effective dates for standards for pollutants, grant waivers of compliance with such standards or take other discretionary actions not to enforce these standards, may decrease demand for our system and services and thus harm our business significantly.

Each groundwater treatment solution, including our contaminant treatment systems, must be permitted by applicable state regulatory agencies prior to use of such systems by our customers. Typically, our customers apply for a permit from the applicable state regulatory agency to use our system, and we assist our customers in completion of the permit application process. The application process for our system is time consuming and often involves several information requests to our customers by the regulatory agencies with respect to our system.

Furthermore, we cannot predict the impact of changing drinking water standards on the approval of our technology for groundwater treatment. The MCLs for contaminants are subject to review and revision by the EPA and applicable state regulatory agencies. The MCLs may be changed to levels below that which our system can treat on a cost-effective basis, and if we are unable to design a system that removes contaminants below the designated MCL, then the state regulatory agencies will fail to approve our system. Without regulatory approval, our system could not be used by our customers, and we would be required to develop technology that meets any revised MCLs.

Although our customers retain title to the brine waste generated by our systems, we facilitate the removal of the waste with a licensed waste disposal service and in some cases contract directly with the waste transporter on behalf of our customers. As such, we may become subject to the provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, or CERCLA. CERCLA, which is also known as Superfund, addresses problems created by the release or threatened release of hazardous substances (as defined in CERCLA) into the environment. CERCLA imposes strict, joint and several liability for remediation of certain disposal sites on: current owners and operators of the site, on former site owners and operators at the time of disposal, on parties who arranged for disposal or treatment or arranged for transportation for disposal or treatment of hazardous substances at the site, and on parties that transport hazardous substances to a site. Because CERCLA liability is joint and several, the costs of a CERCLA cleanup can be substantial. Because liability under CERCLA is strict, it is not premised upon the violation of any law, statute, rule or regulation but is rather based upon a party’s status as an owner, operator, transporter or arranger (as those terms are described above). Such liability can therefore be based upon the release or threatened release, even as a result of lawful, unintentional and non-negligent action, of any one of the more than 700 “hazardous substances” listed by the EPA, even in small amounts.

Our Memphis Facility. Our facility in Memphis supports services that include catalyst recovery, service exchange programs for containers of spent filtration media, and media processing and regeneration of ion-exchange media for other water service providers and end users that have applied the media to capture or recover various metals, organics, or inorganic compounds. Because our facility does not accept or receive materials that have been profiled as hazardous wastes, it does not maintain environmental permits as a treatment, storage, and disposal facility for hazardous wastes as defined by the EPA and the State of Tennessee. The Memphis facility performs its own independent waste stream profiling and acceptance criteria review to ensure that all materials received for processing and regeneration are applicable to the Memphis facility processes and are in accordance with the facility’s environmental permits.

The Memphis facility’s environmental permits include a National Pollution Discharge Elimination System (NPDES) wastewater discharge permit to discharge process wastewater to the City of Memphis, Tennessee’s

publicly owned treatment works (POTW), an NPDES Stormwater Discharge permit issued by the State of Tennessee, and Special Solid Waste Disposal Permits issued by the facility’s solid waste disposal contractor for the land disposal of certain non-hazardous special waste streams.

Since the Memphis facility is also a Small Quantity Generator (SQG) of hazardous waste, we maintain an EPA generator registration and identification number for their hazardous waste disposal activities.

We are also pursuing business opportunities involving the removal of radionuclides from groundwater and/or industrial wastewater streams. Our plans are to sell or lease the removal systems to third party customers, with an associated service contract for removal and disposal of the resin material upon exhaustion. We would use a licensed subcontractor for transportation and disposal of the media. These activities would fall under regulations governed by the Nuclear Regulatory Commission (NRC). All subcontractors, transporters, and disposal facilities would be required to possess the required NRC permits and licenses to engage in these roles. However, should any of the spent radionuclide-containing resins also contain characteristic or listed hazardous wastes, the resins would be classified as “mixed wastes” and would no longer be regulated by the NRC, but, would be subject to the EPA’s Resource Conservation and Recovery Act (RCRA) hazardous waste regulations.

Given our Memphis facility’s onsite chemical inventory and disposal and/or release of chemical substances / wastes / residues as a part of doing business, the Memphis facility is subject to annual reporting requirements as specified by the EPA Superfund Amendment and Reauthorization Act (SARA) (specifically the SARA 312, Tier II Hazardous Chemical Inventory, and SARA 313, Toxic Release Inventory, regulations).

To the extent we do not comply with the various laws and regulations applicable to our activities, we may be subject to fines, regulatory action or private litigation that may adversely affect our business.

Research and Development

Product development activities include 1) the design and evaluation of experimental ion-exchange processes and groundwater treatment systems for the removal of various contaminants, 2) development of “green” processes for recycle and regeneration of spent medias being conducted at the University of Nevada, Las Vegas, or UNLV, and the University of Maryland Biotechnology Institute, or UMBI, and 3) development of processes involving an array of technologies useful in our expansion from an ion-exchange company to a commercial water treatment company. These development activities include extensive piloting efforts on applications related to the removal of nitrate, arsenic and radionuclides from groundwater.

As part of our research and development, we have developed a technology for biologically removing and destroying perchlorate load from spent ion-exchange resins. This technology combines biological and ion-exchange treatment in an innovative method which to our knowledge has not been used in the past. We have patents granted in five European countries directed to the BIONExchange™ process as well as one patent granted by the USPTO, which is directed to a process for the removal of perchlorate. We have also contracted with the East Valley Water District to install a full-scale perchlorate removal system which will utilize this technology pending permitting by DHS.

We have a sponsored research arrangement with UNLV under which they are researching and testing certain aspects related to the regeneration of exchange resins that may be useful in the BIONExchange™ process. Any intellectual property developed by us under the agreement will be owned by us, any intellectual property developed by UNLV under the agreement will be owned by UNLV and intellectual property developed jointly will be jointly owned by the parties. We have an option to acquire intellectual property from UNLV not solely owned by us, and we paid $0.3 million to UNLV from 2005 to 2007.

In 2007, we sponsored research and testing at the UMBI. This research involves the biological destruction of nitrates from residual brine solutions resulting from ion exchange processes to remove nitrates from

groundwater. In our view, management of residual brines accounts for approximately 75 percent of the costs associated with treatment processes to remove nitrates from groundwater. The biological destruction of nitrates to nitrogen gas reduces waste costs from these treatment processes, thus potentially resulting in more economical solutions to deliver nitrate-free water to our customers. We paid $5,000 to UMBI in the year ended December 31, 2007.

Our total research and development expenses were $0.6 million, $0.6 million and $0.7 million in 2007, 2006 and 2005, respectively.

We intend to continue our active research and development efforts internally and through selective strategic alliances to strengthen the position of our groundwater and other treatment technologies through the development of new and improved processes and the filing of additional patent applications. The principal goals of our research program are maintaining our position as a technological leader in solving customers’ problems with technology+services, and acquiring access to and developing new products and services. We may also continue to pursue expanding our expertise into other water treatment technologies through acquisition of, or strategic alliances with other companies.

Intellectual Property

Our intellectual property is the result of many years of research and development efforts as well as strategic acquisitions and contract relationships. We have pursued a broad strategy of protecting our developed and owned intellectual property, including seeking patent protection, safeguarding trade secrets, registering trademarks and using non-disclosure and other contractual agreements to protect other intellectual property rights.

We have developed what we believe to be an innovative process design that significantly improves the economics of using ion exchange for groundwater treatment. As of December 31, 2007, we have two issued United States patents directed to a system and process for the removal of arsenic, one issued United States patent directed to a process for the removal of nitrate and two issued United States patents directed to processes for the removal of perchlorate. We also have one issued patent in the United States and in five European countries directed to our BIONExchange™ process, a proprietary process for biologically removing and destroying perchlorate load from used ion-exchange resins and alternatively from perchlorate-laden ion-exchange resin regeneration brines. We currently are developing technology related to the removal of chromium VI and radium, for which we plan to seek patent protection.

In addition, we hold eight pending United States patent applications and eleven pending foreign patent applications on various aspects of our treatment processes. Our patents and patent applications as a group are related to ion exchange and the treatment of one or more of the following contaminants:

Arsenic

Calcium

Chromium VI

Magnesium

Nitrate

Perchlorate

Selenium

We employ the Basin Water IX™ software program for the operation of our system. We also use this software program for the design of our system to determine the most efficient operating parameters for our system based upon the contaminant profile of the water source being treated.

We have pending trademark applications in the United States for Basin Water® and Basin Water IX™.

As part of our business procedures, we typically enter into confidentiality and invention assignment agreements, or have confidentiality provisions in agreements with our employees, independent contractors and consultants, and non-disclosure agreements with our customers, partners, independent contractors and consultants.

MPT, which was acquired by us in September 2007, holds five United States patents and twelve foreign patents related to various chemical manufacturing processes. These patents relate to 1) an improved process for the recovery of ethylene glycol from spent glycol generated in the manufacture of polyethylene terephthalate, 2) an improved separation process for the continuous catalytic oxidation of aromatic alkyls for the production of aromatic carboxylic acids in a liquid solvent medium, 3) an apparatus and method for the purification of waste wash water derived from the production of aromatic acids, 4) a method of polyester manufacturing using cross flow membrane filtration, and 5) a process for the recovery of molybdenum catalyst from the epoxidation reaction product of olefins with organic hydroperoxides.

MPT also has three pending United States patent applications related to processes for the treatment of the following contaminants: nitrate, ammonia and radium.

The pending patent application related to the treatment of radium has been assigned to us pursuant to our acquisition of MPT. In 2008, we plan to have the other patents and pending patent applications assigned to us.

MPT also holds trademark registrations for Hypersorb®, Hyperflux® and Chromasep®.

Employees

As of December 31, 2007, we employed 107 full-time and 5 part-time employees. None of our employees are represented by a collective bargaining agreement. There are no pending labor-related legal actions against us filed with any state or federal agency. We believe our employee relations are good.

ITEM 1A.RISK FACTORS

Risks Related to Our Business

We have a limited operating history, have incurred significant operating losses in our first few years of operation and have not consistently achieved profitability on an annual basis.

We have a limited operating history and limited revenues derived from our operations. We began our business operations in December 1999 and did not generate our first revenues until 2002. Our revenues grew from $12.2 million in 2005 to $17.1 million in 2006 and $18.8 million in 2007. We have incurred significant net losses attributable to common stockholders since our inception, including net losses of $1.3 million in 2003, $0.6 million in 2004, $11.2 million in 2006 and $15.3 million in 2007. Our net loss in 2006 resulted in part from reserves we recorded in connection with certain of our contracts which have ongoing operating costs in excess of our contract revenues. In addition, our net loss in 2007 resulted in part from additional reserves we recorded in the third quarter of 2007. We took these reserves in connection with certain older legacy projects when it became apparent that most of these projects would be operating at a loss for some period of time. In addition, we may find that additional contracts have ongoing operating costs in excess of revenues, which could have an adverse effect on future results of operations. Though we have taken steps to improve our business processes, we cannot assure you that these improved processes will positively impact our results of operations. At December 31, 2007, we had an accumulated deficit of approximately $30.5 million.

Our operations prior to 2006 primarily focused on development of our technology and onsite regenerable ion exchange treatment system, building our sales and marketing capabilities, commencing the commercial

launch of these systems and developing and maintaining customer relationships. In late 2006 and throughout 2007, we implemented several initiatives to improve our business model, but we cannot assure you that any of these initiatives will result in increased revenues or positively impact our financial results. In addition, our ability to successfully sell our systems and services depends on, among other things, the level of demand for contaminated groundwater treatment, which is an evolving market, and the demand for our technology and services in those geographic areas and markets into which we are expanding. Even if we do achieve significant revenues from our business operations, increased operating expenses associated with any expansion of our business may result in future operating losses in the near term as we, among other things:

market our new technology+services offering to our customers;

seek to acquire new customers in the markets in which we are currently active;

expand our technology offering to broaden our reach into new markets, such as the industrial marketplace;

expand geographically throughout the United States pursuant to our regionalization structure;

make significant capital expenditures to support our ability to provide services under our recurring revenue contracts;

expand our internal sales force and develop strategic relationships with companies serving the water, wastewater, waste reduction and resource recovery industries on a national basis;

fund development costs for our systems and technology; and

incur increased general and administrative expenses as our company grows, including increased costs as a result of being a public company.

As a result of these and other factors, we may not achieve, sustain or increase our profitability on an ongoing basis.

Our future operating results will likely fluctuate significantly from reporting period to reporting period.

We expect our future revenues and operating results to fluctuate significantly from period to period due to a number of factors, including:

customer budgets or commitments for our systems and/or services;

the effectiveness of our new and expanding internal sales and marketing organization;

demand for our systems and/or services;

demand for low life-cycle cost solutions among our current and potential customers;

our ability to develop and market new and enhanced technology and our technology+services business model in a cost-effective manner;

our product and price competition in our market;

length of our sales cycle, which is impacted by procurement bidding processes;

our ability to enter into third-party financing arrangements where a customer selects a long-term capital contract, thus recognizing revenue over longer periods of time;

general economic conditions;

ability to control our costs, including labor and the cost of materials to build our system;

increases in the costs of salt, resin, chemicals, waste disposal and other materials necessary to fulfill our obligations under our recurring revenue contracts;

our ability to pass through increased operating costs to our customers under our recurring revenue contracts;

our ability to work with companies with whom we enter into strategic alliances and relationships in a cost-effective manner; and

our ability to build and install systems and provide services on a timely basis and on a low life-cycle cost basis.

Any of the foregoing factors, some of which are not within our control, may cause our operating expenses to be disproportionately high or cause our revenues and operating results to fluctuate, which could prevent us from maintaining or increasing our business or could harm our results of operations. In addition, our future revenues or our future operating expenses may not be consistent with our past results, which could adversely affect our stock price.

If we do not manage our anticipated growth effectively, we may not be able to develop or implement the infrastructure to support our operations, market our services, manage our relationships with customers and our relationships with strategic partners which could place significant strain on our management and significantly harm our business and operating results.

We have grown rapidly, with our revenues increasing from $4.3 million in 2004 to $12.2 million in 2005, $17.1 million in 2006 and $18.8 million in 2007, and the number of our employees increasing from 44 as of December 31, 2005 to 65 as of December 31, 2006 and 107 full time and 5 part time employees as of December 31, 2007. We expect to continue to expand significantly our management, sales and marketing, engineering functions, field services, research and development, testing, quality control, customer service and support operations as well as financial and accounting controls. For instance, we recently expanded our operations to the Southeast U.S. with our acquisition of MPT. This expansion has placed, and will continue to place, significant strain on our management and administrative, operational, technical and financial infrastructure. If our management is unable to manage growth effectively, the quality of our field services, our ability to attract and retain key personnel, the success of our strategic alliance and relationships, and our business or prospects could be harmed significantly. To manage growth effectively, we must:

continue to expand our fabricating capacity;

increase the size of and continually monitor our field service support capability;

meet the demands placed on us by our customers;

continue to enhance our operations and financial and management systems;

increase our sales and engineering personnel;

maintain and improve effective internal control over financial reporting, disclosure controls and procedures and our budgeting and forecasting processes;

expand, train and manage our employee base; and

allocate sufficient management and other resources to support and manage both our internal operations and our strategic relationships.

We may not be able to effectively manage any expansion in one or more of these areas, and any failure to do so could harm our ability to maintain or increase revenues and operating results. In addition, our growth may require us to make significant capital expenditures or to incur other significant expenses, and may divert the attention of our personnel from our core business operations, any of which could affect our financial performance adversely.

Our financial success will depend in part on the efforts of strategic relationships we may work with in the future.

In November 2007, we announced the formation of an exclusive, service-based alliance with Rohm and Haas. This alliance provides us with exclusive access in selected markets to the Rohm and Haas ion-exchange resin technology which we intend to deploy as part of our business model. Our alliance also provides us access to technology for the removal of organic contaminants from water, support for our business model through access to the Rohm and Haas scientific and laboratory resources and Rohm and Haas’ developed channels to the specified markets. In late 2007, we entered into an agreement with Purifics to provide us with unique engineered systems, solutions and products effective in removing organic contaminants from groundwater. Under this agreement, we can exclusively market the Purifics photocatalysis technology in certain areas of the United States, and we have access to the technology on a non-exclusive basis in a larger market area. We may enter into other such strategic relationships with other companies focused on the water, wastewater, waste reduction and resource recovery industries on a national basis. Our financial success and our anticipated growth will depend in part on the efforts of these strategic relationships as we market and sell our treatment systems and solutions. If Rohm and Haas, Purifics or any other strategic relationships fail to perform satisfactorily under their respective agreements with us, or if we fail to maintain these relationships, or establish new relationships as required, then we may lose our access to their technologies, and our ability to market our treatment systems and our technology+services offering will likely suffer. In addition, our revenues resulting from these strategic relationships may not grow as anticipated, and we could be subject to additional costs which could negatively impact our operating results and financial condition significantly.

Our long sales cycles make predicting our financial results difficult.

Many of our service contracts have a term of five or more years, and some contain an option either to purchase the system or to renew the contract at the end of the initial contract term. Since most of our sales are based on long-term contracts, our customers generally take a longer time to decide to purchase our system and/or services, thus creating a lengthy sales cycle. Other reasons for our long sales cycle include:

the size of the initial capital outlay to be incurred by our customers;

the budget constraints of municipal and industrial customers that may cause delays in project selection;

extensive contract negotiations over the specific terms of the sale of our system and/or services;

the unfamiliarity of some of our customers with utilizing third parties for water and wastewater treatment, waste reduction and resource recovery services;

the resistance by customers to granting control of support functions such as water treatment to external parties;

the availability of many competitive alternatives that may be considered by our customers in the municipal market, including water importation, water blending, coagulation microfiltration (a process of destabilizing charges on contaminants in water by adding chemical coagulants that can then be filtered and removed), reverse osmosis (a pressure-driven separation process that removes contaminants from water by forcing them through a membrane barrier), electrodialysis reversal (a process that transfers contaminants by direct electric current flow through membranes thus removing them from water) and ion exchange processes of our competitors;

the availability of competitive alternatives to our existing and developing technology+services offerings;

the availability of competitive alternatives to our existing and developing offerings in the wastewater treatment, waste reduction and resource recovery industries;

the long approval procedures imposed by government agencies; and

the lengthy approval process of many customers’ equipment/contract procurement procedures due to multiple approvals that may be required by, for example, municipal boards, public bidding or state public utility commission requirements, which is sometimes exacerbated by the initial capital outlay needed to purchase our systems and services.

In addition, to the extent we expand our service to international markets, we may face additional factors that contribute to long sales cycles, including additional time required for travel to foreign locations as well as potential problems caused by language barriers, cultural differences, differing business practices, differing contracting practices, and varying regulatory requirements. Our long sales cycles, as well as the placement of large orders with short lead times on an irregular and unpredictable basis, may cause our revenues and operating results to vary significantly and unexpectedly from period to period. Since our operating expenses are largely based on anticipated revenue trends and a significant portion of our expenses are, and will continue to be, fixed, any delay in generating or recognizing revenues could harm our operating results or financial condition significantly.

Our ion-exchange treatment systems and the technologies upon which they are based may not achieve widespread market acceptance among our customers which may impact demand for our system and services.

We have developed our proprietary ion-exchange technology and processes for groundwater treatment based on ion-exchange technology that competes with other forms of groundwater treatment technologies that currently are in operation throughout the United States. This proprietary technology is used in our onsite regenerable and disposable resin treatment systems. Through our acquisition of MPT, we have expanded our capabilities into central regeneration for ion exchange, smaller ion-exchange systems and technologies to serve customers in the industrial markets. These treatment systems and the technologies on which they are based may not achieve widespread market acceptance. Our success will depend on our ability to market our systems and services to businesses and customers on terms and conditions acceptable to us and to establish and maintain successful relationships with municipal and industrial customers.

We believe that market acceptance of our systems and technology and our related success will depend on many factors including:

the perceived advantages of our systems over competing treatment solutions;

the actual and perceived safety and efficacy of our systems;

the availability and success of alternative treatment solutions;

the pricing and cost effectiveness of our systems;

our ability to market effectively to municipal and industrial customers that may use our systems;

the permitting of our technology by regulatory agencies;

the willingness of potential customers to enter into long-term service contracts;

publicity concerning our systems and technologies or competitive solutions;

timeliness in assembling and installing our systems on customer sites;

whether or not our existing customers continue to use our system and services and/or renew service contracts after their expiration;

our ability to respond to changes in the regulatory standards for maximum contaminant levels of various contaminants;

the ability of our strategic relationships to provide necessary support to our efforts to market their technologies now available to us from our strategic alliance and other agreements;

our ability to provide effective service and maintenance of our system to our customers’ satisfaction; and

our ability to control operating costs.

If our systems or technologies fail to achieve or maintain market acceptance or if new technologies are introduced by others that are more favorably received than our technology, are more cost effective or otherwise render our technologies obsolete, we may experience a decline in demand for our systems and services. If we are unable to market and sell our systems and services successfully, our revenues would decline and our operating results and prospects would suffer.

We may be unable to attract and retain qualified personnel which could harm our business, operating results, financial condition and prospects significantly.

Our future success also will depend, in large part, on our ability to identify, attract and retain sufficient numbers of highly skilled employees, particularly qualified sales, marketing and engineering personnel. As of December 31, 2007, we had 107 full-time and 5 part-time employees. Although we have expanded our sales force somewhat, we have a limited number of sales and marketing employees and consultants, as well as service employees who provide field and other services to our treatment systems. We may not succeed in identifying, attracting and retaining individuals who qualify for these positions. Further, competitors and other companies may attempt to recruit our employees. If we are unable to hire and retain adequate staffing levels, it may be difficult to increase sales of our systems or services or adequately support our installed systems, which could harm our business and prospects.

Our future success also depends on the experience and expertise of our President and CEO, whose talents, efforts and relationships within the water industry have been, and continue to be, critical to our success. We have an employment agreement with our CEO that provides for “at will” employment. However, we cannot prevent our CEO from leaving our employ if he chooses to do so. We do not currently carry “key man” insurance upon the life of our CEO or the lives of any of our employees or officers. The loss of our CEO’s services and access to his abilities and relationships could adversely affect our ability to maintain or increase our customer base and could harm our operating results and prospects significantly.

The current geographic concentration of our customers in California and Arizona and the location of our headquarters in California make our business particularly vulnerable to adverse conditions affecting these markets.

Currently, our customers are concentrated geographically, primarily in the states of California and Arizona. Our revenues and operating results are therefore subject to local regulatory, economic, demographic and weather conditions in those areas. A change in any of these conditions could make it more costly or difficult for us to conduct our business. In addition, we are subject to greater risk of loss from earthquakes and wildfires because our headquarters, where we assemble our onsite regenerable systems, and most of the well locations that utilize our system are concentrated in California. Any of these occurrences could result in increased costs and a disruption in our operations, which would harm our operating results and financial condition significantly.

Due to our current client concentration, a loss of one of our significant customers could harm our business, operating results, financial condition and prospects.

As of December 31, 2007, we had 25 customers, not including approximately 200 small customers we added as a result of our acquisition of MPT. Our top three customers collectively accounted for 53% of our revenues during 2007 and typically have more than one contract with us for services provided to different wells. Our customers, including these top three customers,

may, upon the occurrence of certain circumstances, elect to terminate their contracts with us prior to their contractual expiration date and seek services from our competitors. In addition, upon the expiration of these contracts, our customers may decide not to renew such contracts with us. If we were to lose one or more of these significant customers for any reason, our revenues would decline significantly and our business, operating results and prospects would suffer.

We may face risks associated with our geographic expansion.

We are implementing a regional structure in which we plan to open offices in five regions throughout the United States to support our municipal customers and one office to support our industrial customers. Our ability to expand our offering geographically will depend on our ability to recruit, hire, train and motivate sales, operations and field services personnel. If we are unsuccessful in gathering a critical mass of projects in a regional office, we may find it additionally difficult to recruit and hire sales, operations and field services personnel or leverage our overhead costs or to maintain the profitability of such regional office. Our operations in these regional offices, including our industrial operations office, will be far from our executive offices in Southern California and will require additional management time and attention. Failure to properly supervise the personnel in these offices could result in loss of new business and potentially harm future sales prospects. In addition, as our systems and services for industrial customers become accepted in North America, these customers may require us to support their international activities which will require additional time and resources. Supporting the marketing, development, process design, and operations of potentially distant operations will further challenge our management team and operations and could cause harm to our business or operating results.

Most of our operations are conducted in our facilities in Southern California and our facility in Memphis, Tennessee. Disruptions at these facilities could increase our expenses.

A significant portion of our fabricating operations for our onsite regenerable and disposable resin treatment systems are conducted in one facility in Southern California. In addition, our executive offices are also located in Southern California. Our central resin regeneration operations for our offsite regenerable treatment systems and our base of our operations servicing the industrial markets are located at our facility in Memphis, Tennessee. We take precautions to safeguard our facilities, including obtaining insurance, maintaining health and safety protocols, and using off-site storage of computer data. However, a natural disaster, such as an earthquake, fire or flood in Southern California or a tornado, flood or earthquake in Memphis, could cause substantial delays in our operations, damage or destroy our fabricating equipment, resin regeneration facility or inventory and cause us to incur additional expenses. The insurance we maintain against natural disasters may not be adequate to cover our losses in any particular case, which would require us to expend significant resources to replace any destroyed assets, thereby harming our financial condition and prospects significantly.

We face risks associated with the historical and current operations at our Memphis facility.

We acquired our Memphis facility in September 2007 and have limited operating experience with this facility. From our Memphis facility, we regenerate the ion-exchange resins associated with our offsite regenerable treatment systems and for other customers that have not purchased one of our systems but who require resin. Any problems we face in shipping or transporting resins to our Memphis facility for regeneration, the inability to regenerate certain resins, or any other problems at our Memphis facility that would prevent us from timely providing regeneration services on a cost-effective basis would adversely affect our relationships with our customers, our business and our results of operations.

In connection with our acquisition of MPT, we obtained indemnification from the MPT stockholders for any violations of environmental laws that occurred prior to the acquisition date. We cannot assure you that there are no environmental risks associated with the Memphis facility or that indemnification obligations of the MPT stockholders with respect to any such problems will adequately protect us from any liability we may face. In

addition, we cannot be certain that the materials characterization procedures at our Memphis facility are adequate to properly identify and dispose of hazardous waste. If these procedures are deficient, then we may be in violation of certain environmental laws which could result in potential liability or disruptions in our operations.

Our Memphis facility is over 50 years old and may also contain latent defects or other damage of which we are unaware. In the future, this facility may also lack the capacity to meet our needs for central regeneration of resins or for conducting our industrial market operations. Any of these occurrences could require us to make substantial investment in this facility so that it meets our needs, or require us to relocate our operations from this facility, which would result in significant disruptions in our operations at this facility.

Also in connection with our acquisition of MPT, we assumed certain legacy contracts and other arrangements to which MPT was a party. Some of these contracts may have terms that we do not find to be favorable or compatible with our business plans, including our ability to expand and/or penetrate markets. We may be unable to renegotiate these contracts on more favorable terms or at all, which may adversely impact our business and results of operations.

Because our Memphis facility serves as the base for our marketing efforts in the industrial markets, a disruption at our Memphis facility would significantly impair our ability to market to industrial customers, which could adversely affect the growth of our business. In addition, we may face difficulties in attracting, recruiting, and retaining employees with the requisite technical or operating talent to Memphis for our expansion into industrial markets.

Because our Memphis facility serves as the base for our geographic expansion into the Southeast, a disruption at our Memphis facility could significantly impair our ability to expand our marketing and field services into this region.

We face risks associated with the design and operation of our systems which may prevent us from increasing our revenues.

We take responsibility for the design, construction, initial maintenance and installation of our ion exchange systems. However, we cannot predict whether we will be able to design our systems for every particular contaminant. Thus, we may be required to turn away customers that require treatment of chemical contaminants that our systems do not treat. We also cannot guarantee that once constructed, our systems will operate according to their design or be free from defects. Because many of our systems treat groundwater for dangerous contaminants, if our systems fail to operate properly, it could cause significant public harm, especially for drinking water applications.

Following installation, testing and regulatory certification of a system, actual day-to-day operation of our groundwater treatment systems is transitioned to our customer’s personnel. Though we retain ownership of many of our systems, our customers take responsibility for operation of some of these systems. We, however, continue to be responsible for the maintenance of the installed systems in most cases. We may not be able to provide sufficient employees for the maintenance of those systems. In addition, because our systems are located at our customers’ sites, we will not always be physically present should problems arise.

If there are defects in our system or if significant reliability, quality or performance problems develop with respect to our system or services, this may have a number of negative effects on our business, operating results, financial condition and prospects, including:

loss of revenues;

failure to attract new customers and achieve market acceptance;

delays in collecting accounts receivable;

diversion of management and development resources and the attention of engineering personnel;

significant customer relations problems and loss of existing customers;

high service, support, repair, warranty and insurance expenses;

removal of our systems from service by state regulatory agencies for failure to operate properly; and

legal actions for damages by our customers.

In order to operate our business successfully, we must meet evolving municipal customer requirements for groundwater treatment and invest in the development of our technology.

If we fail to develop or enhance our system and services to satisfy evolving municipal customer demands, our business, operating results, financial condition and prospects may be harmed significantly. The market for groundwater treatment in the municipal markets is characterized by changing technologies, periodic new product introductions and evolving customer and industry standards. For instance, competitors in the groundwater treatment industry are continuously searching for methods of groundwater treatment that are more cost-effective and more efficient. Our current and prospective municipal customers may choose future groundwater treatment solutions and/or services that might be offered at a lower price than our system and/or services. To achieve market acceptance for our system and services, we must effectively and timely anticipate and adapt to customer requirements and offer products and services that meet customer demands. Our municipal customers may require us to provide water treatment solutions for new contaminants or higher volumes of water or to decrease the presence of contaminants well below an applicable MCL which may increase our operating costs for those systems and harm our results of operations. We also may experience design, engineering and other difficulties that could delay or prevent the development, introduction or marketing of any modifications to our system or our new services. Our failure to successfully develop and offer systems or services that satisfy customer requirements would likely cause a decrease in our financial performance. In addition, if our competitors introduce solutions and/or services based on new or alternative water treatment technologies, our existing and future systems and/or services could become obsolete, which would also weaken demand for our systems or services, thereby decreasing our revenues and harming our operating results.

Serving customers in industrial markets presents numerous risks.

We face numerous risks as we expand our services to customers in the industrial markets. We have limited experience in serving industrial market customers and have never provided systems or services to customers in the oil, gas or mining industries. Industrial customers may have different requirements and goals than our municipal customers. Our industrial customers may choose treatment solutions and/or services that are offered on a low life-cycle cost basis or that give them an advantage from a technological standpoint. They may also require us to tailor our systems to meet their specific business needs, which may result in additional development and design costs. We may have difficulty in developing technologies and services that address the needs of these customers and in hiring the appropriate engineering or other talent that can develop such technologies. In some cases, we may be required to conduct a pilot project to address an industrial market customer’s needs. We may expend significant time and resources in building and conducting the pilot project, and there can be no assurance that the pilot will successfully uncover all key process variables required to successfully scale up a particular process or meet the customer’s requirements. Since these processes have not been successfully commercialized, more extensive or other pilot testing may be required.

Even if we meet the customer’s treatment requirements at the pilot stage, when we build the full-scale treatment system, positive results from a pilot test might not provide an accurate indication of the treatment capabilities of and the cost of operation of a full-scale treatment system, and thus, we may have problems meeting the relevant treatment requirements on an economically feasible basis or at all. Additionally, startup of new industrial process facilities could cause increased safety risks until processes and procedures for normal operation, upset conditions and emergency conditions are established and well understood by our employees. To

the extent we are unable to meet these customers’ demands and requirements, our expansion into these markets may not be successful which would adversely affect our business, operating results, financial condition and prospects. The economics of the systems for some of our industrial customers may rely on the recovery of a valuable resource from waste streams. Should the underlying economics of the resource deteriorate significantly, demand for these types of our systems and services may decline which could have an adverse effect on our business and operating results.

Industrial market customers may pose credit risks that we do not necessarily face to the same degree with our municipal market customers. Our industrial market customers may not be economically viable, might be newly formed without adequate capitalization and/or may be highly dependent on commodity prices, such as companies in the oil, gas and mining industries. Changes in commodity prices will particularly impact the viability of our business in recovery of valuable materials. Finally, when we install our treatment system onsite for an industrial customer, we must take into account the location which our customer provides us for the installation. We, our systems or the hazardous chemicals we use in our systems may damage the property or harm our customer’s personnel that may be in proximity to our systems, or we may adversely impact our customer’s operations while we install, service and/or repair our systems. In addition, our employees may be injured by hazardous chemicals, machinery or other dangers at our customer’s site during the installation, operation and/or servicing of our systems. Because of our unfamiliarity with building systems for the industrial markets, we may not understand all of the safety and other risks associated with these systems until we have more experience servicing this industry. Any of these risks could have an adverse effect on our ability to address the industrial market.

Our reliance on third party suppliers and manufacturers poses significant risks to our business and prospects.

We contract for all of the components in our system and for all of the commodities necessary to fulfill our service obligations, including salt, chemicals and replacement resin, with third-party suppliers. We plan to rely on third party suppliers and manufacturers for systems we market to industrial customers. We are subject to substantial risks because of our reliance on these suppliers and manufacturers. For example:

our suppliers may increase prices for these commodities that exceed contract provisions to recover such costs;

our suppliers may not provide components that meet our specifications in sufficient quantities;

our suppliers and manufacturers may face a reduction or an interruption of supply of our components;

our manufacturers may lack the capacity and resources to continue to manufacture our systems or supply them in sufficient quantity to meet our demands;

our suppliers and manufacturers may face production delays due to natural disasters or strikes, lock-outs or other such actions;

one or more suppliers or manufacturers could make strategic changes in its or their product lines;

there may be a lack of alternative suppliers for certain product lines; and

many of our suppliers and manufacturers are small companies which are more likely to experience financial and operational difficulties than larger, well-established companies, because of their limited financial and other resources.

As a result of any of these factors, we may be required to find alternative suppliers for the components of our system or alternative manufacturers for our systems marketed to industrial customers. It may take considerable amounts of time to identify and qualify such alternative suppliers. In addition, we may be required to redesign our system to conform to the components provided by these alternative suppliers. As a result of these factors, we may experience delays in obtaining raw materials and components on a timely basis and in sufficient

quantities from our suppliers, which could result in delays in the production and installation of our system. We may also face delays in the manufacture and assembly of our industrial market systems from third party manufacturers. These delays could impact our ability to sell our systems, enter into recurring revenue contracts or profitably execute our service agreements, which would cause our revenues and operating results to decline. In addition, we have lacked the leverage or have otherwise been unable able to negotiate consistently long-term contracts for the supply of components and commodities necessary to build our systems and fulfill our service obligations. As a result, rising component or commodity prices could increase our expenses and adversely affect our results of operations.

We often place our systems through a party other than the party with whom we enter into a long-term contract which may cause difficulties in selling our systems and offering our services.

When we sell a system to a municipal or industrial customer, we often contract with a general contractor as opposed to our actual customer. We often enter into a separate long-term contract for servicing the system directly with our municipal or industrial customer. Contracting with different parties can create difficulties for us, including having inconsistent terms between the two contracts which makes it more difficult to successfully close the transaction and could harm our relationships with our customers. These difficulties may adversely affect our business and results of operations.

As part of our growth, we intend to increase our ability to provide service to our customers under recurring revenue contracts and develop new technologies internally. Our failure in these endeavors could negatively impact our stock price and cause our business, operating results, financial condition and prospects to suffer.

We plan to continue to grow rapidly for the foreseeable future. As part of this growth, we intend to make significant capital expenditures to support our operations focused on our recurring revenue contracts. In addition, we plan to continue developing new technologies through our research and development efforts. The capital expenditures we incur or the technologies we develop internally may not result in the financial results that we expect. In addition, developing new technologies may cause diversion of management’s attention from our existing business. Any or all of these factors could prevent us from maintaining or increasing our customer base and business and cause the price of our common stock to decline.

The revenues from certain of our long-term contracts for onsite regenerable treatment systems are moderately seasonal, with higher processing fees received in the summer months and lower processing fees received in the winter months.

Our business, particularly the revenues we receive from our long-term contracts, is moderately seasonal due to the impact of summer and hot weather conditions on the water requirements of our customers. In the summer and warmer months, our customers have a higher demand for water and generally increase the utilization of their groundwater resources resulting in a higher volume of groundwater treated during a period and thus higher revenues from our long-term contracts. However, this increased utilization results in increased operating costs for us, which could adversely affect our profit margins and results of operations. Conversely, our customers experience lower demand in cooler months in the first and fourth calendar quarters, resulting in lower revenues from our long-term contracts during those periods. This seasonality in processing fees has resulted in fluctuations in our revenues and operating results. These moderate seasonal trends can cause some reductions in our profit margin and variations in our financial condition.

We own a large stake in Empire Water Corporation, and to the extent that it does not succeed, the value of our investment in Empire Water Corporation may decline.

We recently disposed of our rights to purchase certain water assets to Empire Water Corporation, or Empire, in exchange for approximately 32% of the outstanding stock of Empire. After the closing of an anticipated

second financing, we expect to own approximately 37% of the outstanding stock of Empire. To the extent that Empire does not succeed in its operations or business, the value of Empire’s common stock will likely decline, which would cause the value of our investment in Empire to decline. Such a decline in the value of our investment would have an adverse effect on our financial position and results of operations.

We have been named as a party to lawsuits, including class action and derivative action lawsuits, and we may be named in additional litigation, all of which could require time and attention from certain members of management and result in significant legal expenses. An unfavorable outcome in one or more of these lawsuits could have a material adverse effect on our business, financial condition, results of operations and cash flows.

On October 26, 2007, Veolia Water North America Operating Services, LLC and certain other related parties filed a lawsuit in the United States District Court of the Middle District of Florida, Tampa Division, naming as defendants Basin Water-MPT, Inc. (a wholly owned subsidiary of Basin Water, Inc.) and two of its employees, one of whom is the son of Basin Water, Inc.’s President and Chief Executive Officer. The lawsuit alleges, among other things, certain claims related to trade secrets and unfair trade practices relating to treatment of by-products produced as a result of the phosphate mining industry. The lawsuit does not claim a specific amount of damages.

On December 27, 2007 and January 2, 2008, two purported securities class action complaints were filed in the United States District Court for the Central District of California against Basin Water, Inc., Peter L. Jensen, Michael M. Stark and Thomas C. Tekulve (collectively referred to as the “Basin defendants”) for violations of the Exchange Act. These lawsuits, which contain similar allegations, are captionedPoulos v. Basin Water, et al., Case No. CV 07-8359 GW (FFMx) andNofer v. Basin Water, et al., Case No. CV 08-0002 SGL (JCRx). The lawsuits, among other things, allege that the Basin defendants “issued materially false and misleading statements regarding the Company’s business and financial results” because the Company “had not adequately accounted for reserves in connection with its legacy system contracts.” Plaintiffs allege a putative class period between May 14, 2007 and November 13, 2007, and do not claim a specific amount of damages.

On January 23, 2008, we received a letter dated January 17, 2008, from attorneys representing a purported shareholder demanding that we investigate and remedy alleged breaches of fiduciary duty by certain unnamed officers and directors of the Company. In the demand letter, the attorneys allege that the unnamed officers and directors violated their duties to the Company by, among other things, participating in or permitting the company to issue false and misleading statements regarding our business and financial results giving rise to the above named lawsuits.

