NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
| | | Shares | | Weighted average exercise price | | Weighted average remaining contract term (years) | |
| Warrants outstanding at December 31,2007 | | | 2,588,391 | | $ | 4.39 | | | 2.1 | |
| Granted | | | 12,163,881 | | $ | 2.60 | | | 5.0 | |
| Exercised | | | - | | $ | - | | | - | |
| Forfeited or lapsed | | | (473,500 | ) | $ | 2.00 | | | 0 | |
| Warrants outstanding at September 30, 2008 | | | 14,278,772 | | $ | 2.94 | | | 4.2 | |
The Company’s certificate of incorporation authorizes the issuance of 12,500,000 shares of blank check preferred stock. The Company’s board of directors has the power to establish the designation, rights and preferences of any preferred stock. Accordingly, the board of directors has the power, without stockholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of common stock.
At September 30, 2008, 137,500 shares of 8% Cumulative Convertible Senior Preferred stock were issued and outstanding. During 2008, $104,970 in dividends was accrued, bringing the stated value of that preferred stock to $13.23 / share.
During 2008, 104,000 shares of Series A Convertible Preferred Stock were converted to the Company’s common stock, par value $0.0001 per share. A 20% dividend rate was accrued to the account of the shareholder through December 2007. Beginning in March 2008 upon bringing our filing status current, the dividend accrual reduced to 10%. At September 30, 2008, 718,997 shares of Series A Convertible Preferred stock were issued and outstanding. During 2008, $738,260 in dividends was accrued, bringing the stated value of that preferred stock to $13.25 / share.
In December 2004, the Financial Accounting Standards Board issued FASB 123R, “Share-Based Payment” (“SFAS 123R”). SFAS 123R supersedes SFAS 123, and Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”) and its related implementation guidance. On January 1, 2006, the Company adopted the provisions of SFAS 123R using the modified prospective transition method. Under this method, compensation expense is recorded for all stock based awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding as of the beginning of the adoption. Prior periods have not been restated for the effects of SFAS 123R. Under SFAS 123R, employee-compensation expense related to stock based payments are recorded over the requisite service period based on the grant date fair value of the awards.
The Company’s accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18 “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees.” The measurement date for fair value of the equity instruments is determined by the earlier of (i) the date at which commitment for performance by the vendor or consultant is reached or (ii) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.
The Company has adopted an incentive stock option plan covering an aggregate of 2,000,000 shares of common stock that authorizes a variety of awards including incentive stock options, non-qualified stock options, shares of restricted stock, shares of phantom stock and stock bonuses. The Company has also adopted an outside directors’ stock option plan covering an aggregate of 500,000 shares of common stock which provides that each eligible director will automatically be granted an option to purchase shares having an aggregate fair market value on the date of grant of twenty thousand dollars ($20,000) for each year of his term in office. From time to time, based on the recommendations of the compensation committee of the board of directors, the Company enters into non-plan equity incentive agreements with officers, employees, attorneys and third party consultants.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
During the period ended September 30, 2008, the Company issued a total of 610,000 contractual stock options as follows:
In June 2008, Equity Awards were issued as part of a restructuring of key employee contracts that was designed to provide for the long term stability of the Company:
Our Chief Executive Officer, Thomas Granville, was granted a contractual option to purchase an additional 90,000 shares of our common stock at a price of $2.50 per share. The options vest prorated over the 24-month term of his contract, and are exercisable for a period of five years from the vesting date. These options are valued at $79,872, utilizing the Black-Scholes-Merton option pricing model with $23,296 of compensation expected to be recorded in 2008.
Our Chief Technical Officer, Edward Buiel, was granted a contractual option to purchase an additional 100,000 shares of our common stock at a price of $2.50 per share. The options cliff vest on May 31, 2011, and are exercisable for a period of five years from the vesting date. These options are valued at $95,436, utilizing the Black-Scholes-Merton option pricing model with $18,557 of compensation expected to be recorded in 2008.
Our Chief Financial Officer, Donald Hillier, was granted an option to purchase 180,000 shares of our common stock. The exercise price of the option is $2.50 per share and the option vests at the rate of 5,000 shares per month through the term of the Employment Agreement and are exercisable for a period of 5 years from the vesting date. These options are valued at $179,244, utilizing the Black-Scholes-Merton option pricing model with $34,853 of compensation expected to be recorded in 2008.
Three employees were granted contractual options to purchase an additional 200,000 shares of our common stock at a price of $2.50 per share. 5,000 of these options vested in June upon execution of the employment contracts, with the balance cliff vesting on June 15, 2011, and are exercisable for a period of three years from the vesting date. These options are valued at $165,041, utilizing the Black-Scholes-Merton option pricing model with $34,222 of compensation expected to be recorded in 2008.
The assumptions noted in the following table were used for the options granted for the period ended September 30, 2008.
| Risk-free interest rate | | | 3.4 | % |
| Dividend yield | | | 0 | |
| Expected volatility | | | 50.5 | % |
| Expected term (in years) | | | 5.0 | |
The compensation cost that has been charged against income for options was $227,507 for the period ended September 30, 2008. The impact of this expense was to increase basic and diluted loss per share by $0.011 for the period ended September 30, 2008. The adoption of SFAS 123R did not have an impact on cash flows from operating or financing activities.
A tax deduction is recognized for non-qualified stock options when the options are exercised. The amount of this deduction will be the excess of the fair value of the Company’s common stock over the exercise price at the date of exercise. Accordingly, there is a deferred tax asset recorded related for the tax effect of the financial statement expense recorded. The tax effect of the income tax deduction in excess of the financial statement expense will be recorded as an increase to additional paid-in capital. Due to the uncertainty of the Company’s ability to generate sufficient taxable income in the future to utilize the tax benefits of the options granted, the Company has recorded a valuation allowance to reduce gross deferred tax asset to zero. As a result for the period ended September 30, 2008, there is no income tax expense impact from recording the fair value of options granted. There is no tax deduction allowed by the Company for incentive stock options held to term.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The following table provides summary information on all outstanding options as of September 30, 2008, based on the grant date for options.
| | | Shares | | Weighted average exercise price | | Weighted average fair value | | Weighted average remaining contract term (years) | | Aggregate intrinsic value | |
| Options outstanding at December 31,2007 | | | 1,850,885 | | $ | 4.81 | | $ | 1.00 | | | 2.7 | | | | |
| Granted | | | 610,000 | | $ | 2.63 | | $ | 0.89 | | | 5.2 | | | | |
| Exercised | | | (0 | ) | $ | 0.00 | | $ | 0.00 | | | - | | | | |
| Forfeited or lapsed | | | (0 | ) | $ | 0.00 | | $ | 0.00 | | | - | | | | |
| Options outstanding at September 30, 2008 | | | 2,460,885 | | $ | 4.27 | | $ | 0.98 | | | 3.0 | | $ | 0 | |
| Options exercisable at September 30, 2008 | | | 1,627,885 | | $ | 4.76 | | $ | 0.94 | | | 1.6 | | $ | 0 | |
The weighted-average grant date fair value of options granted during the period ended September 30, 2007 was $.75. The total intrinsic value of options exercised during the period ended September 30, 2007 was $0.00.
The following table provides summary information on all non-vested stock options as of September 30, 2008
| | | All Plan & Non-Plan Compensatory Options | |
| | | Shares | | Weighted average grant date fair value | |
| Options subject to future vesting at December 31,2007 | | | 408,500 | | $ | 1.25 | |
| Options granted | | | 610,000 | | $ | 0.89 | |
| Options forfeited or lapsed | | | ( 0 | ) | $ | - | |
| Options vested | | | ( 185,500 | ) | $ | 1.00 | |
| Options subject to future vesting at September 30, 2008 | | | 833,000 | | $ | 1.04 | |
As of September 30, 2008, there was $865,820 of unrecognized compensation related to non-vested options granted under the plans. The Company expects to recognize the cost over a weighted average period of 1.5 years. The total fair value of options which newly vested during the period ended September 30, 2008 was $185,182 ($236,054 during the comparable period ended September 30, 2007).
| 6. | Earnings/Loss Per Share |
Basic earnings per share is computed by dividing income available to common shareholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) for the period. Diluted earnings per share are computed by assuming that any dilutive convertible securities outstanding were converted, with related preferred stock dividend requirements and outstanding common shares adjusted accordingly. It also assumes that outstanding common shares were increased by shares issuable upon exercise of those stock options for which the market price exceeds the exercise price, less shares which could have been purchased by us with the related proceeds. In periods of losses, diluted loss per share is computed on the same basis as basic loss per share as the inclusion of any other potential shares outstanding would be anti-dilutive.
If the Company had generated earnings during the period ended September 30, 2008, the Company would have added 9,614,969 common equivalent shares to the weighted average shares outstanding to compute the diluted weighted average shares outstanding. If the Company had generated earnings during the period ended September 30, 2007, the Company would have added 8,988,786 common equivalent shares to the weighted average shares outstanding to compute the diluted weighted average shares outstanding.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
| 7. | Comprehensive Income and Significant Non-Cash Transactions |
Statement of Financial Accounting Standard No. 130, “Reporting Comprehensive Income,” establishes standards for reporting comprehensive income and its components in a financial statement. Comprehensive income as defined includes all changes in equity (net assets) during a period from non-owner sources.