On January 31, 2008, Loren Charif, a purported stockholder of our company, filed a shareholder derivative lawsuit in the Superior Court of the State of California, County of San Bernardino, against certain of our executive officers and our current directors. The complaint assumes the truth of the aforementioned allegations in the federal securities class action lawsuits and in connection with those allegations alleges, among other things, breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of California Corporations Code pertaining to allegations of improper selling.

From time to time, we are involved in legal and administrative disputes and proceedings arising in the ordinary course of business, which we believe are not material to the conduct of our business.

We are subject to risks related to our international operations.

We currently serve some international customers from our Memphis facility. We may serve additional international customers or expand our operations internationally. As we expand our international operations, we will be increasingly susceptible to the following risks associated with international operations:

import and export license requirements;

trade restrictions;

changes in tariffs and taxes;

restrictions on repatriating foreign profits back to the United States;

the imposition of foreign and domestic governmental controls;

unfamiliarity with foreign laws and regulations and ability to enforce obligations of foreign partners;

difficulties in staffing and managing international operations;

product registration, permitting and regulatory compliance;

significant, time-consuming and expensive travel to foreign locations;

fluctuations in foreign currencies;

language and cultural barriers;

thefts and other crimes; and

geopolitical conditions, such as terrorist attacks, war or other military action.

In addition, we may develop formal and informal relationships with existing and new local business partners who can provide local expertise and sales and distribution infrastructure to support our expansion in our target international markets, which will be time-consuming and costly. Several of the risks associated with our international business may be within the control (in whole or in part) of these local business partners with whom we have established relationships or may be affected by the acts or omissions of these local business partners. No assurances can be provided that these local business partners will effectively help us in their respective markets and the inability to do so would adversely affect our business, prospects, financial condition and results of operations.

Risks Related to Our Intellectual Property

Failure to protect, or uncertainty regarding the validity, enforceability or scope of, our intellectual property rights could impair our competitive position.

Our treatment systems and services utilize a variety of proprietary rights that are important to our competitive position and success. Because the intellectual property associated with our technology is evolving and rapidly changing, our current intellectual property rights may not protect us adequately. We rely on a combination of patents, trademarks, trade secrets and contractual restrictions to protect the intellectual property we use in our business. In addition, we generally enter into confidentiality or license agreements, or have confidentiality provisions in agreements, with our employees, consultants, strategic relationships and customers and control access to, and distribution of, our technology, documentation and other proprietary information. Our pending patent applications may not be granted or, if granted, the resulting patent may be challenged or invalidated by our competitors or by other third parties. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our intellectual property. In addition, monitoring unauthorized use of our intellectual property is difficult, and we cannot be certain the steps we have taken to protect our intellectual property will prevent unauthorized use of it.

Because legal standards relating to the validity, enforceability and scope of protection of patent and intellectual property rights in new technologies are uncertain and still evolving, the future viability or value of our intellectual property rights is uncertain. Furthermore, our competitors independently may develop similar technologies that limit the value of our intellectual property or design around patents issued to us. If competitors or third parties are able to use our intellectual property or are able to successfully challenge, circumvent, invalidate or render unenforceable our intellectual property, we likely would lose a significant portion of our competitive advantage in the market. We may not be successful in securing or maintaining proprietary or patent

protection for the technology used in our systems or services, and protection that is secured may be challenged and possibly lost. We may have to prosecute unauthorized uses of our intellectual property and the expense, time, delay and burden on management of such litigation could prevent us from maintaining or increasing our business. Our inability to protect our intellectual property adequately for these and other reasons could result in weakened demand for our systems or services, which would result in a decline in our revenues.

In addition, we have entered into an alliance agreement with Rohm and Haas and an agreement with Purifics, pursuant to which we have access to certain of their technologies. To the extent that each of these parties faces a challenge to its intellectual property rights in those technologies, it could have an adverse effect on our ability to market our systems and/or services that incorporate those technologies which would result in a decline in our revenues.

We could become subject to litigation regarding intellectual property rights, which could harm our business significantly.

Our commercial success will continue to depend in part on our ability to make and sell our systems or provide our services without infringing the patents or proprietary rights of third parties. We face these risks with respect to intellectual property that we have developed internally, as well as with respect to intellectual property rights we have acquired from third parties. For example, pursuant to our alliance agreement with Rohm and Haas and our agreement with Purifics, we have access to the technologies owned by each of these companies. To the extent either of these parties has failed to adequately protect the technologies upon which we rely or if these technologies infringe upon the patents or proprietary rights of third parties, we may be unable to continue using such technologies or we may face lawsuits related to our past use of these technologies. In addition, our competitors, many of which have substantially greater resources than us and have made significant investments in competing technologies or products, may seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make or sell our systems or provide our services.

If we are unsuccessful in any challenge to our rights to market and sell our systems, our rights to use third party technologies or to provide our services, we may, among other things, be required to:

pay actual damages, royalties, lost profits and/or increased damages and the third party’s attorneys’ fees, which may be substantial;

cease the development, manufacture and/or marketing of our systems or services that use the intellectual property in question through a court-imposed sanction called an injunction;

expend significant resources to modify or redesign our systems or other technology or services so that they do not infringe others’ intellectual property rights or to develop or acquire non-infringing technology, which may not be possible; or

obtain licenses to the disputed rights, which could require us to pay substantial upfront fees and future royalty payments and may not be available to us on acceptable terms, if at all.

Even if we successfully defend any infringement claims, the expense, time, delay and burden on management of litigation could prevent us from maintaining or increasing our business. Further, negative publicity could decrease demand for our systems and services and cause our revenues to decline, thus harming our operating results significantly.

If we are unable to protect the confidentiality of our proprietary information and know-how, the value of our technology, systems and services could be harmed significantly.

We also rely on trade secrets, know-how and other proprietary information in operating our business. We seek to protect this information, in part, through the use of confidentiality agreements with employees, consultants, advisors and others upon commencement of their relationships with us. These agreements require

that all confidential information developed by the individual or made known to the individual by us during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties. Our agreements with employees also provide that any inventions conceived by the individual in the course of rendering services to us are our exclusive property. Nonetheless, those agreements may not provide adequate protection for our trade secrets, know-how or other proprietary information and prevent their unauthorized use or disclosure. In the event of unauthorized use or disclosure of our trade secrets or proprietary information, these agreements may not provide meaningful protection, particularly for our trade secrets or other confidential information.

To the extent that consultants, key employees or other third parties apply technological information independently developed by them or by others to our proposed products, disputes may arise as to the proprietary rights to such information which may not be resolved in our favor. The risk that other parties may breach confidentiality agreements or that our trade secrets become known or independently discovered by competitors, could harm us by enabling our competitors, who may have greater experience and financial resources, to copy or use our trade secrets and other proprietary information in the advancement of their products, methods or technologies. The disclosure of our trade secrets would impair our competitive position, thereby weakening demand for our systems or services and harming our ability to maintain or increase our customer base.

In addition, to the extent that we do not fulfill our contractual or other obligations to adequately protect the technologies to which we have been granted access by Rohm and Haas or Purifics, we could be liable to either of them for any resulting harm to their businesses or could lose further access to those technologies, which could harm our business, operating results or financial condition.

Risks Related to Our Industry

We are subject to environmental risks that may prevent us from selling our systems and, if such risks are realized, may subject us to clean-up costs or litigation that could adversely affect our business, operating results, financial condition and prospects.

We are subject to a number of governmental regulations with respect to our business activities and operations. See “Business—Government Regulation.” For example, our onsite regenerable ion-exchange technology generates a byproduct known as brine waste. Our customers are required to dispose of any waste materials or byproducts from our treatment process in a manner mandated by the EPA or state regulatory agencies. The EPA or state regulatory agencies may consider these or other byproducts of the ion-exchange process to be hazardous, and in such cases, our customers will be subject to additional requirements relating to the treatment, storage, disposal and transportation of hazardous substances. With respect to our onsite regenerable treatment systems, though our customers take title to all brine waste, together with all other byproducts of the ion-exchange technology process, we generally contract with third parties to secure waste disposal services on our customers’ behalf. We cannot predict whether any new laws, statutes, ordinances, rules or regulations will be enacted that may require significant modification to our system or our services, which may weaken demand for our system or services and harm our business significantly.

In addition, we cannot predict whether any third party will assert against us any claims for violations of any federal, state or local statute, ordinance, law, rule or regulation relating to hazardous or toxic substances in connection with the brine waste or groundwater treatment process or as a result of any actions of the third-party waste disposal services with whom we contract on behalf of our customers who use our onsite regenerable treatment systems. We face similar risks with respect to resins containing contaminants that we transport to our Memphis facility for regeneration, as these resins may contain hazardous substances with our knowledge. CERCLA and analogous state laws provide for the remediation of certain contaminated facilities and impose strict, joint and several liability for remediation costs on current and former owners or operators of a facility at which there has been a release or a threatened release of a “hazardous substance.” This liability is also imposed on persons who arrange for the disposal or transportation of such substances, and on those who transport such substances to the facility. Hundreds of substances are defined as “hazardous” under CERCLA and analogous

state laws and their presence, even in small amounts, can result in substantial liability. The expense of conducting a cleanup can be significant. The actual costs for these liabilities could be significantly greater than the amounts that we might be required to accrue on our financial statements from time to time. In addition to the costs of complying with environmental regulations, we may incur costs to defend against litigation brought by government agencies and private parties. As a result, we may be required to pay fines to governmental agencies if we are found to have violated these environmental laws. In addition, we may in the future be a defendant in lawsuits brought by private parties who assert claims alleging environmental damage, natural resource damages, personal injury, property damage and/or violations of permits and licenses by us. If such claims are asserted against us, and if we do not prevail in defending such claims, we may be required to pay significant damages, causing our financial condition to suffer. Even if we successfully defend against such claims, we may devote significant time and resources to litigation, which would likely prevent us from maintaining or increasing our customer base and business.

We face additional environmental risks related to the parties with whom we do business, particularly those parties that send resin to our Memphis facility for regeneration. Our customers may not be in compliance with federal, state or local statutes, ordinances, laws, rules or regulations relating to hazardous or toxic substances and to the extent we assist them with water and wastewater treatment services offsite regeneration of resins or waste reduction or resource recovery services, we could be subject to liability under these various laws and regulations. In addition, our contracts with these customers may not adequately protect us from these liabilities, and even if our contracts provide these legal protections, these customers may not have the financial resources to provide us with the protection to which we are legally entitled such as the ability to pay indemnity obligations to which they are contractually obligated.

We also face environmental risks associated with our operations targeted to serve industrial customers. These operations involve wastewater treatment, water reuse and the recovery of valuable commodities and often require the discharge of wastewater and other materials. We plan for these activities to take place at our Memphis facility. These activities subject us to numerous stringent permitting requirements as well as numerous federal, state or local statutes, ordinances, laws, rules or regulations relating to hazardous or toxic substances. For example, our Memphis facility’s environmental permits include a NPDES wastewater discharge permit and Special Solid Waste Disposal Permits. In addition, this facility is required to maintain an EPA generator registration and identification number for its hazardous waste disposal activities. Additionally, to the extent these activities involve radionuclides, they would be subject to regulations governed by the NRC. If we do not comply with the applicable environmental laws and regulations applicable to our activities or obtain and maintain the appropriate permits necessary to conduct these activities, we would be subject to numerous

Changes in governmental regulation and other legal uncertainties could adversely affect our customers or decrease demand for our systems, and thus harm our business, operating results and prospects.

In the United States, many different federal, state and local laws and regulations govern the treatment and distribution of contaminated groundwater and disposal of attendant wastes. The increased interest in the treatment of contaminated groundwater due to increased media attention on the adverse health effects from contaminated drinking water may result in intervention by the EPA or state regulatory agencies under existing or newly enacted legislation and in the imposition of restrictions, fees or charges on users and providers of products and services in this area. These restrictions, fees or charges could adversely affect our customers, which could negatively affect our revenues. Conversely, the failure of the EPA or state regulatory agencies to act on a timely basis to set interim or permanent standards for pollutants such as MCLs, or to delay effective dates for standards for pollutants, grant waivers of compliance with such standards or take other discretionary actions not to enforce these standards, may decrease demand for our systems and services because our customers would not be required to bring their water into compliance with such regulatory standards. Changes in regulations affecting our industrial customers, such as with respect to wastewater treatment or water reuse processes, could also impact their need for our systems and/or services. While we are not aware of any currently proposed federal regulation directly affecting our business, we cannot predict whether there will be future legislation regarding the treatment

and distribution of contaminated groundwater, the disposal of attendant wastes, wastewater treatment or water reuse processes. If there are significant changes in such laws and regulations, particularly if such laws and regulations become less stringent, such changes could weaken demand for our systems or services and cause our revenues to decline, thus harming our operating results and prospects.

Each groundwater treatment solution must be permitted by a regulatory agency prior to its use by our customers, and changing drinking water standards and other factors could affect the approval process with respect to our system by such regulatory agencies.

Each groundwater treatment solution, including our groundwater treatment system and those of our competitors, must be permitted by applicable state regulatory agencies prior to use of such systems by our customers. We cannot assure you when or whether the various regulatory agencies will approve our system for use by our customers. The application process for our system is time consuming and often involves several information requests by the regulatory agencies with respect to our system. Any long waiting periods or difficulties faced by our customers in the application process could cause some of our customers to use competing technologies, products, services or sources of drinking water, rather than use our technology.

Also, we cannot predict the impact of changing drinking water standards on the approval of our technology for groundwater treatment. Our system currently treats groundwater so that it meets the MCL for several different contaminants. MCLs are set by the EPA and/or state regulatory agencies that regulate drinking water contaminants. However, the MCL for any contaminant is subject to review and revision by the EPA or state regulatory agencies. MCLs may be changed to levels below that which our system can treat, resulting in state regulatory agencies failing to approve our system. Without regulatory approval, our system could not be used by our customers, and we may be required to develop technology that meets any revised MCLs, and to the extent we cannot do so, sales of our system will suffer. The development of such technology may require increased expenditures, and during this development, we could be delayed in selling our system, which would cause our revenues to decline, thus harming our operating results significantly.

Demand for our groundwater treatment systems would be adversely affected by a downturn in government spending related to groundwater treatment solutions, or in the cyclical residential or non-residential building markets.

Our municipal market business is dependent upon spending on groundwater treatment solutions by utilities, municipalities and other organizations that supply water, which in turn is often dependent upon residential construction, population growth, continued contamination of groundwater sources and regulatory responses to this contamination. As a result, demand for our water treatment systems could be impacted adversely by general budgetary constraints on our governmental or regulated customers, including government spending cuts, the inability of government entities to issue debt to finance any necessary groundwater treatment projects, difficulty of our customers in obtaining necessary permits or changes in regulatory limits associated with the chemical contaminants we seek to address with our groundwater treatment system. It is not unusual for the implementation of water treatment solutions to be delayed and rescheduled for a number of reasons, including changes in project priorities and difficulties in complying with environmental and other government regulations. We cannot assure you that economic conditions will continue such that state and local governments will address groundwater contaminant needs and consider purchasing or entering into long-term contracts for our systems. In addition, although our target markets have experienced population growth in recent years along with related residential building market growth, we have recently witnessed a significant slowdown in the residential building industry, particularly in the arid West. A slowdown of growth in residential and non-residential building would reduce demand for drinking water and for groundwater treatment solutions such as our systems. The residential and non-residential building markets are generally cyclical, and, historically, down cycles have typically lasted a number of years. Any significant decline in the governmental spending on groundwater treatment solutions or residential or non-residential building markets could weaken demand for our systems or services, thus harming our operating results and prospects significantly.

We operate in a competitive market, and if we are unable to compete effectively, our business, operating results and prospects could suffer.

The market environment in which we operate is very dynamic and is characterized by evolving standards, the development of new technology, regulations which continually reduce the acceptable levels for contaminants and affect the means, methods and costs of disposing of wastes derived from groundwater treatment. Though barriers to entry in this market are arguably high, we expect that competition will intensify in the future. We believe that in such a rapidly changing market, key competitive factors include:

development and use of technology;

effectiveness of treatment and waste disposal methods;

changing requirements of the EPA or state regulatory agencies; and

changing requirements of customers in the industrial markets; and

the availability of capital to meet evolving customer needs and requirements for the treatment of contaminated water.

We compete with large groundwater treatment companies, such as Severn Trent PLC, GE Water and Siemens AG, in our business aimed at the municipal markets. We compete with large industrial market companies, such as GE Water and Layne Christensen, in our business aimed at the industrial markets. Many of our current and potential competitors have technical and financial resources, marketing and service organizations and market expertise significantly greater than ours. Many of our competitors also have longer operating histories, greater name recognition and larger customer bases. Moreover, our competitors may forecast the course of market developments more accurately and could in the future develop new technologies that compete with our systems and/or services or even render our system and/or services obsolete. Due to the evolving markets in which we compete, additional competitors with significant market presence and financial resources may enter those markets, thereby further increasing competition. These competitors may be able to reduce our market share by adopting more aggressive pricing policies than we can or by developing technology and services that gain wider market acceptance than our system and/or services. Existing and potential competitors also may develop relationships with distributors of our systems and services or third parties with whom we have strategic relationships in a manner that could harm our ability to sell, market and develop our systems and services significantly. If we do not compete successfully we may never achieve significant market penetration and we may be unable to maintain or increase our business or revenues, causing our operating results and prospects to suffer.

We could become subject to litigation as a result of claims brought against our customers, which could harm our operating results and financial condition significantly.

Our municipal customers are water providers that supply drinking water treated by our system to the general public. If our customers faced claims from consumers related to the quality of the drinking water, such consumers also may bring claims against any other party with whom the customer contracted in the groundwater treatment process. Even if our system treated the groundwater successfully for the contaminants it was designed to remove, we still may be subject to claims from such consumers. Our industrial customers may also face liability from consumers or regulatory agencies with respect to their wastewater treatment or waste reduction activities. These parties may also bring claims or actions against us because our systems and services were utilized in our customer’s activities. Despite any success in defending such claims, the expense, time, delay and burden on management of litigation would likely prevent us from maintaining or increasing our business and negative publicity could weaken demand for our services, cause our revenues to decline and harm our operating results and financial condition significantly.

Risks Related to our Finances and Capital Requirements

We will need additional capital to sustain and grow our business and we cannot provide any assurances that additional financing will be available to us on favorable terms when required, or at all.

We expect that our current cash and cash equivalents will be sufficient to fund our anticipated future growth and operations for the foreseeable future. We cannot guarantee you that we will not need additional capital to finance our growth and operations or to accelerate our expected growth over the next 12-month period. We have based our estimate of liquidity needs on assumptions that may prove to be incorrect, and we may spend our available financial resources much faster than we currently anticipate.

Adequate funds, whether obtained through financial markets or collaborative or other arrangements with water providers, corporate partners or from other sources, may not be available when needed or on terms acceptable to us. We also may need to raise additional funds in order to fund more rapid expansion, to develop new and enhanced technologies, to develop and implement our technology+services model, to respond to competitive pressures or to acquire complementary technologies or assets. If additional funds are raised through the issuance of additional common stock, other equity securities or indebtedness, the percentage ownership of our then-current shareholders may be diluted substantially and the equity or debt securities issued to new investors may have rights, preferences or privileges senior to those of the holders of our then-existing capital stock. If adequate funds are not available or are not available on acceptable terms, we may not be able to take advantage of unanticipated opportunities, develop new products or services or otherwise respond to competitive pressures. Such inability could prevent us from maintaining or increasing our business, result in significant harm to our financial condition and prospects and negatively affect our stock price.

We may incur indebtedness that contains terms that place restrictions on the operation of our business; our failure to comply with these terms could put us in default, which would harm our business and operations.

We may incur indebtedness in the future that contains a number of significant covenants. These covenants may limit our ability to, among other things, do the following:

incur additional indebtedness;

merge, consolidate or dispose of our assets;

pay dividends or repurchase our capital stock;

change our line of business;

accept any prepayments under or otherwise modify contracts with our customers;

enter into transactions with our affiliates; and

grant liens on our assets.

If we were to incur such indebtedness, a material breach of any of these covenants would result in a default under this indebtedness which could result in significant harm to our business and operations.

Our customers may need financing to purchase our systems, which exposes us to additional business and credit risks.

Availability and cost of financing are significant factors that affect demand for our systems and services. Many of our customers can purchase our systems only when financing is available at a reasonable cost. Some customers seek to acquire our systems and services through a long-term contract. We often rely on third parties to purchase the systems that are then subject to long-term contracts with our customers. In certain cases, we will indemnify the third party for any financial damages caused by our default under our long-term services

agreement with our customer. This exposes us to potential additional costs in the event of our failure to perform. In addition, if we are unable to identify third parties that will purchase our systems in connection with the placement of our systems with municipal or industrial customers, we would be faced with either keeping these systems on our balance sheet or requiring our customers to purchase the equipment outright. In the latter case, this may delay or terminate the sale to our customer, which could adversely affect our business and operating results.

We have recorded and will record non-cash expense in future periods that result in a decrease in our net income for a given period.

As required by the Financial Accounting Standards Board, or FASB, we record expense for the fair value of stock options and restricted stock granted and this expense is reflected in our operating results. We rely on stock options to motivate current employees and attract new employees. As a result of the requirement to expense stock options, we may choose to reduce our reliance on stock options as a motivation tool. If we reduce our use of stock options, it may be more difficult for us to attract and retain qualified employees. However, if we do not reduce our reliance on stock options, our reported net loss may increase or our reported net income may decrease.

We have also applied the provisions of SFAS No. 123(R),Share-Based Payment, to warrants issued to lenders and other third parties including Cross Atlantic Partners, Aqua America and BWCA. The fair value of these warrants is expensed over the period of the related agreements, as appropriate. As a result, we recognized expense in 2005 and 2006 which affected our interest expense or selling, general and administrative expense, depending upon the nature of the underlying transaction. In May 2006, we repaid our indebtedness. The remaining fair value of the associated warrants attributed to the debt was charged to interest expense during that period. In future periods, we will recognize expense for the fair value of the warrants issued to third parties other than the lenders. Early completion of the third party agreements under which the warrants were issued will accelerate the recognition of this expense.

We have identified a material weakness in our internal control over financial reporting and may not be able to report financial results accurately.

We have identified a material weakness in our internal control over financial reporting and have determined that our internal control over financial reporting was not effective as of December 31, 2007 (see Item 9A.—“Controls and Procedures”). We cannot assure you that additional material weaknesses, significant deficiencies and control deficiencies in our internal control over financial reporting will not be identified in the future.

We have incurred and expect to incur substantial expenses relating to the remediation of the material weaknesses in our internal control over financial reporting. The effectiveness of our internal control over financial reporting may in the future be limited by a variety of factors including without limitation:

simple errors;

delay in upgrading financial software system; and

the possibility that any enhancements to disclosure controls and procedures or internal controls may still not be adequate to assure timely and accurate financial information.

If we fail to achieve and maintain effective controls and procedures for financial reporting, we could be unable to provide timely and accurate financial information which may have an adverse effect on our company and the trading price of our common stock.

We intend to pursue, but may not be able to identify, finance or successfully complete, strategic acquisitions.

Our growth strategy includes the pursuit of acquisitions. We may not be able to identify acceptable opportunities or complete acquisitions of targets identified in a timely manner or on acceptable terms. Acquisitions involve a number of risks, including the following:

our management’s attention will be diverted from our existing business while evaluating acquisitions and thereafter while integrating the operations and personnel of the new business into our business;

we may experience adverse short-term effects on our operating results;

we may be unable to successfully and rapidly integrate the new businesses, personnel and products with our existing business, including financial reporting, management and information technology systems;

we may experience higher than anticipated costs of integration and unforeseen operating difficulties and expenditures;

an acquisition may be in a market or geographical area in which we have little experience;

we may have difficulty in retaining key employees, including employees who may have been instrumental to the success or growth of the acquired business; and

we may use a substantial amount of our cash, common stock and other financial resources to consummate an acquisition.

We recently acquired MPT, which is located in Tennessee, for approximately $12.2 million, consisting of $6.9 million in cash and 462,746 shares of our common stock with a fair value of $5.3 million. There can be no assurance that we will achieve higher revenues or benefit from any synergies as a result of the acquisition.

In addition, we may require additional debt or equity financing for future acquisitions, and such financing may not be available or on favorable terms, if available at all. We may not be able to successfully integrate or profitably operate any new business we acquire, and we cannot assure you that any such acquisition will meet our expectations. Finally, in the event we decide to discontinue pursuit of a potential acquisition, we will be required to immediately expense all costs incurred in pursuit of the possible acquisition which may have an adverse effect on our results of operations in the period in which the expense is recognized.

Risks Related to Our Common Stock

We expect that the price of our common stock will fluctuate substantially.

The price of our common stock may decline, and the price of our common stock that prevails in the market may be higher or lower than the price you pay, depending on many factors, some of which are beyond our control. Factors that could cause fluctuations in the trading price of our common stock include:

failure of our systems or technology to achieve commercial success;

announcements of the introduction of new products or services by us or our competitors;

market conditions in our industry sectors;

developments concerning product development results or intellectual property rights of others;

litigation or public concern about the safety of our systems and services;

fluctuations in our quarterly operating results;

securities analyst coverage of our common stock;

deviations in our operating results from estimates;

additions or departures of key personnel;

price and volume fluctuations in the overall stock market from time to time;

the outcome of litigation;

general economic trends; or

sales of large blocks of our stock.

In addition, the equity markets in general, and the Nasdaq Global Market in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of water-related companies have been particularly volatile. These broad market and industry factors may affect the market price of our common stock adversely, regardless of our operating performance.

Anti-takeover provisions in our charter documents, as amended and restated, and under Delaware law could delay or discourage a takeover that stockholders may consider favorable.

Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. Some of these provisions include:

a board of directors divided into three classes serving staggered three-year terms;

a prohibition on stockholder action through written consent;

a requirement that special meetings of stockholders be called only by the chairman of our board of directors, the chief executive officer, the president or by a majority of the total number of authorized directors;

advance notice requirements for stockholder proposals and nominations;

a requirement of approval of not less than 66 2/3% of all outstanding shares of our capital stock entitled to vote to amend any bylaws by stockholder action, or to amend specific provisions of our certificate of incorporation; and

the authority of our board of directors to issue preferred stock on terms determined by our board of directors without stockholder approval.

In addition, because we are a Delaware corporation, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our amended and restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by the then-current board of directors, including to delay or impede a merger, tender offer, or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

ITEM 1B.UNRESOLVED STAFF COMMENTS

None.

ITEM 2.PROPERTIES

Facilities

Our corporate headquarters, finance and administration offices are located in Rancho Cucamonga, California where we occupy approximately 10,000 square feet under a lease expiring on February 14, 2013 at an initial annual cost of approximately $256,000 with annual escalations. We also occupy approximately 35,000 square feet under an additional lease expiring on March 31, 2011 comprising our engineering and manufacturing facilities. We have an option to extend the lease for an additional three years. Our rental expense in 2007 was approximately $226,000 for this facility.

We lease our Memphis facility from a limited liability company owned by the former stockholders of MPT. The facility is approximately 55,000 square feet. The lease provides for an annual base rent of $81,900 and an initial lease term of five years, with three 5 year options to extend the lease term. We also lease warehouse and office space in Pasadena, California and outside Phoenix, Arizona, respectively.

In addition, in March 2008 we leased approximately 6,400 square feet for our Southwest Region office under a lease expiring on April 30, 2012 at an initial annual cost of approximately $130,000 with periodic escalators.

We believe that our existing office space will not be adequate for our needs through the end of the term of the lease agreements. We intend to lease additional office space to accommodate our growth. When our leases expire, we may exercise our renewal options or seek additional or alternate space for our operations, and we believe that suitable additional or alternative space will be readily available in the future at commercially reasonable terms.

Property, Plant and Equipment

Property, plant and equipment, net of accumulated depreciation, consisted of the following as of December 31, 2007 (in thousands):

Water treatment facilities

  $8,084

Office furniture and equipment

   514

Vehicles and trailers

   501

Software and other

   704

Machinery and equipment

   1,921

Leasehold improvements

   169

Construction in progress

   4,052
    
   15,945

Less: accumulated depreciation

   1,645
    

Property, plant and equipment, net

  $14,300
    

ITEM 3.LEGAL PROCEEDINGS

On October 26, 2007, Veolia Water North America Operating Services, LLC and certain other related parties filed a lawsuit in the United States District Court of the Middle District of Florida, Tampa Division, naming as defendants Basin Water-MPT, Inc. (a wholly owned subsidiary of Basin Water, Inc.) and two of its employees, one of whom is the son of Basin Water, Inc.’s President and Chief Executive Officer. The lawsuit alleges, among other things, certain claims related to trade secrets and unfair trade practices relating to treatment of by-products produced as a result of the phosphate mining industry. The lawsuit does not claim a specific amount of damages.

On December 27, 2007 and January 2, 2008, two purported securities class action complaints were filed in the United States District Court for the Central District of California against Basin Water, Inc., Peter L. Jensen, Michael M. Stark and Thomas C. Tekulve (collectively referred to as the “Basin defendants”) for violations of the Exchange Act. These lawsuits, which contain similar allegations, are captionedPoulos v. Basin Water, et al., Case No. CV 07-8359 GW (FFMx) andNofer v. Basin Water, et al., Case No. CV 08-0002 SGL (JCRx). The lawsuits, among other things, allege that the Basin defendants “issued materially false and misleading statements regarding the Company’s business and financial results” because the Company “had not adequately accounted for reserves in connection with its legacy system contracts.” Plaintiffs allege a putative class period between May 14, 2007 and November 13, 2007, and do not claim a specific amount of damages.

On January 23, 2008, we received a letter dated January 17, 2008, from attorneys representing a purported shareholder demanding that we investigate and remedy alleged breaches of fiduciary duty by certain unnamed officers and directors of the Company. In the demand letter, the attorneys allege that the unnamed officers and directors violated their duties to the Company by, among other things, participating in or permitting the company to issue false and misleading statements regarding our business and financial results giving rise to the above named lawsuits.

On January 31, 2008, Loren Charif, a purported stockholder of our company, filed a shareholder derivative lawsuit in the Superior Court of the State of California, County of San Bernardino, against certain of our executive officers and our current directors. The complaint assumes the truth of the aforementioned allegations in the federal securities class action lawsuits and in connection with those allegations alleges, among other things, breaches of fiduciary duties, waste of corporate assets, unjust enrichment and violations of California Corporations Code pertaining to allegations of improper selling.

From time to time, we are involved in legal and administrative disputes and proceedings arising in the ordinary course of business, which we believe are not material to the conduct of our business.

ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2007.


PART II

 

ITEM 5.    MARKETMARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

The following table shows the range of market prices of Basin Water’s common stock since its initial public offering in May 2006.for the last two fiscal years. Our common stock is traded on the Nasdaq Global Market under the symbol “BWTR”. There were 8,6015,479 stockholders of record as of March 12, 2008.11, 2009.

 

  Stock Price Range  Stock Price Range
  High  Low

Period from initial public offering to December 31, 2006

    

May 11, 2006—June 30, 2006

  $17.50  $8.66

Third Quarter 2006

  $10.50  $6.88

Fourth Quarter 2006

  $9.86  $6.28
  High  Low

Year ended December 31, 2007

        

First Quarter 2007

  $8.00  $6.18  $8.00  $6.18

Second Quarter 2007

  $8.70  $6.20  $8.70  $6.20

Third Quarter 2007

  $12.50  $8.70  $12.50  $8.70

Fourth Quarter 2007

  $13.06  $5.66  $13.06  $5.66

Year ending December 31, 2008

        

First Quarter through March 12, 2008

  $8.78  $6.08

First Quarter 2008

  $9.00  $4.10

Second Quarter 2008

  $6.47  $3.49

Third Quarter 2008

  $4.75  $1.29

Fourth Quarter 2008

  $1.97  $0.41

Performance Graph

The following graph compares the cumulative total return to holders of Basin Water’s common stock during the period from May 12, 2006 (the date of our initial public offering) through December 31, 2008 to the cumulative total return during that same period achieved by the 35 companies listed in the PowerShares Water Resources Portfolio Fund (PHO:AMEX) (based on the Palisades Water Index) and that achieved by the Standard & Poor’s 500 Stock Index. The comparison assumes an initial investment of $100 made on May 12, 2006 in each of Basin Water common stock, the PowerShares Water Resources Portfolio Fund and the Standard & Poor’s 500 Stock Index. The cumulative total returns assume the reinvestment of all dividends. The historical performance reflected in the graph is not necessarily indicative of future price performance.

BWTR – Basin Water, Inc. common stock

SP 500 – S&P 500 Composite Stock Index

PHO – Power Shares Water Resources Portfolio Fund, which includes VMI, LAYN, URS, IEX, WTS, FELE, DHR, INSU, PNR, ITT, BMI, PLL, LNN, ROP, PWEI, FLS, EMR, SE, GE, GRC, AMN, NLC, CCC, ASH, VE, UU, WTR, SBS, CWT, SWWC, SJW, CWCO and SZE

3


Dividend Policy

We have never declared or paid any cash dividend on our capital stock. We currently intend to retain all future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Consequently, stockholders will need to sell shares of our common stock to realize a return on their investments, if any. Any future determination related to dividend policy will be made at the discretion of our board of directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements, contractual restrictions and such other factors as our board of directors deems relevant.

Repurchases of Securities

In May 2007, our Board of Directors authorized management to repurchase up to $10.0 million of shares of our common stock in the market from time to time. The shares could be repurchased at times and prices as determined by management, and may be completed through open market or privately negotiated transactions. The repurchase program provides that repurchases must be made in accordance with the terms and subject to the restrictions of Rule 10b-18 under the Securities Exchange Act of 1934, as amended.

There were no share repurchases in the fourth quarter of 2008.

Equity Compensation Plans

In November 2007, we repurchased 85,000For an analysis of the shares of our common stock at a priceauthorized for issuance under our equity compensation plans, see Item 11. – “Executive Compensation – Equity Compensation Plan Information”. A description of $6.45 per share. These repurchased shares have been classified as treasury stockour equity compensation plans appears in the December 31, 2007 balance sheet.

ISSUER PURCHASES OF EQUITY SECURITIESItem 11. – “Executive Compensation – Retirement and Other Benefit Plans”.

 

Period

  (a) Total
Number of
Shares
Purchased
  (b) Average
Price Paid
per Share
  (c) Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs
  (d) Maximum Number
(or Approximate
Dollar Value) of
Shares that May Yet
Be Purchased Under
the Plans or Programs

October 2007 (October 1 through October 31)

  —     —    —     —  

November 2007 (November 1 through November 30)

  85,000  $6.45  85,000  $9,451,750

December 2007 (December 3 through December 31)

  —     —    —     —  

Total

  85,000  $6.45  85,000  $9,451,750

ITEM 6.SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K.

   Year Ended December 31, 
   2007(1)  2006  2005  2004  2003 
   (In thousands except per share data) 

Statement of Operations Data:

      

Revenues

  $18,784  $17,114  $12,231  $4,307  $2,095 

Cost of revenues(2)

   24,931   20,106   7,130   2,562   1,567 
                     

Gross profit (loss)

   (6,147)  (2,992)  5,101   1,745   528 

Research and development expense

   564   634   651   316   261 

Selling, general and administrative expense

   13,685   6,827   3,334   1,765   1,511 
                     

Income (loss) from operations

   (20,396)  (10,453)  1,116   (336)  (1,244)

Other income (expense)(3)

   5,146   (714)  (553)  (220)  (64)
                     

Income (loss) before income taxes

   (15,250)  (11,167)  563   (556)  (1,308)

Income tax provision (benefit)

   —     —     —     —     —   
                     

Net income (loss)

  $(15,250) $(11,167) $563  $(556) $(1,308)
                     

Net income (loss) per share:

      

Basic

  $(0.76) $(0.70) $0.06  $(0.06) $(0.14)

Diluted

  $(0.76) $(0.70) $0.04  $(0.06) $(0.14)

Weighted average common shares outstanding:

      

Basic

   20,185   16,048   9,924   9,586   9,507 

Diluted

   20,185   16,048   12,849   9,586   9,507 
   As of December 31, 
   2007  2006  2005  2004  2003 

Balance Sheet Data:

      

Cash and cash equivalents

  $35,456  $54,567  $2,724  $1,704  $356 

Total assets

  $98,212  $90,052  $23,798  $11,723  $6,582 

Total long-term liabilities

  $9,989  $2,825  $7,357  $4,264  $2,103 

Redeemable convertible preferred stock

  $—    $—    $8,779  $8,183  $4,990 

Stockholders’ equity (deficiency)

  $79,289  $79,737  $3,809  $(2,290) $(1,870)

(1) —Includes the results of operations of Mobile Process Technology Co. (MPT) acquired in September 2007 (see Note 3 to our consolidated financial statements).
(2) —For years 2006 and 2007, includes reserves for future contract losses of approximately $3.7 million and $3.6 million (net of $1.4 million of actual losses on the underlying contracts charged against the reserve), respectively (see Note 12 to our consolidated financial statements).
(3) —For 2007, includes a $2.5 million gain on sale of assets to Empire (see Note 15 to our consolidated financial statements).

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the notes to those statements included elsewhere in this Annual Report on Form 10-K. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. See “Forward-Looking Statements” elsewhere in this Annual Report on Form 10-K. As a result of many factors, such as those set forth under “Item 1A. Risk Factors”, our actual results may differ materially from those anticipated in such forward-looking statements.

Overview

We are providers of reliable, long-term process solutions for a range of customers which include designing, building, implementing and servicing systems for the treatment of contaminated groundwater, the treatment of wastewater, waste reduction and resource recovery. We were initially incorporated in December 1999 and during our first two years of operations primarily focused on the development of our ion-exchange regenerable, onsite treatment system. The first permit to be issued by the California Department of Health Services, or DHS, to one of our customers for the operation of our system was issued in 2002. We currently have 79 systems on order or under contract in California, Arizona, North Carolina and New Jersey with an aggregate installed capacity of approximately 113,000 acre-feet per year, or approximately 36.9 billion gallons per year.

In 2007, we marketed our treatment systems and services primarily to utilities, cities, municipalities, special districts, real estate developers and other organizations for use in treating groundwater that does not comply with federal or state drinking water regulations due to the presence of chemical contaminants. We marketed our treatment systems and services through our direct sales force, independent contractors and strategic relationships. Our customers include Arizona American Water, Aqua America, California Water Service Group and American States Water Company, four of the largest investor-owned water utilities in the United States based on population served.

As a manufacturer of treatment systems, our operations necessitate a significant investment in receivables and property and require significant working capital. In the case of sales of ion-exchange regenerable, onsite treatment systems, we must expend all of the costs to build and deliver our system to the customer, and we receive payment for the system primarily when the delivery is completed and the system has been placed into service. For systems that we deliver to customers under our long-term contract arrangements, we must incur the costs to build and deliver our treatment systems, and we receive payment over a typical period of five or more years.

In May 2006, we completed our initial public offering which resulted in the issuance of 6,900,000 shares of our common stock at a price of $12.00 per share for net proceeds of approximately $75.2 million.

On September 14, 2007, we completed the acquisition of Mobile Process Technology Co. (MPT), a provider of technology and services to the water treatment and industrial process markets. This acquisition provides additional capabilities including expanded technological solutions, geographic presence and expanded customer base. The new company provides the ability to service and treat smaller capacity water systems than our product offering.

Outlook

We believe that the following trends and uncertainties, among others, may impact our revenues, income, liquidity and cash flows:

The success of our internal marketing and sales organization in developing new customers and placing our treatment systems through sales or long-term contracts, which would increase our revenues;

Our success in placing our treatment systems throughout the nation pursuant to strategic relationships, expansion of our marketing and sales organization, expansion of our regional structure which would increase our revenues and may decrease our customer concentration and associated risk;

Public awareness of the effects of groundwater contamination, which may increase demand for our groundwater treatment systems;

Changes in federal and state government regulation with respect to drinking water standards which may impact demand for our arsenic treatment systems;

The potential increase in demand for placement of our systems through long-term contracts rather than sales, which will likely require higher capital expenditures and adversely affect our liquidity;

Changes in federal and state government regulation of discharge requirements for wastewater may impact our demand for wastewater treatment systems and services;

Changes in commodity prices, particularly commodities that might be recoverable from waste streams, may impact the demand for our resource recovery system and services;

Changes in general economic conditions which may affect capital expenditures in our markets and demand for our treatment systems and services;

Acceptance by potential customers to utilize third parties for water and wastewater treatment, waste reduction and resource recovery services, including through long-term service agreements;

Continued expansion of our workforce resulting in increased expenses but also supporting our growth; and

Increased utilization and productivity of our personnel, which we anticipate will positively impact our gross profit under our contract revenues.

Financial Operations Review

We evaluate our business using a variety of key financial measures:

Revenues

Our revenues tend to vary from period to period, because customers can choose between purchasing our groundwater treatment systems and entering into long-term contract arrangements for our treatment systems. If a customer chooses to purchase a system, we recognize revenues over a much shorter period of time, generally within one or two quarters, than we would recognize for the same system if the customer chose a long-term contract arrangement for the system. Thus, our revenues will tend to be higher in periods in which we sell rather than place our systems under long-term contracts. For any customers selecting a long-term capital arrangement, we may enter into third-party financing arrangements.

Sales

For treatment systems sold to customers which are sold under fixed-price contracts, or that we enter into a sale under a third-party financing arrangement, we recognize revenues using the percentage-of-completion method. This method takes into account the cost, estimated earnings and revenues to date on systems not yet completed. This method is used because management considers total cost to be the best available method of measuring progress on systems sold to customers. In general, financial statements based on the percentage-of-completion method present the economic substance of production-type activities more clearly than the completed-contract method, and present the relationships between sales, cost of sales and related period costs more accurately. Because of inherent uncertainties in estimating costs, estimates used may change in the near term. Such estimates are adjusted under the cumulative-catch-up method. Unless contractually agreed to otherwise, the sales contract is deemed to be substantially complete when the treatment system has been physically completed and a performance test has been passed. Historically, our sales consisted of large system4

sales and standard system sales. Our large systems consisted of large site regenerable treatment systems that we constructed at our customer’s site as opposed to standard systems which are fabricated at our facilities.

Contract Revenues

Our recurring contract revenues are generated from three sources. The first source of recurring contract revenues is from long-term fixed contracts under which we install our system at the customer’s site and treat the customer’s water. We retain ownership of the installed system. Under this contract we recognize monthly revenues on a straight-line basis over the life of the contract, which represents a return of the capital value of the installed system. The amount of this fixed monthly revenue is based on both the capacity of the system and the type of contaminant(s) being treated. The straight-line method best reflects the value of having the system’s capacity available to the customer at all times and is similar to the method used for calculating depreciation.

The second source of recurring revenues is from long-term contracts for the treatment of the water produced from installed treatment systems, which we also refer to as service revenues. Service revenues are recognized based on the actual volume of water treated each month. Such water-treatment revenues bear a direct relationship to the variable costs for the purchase and delivery of salt, chemicals and resin used in the system, the removal of waste and the cost to maintain and service the system. This revenue stream is generated both by systems that were purchased by our customers and by systems in which we retain ownership and recognize revenue for the monthly capital component.

The third source of contract revenues relates to providing other services for the processing of water, replacement of resins or equipment parts and other water treatment related services.

Under each of the long-term contracts, the customer is typically obligated to pay us for the treatment of its water—not for specific hours worked, supplies purchased or waste-hauls provided. Our newer long-term contracts allow us to recover increased operating costs, including costs for salt, chemicals, resin and removal of waste. Most of our contracts entered into prior to 2005 do not have such provisions.

Under the criteria set forth in EITF 00-21, we have determined that the multiple deliverables of each of our long-term contracts specifically, the capital component and the volume related service charge, qualify for separate accounting treatment. The three criteria required for separate accounting treatment are: 1) that each deliverable has a standalone value to the customer, 2) that there is objective and reliable evidence of fair value of each deliverable and 3) that there are no general refund rights for the deliverables.

In the case of contracts under which we own the system, the customer is obligated to pay us the fixed capital component of the system on a monthly basis. These arrangements are classified and treated as operating leases under Statement of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases, because they meet the four criteria of an operating lease: 1) there is no transfer of title; 2) there is not a bargain purchase option; 3) the lease term is substantially shorter than the economic life of the system; and 4) the present value of the capital component payments is less than 90% of the fair value of the water treatment system at the inception of the contract.

In connection with long-term contracts, we may receive payments from our customers prior to the system being placed in service. Such payments are recorded as deferred revenues. In addition, we may receive payments from our customers in excess of that which can be recognized on a straight-line basis. These payments are also recorded as deferred revenues. All deferred revenues amounts are recognized as revenues in the periods in which services are rendered to the customer.

In each of these arrangements, the contract term is typically five or more years, provided our customers may elect to terminate their contract with us prior to the expiration upon the occurrence of certain circumstances. In the case of the long-term water treatment contracts, they generally contain a purchase option at the end of the agreement.

Cost of Revenues

Our cost of revenues varies based on the type of revenues as follows:

Cost of Systems Sold. Our cost of revenues for a sold system includes our cost of materials included in such system plus costs associated with deploying the system, warranty costs, payroll and payroll related costs for our manufacturing personnel and other manufacturing overhead costs. These costs are recorded under the percentage-of-completion method of accounting. This method takes into account the cost, estimated earnings and revenues to date on systems not yet completed.

Cost of Contract Revenues. Cost of revenues in connection with contract revenues consist of costs associated with the processing of waters, including the cost of salt and other components used in our systems, waste removal on behalf of our customers, maintenance and other service costs of our systems. Cost of revenues in connection with contract revenue that includes capital for systems Basin retains ownership under a water treatment contract includes depreciation expense using a 20-year life under the straight-line method.

During the latter half of 2006 and 2007, improvements to our management controls and accounting systems enabled us to more thoroughly analyze operating results for each service contract and determine that certain, generally older contracts were operating at net cash flow losses. These contracts have sustained increasing operating costs such as waste disposal and salt purchase costs as the direct result of higher fuel, salt and other third-party costs. However, unlike our more recent contracts, these older contracts did not allow management to renegotiate terms to recover such increased costs. Management determined that these contracts would continue to generate net operating cash flow losses through the end of the contract period. Accordingly, we recorded a reserve for future contract losses in the amount of $3.7 million in the fourth quarter of 2006. This amount represented the losses which we expect to incur during the remaining term of these contracts. Actual losses on the underlying contracts are being charged against the reserve as incurred.

During 2007, additional older legacy contracts became operational and were operated during the busy, higher volume summer months. Based on the new operating history, especially during the third quarter, it became apparent that the original reserve was not adequate. Management reviewed each contract’s financial performance and identified the future expected losses for these contracts, resulting in a $4.7 million increase to the reserve (net of third quarter charges against the reserve) for future contract losses, which was charged to cost of contract revenues during the third quarter of 2007. These reserve amounts are being reversed as actual losses are incurred on the underlying contracts. The net reserve for future contract losses included on our balance sheet, both short and long term, as of December 31, 2007 was approximately $7.3 million.

The cost of revenues for a system also varies by the contaminant(s) that the system is designed to address. We purchase components and raw materials from third party vendors which are then assembled into our treatment systems in our manufacturing facilities or assembled at our customers’ site. We are not dependent on any sole source suppliers and generally have multiple vendors for each of our components and raw materials, all of which are located within the United States.

Research and Development Expense

Research and development expense consists primarily of research material costs, payroll and payroll related costs for our research and development personnel and outside sponsored research and consulting expenses associated with the design, development and testing of new and existing technologies and systems.

Selling, General and Administrative Expense

Selling, general and administrative expense consists primarily of payroll and payroll related costs for our corporate management, finance, accounting, sales, marketing and administrative personnel, including

commissions for our sales and marketing personnel. Also included in selling, general and administrative expense are overhead costs associated with these activities, marketing and promotion expenses, recruiting fees, public company costs, director fees, and audit and legal expenses.

Other Income

Other income included in the statements of operations consists primarily of interest income and income from affiliate, partially offset by interest and other expense.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our audited financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, long-lived assets, accrued liabilities, and income taxes. These estimates are based on historical experience, information received from third parties and on various other assumptions that we believe 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. Predicting future events is inherently an imprecise activity and, as such, requires the use of assumptions. Actual results may differ from these estimates under different assumptions or conditions.

An accounting policy is deemed to be critical if it requires an accounting estimate to be based on assumptions about matters that are highly uncertain at the time the estimate is made, and different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact our consolidated financial statements.

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our financial statements:

Revenue Recognition. Our revenues are recognized in two different ways. For groundwater treatment systems that we sell to our customers, revenues are recognized under the percentage-of-completion method by comparing actual costs incurred to total estimated costs to complete each system. The percentage-of-completion method recognizes revenues and associated costs as work progresses on a system, based on the expected total system revenues and costs. In general, financial statements based on the percentage-of-completion method present the economic substance of production-type activities more clearly than the use of the completed-contract method, and present the relationships between sales, cost of sales and related period costs more accurately. For all other groundwater treatment systems delivered to our customers under various contractual arrangements, we recognize revenues for a periodic fee we receive over the life of the contract using the straight-line method and recognize a processing fee as our systems treat the customer’s contaminated water.

Property and Equipment. Property and equipment is stated at cost less accumulated depreciation and amortization. Property consists primarily of groundwater treatment systems which we place with customers under various arrangements. For our groundwater treatment systems placed with our customers under long-term contracts, we capitalize materials, labor, overhead and interest. Depreciation is calculated using the straight-line method over the estimated useful lives of the related assets. We capitalize expenditures for major renewals and betterments that extend the useful lives of property and equipment. We charge expenditures for maintenance and repairs to expense as incurred. Estimated useful lives are generally as follows: auto equipment—three to five years; furniture and fixtures—three to seven years; other equipment—three to 10 years, and groundwater treatment systems—20 years. Judgments and estimates made by us related to the expected useful lives of these

assets are affected by factors such as changes in operating performance and fluctuations in economic conditions. If our assumptions change in the future, we may be required to record impairment charges for these assets.

Intangible Assets and Goodwill. In conjunction with our September 2007 acquisition of MPT, we engaged an independent third party to assess the fair value of the assets acquired in this transaction. The purchase price was allocated to net tangible and intangible assets acquired based on their estimated fair values, with approximately $4.2 million allocated to intangible assets with a weighted-average useful life of approximately 11 years. Such intangible assets consist of a covenant not to compete in the amount of $0.3 million (three year useful life), trade name in the amount of $0.2 million (two year useful life), service agreements and contracts in the amount of $1.3 million (six year useful life), customer relationships in the amount of $0.6 million (15 year useful life) and patents in the amount of $1.8 million (17 year useful life). The excess of the net purchase price over the estimated fair value of assets acquired was approximately $8.7 million, which was recorded as non-tax deductible goodwill. Judgments and estimates made by us related to the expected useful lives of the intangible assets are affected by factors such as changes in operating performance, loss of existing customers or service contracts, failure to obtain final approval for patents, fluctuations in economic conditions and expected future performance. If our assumptions change in the future, we may be required to record impairment charges for these assets, including goodwill.

Inventory. Inventory consists primarily of raw materials and supplies. Inventory items are stated at the lower of cost, on a first-in, first-out basis, or market. Physical counts of inventory items are conducted periodically to help verify the balance of inventory. A reserve is maintained for obsolete inventory, if appropriate. We consider inventory to be obsolete when it is no longer usable as a system component.

Stock-based Compensation: Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R),Share-Based Payment. This statement requires the recognition of the fair value of stock-based compensation awards in financial statements. Under the provisions of SFAS No. 123(R), stock-based compensation expense is measured at the date of grant, based on the calculated fair value of the stock-based award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the award). We elected to adopt the modified prospective transition method as provided under SFAS No. 123(R). This method applies to all new awards or awards modified, repurchased or cancelled on or after January 1, 2006. Accordingly, financial statement amounts for the periods prior to 2006 presented elsewhere in this Annual Report on Form 10-K have not been restated to reflect the fair value method of expensing share-based compensation.

The adoption of SFAS No. 123(R) resulted in $0.6 million and $0.5 million of expense in 2007 and 2006, respectively, and we anticipate that the adoption of SFAS No. 123(R) will result in $0.7 million of expense in 2008 and $0.8 million of expense thereafter, based upon options outstanding as of December 31, 2007. In addition, the adoption of this standard will result in difficulties comparing our operating results for current and future periods to those of our prior periods, since prior periods through 2005 do not reflect stock-based compensation expense under SFAS No. 123(R).

Deferred Charges: During the fourth quarters of 2006 and 2005, we recorded deferred charges in an amount equal to the excess of the deemed fair value of our common stock over the exercise price of warrants issued during these periods. During these same two quarters, we also recorded deferred charges in an amount equal to the excess of the deemed fair value of our common stock over the exercise price of stock options issued during these periods. Such deferred charges have been or will be amortized as charges to the appropriate income statement classification over the period of the underlying transaction for which the warrants were issued in accordance with SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.

Results of Operations

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

   Year Ended December 31, 
   2007  % of
Revenue
  2006  % of
Revenue
  2005  % of
Revenue
 

Revenues

       

System sales

  $13,477  72% $13,861  81% $10,016  82%

Contract revenues

   5,307  28%  3,253  19%  2,215  18%
                

Total revenues

   18,784  100%  17,114  100%  12,231  100%
                

Cost of revenues

       

Cost of system sales

   13,790  73%  12,161  71%  4,467  36%

Cost of contract revenues

   10,698  57%  7,522  44%  2,323  19%

Depreciation expense

   443  2%  423  2%  340  3%
                

Total cost of revenues

   24,931  133%  20,106  117%  7,130  58%
                

Gross profit (loss)

   (6,147) -33%  (2,992) -17%  5,101  42%

Research and development expense

   564  3%  634  4%  651  6%

Selling, general and administrative expense

   13,685  73%  6,827  40%  3,334  27%
                

Income (loss) from operations

   (20,396) -109%  (10,453) -61%  1,116  9%

Other income (expense)

   5,146  27%  (714) -4%  (553) -4%
                

Income (loss) before taxes

   (15,250) -82%  (11,167) -65%  563  5%

Income tax benefit

   —      —      —    
                

Net income (loss)

  $(15,250) -82% $(11,167) -65% $563  5%
                

Years Ended December 31, 2007 and 2006

Revenues, Cost of Revenues and Gross Profit (Loss)

The following table summarizes the significant components of revenues, cost of revenues and gross profit (loss) for the year ended December 31, 2007 compared to the prior year.

   2007  2006  Increase
(Decrease)
 
   (In thousands) 

Revenues:

    

Large system sales

  $2,010  $5,891  $(3,881)

Standard system sales

   11,467   7,970   3,497 

Contract operations

   5,307   3,253   2,054 
             

Total Revenues

   18,784   17,114   1,670 
             

Cost of Revenues:

    

Large system sales

   4,659   7,724   (3,065)

Standard system sales

   9,131   4,437   4,694 

Contract operations

   7,147   3,798   3,349 

Reserve for future contract operations

   3,551   3,724   (173)

Depreciation expense

   443   423��  20 
             

Total Cost of Revenues

   24,931   20,106   4,825 
             

Gross Profit (Loss):

    

Large system sales

   (2,649)  (1,833)  (816)

Standard system sales

   2,336   3,533   (1,197)

Reserve for future contract operations

   (3,551)  (3,724)  173 

Contract operations

   (2,283)  (968)  (1,315)
             

Total Gross Loss

  $(6,147) $(2,992) $(3,155)
             

Revenues

Revenues increased by $1.7 million, or 10%, to $18.8 million in 2007 from $17.1 million in 2006. This increase occurred primarily as a result of (i) our acquisition of MPT in September 2007 and (ii) growth in our contract revenues, offset in part by a decrease in our revenues from system sales. Revenues recognized for sales of groundwater treatment systems decreased from $13.9 million in 2006 to $13.5 million in 2007, a decrease of $0.4 million, or 3%, primarily due to decreased groundwater treatment systems sales volume. Revenues from system sales represented 72% and 81% of our total revenues during 2007 and 2006, respectively. Contract revenues increased to $5.3 million in 2007 from $3.2 million in 2006, an increase of $2.1 million, or 66%, as the number of systems placed in service with customers increased in 2007 compared to 2006. We anticipate that our annual revenues will continue to increase in the future as we sell more systems and enter into more contracts with our customers. However, the percentage of increase from year to year will likely fluctuate as our base of revenues increases.

Cost of Revenues

Cost of revenues increased by $4.8 million, or 24% to $24.9 million in 2007 from $20.1 million in 2006. This increase was partially due to an increase in the cost of systems sold of $1.6 million, or 13%, to $13.8 million in 2007 compared to $12.2 million in 2006. This increase was primarily due to significantly higher than anticipated costs on our largest project, as well as lower than normal margins on the sale of existing systems. Operating costs for our contract revenues increased by $3.4 million, or 89%, to $7.2 million in 2007 from $3.8 million in 2006. The increase in operating costs was primarily due to higher costs of waste disposal, salt, chemicals and increased field service labor expense, as well as higher depreciation expense, all as a result of having more systems placed in service with customers in 2007 compared to 2006. During 2007 we recorded a

$3.6 million reserve for future contract losses (net of approximately $1.4 million of charges against the reserve for actual contract losses during 2007) as a result of management’s evaluations of certain loss contracts, compared to a $3.7 million reserve for future contract losses recorded in 2006 (see “Management’s Discussion and Analysis of Financial Condition—Financial Operations Review” for a further discussion of this reserve). We expect that our cost of revenues will increase in absolute dollars in future periods due to both an increase in the number of systems sold and higher costs of salt, waste disposal and increased field service labor expense, as well as higher depreciation expense, as a result of having more systems placed in service in future periods.

Gross Loss

Our gross loss increased to $6.1 million in 2007 from $3.0 million in 2006. Our gross profit percentage in 2007 was negative 33% compared to negative 17% in 2006. This increase in gross loss was primarily the result of (i) an increase of $1.3 million in our negative margins from contract operations, (ii) a decrease of $1.2 million in our gross margins on standard system sales and (iii) an increase in our negative gross margin on large system sales of $0.8 million.

As noted above, in both 2006 and 2007 we recorded a reserve for future contract losses (net of $1.4 million of charges against the reserve for actual contract losses during 2007) of $3.7 million and $3.6 million, respectively, which severely impacted our operating profit. In addition to this reserve, the gross loss on our contract operations was $2.3 million prior to applying any charges against the contract loss reserve; this compared to $1.0 million gross loss in the prior year. The increased gross loss was due primarily to the certain legacy contracts booked in prior periods that became operational in 2007 that included, among other things, poor pricing and inadequate contract terms.

Research and Development Expense

Research and development expense was approximately $0.6 million in both 2007 and 2006. We incurred research and development costs for outside consultant expense, research material costs and personnel costs. We expect our research and development expense to increase in absolute dollars in subsequent periods as we develop additional groundwater treatment systems and expand our research and development personnel, but to decrease as a percentage of revenues as our revenues grow. We anticipate that our research and development expense will fluctuate significantly from period to period based upon the timing of our internal and sponsored research projects.

Selling, General and Administrative Expense

The following table summarizes the significant changes in selling, general and administrative expense for the year ended December 31, 2007 compared to the prior year.

   2007  2006  Increase
(Decrease)
   (In thousands)

Compensation and benefits

  $5,126  $2,535  $2,591

Stock-based compensation expense

   831   744   87

Bad debt expense

   634   500   134

Amortization—intangibles

   437   257   180

Outside selling, marketing & promotion

   1,062   666   396

Insurance

   329   263   66

Directors fees and public company costs

   614   174   440

Sarbanes Oxley 404 expense

   442   —     442

Travel & entertainment

   605   400   205

Restricted stock expense

   875   93   782

Professional fees

   1,786   513   1,273

Other SG&A expense

   944   682   262
            

Total SG&A Expense

  $13,685  $6,827  $6,858
            

Selling, general and administrative expense increased by $6.9 million, or 101%, to $13.7 million in 2007 from $6.8 million in 2006. The increase was primarily due to an increase in compensation expense and related employee benefits of $2.6 million due to additional executive and management personnel and related costs to support our overall growth (including approximately $0.8 million added expense as a result of the September 2007 acquisition of MPT), an increase in professional fees of $1.3 million, primarily due to higher legal fees incurred in connection with various litigation; an increase in restricted stock expense of $0.5 million, primarily for restricted stock granted in October 2006; approximately $0.5 million of expense incurred in connection with the development and implementation of internal controls over financial reporting to comply with Section 404 of the Sarbanes Oxley Act of 2002; an increase of $0.4 million in directors fees and public company costs (as 2007 was our first full year as a public company); and an increase of $0.4 million in outside selling, marketing and promotion. We expect our selling expense to continue to increase in future periods as we expand our sales and marketing force. We also anticipate that our general and administrative expense will continue to increase in future periods as we incur additional costs associated with operating as a public company, and expand our administrative organization to support our overall growth.

Other Income (Expense)

The following table summarizes the significant changes in other expense for the year ended December 31, 2007 compared to the prior year.

   2007  2006  Expense
(Increase)
Decrease
 
   (In thousands) 

Interest income

  $2,736  $2,061  $675 

Interest expense—notes & loans

   40   (681)  721 

Amortization—fair value of warrants

   —     (138)  138 

Amortization—loan acquisition costs

   (38)  (89)  51 

Write off—fair value of warrants

   —     (1,524)  1,524 

Write off—loan acquisition costs

   —     (357)  357 

Capitalized interest & other

   —     14   (14)

Other expense—affiliate

   (92)  —     (92)

Other income—affiliate

   2,500   —     2,500 
             

Total Other Income (Expense)

  $5,146  $(714) $5,860 
             

We recorded other income of $5.1 million in 2007 compared to other expense of $0.7 million in 2006. The overall increase in other income is primarily due to (i) a gain on sale to an affiliate of $2.5 million recorded in the fourth quarter of 2007 as the result of the assignment to Empire of our contract to purchase certain water assets (see Note 15 to our consolidated financial statements) and (ii) an increase in interest income of $0.6 million, or 29%, to $2.7 million in 2007 from $2.1 million in 2006.

In addition, during 2006, the write off of approximately $1.5 million in unamortized fair value of warrants and the write off of approximately $0.4 million in unamortized loan costs in connection with the repayment of amounts outstanding under our loan, and our Notes, respectively, both of which are more fully discussed below under “Liquidity and Capital Resources,” resulted in higher interest expense. We expect that we would have net interest income for 2008 due to our large cash balance.

In addition, Empire plans to sell up to an additional 8,000,000 shares of its common stock at a price of $2.00 per share in a private placement during the first half of 2008. If Empire is successful in raising additional capital of at least $10.0 million on or before June 30, 2008, then we will receive an additional 6,000,000 shares of Empire common stock. We anticipate that, if we receive such additional consideration and Empire sells 8,000,000 shares in its private placement, then we will have an ownership interest of approximately 37% in Empire.

Years Ended December 31, 2006 and 2005

Revenues, Cost of Revenues and Gross Profit (Loss)

The following table summarizes the significant components of revenues, cost of revenues and gross profit (loss) for the year ended December 31, 2006 compared to the prior year.

   2006  2005  Increase
(Decrease)
 
   (In thousands) 

Revenues:

    

Large system sales

  $5,891  $3,489  $2,402 

Standard system sales

   7,970   6,527   1,443 

Contract operations

   3,253   2,215   1,038 
             

Total Revenues

   17,114   12,231   4,883 
             

Cost of Revenues:

    

Large system sales

   7,724   2,302   5,422 

Standard system sales

   4,437   2,165   2,272 

Contract operations

   3,798   2,323   1,475 

Reserve for future contract operations

   3,724   —     3,724 

Depreciation expense

   423   340   83 
             

Total Cost of Revenues

   20,106   7,130   12,976 
             

Gross Profit (Loss):

    

Large system sales

   (1,833)  1,187   (3,020)

Standard system sales

   3,533   4,362   (829)

Reserve for future contract operations

   (3,724)  —     (3,724)

Contract operations

   (968)  (448)  (520)
             

Total Gross Profit (Loss)

  $(2,992) $5,101  $(8,093)
             

Revenues

Revenues increased by $4.9 million, or 40%, from $12.2 million in 2005 to $17.1 million in 2006. This increase occurred primarily as a result of growth in sales of our groundwater treatment systems. Revenues recognized for sales of groundwater treatment systems increased from $10.0 million in 2005 to $13.9 million in 2006, an increase of $3.9 million, or 39%, primarily due to increased groundwater treatment systems sales volume. Revenues from system sales represented 81% and 82% of our total revenues during 2006 and 2005, respectively. Contract revenues increased from $2.2 million in 2005 to $3.2 million in 2006, an increase of $1.0 million, or 45%, as the number of systems placed in service with customers increased in 2006 compared to 2005. We anticipate that our annual revenues will continue to increase in the future as we sell more systems and enter into more contracts with our customers. However, the percentage of increase from year to year will likely fluctuate as our base of revenues increases.

Cost of Revenues

Cost of revenues increased by $13.0 million, or 183% from $7.1 million in 2005 to $20.1 million in 2006. This increase was primarily due to an increase in the cost of systems sold of $7.7 million, or 171%, from $4.5 million in 2005 to $12.2 million in 2006. This was primarily due to the significantly higher than anticipated costs on our largest project, including a $1.3 million reserve. Operating costs for our contract revenues also increased by $1.5 million, or 65%, from $2.3 million in 2005 to $3.8 million in 2006. The increase in operating costs was primarily due to higher costs of waste disposal, salt, and increased field service labor expense, as well as higher depreciation expense, all as a result of having more systems placed in service with customers in 2006

compared 2005. In addition, we recorded a $3.7 million reserve for future contract losses as a result of management’s evaluations of certain loss contracts (see “Management’s Discussion and Analysis of Financial Condition—Financial Operations Review” for a further discussion of this reserve). We expect that our cost of revenues will increase in absolute dollars in future periods due to both an increase in the number of systems sold and higher costs of salt, waste disposal and increased field service labor expense, as well as higher depreciation expense, as a result of having more systems placed in service in future periods. As a percentage of revenues, we expect that our cost of revenues will vary from year to year, depending upon the percentage of our revenues recognized from systems sold as opposed to revenues recognized from long-term contracts.

Gross Profit (Loss)

We recorded a gross loss of $3.0 million in 2006 compared to gross profit of $5.1 million in 2005. Our gross profit percentage in 2006 was negative 17% compared to a 42% profit in 2005. This decrease in gross profit was primarily the result of (i) a 2006 reserve for future contract losses in the amount of $3.7 million as discussed above, and (ii) higher than anticipated costs on our largest system sale project. Additionally, the 2006 system sales gross loss reflects the low margins on two projects with special requirements for the construction of buildings through the use of subcontractors during 2006. Excluding this largest system sale project and the two projects involving the construction of buildings (large system sales), our standard system sales gross profit percentages were in the normal mid 40% range during 2006.

Our contract operations gross profit was impacted by higher volume-related contract operating costs, particularly waste hauling charges and increased field service labor and engineering expense, especially on certain older contracts. In general, our gross profit percentage is higher on systems we sell than on systems we place with customers under long-term contracts. We expect our gross profit and gross margin to fluctuate based on the portion of our revenues derived from system sales as opposed to long-term contracts. As noted above, we recorded a $3.7 million reserve for future losses primarily on older contracts which severely impacted our operating profit.

Research and Development Expense

Research and development expense was approximately $0.6 million in both 2006 and 2005. We incurred research and development costs for outside consultant expense, research material costs, and personnel costs. We expect our research and development expense to increase in absolute dollars in subsequent periods as we develop additional groundwater treatment systems and expand our research and development personnel, but to decrease as a percentage of revenues as our revenues grow. Our research and development expense constituted a higher percentage of our revenues in prior periods when we were selling our first systems. We anticipate that our research and development expense will fluctuate significantly from period to period based upon the timing of our internal and sponsored research projects.

Selling, General and Administrative Expense

The following table summarizes the significant changes in selling, general and administrative expense for the year ended December 31, 2006 compared to the prior year.

   2006  2005  Increase
(Decrease)
   (In thousands)

Compensation and benefits

  $2,535  $1,415  $1,120

Stock-based compensation expense

   744   31   713

Bad debt expense

   500   22   478

Amortization—fair value of warrants

   257   —     257

Outside selling, marketing & promotion

   666   465   201

Insurance

   263   67   196

Directors fees and public company costs

   174   —     174

Travel & entertainment

   400   293   107

Restricted stock expense

   93   —     93

Professional fees

   513   433   80

Other SG&A expense

   682   608   74
            

Total SG&A Expense

  $6,827  $3,334  $3,493
            

Selling, general and administrative expense increased by $3.5 million, or 106%, from $3.3 million in 2005 to $6.8 million in 2006. The increase was primarily due to stock-based compensation of $0.7 million recorded in 2006 in accordance with the provisions of SFAS No. 123(R); bad debt expense in the amount of $0.5 million primarily due to a default under one contract; and an increase in compensation expense and related employee benefits of $1.1 million due to increased personnel and related costs to support our overall growth. In addition, we incurred approximately $0.4 million in higher liability insurance costs and certain professional fees directly related to our becoming a publicly traded company in 2006. We expect our selling expense to continue to increase in future periods as we expand our sales and marketing force. We also expect our general and administrative expense to continue to increase in future periods as we incur additional costs associated with operating as a public company, and expand our administrative organization to support our overall growth.

Other Expense

The following table summarizes the significant changes in other expense for the year ended December 31, 2006 compared to the prior year.

   2006  2005  Expense
(Increase)
Decrease
 
   (In thousands) 

Interest income

  $2,061  $52  $2,009 

Interest expense—notes & loans

   (681)  (417)  (264)

Amortization—fair value of warrants

   (138)  (162)  24 

Amortization—loan acquisition costs

   (89)  (40)  (49)

Write off—fair value of warrants

   (1,524)  —     (1,524)

Write off—loan acquisition costs

   (357)  —     (357)

Capitalized interest & other

   14   14   —   
             

Total Other Expense

  $(714) $(553) $(161)
             

Other expense increased by $0.2 million, or 40%, from $0.5 million in 2005 to $0.7 million in 2006. The overall increase in other expense is primarily due to the write off of approximately $1.5 million in unamortized

fair value of warrants and the write off of approximately $0.4 million in unamortized loan costs in connection with the repayment of amounts outstanding under our BWCA loan, and our XACP Notes, both of which are more fully discussed below under “Liquidity and Capital Resources,” resulting in higher interest expense. These increases in interest expense were partially offset by an increase of approximately $2.0 million in interest income earned on net proceeds from our initial public offering in mid-May 2006. We expect that we will have net interest income for 2007.

Liquidity and Capital Resources

From our inception until our initial public offering in May 2006, we financed our growth and operations primarily with proceeds from the issuance of preferred stock and common stock, as well as the incurrence of indebtedness under the BWCA loan, our subordinated notes payable to The Co-Investment 2000 Fund, LP, Cross Atlantic Technology Fund II, LP and Catalyst Basin Water, LLC (the “XACP Notes”), and our $2.0 million subordinated note to Aqua America, Inc. (the “Aqua Note”).

In connection with our initial public offering in May 2006, we received net cash proceeds of approximately $75.2 million, of which $11.0 million was used to repay the $4.0 million BWCA loan, $5.0 million in XACP Notes and the $2.0 million Aqua Note.

Our long-term future capital requirements will depend on many factors, including our level of revenues, the expansion of our sales and marketing activities, the success of our strategic relationships in the marketing of our treatment systems, our ability to place our systems under long-term contracts and provide service under our long-term contracts, our need to make capital expenditures to increase our resin regeneration capacity including through building new or expanding existing facilities and the continuing market acceptance of our systems and services.

We anticipate continued revenue growth. Our revenue growth impacts our liquidity and places increased demands on our capital resources. For example, as our system sales to customers increase, we require an increased investment in accounts receivable, as system sales accounts receivable may have repayment terms from several months to one year or beyond. Additionally, as our long-term contract revenues increase, we will experience much higher capital expenditure requirements.

We expect that our current cash and cash equivalents will be sufficient to fund our anticipated future growth and operations for at least the next 12 months. We anticipate that we may need additional capital to finance our growth and operations after such 12-month period or to accelerate our expected growth during such 12-month period. In such an event, we anticipate that we would be able to raise additional capital through a combination of bank credit facilities, issuance of long-term debt and private or public equity offerings. If we were unable to obtain additional capital through one or more of these sources, our investment in groundwater treatment systems and our revenue growth would be delayed, or we would focus our sales and marketing on the sales of systems as opposed to placing such systems under long-term contracts. We also expect to use third-party financing with respect to systems placed through long-term contracts, resulting in the sale of the systems.

We also expect to consider opportunities to acquire or make investments in other technologies, products and businesses that could enhance our technical capabilities, complement our current products and services or expand the breadth of our customer base. These activities would require additional capital resources.

At December 31, 2007, we had $35.5 million in cash and cash equivalents. We have invested substantially all of our available cash funds in money market funds placed with reputable institutions for which credit loss is not anticipated.

The following table summarizes our primary sources of cash in the periods presented:

   Year Ended December 31, 
   2007  2006  2005 
   (in thousands) 

Net cash provided by (used in):

    

Operating activities

  $(13,256) $(12,361) $(6,409)

Investing activities

   (11,592)  (3,941)  (1,695)

Financing activities

   5,737   68,145   9,124 
             

Net increase (decrease) in cash and cash equivalents

  $(19,111) $51,843  $1,020 
             

Operating Activities

Net cash used by operating activities was $13.3 million during 2007 compared to net cash used in operating activities of $12.4 million during 2006. This increase in net cash used by operating activities was due primarily to (i) an increase in our net loss of $4.1 million to $15.3 million in 2007 from $11.2 million in 2006, (ii) an increase in gain on sale to affiliate of $2.5 million, (iii) the issuance of $3.3 million in notes receivable in 2007 and (iv) a $3.5 million decrease in accrued expenses compared to the prior year (excluding accrued expenses arising from our acquisition of MPT in September 2007). The foregoing increases in net cash used by operating activities were offset in part by (i) an increase of $3.4 million in net book value of systems sold, (ii) a $2.7 million decrease in accounts receivable arising from more timely collection of accounts receivable from our customers, (iii) a $2.2 million increase in accounts payable as a result of increased operating activity and increases in construction in process and (iv) a $3.2 million decrease in other assets and liabilities during 2007.

Net cash used by operating activities was $12.4 million during 2006 compared to net cash used in operating activities of $6.4 million during 2005. In addition to our net loss of $11.2 million, the increase in net cash used by operating activities was due primarily to a $2.1 million decrease in accounts payable reflecting expedited settlements of obligations to our vendors when compared to the prior year. In addition, as noted above, our prepaid expenses increased due to much higher insurance premiums incurred for our corporate liability coverage, most notably directors’ and officers’ liability insurance. Accounts receivable balances were higher in 2006 when compared to 2005, resulting in approximately $4.5 million use of cash for operating activities. The increase in accounts receivable was offset by the $3.7 million contract loss reserve recorded in 2006.

In general, accounts receivable arising from systems sales to customers are due in accordance with the provisions of the sales contract, which may provide for extended payment terms ranging from several months to one year or more for a significant portion of the contract price. In contrast, accounts receivable from systems placed under long-term contracts with customers are usually due within a much shorter period, generally within one month after the date services have been performed and the customer has been billed. Accordingly, in periods in which our revenues from system sales are higher, our collection of accounts receivable will be much slower due to the nature of the sales contracts, and we will require additional cash to fund these system sales accounts receivable.

Investing Activities

Net cash used in investing activities was $11.6 million in 2007 compared to $3.9 million in 2006. The increase in cash used in investing activities was due primarily to $6.2 million in cash paid as partial consideration for the acquisition of MPT, net of cash acquired. In addition, we experienced a $1.4 million increase in capital expenditures in 2007 compared to 2006. This increase in capital expenditures was the result of more systems placed with customers under long-term contracts during 2006 than during 2005 since more customers chose to purchase systems from us rather than pay us under long-term contracts.

Net cash used in investing activities was $3.9 million in 2006 compared to $1.7 million in 2005. This increase was due primarily to a $2.0 million increase in capital expenditures in 2006 compared to 2005. This increase in capital expenditures was the result of more systems placed with customers under long-term contracts during 2006 than during 2005, since more customers chose to pay us under long-term contracts rather than purchase systems from us.

Financing Activities

Net cash provided by financing activities was $5.7 million in 2007 compared to $68.1 million in 2006. This decrease was due primarily to $75.2 million in net proceeds from sales of common stock (attributable to our initial public offering) and $2.0 million in net proceeds received from notes payable receipt. These decreases in net cash provided by financing activities were offset in part by $8.1 million in net proceeds from exercise of common stock warrants and a decrease of $6.8 million in repayments of notes payable and capital lease obligations during 2007 compared to the prior year.

Net cash provided by financing activities was $68.1 million in 2006 compared to $9.1 million in 2005. The increase was due primarily to an increase of $71.6 million in net proceeds from sales of common stock (attributable to our initial public offering in May 2006), offset in part by a $3.2 million decrease in net proceeds from notes payable and an $8.9 million increase in principal payments on notes payable and capital leases.

Capital Expenditures

Our capital expenditures are primarily for groundwater treatment systems that we build and then contract to customers under long-term contracts. Capital expenditures totaled $5.3 million, $3.9 million and $1.9 million during the years ended December 31, 2007, 2006 and 2005, respectively. Our future capital expenditures will fluctuate depending on the number of our systems we place with customers under long-term contracts.

We anticipate that our capital expenditures will continue to increase in future years. We anticipate the use of cash of approximately $5.0 million to $7.0 million for capital expenditures during 2008 for increases in our resin regeneration capacity, development of certain pilot plants for treatment technologies and improving or expanding our existing facilities. In addition, capital expenditures could increase further relative to any increases in the number of treatment systems delivered to customers under long-term contract arrangements, though it is our intent to sell these arrangements to a third party financing company, thus reducing the use of cash for that customer system.

Outstanding Indebtedness

At December 31, 2007, we had no outstanding indebtedness.

Warrants Issued in connection with Indebtedness and other Transactions

In connection with the BWCA loan (which was repaid in full in May 2006), we issued to the lender warrants to purchase an aggregate of 717,450 shares of our common stock at an exercise price of $4.00 per share. These warrants are immediately exercisable and expire in November, 2008, provided, that the warrant shall no longer be exercisable on the date of a change in control of our company.

On August 13, 2007, we entered into an Omnibus Amendment to Business Loan Agreement and Warrants dated October 3, 2003, April 30, 2004 and February 10, 2006 (Omnibus Amendment) with BWCA I, LLC. Pursuant to the terms of the Omnibus Amendment, the prepayment penalty associated with the May 2006 repayment of the loans previously outstanding and owed to BWCA I, LLC was reduced from 5.0% to 2.5%, and each of the warrants previously issued to BWCA I, LLC was amended to allow the holder thereof to effect a “net” or “cashless” exercise of the warrant.

The number of shares of common stock that will be issued to BWCA I, LLC upon cashless exercise will be reduced from the 767,450 shares originally issuable under the warrants. These warrants have an aggregate exercise price of $3.3 million, which the warrant holder would normally pay in cash to us. Instead, upon exercise the warrant holder will receive a reduced number of shares of our common stock, effectively foregoing shares equal to $3.3 million in market value at the time of exercise.