The components of comprehensive loss for the year-to-date periods ended September 30, 2008 and 2007 are as follows:
| | | 2008 | | 2007 | |
| Deficit accumulated during development stage | | $ | ( 8,317,348 | ) | $ | ( 11,896,620 | ) |
| Foreign currency translation adjustment | | $ | ( 4,249 | ) | $ | 21,099 | |
| Comprehensive Income/(loss) | | $ | ( 8,321,597 | ) | $ | ( 11,875,521 | ) |
| | | 2008 | | 2007 | |
| Satisfaction of 2007 liability to issue equity instruments | | $ | 103,339 | | $ | - | |
| Preferred converted to common stock | | $ | 1,338,875 | | $ | - | |
| Preferred Dividends attributable to warrant modifications | | $ | - | | $ | 164,179 | |
| Dividend accrued to preferred stock - Senior | | $ | 104,970 | | $ | 96,948 | |
| Dividend accrued to preferred stock - Series A | | $ | 738,260 | | $ | 1,308,667 | |
| Warrants issued for commission on sale of stock | | $ | 1,193,735 | | $ | 53,230 | |
| Beneficial conversion feature on preferred stock | | $ | - | | $ | 6,496,634 | |
| Fair value of warrants issued with related party note | | $ | 601,753 | | $ | 130,589 | |
| Origination fees issued with related party note | | $ | 7,500 | | $ | - | |
| Notes payable converted to common stock | | $ | 1,072,916 | | $ | - | |
| Interest converted to common stock | | $ | 7,768 | | | | |
| 8. | Commitments and Contingencies |
Employment Agreements: We have entered into executive employment agreements with Thomas Granville, Edward Buiel, Andrew Carr Conway, Jr., Robert Nelson and Donald T. Hillier; however, our agreement with Mr. Conway terminated on July 4, 2008. These agreements generally require each executive to devote substantially all of his business time to our affairs, establish standards of conduct, prohibit competition with our company during their term, affirm our rights respecting the ownership and disclosure of patents, trade secrets and other confidential information, provide for the acts and events that would give rise to termination of such agreements and provide express remedies for a breach of the agreement. Each of our executives will participate, without cost, in our standard employee benefit programs, including medical/hospitalization insurance and group life insurance, as in effect from time to time. Each of the covered executives will generally receive an automobile allowance and reimbursement for all reasonable business expenses incurred by him on behalf of the Company in the performance of his duties. The provisions of the individual agreements set forth in the following table:
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Name | | Position | | Date | | Term | | Salary | | Options | | Price | | Vesting | | Stock | |
| Thomas Granville (1) | | | CEO | | | 6/23/08 | | | 2-year | | $ | 324,000 | | | 90,000 | | $ | 2.50 | | | Monthly | | | 0 | |
| Donald T. Hillier (2) | | | CFO | | | 6/18/08 | | | 3-year | | $ | 150,000 | | | 180,000 | | $ | 2.50 | | | Monthly | | | 90,000 | |
| Dr. Edward Buiel (3) | | | VP and CTO | | | 6/23/08 | | | 2-year | | $ | 180,000 | | | 100,000 | | $ | 2.50 | | | 05/31/10 | | | 80,000 | |
| Andrew Carr Conway, Jr. (4) | | | Former CFO | | | 8/31/07 | | | 6 months | | $ | 180,000 | | | 120,000 | | $ | 4.50 | | | Monthly | | | 0 | |
| Dr. Robert Nelson (5) | | | VP Mfg. Eng. | | | 12/1/07 | | | 2-year | | $ | 132,000 | | | 108,000 | | $ | 5.00 | | | Monthly | | | 36,000 | |
| 1. | Thomas Granville. On June 23, 2008, we entered into an Executive Employment Agreement with Thomas Granville as Chief Executive Officer. Pursuant to this agreement, Mr. Granville receives a monthly base salary of $27,000 for the period commencing June 1, 2008, and terminating May 31, 2010. Mr. Granville’s base salary is subject to annual review, and such salary is subject to renegotiation on the basis of Mr. Granville’s and the Company’s performance. In addition, Mr. Granville received a signing bonus of $250,000, paid 50% within ten (10) days of the execution of the agreement and 50% upon receipt of the final $10,000,000 investment from the Quercus Trust. The Company also granted Mr. Granville an option to purchase 90,000 shares of our common stock at a price of $2.50 per share at a vesting rate of 3,750 shares per month through the term of the agreement. Mr. Granville is eligible to participate in any executive compensation plans adopted by the shareholders of the Company and the Company's standard employee benefit programs. |
| 2. | Donald T. Hillier. On June 18, 2008, we entered into an Executive Employment Agreement with Donald T. Hillier as Chief Financial Officer. Pursuant to this agreement, Mr. Hillier receives a monthly base salary of $12,500 for the period commencing June 16, 2008, and terminating June 15, 2011. Mr. Hillier's base salary is subject to review after six (6) months and then on an annual basis thereafter, and such salary is subject to renegotiation on the basis of Mr. Hillier's and the Company's performance. The Company also granted to Mr. Hillier 90,000 shares of common stock which will vest in equal 30,000 share amounts on June 16 of each of 2009, 2010 and 2011. In addition, Mr. Hillier was granted an option to purchase 180,000 shares of common stock at a price of $2.50 per share at a vesting rate of 5,000 shares per month through the term of the agreement. Mr. Hillier is eligible to participate in any executive compensation plans adopted by the shareholders of the Company and the Company's standard employee benefit programs. |
| 3. | Edward Buiel, Ph.D. On June 23, 2008, we entered into an Executive Employment Agreement with Dr. Edward Buiel as Vice President and Chief Technology Officer. Pursuant to this agreement, Dr. Buiel receives a monthly salary of $15,000 for the period commencing June 1, 2008 and terminating May 31, 2010. Dr. Buiel’s base salary is subject to annual review, and such salary is subject to renegotiation on the basis of Dr. Buiel’s and the Company’s performance. In addition, Dr. Buiel received a signing bonus of $110,000, paid 90% within ten (10) days of the execution of the agreement and 10% upon the receipt of the final $10,000,000 investment from the Quercus Trust. Also, if Dr. Buiel is still employed with the Company on June 1, 2011, he will receive a bonus of $50,000, notwithstanding any other bonus arrangement. The Company also reconfirmed Dr. Buiel’s option to purchase 100,000 shares of our common stock, which had been previously granted in his prior Executive Employment Agreement dated December 29, 2006. These existing options remain exercisable at a price of $3.75 per share and shall vest 50% on December 29, 2009 and 50% on December 29, 2010 assuming Dr. Buiel is still employed by the company on each of those respective dates. In addition, Dr. Buiel was granted an option to purchase 100,000 shares of our common stock in recognition of the opportunity cost associated with the one year extension of his new Executive Employment Agreement. These options are exercisable at a price of $2.50 per share and shall vest on May 31, 2011. Dr Buiel was also granted 80,000shares of common stock, of which 30,000 vests on December 29, 2009, and 50,000 will vest on May 31, 2011. Dr. Buiel is eligible to participate in any executive compensation plans adopted by the shareholders of the Company and the Company's standard employee benefit programs. Certain of these equity awards were awarded under Dr. Buiel’s 2006 employment agreement and the terms of such awards have been incorporated into his new Executive Employment Agreement. |
| 4. | Andrew C. Conway, Jr. Under the terms of his employment agreement effective August 2007, which had an original term of six months, Mr. Conway received an annualized salary of $180,000, bonuses as determined by the compensation committee and an option to purchase 10,000 shares of our common stock at a price of $4.50 per share for each month of service. 30,000 options vested with the execution of the contract, and the balance vest periodically over the remainder of the contract. The contract automatically renewed for an additional six month term ending August 31, 2008. A total of 120,000 options were awarded under the extended contract. Mr. Conway served as the Company’s CFO through June 2008, and his employment agreement terminated, as mutually agreed, on July 4, 2008. |
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
| 5. | Dr. Robert F. Nelson. Under the terms of his employment agreement effective December 2007, which has a term of two years, Dr. Nelson receives an annual salary of $132,000 and bonuses as determined by the compensation committee. In addition, Dr. Nelson receives an option to purchase 108,000 shares of our common stock at a price of $5.00 per share and 36,000 shares of restricted common stock, each that vest over three years from the effective date of his employment agreement. |
We have no retirement plans or other similar arrangements for any directors, executive officers or employees.
| 9. | Related Party Transactions |
Options and Warrants: In conjunction with loan obligations carried over from 2007, the Company satisfied the remainder of its obligations to issue 397,750 warrants to two of its directors. Because of the delay in processing, these 3 year warrants, exercisable at a price of $6.00, are being issued with an expiration date of March 31, 2011. Due to lower stock prices at the time of modification, the modification of these instruments resulted in a net decrease in fair value of these instruments. Decreases in fair value of embedded options resulting from a modification should not be recognized and accordingly are not reflected on the Company’s financial statements.
Interest Expense: Interest expense recognized for the period ended September 30, 2008 in connection with certain notes payable to related parties amounted to $1,175,370. Of this total $277,045 relates to the interest coupon and $878,325 to the amortization of note discount associated with loan origination fees and detachable warrants. The amounts reported under the related party caption on the face of the financial statement includes payments to four accredited investors with certain associations to related parties.
| 10. | Recent Financing Activities |
Bridge Loan Financing In November of 2007 we structured short term secured bridge loan arrangements in increments of $100,000, the "Bridge Loans" with certain of our directors, officers and significant investors, such loans to bear interest at the rate of 14% and were secured by all of our assets, including our intellectual property and all of the equipment and inventory assets of our wholly-owned subsidiary, Axion Power Battery Manufacturing Inc. Total funding received under the Bridge Loans was approximately $2,640,000, of which $100,000 was received in 2008.
The Bridge Loans had an original maturity date of March 31, 2008, with three extensions of the maturity date at the option of the Company, with higher interest rates to apply to each such extension. On March 31, 2008, we sent notice to the investors of our intention to extend the loan until April 30, 2008. In accordance with the option terms contained in the loan agreement, three of the investors chose to convert a total of $328,984 into equity under the same terms offered to Quercus. One of these investors later rescinded his election, opting for repayment. This resulted in a net conversion of $276,484 into equity under the same terms offered to Quercus. The extension entitled the remaining investors to earn an additional 1% extension fee based on the original loan amount and interest at the annual rate of 15%. On April 29, 2008, we sent notice to the investors of our intention to extend the loan until May 31, 2008. The extension entitles investors to earn an additional 1% extension fee based on the original loan amount and interest at the annual rate of 16%. On May 29, 2008, a related party converted $4,200 of his Bridge Loan into equity under the same terms offered to Quercus, with the balance repaid under the terms of the note for the Bridge Loan. On May 30, 2008, we sent notice to the remaining investors of our intentions to extend the loan until June 30, 2008. The interest rate during the extension period increased to 18% with an extension fee equal to 2% of the original loan and an extension fee of 2% of the original loan was paid to the holders of the Bridge Loans. A loan origination fee was paid equal to 8% of the original loan. The origination fee decreased by one-half percent each week after December 15, 2007 until the loan closed on January 7, 2008. Warrants exercisable at $2.35 until December 31, 2012 are included. For each $100,000 increment of the Bridge Loan, the investors were issued warrants as follows: 3,405 warrants upon occurrence of the secured bridge loan:
851 additional warrants upon the extension of the loan to April 30, 2008; 1,276 additional warrants upon extension of the loan to May 31, 2008 and 2,128 additional warrants upon extension of the loan to June 30, 2008. Typical anti-dilution provisions apply to the warrants as do piggyback registration rights.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
On June 30, 2008, a director, exercising his rights to convert under the same terms converted $800,000 of indebtedness under the Bridge Loans into 380,952 shares of common stock and warrants to purchase 380,952 shares of common stock at an exercise price of $2.60 per share, such warrants will expire on June 29, 2013. The remaining balance due, $1,235,028 , of indebtedness from the Bridge Loans was repaid on July 1, 2008 with a portion of the proceeds from the Final Quercus Investment (as described below). The Bridge Loans have been fully repaid or converted, and there is no remaining indebtedness under these instruments.
The Quercus Investment On January 14, 2008, we entered into the Securities Purchase Agreement with Quercus, pursuant to which we agreed to issue to Quercus up to 8,571,429 shares of our common stock, together with a five year common stock purchase warrants that will entitle the holder to purchase up to 10,000,000 additional shares of our common stock.