Subsequent to the Omnibus Agreement, during the last two quarters of 2007, holders of 56,066 warrants exercised such warrants through cashless exercises, and received 38,995 shares of our common stock.

In connection with the XACP Notes (which were repaid in full in May 2006), we issued to the purchasers warrants to purchase an aggregate of 750,000 shares of our common stock at an exercise price of $5.50 per share and warrants to purchase an aggregate of 250,000 shares of our common stock at an exercise price of $7.00 per share. These warrants are immediately exercisable and expire on the earliest of November 11, 2008 and immediately prior to a change in control of our company. During the third and fourth quarters of 2007, the holders of the XACP warrants exercised 725,000 warrants at an exercise price of $5.50 per share and 225,000 warrants at an exercise price of $7.00 per share, resulting in the issuance of 950,000 shares of our common stock and net proceeds to us of approximately $5.6 million.

In connection with our nationwide strategic relationship with Aqua America and issuance of the Aqua Note (which was repaid in full in May 2007), we granted to Aqua America a warrant to purchase 300,000 shares of our common stock at an exercise price of $6.00 per share and a warrant to purchase 100,000 shares of our common stock at an exercise price of $7.00 per share. During the fourth quarter of 2007, the holders of the Aqua warrants exercised all of their warrants, resulting in the issuance of 400,000 shares of our common stock and net proceeds to us of $2.5 million.

In addition, in connection with the consent granted by BWCA I, LLC with respect to our issuance of the Aqua Note, we granted to BWCA I, LLC a warrant to purchase 50,000 shares of our common stock at an exercise price of $8.00 per share.

Pursuant to our December 2005 binding commitment letter with Shaw, Shaw committed to purchase a total of $5.0 million of our groundwater treatment systems prior to December 31, 2006. We granted to Shaw a warrant to purchase 300,000 shares of our common stock at an exercise price of $7.00 per share in connection with its purchase of our groundwater treatment systems. One-fifth of the shares subject to this warrant vest upon each $1.0 million of our groundwater treatment systems paid for by Shaw. As of December 31, 2007, no shares had vested under the Shaw warrant. The warrant may be exercised for five years after the date of grant. In 2005, we recognized revenues of approximately $1.6 million from Shaw’s purchase of our systems, which was offset by approximately $0.2 million attributable to the warrant that we granted to Shaw pursuant to the transaction. During 2006, we recognized revenues in the amount of $2.9 of the remaining $3.4 million pursuant to this commitment which was offset by approximately $0.3 million attributable to the warrants we granted to Shaw.

We have applied the provisions of SFAS No. 123 and SFAS No. 123(R) to the warrants issued in connection with these transactions. Accordingly, the total fair value of the warrants issued has been calculated using the Black-Scholes method. In accordance with the provisions of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, the fair values of those warrants primarily related to indebtedness have been or will be recorded as a discount to notes payable, with a corresponding increase in common stock. The fair value of such warrants is being amortized through the end of each respective loan term under the interest method.

Off Balance Sheet Arrangements

Through December 31, 2007, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have

been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in these relationships. We do not have relationships or transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.

Contractual Obligations

The following table summarizes our significant contractual obligations as of December 31, 2007:

Payments Due by Period

  Less than
1 Year
2008
  1 to 3
Years
(2009-2010)
  3 to 5
Years
(2011-2012)
  More than
5 Years
(After 2012)
  Total
   (In thousands)

Principal payments—notes payable

  $—    $—    $—    $—    $—  

Interest payments—fixed rate notes payable

   —     —     —     —     —  

Capital lease obligations

   11   15   —     —     26

Operating lease obligations

   645   1,474   929   34   3,082

Capital commitments(1)

   2,172   —     —     —     2,172

Purchase commitments(2)

   —     —     —     —     —  
                    

Totals

  $2,828  $1,489  $929  $34  $5,280
                    

(1) —Represents estimated costs to complete groundwater treatment systems under current contracts with customers
(2) —There are no minimum purchase arrangements with vendors

Effect of Inflation and Seasonality

We do not believe that inflation will have a material impact on our financial condition or results of operations. We believe current contracts and pricing policies will allow for these costs to be appropriately passed on to our customers. We identified certain older contracts where we did not provide for the ability to offset cost increases and have recorded a $3.7 million reserve in 2006 for these future losses.

During 2007, additional older legacy contracts became operational and were operated during the busy, higher volume summer months. Based on the new operating history, especially during the third quarter, it became apparent that the original reserve was not adequate. Management reviewed each contract’s financial performance and identified the future expected losses for these contracts, resulting in a $4.7 million increase to the reserve for future contract losses, which was charged to cost of contract revenues during the third quarter of 2007. The net reserve for future contract losses included on our balance sheet, both short and long term, as of December 31, 2007 was approximately $7.3 million.

Our business, particularly the revenues we receive from our long-term contracts, is moderately seasonal due to the impact of summer and hot weather conditions on the water requirements of our customers. In the summer and warmer months, our customers have a higher demand for water and must increase the utilization of their groundwater resources resulting in a higher volume of groundwater treated during these periods and thus higher revenues from our long-term contracts. Our net sales and net income have historically been lowest in the three-month periods ending December 31 and March 31, when the Arid West generally faces cooler weather that reduces the utilization of groundwater sources which in turn reduces the processing fees we receive from our long-term contracts. Historically, the impact of seasonality has been mitigated through the impact of the sales of our systems in certain periods. We also expect sales of our systems to continue to mitigate the impact of seasonality in future periods in the near-term.

Recently Issued Accounting Standards

In June 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 became effective for the Company on January 1, 2007. The provisions of FIN 48 are to be applied to all tax positions upon initial application of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption. The cumulative effect of applying the provisions of FIN 48, if any, must be reported as an adjustment to the opening balance of retained earnings or other appropriate components of equity for the fiscal year of adoption. The adoption of FIN 48 had no material impact on our financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements. This statement establishes a single authoritative definition of fair value, sets out framework for establishing fair value, and requires additional disclosures about fair value measurements. This statement applies only to fair value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements. Adoption of SFAS 157 is required for our fiscal year beginning January 1, 2008, and will be applied prospectively under most circumstances. We do not expect adoption of SFAS No. 157 to have a material impact on our financial statements.

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115. This statement permits companies to choose to measure many financial instruments and other specified items at fair value. This statement is effective for our fiscal year beginning January 1, 2008 and will be applied prospectively. We do not expect adoption of SFAS No. 159 to have a material impact on our financial statements.

In December 2007, the FASB issued SFAS No. 141(R),Business Combinations (SFAS No. 141R(R)). This statement replaces SFAS No. 141in its entirety and retains the fundamental requirements in SFAS 141, including that the purchase method be used for all business combinations and for an acquirer to be identified for each business combination. This standard defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control instead of the date that the consideration is transferred. SFAS 141(R) requires an acquirer in a business combination, including business combination, including business combinations achieved in states (step acquisition), to recognize the assets acquired, liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values of that date, with limited exceptions. It also requires the recognition of assets acquired and liabilities assumed arising from certain contractual contingencies as of the acquisition date, measured at their acquisition-date fair values. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first reporting period beginning on or after December 15, 2008, and may not be applied before that date. We are currently evaluating the impact SFAS 141(R) could have on our 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), which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This statement is effective for the fiscal year beginning January 1, 2009 and will be applied prospectively. We do not expect adoption of SFAS No. 160 to have a material impact on our consolidated financial statements.

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At December 31, 2007, we had no outstanding indebtedness. The amount of our outstanding debt at any time may fluctuate and we may from time to time be subject to refinancing risk. A hypothetical 100 basis point increase in interest rates would not have a material effect on our annual interest expense, our results of operations or financial condition. We derive substantially all of our revenues from sales within the United States. Since transactions in foreign currencies are immaterial to us as a whole because we do not currently have any significant foreign customers nor do we enter into contracts with foreign entities except contracts denominated in United States currency, we do not consider it necessary to hedge against currency risk.

ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our financial statements, supplementary financial data and financial statement schedules are included in a separate section at the end of this Report. The financial statements, supplementary data and schedules are listed in the index on page F-1 of this Report and are incorporated herein by reference.

ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A.CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC and that such information is accumulated and communicated to management, including our chief executive officer (CEO) and chief financial officer (CFO), as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Management, with participation by our CEO and CFO, has designed the Company’s disclosure controls and procedures to provide reasonable assurance of achieving the desired objectives. As required by SEC Rule 13a-15(b), in connection with filing this Annual Report on Form 10-K, management conducted an evaluation, with the participation of our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as of December 31, 2007, the end of the period covered by this report.

Based upon the evaluation conducted by management in connection with the audit of the Company’s financial statements for the years ended December 31, 2007 and 2006, we identified a material weakness in our internal control over financial reporting. A material weakness is “a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected by us in a timely manner.” As a result of this material weakness, our CEO and CFO concluded that our disclosure controls and procedures were not effective at the reasonable assurance level as of December 31, 2007.

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

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

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

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

Our independent registered public accounting firm has issued an attestation report on our internal control over financial reporting, which is included in Item 8 of this Report.

The ineffectiveness of internal controls as of December 31, 2007 stemmed in large part from several significant changes within the Company. The organization structure was changing as we hired additional management, and we were establishing the new accounting information system. This placed additional stress on the organization and our internal controls as these new structures were being instituted within the company. Additionally, the acquisition of MPT in the third quarter of 2007 caused additional changes to our organization structure and accounting systems. While we believe the new organization and the accounting information system will strengthen our internal control functions into the future, during the transition, these changes caused control deficiencies, which in the aggregate resulted in a material weakness.

These control deficiencies could result in a misstatement of account balances that would result in a reasonable possibility that a material misstatement to our financial statements may not be prevented or detected on a timely basis. Accordingly, we have determined that these control deficiencies as described above together constitute a material weakness.

In light of this material weakness, we performed additional analyses and procedures in order to conclude that our consolidated financial statements for the year ended December 31, 2007 included in this Annual Report on Form 10-K were fairly stated in accordance with US GAAP. Accordingly, management believes that despite our material weaknesses, our financial statements for the year ended December 31, 2007 are fairly stated, in all material respects, in accordance with US GAAP.

We may in the future identify further material weaknesses or significant deficiencies in our internal control over financial reporting that we have not discovered to date. We plan to refine our internal control over financial reporting to meet the internal control reporting requirements included in Section 404 of the Sarbanes-Oxley Act (SOX 404) to have effective internal controls by December 31, 2008. The effectiveness of the measures we implement in this regard will be subject to ongoing management review supported by confirmation and testing by management and by our internal auditors, as well as audit committee oversight. As a result, we expect that additional changes could be made to our internal control over financial reporting and disclosure controls and procedures.

(c) Plan for Remediation of Material Weaknesses

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

We retained an experienced consultant to assist us in our SOX 404 preparedness project;

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

We have completed our corporate governance documents including our Code of Business Conduct and Ethics, electronic communication and retention policies;

We have completed implementation of a new financial software system to enhance our financial reporting process; and

We have established an internal audit function, either through use of a consultant or by hiring our own personnel; and

We have implemented a system of disclosure controls and procedures that is designed to ensure that information required in our future Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow for timely decisions regarding required disclosure.

During 2008, we intend to take the following remediation efforts:

increase our accounting and finance resources to meet the demands of the company;

reinforce policies and procedures with the employees of the company;

monitor and reinforce the stabilization of the organization;

implement new policies and procedures specific to known control deficiencies surrounding cutoff, reporting and processing procedures; and

seek to have effective internal control over financial reporting by December 31, 2008.

We believe these remediation efforts will contribute towards an effective internal control environment for financial reporting.

(d) Changes in Internal Control over Financial Reporting

Other than as described above, there were no changes in our internal control over financial reporting during the quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B.OTHER INFORMATION

None.


PART III

 

ITEM 10.    DIRECTORS,DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Board of Directors

Information relating to the officers andAt March 31, 2009, our board of directors consisted of the Company, other corporate governance mattersfollowing members:

Name

Age

Position with the Company

Scott A. Katzmann

53Director, Chairman of the Board

Michael M. Stark

65Director, President and Chief Executive Officer

Victor J. Fryling

61Director, Chairman of the Audit Committee

Keith R. Solar

48Director, Chairman of the Compensation Committee and Chairman of the Nominating & Governance Committee

Roger S. Faubel

60Director

Stephen A. Sharpe

57Director

Susan H. Snow

51Director

Scott A. Katzmannhas served as a director since August 2001 and other information required under this Item 10 is set forthas Chairman of the Board since March 6, 2008. Since 1993, he has served as Managing Director at Paramount BioCapital, Inc., an investment banking firm. Prior to joining Paramount, from 1982 to 1993, Mr. Katzmann worked in our Proxy Statement for our 2008 Annual Meetingthe investment banking department of Stockholders (Proxy Statement)Credit Suisse First Boston where he specialized in the placement of a wide variety of private equity-oriented securities. From 1997 to 1999, Mr. Katzmann served as a director of Western Water Company. Mr. Katzmann received his B.A. in economics from Tulane University and is incorporated herein by reference.

Executive Officersan MBA in finance from the Wharton School at the University of Pennsylvania.

Michael M. Starkjoined the board as a director in May 2008, and has served as our President and Chief Executive Officer since February 2008 and as our President and Chief Operating Officer from October 2006 to February 2008. Mr. Stark served from 1997 to 2005 as President of Veolia Water North America, previously known as USFilter, a water services company. From 2005 to 2006, Mr. Stark has beenwas an independent consultant to companies in the water industry. From 1992 to 1997, Mr. Stark served as President and Chief Executive Officer of Mobley Environmental Services, a company specializing in non-hazardous hydrocarbon recycling. Prior to that time, Mr. Stark has held executive positions at a variety of companies, and has been in the water, environmental and specialty chemical industry since 1965. Mr. Stark holds a B.S. in Biology from Marietta College.

ThomasVictory J. Frylinghas served as a director since April 2003. Since December 2000, Mr. Fryling has served as a consultant and principal of Integrum Energy Ventures LLC, a management consulting firm. From 1990 to 2000, Mr. Fryling served as a director of CMS Energy Corporation, a provider of natural gas and electricity service. At CMS Energy Corporation, Mr. Fryling also served as its President from 1990 to 2000, as its Chief Financial Officer from 1988 to 1990 and as its Chief Operating Officer from 1990 to 2000. Mr. Fryling currently serves on the Board of Directors of Renewable Energy Systems Americas and Renewal Power and Light. Mr. Fryling received his B.A. in accounting and finance from Wayne State University.

Keith R. Solarhas served as a director since February 2000 and our Secretary from November 2002 until January 2006. Since June 2007, he has been the Managing Partner of the San Diego office of Buchanan Ingersoll & Rooney LLP. From February 2000 until June 2007, he was a partner at the law firm of Alhadeff & Solar, LLP. From 1991 to 2000, he was a partner at the law firm of Alhadeff Cannon Rose Solar & Parks, LLP. Mr. Solar received his A.B. in journalism from Indiana University and his J.D. from the University of the Pacific, McGeorge School of Law.

Roger S. Faubel joined Basin Water as a director in April 2007. In 1997, Mr. Faubel established Faubel Public Affairs and has served as its President and CEO for the last twelve years. Prior to that, he served as the Director of Public Affairs for Southern California Edison until his retirement in 1997. He was re-elected in 2002 to the Santa Margarita Water District Board of Directors and is a founding board member of the Urban Water Institute. Mr. Faubel received his B.A. in English literature from the California State University, Fullerton.

Stephen A. Sharpe joined Basin Water as a director in April 2007. Since 2002, Mr. Sharpe has been a consultant in the energy, infrastructure and real estate industries. Prior to that, Mr. Sharpe held executive positions with Peter Kiewit, a construction company, U.S. Generating, an energy company, and several banks including Shearson Lehman, Lloyds and Chemical. Mr. Sharpe received his B.A. in Economics from Rhodes College and an MBA in finance from Emory University.

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Susan H. Snowjoined the board as a director in May 2008. From 2002 to 2007, she served as Chief Financial Officer, Chief Administrative Officer and on the Board of Directors of Maxim Systems, Inc. Prior to this, she held Chief Financial Officer positions at Network Insight, LLC and AP Labs, Inc. Earlier in her career, Ms. Snow served in CFO and executive positions at water systems companies including Desalination Systems, Inc. and Nimbus Water Systems, Inc. Ms. Snow serves as a Board Director and Board Advisor for a number of organizations including PRI, Inc., Red Horse, Inc., CONNECT and the Corporate Directors Forum. She is also a member of the University of San Diego Business School Advisory Board. Ms. Snow received her M.S. in Accounting from Northeastern University.

There is no family relationship between any director and any of our other directors or executive officers.

Nominating and Governance Committee

The members of the Nominating and Governance Committee are Messrs. Solar (Chair) and Faubel and Ms. Snow. Ms. Snow replaced Mr. Ball on the Nominating and Governance Committee in May 2008. The Board has determined that all members meet the criteria required under applicable SEC and NASDAQ listing standards for independence. The Nominating and Governance Committee’s written charter can be found in the Investor Relations section of our website atwww.basinwater.com. On behalf of the Board, the Nominating and Governance Committee assists the Board by identifying individuals qualified to become directors consistent with criteria established by the Board. Among other matters, the committee’s responsibilities include the following:

evaluating the composition, size and governance of our Board and its committees and making recommendations regarding future planning and the appointment of directors to committees of our Board;

administering a policy for considering nominees for election to our Board;

overseeing our director performance and self-evaluation process;

developing continuing education programs for our Board;

reviewing our corporate governance principles and providing recommendations to our Board concerning possible changes; and

reviewing and monitoring compliance with our Code of Business Conduct and Ethics and our insider trading policy.

Selection of Board Nominees

Prior to our initial public offering, as a privately held company, we informally identified potential candidates for nomination as directors. Generally, Board members have been our officers or persons who have had significant industry or other relevant experience, and have been known to one or more of our Board members or officers. Following the establishment of our Nominating and Governance Committee, the Nominating and Governance Committee has reviewed the qualifications of potential director candidates in accordance with its charter and our Corporate Governance Guidelines.

The Nominating and Governance Committee’s consideration of a candidate as a director includes assessment of the individual’s understanding of our business, the individual’s professional and educational background, skills, and abilities and potential time commitment and whether such characteristics are consistent with our Corporate Governance Guidelines and other criteria established by the Nominating and Governance Committee from time to time. To provide such a contribution to the Company, a director must generally possess one or more of the following, in addition to personal and professional integrity:

experience in corporate management;

experience in our Company’s industry;

experience as a board member or officer of another publicly held company;

diversity of expertise and experience in substantive matters related to our Company’s business; and

practical and mature business judgment.

The Nominating and Governance Committee may also adopt such procedures and criteria not inconsistent with our Corporate Governance Guidelines as it considers advisable for the assessment of director candidates. The Nominating and Governance Committee retains the services of an executive search or other firm to conduct background checks on each director nominee. Other than the foregoing, there are no stated minimum criteria for director nominees. The Nominating and Governance Committee does however recognize that at least one member of the Board should meet the criteria for an “audit committee financial expert” as defined by SEC rules, and that at least a majority of the members of the Board must meet the definition of “independent director” under the Nasdaq Marketplace rules.

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Stockholder Nominations

Pursuant to our Bylaws, only persons who are nominated in accordance with the following procedures are eligible for election as directors. Nominations of persons for election to the Board may be made at a meeting of stockholders only (1) by or at the direction of the Board or (2) by a stockholder who is a stockholder of record at the time of the giving of the required notice described below, who is entitled to vote for the election of directors at the meeting, and who complies with the following notice procedures. All nominations, other than those made by or at the direction of the Board, must be made pursuant to timely notice in writing to our Secretary.

Our Bylaws provide that to be timely, a stockholder’s notice must be delivered to our Secretary at our principal executive offices not less than 90 days nor more than 120 days prior to the first anniversary of the preceding year’s annual meeting. However, if the date of the 2010 Annual Meeting of Stockholders is advanced by more than 30 days prior to or more than 60 days after the anniversary of this year’s annual meeting, notice of nominations by a stockholder for the 2010 Annual Meeting of Stockholders to be timely must be delivered not earlier than the close of business on the 120th calendar day prior to such annual meeting nor later than the close of business on the later of the 90th calendar day prior to such annual meeting or the 10th calendar day following the earlier of (1) the day on which notice of the meeting was mailed or (2) on which public announcement of the date of such meeting is first made by us.

A stockholder’s notice to our Secretary with respect to persons that the stockholder proposes to directly nominate as a director must set forth (a) as to each individual whom the stockholder proposes to nominate, all information relating to the person that is required to be disclosed in solicitations of proxies for the election of directors or is otherwise required, pursuant to Regulation 14A (or any successor provisions) under the Exchange Act (including their name, age, business address, residence address, principal occupation or employment, the number of shares beneficially owned by such candidate, and the written consent of such person to be named in the proxy statement as a nominee and to serve as a director if elected) and (b) as to the stockholder proposing to make such nomination, the same information as is described above with respect to proposals to be made by a stockholder.

The Nominating and Governance Committee will consider all stockholder recommendations for candidates for the Board, which should be sent to the Nominating and Governance Committee, c/o Secretary, Basin Water, Inc., 9302 Pittsburgh Avenue, Suite 210, Rancho Cucamonga, California 91730.

The Nominating and Governance Committee will evaluate recommendations for director nominees submitted by directors, management or qualifying stockholders in the same manner, using the criteria stated above. All directors and director nominees will be required to submit a completed directors’ and officers’ questionnaire as part of the nominating process. The process may also include interviews and additional background and reference checks for non-incumbent nominees, at the discretion of the Nominating and Governance Committee.

Corporate Governance Guidelines

Our Company has adopted Corporate Governance Guidelines that we believe reflect our Board’s commitment to a system of governance that enhances corporate responsibility and accountability. The Nominating and Governance Committee is responsible for implementing the guidelines and making recommendations to the Board concerning corporate governance matters. The guidelines are available on the Investor Relations section of our website atwww.basinwater.com. We will also furnish copies of the guidelines to any person who requests them. Requests for copies should be directed to the Basin Water, Inc., 9302 Pittsburgh Avenue, Suite 210, Rancho Cucamonga, California 91730, Attention: Secretary.

Among other matters, the guidelines include the following:

membership on our Board will consist of a majority of independent directors who, at a minimum, meet the criteria for independence required by Nasdaq listing standards;

non-employee directors will meet in executive session without management directors or management present on a regularly scheduled basis, but not less than two (2) times a year;

our Board and its committees are each required to conduct an annual self-evaluation;

directors are expected to attend all meetings of our Board and of committees of which they are members;

directors should ensure that our Company’s business is conducted with the highest standards of ethical conduct and in conformity with applicable laws and regulations; and

to effectively discharge their oversight duties, directors have full and free access to our officers and employees.

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Audit Committee

The members of the Audit Committee are Messrs. Fryling (Chair), Sharpe and Ms. Snow. On May 6, 2008, Ms. Snow replaced Russell C. TekulveBall, who resigned as a director in May 2008. The Board has determined that members of the Audit Committee satisfy the criteria required under applicable SEC and Nasdaq listing standards for financial literacy and the SEC and Nasdaq standards for independence. The Audit Committee’s written charter can be found in the Investor Relations section of our website atwww.basinwater.com.

The Audit Committee oversees our accounting and financial reporting processes, internal control systems, independent auditor relationships and the audits of our financial statements. Among other matters, the Audit Committee’s responsibilities include the following:

selecting and hiring our independent registered public accounting firm;

evaluating the qualifications, independence and performance of our independent registered public accounting firm;

reviewing and approving the audit and non-audit services to be performed by our independent registered public accounting firm;

reviewing the design, adequacy, implementation and effectiveness of our internal controls established for finance, accounting, legal compliance and ethics;

reviewing the design, adequacy, implementation and effectiveness of our critical accounting and financial policies;

overseeing and monitoring the integrity of our financial statements and our compliance with legal and regulatory requirements as they relate to our financial statements of accounting matters;

reviewing with management and our independent registered public accounting firm the results of our annual and quarterly financial statements;

reviewing with management and our independent registered public accounting firm any earnings announcements or other public announcements concerning our operating results; and

reviewing and approving any related party transactions.

Audit Committee Financial Expert. The Board has determined that Mr. Fryling is the “audit committee financial expert” as defined under SEC rules and regulations implementing Section 407 of The Sarbanes-Oxley Act of 2002. The Board has also determined that Mr. Sharpe and Ms. Snow qualify as audit committee financial experts.

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Audit Committee Report

The following report of our audit committee does not constitute soliciting material and shall not be deemed filed or incorporated by reference into any other Company filing under the Securities Act or the Exchange Act, except to the extent that we specifically incorporate this report by reference.

The Audit Committee is comprised of three non-employee directors – Victor J. Fryling, Stephen A. Sharpe and Susan H. Snow – and operates under a written charter, adopted by the Board, which is posted on the Investor Relations section of the Company’s website atwww.basinwater.com. We believe the charter is in compliance with SEC regulations and the NASDAQ listing standards.

The primary purposes of the Audit Committee are to assist the Board in fulfilling its responsibility to oversee (i) the integrity of the financial statements of Basin Water, (ii) the independent registered public accounting firm’s qualifications, independence and performance and (iii) the audit of Basin Water’s financial statements. The Audit Committee is directly responsible for the appointment, compensation, and oversight of the work of the independent registered public accounting firm. The independent registered public accounting firm reports directly to the Audit Committee.

Management has the primary responsibility for the preparation of the financial statements and the reporting process. The Company’s management has represented to the Audit Committee that the consolidated financial statements for the fiscal year ended December 31, 2008 were prepared in accordance with generally accepted accounting principles. The Company’s independent registered public accounting firm is responsible for auditing these consolidated financial statements. In the performance of its oversight function, the Audit Committee reviewed and discussed the audited consolidated financial statements with management and the independent registered public accounting firm. The Audit Committee discussed with management the critical accounting policies applied by the Company in the preparation of its consolidated financial statements. The Audit Committee also discussed with the Company’s management the process for certifications by the Chief Executive Officer and Chief Financial Officer. The Audit Committee discussed with the independent registered public accounting firm the matters required to be discussed by Statement on Auditing Standards No. 61 (Communication with Audit Committees), as amended by Statement on Auditing Standards No. 90 (Audit Committee Communications).

In addition, the Audit Committee received from the independent registered public accounting firm the written disclosures required by Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees) and discussed with them their independence from the Company and its management. The Audit Committee also evaluated whether the independent registered public accounting firm’s provision of non-audit services to the Company was compatible with the auditor’s independence and determined it was compatible.

In May 2008, Ms. Snow was appointed to the Audit Committee to replace Russell C. Ball, who resigned as a director. The Board determined that Messrs. Fryling, Sharpe and Snow meet the independence requirements of Rule 10A-3 of the Exchange Act and applicable NASDAQ independence rules.

In reliance on the reviews and discussions referred to above, the Audit Committee recommended to the Board of Directors, and the Board approved, that the audited consolidated financial statements be included in Basin Water, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2008, and any amendments thereto, for filing with the SEC.

Victor J. Fryling (Chair)

Stephen A. Sharpe

Susan H. Snow

April 30, 2009

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Executive Officers

At March 31, 2009, our executive officers consisted of the following:

Name

Age

Position with the Company

Michael M. Stark

65President and Chief Executive Officer

W. Christopher Chisholm

50Vice President and Chief Financial Officer

Richard A. Reese

48Vice President of Marketing

Scott B. Hamilton

50General Counsel and Secretary

See “Board of Directors” for the biography of Mr. Stark.

W. Christopher Chisholm has served as our Vice President and Chief Financial Officer Treasurersince June 2008. From 2003 to 2008, Mr. Chisholm served as Executive Vice President, Finance & Administration and Chief AdministrativeFinancial Officer since October 2004.of Veolia Water North America. Subsequent to the 1999 acquisition of USFilter by Veolia Environment, Mr. Tekulve alsoChisholm served as our Secretary from February 2006Executive Vice President, Finance of US Filter until August 2007. From January 19992003. In 1997, Mr. Chisholm joined US Filter (prior to September 2004, Mr. Tekulveit becoming part of Veolia Water) as its Vice President and Group Controller for North American operations and later served as Vice President of Finance and Treasurer of Southwest Water Company, a company engaged in the business of water production and distribution, wastewater collection and treatment, public works services and utility submetering. From 1995 to 1998, he served as Chief Financial Officer of SafeGuard Health Enterprises, a providerUSFilter’s Water & Wastewater Group until 1999. From 1991 to 1997, Mr. Chisholm served as Vice President and Chief Financial Officer of dentalMobley Environmental Services, which was acquired in 1997 by USFilter. Prior to his career in the environmental services and vision care benefit programs. From 1984 to 1994,water industries, Mr. Tekulve servedChisholm spent 11 years in the audit practice of KPMG, an international public accounting firm, serving clients in a wide variety of executive positions at Beckman Coulter, Inc., including as Directorindustries. Mr. Chisholm is an accounting graduate of International Finance. Mr. Tekulve is a certified public accountant and holds an MBA from Portland State University and a B.S. in accounting from California State University, Northridge.

Scott B. Hamilton has served as the Company’s General Counsel since July 2007 and as the Company’s Secretary since August 2007. From 2005 to 2007, Mr. Hamilton served as Associate General Counsel of Veolia Water North America Operating Services, LLC, previously known as USFilter Operating Services, Inc., a water services company, and from 1999 to 2004, served as Senior Counsel of the same company. From 1998 to 1999, Mr. Hamilton served as the Vice President, General Counsel and Assistant Secretary of US Filter Operating Services, Inc., and Regional Counsel of United States Filter Corporation, before its acquisition by Veolia Water North America. From 1992 to 1998, Mr. Hamilton served in the enforcement division of the Securities and Exchange Commission, and prior to that was involved in the private practice of law for several years. Mr. Hamilton holds a B.A. in Comparative Area Studies and History from Duke University and a J.D. from the University of Illinois College of Law.Louisiana at Monroe and obtained his certification as a Certified Public Accountant in 1981.

Richard A. Reese joined Basin Water in September of 2007 as the Marketingour Vice President of Marketing, and was named an Executive Officer in January of 2008. From 1997 to 2008, Mr. Reese served in management roles within Siemens Water Technologies, Inc., previously known as United States Filter Corporation (USFilter).USFilter. These roles includeincluded Vice President, General Manager of Aftermarket within the Services & Products segment (2003 – 2007), Senior Vice President, Marketing within the Services Group of USFilter/Veolia Water (2002 – 2003), Vice President, Customer Service & Satisfaction (2000 – 2002) for USFilter, and Vice President, General Manager of the Recovery Services Southwest business unit of USFilter (1997 – 2000). Prior to joining USFilter, Mr. Reese served in Regional Vice President and Business Development roles with Mobley Environmental Services, Inc., as an Operations manager for Browning Ferris Waste Management Systems Inc., and as an engineer for R.J. Brown and Associates of America and J.P. Kenny Offshore Engineering. Mr. Reese holds a B.S. in Ocean Engineering from Texas A&M University and an MBA from the University of Texas.

Scott B. Hamilton has served as our General Counsel since July 2007 and as our Secretary since August 2007. From 2005 to 2007, Mr. Hamilton served as Associate General Counsel of Veolia Water North America Operating Services, LLC, previously known as USFilter Operating Services, Inc., a water services company, and from 1999 to 2004, served as Senior Counsel of the same company. From 1998 to 1999, Mr. Hamilton served as the Vice President, General Counsel and Assistant Secretary of USFilter Operating Services, Inc., and Regional Counsel of USFilter, before its acquisition by Veolia Water North America. From 1992 to 1998, Mr. Hamilton served in the enforcement division of the Securities and Exchange Commission, and prior to that was involved in the private practice of law for several years. Mr. Hamilton holds a B.A. in Comparative Area Studies and History from Duke University and a J.D. from the University of Illinois College of Law.

There is no family relationship between any executive officer and any of our other executive officers or directors.

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Code ofBusiness Conduct and Ethics

We have adopted the Basin Water, Inc. Code of Business Conduct and Ethics (Code of Ethics). The Code of Ethics applies that complies with the SEC and NASDAQ listing standards and is applicable to all of our directors, officers and employees, including our chief executive officer and chief financial officer (who is also our principal accounting officer),. On November 8, 2007, the Board adopted a revised Code of Business Conduct and Ethics. The revised Code of Business Conduct and Ethics is available to the public in the Investor Relations section of our website atwww.basinwater.com.www.basinwater.com. We intend to post amendments to or waivers, if any, from our Code of Business Conduct and Ethics (to the extent applicable to our directors or our chief executive officer, principal financial officer, or principal accounting officer) at this location on our website.

Among other matters, this Code of Business Conduct and Ethics is designed to promote:

 

honest and ethical conduct;

avoidance of conflicts of interest;

full, fair, accurate, timely and understandable disclosure in reports and documents that we file with, or submit to, the SEC and in our other public communications;

compliance with applicable governmental laws and regulations and stock exchange rules;

prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and

accountability for adherence to the code.

16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our officers and directors, and persons who own more than ten percent (10%) of a registered class of our equity securities, to file reports of securities ownership and changes in such ownership with the SEC. Officers, directors and greater than ten percent stockholders also are required by rules promulgated by the SEC to furnish us with copies of all Section 16(a) forms they file.

Based solely on our review of these forms and written representations from the executive officers and directors, we believe that all Section 16(a) filing requirements were met during fiscal year 2008, other than (a) the late filing of the Forms 4 on May 12, 2008 on behalf of Messrs. Faubel, Fryling, Katzmann, Sharpe and Solar and the Form 4 filed on May 13, 2008 on behalf of Ms. Snow, with respect to the annual grant of stock options and restricted stock made to our directors, and (b) the late filing of the Form 4 filed on June 23, 2008 on behalf of Mr. Chisholm, with respect to the grant of stock options and restricted stock in connection with the commencement of his employment.

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ITEM 11.    EXECUTIVEEXECUTIVE COMPENSATION

Information relatingCompensation Discussion and Analysis

Overview

This Compensation Discussion and Analysis describes the material elements of compensation awarded to, earned by, or paid to our Chief Executive Officer, Chief Financial Officer, and the two other executive officers of the Company (collectively the Named Executive Officers) during the last completed fiscal year. This Compensation Discussion and Analysis focuses on the information contained in the following tables and related footnotes and narrative for primarily the last completed fiscal year. However, we also describe compensation actions taken before and after the last completed fiscal year to the extent it enhances the understanding of our executive compensation disclosure. The Compensation Committee of the Board of Directors (the Committee) oversees the design and administration of our executive compensation program in accordance with the processes and procedures discussed in the section entitled “Compensation Committee” presented elsewhere in this Annual Report on Form 10-K/A.

Compensation Philosophy

We believe executive compensation programs impact all employees by setting general levels of compensation and helping to create an environment of goals, rewards and expectations. We also believe that the compensation cost for our employees is an investment in human capital to secure certain knowledge and performance capabilities necessary for our business. To this end, our compensation programs for all employees, including our Named Executive Officers, are designed to: (1) provide a competitive total compensation package, sufficient to attract, motivate and retain high caliber, proven performers, (2) support and recognize attainment of tactical and strategic goals of our organization, (3) align employee compensation with the interests of stockholders, and (4) provide retention incentives, securing the services of key contributors to our business over an extended period of time.

The Committee will take into account several factors in determining compensation, including: (1) current market value of a particular position, based on the skills, knowledge, experience and competencies required for the position (including taking into consideration the broader labor market depending on the nature of the position), (2) internal comparability of a position as compared to other similar positions within the organization, (3) our ability to pay, based on current economic and business factors, (4) individual performance within the position, and (5) contribution to the financial performance of the employee’s division, or our entire Company, as applicable.

Compensation Methodology

During 2008, the Committee retained Strategic Compensation Planning, Inc. (SCP), a Philadelphia-based consulting firm that provides total compensation plan design and program management support, to make recommendations regarding our compensation philosophy and policies. The Committee conducted discussions with SCP specifically related to (1) annual cash incentive plan design and (2) intermediate and long-term incentive awards. SCP provides no other services to, and receives no other compensation from, the Company or its executives.

Role of Chief Executive Officer in Compensation Decisions.During 2008, Mr. Stark, in his role as President and Chief Executive Officer, offered his opinions and assessment of the performance for the other Named Executive Officers to the Committee regarding compensation changes affecting the other Named Executive Officers, including with respect to (1) changes in base salaries, (2) option grants and (3) bonus awards. The Committee took into account Mr. Stark’s opinions and recommendations, but the Committee makes its own independent assessment of any compensation decision affecting officers of the Company (with the input of its compensation consultant). Mr. Stark did not play any role with respect to any matter impacting his own compensation. The Committee met in executive session when considering Mr. Stark’s compensation.

Components of Named Executive Officers Compensation

The executive compensation program for our Named Executive Officers is intended to be composed of four basic components tied to performance standards (both objective and subjective) and market practice: (1) base salary, (2) annual cash incentive opportunity, (3) intermediate-term incentive awards in the form of restricted stock and (4) long-term incentive awards in the form of stock options.

Base Salary

Base salary compensation for our Named Executive Officers is generally established by the terms of employment agreements between us and the Named Executive Officer. The level of base salary is intended to provide appropriate base pay to each of our Named Executive Officers taking into account their responsibilities, level of experience, individual performance and internal equity considerations. In addition, the Committee takes into account both Company and individual performance in setting compensation. We have recognized that to attract talented employees from secure positions at other more stable growth companies, we must be able to pay competitive base salaries, while also supplementing the salaries with equity compensation. Each of the employment agreements

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for our Named Executive Officers provides for annual salary reviews by the Committee. The Committee believes in relatively median level salaries and significant equity appreciation opportunities. The amount of a Named Executive Officer’s base salary is the reference point for much of the other compensation received by the executive. For example, the potential annual incentive award for each executive is a percentage of the executive’s base salary.

When hiring Mr. Chisholm, the Committee determined an appropriate salary for the chief financial officer position based on the factors detailed above, its review of his qualifications and experience, the scope of the responsibilities of that position and the input and recommendation of SCP.

There were no changes to the base compensation of our Named Executive Officers during 2008.

Annual Cash Incentive Opportunity

All of the employment agreements for our Named Executive Officers provide that each officer is eligible to receive an annual cash bonus equal to between 15% and 75% of his base salary depending on whether we meet certain annual targeted revenue and net income targets set by the Committee. In April 2008, the Committee approved the 2008 Annual Incentive Plan, under which the Named Executive Officers were eligible to receive a cash bonus equal to 50% of their respective base salaries depending on the achievement in fiscal year 2008 of (a) corporate performance goals measured by certain financial metrics, including revenues, gross margins, cash flow, operating income and earnings per share, (b) business unit or functional performance goals and (c) personal performance goals, in each case, as determined by the Committee. Participants are not entitled to any bonus payment if corporate performance is below 80% of the target; provided that, the Committee may in its discretion award bonuses at corporate performance below 80% of the target. Participants are eligible for a maximum of 120% of the target bonus for performance above the target. Corporate performance relative to the objectives approved by the Committee was below 80% of the target levels and, accordingly, no cash bonuses were paid under the 2008 Annual Incentive Plan.

In addition, all of the employment agreements for our Named Executive Officers provide that each officer may receive a discretionary bonus of up to 25% of his salary based on factors not related to the achievement of performance targets. In December 2008, the Committee reviewed our financial performance along with our other achievements in 2008, including the development of our infrastructure and business processes, our integration of Mobile Process Technology Company, our acquisition of Envirogen from Shaw Environmental and Infrastructure, Inc. and two of its affiliates (Shaw), our alliance with Rohm and Haas Company, and our effort in the restatement of financial statements for 2007 and 2006. The Committee also discussed management’s recommendation for 2008 cash incentive, stock and option awards for each Named Executive Officer and assessed each Named Executive Officer’s accomplishments and contributions to our Company in 2008, each Named Executive Officer’s total compensation (base, bonus and option awards) under various possible award scenarios, and the recommendations of SCP. Based on these various factors, in February 2009, the Committee awarded discretionary bonuses to the following Named Executive Officers, in the amounts indicated: Mr. Chisholm—$30,000, Mr. Reese—$25,000, and Mr. Hamilton—$30,000. Mr. Stark did not receive a discretionary bonus as the Committee believes his incentive compensation should be tied solely to corporate financial performance.