At the initial closing on January 14, 2008, Quercus invested $4.0 million in exchange for 1,904,762 shares and warrants to purchase an additional 2,857,143 shares at an exercise price of $2.60 per share. At the second closing on April 17, 2008, Quercus invested an additional $4.0 million in exchange for 1,904,762 shares of our common stock and warrant to purchase an additional 2,380,953 shares of at an exercise price of $2.60 per share.
On June 30, 2008, the Company completed the third and final tranche of the Quercus investment, whereby Quercus invested $10.0 million in exchange for 4,761,905 shares of our common stock and warrants to purchase an additional 4,761,905 shares of stock at an exercise price of $2.60 per share. All of the warrants issued to Quercus expire by June 29, 2013. A portion of the proceeds of the June 30, 2008 financing were used to retire the remainder of the $2,640,000 December 2007 Bridge Loan that the Company had previously entered into. By June 30, certain of the bridge lenders had converted $1,080,000 into 514,611 shares of common stock and warrants to purchase 580,940 shares of common stock at an exercise price of $2.60 per share. The warrant expires on June 29, 2013 and the entire conversion was under the same terms as the Quercus investment. As a result of conversion and repayment, the December 2007 Bridge Loans have been completely retired, extinguishing all indebtedness under those instruments as of July 1, 2008
The warrants contain conventional anti-dilution provisions for adjustment of the exercise price in the event we issue additional shares of our common stock or securities convertible into common stock (subject to certain specified exclusions) at a price less than $1.00 per share.
On October 6, 2008, the Company received notice that it is the recipient of a federal grant in the amount of $1,200,000 for development of new lightweight, highpowered batteries used in vehicles operated by the U.S. Marine Corps. In December of 2006 and January of 2007, the Company presented its unique technology to branches of the Armed Forces. In February of 2007, after receiving a letter of support from the Office of Naval Research, the Company submitted a proposal to the Department of Defense. The proposal to further study the applicability of the Company’s PbC technology for use in military assault vehicles was sponsored by Congressman Jason Altmire . The grant was not approved in the 2008 federal budget, but was resubmitted and approved in the 2009 budget and the Company received formal notice on October 6, 2008. The potential 3 year $5,000,000 grant has an initial year funding of $ 1,200,000. and Congressman Altmire personally presented Axion with a replica check in early October. Under the grant program, the Company and the Navy and Marine Corps will study the feasibility of utilizing one of the Company's PbC products in their assault and silent watch vehicles. The next phase is the joint development and testing of the product, which is expected to be lighter in weight and more powerful in discharge than some of the existing products in use.
On October 15, 2008, the Company filed its Definitive Proxy Statement for its Annual Meeting of Shareholders to be held on November 12, 2008 on Schedule 14A.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
On November 3, 2008, the Company received the first purchase order in what will be a series of "confirming purchase orders and delivery release" pursuant to an agreement for toll contract manufacturing of standard flooded lead acid batteries for a large North American lead acid battery company . The initial three types of batteries covered in this purchase order have successfully completed customer testing, and shipment is expected to begin in November of this year. . The initial purchase order calls for the shipment of 92,250 batteries, spread fairly equally over 11 months, with a total aggregate base purchase price of $6,400,000. Raw materials will have an agreed upon base price with regular adjustments (not less than monthly) to account for market price fluctuations, which could cause fluctuations in the final purchase invoice. The Company has begun preparations for the next set of battery types scheduled for customer acceptance and shipping beginning in the first quarter of 2009. When all anticipated battery types are phased in, which is anticipated to occur by the end of the second quarter in 2009, the anticipated battery production for this contract will be approximately 50,000 units per month. All production will take place on an ancillary "flooded battery line" so the production will not reduce capacity from the Company’s development of its proprietary PbC technologies, which will utilize the primary "AGM battery line" for production.
The Cypress Avenue Partners, LLC litigation was settled on November 7, 2008, with the exchange of general releases and certain consideration, which is not deemed to be material.
| ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Overview
We are a development stage company that was formed in September 2003 to acquire and develop certain innovative battery technology. Since inception, APC has been engaged in R&D of the new technology for the production of lead-acid-carbon energy storage devices that we refer to as our proprietary lead/carbon (“PbC”) devices. As of December 31, 2003, APC engaged in a reverse acquisition with Tamboril, a public shell company. Tamboril was originally incorporated in Delaware in January 1997, operated a wholesale cigar business until December 1998 and was an inactive public shell thereafter until December 2003. The information presented herein relates to the operations of APC, the accounting acquirer. Tamboril, the legal acquirer, changed its name to Axion Power International, Inc. We formed a new corporation, Axion Power Battery Manufacturing Inc., which purchased the foreclosed assets of a failed battery manufacturing plant and now conducts our manufacture of specialty batteries.
At September 30, 2008, we have incurred cumulative net losses of approximately $8.3 million applicable to the common shareholder. This includes approximately $1.2 million in accrued interest of which $0.6 million relates to discount on notes. We have an additional $0.8 million in accumulated preferred stock dividends. We had approximately $9.3 million in current assets and $1.8 million in current liabilities at September 30, 2008, which left a net working capital surplus of approximately $7.5 million. As discussed below, we received an aggregate amount of $16.5 million, net of offering costs, in long term equity financing on January 14, 2008, April 7, 2008, and June 30, 2008 from Quercus. Management believes those funds will support operations through the next 15 months.
On July 3, 2008 we moved from the Pink Sheets back to the OTCBB. We lost our OTCBB listing and moved to the Pink Sheets in October of 2006 when our filings became delinquent due to the restatements of its financial statements that the Company undertook for the years 2003, 2004 and 2005. Our financial reporting became current at the beginning of the second quarter of 2008, and it is our intention to remain current on a going forward basis.
During the 3rd quarter of 2008, we fabricated several different types of lead acid batteries to prepare for the testing of those products by another company under a purchase order. At the end of September 2008, we were released to begin production on three of eleven items covered by the order. On November 3, 2008, the Company received the first purchase order in what will be a series of "confirming purchase orders and delivery releases" pursuant to the original agreement. See further discussion under subsequent events” In order to continue following our business plan, we expect to make use of our short term excess manufacturing capacity by producing standard lead acid batteries on a contract manufacturing basis for other battery companies. We have devoted time and financial resources to upgrading, and where necessary replacing, existing battery manufacturing equipment as part of our long range business plan. In the future, a large portion of this upgraded equipment will be used to manufacture our proprietary PbC lead carbon product. The Quercus Trust investment of $4 million in April allowed us to move this upgrade forward. Likewise the Quercus $10 million investment that we received on June 30th will allow us to pursue automated fabrication equipment, which will be used in the manufacture of the PbC carbon electrode device in commercialization quantities.
Key Performance Indicators
Because of our early stage of development the usual financial measures are not particularly relevant or helpful in the assessment of company operations.
We do not use non-financial measures to evaluate our performance other than the degree of success of our R&D and demonstration projects. Our demonstration projects entail extended periods of time to assess our energy devices over multiple charge and deep discharge cycles. Further, the results of our demonstration projects do not lend themselves to simple measurement and presentation.
The single most significant financial metric for us is the adequacy of working capital in order to continue to fund our research and development efforts. Capital is also necessary to fund the equipment and methods required to progress from demonstration projects to full commercial readiness for deployment. After consideration of the working capital balance on September 30, 2008 we believe we can maintain operations and fund R&D for approximately 15 months without further capital infusions.
We believe we need to continue to characterize and perfect our products in house and through a limited number of demonstration projects before moving into mass production. While the results of this work are promising to date, we cannot assure you that the products will be successful in their present design or that further research and development will not be needed. The successful completion of present and future characterization and demonstration projects are critical to the development and acceptance of our technology.
We must devise methodologies to manufacture our energy storage devices in commercial quantities. While we have assembled a management team that we believe can accomplish this goal, and are adding to it as we go forward, there is no assurance that we will be able to successfully mass produce our product.
If we successfully complete our characterization and demonstration projects, we must present sufficiently compelling evidence to prospective users of energy storage devices in order to persuade them to purchase our technology.
Material Trends and Uncertainties
We will continue to require substantial funds for R&D. Even with adequate funding there is no assurance our new technology can be successfully commercialized. While we intend to continue to manufacture specialty batteries and other standard lead-acid products, there is no assurance of profits or whether those profits will be sufficient to sustain our operations as we continue to develop our new technology.
Recent Financing Activities
Bridge Loan Financing In November of 2007 we structured short term secured bridge loan arrangements in increments of $100,000, the "Bridge Loans" with certain of our directors, officers and significant investors, such loans to bear interest at the rate of 14% and were secured by all of our assets, including our intellectual property and all of the equipment and inventory assets of our wholly-owned subsidiary, Axion Power Battery Manufacturing Inc. Total funding received under the Bridge Loans was approximately $2,640,000, of which $100,000 was received in 2008.
The Bridge Loans had an original maturity date of March 31, 2008, with three extensions of the maturity date at the option of the Company, with higher interest rates to apply to each such extension. On March 31, 2008, we sent notice to the investors of our intention to extend the loan until April 30, 2008. In accordance with the option terms contained in the loan agreement, three of the investors chose to convert a total of $328,984 into equity under the same terms offered to Quercus. One of these investors later rescinded his election, opting for repayment. This resulted in a net conversion of $276,484 into equity under the same terms offered to Quercus. The extension entitled the remaining investors to earn an additional 1% extension fee based on the original loan amount and interest at the annual rate of 15%. On April 29, 2008, we sent notice to the investors of our intention to extend the loan until May 31, 2008. The extension entitled investors to earn an additional 1% extension fee based on the original loan amount and interest at the annual rate of 16%. On May 29, 2008, a related party converted $4,200 of his Bridge Loan into equity under the same terms offered to Quercus, with the balance repaid under the terms of the note for the Bridge Loan. On May 30, 2008, we sent notice to the remaining investors of our intention to extend the Loans until June 30, 2008. The interest rate during the extension period increased to 18% with an extension fee equal to 2% of the original loan and an extension fee of 2% of the original loan was paid to the holders of the Bridge Loans. A loan origination fee was paid equal to 8% of the original principal amount of the Loan. The origination fee decreased by one-half percent each week after December 15, 2007 until the loan closed on January 7, 2008. Warrants exercisable at $2.35 until December 31, 2012 are included. For each $100,000 increment of the Bridge Loan, the investors were issued warrants as follows: 3,405 warrants upon occurrence of the secured bridge loan: 851 additional warrants upon the extension of the loan to April 30, 2008; 1,276 additional warrants upon extension of the loan to May 31, 2008 and 2,128 additional warrants upon extension of the loan to June 30, 2008. Typical anti-dilution provisions apply to the warrants as do registration rights.
On June 30, 2008, a director, exercising his rights to convert under the same terms converted $800,000 of indebtedness under the Bridge Loans into 380,952 shares of common stock and warrants to purchase 380,952 shares of common stock at an exercise price of $2.60 per share, such warrants will expire on June 29, 2013. The remaining balance due, $1,235,028, of indebtedness from the Bridge Loans was repaid as of July 1, 2008 with a portion of the proceeds from the Final Quercus Investment (as described below). The Bridge Loans have been fully repaid or converted, and there is no remaining indebtedness under these instruments.
The Quercus Investment On January 14, 2008, we entered into the Securities Purchase Agreement with Quercus, pursuant to which we agreed to issue to Quercus up to 8,571,429 shares of our common stock, together with a five year common stock purchase warrants that will entitle the holder to purchase up to 10,000,000 additional shares of our common stock.
At the initial closing on January 14, 2008, Quercus invested $4.0 million in exchange for 1,904,762 shares and warrants to purchase an additional 2,857,143 shares at an exercise price of $2.60 per share. At the second closing on April 17, 2008, Quercus invested an additional $4.0 million in exchange for 1,904,762 shares of our common stock and warrant to purchase an additional 2,380,953 shares of at an exercise price of $2.60 per share.
On June 30, 2008, the Company completed the third and final tranche of the Quercus investment, whereby Quercus invested $10.0 million in exchange for 4,761,905 shares of our common stock and warrants to purchase an additional 4,761,905 shares of stock at an exercise price of $2.60 per share. All of the warrants issued to Quercus expire by June 29, 2013. A portion of the proceeds of the June 30, 2008financing were used to retire the remainder of the $2,640,000 December 2007 Bridge Loan that the Company had previously entered into. By June 30, certain of the bridge lenders had converted $1,080,000 into 514,611 shares of common stock and warrants to purchase 580,940 shares of common stock at an exercise price of $2.60 per share. The warrant expires on June 29, 2013 and the entire conversion was under the same terms as the Quercus investment. As a result of conversion and repayment, the December 2007 Bridge Loans have been completely retired, extinguishing all indebtedness under those instruments as of July 1, 2008
The warrants contain conventional anti-dilution provisions and full ratcheting of the exercise price in the event we issue additional shares of our common stock or securities convertible into common stock (subject to certain specified exclusions) at a price less than $1.00 per share.
Results of Operations
Overview
The comparative data below presents our results of operations for the three months and nine months ended September 30, 2008 and 2007. While certain of the data is not strictly comparable because some line items are positive and some negative, the provided percentages demonstrate the relative significance of the individual line items and also the relative changes from year to year.
| · | Our primary operations in our current development stage consist of research and development efforts for advanced battery applications and PbC carbon electrode devices. Revenues are for batteries sold to customers. Manufacturing costs includes raw materials, components, labor and manufacturing overhead including the costs of excess capacity. |
| · | Selling, general and administrative expenses include substantial non-recurring legal, auditing, accounting and other costs associated with becoming current with our public filings, public relations, registration and litigation costs and also one time employee costs in relation to restructuring of employment agreements. |
| · | Research & development expenses are incurred to design, develop and test advanced batteries and an energy storage product based on our patented lead carbon battery (PbC). |
| · | Interest expense was incurred for the bridge loan financing offered during the fourth quarter of 2007. The bridge loans were retired as of July 1, 2008. |
Statements of Operations
The following table shows the percentage relationship of the line items to the net loss applicable to the common shareholder. |
| | | Three Months Ended | | Nine Months Ended | |
| | | September 30, | | September 30, | |
Statements of Operations | | 2008 | | % of net loss | | 2007 | | % of net loss | | 2008 | | % of net loss | | 2007 | | % of net loss | |
| | | | | | | | | | | | | | | | | | |
Revenues | | $ | 149,441 | | | | | $ | 135,059 | | | | | $ | 541,248 | | | | | $ | 432,650 | | | | |
| Manufacturing costs | | | 596,004 | | | | | | 268,302 | | | | | | 1,243,737 | | | | | | 694,397 | | | | |
| Gross (loss) | | | (446,563 | ) | | 20.4 | % | | (133,243 | ) | | 6.7 | % | | (702,489 | ) | | 8.4 | % | | (261,747 | ) | | 2.2 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
Expenses | | | | | | | | | | | | | | | | | | | | | | | | | |
| Selling, general & administrative | | | 993,479 | | | 45.5 | % | | 985,257 | | | 49.7 | % | | 4,172,675 | | | 50.2 | % | | 2,722,081 | | | 22.9 | % |
| Research & development | | | 518,976 | | | 23.8 | % | | 303,051 | | | 15.3 | % | | 1,460,952 | | | 17.6 | % | | 981,308 | | | 8.2 | % |
| Impairment of assets | | | - | | | 0.0 | % | | (6,929 | ) | | | | | - | | | 0.0 | % | | - | | | 0.0 | % |
| Interest expense - related party | | | (2,500 | ) | | -0.1 | % | | 135,560 | | | 6.8 | % | | 1,175,370 | | | 14.1 | % | | 135,560 | | | 1.1 | % |
| Derivative revaluation | | | - | | | 0.0 | % | | (59,358 | ) | | -3.0 | % | | (2,844 | ) | | 0.0 | % | | (59,358 | ) | | -0.5 | % |
| Interest & other income, net | | | (42,961 | ) | | -2.0 | % | | (451 | ) | | 0.0 | % | | (34,524 | ) | | -0.4 | % | | (46,969 | ) | | -0.4 | % |
Net loss before income taxes | | | (1,913,557 | ) | | 87.6 | % | | (1,490,373 | ) | | 75.2 | % | | (7,474,118 | ) | | 89.9 | % | | (3,994,369 | ) | | 33.6 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Income Taxes | | | - | | | 0.0 | % | | - | | | 0.0 | % | | - | | | 0.0 | % | | - | | | 0.0 | % |
Deficit accumulated during development stage | | | (1,913,557 | ) | | 87.6 | % | | (1,490,373 | ) | | 75.2 | % | | (7,474,118 | ) | | 89.9 | % | | (3,994,369 | ) | | 33.6 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Less preferred stock dividends and beneficial conversion feature | | | (270,944 | ) | | 12.4 | % | | (492,089 | ) | | 24.8 | % | | (843,230 | ) | | 10.1 | % | | (7,902,251 | ) | | 66.4 | % |
| Net loss applicable to common shareholders | | $ | (2,184,501 | ) | | 100.0 | % | $ | (1,982,462 | ) | | 100.0 | % | $ | (8,317,348 | ) | | 100.0 | % | $ | (11,896,620 | ) | | 100.0 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Basic and diluted net loss per share | | $ | (0.08 | ) | | | | $ | (0.12 | ) | | | | $ | (0.39 | ) | | | | $ | (0.73 | ) | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| Weighted average common shares outstanding | | | 26,045,156 | | | | | | 16,247,298 | | | | | | 21,263,533 | | | | | | 16,247,299 | | | | |
Summary of Consolidated Results for period ending September 30, 2008 compared with September 30, 2007
Revenue
Revenues for the quarter and nine months ended September 30, 2008 were approximately $.1 million and $.5 million, respectively, compared to revenues of approximately $.1 million and $.4 million, respectively, for the same periods in 2007. This represents an increase of 11% and 25% in revenues for the quarter and nine months ended September 30, 2008 as compared to the same time periods last year. This increase is primarily due to another year of exposure, especially in the race car and classic car industries, and the sale of uninterruptable power supply batteries to one of our customers. We have one customer that accounted for approximately 11% of revenue in each of the nine months ended September 30, 2008 and 2007.
Manufacturing Costs
Manufacturing costs include various raw materials with lead being the most prominent and costly. We also use components such as plastic battery cases and covers and separators. Our PbC batteries use specialty activated carbon for the negative electrode component of the battery. The cost of lead has increased over 2007 price levels despite recent softening in the global market. We also incur manufacturing labor and overhead costs as well as costs for packaging and shipping. Manufacturing costs increased by approximately $.3 million and $.5 million, respectively, for the quarter and nine months ended September 30, 2008, as compared to the same time period last year. Year to date, 2008 costs are 79% higher than for the first nine months of 2007. Whereas 25% of the increase is attributable to volume, the remaining increase is primarily attributable to additional costs incurred to prepare the manufacturing plant for expected future increased production. Gross loss for the quarter and nine months ended September 30, 2008 includes gross profit from the sale of batteries and loss from manufacturing activities primarily in preparing the plant for increased production Under utilization of the plant’s capacity; pilot production; and developmental activities have also contributed to the loss. Gross loss was approximately $.4 million and $.7 million, respectively. This compares to gross losses of $.1 million and $.3 million, respectively, for the same periods last year. Gross losses for the quarter and nine months ended September 30, 2008, and for the respective periods in 2007, reflect the manufacturing facilities being utilized at significantly less than full capacity during this development stage.
Selling, General & Administrative Expenses
Selling, general and administrative expenses include compensation for employees and contractors, legal and accounting fees, and costs incurred for investor relations and activities associated with fund raising. Selling, general and administrative costs for the quarter and nine months ended September 30, 2008 were approximately $1.0 million and $4.2 million, respectively, compared to $1.0 million and $2.7 million, respectively, for the same periods in 2007. This represents a 53% year to date increase in spending over the same period during 2007. Cost increases are primarily due to substantial non-recurring legal, auditing, accounting and other costs associated with becoming current with our public filings, public relations, registration and litigation costs and also one-time employee costs with respect to restructuring of employment agreements.
Research & Development Expenses
Research and development expenses include compensation for employees and contractors, as well as small test equipment, supplies and overhead. Research and development expenses for the quarter and nine months ended September 30, 2008 were $.5 million and $1.5 million, respectively, compared to $.3 million and $1.0 million, respectively, for the same periods in 2007, representing a year to date 49% increase in spending, as compared to the same period in 2007. The increase is due to increased costs associated with additional efforts incurred to design, develop and test advanced batteries and an energy storage product based on our patented lead carbon battery (PbC).
Interest Expense - Related Party
Interest expense - related party represents interest costs incurred primarily for the bridge loan financing offered during the fourth quarter of 2007. Related party interest expense includes the coupon value of interest on debt, as well as the debt discount on detachable warrants and origination fees. Expenses incurred during the nine months ended September 30, 2008 were approximately $1.2 million as compared to $.1 million, for the same period in 2007. Whereas 2007 financing was sustained through the issuance of the Series A preferred offering, 2007 did not have a comparable level of interest expense as was recognized during 2008 The 2007 bridge loans were retired as of June 30, 2008.
Derivative Revaluation
Derivative revaluations are recognized whenever the Company incurs a liability to issue an equity instrument. The instrument is revalued quarterly until the point in time that the liability is settled. There were no derivative revaluations during the quarter ended September 30, 2008 and only $(.06) during the comparable period of 2007. Derivative revaluation expense for the period ended September 30, 2008 year to date resulted in a credit of $(.003) million compared with an expense of $(.06) million in the period ended September 30, 2007 year to date. During 2007, the Company funded its capital needs with debt that offered detachable warrants. These warrants were not settled until March 2008, at which point the Company’s stock values were lower, giving rise to the nominal credit in 2008. There are no new obligations as of September 30, 2008.