In October 2008, the Committee also awarded a one-time cash bonus of $20,000 to Mr. Hamilton in recognition of the significant efforts he made during 2008 in connection with our litigation and other legal matters.

Intermediate-Term Incentive Awards. An important component of our executive compensation has been the use of intermediate-term incentive awards in the form of restricted stock. The 2006 Plan authorizes us to grant restricted stock to employees, directors and consultants. In October 2006, Mr. Stark was granted a restricted stock award of 200,000 shares of our common stock, as to which one-third of the shares vested on the first anniversary date and one-third of the shares will vest on each of the second and third anniversaries of the grant date. In July 2007, Mr. Hamilton was granted a restricted stock award of 25,000 shares of our common stock, as to which one-third of the shares vested on the first anniversary date and one-third of the shares will vest on each of the second and third anniversaries of the grant date. In September 2007, Mr. Reese was granted a restricted stock award of 10,000 shares of our common stock, as to which one-third of the shares vested on the first anniversary date and one-third of the shares will vest on each of the second and third anniversaries of the grant date.

In June 2008, Mr. Chisholm was granted a restricted stock award of 150,000 shares of our common stock in connection with his commencement of employment, as to which 25,000 shares vested on December 31, 2008, while 50,000 shares will vest on December 31, 2009 and 75,000 shares will vest on December 31, 2010. The size of the award to Mr. Chisholm was determined based on the Committee’s review of his qualifications and experience and the scope of the responsibilities of his position.

There were no other awards of restricted stock to Named Executive Officers during 2008.

The Committee considers the use of restricted stock as particularly important for the hiring of our key executives as these grants (1) provide an incentive for our executives to remain in our employ without the need for a short-term significant increase in our stock price and (2) retain value despite short-term decreases in our stock price, unlike stock options which lose significant value if our stock price falls below the exercise price. For our Named Executive Officers, the restricted stock grants made to them at the time of hire were a part of their initial compensation package, similar to a “sign-on bonus,” for accepting the risk of joining a development stage company and for assisting in our Company’s growth at an early stage.

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The Committee determines the restricted stock awards to the Named Executive Officers, and takes into account the recommendations of the Chief Executive Officer in making such awards to the other Named Executive Officers and to other employees. In determining the number of shares and vesting schedule of restricted stock awards granted to Named Executive Officers and to other employees, the Committee generally takes into account the individual’s position, scope of responsibilities, value of the award in relation to the other elements of the individual’s total compensation and, where applicable, the need to attract the individual from their current position.

Long-Term Incentive Awards. Stock options have been the primary vehicle for payment of long-term compensation to our Named Executive Officers and non-Named Executive Officer management employees. Our 2006 Plan authorizes us to grant stock options to employees, directors and consultants. The Committee believes that stock options are a necessary part of compensation packages granted to employees because: (1) they help attract and retain employees, (2) the value received by the recipient of a stock option is based on the growth of our stock price – thereby creating and enhancing incentives to increase our stock price and maximize stockholder value, and (3) they create a balance with shorter term incentives such as base salary and bonuses and intermediate-term incentives such as restricted stock. The Committee determines the stock option awards to the Named Executive Officers, and takes into account the recommendations of the Chief Executive Officer in making decisions on the other Named Executive Officers.

In determining the number and vesting schedule of stock options granted to Named Executive Officers and other employees, the Committee generally takes into account the individual’s position, scope of responsibility, value of stock options in relation to the other elements of the individual’s total compensation and, where applicable, the need to attract the individual from their current position. The Committee assesses the appropriate vesting schedule for these stock options, based not only on time but also on achievement of significant Company milestones.

On December 28, 2007, the Committee approved option grants for each Named Executive Officer based on an evaluation of each executive officer’s performance during 2007 and the achievement of certain corporate objectives, including the consummation of several significant transactions during 2007. The option grants were also made to the Named Executive Officers to provide incentives for performance in the coming fiscal year. Each option has an exercise price per share of $7.31, the closing price of the Company’s common stock on the Nasdaq Global Market on January 4, 2008, the date of grant, has a term of ten years, and will vest in three substantially equal annual tranches the first of which vested on December 28, 2008, and the next two tranches vesting on December 31, 2009 and 2010. The Named Executive Officers were granted stock options to purchase the following number of shares: Mr. Jensen – 55,000 shares; Mr. Stark – 50,000 shares; Mr. Tekulve – 35,088 shares; Mr. Reese – 17,000 shares; and Mr. Hamilton – 23,000 shares.

The 2008 Incentive Plan described above also provided for the grant of stock options by the Committee to the Named Executive Officers. The number of shares under such grants that each Named Executive Officer was eligible to receive was equal to 70% of his base salary divided by the closing price of our common stock on the Nasdaq Global Market as of the grant date. These stock options have a term of ten years, and one-third of the shares subject to the options will vest on each of the first, second and third anniversaries of the grant date. On May 5, 2008, the Committee approved the grant of stock options to our Named Executive Officers and certain other employees under the 2006 Plan, with a grant date of May 15, 2008 and an exercise price of $5.00 per share, which was equal to the closing price of our stock on the Nasdaq Global Market on such grant date. The Named Executive Officers were granted stock options to purchase the following number of shares: Mr. Stark – 57,018 shares; Mr. Tekulve – 35,088 shares; Mr. Reese – 35,088 shares; and Mr. Hamilton – 30,702 shares. Each of these options vests one-third on each of the first, second, and third anniversaries of the grant date. In connection with his resignation from our Company in October 2008, all of Mr. Tekulve’s stock options vested on October 13, 2008 and expire on July 1, 2011 – see “Former Chief Financial Officer Resignation” below.

On May 29, 2008, the Committee approved the grant of a stock option to purchase 43,240 shares to Mr. Chisholm, effective upon the date of his employment with us, which was June 17, 2008, with an exercise price of $4.29 per share, which was equal to the closing price of our stock on the Nasdaq Global Market on such grant date. The number of shares subject to this stock option grant to Mr. Chisholm was based on 70% of his base salary divided by the closing price of our common stock on the Nasdaq Global Market on the grant date.

No other stock options were awarded to executive officers in 2008 or with respect to services performed during 2008.

All stock option grants are required to be approved by the Committee. We have not timed the award of stock options or other equity-based compensation to coincide with the release of favorable or unfavorable information about our Company. We have no intention of timing the award of stock options or other equity-based compensation to coincide with the release of favorable or unfavorable information about our Company in the future.

14


Severance Arrangements and Change in Control Payments

We have entered into employment agreements with Messrs. Stark, Chisholm, Reese and Hamilton. The terms of the employment agreements with each of our Named Executive Officers provide each of them with certain severance benefits in the event his employment is terminated by us other than for cause or if he resigns with good reason.

The employment agreements for our Named Executive Officers provide severance and change in control protection under market-competitive terms. The specific provisions are summarized in the narrative accompanying the tables under “Potential Payments Upon Termination or Change in Control.”

Our outlook with respect to these severance and change-in-control provisions is that they are appropriate because they make it easier for the executives to focus on the best interests of Basin Water and our stockholders rather than the implications for them personally in the event we face the possibility of a change in control. These provisions were designed to:

be consistent with or below current market practices,

afford reasonable protection without creating any undue windfall,

enhance our ability to retain key employees during critical but uncertain times, and

enhance an acquirer’s potential interest in retaining key executives.

Severance payments are only made under the employment agreements if the Named Executive Officer complies with the confidentiality, non-compete and non-solicitation provisions of the agreements. We believe that these severance and change in control payment provisions in our Named Executive Officers’ employment agreements are necessary in order for us to provide competitive compensation within our industry and to encourage our Named Executive Officers to remain in our employ.

Compensation Differences Among the Named Executive Officers

Differences in compensation among the Named Executive Officers are based on experience in the industry, longevity with our Company and relative level of responsibility. Our President and CEO earns more in base salary than our Chief Financial Officer. Our Chief Financial Officer earns more in base salary than our Vice President of Marketing, and our Vice President of Marketing earns more than our General Counsel. Although each Named Executive Officer’s contributions to our Company are important, the Committee believes that the responsibilities and contributions of the President and Chief Executive Officer and the Chief Financial Officer are the most significant. As stated above, base salary is the one of the bases for annual incentive awards of cash bonus and equity awards.

Perquisites, Personal Benefits and Other Compensation

In 2008, Mr. Jensen received reimbursement for Company vehicle use, office lease payments, accrued vacation, severance and consulting payments and other expenses in the amount of $628,401. In 2008, Mr. Tekulve received severance payments, accrued vacation and other expenses in the amount of $143,385 in connection with his resignation from Basin Water.

Under their employment agreements, each of Messrs. Stark and Chisholm is entitled to (1) long-term disability insurance in an amount equal to 75% of his base salary, up to a maximum of $30,000 per month, (2) life insurance in a face amount equal to three times his annual base salary, and (3) reimbursement of out-of-pocket expenses up to a maximum of $3,000 for a biennial physical examination.

Under his employment agreement, Mr. Chisholm is also entitled to reimbursement of certain out-of pocket expenses related to the maintenance of his Certified Public Accountant license, continuing education required to maintain that license and his membership in up to two professional organizations of which he is a member.

Under their employment agreements, each of Messrs. Reese and Hamilton is entitled to long-term disability insurance in an amount equal to 70% of his base salary, up to a maximum of $12,500 per month. Under his employment agreement, Mr. Hamilton is also entitled to reimbursement of certain out-of-pocket expenses related to bar and/or registration dues and fees, continuing legal education and membership in certain legal associations.

All of our Named Executive Officers also receive supplemental life insurance coverage of $250,000, as well as supplemental long-term disability insurance coverage.

Our Named Executive Officers are eligible to participate in all of our employee benefit plans, including medical, dental, vision, long- and short-term disability and life insurance coverage of $50,000, in each case on the same basis as our other employees.

We have no outstanding loans of any kind to any of our Named Executive Officers, and federal law prohibits us from making any new loans to our Named Executive Officers. We have no pension plans or other defined benefit retirement plans. We have no non-qualified deferred compensation plans or supplemental executive retirement plans.

15


We reimburse travel expenses between home and our corporate headquarters, including expenses for hotel rooms and meals, to Messrs. Stark, Chisholm and Reese, all of whom reside in Houston, Texas, and to Mr. Hamilton, who resides in Chicago, Illinois.

Former Chief Executive Officer Employment Transition

On February 19, 2008, we announced the resignation of Mr. Jensen as our Chief Executive Officer and Chairman of the Board. At that time, Mr. Jensen remained on our Board of Directors. In connection with his resignation, we entered into an Employment Transition and Consulting Agreement dated February 19, 2008 (the Separation Date) with Mr. Jensen (the Transition Agreement).

On March 11, 2008, Mr. Jensen resigned from our Board of Directors.

The Transition Agreement provided Mr. Jensen with the following benefits: (1) he received a cash lump sum payment of $422,797, (2) we agreed to pay for his healthcare insurance for 18 months following the Separation Date (or until he accepts employment with another employer providing comparable benefits), (3) he was retained as our consultant for two years after the Separation Date, for which he will receive $200,000 per year (payable each year in 12 equal monthly installments), (4) he received compensation for his services as a director in accordance with our Amended and Restated Director Compensation Policy for non-employee directors (for the applicable period until his resignation from our Board of Directors) and (5) he retained all Basin Water personal property, including computer equipment, printers, cameras and a used Company truck, that was in his possession as of the Separation Date. Mr. Jensen will not be entitled to any further benefits under his employment agreement in effect prior to the Separation Date except as provided in the Transition Agreement. The Transition Agreement contained other customary terms and conditions, including mutual releases and indemnification obligations (including with respect to Mr. Jensen’s wife).

Mr. Jensen’s consulting services pursuant to the Termination Agreement were terminated in November 2008.

Former Chief Financial Officer Resignation

On June 23, 2008, we announced the resignation of Mr. Tekulve as our Chief Financial Officer. At that time, he was appointed as Vice President of Finance – Business Development. On October 8, 2008 (the Separation Date), Mr. Tekulve resigned as an employee. In connection with his resignation, we entered into a Confidential Resignation Agreement dated October 13, 2008 with Mr. Tekulve (the Separation Agreement) which provided him with the following benefits: (1) he received a cash lump sum payment of $115,000, (2) we paid for his healthcare insurance for six months following the Separation Date and (3) all restricted stock awards and stock option grants previously granted to him became 100% vested on October 13, 2008. All of Mr. Tekulve’s outstanding stock options will remain exercisable until July 1, 2011.

Tax and Accounting Information

Section 162(m) of the Code and the Omnibus Budget Reconciliation Act of 1993 and regulations adopted thereunder, place limits on deductibility of compensation in excess of $1.0 million paid in any one year to the our chief executive officer and our three other most highly compensated executive officers (other than our chief financial officer), employed at year end, unless this compensation qualifies as “performance based.” The non-performance based compensation paid in cash to each of our Named Executive Officers did not exceed the $1.0 million limit per officer in 2008, and the Committee does not anticipate that the non-performance based compensation to be paid in cash to our Named Executive Officers will exceed that limit in 2009. Although it will consider the tax implications of its compensation decisions, the Committee believes its primary focus should be to attract, retain, and motivate high caliber executives and to align the executives’ interests with those of our stockholders.

For 2006 and continuing thereafter, the Committee has considered and will continue to consider the impact of the requirement under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123(R),Share-Based Payment(SFAS 123(R)), that we record in our financial statements the expense incurred when stock options are granted to employees. In addition, the Committee will examine the tax impact on employees and the potential tax deductions to Basin Water with respect to the exercise of stock option grants. We do not pay or reimburse any Named Executive Officer for any taxes due upon exercise of a stock option.

16


Compensation Committee

The members of the Compensation Committee of the Board (the Committee) are Messrs. Solar (Chair), Faubel and Fryling. The Committee is comprised of a majority of independent, outside directors within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended (the Code) and independent non-employee directors within the meaning of Rule 16b-3 under the Exchange Act. All members of the Committee meet the independence requirements of Nasdaq listing standards. The Committee’s written charter can be found in the Investor Relations section of our website atwww.basinwater.com. The Committee has responsibility for the review, evaluation and approval of executive compensation, including the compensation philosophy, policies and plans for our executive officers.

On behalf of our Board, the Committee monitors and assists our Board in determining compensation for our senior management, directors and employees. Among other matters, the Committee’s responsibilities include the following:

setting performance goals for our officers and reviewing their performance against these goals;

reviewing and recommending compensation and directorbenefit plans for our officers and compensation policies for our Board and members of our Board committees;

reviewing the terms of offer letters to and employment agreements and arrangements with our officers;

independently assessing external market information on industry compensation practices;

reviewing and discussing with our Company’s management the Compensation Discussion and Analysis (CD&A) and determining whether to recommend to our Board that the CD&A be included in our proxy statement and in our annual report on Form 10-K; and

producing an annual report on executive compensation for inclusion in our proxy statement.

Compensation Committee Report

The following Compensation Committee report does not constitute soliciting material and shall not be deemed filed or incorporated by reference into any other Company filing under the Securities Act or the Exchange Act, except to the extent that the Company specifically incorporates this report by reference therein.

The Committee has reviewed and discussed with the Company’s management the Compensation Discussion and Analysis (CD&A) set forth above. Based on such review and discussion, the Committee has recommended to the Board of the Company that the CD&A be included in this Annual Report on Form 10-K/A for the year ended December 31, 2008.

Keith R. Solar (Chair)

Victor J. Fryling

Roger S. Faubel

April 30, 2009

17


Summary Compensation Table

The following table and accompanying notes provide information with respect to total compensation earned or paid by the Company to the Chief Executive Officer, former Chief Executive Officer, Chief Financial Officer, former Chief Financial Officer and the other two executive officers of the Company serving at the end of fiscal 2008 (the Named Executive Officers) during fiscal years 2008, 2007 and 2006.

Name and Principal Position

  Year  Salary
($)(1)
  Bonus
($)(2)
  Stock Awards
($)(3)
  Option
Awards
($)(3)
  Non-Equity
Incentive Plan
Compensation
  All Other
Compensation
($)(4)
  Total ($)

Michael M. Stark (5)

  2008  $325,000   —    $556,676  $184,743  —    $50,931  $1,117,350

President & Chief

  2007  $325,000  $80,000  $556,676  $114,624  —    $41,864  $1,118,164

Executive Officer

  2006  $63,356   —    $92,777  $19,104  —    $6,345  $181,582

Peter L. Jensen (6)

  2008  $55,000   —    $62,005  $156,805  —    $628,401  $902,211

Former Chairman of the

  2007  $269,550  $83,000  $45,088   —    —    $24,078  $421,716

Board & Chief Executive

Officer

  2006  $152,344  $127,385  $28,188   —    —    $43,875  $351,792

W. Christopher Chisholm (7)

                

Vice President,

Chief Financial Officer,

Treasurer & Assistant

Secretary

  2008  $143,542  $30,000  $254,420  $14,706  —    $28,050  $470,718

Thomas C. Tekulve (8)

  2008  $154,615   —    $38,678  $202,580  —    $143,385  $539,258

Former Chief Financial Officer,

  2007  $181,738  $50,000  $25,376  $50,525  —    $1,812  $309,451

Chief Administrative Officer,

Treasurer, Assistant Secretary &

Vice President of Finance -

Business Development

  2006  $143,406  $100,000  $15,867  $154,512  —     —    $413,785

Richard A. Reese (9)

  2008  $200,000  $25,000  $40,952  $68,842  —    $15,494  $350,288

Vice President of Marketing

  2007  $53,898  $15,000  $11,258  $10,509  —    $7,743  $98,408

Scott B. Hamilton (10)

  2008  $175,000  $50,000  $93,320  $100,083  —    $35,807  $454,210

General Counsel & Secretary

  2007  $72,932  $40,000  $38,887  $27,867  —    $12,211  $191,897

(1)Salary includes all regular wages paid to the executive, and any amount which was voluntarily deferred by the executive pursuant to the 401(k) Plan.

(2)Bonus for 2008 consists of cash compensation paid for service during 2008.

(3)Stock awards and option awards for 2008 equal the accounting charge for compensation expense incurred by us in 2008 for restricted stock and stock option awards granted in 2008 and prior years, calculated in accordance with the provisions of SFAS No. 123(R),Share-Based Payment,as described in Note 20 to our audited consolidated financial statements included in this Annual Report on Form 10-K/A (without regard to estimates for forfeitures).

(4)All other compensation in 2008 for Mr. Jensen includes: (i) a severance payment of $422,797 upon his resignation as Chief Executive Officer in February 2008, (ii) consulting payments of $133,333 paid in connection with a two-year consulting agreement between Mr. Jensen and us, (iii) a lump sum payment of $40,611 for accrued vacation as of the date of his resignation, (iv) the premiums for supplemental life and disability insurance coverage paid by us, (v) his personal use of our vehicles, (vi) office lease payments made by us, (vii) $20,000, which represents the fair value of equipment transferred by us to Mr. Jensen upon his resignation, (viii) non-employee director fees paid for his service on our Board from the date of his resignation as our Chief Executive Officer until his resignation as a director and (v) the premiums for supplemental life and disability insurance coverage paid by us.

All other compensation in 2008 for Messrs. Stark, Chisholm, Reese and Hamilton includes: (i) premiums for supplemental life and disability insurance coverage paid by us (including $13,991 of premiums for Mr. Stark’s supplemental life insurance coverage), (ii) reimbursements for travel expenses between home and our corporate headquarters (including $30,418 for Mr. Stark, $22,114 for Mr. Chisholm, $12,284 for Mr. Reese and $34,215 for Mr. Hamilton), (iii) reimbursement of the cost of an annual physical examination for Mr. Stark and (iv) employer matching contributions made by us to the 401(k) retirement plan and the 125(b) healthcare plan.

All other compensation in 2008 for Mr. Tekulve includes: (i) a severance payment of $115,000 upon his resignation in October 2008, (ii) a lump sum payment of $24,335 for accrued vacation as of the date of his resignation, (iii) the premiums for supplemental life and disability insurance coverage paid by us and (iv) employer matching contributions made by us to the 401(k) retirement plan and the 125(b) healthcare plan.

(5)Mr. Stark became our Chief Executive Officer on February 19, 2008. From October 23, 2006 to February 19, 2008, Mr. Stark was employed as our President and Chief Operating Officer. His annual base salary is $325,000.

(6)Mr. Jensen’s annual base salary was increased to $330,000 effective as of May 16, 2007. Mr. Jensen resigned as our Chairman of the Board and Chief Executive Officer on February 19, 2008.

18


(7)Mr. Chisholm has been employed as our Chief Financial Officer since June 17, 2008. His annual base salary is $265,000.

(8)Mr. Tekulve’s annual base salary was increased to $200,000 effective as of May 16, 2007. Mr. Tekulve resigned as our Chief Financial Officer on June 17, 2008, and was appointed as our Vice President of Finance – Business Development. Mr. Tekulve resigned as our Vice President of Finance – Business Development on October 8, 2008.

(9)Mr. Reese has been employed as Vice President of Marketing since September 24, 2007. His annual base salary is $200,000.

(10)Mr. Hamilton has been employed as General Counsel and Secretary since July 30, 2007. His annual base salary is $175,000.

Grants of Plan-Based Awards

The following table and accompanying notes summarize certain information regarding grants of plan-based awards to the Named Executive Officers during 2008.

Name and Principal
Position

 Grant
Date
 Date of
Authori-
zation of
Grant
 Estimated Future Payouts Under
Non-Equity Incentive Plan
Awards (1)
 Estimated Future Payouts
Under Equity Incentive Plan
Awards
 All Other
Stock
Awards:
Number of
Shares of
Stock or
Units (#)
  All Other
Option
Awards:
Number of
Securities
Underlying
Options (#)
  Exercise or
Base Price
of Option
Awards (#)
 Grant Date
Fair Value
of Stock
and Option
Awards
      Threshold
($)
 

Target

($)

 Maximum
($)
 Threshold
(#)
 Target
(#)
 Maximum
(#)
          
Michael M. Stark —   —   —   $162,500 $195,000 —   —   —   —    —     —    —  
President & Chief 1/4/08 12/28/07 —    —    —   —   —   —   —    50,000 (2) $7.31 $142,550
Executive Officer 5/15/08 5/5/08 —    —    —   —   —   —   —    57,018 (3) $5.00 $111,185
Peter L. Jensen —   —   —    —    —   —   —   —   —    —     —    —  

Former Chairman ofthe Board & Chief

Executive Officer

 1/4/08 12/28/07 —    —    —   —   —   —   —    55,000 (2) $7.31 $156,805
W. Christopher Chisholm(4) —   —   —   $132,500 $159,000 —   —   —   —    —     —    —  
Vice President, 6/17/08 5/29/08 —    —    —   —   —   —   —    43,240 (5) $4.29 $72,341

Chief Financial Officer,

Treasurer & Assistant

Secretary

 6/17/08 5/29/08 —    —    —   —   —   —   150,000 (6) —     —   $643,500
Thomas C. Tekulve(7) —   —   —   $100,000 $120,000 —   —   —   —    —     —    —  
Former Chief Financial Officer, 1/4/08 12/28/07 —    —    —   —   —   —   —    29,000 (2) $7.31 $82,679

Chief Administrative Officer,

Treasurer, Assistant Secretary &

Vice President of Finance -

Business Development

 5/15/08 5/5/08 —    —    —   —   —   —   —    35,088 (3) $5.00 $68,422
Richard A. Reese —   —   —   $100,000 $120,000 —   —   —   —    —     —    —  
Vice President of 1/4/08 12/28/07 —    —    —   —   —   —   —    17,000 (2) $7.31 $48,467

Marketing

 5/15/08 5/5/08 —    —    —   —   —   —   —    35,088 (3) $5.00 $68,422
Scott B. Hamilton —   —   —   $87,500 $100,000 —   —   —   —    —     —    —  
General Counsel & 1/4/08 12/28/07 —    —    —   —   —   —   —    23,000 (2) $7.31 $65,573
Secretary 5/15/08 5/5/08 —    —    —   —   —   —   —    30,702 (3) $5.00 $59,869

(1)Represent target and maximum bonus opportunities under our 2008 Annual Incentive Plan.

(2)The stock option grants were approved by the Committee on December 28, 2007 and were effective on January 4, 2008, two business days after public disclosure of the Empire Water transaction. One-third of the shares subject to these options vested on December 28, 2008, and the remaining shares subject to these options will vest in equal installments on December 28, 2009 and 2010, respectively.

(3)The stock option grants were approved by the Committee on May 5, 2008 and were effective on May 15, 2008, two business days after public disclosure of our earnings for the first quarter of 2008. These grants vest in three equal installments on each of the first three anniversaries of the grant date.

(4)The stock option and restricted stock grants to Mr. Chisholm were approved by the Committee on May 29, 2008 in connection with the approval of Mr. Chisholm’s employment agreement, and were effective as of June 17, 2008, the date of his employment agreement. Pursuant to the terms of Mr. Chisholm’s employment agreement, the exercise price of the stock options granted to Mr. Chisholm was set equal to the closing price of our common stock on the date of grant.

(5)Mr. Chisholm was granted an option to purchase 43,240 shares of our common stock. One-third of the shares subject to the stock option will vest on each of the first, second and third anniversaries of the grant date.

(6)Mr. Chisholm was granted 150,000 shares of restricted stock, of which 25,000 shares vested and all restrictions lapsed on December 31, 2008. Of the remaining 125,000 shares, 50,000 shares and 75,000 shares will vest and all restrictions will lapse on December 31, 2009 and December 31, 2010, respectively. Mr. Chisholm paid $0.001 per share of restricted stock.

(7)All of Mr. Tekulve’s stock awards vested in October 2008 in accordance with the terms of his Separation Agreement.

19


Outstanding Equity Awards at Fiscal Year-End

The following table and accompanying notes summarize certain financial information regarding outstanding equity awards held by the Named Executive Officers at December 31, 2008.

  Option Awards Stock Awards

Name and Principal
Position

 Number of
Securities
Underlying
Unexercised
Options (#)
Exercisable
 Number of
Securities
Underlying
Unexercised
Options
Unexercisable
(#)
  Equity
Incentive
Plan
Awards:
Number of
Securities
Underlying
Unexercised
Unearned
Options (#)
  Option
Exercise
Price
($)
 Option
Expiration
Date (1)
 Number
of Shares
or Units
of Stock
That
Have Not
Vested (#)
  Market
Value of
Shares
or Units
of Stock
That
Have Not
Vested
($)(2)
 Equity
Incentive
Plan
Awards:
Number
of
Unearned
Shares,
Units or
Other
Rights
That
Have Not
Vested
(#)
 Equity
Incentive
Plan
Awards:
Market
or Payout
Value of
Unearned
Shares,
Units or
Other
Rights
That
Have Not
Vested
($)
Michael M. Stark —   —    300,000 (3) $8.35 10/27/16 —     —   —   —  
President & Chief 16,667 33,333 (4) —    $7.31 12/28/17 —     —   —   —  
Executive —   57,018 (6) —    $5.00 5/15/18 —     —   —   —  

Officer

 —   —    —     —   —   66,667 (5) $34,667 —   —  
Peter L. Jensen         
Former Chairman of —   —    —     —   —   2,808 (5) $1,460 —   —  

the Board & Chief

Executive Officer

 18,333 36,667 (4) —    $7.31 12/28/17 —     —   —   —  
W. Christopher Chisholm         
Vice President, —   43,240 (6) —    $4.29 6/17/18 —     —   —   —  

Chief Financial Officer,

Treasurer & Assistant Secretary

 —   —    —     —   —   125,000 (7) $65,000 —   —  
Thomas C. Tekulve (8) 110,000 —    —    $4.00 7/1/11 —     —   —   —  
Former Chief Financial 60,000 —    —    $5.00 7/1/11 —     —   —   —  
Officer, Chief 50,000 —    —    $5.00 7/1/11 —     —   —   —  
Administrative Officer, 29,000 —    —    $7.31 7/1/11 —     —   —   —  

Treasurer, Assistant Secretary &

Vice President of Finance -

Business Development

 35,088 —    —    $5.00 7/1/11 —     —   —   —  
Richard A. Reese 8,333 16,667 (6) —    $12.29 9/24/17 —     —   —   —  
Vice President of 5,667 17,000 (4) —    $7.31 12/28/17 —     —   —   —  

Marketing

 —   35,088 (6) —    $5.00 5/15/18 —     —   —   —  
 —   —    —     —   —   6,667 (10) $3,467 —   —  
Scott B. Hamilton 8,333 16,667 (6) 45,000 (9) $11.20 7/30/17 —     —   —   —  
General Counsel & —   23,000 (4) —    $7.31 12/28/17 —     —   —   —  

Secretary

 —   30,702 (6) —    $5.00 5/15/18 —     —   —   —  
 —   —    —     —   —   16,667 (10) $8,667 —   —  

(1)The expiration date of each option occurs 10 years after the date of grant of such option, with the exception of options granted to Mr. Tekulve which expire on July 1, 2011 per the terms of his Separation Agreement.

(2)Based on the closing price of our common stock on December 31, 2008 of $0.52 per share.

(3)The stock option grant to Mr. Stark for 300,000 shares becomes exercisable as follows: 100,000 shares vest upon our stock price reaching and staying at or above $15.25 for at least 45 consecutive days within three years from the grant date; 100,000 shares vest upon our stock price reaching and staying at or above $19.00 for at least 45 consecutive days within three years from the grant date; and 100,000 shares vest upon our stock price reaching and staying at or above $23.50 for at least 45 consecutive days within four years from the grant date.

(4)One-third of the shares subject to these stock options vested on December 28, 2008, and the remaining shares subject to these options will vest in equal installments on December 28, 2009 and 2010, respectively.

(5)The shares of restricted stock granted to Messrs. Jensen and Stark will vest and all restrictions will lapse on the third anniversary of the grant date. The restricted stock granted to Messrs. Jensen and Tekulve was granted on May 11, 2006. The restricted stock granted to Mr. Stark was granted on October 27, 2006.

(6)One-third of the shares subject to these stock options will vest on each of the first, second and third anniversaries of the grant date.

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(7)Of the shares of restricted stock granted to Mr. Chisholm, 25,000 shares vested on December 31, 2008, and 50,000 shares and 75,000 shares will vest and all restrictions will lapse on December 31, 2009 and December 31, 2010, respectively. The restricted stock was granted to Mr. Chisholm on June 17, 2008.

(8)All of Mr. Tekulve’s stock awards vested in October 2008 in accordance with the terms of his Separation Agreement.

(9)The stock option grant to Mr. Hamilton for 45,000 shares becomes exercisable as follows: 6,667 shares vest upon our stock reaching and staying at or above $15.25 for at least 45 consecutive days within three years from the grant date; 6,667 shares vest upon our stock price reaching and staying at or above $19.00 for at least 45 consecutive days within three years from the grant date; and 31,666 shares vest upon our stock price reaching and staying at or above $24.00 for at least 45 consecutive days within four years from the grant date.

(10)One-half of the shares of restricted stock granted to Messrs. Hamilton and Mr. Reese will vest and all restrictions will lapse on such portion of shares on each of the second and third anniversaries of the grant date. The restricted stock granted to Mr. Hamilton was granted on July 30, 2007. The restricted stock granted to Mr. Reese was granted on September 24, 2007.

Options Exercised and Stock Vested

The following table provides information about stock option exercises and the vesting of restricted stock by the Named Executive Officers during fiscal year-end 2008.

    Option Awards  Stock Awards

Name and Principal Position

  Number of
Shares
Acquired on
Exercise (#)
  Value
Realized
on Exercise
($)
  Number of
Shares
Acquired on
Vesting
(#)(1)
  Value
Realized on
Vesting
($)(2)

Michael M. Stark

        

President & Chief Executive Officer

  —    —    66,667  $56,667

Peter L. Jensen

        

Former Chairman of

the Board & Chief

Executive Officer

  —    —    2,709  $11,649

W. Christopher Chisholm

        

Vice President,

Chief Financial Officer,

Treasurer & Assistant

Secretary

  —    —    25,000  $13,000

Thomas C. Tekulve

        

Former Chief Financial Officer,

Chief Administrative Officer,

Treasurer, Assistant Secretary &

Vice President of Finance -

Business Development

  —    —    3,217  $8,815

Richard A. Reese

        

Vice President of Marketing

  —    —    3,333  $6,733

Scott B. Hamilton

        

General Counsel & Secretary

  —    —    8,333  $31,665

(1)Represents two-thirds of the restricted stock granted to Mr. Tekulve on May 11, 2006, one-third of the restricted stock granted to Mr. Jensen on May 11, 2006, one-third of the restricted stock granted to Mr. Stark on October 27, 2006, one-third of the restricted stock granted to Mr. Hamilton on July 30, 2007, one-third of the restricted stock granted to Mr. Reese on September 24, 2007 and 25,000 shares of the restricted stock granted to Mr. Chisholm on June 17, 2008.

(2)The value realized upon vesting of restricted stock is based on the closing price of our common stock on the vesting date multiplied by the number of shares vesting on such date.

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Equity Compensation Plan Information

The following table sets forth certain information, as of December 31, 2008, concerning shares of common stock authorized for issuance under all of our equity compensation plans.

    Number of
Securities to be
Issued Upon
Exercise of
Outstanding
Options,
Warrants and
Rights
  Weighted
Average
Exercise Price
of Outstanding
Options,
Warrants and
Rights
  Number of
Securities
Remaining
Available for
Future Issuance
Under Equity
Compensation
Plans (Excluding
Securities
Reflected in
Column (a))
   (a)  (b)  (c)

Equity compensation plans

    

approved by stockholders

  1,977,351  $5.82  2,737,605

Equity compensation plans

    

not approved by stockholders

  190,000  $4.00  —  
          

Total equity compensation plans

  2,167,351(1) $5.66(2) 2,737,605
          

(1)As of December 31, 2008, 2,167,351 securities are issuable upon the exercise of outstanding options. The weighted average contractual life of outstanding options is 7.3 years as of that date.

(2)As of December 31, 2008, the weighted-average exercise price of outstanding options was $5.66 per share.

Employment Agreements

We have entered into employment agreements with Messrs. Stark, Chisholm, Reese and Hamilton. The employment agreements of Messrs. Stark, Reese and Hamilton were amended on December 16, 2008 to conform to certain provisions that were intended to be in effect for all of our executive officers and to make certain changes necessary to assure timely compliance with Section 409A of the Code. The terms of the employment agreements with each of our executive officers provide each executive with certain severance benefits in the event his employment is terminated by us other than for cause or if the executive resigns with good reason.

The employment agreements with our executive officers each provide that, in the event his employment is terminated by us other than for cause or if the executive resigns with good reason, then, conditioned upon his signing of a release, he will receive (1) severance of 12 months’ base salary payable in a lump sum, (2) an amount equal to the greater of (a) the executive’s bonus for the year prior to the date of termination or (b) the executive’s target bonus for the year in which the date of termination occurs (prorated for the period of his employment during that year) payable in a lump sum as soon as practicable, (3) 12 months’ healthcare benefits continuation at our expense and (4) $15,000 towards outplacement services.

In the event of an executive officer’s termination by us other than for cause or resignation for good reason within 24 months following a change in control of the Company, the executive officer will be entitled to the same termination and benefit amounts set forth above, except that instead of a prorated bonus, the executive will be entitled to receive an amount equal to his entire target bonus for the year in which the termination occurs. Further, 100% of the executive’s stock awards (including any performance vesting awards) will be accelerated immediately.

In addition, in the event of a change of control of Basin Water, if an executive officer is terminated without cause or leaves our employment for good reason, then (1) the vesting of 100% of each executive’s stock awards will be accelerated immediately prior to a change of control and (2) the vesting of 100% of each executive’s stock awards (other than any awards the vesting of which is performance-based and with respect to which the performance objectives have not been achieved as of the date of termination, if any) will be accelerated immediately if such executive is terminated without cause or leaves our employment for good reason.

In addition to the salary, bonus, severance and change in control payment provisions discussed above, the employment agreements contain customary non-competition and non-solicitation covenants on the part of the Named Executive Officers. The

22


terms of the employment agreements also prohibit the Named Executive Officers from disclosing our confidential information and require the Named Executive Officers to return all of our confidential information to us upon the expiration or termination of employment. Receipt of any of the severance payments described above is conditioned upon the executive executing a release as well as abiding by the foregoing covenants.

For purposes of the employment agreements, “cause” generally means any of the following: (i) the commission of an act of fraud or embezzlement by the executive involving Basin Water or any successor or affiliate thereof or the executive’s commission of any other act of dishonesty that has a material adverse impact on the Company or any successor or affiliate thereof; (ii) a conviction of, or plea of “guilty” or “no contest” to, a felony by the executive or any other crime involving moral turpitude (it being understood that violation of the motor vehicle code does not constitute such a crime); (iii) any unauthorized use or disclosure by the executive of confidential information or trade secrets of Basin Water or any successor or affiliate thereof; (iv) the executive’s gross negligence, insubordination or material violation of any duty of loyalty to Basin Water or any successor or affiliate thereof or any other material misconduct on the part of the executive; (v) the executive’s ongoing and repeated failure or refusal to perform or neglect of the executive’s duties as required by the employment agreement, which failure, refusal or neglect continues for 15 days following the executive’s receipt of written notice from our president or the board of directors stating with specificity the nature of such failure, refusal or neglect; or (vi) the executive’s breach of any material provision of the employment agreement.

For purposes of the employment agreements, “good reason” generally means the executive’s voluntary resignation following any one or more of the following that is effected without the executive’s written consent: (i) a material change in the geographic location at which the executive must perform his duties (and a relocation of the office of the executive more than 50 miles from the executive’s principal place of employment is deemed to be a material change for these purposes) (or, in the case of Mr. Hamilton, our requiring him to relocate his residence outside of the Chicago, Illinois metropolitan area); (ii) a material reduction in the executive’s authority, duties or responsibilities (provided that the fact that Basin Water becomes a subsidiary of an acquirer or a division of an acquirer shall not in and of itself by considered a material reduction or change to the executive’s authority, duties or responsibilities); (iii) a material reduction in the executive’s base compensation, other than pursuant to a Company-wide reduction of base salaries for our employees generally, provided that such reduction is no greater in proportion to the reduction in base compensation for our other senior executives; (iv) a material diminution in the authority, duties or responsibilities of the supervisor to whom the executive is required to report; or (v) any other action or inaction that causes a material breach by us to the executive under the employment agreement.

For purposes of the employment agreements, “change in control” has the same meaning as given to such term under our 2006 Equity Incentive Award Plan, described below under “—Retirement and Other Benefit Plans—2006 Equity Incentive Award Plan.”

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Potential Payments upon Termination or Change in Control

The following tables set forth potential payments payable to each of our Named Executive Officers under the following three scenarios: (1) termination of employment by us without cause or resignation for good reason prior to a change in control or more than 24 months following a change in control; (2) the occurrence of a change in control without a termination of employment; and (3) termination of employment by us without cause or resignation for good reason within 24 months following a change in control. The tables assume that any termination of employment and/or change in control occurred on December 31, 2008, and the value of accelerated vesting of equity awards was calculated using the closing price of $0.52 per share of our common stock on the Nasdaq Global Market on December 31, 2008.