Liquidity and Capital Resources
Our primary source of liquidity has historically been cash generated from issuances of our equity or debt securities. From inception until the fiscal year ended December 31, 2005, we generated no revenue from operations. We believe we had sufficient funds on September 30, 2008 to conduct our operations for the next 15 months. If we do not significantly increase our revenues over the next 15 months we will likely be unable to implement our business plan, fund our liquidity needs or even continue our operations after this period. Any equity or debt financings, if available at all, may be on terms which are not favorable to us and, in the case of equity financings, most likely will result in further dilution to our stockholders.
Cash, Cash Equivalents and Working Capital
At September 30, 2008, we had approximately $8.0 million of cash and cash equivalents compared to approximately $0.7 million at December 31, 2007. At September 30, 2008 working capital was $7.5 million compared to a working capital deficit of $(2.9) million at December 31, 2007. Cash equivalents consist of short-term liquid investments readily convertible into cash and consist of the following at September 30, 2008:
| | | Coupon / Yield | | Maturity | | September 30, 2008 | |
| Certificate of Deposit, Pacific Capital | | | 2.9% | | | Mar-09 | | $ | 94,000 | |
| Certificate of Deposit, Wachovia MTG FSB | | | 2.9% | | | Mar-09 | | $ | 94,000 | |
| United States Treasury Bills | | | | | | Nov-08 | | $ | 2,996,280 | |
| United States Treasury Bills | | | | | | Feb-09 | | $ | 1,990,060 | |
| Fidelity Institutional Money Market | | | 2.86% | | | n/a | | $ | 2,196,236 | |
Cash Flows from Operating Activities
Net cash used in operations for the nine months ended September 30, 2008 was $(6.6) million. Cash used in operations for this same period ended September 30, 2007 was approximately $(3.1) million, an increase of $3.5 million or 112.9%. The use of cash in operations is reflective of the development stage of the business from an operations standpoint. The cash used in operations for the nine months ended September 30, 2008 is also reflective of the buildup of inventories as we gear up production, non-recurring legal and accounting costs as well as one-time compensation costs arising from restructuring of employment contracts.
Cash Flows from Investing Activities
Net cash used in investing activities for the nine months ended September 30, 2008 was $(1.1) million compared to $(1.0) million for the same period ended September 30, 2007, an increase of $0.1 million or 10%. Cash used by investing activities was predominately used for the purchase of equipment for both production and research and development for both periods.
Cash Flows from Financing Activities
Net cash provided by financing activities in the nine months ended September 30, 2008 was approximately $15.0 million compared to $0.6 million for the same period ended September 30, 2007, an increase of $14.4 million or 2,571.4%. Financing activities for the nine months ended September 30, 2008 consisted of $16.5 million from the issuance of common stock less repayment of $1.5 million for retirement of the 2007 bridge loans during 2008.
Significant Financing Arrangements
December 2007 Secured Bridge Loan Transaction: In December 2007, we offered certain of our directors, officers, and significant investors the opportunity to participate in a short term bridge loan arrangement in increments of $100,000, each such loan to bear interest at 14% and to be secured by all of our assets, including our intellectual property assets and the assets of Axion Power Battery Manufacturing Inc. Total funding received under the secured bridge loan as of December 31, 2007 amounted to $2,540,000, with additional funding of $100,000 received in January of 2008. $516,000 was repaid through June 2008 along with $60,000 of interest; the balance of the proceeds was used to fund ongoing operations. As of July 1, 2008, the Bridge Loans have been fully repaid or converted, and there is no remaining indebtedness under these instruments.
The Quercus Investment On January 14, 2008, we entered into the Securities Purchase Agreement with Quercus, pursuant to which we agreed to issue to Quercus up to 8,571,429 shares of our common stock, together with a five year common stock purchase warrants that will entitle the holder to purchase up to 10,000,000 additional shares of our common stock.
At the initial closing on January 14, 2008, Quercus invested $4.0 million in exchange for 1,904,762 shares and warrants to purchase an additional 2,857,143 shares at an exercise price of $2.60 per share. At the second closing on April 17, 2008, Quercus invested an additional $4.0 million in exchange for 1,904,762 shares of our common stock and warrant to purchase an additional 2,380,953 shares of at an exercise price of $2.60 per share.
On June 30, 2008, the Company completed the third and final tranche of the Quercus investment, whereby Quercus invested $10.0 million in exchange for 4,761,905 shares of our common stock and warrants to purchase an additional 4,761,905 shares of stock at an exercise price of $2.60 per share. All of the warrants issued to Quercus expire by June 29, 2013. A portion of the proceeds of the June 30, 2008 financing were used to retire the remainder of the $2,640,000 December 2007 Bridge Loan that the Company had previously entered into. Prior to June 30, certain of the bridge lenders had converted $335,000 into 158,659 shares of common stock and warrants to purchase 237,488 shares of common stock at an exercise price of $2.60 per share. On June 30, 2008, one of the Company’s directors converted $800,000 of Bridge Loan indebtedness into 380,952 shares of common stock and a warrant to purchase 380,952 shares at an exercise price of $2.60 per share. The warrant expires on June 29, 2013 and the entire conversion was under the same terms as the Quercus investment. As a result of conversion and repayment, the December 2007 Bridge Loans have been completely retired, extinguishing all indebtedness under those instruments.
The warrants contain conventional anti-dilution provisions for adjustment of the exercise price in the event we issue additional shares of our common stock or securities convertible into common stock (subject to certain specified exclusions) at a price less than $1.00 per share.
Critical Accounting Policies, Judgments and Estimates
The “Management’s Discussion and Analysis of Financial Condition or Plan of Operation” section of this report discusses our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). To prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities. These estimates also affect our reported revenues and expenses. On an ongoing basis, management evaluates its estimates and judgment, including those related to revenue recognition, accrued expenses, financing operations and contingencies and litigation. Management bases its estimates and judgment on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.
Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statement and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.
Principles of Consolidation: The condensed consolidated financial statements include the accounts of the Company, and its wholly owned subsidiaries, Axion Power Battery Manufacturing, Inc., APC and C&T. All significant inter-company balances and transactions have been eliminated in consolidation.
Revenue Recognition: The Company recognizes revenue upon transfer of title at the time of shipment (F.O.B. shipping point), when all significant contractual obligations have been satisfied, the price is fixed or determinable and collection is reasonably assured.
Stock-Based Compensation: Prior to January 1, 2006, the Company accounted for stock option awards in accordance with the recognition and measurement provisions of APB 25 and related interpretations, as permitted by Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”). Under APB 25, compensation cost for stock options issued to employees was measured as the excess, if any, of the fair value of the Company’s stock at the date of grant over the exercise price of the option granted. Compensation cost was recognized for stock options, if any, ratably over the vesting period. As permitted by SFAS 123, the Company reported pro-forma disclosures presenting results and earnings as if the Company had used the fair value recognition provisions of SFAS 123 in the Notes to the Condensed Consolidated Financial Statements.
Effective January 1, 2006, the Company adopted SFAS 123R using the modified prospective transition method. See footnote captioned “Equity Compensation” for further detail on the impact of SFAS 123R to the Company’s condensed consolidated financial statements.
Stock-based compensation related to non-employees is recognized as compensation expense in the accompanying condensed consolidated statements of operations and is based on the fair value of the services received or the fair value of the equity instruments issued, whichever is more readily determinable. The Company’s accounting policy for equity instruments issued to consultants and vendors in exchange for goods and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” and EITF 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments granted to Other Than Employees.” The measurement date for the fair value of the equity instruments issued is determined at the earlier of (1) the date at which a commitment for performance by the consultant or vendor is reached or (2) the date at which the consultant or vendor’s performance is complete. In the case of equity instruments issued to consultants, the fair value of the equity instrument is recognized over the term of the consulting agreement.
Research and Development: R&D costs are recorded in accordance with FASB No. 2, “Accounting for Research and Development Costs,” which requires that costs incurred in R&D activities covering basic scientific research and the application of scientific advances to the development of new and improved products and their uses be expensed as incurred. The policy of expensing the costs of R&D activities relate to (1) in-house work conducted by the Company, (2) costs incurred in connection with contracts that outsource R&D to third party developers and (3) costs incurred in connection with the acquisition of intellectual property that is properly classified as in-process R&D. All R&D costs have been expensed.
Off Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, an effect on our financial condition, financial statements, revenues or expenses.
Evaluation of Disclosure Controls and Procedures
As of September 30, 2008, management performed, with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the report we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s forms, and that such information is accumulated and communicated to our management including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosures. Based on the evaluation and the identification of the material weaknesses in our internal control over financial reporting described below, our Chief Executive Officer and our Chief Financial Officer concluded that, as of September 30, 2008, our disclosure controls and procedures were not effective.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. 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 in accordance with GAAP. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projection of any evaluation of effectiveness to future periods is 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.
Management has conducted, with the participation of our Chief Executive Officer and our Chief Financial Officer, an assessment, including testing of the effectiveness, of our internal control over financial reporting as of December 31, 2007. Management’s assessment of internal control over financial reporting was conducted using the criteria in Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. In connection with our management’s assessment of our internal control over financial reporting as required under Section 404 of the Sarbanes-Oxley Act of 2002, we identified the following material weaknesses in our internal control over financial reporting as of December 31, 2007:
| · | We failed to hire, or subsequently train, accounting personnel that had the appropriate knowledge of GAAP. As a result, financial statements submitted to the Commission had to be restated for the years 2003-2005. Financial statements for fiscal year 2006 were filed on March 31, 2008 and fiscal year 2007 during the extension period following that date. |
| · | We do not have a whistleblower program in place. Employees need a process for making issues affecting them in the workplace known to the appropriate person(s) without fear of retribution. Without an effective process for employees to anonymously report wrongdoing, such as falsification of accounting records, those employees will not risk a phone call to disclose their suspicions of wrongdoing. |
| · | We do not have documented job descriptions for each position in the Company. Performance appraisals have not been performed consistently on an annual basis and, as a result, our employees may not have a clear understanding of their responsibilities or performance compared to these responsibilities |
| · | We have not maintained sufficient segregation of duties as evidenced by: |
| | · | Our Sales Manager approves the credit worthiness of new customers and also has the ability and responsibility for entering sales orders into our accounting system. Credit limit approval for new customers and sales order entry should not be performed by sales personnel. |
| | · | Some of our employees have the ability to purchase and receive goods. The receipt of goods should be kept separate from the purchasing functions. |
| · | Our accounting staff employees with payable responsibilities also have access to vendor maintenance controls. Access to vendor accounts should be kept separate from the accounts payable functions. |
| · | We have concluded that there were not effective financial reporting controls in the following areas that could lead to inaccurate financial reporting: |
| | · | All financial personnel have the ability to change account structures without approval. |
| | · | General Ledger journal entries are not always approved prior to entry. |
| | · | Documented processes do not exist for several key processes such as a closing checklist, budget-to-actual analyses, balance sheet variation analysis, pro forma financial statements, and the usage of key spreadsheets. |
| · | We have identified weaknesses in our inventory controls: |
| | · | Documented processes do not exist for several key inventory control processes including inventory adjustments, reserves for excess, defective and obsolete inventory, product shipments and the tracking and recording of in-transit inventory. |
| | · | Inventory valuation processes are lacking or do not exist including costs to be expensed versus inventoried, standard cost changes, actual versus standard cost analysis and the accurate accumulation of total production costs. |
| · | We do not have a closed loop monitoring process in place, to ensure that issues, improvement and other directed actions have been completed in a timely manner. |
| · | We do not do criminal background checks on the board of directors and employees. |
| | o | Per the KPMG, Fraud Risk Management White Paper, “U.S. sentencing guidelines (amended, November 2004) for organizational defendants establish minimum compliance and ethics program requirements for organizations seeking to mitigate penalties for corporate misconduct. Specifically, the amended guidelines call on organizations to: (1) promote a culture that encourages ethical conduct and a commitment to compliance with the law (2) establish standards and procedures to prevent and detect criminal misconduct and (3) Use reasonable efforts and exercise due diligence to exclude individuals from positions of substantial authority who have engaged in illegal activities or other conduct inconsistent with an effective compliance and ethics program.” |
| · | We have key financial, sales order processing, shipping and receiving processes that are used to operate our business on a daily basis that are not formally documented. |
| · | We do not have formal guidelines for creating properly authorized levels for entering into agreements (i.e. purchase orders, non-disclosure agreements, sales and other contracts) or distributing cash (signing checks, creating authorizing wire transfers). |
Because of the material weaknesses noted above, management has concluded that we did not maintain effective internal control over financial reporting as of September 30, 2008, based on Internal Control over Financial Reporting - Guidance for Smaller Public Companies issued by COSO.