Michael M. Stark, President and Chief Executive Officer

Executive Benefits and Payments Upon Termination

  Termination
Without Cause or
Resignation for
Good Reason Apart
from Change in
Control
  Change in Control;
No Termination
  Termination
Without Cause or
Resignation for
Good Reason
Within 24 Months
Following Change
in Control

Compensation:

      

Base Salary (1)

  $325,000   —    $325,000

Bonus (2)

  $162,500   —    $162,500

Stock Options (3)

   —     —     —  

Restricted Stock (4)

  $34,667  $34,667  $34,667

Benefits and Perquisites:

      

Healthcare Benefits (5)

  $16,883   —    $16,883

Outplacement Services

  $15,000   —    $15,000

Accrued Vacation Pay

  $25,061   —    $25,061
            

Totals

  $579,111  $34,667  $579,111
            

(1)Represents a lump sum payment equal to 12 months of Mr. Stark’s current annual base salary of $325,000.

(2)Represents a lump sum payment equal to Mr. Stark’s target bonus for 2008.

(3)Mr. Stark’s unvested stock options have exercise prices which are higher than the price per share of our common stock of $0.52 as of December 31, 2008.

(4)Represents the value of 100% of Mr. Stark’s unvested stock awards under accelerated vesting.

(5)Represents the value of 12 months of healthcare benefits.

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W. Christopher Chisholm, Vice President and Chief Financial Officer

Executive Benefits and Payments Upon Termination

  Termination
Without Cause or
Resignation for
Good Reason Apart
from Change in
Control
  Change in Control;
No Termination
  Termination
Without Cause or
Resignation for
Good Reason
Within 24 Months
Following Change
in Control

Compensation:

      

Base Salary (1)

  $265,000   —    $265,000

Bonus (2)

  $132,500   —    $132,500

Stock Options (3)

   —     —     —  

Restricted Stock (4)

  $65,000  $65,000  $65,000

Benefits and Perquisites:

      

Healthcare Benefits (5)

  $11,780   —    $11,780

Outplacement Services

  $15,000   —    $15,000

Accrued Vacation Pay

  $16,125   —    $16,125
            

Totals

  $505,405  $65,000  $505,405
            

(1)Represents a lump sum payment equal to 12 months of Mr. Chisholm’s current annual base salary of $265,000.

(2)Represents a lump sum payment equal to Mr. Chisholm’s target bonus for 2008.

(3)Mr. Chisholm’s unvested stock options have an exercise price which is higher than the closing price of our common stock of $0.52 per share as of December 31, 2008.

(4)Represents the value of 100% of Mr. Chisholm’s unvested stock awards under accelerated vesting.

(5)Represents the value of 12 months of healthcare benefits.

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Richard A. Reese, Vice President of Marketing

Executive Benefits and Payments Upon Termination

  Termination
Without Cause or
Resignation for
Good Reason Apart
from Change in
Control
  Change in Control;
No Termination
  Termination
Without Cause or
Resignation for
Good Reason
Within 24 Months
Following Change
in Control

Compensation:

      

Base Salary (1)

  $200,000   —    $200,000

Bonus (2)

  $100,000   —    $100,000

Stock Options (3)

   —     —     —  

Restricted Stock (4)

  $3,467  $3,467  $3,467

Benefits and Perquisites:

      

Healthcare Benefits (5)

  $16,883   —    $16,883

Outplacement Services

  $15,000   —    $15,000

Accrued Vacation Pay

  $17,216   —    $17,216
            

Totals

  $352,566  $3,467  $352,566
            

(1)Represents a lump sum payment equal to 12 months of Mr. Reese’s current annual base salary of $200,000.

(2)Represents a lump sum payment equal to Mr. Reese’s target bonus for 2008.

(3)Mr. Reese’s unvested stock options have exercise prices which are higher than the closing price of our common stock of $0.52 per share as of December 31, 2008.

(4)Represents the value of 100% of Mr. Reese’s unvested stock awards under accelerated vesting.

(5)Represents the value of 12 months of healthcare benefits.

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Scott B. Hamilton, General Counsel and Secretary

Executive Benefits and Payments Upon Termination

  Termination
Without Cause or
Resignation for
Good Reason Apart
from Change in
Control
  Change in Control;
No Termination
  Termination
Without Cause or
Resignation for
Good Reason
Within 24 Months
Following Change
in Control

Compensation:

      

Base Salary (1)

  $175,000   —    $175,000

Bonus (2)

  $87,500   —    $87,500

Stock Options (3)

  $—     —     —  

Restricted Stock (4)

  $8,667  $8,667  $8,667

Benefits and Perquisites:

      

Healthcare Benefits (5)

  $5,467   —    $5,467

Outplacement Services

  $15,000   —    $15,000

Accrued Vacation Pay

  $15,673   —    $15,673
            

Totals

  $307,307  $8,667  $307,307
            

(1)Represents a lump sum payment equal to 12 months of Mr. Hamilton’s current annual base salary of $175,000.

(2)Represents a lump sum payment equal to Mr. Hamilton’s target bonus for 2008.

(3)Mr. Hamilton’s unvested stock options have exercise prices which are higher than the closing price of our common stock of $0.52 per share as of December 31, 2008.

(4)Represents the value of 100% of Mr. Hamilton’s unvested stock awards under accelerated vesting.

(5)Represents the value of 12 months of healthcare benefits.

Retirement and Other Benefit Plans

401(k) Plan

The 401(k) Plan has qualified as an employee retirement plan under Section 401(a) and 401(k) of the Code. Participation is optional for employees once they are eligible to participate.

2006 Equity Incentive Award Plan

In May 2006, we adopted our 2006 Equity Incentive Award Plan (the 2006 Plan). The principal purpose of the 2006 Plan is to provide incentives for our officers, employees and consultants, as well as the officers, employees and consultants of any of our subsidiaries. We believe that grants of options, restricted stock and other information requiredawards will stimulate their personal and active interest in our development and financial success, and induce them to remain in our employ or continue to provide services to us. In addition to awards made to officers, employees or consultants, the 2006 Plan permits us to grant options to our directors.

Under the 2006 Plan, 2,500,000 shares of our common stock (or the equivalent in other equity securities) were reserved initially for issuance upon exercise of options, stock appreciation rights, or SARs, and other awards, or upon vesting of restricted stock awards or restricted stock units. As of December 31, 2008, options to purchase 1,257,184 shares of our common stock and 510,514 shares of restricted stock had been granted under the 2006 Plan. The options were exercisable at a weighted average price of $6.88 per share.

In addition, the 2006 Plan contains an evergreen provision that allows for an annual increase in the number of shares available for issuance under the plan on January 1 of each year during the ten-year term of the 2006 Plan, beginning on January 1, 2007. Under this Item 11evergreen provision, the annual increase in the number of shares shall be equal to the least of:

5.0% of our outstanding capital stock on the first day of the relevant fiscal year;

1,000,000 shares; and

an amount determined by our board of directors.

27


In no event shall the number of shares of our common stock that may be issued or transferred pursuant to awards under the 2006 Plan exceed an aggregate of 12,500,000 shares. As of January 1, 2007, the number of total shares of our common stock that may be issued under the 2006 Plan automatically increased to 3,495,383 shares. As of January 1, 2008, the number of total shares of our common stock that may be issued under the 2006 Plan automatically increased to 4,495,383 shares. As of January 1, 2009, the number of total shares of our common stock that may be issued under the 2006 Plan automatically increased to 5,495,383 shares.

No individual may be granted awards under the 2006 Plan representing more than 2,000,000 shares in any calendar year.

Administration. The Committee administers the 2006 Plan. To administer the 2006 Plan, the Committee must consist of at least two members of our board of directors, each of whom is an “outside director,” within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended, or the Code, a non-employee director for purposes of Rule 16b-3 under the Exchange Act, and an independent director under the Nasdaq listing standards.

Our board of directors may at any time abolish the Committee and revest in itself the authority to administer the 2006 Plan. Our entire Board will administer the 2006 Plan with respect to awards to non-employee directors.

Eligibility. Options, SARs, restricted stock and other awards under the 2006 Plan may be granted to individuals who are then our officers or employees or are the officers or employees of any of our subsidiaries. Such awards also may be granted to our directors and consultants. Only employees may be granted incentive stock options, or ISOs.

Awards. The 2006 Plan provides that the Committee (or the Board, in the case of awards to non-employee directors) may grant or issue stock options, SARs, restricted stock, restricted stock units, dividend equivalents, performance awards, stock payments and other stock related benefits, or any combination thereof. Each award will be set forth in a separate agreement with the person receiving the award and will indicate the type, terms and conditions of the award. On May 10, 2007, the definition of “fair market value” in the 2006 Plan was changed to the closing price of our Proxy Statementcommon stock on the date of grant of an award.

Corporate Transactions. In the event of a change in control where the acquirer does not assume or replace awards granted under the 2006 Plan, awards issued under the 2006 Plan will be subject to accelerated vesting such that 100% of such award will become vested and exercisable or payable, as applicable.

In addition, the Committee may make appropriate adjustments to awards under the Plan and is incorporated hereinauthorized to provide for the acceleration, cash-out, termination, assumption, substitution or conversion of such awards. Under the 2006 Plan, a “change in control” is generally defined as:

the transfer or exchange in a single or series of related transactions by our stockholders of more than 50% of our voting stock to a person or group;

the replacement of two-thirds of the incumbent members of the Board with new directors whose nominations have not been approved by an affirmative vote of the incumbent members or their nominees during any two-year period;

a merger or consolidation in which we are a party, other than a merger or consolidation which results in our outstanding voting securities immediately before the transaction continuing to represent a majority of the voting power of the acquiring company’s outstanding voting securities;

the sale, exchange, or transfer of all or substantially all of our assets; or

our liquidation or dissolution.

2001 Stock Option Plan

We initially adopted the 2001 Stock Option Plan (the 2001 Plan) in August 2001. As amended to date, we have reserved a total of 2,100,000 shares of our common stock for issuance under the 2001 Plan. As of December 31, 2008, options to purchase a total of 636,916 shares of our common stock had been exercised and options to purchase 720,167 shares of our Common Stock were outstanding under the 2001 Plan. As of December 31, 2008, these outstanding options were exercisable at a weighted average exercise price of $3.97 per share.

No additional awards may be granted under the 2001 Plan.

Administration. The Committee administers the 2001 Plan. Subject to the terms and conditions of the 2001 Plan, the Committee has the authority to select the persons to whom awards are to be made, to determine the number of shares to be subject thereto and the terms and conditions thereof, and to make all other determinations and to take all other actions necessary or advisable for the administration of the 2001 Plan. The Committee also is authorized to adopt, amend or rescind rules relating to administration of the 2001 Plan. The Board at any time may abolish the Committee and revest in itself the authority to administer the 2001 Plan.

28


Eligibility. Options under the 2001 Plan were granted to individuals who were then our officers, employees or consultants or were the officers, employees or consultants of any of our subsidiary corporations. Such awards were also granted to our directors. Only employees may be granted ISOs.

Awards.The 2001 Plan provides that the Board may grant or issue stock options. Each award will be set forth in a separate agreement with the person receiving the award and will indicate the type, terms and conditions of the award.

Corporate Transactions. In the event of (i) a change of control, (ii) a merger or consolidation in which we are not the surviving corporation, or (iii) the sale of all or substantially all of our assets or stock, all NQSOs and ISOs awarded under the 2001 Plan will vest immediately and become exercisable as of the date of the consummation of such event.

2006 Employee Stock Purchase Plan

In May 2006, we adopted our 2006 Employee Stock Purchase Plan (the 2006 Purchase Plan). The Board will determine when the 2006 Purchase Plan will become effective. The 2006 Purchase Plan is designed to allow our eligible employees to purchase shares of common stock with their accumulated payroll deductions.

We initially reserved a total of 500,000 shares of our common stock for issuance under the 2006 Purchase Plan. The 2006 Purchase Plan provides for an annual increase to the shares of common stock reserved under the 2006 Purchase Plan on each January 1 during the 10-year term of the 2006 Purchase Plan, beginning on January 1, 2007, equal to the least of:

1.0% of our outstanding shares on the applicable January 1;

250,000 shares; or

A lesser amount determined by the Board.

Individuals scheduled to work more than 20 hours per week for more than five calendar months per year may join an offering period on the first day of the offering period. The Board has not yet made any decision to increase the size of the 2006 Purchase Plan.

Participants may contribute up to 20% of their cash earnings through payroll deductions, and the accumulated deductions will be applied to the purchase of shares on each purchase date. The purchase price per share will be determined by the administrator of the 2006 Purchase Plan and will not be less than 85% of the market value per share on the first day of the offering period or the purchase date, whichever is lower.

The 2006 Purchase Plan will terminate no later than the 10th anniversary of the 2006 Purchase Plan’s initial adoption by the Board. The Company made no offering under the 2006 Purchase Plan during 2008, 2007 or 2006.

Board of Directors Compensation

In connection with our initial public offering, the Board approved, at the recommendation of the Compensation Committee, a compensation program for non-employee directors. The general policy of the Board is that compensation for independent directors should be a mix of cash and equity-based compensation. Basin Water does not pay employee directors for Board service in addition to their regular employee compensation.

The table below details the compensation earned by Basin Water’s non-employee directors in 2008. Compensation information for Mr. Stark, our President and Chief Executive Officer, and for Mr. Jensen, our former Chief Executive Officer, is reported in the Summary Compensation Table under “Executive Compensation.”

Non-Employee Director

  Fees Earned
or Paid in
Cash
($)(1)
  Restricted
Stock
Awards
($)(2)
  Option
Awards
($)(2)
  Non-Equity
Incentive Plan
Compensation
($)
  All Other
Compensation
($)(3)
  Total
Compensation
($)(4)

Roger S. Faubel

  $59,250  $40,523  $18,997  $—    $—    $118,770

Victor J. Fryling

  $63,608  $63,912  $30,028  $—    $15,000  $172,548

Scott A. Katzmann

  $86,305  $46,150  $21,654  $—    $—    $154,109

Stephen A. Sharpe

  $55,000  $40,038  $18,766  $—    $—    $113,804

Susan H. Snow

  $24,734  $23,403  $11,092  $—    $—    $59,229

Keith R. Solar

  $67,904  $62,311  $29,316  $—    $—    $159,531

Russell C. Ball III (5)

  $23,052  $—    $—    $—    $—    $23,052

(1)Annual Retainer and Meeting Fees: From March 27, 2007 until April 18, 2008, the Amended and Restated Director Compensation Policy provided for the following compensation for non-employee directors: (a) an annual retainer of $24,000, (b) Board meeting fees of $1,500 ($750 telephonic), (c) committee meeting fees of $1,000 ($500 telephonic), (d) Audit Committee chair annual retainer of $6,000,

29


(e) Compensation and Nominating and Governance Committee chair annual retainers of $4,500, (f) an annual stock option grant for each non-employee director with a face value equal to approximately two times the cash compensation payable to such director for such year and (g) a restricted stock grant for each non-employee director with a face value equal to approximately one and one-half times the cash compensation payable to such director for such year.

Upon recommendation of the Compensation Committee’s outside consultant, the Compensation Committee approved a further amendment to the Amended and Restated Director Compensation Policy. Effective on May 6, 2008, the policy provides for the following compensation for non-employee directors: (a) an annual retainer of $112,000 for the non-executive Chairman of the Board, (b) an annual retainer for all other directors of $24,000, (c) Board meeting fees of $2,000 per meeting ($1,000 telephonic), (d) committee meeting fees of $1,250 ($750 telephonic), (e) Audit Committee chair annual retainer of $7,500 and (f) Compensation and Nominating and Governance Committee chair annual retainers of $5,000. In addition, the non-employee Chairman of the Board is no longer entitled to receive separate fees for attendance at Board committee meetings. The policy provisions relating to annual stock option grants and restricted stock grants remained unchanged.

(2)Stock awards and option awards: Equals the accounting charge for compensation expense incurred by us in 2008 for restricted stock and stock option awards granted in 2008 and prior years, calculated in accordance with the provisions of SFAS No. 123(R),Share-Based Payment, as described in Note 20 to our audited consolidated financial statements included in this Annual Report on Form 10-K/A (without regard to estimates for forfeitures).

In 2008, the annual stock option and restricted stock grants were awarded by reference except forto the information set forthtotal cash compensation payable to each director under the caption “Compensation Committee Report” which specifically is not incorporated hereinAmended and Restated Director Compensation Policy during 2008. For future years, such awards will be made by reference.reference to actual cash compensation paid to each director during the prior year. Stock options granted to non-employee directors pursuant to this policy will have an exercise price equal to the fair market value per share of our common stock on the grant date. Restricted stock granted pursuant to this policy will have a purchase price per share equal to $0.001. Each such stock award shall vest in full on the first anniversary of the grant date and will vest in full in the event of a change in control (as defined under the 2006 Plan) or in the event of a director’s termination of service by reason of death or disability.

At December 31, 2008, our non-employee directors had the following stock awards and stock options grants outstanding: (i) Mr. Faubel held 10,489 shares of restricted stock and options to purchase 21,054 shares of common stock, (ii) Mr. Fryling held 18,156 shares of restricted stock and options to purchase 81,378 shares of common stock, (iii) Mr. Katzmann held 12,624 shares of restricted stock and options to purchase 23,901 shares of common stock, (iv) Mr. Sharpe held 10,303 shares of restricted stock and options to purchase 20,807 shares of common stock (v) Ms. Snow held 8,911 shares of restricted stock and options to purchase 11,881 shares of common stock and (vi) Mr. Solar held 16,986 shares of restricted stock and options to purchase 162,369 shares of common stock.

The grant date fair values, calculated in accordance with the provisions of SFAS No. 123(R), of the restricted stock awards and option awards granted to each of our non-employee directors during 2008 were as follows:

 

   Grant Date Fair Values
   Restricted
Stock
Awards
  Stock
Option
Awards

Roger S. Faubel

  $42,376  $20,054

Victor J. Fryling

  $73,350  $34,714

Scott A. Katzmann

  $51,041  $24,137

Stephen A. Sharpe

  $41,624  $19,700

Susan H. Snow

  $36,000  $17,037

Keith R. Solar

  $68,260  $32,479

(3)All Other Compensation:Consists of fees paid to non-employee directors for special projects approved by the Board.

(4)Total Compensation:Total compensation reflects the sum of all fees earned, all accounting charges for compensation expense incurred in 2008 for restricted stock and stock option awards and all other compensation paid in 2008.

(5)Mr. Ball resigned as a director in May 2008.

Compensation Committee Interlocks and Insider Participation

The current members of the Compensation Committee are Messrs. Faubel, Fryling and Solar, none of whom are employees of Basin Water and all of whom are considered “independent” directors under the applicable Nasdaq Marketplace rules. There were no interlocks or insider participation between any member of the Board or Compensation Committee and any member of the board of directors or compensation committee of another company.

During the year ended December 31, 2008, we paid legal fees and reimbursement of costs in the aggregate amount of approximately $173,000 to Buchanan Ingersoll & Rooney PC law firm whose partner, Mr. Keith Solar, is one of our directors. See Item 13. “Certain Relationships and Related Party Transactions”.

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ITEM 12.    SECURITYSECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERSTOCK MATTERS

Information concerningSecurity Ownership of 5% Holders, Directors, Nominees and Executive Officers

The following table sets forth information with respect to beneficial ownership of our common stock for (i) those persons known by our management to beneficially own 5% or more of Basin Water common stock, (ii) each director and other securitiesnominee, (iii) the named executive officers from the Summary Compensation Table in Part III – Item 11. “Executive Compensation” and (iv) all of our executive officers and directors as a group. The information for the officers and directors is provided as of March 31, 2009 and the information for 5% or more stockholders is as of the most recent filings with the SEC that were provided to us.

Beneficial ownership is determined under the rules of the SEC and generally includes voting or investment power with respect to securities. Except as indicated in the footnotes to this table, to our knowledge the persons named in the table below have sole voting and investment power with respect to all shares of common stock beneficially owned. The number of shares beneficially owned by certain personseach person or group as of March 31, 2009 includes shares of common stock that such person or group had the right to acquire on or within 60 days after March 31, 2009, including, but not limited to, upon the exercise of options or warrants. For each individual and other information required under this Item 12group included in the table below, percentage ownership is set forthcalculated by dividing the number of shares beneficially owned by such person or group by the sum of the 22,223,364 shares of common stock outstanding on March 31, 2009 plus the number of shares of common stock that such person or group had the right to acquire on or within 60 days after March 31, 2009. We are not aware of any pledge of common stock that could result in our Proxy Statement and is incorporated herein by reference.a change of control of the Company.

 

   Amount and Nature of Beneficial
Ownership
 

Name

  No. of Shares of
Common Stock (1)
  Percentage of
Common Stock
Outstanding
 

5% or Greater Stockholders

    

Winslow Management Company, LLC (2)

  1,623,445  7.31%

Avenir Corporation (3)

  1,373,250  6.18%

Heartland Advisors, Inc. (4)

  1,280,300  5.76%

Named Executive Officers and Directors

    

Michael M. Stark (5)

  235,673  1.06%

Peter L. Jensen (6)

  26,458      *

W. Christopher Chisholm (7)

  150,000      *

Thomas C. Tekulve (8)

  288,963  1.28%

Richard A. Reese (9)

  35,696      *

Scott B. Hamilton (10)

  68,675      *

Scott A. Katzmann (11)

  843,381  3.78%

Keith R. Solar (12)

  385,404  1.72%

Victor J. Fryling (13)

  146,161      *

Roger S. Faubel (14)

  93,395      *

Stephen A. Sharpe (15)

  36,412      *

Susan H. Snow (16)

  20,792      *

All directors, nominees and executive officers as a group (10 individuals) (17)

  2,015,589  8.88%

*Indicates beneficial ownership of less than one percent of total outstanding common stock.

(1)This column lists voting securities, including shares held of record, shares held by a bank, broker or nominee for the person’s interest, shares held through family trust arrangements, and for Named Executive Officers.

(2)

Based on information set forth in a Schedule 13G/A filed with the Securities and Exchange Commission on February 17, 2009 by Winslow Management Company, LLC, reporting sole power to vote or direct the vote over 1,623,445 shares and sole power to dispose or direct the disposition of 1,623,445 shares. The address of Winslow Management Company, LLC is 99 High Street, 12th Floor, Boston, MA 02110.

(3)

Based on information set forth in a Schedule 13G/A filed with the Securities and Exchange Commission on February 13, 2009 by Avenir Corporation, reporting sole power to vote or direct the vote over 1,373,250 shares and sole power to dispose or direct the disposition of 1,373,250 shares. The address of Avenir Corporation is 1919 Pennsylvania Avenue NW, 4th Floor, Washington, DC 20006.

(4)Based on information set forth in a Schedule 13G filed with the Securities and Exchange Commission on February 11, 2009 by Heartland Advisors, Inc. and William J. Nasgovitz, reporting shared power to vote or direct the vote over 1,280,300 shares and shared power to dispose or direct the disposition of 1,280,300 shares. The address of Heartland Advisors, Inc. and The Heartland Fund is 789 North Water Street, Milwaukee, Wisconsin 53202.

31


(5)Consists of 133,333 shares, plus 66,667 shares of restricted stock granted in October 2006, as to which all of the shares will vest on the third anniversary of the grant date, as well as 35,673 shares which Mr. Stark has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009.

(6)Includes 5,417 shares, plus 2,708 shares of restricted stock granted upon the completion of our initial public offering in May 2006, as to which all of the shares will vest on the third anniversary of the grant date. Also includes 18,333 shares which Mr. Jensen has the right to acquire pursuant to outstanding options that are exercisable within 60 days after March 31, 2009.

(7)Includes 25,000 shares, plus 125,000 shares of restricted stock granted in June 2008, as to which 50,000 shares will vest 12 months after the grant date and 75,000 shares will vest 18 months after the grant date.

(8)Includes 4,875 shares, plus options to purchase 220,000 shares of common stock that became fully vested and exercisable upon completion of our initial public offering in May 2006, and options to purchase 64,088 shares of common stock that became fully vested and exercisable on October 13, 2008, in accordance with the terms of Mr. Tekulve’s Separation Agreement.

(9)Consists of 3,333 shares, plus 6,667 shares of restricted stock granted in September 2007, as to which one-half of the shares will vest on each of the second and third anniversaries of the grant date, as well as 25,696 shares which Mr. Reese has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009.

(10)Includes 8,333 shares, plus 17,441 shares of common stock granted to Mr. Hamilton in February 2009 which were fully vested at the grant date and 16,667 shares of restricted stock granted in July 2007, as to which one-half of the shares will vest on each of the second and third anniversaries of the grant date, as well as 26,234 shares which Mr. Hamilton has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009.

(11)Includes 740,256 shares, plus 12,624 shares of restricted stock granted in May 2008 that will vest on the first anniversary of the grant date and 23,901 shares which Mr. Katzmann has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009, as well as 26,600 shares held by Mr. Katzmann that are issuable upon exercise of warrants that are immediately exercisable.

(12)Consists of 206,049 shares (including 500 shares held in Mr. Solar’s 401(k) retirement plan), plus 16,986 shares of restricted stock granted in May 2008 that will vest on the first anniversary of the grant date and 162,369 shares which Mr. Solar has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009.

(13)Consists of 61,852 shares, plus 18,156 shares of restricted stock granted in May 2008 that will vest on the first anniversary of the grant date and 81,738 shares which Mr. Fryling has the right to acquire pursuant to outstanding options that are exercisable within 60 days of March 31, 2009.

(14)Includes 46,627 shares, plus 10,489 shares of restricted stock granted in May 2008 that will vest on the first anniversary of the grant date and 21,054 shares which Mr. Faubel has the right to acquire pursuant to outstanding options that are exercisable within 60 days after March 31, 2009.

(15)Consists of 5,302 shares, plus 10,303 shares of restricted stock granted in May 2008 that will vest on the first anniversary of the grant date and 20,807 shares which Mr. Sharpe has the right to acquire pursuant to outstanding options that are exercisable within 60 days after March 31, 2009.

(16)Consists of 8,911 shares of restricted stock granted to Ms. Snow in May 2008 that will vest on the first anniversary of the grant date and an option to purchase 11,881 shares of common stock granted in May 2008 that will vest on the first anniversary of the grant date and is exercisable within 60 days after March 31, 2009.

(17)Our directors and officers as a group beneficially own 2,015,589 shares of common stock, which includes 215,001 shares of restricted stock and options to purchase 448,993 shares of common stock that are exercisable within 60 days after March 31, 2009.

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ITEM 13.    CERTAINCERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information concerning certain relationshipsCertain Relationships and Related Transactions

In 2007, our Board adopted a written policy regarding the review, approval and ratification of any related transactionsparty transaction. Under this policy, our Audit Committee will review the relevant facts and director independencecircumstances of each related party transaction, including if the transaction is on terms comparable to those that could be obtained in arm’s length dealings with an unrelated third party and other information required under this Item 13 isthe extent of the related party’s interest in the transaction, and either approve or disapprove the related party transaction. Any related party transaction shall be consummated and shall continue only if the Audit Committee has approved or ratified such transaction in accordance with the guidelines set forth in the policy.

A “related party transaction” is a transaction, arrangement or relationship (or any series of similar transactions, arrangements or relationships) in which we were, are or will be a participant and in which any related party had, has or will have a direct or indirect interest (other than solely as a result of being a director or a less than five percent beneficial owner of another entity).

A “related party” is any (a) person who is or was (since the beginning of the company’s last fiscal year) an executive officer, director or nominee for election as a director, (b) greater than five percent beneficial owner of any class of the company’s voting securities, or (c) immediate family member of any of the foregoing, which means any child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law or sister-in-law of such person, and anyone (other than a tenant or employee) sharing the household of such person.

The following is a description of related party transactions in the year ended December 31, 2008 to which we have been a party, in which the amount involved exceeds $120,000, other than compensation and employment arrangements described elsewhere in this Annual Report on Form 10-K/A. We believe the terms obtained or consideration that we paid or received, as applicable, in connection with the transactions below were comparable to terms available or the amounts that would be paid or received, as applicable, in arm’s length transactions. The following transactions were all approved by the Audit Committee or the Board.

Severance Payments and Arrangements with Former Officers

In January 2008, Peter L. Jensen resigned as our Proxy StatementChief Executive Officer. In connection with his resignation, the Board approved a lump-sum severance payment to Mr. Jensen in the amount of $422,797, which was paid in February 2008. The Board also agreed to enter into a consulting agreement with Mr. Jensen which provides for aggregate consulting fees of $400,000 to be paid in monthly installments over the 24-month period from March 2008 through February 2010. Mr. Jensen’s consulting services were terminated in November 2008. In February 2008, Mr. Jensen also resigned as the Chairman of our Board and as a director. The aggregate amount of payments made to Mr. Jensen during 2008 under the terms of his severance agreement and other arrangements, including his lump-sum severance payment, consulting payments and accrued vacation, was $616,741.

In June 2008, Thomas C. Tekulve resigned as our Chief Financial Officer, and in October 2008, he resigned as our Vice President of Finance – Business Development. In connection with his October 2008 resignation, the Board approved a lump-sum severance payment to Mr. Tekulve in the amount of $115,000, which was paid in October 2008. At that same time, 100% of the unvested stock awards and stock options previously granted to Mr. Tekulve became vested in accordance with the terms of his Separation Agreement. These vested stock options will expire on July 1, 2011. The aggregate amount of payments made to Mr. Tekulve during 2008 under the terms of his severance agreement, including his lump-sum severance payment and accrued vacation, was $139,335.

Legal Services

Since June 1, 2007, Keith R. Solar, one of our directors, has been a partner and shareholder of Buchanan Ingersoll & Rooney PC. During the year ended December 31, 2008, we paid legal fees and reimbursement of costs in the aggregate amount of approximately $173,000 to this firm.

Employment

On October 25, 2007 we hired Robert D. Stark to become the Director of Sales for Industrial Operations for Basin Water – MPT, Inc. at an annual salary of $140,000. Mr. Stark has over fourteen years of experience in business development and marketing technology solutions and service offering to industrial customers, with a focus in the hydrocarbon, chemical and refining industries, among others. Robert D. Stark is incorporated hereinthe son of our President and Chief Executive Officer, Michael M. Stark. We also indemnified Mr. Robert Stark with respect to claims against him in certain litigation by reference.Veolia Water North America Operating Services, LLC, which was settled during the year ended December 31, 2008.

 

33


Empire Water Transaction

In June 2008, we received a payment of $600,000 from Empire Water Corporation with respect to the sale of a water treatment system, which represented the remaining balance receivable from Empire Water for this sale. See Note 18 to our consolidated financial statements. We currently own approximately 31% of the outstanding shares of Empire Water Corporation. Our former Chief Executive Officer and Chairman of the Board, Peter Jensen, is the current President and Chief Executive Officer of Empire Water Corporation. Mr. Jensen resigned as our Chief Executive Officer on February 18, 2008.

Board Independence

We currently have seven directors on our Board. The listing standards of NASDAQ require listed companies to have a board of directors with at least a majority of independent directors. For a director to qualify as independent, the Board must affirmatively determine that the director has no material relationship with Basin Water, either directly or as a partner, stockholder or officer of an organization that has a relationship with Basin Water which, in the opinion of the Board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

To assist it in making independence determinations, the Board has adopted independence standards based on NASDAQ rules. Under these standards, a director is not independent if:

The director is, or has been within the last three years, an employee of Basin Water or any of its subsidiaries, or an immediate family member is, or has been within the last three years, an executive officer of Basin Water.

The director has received, or has an immediate family member who has received, during any twelve-month period within the last three years, more than $120,000 in direct compensation from us (other than compensation for Board or committee service, compensation to a family member who is an employee but not an executive officer, or benefits under a tax-qualified retirement plan or non-discretionary compensation).

The director is, or has a family member that is, a partner in, or a controlling stockholder or an executive officer of, any organization to which we made, or from which we received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year or $200,000, whichever is greater, other than payments arising solely from investments in our securities or payments under non-discretionary charitable contribution matching programs.

The director or an immediate family member is, or has been within the last three years, employed as an executive officer of another company where any of our present executive officers at the same time serves or served on that company’s compensation committee.

The director is or has a family member that is a current partner of our outside auditor, or was a partner or employee of our outside auditor who worked on our audit at any time during any of the past three years.

On the basis of these standards, the Board has determined that Messrs. Faubel, Fryling, Katzmann, Sharpe and Solar and Ms. Snow are independent under the Nasdaq listing standards. The Board has also determined that each member of the Audit Committee of the Board qualifies as independent under Rule 10A-3 promulgated under the Exchange Act.

34


ITEM 14.    PRINCIPALPRINCIPAL ACCOUNTING FEES AND SERVICES

InformationAudit and All Other Fees

The following is a summary of the fees billed to us by SingerLewak LLP for professional services rendered for the fiscal years ended December 31, 2008 and 2007:

Fee Category

  Fiscal 2008
Fees
  Fiscal 2007
Fees

Audit and Audit Related Fees (1)

  $561,099  $460,494

Tax Fees (2)

   —     —  

All Other Fees (3)

   —     —  
        

Total Fees

  $561,099  $460,494
        

(1)Fees for audit services consist of the fees associated with the annual audit, fees for the audit of internal controls over financial reporting, and fees for quarterly SAS 100 reviews and reviews of Form 10-Q. SingerLewak LLP did not receive any audit related fees from us for either of the fiscal years ended December 31, 2008 or 2007.

(2)SingerLewak LLP did not receive any tax fees from us for either of the fiscal years ended December 31, 2008 or 2007.

(3)SingerLewak LLP did not receive any other fees from us for either of the fiscal years ended December 31, 2008 or 2007.

Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Public Accounting Firm

The Audit Committee has, by resolution, adopted policies and procedures regarding principal accounting feesthe pre-approval of the performance by SingerLewak LLP of certain audit and non-audit services. SingerLewak LLP may not perform any service unless the approval of the Audit Committee is obtained prior to the performance of the services, and other information required under this Item 14 is set forth in our Proxy Statement and is incorporated hereinexcept as may otherwise be provided by reference.law or regulation. All services described above were approved by the Audit Committee.

35


PART IV

ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(A) Documents filed as part of this report.

1. The following consolidated financial statements of Basin Water, Inc. and subsidiaries and Reports of Singer Lewak Greenbaum & Goldstein LLP, independent registered public accounting firm, are included in this report:

Reports of Singer Lewak Greenbaum & Goldstein LLP, Independent Registered Public Accounting Firm

Consolidated balance Sheets as of December 31, 2007 and 2006

Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and 2005

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2007, 2006 and 2005

Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005

Notes to Consolidated Financial Statements

2. List of financial statement schedules-Schedule II—Valuation and Qualifying Accounts.

3. List of exhibits required by Item 601 of Regulation S-K. See part (B) below.

(B) Exhibits.