Remediation of Material Weaknesses in Internal Control over Financial Reporting
We are in the process of implementing remediation efforts with respect to the material weaknesses noted above as follows:
| | · | In June 2008, we hired a CFO and in August 2008, we promoted a controller, both of whom have a significant background with GAAP. We are evaluating formal training plans and continuing education programs to ensure accounting personnel stay abreast of updates to GAAP. |
| | · | We are in the process of hiring a Director of Human Resources who will conduct employee training sessions and have all employees acknowledge key policies and sign the Code of Conduct. |
| | · | On September 24, 2008, we formalized our whistleblower policy and announced the program to our employees. The policy is posted on a corporate web site in the governance section and in the common areas of the office. We contracted with Ethics Point, a third party whistleblower company, to monitor the hotline and provide monthly reports of activity to our board of directors. |
| | · | We will document job descriptions for all positions and conduct performance appraisals for each employee annually. |
| | · | We are developing a plan to reorganize our accounting functions so one person is responsible for verifying the worthiness of new customers. Additionally, we will reassign sales order entry to a person outside sales and remove the access to the sales module in our accounting software to all sales personnel. |
| | · | We are separating purchasing from receipt of goods functions and restrict system access accordingly. |
| | · | We are changing our accounting system access so that employees with accounts payable responsibilities cannot add, delete or change vendor accounts. |
| | · | We are improving our financial reporting controls by: |
| | o | Establishing a procedure for changing account structures and system access accordingly. |
| | o | Implementing a process to review all journal entries prior to entry into the General Ledger. |
| | o | Documenting all key financial reporting processes. |
| | o | Establishing an effective document control and retention procedure. |
| | · | We will document all key inventory control processes and will develop and document inventory valuation processes. |
| | · | We are establishing a closed loop monitoring process. This process will include the documentation of outstanding actions, the responsible individuals, expected completion dates and the status of the progress of these actions. The document will be reviewed and updated on an ongoing basis. |
| | · | We are evaluating the use of criminal background checks for all new members of the board of directors, prior to their appointment. We are also evaluating the use of criminal background checks for all potential new hires. |
| | · | We will implement a process to document key business processes and procedures and make them accessible to all appropriate personnel. |
| | · | We are determining and will document authorization levels stating who is allowed to approve key transactions and at what level of spending. |
We believe the foregoing efforts will enable us to improve our internal control over financial reporting. Management is committed to continuing efforts aimed at improving the design adequacy and operational effectiveness of its system of internal controls. The remediation efforts noted above will be subject to our internal control assessment, testing and evaluation process.
This quarterly report does not include an attestation report of the company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the company's registered public accounting firm pursuant to temporary rules of the Commission that permit the company to provide only management's report in this quarterly report.
On February 10, 2004, Lewis “Chip” Taylor, Chip Taylor in Trust, Jared Taylor, Elgin Investments, Inc. and Mega-C Technologies, Inc. (collectively the “Taylor Group”) filed a lawsuit in the Ontario Superior Court of Justice Commercial List (Case No. 04-CL-5317) that named Tamboril, APC, Rene Pardo, Marvin Winick, Kirk Tierney, Joseph Piccirilli, Ronald Bibace, Robert Averill, James Smith, James Eagan, Thomas Granville, Joseph Souccar, Glenn W. Patterson, Canadian Consultants Bureau Inc., Robert Appel, Harold Rosen, Igor Filipenko, Valeri Shtemberg, Yuri Volfkovich, Pavel Shmatko, Michael Kishinevsky, Mega-C Power Corporation (Nevada), Mega-C Power Corporation (Ontario), C&T, Turitella Corporation, Gary Bouchard, Fogler Rubinoff LLP, Netprofitetc Inc., 503124 Ontario Ltd., HAP Investments LLC, Infinity Group LLC, James Keim, Benjamin Rubin and John Doe Corporation as defendants (the “Taylor Litigation”). As discussed more fully below, by virtue of an order entered on February 11, 2008 by the Bankruptcy Court in the Mega-C bankruptcy case, this action against us, Mega-C Power Corporation (Nevada), Robert Averill, Glenn Patterson, Igor Filipenko, Thomas Granville and HAP Investments is subject to the permanent injunction of the confirmed Chapter 11 Plan of Mega-C. No amounts have been provided for in the accompanying financial statements pursuant to the requirements of Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.” We have offered to provide a coordinated legal defense for all individual defendants who agree to be represented by counsel for us in Canada. Any named defendant will be free to retain independent legal counsel, but we are not responsible for the costs of separate legal counsel. We have not agreed to indemnify any party against damage awards rendered against them or amounts paid in settlement of claims.
In February 2005, the Bankruptcy Court stayed the Taylor Litigation pending resolution of Mega-C’s Chapter 11 bankruptcy case. On December 12, 2005, we entered into a settlement agreement with Mega-C, through its Chapter 11 Trustee, and various others that was approved by an order entered in the bankruptcy case on February 1, 2006 and which became fully effective when the Court confirmed Mega-C’s Chapter 11 Plan of Reorganization in an order entered on November 8, 2006. The details of the settlement agreement and the current state of the Taylor Group's litigation are discussed below.
Bankruptcy Court Litigation
| | · | In April 2004, we filed an involuntary Chapter 11 petition against Mega-C in the U.S. Bankruptcy Court for the District of Nevada (Case No. 04-50962-gwz). In March 2005, the Bankruptcy Court appointed William M. Noall (“Noall”) to serve as Chapter 11 Trustee for the Mega-C case. On June 7, 2005, the Chapter 11 Trustee commenced an adversary proceeding against Sally Fonner (“Fonner”), the trustee of the Mega-C Trust (Adversary Proceeding No. 05-05042-gwz), demanding, among other things, the turnover of at least 7,327,500 shares held by the Mega-C Trust as property of the bankruptcy estate. On July 27, 2005, we commenced an adversary proceeding against Noall and Fonner (Adversary Proceeding No. 05-05082-gwz). |
Settlement Agreement
On December 12, 2005, we entered into the Settlement Agreement with Mega-C, represented by Chapter 11 Trustee Noall, and the Mega-C Trust, represented by its trustee Fonner. Additional signatories to the Settlement Agreement include: (1) our subsidiaries APC and C&T, (2) Fonner in both her capacity as Mega-C’s sole officer and director and as trustee of the Mega-C Trust, (3) certain former Stockholders of APC including Robert Averill, Joe Piccirilli, Canadian Consultants Bureau Inc., James Smith, James Eagan, Tom Granville, Joe Souccar, HAP Investments, LLC, Glenn Patterson, Igor Filipenko, Ron Bibace, Kirk Tierney, Infinity Group, LLC, James Keim and Turitella Corporation, (4) Paul Bancroft and (5) certain former Stockholders of C&T, including Yuri Volkovich, Pavel Shmatko, Albert Shtemberg, Edward Shtemberg, C&T Co., Inc. in Trust, Oksana Fylypenko, Andriy Malitskiy, Valeri Shtemberg, Yuri Shtemberg, Victor Eshkenazi, Miraslav E. Royz, and Rimma Shtemberg.
The Settlement Agreement was approved by the Bankruptcy Court after a hearing in an order dated February 1, 2006. Certain terms were subject to confirmation and effectiveness of Mega-C’s Chapter 11 plan of reorganization. On November 8, 2006, the Bankruptcy Court entered an order confirming the Chapter 11 plan. The confirmed Chapter 11 plan was subsequently substantially consummated on November 21, 2006. The Settlement Agreement was fully incorporated in the confirmed Chapter 11 plan. The plan is fully effective and substantially consummated. Accordingly, all pending and potential disputes between the parties have been resolved. By way of summary of the Chapter 11 plan, the following steps have been accomplished:
| | · | we have compromised and withdrawn our notes receivable from Mega-C to an allowed unsecured claim of $100; |
| | · | Mega-C has assigned all of right, title and interest, if any, in the technology and any and all tangible and intangible personal property in our possession to us; |
| | · | the Mega-C Trust has been restated as the Second Amended Stockholders Trust of Mega-C Power Corporation and retained title to 4,700,000 shares that will be sold to pay creditor claims that remain unsatisfied from the Liquidation Trust described below, with the balance to be proportionately distributed to the holders of allowed equity interests in Mega-C. The Second Amended Stockholders Trust also has title to certificates for 685,002 shares of our common stock, which serve as collateral for loans in the amount of $2,055,000 paid to the newly created Liquidation Trust to fund the confirmed Chapter 11 plan; |
| | · | a newly created liquidation trust (the “Liquidation Trust”) received the proceeds of loans in the amount of $2,055,000, secured by 685,002 shares, and legal title to 314,998 shares that will be sold to pay creditor claims and expenses; |
| | · | the former trustee of the Mega-C Trust has received 627,500 shares as compensation by the Mega-C Trust through the effective date of the Chapter 11 plan; and |
| | · | the Mega-C Trust surrendered 1,500,000 shares to us which were promptly cancelled. |
The litigation settlement and releases provided by the Chapter 11 plan are now binding on Mega-C, the Chapter 11 trustee, the Taylor Group and all other parties described in the plan of reorganization. In an order entered on February 11, 2008, the Bankruptcy Court granted our motion for partial summary judgment, holding that the alleged “oral” agreement creating rights or interests in the Technology in favor of the Taylor Group never existed and, even if it had, the Taylor Group transferred any such rights to the Debtor which were then transferred to us by the confirmed Chapter 11 plan. The Bankruptcy Court held that the Taylor Group has no interest in or rights to the Technology. The Bankruptcy Court held that the only rights the Taylor Group has are as putative creditors or Stockholders of Mega-C and that any attempts to claim an interest in or contest our title to the technology are contrary to the permanent injunction of the Chapter 11 plan. The Bankruptcy Court held that the Taylor Litigation against us is barred by the permanent injunction of the confirmed Chapter 11 plan.
In orders entered on June 9, 2008, the Bankruptcy Court mandated that the Taylor Group litigation against us be dismissed. On June 18, 2008, the Taylor Group filed a notice of appeal from these orders. The Taylor Group signed a pleading consenting to dismiss us from the Taylor Group litigation in Canada. On June 27, 2008, we filed a notice of cross-appeal from the Bankruptcy Court’s orders denying our request for sanctions and our request to hold the Taylors in contempt of court for their failure to comply with the permanent injunction of the confirmed chapter 11 plan. The Taylors appeal and our cross-appeal are pending in the United States Bankruptcy Appellate Panel for the Ninth Circuit.
While certain aspects of the bankruptcy litigation discussed above relating to the confirmation of the Chapter 11 plan are on appeal to the United States District Court for the District of Nevada, we believe the possibility of any adverse decision to us to be remote. In connection with a related adversary proceeding in the Bankruptcy Court, the Liquidation Trustee and the Taylors placed a settlement agreement on the record whereby, among other things, the Taylors agreed to dismiss their appeals from the confirmation order and from the settlement agreement. The Taylors’ appeals from the confirmation order and from the settlement agreement have now been dismissed. The Ninth Circuit recently dismissed the appeal from the Settlement Agreement by a group identifying themselves as the “Unaffiliated Shareholders,” The Ninth Circuit awarded double costs on appeal to the Company.
By virtue of the confirmed Chapter 11 plan, all of the Mega-C’s right, title and interest, if any, in the technology was transferred to us. By virtue of the February 11, 2008 orders of the Bankruptcy Court, the Taylor Group has no interest in or rights to the technology.
We agreed to sell 1,000,000 shares of common stock to a foreign partnership, Mercatus & Partners Limited at a price of $2.50 per share as part of a group of comparable transactions where the purchaser planned to contribute a portfolio of small public company securities to a pair of offshore funds in exchange for fund units, and then use the fund units as security for bank financing that would be used to pay for the underlying securities. Contrary to the terms and conditions of our agreement, the foreign partnership was in possession of a stock certificate representing these 1,000,000 shares; however, completion of the transaction was contingent upon receipt of the proceeds from the foreign partnership, which were not received. The 1,000,000 shares were recovered on December 4, 2007 and forwarded to Continental Stock Transfer Agency for cancellation, which took place that same month.
In connection with the offering described above, four holders of warrants to purchase shares of our common stock agreed to exercise their warrants to purchase, in the aggregate, 301,700 shares of common stock (the “Incompletely Exercised Warrant Shares”) for the purpose of selling them to the foreign partnership in a transaction that was substantially similar to the one we entered into with the same foreign partnership. These shares were to be issued to the foreign partnership upon receipt of payment, which was in turn contingent upon the foreign partnership tendering the payment of the purchase price for these shares. Contrary to the terms and conditions of their agreements, the foreign partnership transferred the shares to two of its creditors who both hold the shares as holders-in-due-course. We are pursuing the partnership and the custodians of the stock for the monetary value of the stock. We retained counsel to cause the parties who have possession of the Incompletely Exercised Warrant shares to return the shares absent payment. Counsel was retained October 6, 2007.
Peter Roston Litigation:
A prior Chief Financial Officer, Mr. Peter Roston, filed a lawsuit to recover the full amount of compensation and benefits that would have been paid to him through the initial term of his employment for alleged breaches in his employment agreement after he was discharged for cause by us in December 2006. We determined the range of potential loss to be CAD $250,000 to CAD $275,000. Arbitration proceedings for this matter began in April 2008 and were adjourned to July 2, 2008. On July 2, 2008, following mediation, a potential settlement was reached to resolve the claim. By agreement, the terms of this potential settlement are confidential, although the settlement amount is substantially below the range of potential losses and are not material to Axion’s financial position.
Cypress Avenue Partners, LLC
On May 8, 2008, Cypress Avenue Partners, LLC (“Cypress”), filed a complaint against us and several others in the United States District Court for the Northern District of California. The complaint alleges, among other things, that Cypress entered into a contract with us under which Cypress was to act as a finder and was entitled to certain remuneration which it was not paid. Cypress claims it is entitled to purchase 200,000 shares of our common stock and is owed $900,000, representing a five percent placement fee on the amount of $18 million which reflects the closing of all rounds of Quercus financing. We have denied any obligation to pay the cash placement fee to Cypress under the terms of an October 2006 letter agreement between us and Cypress. We filed a Motion to Dismiss the Complaint on June 30, 2008. The Motion to Dismiss was granted by Order dated August 4, 2008, and Defendant’s Motion by Plaintiff to reconsider was denied on August 11, 2008. The Cypress Avenue Partners, LLC litigation was settled on November 7, 2008, with the exchange of general releases and certain consideration, which is not deemed to be material.
Risks related to our business
We are a development stage company and our business and prospects are extremely difficult to evaluate.
Since our inception in September 2003, the majority of our resources have been dedicated to our R&D efforts and we have only recently begun to transition into the very early stages of commercial prototype production. We do not have a stable operating history that you can rely on in connection with your evaluation of our business and our future business prospects. Our business and prospects must be carefully considered in light of the limited history of PbC technology and the many business risks, uncertainties and difficulties that are typically encountered by development stage companies that have sporadic revenues and are committed to focusing on research, development and product testing for an indeterminate period of time. Some of the principal risks and difficulties we have and expect to continue to encounter include, but are not limited to, our ability to:
| · | Raise the necessary capital to finance our business until we can introduce revenue-generating products on a full-scale basis; |
| · | Maintain effective control over the cost of our research, development and product testing activities; |
| · | Develop cost effective manufacturing methods for essential components of our proposed products; |
| · | Improve the performance of our commercial prototype batteries; |
| · | Successfully transition from our laboratory research efforts to commercial manufacturing of our battery technologies; |
| · | Adapt and successfully execute our rapidly evolving and inherently unpredictable business plan; |
| · | Implement and improve operational, financial and management control systems and processes; |
| · | License complementary technologies if necessary and successfully defend our intellectual property rights against potential claims; |
| · | Respond effectively to competitive developments and changing market conditions; |
| · | Continue to attract, retain and motivate qualified personnel; and |
| · | Manage each of the other risks set forth below. |
Because of our limited operating history and our relatively recent transition into the production of prototype PbC devices that we are relying on to become our core revenue generating products, we have limited insight into trends and conditions that may exist or might emerge and affect our business. There is no assurance that our business strategy will be successful or that we will successfully address the risks identified in this report.
We have incurred net losses from inception and do not expect to introduce our first commercial PbC products for 9 to 15 months.
From our inception we have incurred net losses and expect to continue to incur substantial and possibly increasing losses for the foreseeable future as we increase our spending to finance the development of our PbC technology, our administrative activities, and the costs associated with being a public company. Our operating losses have had, and will continue to have, an adverse impact on our working capital, total assets and stockholders’ equity. For the year ended December 31, 2007, we had net losses of approximately $14.3 million, a net loss of $7.9 million for the year ended December 31, 2006 and cumulative losses from inception (September 18, 2003) to September 30, 2008 of $46.8 million. Our PbC technology has not reached a point where we can mass produce batteries based on the technology and we will not be in a position to commercialize such products until we complete the development and testing activities. We believe the development and testing process will require a minimum of an additional 9 to 15 months. There can be no assurance that our development and testing activities will be successful or that our proposed products will achieve market acceptance or be sold in sufficient quantities and at prices necessary to make them commercially viable. If we do not realize sufficient revenue to achieve profitability, our business could be harmed.
Our revenues may suffer if general economic conditions worsen.
Our revenues and our ability to generate earnings may be affected by general economic factors, such as excessive inflation, currency fluctuations and employment levels, resulting in a temporary or longer-term overall decline in demand for our products. Therefore, any significant downturn or recession in the United States or Canada could have a material adverse effect on our business, results of operations and financial condition.
Our business will not succeed if we are unable to raise additional capital.
Our management believes our current financial resources will support operations for the next 15 months. We will not be able to continue our operations at planned levels of effort beyond that time frame without increased revenues or additional financing. We cannot assure you that any additional capital will be available to us on favorable terms, or at all. If we are unable to generate sufficient revenues or obtain additional capital when needed, our research, development and testing activities will be materially and adversely affected and we may be unable to take advantage of future opportunities or respond to competitive pressures. Any inability to generate revenue or raise capital when we require it would seriously harm our business.
We are currently involved in litigation.
We are currently involved in other litigation as described in Item 1 of this Part II of this Quarterly Report on Form 10-Q. There are no assurances that we will prevail on any litigation to which we are a party and, if we do prevail, at what cost in terms of financial and personnel resources, as well as on what terms.
We are in breach of certain registration rights.
We have outstanding obligations to register approximately 3,950,000 shares of common stock held by the Mega-C Trust, and 750,000 shares held by the Mega-C liquidation trust, in addition we have outstanding obligations to register approximately 1,063,262 shares of common stock that may be issued upon conversion of our 8% Cumulative Convertible Senior Preferred Stock, 7,992,941 shares of common stock that may be issued upon conversion of our Series A Convertible Preferred Stock, approximately 539,611 shares of common stock and issued pursuant to a certain secured bridge loan arrangement and an additional 14,316,272 shares of common stock issuable upon the exercise of certain of our outstanding warrants. We are still in breach of all of our obligations to register these shares. There are no liquidated damages stipulated for our failure to register such shares; however, the holders of these securities may still elect to pursue remedies against the Company for our failure to meet these registration obligations and, as a result, our business operations, or our ability to raise additional capital in the future, may be adversely affected.
As we sell our products, we may become the subject of product liability claims.
Due to the hazardous nature of many of the key materials used in the manufacturing of batteries, the producers of such products may be exposed to a greater number of product liability claims, including possible environmental claims. We currently have product liability insurance up to $1,000,000 per occurrence and $5,000,000 in the aggregate to protect us against the risk that in the future a product liability claim or product recall could materially and adversely affect our business operations. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of our product. We cannot assure you that as we continue distribution of our products that we will be able to obtain or maintain adequate coverage on acceptable terms, or that such insurance will provide adequate coverage against all potential claims. Even if we maintain adequate insurance, any successful claim could materially and adversely affect our reputation and prospects, and divert management’s time and attention. If we are sued for any injury allegedly caused by our future products our liability could exceed our total assets and our ability to pay such liability.