The following exhibits are filed as part of, or incorporated by reference into, this report:

 

Exhibit

Number

    

Exhibit Description

  2.1 (1)  Agreement and Plan of Merger, dated August 31, 2007, by and among the Registrant, Basin Water, Inc., BW Acquisition Merger Sub, Inc., Basin Water-MPT, Inc., Mobile Process Technology, Co. and the stockholders of Mobile Process Technology, Co.
  3.1 (2)  Amended and Restated Certificate of Incorporation of the Registrant
  3.2 (2)  Amended and Restated Bylaws of the Registrant
  4.1 (2)  Form of the Registrant’s Common Stock Certificate
  4.2 (2)  Registration Rights Agreement, dated June 28, 2005, among the Registrant and holders of Preferred Stock
  4.3 (2)  Form of Common Stock Warrant
  4.4 (2)  Form of Preferred Stock Warrant
  4.5 (2)  Form of Note issued to BWCA I, LLC
  4.6 (2)  Form of Warrant issued to BWCA I, LLC
  4.7 (2)  Form of Senior Subordinated Note issued to The Co-Investment 2000 Fund, L.P. and other purchasers
  4.8 (2)  Form of Warrant issued to The Co-Investment 2000 Fund, L.P. and other purchasers
  4.9 (2)  Registration Rights Agreement, dated October 14, 2005, among The Co-Investment 2000 Fund, L.P. and other purchasers

Exhibit

Number

Exhibit Description

  2.1 (1)Agreement and Plan of Merger, dated August 31, 2007, by and among the Registrant, BW Acquisition Merger Sub, Inc., Basin Water-MPT, Inc., Mobile Process Technology, Co. and the stockholders of Mobile Process Technology, Co.
  2.2† (3)Asset Purchase Agreement, dated as of September 18, 2008, by and among Shaw Environmental & Infrastructure, Inc., Shaw Environmental, Inc., Envirogen Inc. and the Registrant
  3.1 (3)Amended and Restated Certificate of Incorporation of the Registrant
  3.2 (3)Amended and Restated Bylaws of the Registrant
  4.1 (3)Form of the Registrant’s Common Stock Certificate
  4.2 (3)Registration Rights Agreement, dated June 28, 2005, among the Registrant and holders of Preferred Stock
  4.3 (3)Form of Common Stock Warrant
10.1 #(4)Form of Amended and Restated Indemnification Agreement for Directors and Executive Officers
10.2 #(3)2001 Stock Option Plan, as amended and restated and form of option agreement thereunder
10.3 #(5)Amended and Restated Director Compensation Policy, dated March 27, 2007
10.4 #(3)2006 Equity Incentive Award Plan and forms of option and restricted stock agreements thereunder
10.5 #(3)2006 Employee Stock Purchase Plan
10.6 (3)Standard Industrial/Commercial Single-Tenant Lease, dated June 7, 2002 between the Registrant and White Oak, LLC for the property located at 8731 Prestige Court, Rancho Cucamonga, California 91730
10.7 (3)First Amendment to Standard Industrial/Commercial Single-Tenant Lease—Gross, dated August 4, 2004, between the Registrant and White Oak, LLC
10.8 (3)Second Amendment to Standard Industrial/Commercial Single-Tenant Lease-Gross, dated February 15, 2006, between the Registrant and White Oak, LLC
10.9 #(6)Employment Agreement, dated October 27, 2006, between Michael Stark and Registrant
10.10 #(7)Amendment No. 1 to 2006 Equity Incentive Award Plan dated May 10, 2007

Exhibit

Number

    

Exhibit Description

  4.10 (2)  Senior Subordinated Note issued to Aqua America, Inc. dated February 10, 2006
  4.11 (2)  Form of Warrant issued to Aqua America, Inc.
  4.12 (2)  Registration Rights Agreement, dated February 10, 2006, between the Registrant and Aqua America, Inc.
  9.1 (2)  Amended and Restated Voting Trust Agreement, dated September 20, 2005
10.1   Form of Amended and Restated Indemnification Agreement for Directors and Executive Officers (filed herewith)
10.2 #(2)  2001 Stock Option Plan, as amended and restated and form of option agreement thereunder
10.3 #(3)  Amended and Restated Director Compensation Policy, dated March 27, 2007
10.4 #(2)  2006 Equity Incentive Award Plan and forms of option and restricted stock agreements thereunder
10.5 #(2)  2006 Employee Stock Purchase Plan
10.6 #(2)  Employment Agreement between the Registrant and Peter L. Jensen dated October 1, 2005
10.7 #(2)  Form of Employment Agreement between Registrant and Peter L. Jensen
10.8 #(2)  Employment Agreement between the Registrant and Thomas C. Tekulve dated August 27, 2004, First Amendment to Employment Agreement dated January 31, 2005 and Second Amendment to Employment Agreement dated June 27, 2005
10.9 #(2)  Form of Employment Agreement between Registrant and Thomas C. Tekulve
10.10 (2)  Standard Industrial/Commercial Single-Tenant Lease, dated June 7, 2002 between the Registrant and White Oak, LLC for the property located at 8731 Prestige Court, Rancho Cucamonga, California 91730
10.11 (2)  First Amendment to Standard Industrial Commercial Single Tenant Lease—Gross, dated August 4, 2004, between the Registrant and White Oak, LLC
10.12 (2)  Business Loan Agreement, dated July 1, 2003, between BWCA I, LLC and the Registrant
10.13 (2)  Commercial Security Agreement, dated July 1, 2003, between BWCA I, LLC and the Registrant
10.14 (2)  Subordinated Note with Warrants Purchase Agreement, dated October 14, 2005, among the Registrant, The Co-Investment 2000 Fund, L.P. and the other purchasers party thereto
10.15 (2)  Security Agreement, dated October 14, 2005, among the Registrant, The Co-Investment 2000 Fund, L.P. and the other purchasers party thereto
10.16 (2)†  National Arsenic Sales Agreement, dated December 9, 2005, between the Registrant and Shaw Environmental, Inc.
10.17 (2)†  Sales Commitment Letter, dated December 23, 2005, between the Registrant and Shaw Environmental, Inc.
10.18 (2)  Subordinated Note with Warrants Purchase Agreement, dated February 10, 2006, between the Registrant and Aqua America, Inc.
10.19 (2)  Security Agreement, dated February 10, 2006, between the Registrant and Aqua America, Inc.
10.20 (2)  Second Amendment to Standard Air Industrial Commercial Single-Tenant Lease-Gross, dated February 15, 2006, between the Registrant and White Oak, LLC
36

Exhibit

Number

    

Exhibit Description

10.21 #(4)  Employment Agreement, dated October 27, 2006, between Michael Stark and Registrant
10.22 #(5)  Amendment No. 1 to 2006 Equity Incentive Award Plan dated May 10, 2007
10.23 #(6)  Employment Agreement, dated June 29, 2007, between Scott Hamilton and Registrant
10.24 (7)  Omnibus Amendment to Business Loan Agreement and Warrants dated October 3, 2003, April 30, 2004, October 26, 2004 and February 10, 2006 between Registrant and BWCA I, LLC
10.25 (8)  Escrow Agreement, dated September 14, 2007, among Registrant, Mobile Process Technology, Co., the Stockholders’ Representative and Computershare Trust Company, N.A.
10.26 (8)  Lease Agreement, dated September 14, 2007, by and between Basin Water-MPT, Inc. and Craft Real Property, LLC
10.27 (8)  Form of Non-Compete and Non-Solicitation Agreement, dated September 14, 2007, by and between Registrant and the other parties thereto
10.28   Alliance Agreement, dated November 14, 2007, between Rohm and Haas Chemicals LLC and Registrant (filed herewith)
10.29 (9)  Assignment and Amendment Agreement, dated December 21, 2007, among Empire Water Corporation, Basin Water Resources, Inc. and Indian Hills Water Conservation Corporation, West Riverside Canal Company, West Riverside 350 Inch Company, Henry Cox and John L. West
10.30 (9)  Stock Purchase Agreement between Empire Water Corporation and Basin Water Resources, Inc., dated as of December 21, 2007
10.31 #(10)  Employment Transition and Consulting Agreement, dated February 19, 2008, between Peter L. Jensen and Registrant
23.1   Consent of Singer Lewak Greenbaum & Goldstein LLP, independent registered public accounting firm (filed herewith)
31.1   Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
31.2   Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.1 *  Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002 (filed herewith)
32.2 *  Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002 (filed herewith)


Exhibit

Number

Exhibit Description

10.11 #(8)Employment Agreement, dated June 29, 2007, between Scott Hamilton and Registrant
10.12 (9)Omnibus Amendment to Business Loan Agreement and Warrants dated October 3, 2003, April 30, 2004, October 26, 2004 and February 10, 2006 between Registrant and BWCA I, LLC
10.13 (10)Escrow Agreement, dated September 14, 2007, among Registrant, Mobile Process Technology, Co., the Stockholders’ Representative and Computershare Trust Company, N.A.
10.14 (10)Lease Agreement, dated September 14, 2007, by and between Basin Water-MPT, Inc. and Craft Real Property, LLC
10.15 (10)Form of Non-Compete and Non-Solicitation Agreement, dated September 14, 2007, by and between Registrant and the other parties thereto
10.16 †(4)Alliance Agreement, dated November 14, 2007, between Rohm and Haas Chemicals LLC and Registrant
10.17 (11)Assignment and Amendment Agreement, dated December 21, 2007, among Empire Water Corporation, Basin Water Resources, Inc. and Indian Hills Water Conservation Corporation, West Riverside Canal Company, West Riverside 350 Inch Company, Henry Cox and John L. West
10.18 (11)Stock Purchase Agreement between Empire Water Corporation and Basin Water Resources, Inc., dated as of December 21, 2007
10.19 #(12)Employment Transition and Consulting Agreement, dated February 19, 2008, between Peter L. Jensen and Registrant
10.10 (13)Agreement to Sell and Purchase, dated September 14, 2007, between VL Capital LLC and Registrant
10.21 (13)Term Loan Agreement, dated September 2007, and amendment, between VL Capital LLC and Registrant
10.22 (13)Security Agreement, dated September 14, 2007 between VL Capital LLC and Registrant
10.23 (14)Release of All Claims dated February 13, 2008 between the Registrant and GBM Newco, LLC
10.24 (15)Employment Agreement between W. Christopher Chisholm and Registrant dated June 17, 2008
10.25 (16)Basin Water, Inc. 2008 Annual Incentive Plan adopted on April 23, 2008
10.26 (16)Second Amended and Restated Director Compensation Policy, effective as of May 6, 2008
10.27 (17)Settlement Agreement, dated as of September 18, 2008, by and among Shaw Environmental & Infrastructure, Inc., Shaw Environmental, Inc. and Registrant
10.28 †(17)Biological Materials Sales Agreement, dated as of September 18, 2008, by and between Shaw Environmental, Inc. and Registrant
10.29 #(18)Resignation Letter Agreement, dated October 13, 2008, between the Registrant and Thomas C. Tekulve
10.30 (19)Standard Multi-Tenant Office Lease, dated June 1, 2007, between the Registrant and Sixth & Pittsburgh, LLC
10.31 #(20)Amended and Restated Employment Agreement, dated December 16, 2008, between Michael M. Stark and the Registrant
10.32 #(20)Amended and Restated Employment Agreement, dated December 16, 2008, between Scott B. Hamilton and the Registrant
10.33 #(20)Amended and Restated Employment Agreement, dated December 16, 2008, between Richard A. Reese and the Registrant
10.34 (21)Settlement Agreement and Release, effective as of December 8, 2008, by and among Process Water Solutions, LLC, Veolia Water North America Operations Services, LLC, Clean Water Technologies, LLC, Dr. Phosphate, Inc., Basin Water-MPT, Inc., Registrant, Robert Gorgol, Robert Stark and Michael Stark
10.35 (21)Settlement Agreement and Mutual General Release, effective as of February 5, 2009, by and among Registrant, BionBasin, Inc., Opus Trust, Inc. and Martin A. Benowitz, individually and as Trustee of the Martin A. Benowitz Qualified Profit Sharing Plan

37


Exhibit

Number

Exhibit Description

23.1 (22)Consent of SingerLewak LLP, independent registered public accounting firm
31.1Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
31.2Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.1 *Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002 (filed herewith)
32.2 *Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002 (filed herewith)

 

(1)Incorporated by reference to the Registrant’s Current Report on Form 8-K/A filed on September 6, 2007.
(2)Incorporated by reference to the Registrant’s Current Report on Form 8-K/A filed on September 22, 2008.
(3)Incorporated by reference to the Registrant’s Registration Statement on Form S-1 filed on February 13, 2006, as amended.
(3)(4)Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on March 17, 2008.
(5)Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on April 2, 2007.
(4)(6)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on October 30, 2006.
(5)(7)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on May 16, 2007.
(6)(8)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on July 6, 2007.
(7)(9)Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q filed on August 14, 2007.
(8)(10)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on September 17, 2007.
(9)(11)Incorporated by reference to the Schedule 13D/A filed by the Registrant with respect to Empire Water Corporation on January 10, 2008.

(10)(12)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on February 25, 2008.
(13)Incorporated by reference to the Registrant’s Annual Report on Form 10-K/A filed on February 10, 2009.
(14)Incorporated by reference to the Registrant’s Quarterly Report Form 10-Q/A for the quarter ended March 31, 2008, filed on February 10, 2009.
(15)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on June 23, 2008.
(16)Incorporated by reference to the Registrant’s Quarterly Report Form 10-Q for the quarter ended June 30, 2008, filed on February 10, 2009.
(17)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on September 22, 2008.
(18)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on October 14, 2008.
(19)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on November 18, 2008.
(20)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on December 19, 2008.
(21)Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on February 10, 2009.
(22)Incorporated by reference to the Registrant’s Annual Report on Form 10-K filed on March 31, 2009.
#Indicates management contract or compensatory plan.
Confidential treatment has been requested for portions of this exhibit.
*These certifications are being furnished solely to accompany this Annual Report on Form 10-K10-K/A pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not being incorporated by reference into any filing of Basin Water, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

38


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized and in the capacities indicated.

Basin Water, Inc. (Registrant)

 

Basin Water, Inc. (Registrant)
BY: 

/s/ MICHAELMICHAEL M. STARK        STARK

 BY:/s/    THOMAS C. TEKULVE        
 

BY:

/s/ W. CHRISTOPHER CHISHOLM

Michael M. Stark

W. Christopher Chisholm
Chief Executive Officer and Director

Chief Financial Officer
(Principal Executive Officer)

   

Thomas C. Tekulve

Chief Financial Officer

(Principal Financial and Accounting Officer)

Date: March 17, 2008April 30, 2009

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons on behalf of the Registrant and in the capacities indicated and on the date indicated.

 

BY: 

/s/ SCOTTSCOTT A. KATZMANN        KATZMANN

 Scott A. Katzmann
 Chairman of the Board of Directors

BY: 

/s/ RUSSELL C. BALL III        ROGER S. FAUBEL

Russell C. Ball III
Director
BY:/s/    ROGER S. FAUBEL        
 Roger S. Faubel
 Director

BY: 

/s/ VICTORVICTOR J. FRYLING        FRYLING

 Victor J. Fryling
 Director

BY: 

/s/ STEPHENSTEPHEN A. SHARPE        SHARPE

 Stephen A. Sharpe
 Director

BY: 

/s/ KEITH R. SOLAR        SUSAN H. SNOW

Susan H. Snow
Director

BY:

/s/ KEITH R. SOLAR

 Keith R. Solar
 Director

Date: March 17, 2008

BASIN WATER, INC.

INDEX TO FINANCIAL STATEMENTS

Page

Reports of Independent Registered Public Accounting Firm

F-2

Consolidated Balance Sheets as of December 31, 2007 and 2006

F-5

Consolidated Statements of Operations for the Years Ended December 31, 2007, 2006 and 2005

F-6

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2007, 2006 and 2005

F-7

Consolidated Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and 2005

F-8

Notes to Consolidated Financial Statements

F-9

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Basin Water, Inc.

Rancho Cucamonga, California

We have audited the consolidated balance sheets of Basin Water, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule of Basin Water, Inc. listed in Schedule II. These consolidated financial statements and financial statement schedule are the responsibility of Basin Water, Inc.’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Basin Water, Inc. and subsidiaries as of December 31, 2007 and 2006, 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 U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements, taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Basin Water Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our report dated March 17, 2008 expressed an opinion that Basin Water Inc. had not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

Irvine, California

March 17, 2008

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Basin Water, Inc.

Rancho Cucamonga, California

We have audited the internal control over financial reporting of Basin Water, Inc. and subsidiaries (the Company) as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Evaluation of Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in management’s assessment:

During the Company’s assessment of internal control over financial reporting, there were numerous significant control deficiencies. If assessed on an individual basis, none of these deficiencies was determined to be a material weakness. However, taken in the aggregate, they constitute a material weakness.

Financial Statement Close Process

Timely reconciliation of certain non-routine transactions and the related financial statement disclosures were not performed.

Purchasing Process

Certain expenditures were not properly authorized based on the Company’s delegation of authority policy

Treasury Process

Certain bank account reconciliations were not reviewed and approved on a timely basis

Payroll Process

Timely review of certain payroll changes was not performed

Timely review by management of certain time cards was not performed

Information Technology Controls

Information Technology Controls are policies and procedures that relate to many applications and support the effective functioning of application controls by helping to ensure the proper operation of information systems. As of December 31, 2007, the Company had ineffective information technology controls relating to:

Periodic user access review

Configuration of active directory password parameters not in compliance with the Company’s Information Security Policy

Lack of a formal process to add new users and modify or terminate existing users

The material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 financial statements, and this report does not affect our report dated March 17, 2008 on those financial statements.

In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

Irvine, California

March 17, 2008

BASIN WATER, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

   December 31,
2007
  December 31,
2006
 

ASSETS

   

Current assets

   

Cash and cash equivalents

  $35,456  $54,567 

Accounts receivable, net of $72 and $67 allowance for doubtful accounts

   3,167   2,416 

Unbilled receivables, net of $524 and $433 allowance for doubtful accounts

   11,443   9,123 

Inventory

   1,055   714 

Current portion of notes receivable

   338   —   

Prepaid expenses and other

   1,233   634 
         

Total current assets

   52,692   67,454 
         

Property and equipment

   

Property and equipment

   15,945   13,621 

Less: accumulated depreciation

   1,645   1,394 
         

Property and equipment, net

   14,300   12,227 
         

Other assets

   

Goodwill

   8,682   —   

Unbilled receivables, net of current portion

   7,664   7,466 

Notes receivable, net of current portion

   3,015   —   

Intangible assets, net

   3,416   1,641 

Patent costs, net

   2,274   383 

Investment in affiliate

   4,502   —   

Other assets

   1,667   881 
         

Total other assets

   31,220   10,371 
         

Total assets

  $98,212  $90,052 
         

LIABILITIES AND STOCKHOLDERS’ EQUITY

   

Current liabilities

   

Accounts payable

  $3,553  $1,562 

Current portion of notes payable

   —     2,007 

Current portion of capital lease obligations

   11   17 

Current portion of deferred revenue and advances

   266   292 

Current portion of contract loss reserve

   1,964   1,321 

Accrued expenses and other

   3,140   2,291 
         

Total current liabilities

   8,934   7,490 

Notes payable, net of current portion

   —     10 

Capital lease obligations, net of current portion

   15   24 

Deferred revenue, net of current portion

   296   387 

Deferred revenue—affiliate

   1,920   —   

Contract loss reserve, net of current portion

   5,311   2,404 

Deferred income tax liability

   2,268   —   

Other long-term liabilities

   179   —   
         

Total liabilities

   18,923   10,315 
         

Commitments and contingencies

   

Stockholders’ equity

   

Common stock, $0.001 par value—100,000,000 shares authorized, 21,948,704 and 19,887,672 shares issued and outstanding

   22   20 

Additional paid-in capital

   110,354   95,002 

Treasury stock

   (552)  —   

Accumulated deficiency

   (30,535)  (15,285)
         

Total stockholders’ equity

   79,289   79,737 
         

Total liabilities and stockholders’ equity

  $98,212  $90,052 
         

See accompanying Independent Registered Public Accountant’s Report.

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

BASIN WATER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

   Years Ended December 31, 
   2007  2006  2005 

Revenues

    

System sales

  $13,477  $13,861  $10,016 

Contract revenues

   5,307   3,253   2,215 
             

Total revenues

   18,784   17,114   12,231 
             

Cost of revenues

    

Cost of system sales

   13,790   12,161   4,467 

Cost of contract revenues

   10,698   7,522   2,323 

Depreciation expense

   443   423   340 
             

Total cost of revenues

   24,931   20,106   7,130 
             

Gross profit (loss)

   (6,147)  (2,992)  5,101 

Research and development expense

   564   634   651 

Selling, general and administrative expense

   13,685   6,827   3,334 
             

Income (loss) from operations

   (20,396)  (10,453)  1,116 
             

Other income (expense)

    

Interest expense

   (98)  (2,781)  (621)

Interest income

   2,736   2,061   52 

Gain on sale to affiliate

   2,500   —     —   

Other income

   8   6   16 
             

Total other income (expense)

   5,146   (714)  (553)
             

Income (loss) before taxes

   (15,250)  (11,167)  563 

Income tax benefit

   —     —     —   
             

Net income (loss)

  $(15,250) $(11,167) $563 
             

Net income (loss) per share:

    

Basic

  $(0.76) $(0.70) $0.06 

Diluted

  $(0.76) $(0.70) $0.04 

Weighted average common shares outstanding:

    

Basic

   20,185   16,048   9,924 

Diluted

   20,185   16,048   12,849 

See accompanying Independent Registered Public Accountant’s Report.

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

BASIN WATER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands)

   Common Stock  Additional
Paid-in Capital
  Treasury
Stock
  Accumulated
Deficiency
  Totals 
   Shares  Amount      

Balance—January 1, 2005

  9,586  $2,391  $—    $—    $(4,681) $(2,290)

Issuance of common stock

  717   3,584   —     —     —     3,584 

Fair value of options and warrants issued

  —     1,952   —     —     —     1,952 

Net income

  —     —     —     —     563   563 
                        

Balance—December 31, 2005

  10,303   7,927   —     —     (4,118)  3,809 

Issuance of common stock for services

  213   —     —     —     —     —   

Reincorporation at time of initial public offering

    (7,917)  7,917   —     —     —   

Net proceeds from sales of common stock in the initial public offering

  6,900   7   75,171   —     —     75,178 

Conversion of preferred stock to common

  2,362   3   8,776   —     —     8,779 

Stock options exercised

  110   —     163   —     —     163 

Stock-based compensation expense

  —     —     539   —     —     539 

Fair value of options issued

  —     —     495   —     —     495 

Fair value of warrants issued

  —     —     1,941   —     —     1,941 

Net loss

  —     —     —     —     (11,167)  (11,167)
                        

Balance—December 31, 2006

  19,888   20   95,002   —     (15,285)  79,737 

Stock options exercised

  225   —     527   —     —     527 

Warrants exercised

  1,389   2   8,058   —     —     8,060 

Stock-based compensation expense

  —     —     1,501   —     —     1,501 

Deferred stock compensation

  70   —     —     —     —     —   

Fair value of stock issued for acquisition

  462   —     5,266   —     —     5,266 

Repurchase of common stock

  (85)  —       (552)   (552)

Net loss

  —     —     —     —     (15,250)  (15,250)
                        

Balance—December 31, 2007

  21,949  $22  $110,354  $(552) $(30,535) $79,289 
                        

See accompanying Independent Registered Public Accountant’s Report.

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

BASIN WATER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

   Years Ended December 31, 
   2007  2006  2005 

Cash flows from operating activities

    

Net income (loss)

  $(15,250) $(11,167) $563 

Adjustments to reconcile net loss to net cash provided by operating activities:

    

Depreciation and amortization

   995   1,024   506 

Stock-based compensation expense

   1,706   744   31 

Gain on sale to affiliate

   (2,500)  —     —   

Issuance of warrants for services

   —     34   417 

Write off of loan acquisition costs

   —     401   —   

Changes in operating assets and liabilities:

    

Accounts receivable including unbilled

   (1,817)  (4,489)  (6,279)

Inventory

   103   (367)  (268)

Prepaid expenses and other

   (542)  (445)  (80)

Accounts payable

   1,600   (588)  1,468 

Deferred revenues

   (117)  (501)  (354)

Accrued expenses and other

   (1,515)  2,018   397 

Contract loss reserve

   3,550   3,725   —   

Net book value of systems sold

   4,091   636   —   

Issuance of notes receivable

   (3,353)  —     —   

Other assets and other liabilities

   (207)  (3,386)  (2,810)
           �� 

Net cash used in operating activities

   (13,256)  (12,361)  (6,409)
             

Cash flows from investing activities

    

Purchase of property, plant and equipment

   (5,347)  (3,942)  (1,913)

Acquisition of business, net of cash acquired

   (6,214)  —     —   

Collection of notes receivable

   —     100   325 

Patent costs

   (31)  (99)  (107)
             

Net cash used in investing activities

   (11,592)  (3,941)  (1,695)
             

Cash flows from financing activities

    

Issuance of common stock

   —     75,178   3,584 

Repurchase of common stock

   (552)  —     —   

Proceeds from employee stock option exercises

   527   162   —   

Proceeds from warrant exercises

   8,060   —     —   

Issuance of redeemable preferred stock

   —     —     596 

Proceeds from notes payable

   —     2,000   5,156 

Loan origination fees

   —     (100)  (100)

Repayments of notes payable and capital lease obligations

   (2,298)  (9,095)  (112)
             

Net cash provided by financing activities

   5,737   68,145   9,124 
             

Net increase (decrease) in cash and cash equivalents

   (19,111)  51,843   1,020 

Cash and cash equivalents, beginning of period

   54,567   2,724   1,704 
             

Cash and cash equivalents, end of period

  $35,456  $54,567  $2,724 
             

See accompanying Independent Registered Public Accountant’s Report.

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

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)

Note 1—Business Activity

Basin Water, Inc. and its subsidiaries (the Company) are providers of reliable, long-term process solutions for a range of customers which include designing, building, implementing, and servicing systems for the treatment of contaminated groundwater, the treatment of wastewater, waste reduction and resource recovery. Customers can choose between purchasing the Company’s systems or entering into long-term contracting arrangements for the Company’s systems.

The Company markets its treatment systems and services primarily to utilities, cities, municipalities, special districts, real estate developers and other organizations for use in treating groundwater that does not comply with federal or state drinking water regulations due to the presence of chemical contaminants. The Company markets its treatment systems and services through its direct sales force, independent contractors and strategic relationships. The Company’s customers include Arizona American Water, Aqua America, California Water Service Group and American States Water Company, four of the largest investor-owned water utilities in the United States based on population served.

In May 2006, the Company registered for sale and sold 6,900,000 shares of $0.001 par value common stock at a price of $12.00 per share in its initial public offering. After underwriting discounts and commissions and offering expenses in the amount of $7,600, the net proceeds from the Company’s initial public offering were approximately $75,200.

In connection with this initial public offering, all 2,361,625 shares of Series A and Series B preferred stock were converted into shares of common stock. After the initial public offering, the Company’s amended and restated certificate of incorporation provides for a total of 100,000,000 authorized shares of common stock, $0.001 par value. Also, immediately prior to the initial public offering, the Company reincorporated in Delaware.

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

Note 2—Summary of Significant Accounting Policies

Basis of Presentation and 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 certain reported

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)April 30, 2009

 

amounts of assets, liabilities, revenues and expenses, and related disclosures. Accordingly, actual results could differ from those estimates.

Reclassifications have been made to prior years’ financial statement presentation to conform to the current year presentation.

Revenue Recognition

The Company recognizes revenues in two different ways. For groundwater treatment systems that are sold to customers, revenues are recognized under the percentage-of-completion method by comparing actual costs incurred to total estimated costs to complete each system. The percentage-of-completion method recognizes revenues and associated costs as work progresses on a system, based on the expected total system revenues and costs. In general, financial statements based on the percentage-of-completion method present the economic substance of production-type activities more clearly than the use of the completed-contract method, and present the relationships between sales, cost of sales and related period costs more accurately. For all other groundwater treatment systems delivered to customers under various contractual arrangements, the Company recognizes revenues for a periodic fee received over the life of the contract using the straight-line method and recognizes a processing fee as the Company’s systems treat the customer’s contaminated water.

The Company recognizes revenues either from a sale of a system or as recurring revenues from a long-term contract under which a system is placed.

Sale. For treatment systems which are sold to customers under fixed-price contracts, the Company recognizes revenues using the percentage-of-completion method. This method takes into account the cost, estimated earnings and revenues to date on systems not yet completed. This method is used because management considers total cost to be the best available method of measuring progress on systems sold to customers. In general, financial statements based on the percentage-of-completion method present the economic substance of production-type activities more clearly than the completed-contract method, and present the relationships between sales, cost of sales and related period costs more accurately. Because of inherent uncertainties in estimating costs, estimates used may change within the near term. Such estimates are adjusted under the cumulative-catch-up method. Unless contractually agreed to otherwise, the sales contract is deemed to be substantially complete when the treatment system has been physically completed and a performance test has been passed. During the years ended December 31, 2007 and 2006, the Company incurred losses on the sale of certain groundwater treatment systems. The Company has recorded an estimated provision for anticipated losses on these groundwater treatment system sales as of December 31, 2007 and 2006.

Contract Revenue.The Company generates recurring contract revenues from three sources. The first source of recurring contract revenues is from long-term contracts under which the system is installed at the customer’s site and treats the customer’s water. We retain ownership of the installed system. Under this contract, the Company recognizes monthly revenues, on a straight-line basis over the life of the contract, which represents a return of the capital value of the installed system. The amount of this fixed monthly revenue is based on both the capacity of the system and the type of contaminant(s) being treated. The straight-line method best reflects the value of having the system’s capacity available to the customer at all times and is similar to the method used for calculating depreciation.

The second source of recurring revenues is from long-term contracts for the treatment of the water produced from installed treatment systems, which is also referred to as service revenues. Service revenues are recognized39

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

based on the actual volume of water treated each month. Such water-treatment revenues bear a direct relationship to the variable costs for the purchase and delivery of salt, chemicals and resin used in the system, the removal of waste and the cost to maintain and service the system. This revenue stream is generated both by systems that were purchased by the Company’s customers and by systems in which the Company retains ownership and recognizes revenue for the monthly capital component.

The third source of contract revenues relates to providing other services for the processing of water, replacement of resins or equipment parts and other water treatment related services.

Under each of the long-term contracts, the customer is obligated to pay the Company for the treatment of its water—not for specific hours worked, supplies purchased or waste-hauls provided. Certain of the Company’s long-term contracts allow it to recover increased operating costs, including costs for salt, resin and removal of waste.

Under the criteria set forth in EITF 00-21, the Company has determined that the multiple deliverables of each of its long-term contracts, specifically the capital component and the volume related service charge, qualify for separate accounting treatment. The three criteria required for separate accounting treatment are: 1) that each deliverable has a standalone value to the customer, 2) that there is objective and reliable evidence of fair value of each deliverable and 3) that there are no general refund rights for the deliverables.

In the case of contracts under which the Company owns the system, the customer is obligated to pay the Company the fixed capital component of the system on a monthly basis. These arrangements are classified and treated as operating leases under Statement of Financial Accounting Standards (SFAS) No. 13,Accounting for Leases, because they meet the four criteria of an operating lease: 1) there is no transfer of title; 2) there is not a bargain purchase option; 3) the lease term is substantially shorter than the economic life of the system; and 4) the present value of the capital component payments is less than 90% of the fair value of the water treatment system at the inception of the contract.

Accounts Receivable

In general, accounts receivable arising from systems sales to customers are due in accordance with the provisions of the sales contract, which may provide for extended payment terms ranging from several months to one year or more for a significant portion of the sales price. In contrast, accounts receivable from systems placed under long-term contracts with customers are usually due within a much shorter period of time, generally within one month after the date services have been performed and the customer has been billed. Accordingly, in periods in which the Company’s revenues from system sales are higher relative to revenues from long-term contracts, the collection of accounts receivable will be much slower due to the nature of the sales contracts. Management has assessed the collectability of accounts receivable and recorded an allowance for doubtful accounts of $596 and $500 based upon this assessment at the end of December 31, 2007 and 2006, respectively.

Inventory

Inventory consists primarily of raw materials and supplies. Inventory items are stated at the lower of cost, on a first-in, first-out (FIFO) basis, or market. Physical counts of inventory are conducted periodically to help verify the balance of inventory. A reserve is maintained for obsolete inventory, if appropriate. The Company considers inventory to be obsolete when it is no longer usable as a system component. There was no obsolete inventory at December 31, 2007 and 2006.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

Property and Equipment

Property and equipment is stated at cost less accumulated depreciation and amortization. Property consists primarily of treatment systems which the Company places with customers under various arrangements. For groundwater treatment systems placed with customers under long-term contracts, the Company capitalizes materials, labor, overhead and interest. Depreciation is calculated using the straight-line method over the estimated useful lives of the related assets.

The Company capitalizes expenditures for significant renewals and betterments that extend the useful lives of property and equipment. The Company charges expenditures for maintenance and repairs to expense as incurred. Estimated useful lives are generally as follows: auto equipment—three to five years; furniture and fixtures—five to seven years, other equipment—five to 10 years, and groundwater treatment systems—20 years. Judgments and estimates made by the Company related to the expected useful lives of these assets are affected by factors such as changes in operating performance and fluctuations in economic conditions.

Construction in progress is recorded when costs related to the construction of water treatment systems are incurred.

The Company evaluates long-lived assets for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount, the Company would measure an impairment loss in an amount equal to the excess of the carrying amount over the discounted cash flows. No impairment losses were recorded for the years ended December 31, 2007, 2006 and 2005.

Deferred Revenues

In connection with long-term contracts, the Company may receive payments from its customers prior to the system being placed in service. Such payments are recorded as deferred revenues. In addition, the Company may receive payments from its customers in excess of that which can be recognized on a straight-line basis. These payments are also recorded as deferred revenues. All deferred revenues amounts are recognized as revenues in the periods in which services are rendered to the customer.

Income Taxes

The Company accounts for income taxes pursuant to the asset and liability method under SFAS No. 109, Accounting for Income Taxes, which requires deferred income tax assets and liabilities to be computed annually for temporary differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Valuation of Intangible Assets and Goodwill

The Company assesses intangible assets, excluding goodwill, for recoverability in accordance with the provisions of SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144).

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

Such intangible assets are assessed for recoverability whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable through the estimated future discounted cash flows arising from the use of such assets. If the Company determines that the carrying value of intangible assets may not be recoverable, the amount of impairment expense is determined by using the projected discounted cash flow method in accordance with SFAS No. 144.

The Company tests goodwill for impairment in accordance with SFAS No. 142,Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 142 requires annual testing for impairment, or more frequent testing if events or circumstances indicate that carrying value of goodwill may not be recoverable. The Company evaluates goodwill for impairment using discounted cash flow methods, transaction values for comparable companies, and other recognized valuation techniques.

Patents

At December 31, 2007 and 2006, the Company has incurred cumulative legal fees in the amount of $626 and $387, respectively, as a result of application for a series of patents. At the time the patents are received, all costs incurred in obtaining the patents are then amortized over their estimated useful lives of 17 years. In addition, the Company acquired patents with a fair value of $1,812 as a result of the acquisition of MPT in September 2007. These acquired patents also have estimated remaining useful lives of 17 years. The amount of patent amortization expense was $29, $3 and $2 for the years ended December 31, 2007, 2006 and 2005, respectively.

Research and Development Expenses

Research and development expenses are charged to operations in the year incurred. Research and development expenses totaled $564, $634 and $651 for the years ended December 31, 2007, 2006 and 2005, respectively.

Stock-based Compensation

2006 Equity Incentive Award Plan

In May 2006, the Company adopted the Basin Water 2006 Equity Incentive Award Plan, or 2006 Equity Plan. The 2006 Equity Plan replaces the 2001 Stock Option Plan, and became effective immediately prior to the completion of the initial public offering in May 2006. Under the 2006 Equity Plan, 2,500,000 shares of the Company’s common stock were reserved for issuance. This replaces the 2,100,000 shares of common stock initially reserved under the 2001 Stock Option Plan.

2001 Stock Option Plan

On August 27, 2001, the Company established the Basin Water 2001 Stock Option Plan. Under the plan, 900,000 shares of Company common stock were initially reserved for issuance upon exercise of options pursuant to the plan. In June 2005, the plan was amended to increase the number of shares of Company common stock reserved for issuance to 2,100,000. In May 2006, the 2001 Stock Option Plan was replaced by the 2006 Equity Plan.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

Change in Accounting Principle

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R),Share-Based Payment. This statement requires the recognition of the fair value of stock-based compensation awards in financial statements. Under the provisions of SFAS No. 123(R), stock-based compensation expense is measured at the date of grant, based on the calculated fair value of the stock-based award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the award). The Company elected to adopt the modified prospective transition method as provided under SFAS No. 123(R). This method applies to all new awards or awards modified, repurchased or cancelled on or after January 1, 2006. Accordingly, financial statement amounts for the prior periods presented herein have not been restated to reflect the fair value method of expensing share-based compensation.

Redeemable Convertible Preferred Stock

The Company sold 149,250 shares of no par value Series B preferred stock for $4.00 per share during the year ended December 31, 2005. Also, at December 31, 2004, the Company had committed to issue an additional 37,500 shares of Series B preferred stock for which it had received proceeds of $4.00 per share as of that date. Such stock was issued in January 2005. Costs of the offering totaled $2 in 2005. Additionally, as part of the offering, the Company issued seven-year warrants to purchase 78,488 shares of Series B convertible stock at an exercise price of $4.40 per share. The estimated fair value of the warrants granted was determined to be approximately $61 based on the Black-Scholes valuation model. The warrants are fully exercisable and expire in 2010. In connection with the initial public offering in May 2006, all 2,361,625 shares of Series A and Series B preferred stock outstanding were converted into shares of common stock.

Impact of Recent Accounting Pronouncements

In June 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109(FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 became effective for the Company on January 1, 2007. The provisions of FIN 48 are to be applied to all tax positions upon initial application of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption. The cumulative effect of applying the provisions of FIN 48, if any, must be reported as an adjustment to the opening balance of retained earnings or other appropriate components of equity for the fiscal year of adoption. The adoption of FIN 48 had no material impact on the Company’s financial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements. This statement establishes a single authoritative definition of fair value, sets out framework for establishing fair value, and requires additional disclosures about fair value measurements. This statement applies only to fair value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements. Adoption of SFAS No. 157 is required for the Company’s fiscal year beginning January 1, 2008, and will be applied prospectively under most circumstances. The Company does not expect adoption of SFAS No. 157 to have a material impact on the Company’s financial statements.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 2—Summary of Significant Accounting Policies (continued)

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

In December 2007, the FASB issued SFAS No. 141(R),Business Combinations (SFAS No. 141 (R)). This statement replaces SFAS No. 141 in its entirety and retains the fundamental requirements in SFAS No. 141, including that the purchase method be used for all business combinations and for an acquirer to be identified for each business combination. This standard defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control instead of the date that the consideration is transferred. SFAS No. 141(R) requires an acquirer in a business combination, including business combinations achieved in steps (step acquisition), to recognize the assets acquired, liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values of that date, with limited exceptions. It also requires the recognition of assets acquired and liabilities assumed arising from certain contractual contingencies as of the acquisition date, measured at their acquisition-date fair values. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first reporting period beginning on or after December 15, 2008, and may not be applied before that date. The Company is currently evaluating the impact SFAS No. 141(R) could have 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) which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This statement is effective for the fiscal year beginning January 1, 2009 and will be applied prospectively. The Company does not expect adoption of SFAS No. 160 to have a material impact on its consolidated financial statements.

Note 3—Acquisition

On September 14, 2007, a newly formed subsidiary of the Company acquired 100% of the business of Mobile Process Technology Co., an Arkansas corporation based in Memphis, Tennessee, through the means of a merger agreement, and upon completion of the merger and acquisition, the business was renamed Basin Water-MPT, Inc. (MPT). MPT is a provider of technology and services to the water treatment and industrial process markets. This acquisition provides additional capabilities including expanded technological solutions, geographic presence and expanded customer base. The new company also provides the ability to service and treat smaller capacity water systems than the Company’s current product offering.

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

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 3—Acquisition (continued)

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

Current assets

  $2,585 

Property, plant and equipment

   2,191 

Goodwill

   8,682 

Intangible assets

   4,238 
     

Total assets acquired

   17,696 
     

Current liabilities

   (2,754)

Long-term debt

   (266)

Deferred income tax liability

   (2,268)

Other liabilities

   (179)
     

Total liabilities assumed

   (5,467)
     

Net assets acquired

  $12,229 
     

The net assets acquired in the table above represent cash consideration of $6,214 (net of cash acquired), $749 of cash acquired included in current assets above and common stock consideration of $5,266. The purchase price was allocated to net tangible and intangible assets acquired based on their estimated fair values, with approximately $4,200 allocated to intangible assets with a weighted-average useful life of approximately 11 years.

As of December 31, 2007, approximately $1,250 of the cash portion of the purchase price was placed into an escrow account as a reserve for unidentified liabilities of the acquired business. In February 2008, $326 was released from the escrow account to the Company, reducing the purchase price.

Such intangible assets consist of a covenant not to compete in the amount of $322 (three year useful life), trade name in the amount of $180 (two year useful life), service agreements and contracts in the amount of $1,355 (six year useful life), customer relationships in the amount of $569 (15 year useful life) and patents in the amount of $1,812 (17 year useful life). The excess of the net purchase price over the estimated fair value of assets acquired was approximately $8,700, which was recorded as non-tax deductible goodwill.

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

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 3—Acquisition (continued)

The unaudited pro forma condensed combined statements of operations table below reflects the results of operations of the Company and MPT for the years ended December 31, 2007, 2006 and 2005, as if the acquisition of MPT had occurred at the inception of each of the periods presented. Unaudited pro forma condensed combined statements of operations are not necessarily indicative of the results that would have been achieved had the transaction been consummated as of the date indicated or had the entities been a single entity during these periods. The unaudited pro forma statements of operations are not necessarily indicative of the results that may be achieved in the future.

   Years Ended December 31, 
   2007  2006  2005 
   (Unaudited pro forma) 

Revenues

  $23,199  $22,152  $16,082 
             

Net loss

  $(16,040) $(12,362) $(577)
             

Net loss per share

    

Basic

  $(0.78) $(0.75) $(0.06)

Diluted

  $(0.78) $(0.75) $(0.06)

Note 4—Earnings Per Share

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

The Company incurred a net loss for the years ended December 31, 2007 and 2006. As a result, approximately 529,000 and 719,000 shares issuable upon exercise of outstanding stock options, as well as 823,000 and 1,034,000 warrants and 0 and 908,000 shares of redeemable convertible preferred stock have been excluded from the computation of diluted EPS in 2007 and 2006, respectively, due to the antidilutive effect of such common stock equivalents.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 4—Earnings Per Share (continued)

Also, approximately 105,000 stock options have been excluded from the computation of diluted EPS for 2007, and approximately 414,000 stock options and 50,000 warrants have been excluded from the computation of diluted EPS for 2006 as the exercise prices of such options and warrants were higher than the weighted average price of the Company’s common stock during those years. The following tables contain a reconciliation of the numerators (net income or loss) and denominators (weighted average shares) used in both basic and diluted EPS calculations:

   Years Ended December 31,

Net income (loss) per share

  2007  2006  2005

Numerator:

    

Net income (loss) applicable to common shares

  $(15,250) $(11,167) $563
            

Denominator:

    

Weighted average common shares outstanding

   20,185   16,048   9,924
            

Net income (loss) per common share

  $(0.76) $(0.70) $0.06
            

Net income (loss) per share—assuming dilution

         

Numerator:

    

Net income (loss) applicable to common shares

  $(15,250) $(11,167) $563
            

Denominator:

    

Weighted average common shares outstanding

   20,185   16,048   9,924

Add shares issued on assumed:

    

Exercise of stock options

   —     —     391

Exercise of warrants

   —     —     196

Conversion of redeemable convertible preferred stock

   —     —     2,338
            

Weighted average common shares outstanding

   20,185   16,048   12,849
            

Net income (loss) per common share—diluted

  $(0.76) $(0.70) $0.04
            

Note 5—Concentrations of Risk

Cash

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company considers all highly liquid debt instruments with an original maturity of three months or less when purchased to be cash equivalents. The Company maintains its cash and cash equivalents with high-credit quality financial institutions. At times, such amounts may exceed federally insured limits. At December 31, 2007 and 2006, the Company had cash balances of $35,256 and $54,467, respectively, in excess of the FDIC insured limit. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on its cash equivalent accounts.

Major Customers

In 2007, the Company had three customers from which it received approximately 53% of revenues. The largest customer represented 26% of revenues. In 2006, the Company had two customers from which it received approximately 47% of revenues. The largest customer represented 30% of revenues. In 2005, the Company had

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 5—Concentrations of Risk (continued)

four customers from which it received approximately 71% of revenues. The largest customer represented 34% of revenues. At December 31, 2007 and 2006, accounts receivable from these same customers amounted to 53% and 48% of total accounts receivable, respectively.

Note 6—Inventory

Inventory consists primarily of raw materials and supplies used in the fabrication of the Company’s groundwater treatment units, as well as the reprocessing and conditioning of resins. Inventory items are stated at the lower of cost, on a first-in, first-out basis, or market. Physical counts of inventory items are conducted periodically to help verify the balance of inventory. A reserve is maintained for obsolete inventory, if appropriate. The Company considers inventory to be obsolete when it is no longer usable as a system component. The value of the Company’s inventory was $1,055 and $714 as of December 31, 2007 and 2006, respectively.

Note 7—Property and Equipment

Property and equipment consists of the following:

   December 31,
   2007  2006

Water treatment facilities

  $8,084  $7,945

Office furniture and equipment

   514   423

Vehicles and trailers

   501   206

Software and other

   704   186

Machinery and equipment

   1,921   95

Leasehold improvements

   169   —  

Construction in progress

   4,052   4,766
        
   15,945   13,621

Less: accumulated depreciation

   1,645   1,394
        

Property, plant and equipment, net

  $14,300  $12,227
        

Depreciation and amortization expense for property and equipment was approximately $670, $538, and $435 for the years ended December 31, 2007, 2006 and 2005, respectively.

Note 8—Equipment Placed with Customers

As indicated in Note 2, for those systems not sold to customers, the Company retains ownership of such systems and bills the customers a fixed monthly amount, which represents a return of the capital value of the installed system. These long-term contract arrangements are classified as operating leases, and the systems are depreciated over their estimated useful lives, typically 20 years. Equipment under such long-term arrangements and the related accumulated depreciation were as follows:

   December 31,
   2007  2006

Equipment on long-term contracts

  $8,084  $7,945

Less: accumulated depreciation

   931   951
        

Equipment on long-term contracts—net

  $7,153  $6,994
        

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 8—Equipment Placed with Customers (continued)

Depreciation expense for the systems placed under these long-term arrangements was approximately $412, $407 and $340 for the years ended December 31, 2007, 2006 and 2005, respectively.

The Company’s long-term contract arrangement terms are for five to ten years, with an option to renew or to purchase the system. The purchase option is not a bargain purchase. As of December 31, 2007, scheduled minimum future contract revenues on these operating lease arrangements with original terms of one year or longer are as follows:

Year Ending December 31,

  Amount

2008

  $1,045

2009

   1,056

2010

   813

2011

   622

2012

   471

Thereafter

   230
    

Total

  $4,237
    

The Company had no contingent long-term contract revenues during any of the years ended December 31, 2007, 2006 and 2005.

Note 9—Other Assets

Goodwill

The table below summarizes the changes in the carrying amount of goodwill for the year ended December 31, 2007:

Balance at December 31, 2006

  $—  

Acquisition of business during the period

   8,682
    

Balance at December 31, 2007

  $8,682
    

Long-term Accounts Receivable and Notes Receivable

The Company has four customer system sales agreements which provide for payment terms ranging from two to five years, unless certain conditions are met, in which case the payment terms are accelerated. At December 31, 2007 and 2006, the amount of long-term accounts receivable was $7,664 and $7,466, respectively, which represents the balance due from these four customers under the extended payment terms.

In 2004, in connection with the sale of a system, the Company received a $300 unsecured note that provides for interest at a rate of 3% per annum. The Company received a payment of $200 in connection with this note in 2005. The final principal payment of $100 became due in 2006, and as such, the note has been classified as current. The Company has reserved $67 of this note as of December 31, 2007 and 2006. Both the note and the related allowance for doubtful accounts have been classified as current assets and are included in the accounts receivable balance at December 31, 2007 and 2006.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 9—Other Assets (continued)

At December 31, 2007, long-term notes receivable consist of non-interest bearing notes receivable from VL Capital, due in 72 monthly installments of $63 beginning April 2008, with a net present value of $3,353, calculated using an imputed interest rate of 5.0% per annum.

Intangible Assets

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

   December 31,
   2007  2006

Deferred stock based compensation

  $189  $394

Fair value of warrants, net

   916   1,210

Service agreements and contracts

   1,299   —  

Customer relationships

   560   —  

Covenant not to compete

   295   —  

Trade name

   157   —  

Loan costs, net

   —     37
        

Intangible assets, net

  $3,416  $1,641
        

The amortization period of intangible assets are as follows: customer relationships—15 years; covenant not to compete—three years; trade name—two years; service agreements and contracts—six years; deferred stock-based compensation—three years; and fair value of warrants issued to a joint venture partner—five years.

Patent Costs

The Company capitalizes costs of patent applications. As a result of the September 2007 acquisition of MPT, the Company recorded an additional $1,812 representing the fair value of patents acquired. When patents are issued, the Company amortizes the patent cost over the life of the patent, usually 17 years. Future amortization of patent costs at December 31, 2007 is approximately $107 per year for each of the five years ended December 31, 2008 through 2013, and $107 each year thereafter through 2024. If a patent is denied, capitalized patent costs are written off in the period in which a patent application is denied.

Investment in Empire Water Corporation (Empire)

In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007.

The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company’s ownership interest in Empire. This reduction of approximately $1,900 has been recorded as deferred revenue—affiliate on the balance sheet of the Company at December 31, 2007.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 9—Other Assets (continued)

The Company has recorded its investment in Empire at approximately $4,500, while the amount of underlying equity in the net assets of Empire is approximately $3,000. The difference of approximately $1,500 represents the excess of the market value of the Company’s investment in Empire over the Company’s 32% interest in the net assets of Empire.

The following tables present summarized information concerning the assets, liabilities and results of operations of Empire for the most recent periods for which information is available:

   Dec 31,
2007
    

Assets

  $9,460  
      

Liabilities

  $101  
      
   Six Months
Ended
Dec 31,
2007
  Year
Ended
June 30,
2007
 

Revenues

  $  —  $—   
         

Net loss

  $(11) $(33)
         

Note 10—Notes Payable

Notes payable consist of the following:

   December 31, 
   2007  2006 

Aqua note, interest payable semi-annually at 7.0% per annum, principal due in full in May 2007

  $—    $2,000 

Contract payable to a financing company in monthly installments including interest at 1.9% per annum

     17 
         

Total notes payable

   —     2,017 

Less: current portion of notes payable

   —     (2,007)
         

Notes payable, net of current portion

  $—    $10 
         

Aqua Note

In February 2006, the Company issued a $2,000 subordinated note to Aqua America, Inc. (the Aqua Note). The Aqua Note was secured by substantially all of the Company’s assets, including its water contracts and water services agreements. The Aqua Note accrued interest at a rate of 7.0% per annum, payable on a semiannual basis beginning July 1, 2006. The Aqua Note matured on May 11, 2007 and was repaid in full, including all accrued interest.

In connection with a nationwide strategic relationship with Aqua America and issuance of the Aqua Note, the Company issued to Aqua America a warrant to purchase 300,000 shares of the Company’s common stock at

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 10—Notes Payable (continued)

an exercise price of $6.00 per share and a warrant to purchase 100,000 shares of the Company’s common stock at an exercise price of $7.00 per share. These warrants are immediately exercisable and expire on the earliest of November 11, 2008 and immediately prior to a change in control of the Company. The Company has applied the provisions of SFAS No. 123(R),Share-Based Payment, to the warrant issued to Aqua America. Accordingly, the total fair value of the warrant issued is approximately $568. The fair value of this warrant is being amortized over the term of the strategic relationship with Aqua America. Amortization expense of the fair value of this warrant was approximately $114 and $100 during the years ended December 31, 2007 and 2006, respectively.

Repayment of Notes Payable

Pursuant to the terms of a business loan agreement with BWCA I, LLC (the BWCA loan), after completion of the Company’s initial public offering in May 2006, the Company repaid $4,000 to BWCA I, LLC, plus all accrued interest. In addition, the remaining unamortized fair value of warrants issued to the lender in connection with the BWCA loan in the amount of $400 was written off in the second quarter of 2006, as the principal on the loan was repaid in full.

In accordance with the terms of the $5,000 in subordinated notes payable to The Co-Investment 2000 Fund, L.P., Cross Atlantic Technology Fund II, L.P. and Catalyst Basin Water, LLC (the XACP Notes), after completion of the Company’s initial public offering in May 2006, the Company repaid in full the XACP Notes, plus all accrued interest. In addition, the remaining unamortized fair value of warrants issued in connection with the XACP Notes in the amount of $1,100 was written off in the second quarter of 2006, as these notes were repaid in full.

Also, the remaining unamortized loan costs of $400 for the BWCA loan and the XACP Notes were written off in the second quarter of 2006, as the principal amount of these debt instruments was repaid in full.

Note 11—Capital Lease Obligations

The Company leases vehicles and certain office equipment under capital leases. The economic substance of the leases is that the Company is financing the acquisitions of vehicles and equipment through leases and, accordingly, they are recorded in the Company’s assets and liabilities. Included in depreciation expense is amortization of vehicles and equipment held under capital leases. At December 31, 2007, the net book value of assets subject to capital leases was $26.

The following is a schedule by year of the future minimum lease payments required under capital leases together with their present value as of December 31, 2007:

Year Ending December 31,

  Amount

2008

  $11

2009

   11

2010

   4

2011

   —  

2012

   —  

Thereafter

   —  
    

Total future capital lease payments

  $26
    

Net present value of minimum lease payments

  $26

Less: current portion of capital lease obligations

   11
    

Capital lease obligations, net of current portion

  $15
    

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 12—Contract Loss Reserve

Beginning in 2006, the Company determined that certain of its service contracts were operating at net cash flow losses, and that these contracts would continue to generate such losses. Accordingly, the Company recorded a reserve for future contract losses at the end of 2006 in the amount of approximately $3,700. An additional reserve for future contract losses in the amount of $4,700 (net of third quarter charges against the prior reserve) was recorded in the third quarter of 2007 as more service contracts entered into full operation. Actual losses on the underlying contracts are being charged against the reserve as incurred. Such charges against the reserve totaled approximately $1,400 during 2007. The reserve for future contract losses included on the balance sheet, both short and long term, as of December 31, 2007 was approximately $7,300.

Note 13—Income Taxes

The components of the provision for income taxes consisted of the following:

   Year Ended December 31, 
   2007  2006  2005 

Current:

    

Federal

  $(3,218) $(1,457) $(1,229)

State

   (854)  (321)  (323)
             
   (4,072)  (1,778)  (1,552)
             

Deferred:

    

Federal

   (1,488)  (1,981)  1,380 

State

   (415)  (659)  366 
             
   (1,903)  (2,640)  1,746 
             

Less: valuation allowance

   5,975   4,418   (194)
             

Income tax provision (benefit)

  $—    $—    $—   
             

A reconciliation of the U.S. statutory federal income tax rate to the effective income tax rate is as follows:

   Year Ended December 31, 
   2007  2006   2005 

U.S. federal statutory income tax rate

  34.0% 34.0%  34.0%

State taxes, net of federal income tax impact

  5.5% 5.8%  6.4%

Other

  (0.3)% (0.2)%  3.4%
           
  39.2% 39.6%  43.8%

Less: impact of valuation allowance

  (39.2) (39.6)%  (43.8)%
           

Effective income tax rate

  0.0% 0.0%  0.0%
           

At December 31, 2007, the Company has Federal and state income tax net operating loss carryforwards of approximately $25,900 and $25,200, respectively. The Federal net operating losses begin to expire in 2020. The California net operating losses have been suspended for two years and will begin to expire in 2010. Pursuant to the provisions of the Internal Revenue Code, the utilization of Federal net operating loss (NOL) carryforwards in future years may be subject to substantial annual limitations if a change of more than 50% in the ownership of the Company occurs. The Company has determined that, through the year ended December 31, 2007, there has been no ownership change of more than 50%. Accordingly, all NOL carryforwards are available to the Company.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 13—Income Taxes (continued)

The following summarizes the Company’s net deferred tax assets:

   December 31, 
   2007  2006 

Deferred tax assets:

   

NOL carryforwards

  $9,898  $6,678 

Contract loss reserve

   3,085   1,596 

Other reserves and allowances

   956   214 

Deferred revenues

   659   715 

Stock-based compensation

   277   332 

Other

   338   846 
         

Total deferred tax assets

   15,213   10,381 
         

Deferred tax liabilities:

   

Revenue recognition

   (2,383)  (2,709)

Intangible assets

   (1,631)  —   

Depreciation

   (1,367)  (848)

Other

   (557)  (532)
         

Total deferred tax liabilities

   (5,938)  (4,089)
         

Less: valuation allowance

   (11,543)  (6,292)
         

Net deferred income tax liability

  $(2,268) $—   
         

The valuation allowance increased approximately $5,251 in 2007 and $4,740 in 2006. Due to the uncertainty of the Company’s ability to utilize the net operating loss carryforwards, the Company has recorded a valuation allowance to offset the net deferred tax asset at December 31, 2007 and 2006.

In connection with the acquisition of MPT in September 2007, the Company recorded an increase to the book basis of certain assets to reflect fair value at the date of acquisition. However, the income tax basis of these assets–primarily property and equipment and intangible assets–is carried forward from the acquired entity. Accordingly, the Company has recorded a deferred income tax liability in the amount of $2,268 which represents the tax-effected difference between the book and income tax basis of those assets.

Note 14—Stockholders’ Equity

Common Stock

The Company is authorized to issue 100,000,000 common shares of $0.001 par value common stock, of which approximately 21.9 million and 19.9 million shares were issued and outstanding as of December 31, 2007 and 2006, respectively. As of December 31, 2007, there were also options outstanding to purchase 1,710,250 shares of common stock, and warrants outstanding to purchase 1,397,622 shares of common stock. Also, as of December 31, 2007, there were approximately 5,600,000 shares of common stock reserved for issuance upon exercise of all options, warrants and for future issuances under the 2006 Option Plan.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 14—Stockholders’ Equity (continued)

Initial Public Offering

In May 2006, the Company registered for sale and sold 6,900,000 shares of $0.001 par value common stock at a price or $12.00 per share in its initial public offering. After underwriting discounts and commissions and offering expenses in the amount of $7,600, the net proceeds from the Company’s initial public offering were approximately $75,200.

After the initial public offering, the Company’s amended and restated certificate of incorporation provides for a total of 100,000,000 authorized shares of common stock, $0.001 par value. Also, immediately prior to the initial public offering, the Company reincorporated in Delaware.

Other Sales of Common Stock

During the period from May 2005 through September 2005, the Company sold 717,000 shares of no par value common stock at a price of $5.00 per share. After offering costs in the amount of $1, the net proceeds from these stock sales were approximately $3,584.

Issuance of Non-Vested Stock

During the years ended December 31, 2007 and 2006, the Company issued non-vested common stock grants to certain of its officers and management, as well as to the members of its Board of Directors. The grants to officers and management are subject to a three-year vesting period from date of grant, with one-third of the stock vesting on the anniversary dates of the grants each year during the three-year period. The grants to directors are subject to a one-year vesting period.

The fair value of these non-vested stock grants is based on the grant date closing price of the Company’s common stock, and is recorded as stock-based compensation expense on a straight-line basis over the vesting period of each grant, with a corresponding credit to common stock and additional paid-in capital.

The fair value of non-vested common stock granted in 2007 and 2006 was $641 and $1,886, respectively. The amount of stock-based compensation expense recognized was $875 and $93 during the years ended December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006, the amount of unamortized grant date fair value of non-vested stock grants was $1,560 and $1,788, respectively. The unamortized amount of grant date fair value at December 31, 2007 will be amortized over a weighted average period of 1.7 years.

Repurchase of Common Stock

In May 2007, the Company’s Board of Directors authorized management to repurchase shares of the Company’s common stock in the market from time to time.

In November 2007, the Company repurchased 85,000 shares of its common stock at a price of $6.45 per share. These repurchased shares have been classified as treasury stock on the Company’s balance sheet as of December 31, 2007.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 15—Related Party Transactions

The Company paid legal fees to a legal firm whose partner is a director. The total payments for legal fees to this firm were $315, $192 and $154 for the years ended December 31, 2007, 2006 and 2005, respectively.

The Company also leases office space and equipment from two individuals, one of whom is a director and employee and the other an employee, under month-to-month agreements. The total payments under these related party rental agreements were $57, $54 and $55 for the years ended December 31, 2007, 2006 and 2005, respectively.

In May 2007, the Company entered into an agreement to acquire certain water rights and related assets. In December 2007, the Company sold its rights to purchase these assets to Empire. As consideration for the sale of these assets, the Company received 6,000,000 shares of Empire common stock, which represents an ownership interest of approximately 32% in Empire as of December 31, 2007.

The Company accounted for the December 2007 transaction under the equity method. Specifically, the Company recorded $2,500 as gain on sale to affiliate upon the receipt of the shares of Empire common stock by estimating the fair value of such stock based upon concurrent sales of Empire common stock to third parties, and reducing the fair value by the Company’s ownership interest in Empire.

In addition, Empire agreed to purchase one water treatment system from the Company concurrent with the December 2007 closing for a total price of $900. During the year ended December 31, 2007, the Company recorded $653 of system sales revenue and $287 of gross margin on this transaction under the percentage-of-completion method of revenue recognition. The Company has recorded $92 as a charge against other income under the equity method, which represents 32% of the Company’s gross margin on this system sale to a related party.

Note 16—Consolidated Statements of Cash Flows

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

   Years Ended December 31,
   2007  2006  2005

Supplemental disclosures of cash flow information:

     

Cash paid during the period for:

     

Interest

  $147  $727  $372
            

Income taxes

  $—    $—    $—  
            

Cash paid for acquisition:

     

Fair value of assets acquired

  $11,682  $—    $—  

Liabilities assumed

   (5,468)  —     —  
            

Cash paid for acquisition (net of cash acquired)

  $6,214  $—    $—  
            

Non-cash financing activities:

     

Common stock issued for acquisition

  $5,266  $—    $—  
            

Warrants issued for services and other

  $—    $1,941  $1,952
            

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 17—Stock-Based Incentive Compensation Plans

2006 Equity Incentive Award Plan

In May 2006, the Company adopted the Basin Water 2006 Equity Incentive Award Plan, or 2006 Equity Plan. The 2006 Equity Plan became effective immediately prior to the completion of the initial public offering in May 2006. The 2006 Equity Plan replaces the 2001 Stock Option Plan. Under the 2006 Equity Plan, 2,500,000 shares of the Company’s common stock were initially reserved for issuance. During 2007, the authorized number of shares under the 2006 Equity Plan was increase by approximately 995,000 shares. As of December 31, 2007, there were 2,451,925 shares of common stock reserved for issuance under the 2006 Equity Plan. Options issued under the plan are issued at the closing price of the stock on the date of the grant. Option grants are generally exercisable over three years, starting one year from the date of grant, and they expire 10 years from the date of grant.

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

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

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

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

Expected future earnings performance;

Liquidity and future capital requirements;

Stage of development and business strategy;

Marketplace developments and major competition;

Market barriers to entry;

Strategic relationships with third parties;

Size of workforce and related skills;

The illiquidity of the common stock; and

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

In connection with the Company’s initial public offering, the Company re-evaluated the historical fair value of its common stock. As a result of this re-evaluation, the Company recorded deferred stock-based compensation

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 17—Stock-Based Incentive Compensation Plans (continued)

for the years ended December 31, 2006 and 2005 in the amount of $401 and $229, respectively, which represents the difference between the exercise price of stock options granted in the first quarter of 2006 and in the fourth quarter of 2005 and the revised fair value of the common stock underlying such options on the date of grant.

Pursuant to FASB Interpretation (FIN) No. 28, the Company is amortizing these deferred compensation amounts using the straight-line attribution method over the vesting period of the options, which is generally three years. As a result of the amortization of the deferred compensation amounts, the Company recorded $205, $205 and $31 of non-cash stock-based compensation expense for the years ended December 31, 2007, 2006 and 2005, respectively.

Change in Accounting Principle

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R),Share-Based Payment. This statement requires the recognition of the fair value of stock-based compensation awards in financial statements. Under the provisions of SFAS No.123(R), stock-based compensation cost is measured at the date of grant, based on the calculated fair value of the stock-based award, and is recognized as expense over the employee’s requisite service period (generally the vesting period of the award). The Company elected to adopt the modified prospective transition method as provided under SFAS No.123(R). This method applies to all new awards or awards modified, repurchased or cancelled on or after January 1, 2006. Accordingly, financial statement amounts for the prior periods presented herein have not been restated to reflect the fair value method of expensing share-based compensation.

Prior to January 1, 2006, the Company accounted for stock-based compensation in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations. In addition, the Company complied with the disclosure only requirements of SFAS No. 123,Accounting for Stock-Based Compensation, as amended by SFAS No. 148,Accounting for Stock-Based Compensation—Transition and Disclosure.

Had the Company accounted for stock-based compensation awards issued prior to 2006 using the fair value based accounting method described in SFAS No. 123 for the periods prior to fiscal year 2006, the Company’s net income per share for the year ended December 31, 2005 would have been as follows:

   Year Ended
December 31,
2005
 

Net income as reported

  $563 

Add: employee stock-based compensation expense included in reported net income

   31 

Less: stock-based compensation expense determined using the fair-value accounting method

   (370)
     

Pro forma net income

  $224 
     

Basic earnings per share:

  

As reported

  $0.06 

Pro forma

  $0.02 

Diluted earnings per share:

  

As reported

  $0.04 

Pro forma

  $0.02 

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 17—Stock-Based Incentive Compensation Plans (continued)

The Company estimated the fair value of stock options granted during the years ended December 31, 2007, 2006 and 2005 using the Black-Scholes method. Key assumptions used to estimate the fair value of stock options include the exercise price of the award, the fair value of the Company’s common stock on the date of grant, the expected option term, the risk free interest rate at the date of grant, the expected volatility of the Company’s common stock over the expected option term, and the expected annual dividend yield on the Company’s common stock.

The fair value of each option grant during the years ended December 31, 2007, 2006, and 2005 was estimated on the date of grant using the following assumptions:

   Years Ended December 31,
   2007  2006  2005

Expected option term in years

  5.0 to 7.0  6.5 to 7.5  0.8 to 7.5

Risk free interest rate

  4.5% to 4.8%  4.3% to 5.0%  4.0% to 4.2%

Expected volatility

  26.9% to 28.4%  28.3% to 29.6%  30.0%

Expected dividend yield

  0.0%  0.0%  0.0%

The expected option term in years was calculated using an average of the vesting period and the option term, in accordance with the “simplified method” for “plain vanilla” stock options allowed under Staff Accounting Bulletin (SAB) 107. The risk free interest rate is the rate on a zero-coupon U.S. Treasury bond with a remaining term equal to the expected option term. The expected volatility was derived from an industry-based index, in accordance with the calculated value method allowed under SFAS No. 123(R).

SFAS No. 123(R) requires entities to estimate the number of forfeitures expected to occur and record expense based upon the number of awards expected to vest. Prior to adoption of SFAS No. 123(R), the Company accounted for forfeitures as they occurred, as permitted under SFAS No. 123. The cumulative effect of adopting the method change of estimating forfeitures is not material to the Company’s financial statements for the year ended December 31, 2006.

Stock Option Activity

A summary of stock option activity for the years ended December 31, 2007 and 2006 is as follows:

(In thousands, except exercise prices)

  Number
of Shares
  Weighted
Average
Exercise
Price

Options outstanding at December 31, 2005

  1,209  $3.15

Granted

  554   7.55

Exercised

  (110)  1.48

Forfeited

  (125)  5.00
     

Options outstanding at December 31, 2006

  1,528   4.72

Granted

  466   8.18

Exercised

  (224)  2.36

Forfeited

  (60)  7.60
     

Options outstanding at December 31, 2007

  1,710  $5.85
     

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 17—Stock-Based Incentive Compensation Plans (continued)

The following table summarizes information about stock options outstanding and exercisable as of December 31, 2007:

(In thousands, except exercise prices)

  Outstanding  Exercisable

Number of shares

   1,710   841

Weighted average remaining contractual life in years

   7.7   6.1

Weighted average exercise price per share

  $5.85  $3.61

Aggregate intrinsic value (at December 31, 2007 closing price of $8.27 per share)

  $4,138  $3,919

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the Company’s closing stock price as of December 31, 2007 and the weighted average exercise price multiplied by the number of shares) that would have been received by the option holders had all option holder exercised their options on December 31, 2007. This intrinsic value will vary as the Company’s stock price fluctuates.

The weighted average grant-date fair value of options granted by the Company during the years ended December 31, 2007 and 2006 was $2.94 and $1.88 per share, respectively.

Compensation expense arising from stock option grants was $626 and $539 for the years ended December 31, 2007 and 2006, respectively, all of which expense was included in selling, general and administrative expense for each year. No related income tax benefit was recorded as the Company has significant net operating loss carryforwards (see Note 13).

As of December 31, 2007, approximately $1,588 of unrecognized compensation expense related to stock options is expected to be recognized over a weighted average period of 1.3 years. The total fair value of options vested during the years ended December 31, 2007 and 2006 was $195 and $494, respectively.

   Options Outstanding  Options Exercisable

Exercise Price

  Number of
Options
Outstanding
  Weighted
Average
Exercise
Price
  Weighted
Average
Remaining
Contractual
Life of Options
Outstanding
  Number of
Options
Exercisable
  Weighted
Average
Exercise
Price

$0.83 - $1.33

  247  $1.00  3.7 yrs  247  $1.00

$4.00

  308  $4.00  6.4 yrs  292  $4.00

$5.00

  325  $5.00  7.6 yrs  271  $5.00

$6.79 - $9.00

  725  $7.87  9.3 yrs  31  $8.49

$9.87 - $12.29

  105  $11.33  9.6 yrs  —    
            
  1,710  $5.85    841  $3.61
            

The total intrinsic value of stock options exercised during the years ended December 31, 2007 and 2006 was $1,736 and $629, respectively.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 17—Stock-Based Incentive Compensation Plans (continued)

Non-vested Stock

Under the 2006 Equity Plan, the Company has granted non-vested common stock to management, officers and directors, which is subject only to a service condition. In general, such non-vested stock vests over three years for management and one year for directors. The total cumulative number of shares of non-vested stock granted under the 2006 Equity Plan through December 31, 2007 is 283,125, of which 70,999 shares had vested as of December 31, 2007.

The fair value of non-vested stock is measured at the date of grant based upon the closing price of the Company’s common stock on that date, and such fair value is recognized as stock-based compensation expense over the requisite vesting period. Compensation expense arising from grants of non-vested stock during the years ended December 31, 2007 and 2006 was $875 and $93, respectively. As of December 31, 2007, approximately $1,560 of unrecognized compensation expense related to non-vested stock grants is expected to be recognized over a weighted average period of 1.7 years.

2001 Stock Option Plan

On August 27, 2001, the Company established the Basin Water 2001 Stock Option Plan. Under the plan, 900,000 shares of the Company’s common stock were initially reserved for issuance upon exercise of options pursuant to the plan. In June 2005, the plan was amended to increase the number of shares of Company common stock reserved for issuance to 2,100,000. In May 2006, the 2001 Stock Option Plan was replaced by the 2006 Equity Plan, and no further shares may be issued from the 2001 Stock Option Plan.

Note 18—Warrants

From time to time, the Company has issued common stock warrants to non-employees in connection with various transactions, primarily the issuance of notes payable (see Note 15). During the year ended December 31, 2007, the holders of 1,350,000 warrants exercised such warrants, resulting in net proceeds to the Company of $8,060. In addition, during the year ended December 31, 2007, the holders of 56,066 warrants elected cashless exercise of such warrants, and the Company issued 38,995 shares of common stock in these cashless exercises. A summary of common stock warrant activity during the three years ended December 31, 2007 is as follows:

   Warrants
Outstanding
  Weighted
Average
Exercise Price

Balance—January 1, 2005

  874  $4.01

Warrants issued

  1,480  $6.06
     

Balance—December 31, 2005

  2,354  $5.30

Warrants issued

  450  $6.44
     

Balance—December 31, 2006

  2,804  $5.48

Warrants issued

  —    

Warrants exercised

  (1,406) $5.87
     

Balance—December 31, 2007

  1,398  $5.10
     

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 18—Warrants (continued)

The Company has applied the provisions of SFAS No. 123(R) to estimate the fair market value of both the common stock and preferred stock warrants on the date of issuance using the Black Scholes option-pricing model with the following assumptions:

   Years Ended December 31,
   2007  2006  2005

Expected life in years

  —    2.5  2.5 to 3.0

Risk free interest rate

  —    3.8%  3.8%

Volatility

  —    30.0%  30.0%

Dividend yield

  —    0.0%  0.0%

The expected life in years was calculated using an average of the vesting period and the option term, in accordance with the “simplified” method for “plain vanilla” stock options allowed under SAB 107. The risk-free interest rate is the rate on a zero-coupon U.S. Treasury bond with a remaining term equal to the expected life of the option. The volatility was derived from an industry-based index, in accordance with the calculated-value method allowed under SFAS No. 123(R).

As a result of these computations of the fair value of warrants issued, the following amounts have been recorded in the financial statements:

Warrants to purchase 717,450 shares of stock issued to the lender under the BWCA loan in 2003 and 2004 with an aggregate fair value of $435 have been recorded as a discount to debt with a corresponding credit to common stock, and this discount was being amortized to interest expense over the life of the BWCA loan until after completion of the Company’s initial public offering in May 2006, when the Company repaid the BWCA loan in full pursuant to the terms of a business loan agreement with BWCA I, LLC. The remaining unamortized fair value of warrants in the amount of $392 was written off in the second quarter of 2006 (see Note 10).

Warrants to purchase 1,000,000 shares of stock issued to the purchasers of the XACP Notes in October 2005 with an aggregate fair value of $1,337 have been recorded as a discount to debt with a corresponding credit to common stock, and this discount was being amortized to interest expense over the life of the XACP Notes until after completion of the Company’s initial public offering in May 2006, when the Company repaid the XACP Notes in full pursuant to the terms of a business loan agreement with BWCA I, LLC. The remaining unamortized fair value of warrants in the amount of $1,132 was written off in the second quarter of 2006 (see Note 10).

Pursuant to a $1,500 binding commitment letter with a customer in September 2005, the customer committed to purchase two of the Company’s groundwater treatment systems. As part of this transaction, the Company granted to the customer a warrant to purchase 180,000 shares of common stock at an exercise price of $5.50 per share. This warrant is fully vested upon issuance, and may be exercised for five years after the date of grant. This warrant has a fair value of $168, which is being recorded as a charge to revenues as the related revenues are recognized. Such charges totaled $14 and $154 during the years ended December 31, 2006 and 2005, respectively.

Pursuant to a binding commitment letter with Shaw Environmental, Inc. (Shaw) in December 2005, Shaw committed to purchase a total of $5,000 of the Company’s groundwater treatment systems prior to December 31, 2006. The Company granted to Shaw a warrant to purchase 300,000 shares of common stock at an exercise price of $7.00 per share in connection with Shaw’s purchase of the

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 18—Warrants (continued)

Company’s groundwater treatment systems. One-fifth (20%) of this warrant vests for each $1,000 paid in cash by Shaw to the Company in connection with this $5,000 purchase commitment, and may be exercised for five years after the date of grant. As of December 31, 2007, no shares had vested under the Shaw warrant. This warrant has a fair value of $537, which is being recorded as a charge to revenues as the related revenues are recognized under the $5,000 shares under purchase commitment. Such charges totaled $342 and $173 during the years ended December 31, 2006 and 2005, respectively.

In February 2006, in connection with the consent granted by BWCA I, LLC with respect to the Company’s issuance of the Aqua Note, the Company granted to BWCA I, LLC a warrant to purchase 50,000 shares of the Company’s common stock at an exercise price of $8.00 per share. This warrant is immediately exercisable and may be exercised for five years after the date of grant. This warrant has a fair value of $91, and was written off with the repayment of the BWCA loan in the second quarter of 2006 (see Note 10).

Warrants to purchase 400,000 shares of stock issued to Aqua America in connection with a nationwide strategic relationship with Aqua America and issuance of the Aqua Note in February 2006 with an aggregate fair value of $568 have been recorded as an asset, and are being amortized to selling expense over the life of the nationwide strategic relationship.

To the extent that the deemed fair value of the common stock exceeds the exercise price of warrants on the date of the grant, the Company records deferred charges and amortizes such deferred charges over the life of the underlying transaction with which the warrants were issued. Prior to the Company’s initial public offering in May 2006, the fair value of the Company’s common stock was determined by the Board.

In the absence of a public trading market prior to the initial public offering for the Company’s common stock, the Board considered both objective and subjective factors in determining the fair value of the Company’s common stock and related warrants. Consistent with the guidance provided by the American Institute of Certified Public Accountants in its Technical Practice Aid (TPA) entitled The Valuation of Privately Held Company Equity Securities Issued as Compensation, such considerations included, but were not limited to, the following factors:

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

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

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

Expected future earnings performance;

Liquidity and future capital requirements;

Stage of development and business strategy;

Marketplace developments and major competition;

Market barriers to entry;

Strategic relationships with third parties;

Size of workforce and related skills;

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 18—Warrants (continued)

The illiquidity of the common stock; and

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

In connection with the Company’s initial public offering, the Company re-evaluated the historical fair value of its common stock. As a result of this re-evaluation, the Company recorded deferred charges for warrants issued during the years ended December 31, 2006 and 2005 in the amounts of $925 and $60, respectively, which represent the difference between the exercise price of warrants granted in the first quarter of 2006 and in the fourth quarter of 2005 and the revised fair value of the common stock underlying such warrants on the date of grant. Pursuant to FASB Interpretation (FIN) No. 28, the Company is amortizing such deferred charges over the appropriate period of the underlying transaction.

The deferred charges recorded in the fourth quarter of 2005 related to the warrants granted to Shaw totaled $60. The Company recorded $39 and $18 of non-cash charges against revenues in the years ended December 31, 2006 and 2005 respectively. There was no amortization of these deferred charges during the year ended December 31, 2007. As of December 31, 2007, the remaining unamortized deferred charge related to the Shaw warrants was $3, which will be amortized as charges to revenues as the remaining revenues are recognized under the $5,000 Shaw purchase commitment.

Deferred charges recorded in the first quarter of 2006 related to the warrants granted to BWCA I, LLC totaled $25. The Company amortized this amount in full as non-cash interest expense during the year ended December 31, 2006.

Additionally, the Company recorded $900 of deferred charges in the first quarter of 2006 related to the warrants granted to Aqua America. The Company amortized $180 and $158 of these deferred charges as selling expense during the years ended December 31, 2007 and 2006, respectively. As of December 31, 2007 and 2006, the remaining unamortized deferred charge balances related to the Aqua America warrants were $562 and $742, respectively, which will be amortized as selling expense over the remaining life of the nationwide strategic alliance with Aqua America. Future amortization expense of the deferred charges related to the Aqua America warrants will be $180 during each of the years ending December 31, 2008, 2009 and 2010 and $22 during the year ending December 31, 2011.

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 19—Commitments and Contingencies

Customer Contracts

The Company has long-term water treatment contracts with various customers. Under the terms of these contracts, the Company is entitled to monthly standby fees from these customers for periods ranging from three to five years. Additionally, the Company has received prepayments in conjunction with certain long-term treatment contracts. These prepayments are recorded as deferred revenues. As of December 31, 2007, deferred revenues are expected to be recognized as revenues in future years as follows:

Year Ending December 31,

  Amount

2008

  $266

2009

   235

2010

   169

2011

   169

2012

   164

Thereafter

   488
    

Total

  $1,491
    

Operating Leases

The Company has entered into operating leases for office space, facilities and equipment. The office space lease agreements provide for extensions of the leases. The facility lease requires payment of common area maintenance, insurance and property taxes in addition to rental payments. The total gross rental expense for all operating leases for the years ended December 31, 2007, 2006 and 2005 was $441, $254 and $173, respectively. As of December 31, 2007, the minimum future payments under these operating leases are as follows:

Year Ending December 31,

  Amount

2008

  $645

2009

   740

2010

   734

2011

   560

2012

   369

Thereafter

   34
    

Total

  $3,082
    

Litigation

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

BASIN WATER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(In thousands, except share and per share data)

Note 20—Selected Quarterly Financial Information (Unaudited)

Selected unaudited quarterly consolidated financial information is presented in the tables below:

   Year Ended December 31, 2007 

(In thousands, except per share data)

  1st
Quarter
  2nd
Quarter
  3rd
Quarter
  4th
Quarter
 

Revenues

  $1,607  $6,414  $5,346  $5,417 

Gross profit (loss)

   (287)  25   (6,779)  894 

Net loss

   (2,157)  (1,789)  (9,868)  (1,436)

Net loss per share:

     

Basic

  $(0.11) $(0.09) $(0.50) $(0.07)

Diluted

  $(0.11) $(0.09) $(0.50) $(0.07)
   Year Ended December 31, 2006 

(In thousands, except per share data)

  1st
Quarter
  2nd
Quarter
  3rd
Quarter
  4th
Quarter
 

Revenues

  $3,703  $4,963  $4,846  $3,602 

Gross profit (loss)

   1,147   1,398   309   (5,846)

Net loss

   (371)  (1,990)  (781)  (8,025)

Net loss per share:

     

Basic

  $(0.04) $(0.14) $(0.04) $(0.41)

Diluted

  $(0.04) $(0.14) $(0.04) $(0.41)

Note 21—Subsequent Event

On February 19, 2008 (the Separation Date), the Company entered into an Employment Transition and Consulting Agreement (the Transition Agreement) with its former chief executive officer. The Transition Agreement provides the former chief executive officer with the following benefits: (1) he will receive a cash lump sum payment of $423, (2) the Company will pay for his healthcare insurance for 18 months following the Separation Date (or until he accepts employment with another employer providing comparable benefits), (3) he will be retained as a consultant to the Company for two years after the Separation Date for which he will receive $200 per year (payable each year in 12 equal monthly installments), (4) he will be entitled to receive compensation for his services as a director in accordance with the Company’s Amended and Restated Director Compensation Policy for non-employee directors, (5) he will be entitled to retain all Company personal property, including computer equipment, printers, cameras and a used Company truck, that is in his possession as of the Separation Date and (6) he will not be entitled to any further benefits under his employment agreement in effect prior to the Separation Date except as provided in the Transition Agreement.

BASIN WATER, INC.

Schedule II—Valuation and Qualifying Accounts

(In thousands)

   Balance at
Beginning
of Year
  Valuation
Account
Increases
  Valuation
Account
Decreases
  Balance
at End of
Year

Valuation allowance for net deferred tax assets:

       

Year ended December 31, 2005

  $1,868  $—    $(316) $1,552

Year ended December 31, 2006

  $1,552  $4,740  $—     6,292

Year ended December 31, 2007

  $6,292  $5,251  $—    $11,543
   Balance at
Beginning
of Year
  Valuation
Account
Increases
  Valuation
Account
Decreases
  Balance
at End of
Year

Allowance for doubtful accounts:

       

Year ended December 31, 2005

  $—    $—    $—    $—  

Year ended December 31, 2006

  $—    $500  $—    $500

Year ended December 31, 2007

  $500  $96  $—    $596
   Balance at
Beginning
of Year
  Valuation
Account
Increases
  Valuation
Account
Decreases
  Balance
at End of
Year

Contract loss reserve:

       

Year ended December 31, 2005

  $—    $—    $—    $—  

Year ended December 31, 2006

  $—    $3,725  $—    $3,725

Year ended December 31, 2007

  $3,725  $5,005  $(1,455) $7,275

F-38