Our products contain hazardous materials including lead.
Lead is a toxic material that is a primary raw material in our PbC. We also use, generate and discharge other toxic, volatile and hazardous chemicals and wastes in our research, development and manufacturing activities. We are required to comply with federal, state and local laws and regulations regarding pollution control and environmental protection. Under some statutes and regulations, a government agency, or other parties, may seek to recover response costs from operators of property where releases of hazardous substances have occurred or are ongoing, even if the operator was not responsible for such release or otherwise at fault. In addition, more stringent laws and regulations may be adopted in the future, and the costs of complying with those laws and regulations could be substantial. If we fail to control the use of, or inadequately restrict the discharge of, hazardous substances, we could be subject to significant monetary damages and fines, or be forced to suspend certain operations.
We are subject to stringent environmental regulation
We use or generate certain hazardous substances in our research and manufacturing facilities. We believe that our handling of such substances is in material compliance with applicable local, state and federal environmental, safety and health regulations. We invest substantially in proper protective equipment, process controls and specialized training to minimize risks to employees, surrounding communities and the environment due to the presence and handling of such hazardous substances. We regularly conduct employee physical examinations and workplace monitoring regarding such substances. When exposure problems or potential exposure problems have been uncovered, corrective actions have been implemented and re-occurrence has been minimal or non-existent. We do not carry environmental impairment insurance. We believe that all permits and licenses required for the operation of our business are in place. Although we do not know of any material environmental, safety or health problems in our property or processes, there can be no assurance that problems will not develop in the future which could have a material adverse effect on our business, results of operation, or financial condition.
The growth we seek is rare and inherently problematic.
The realization of our business objectives will require substantial future growth. Growth of this magnitude in the battery industry is rare. Even in the event we are able to complete the development of our prototypes, introduce our products to the market and grow our business, we expect that rapid growth will place a significant strain on our managerial, operational and financial resources. We must manage our growth, if any, through appropriate systems and controls. We must also establish, train and manage a much larger work force. If we do not manage the growth of our business effectively, our potential could be materially and adversely affected.
Being a public company increases our administrative costs significantly.
As a public company, we incur significant legal, accounting and other expenses that would not be incurred by a comparable private company. Commission rules and regulations have made some activities more time consuming and expensive and required us to implement corporate governance and internal control procedures that are not typical for development stage companies. We also incur a variety of internal and external costs associated with the preparation, filing and distribution of the periodic public reports and proxy statements required by the Securities Exchange Act of 1934, as amended. During the year ended December 31, 2007, we spent approximately $528,246 for public accounting and compliance. During 2008, these expenses are exceeding those incurred in 2007 with $822,212 in compliance costs incurred through September 30, 2008. We expect Commission rules and regulations to continue to make it more difficult and expensive for us to attract and retain qualified directors and executive officers.
We depend on key personnel and our business may be severely disrupted if we lose the services of our key executives and employees.
Our business is dependent upon the knowledge and experience of our key scientists, engineers and executive officers. Given the competitive nature of our industry, there is risk that one or more of our key scientists or engineers will resign their positions, which could have a disruptive impact on our operations. If any of our key scientists, engineers or executive officers do not continue in their present positions, we may not be able to easily replace them and our business may be severely disrupted. If any of these individuals joins a competitor or forms a competing company, we could lose important know-how and experience and incur substantial expense to recruit and train suitable replacements.
Our certificate of incorporation and by-laws provide for indemnification and exculpation of our officers and directors.
Our certificate of incorporation provides for indemnification our officers, directors and employees to the fullest extent permitted by Delaware law. It also provides exculpation of our directors for monetary damages arising from breach of their fiduciary duties in cases that do not involve fraud or willful misconduct. The Commission has advised that it believes that indemnification for liabilities arising under the securities laws is against public policy as expressed in the securities laws and is therefore unenforceable.
We have limited manufacturing experience which may translate into substantial cost overruns in manufacturing and marketing our products.
As we transition into the commercial production of our prototype devices we may experience substantial cost overruns in manufacturing and marketing our PbC technology, and may not have sufficient capital in the future to successfully complete such tasks. In addition, we may not be able to manufacture or market our products because of industry conditions, general economic conditions, and/or competition from potential manufacturers and distributors. Either of these inabilities could cause us to abandon our current business plan and may cause our operations to eventually fail.
Risks related to our PbC technology
We need to improve the performance of our commercial prototypes to achieve large scale production.
Our commercial prototypes do not satisfy all our performance expectations and we need to continue to improve various aspects of our PbC technology as we move forward with larger scale production of our commercial prototypes. There is no assurance that we will be able to resolve the known technical issues. Future testing of our prototypes may reveal additional technical issues that are not currently recognized as obstacles. If we cannot improve the performance of our prototypes in a timely manner, we may be forced to redesign or delay the large scale production of commercial prototypes or possibly cause us to abandon our product development efforts altogether.
We cannot begin full-scale commercial production of our PbC technology for 9 to 15 months.
We will not be able to begin full commercial production of our PbC energy storage devices until we complete our current testing operations, our planned application evaluation and our planned product development. We believe our commercialization path will require a minimum of 9 to 15 months. Even if our prototype development operations are successful, there can be no assurance that we will be able to establish and maintain our facilities and relationships for the manufacturing, distribution and sale of our PbC batteries or that any future products will achieve market acceptance and be sold in sufficient quantities and at prices necessary to make them commercially successful. Even if our proposed products are commercially successful there can be no assurance that we will realize enough revenue and gross margin from the sale of products to achieve profitability.
We do not have any long term vendor contracts.
We currently purchase the raw materials for our carbon electrodes and a variety of other components from third parties. We then fabricate our carbon electrodes and build our prototypes in-house. We do not have any long-term contracts with suppliers of raw materials and components and our current suppliers may be unable to satisfy our future requirements on a timely basis. Moreover, the price of purchased raw materials and components could fluctuate significantly due to circumstances beyond our control. If our current suppliers are unable to satisfy our long-term requirements on a timely basis, we may be required to seek alternative sources for necessary materials and components, or redesign our proposed products to accommodate available substitutes.
We do not have extensive manufacturing experience.
We do not have extensive manufacturing experience with respect to manufacturing our commercial prototypes in quantities required to achieve our operational goals and there is no assurance that we will be able to retain a qualified manufacturing staff or effectively manage the manufacturing of our proposed products when we are ready to do so.
We will be a small player in an intensely competitive market and may be unable to compete.
The lead-acid battery industry is large, intensely competitive and resistant to technological change. If our product development efforts are successful, we will have to compete or enter into strategic relationships with well-established companies that are much larger and have greater financial capital and other resources than we do. We may be unable to convince end users that products based on our PbC technology are superior to available alternatives. Moreover, if competitors introduce similar products, they may have a greater ability to withstand price competition and finance their marketing programs. There is no assurance that we will be able to compete effectively.
To the extent we enter into strategic relationships, we will be dependent upon our partners.
Some of our products are not intended for direct sale to end users and our business strategy will likely require us to enter into strategic relationships with manufacturers of other power industry equipment that use batteries and other energy storage devices as important components of their finished products. The agreements governing any future strategic relationships are unlikely to provide us with control over the activities of any strategic relationship we negotiate and our future partners, if any, could retain the right to terminate the strategic relationship at their option. Our future partners will have significant discretion in determining the efforts and level of resources that they dedicate to our products and may be unwilling or unable to fulfill their obligations to us. In addition, our future partners may develop and commercialize, either alone or with others, products that are similar to or competitive with the products that we intend to produce.
Risks relating to our intellectual property
We may rely on licenses for our PbC technology, which may affect our continued operations with respect thereto.
As we develop our PbC technology, we may need to license additional technologies to optimize the performance of our products. We may not be able to license these technologies on commercially reasonable terms or at all. In addition, we may fail to successfully integrate any licensed technology into our proposed products. Our inability to obtain any necessary licenses could delay our product development and testing until alternative technologies can be identified, licensed and integrated. The inability to obtain any necessary third-party licenses could cause us to abandon a particular development path, which could seriously harm our business, financial position and results of our operations.
If we are unable to protect our proprietary technology and preserve our trade secrets, we will increase our vulnerability to competitors which could materially adversely impact our ability to remain in business.
Our ability to commercialize successfully our products will depend, in large measure, on our ability to protect those products and our technology with domestic and foreign patents. We will also need to continue to preserve our trade secrets. The issuance of a patent is not conclusive as to its validity or as to the enforceable scope of the claims of the patent. The patent positions of technology companies, including our Company, are uncertain and involve complex legal and factual issues.
We cannot assure you that our patents will prevent other companies from developing similar products or products which produce benefits substantially the same as our products, or that other companies will not be issued patents that may prevent the sale of our products or require us to pay significant licensing fees in order to market our products. Accordingly, if our patent applications are not approved or, even if approved, if such patents are circumvented or not upheld in a court of law, our ability to competitively exploit our patented products and technologies may be significantly reduced. Additionally, the coverage claimed in a patent application can be significantly reduced before the patent is issued.
From time to time, we may need to obtain licenses to patents and other proprietary rights held by third parties in order to develop, manufacture and market our products. If we are unable to timely obtain these licenses on commercially reasonable terms, our ability to commercially exploit such products may be inhibited or prevented. Additionally, we cannot assure investors that any of our products or technology will be patentable or that any future patents we obtain will give us an exclusive position in the subject matter claimed by those patents. Furthermore, we cannot assure investors that our pending patent applications will result in issued patents, that patent protection will be secured for any particular technology, or that our issued patents will be valid or enforceable or provide us with meaningful protection.
If we are required to engage in expensive and lengthy litigation to enforce our intellectual property rights, the costs of such litigation could be material to our results of operations, financial condition and liquidity and, if we are unsuccessful, the results of such litigation could materially adversely impact our entire business.
We may find it necessary to initiate litigation to enforce our patent rights, to protect our trade secrets or know-how or to determine the scope and validity of the proprietary rights of others. We plan to aggressively defend our proprietary technology and any issued patents, if funding is available to do so. Litigation concerning patents, trademarks, copyrights and proprietary technologies can often be time-consuming and expensive and, as with litigation generally, the outcome is inherently uncertain.
Although we have entered into invention assignment agreements with our employees and with certain advisors, if those employees or advisors develop inventions or processes independently which may relate to products or technology under development by us, disputes may also arise about the ownership of those inventions or processes. Time-consuming and costly litigation could be necessary to enforce and determine the scope of our rights under these agreements.
We also rely on confidentiality agreements with our strategic partners, customers, suppliers, employees and consultants to protect our trade secrets and proprietary know-how. We may be required to commence litigation to enforce such agreements and it is certainly possible that we will not have adequate remedies for breaches of our confidentiality agreements.
Other companies may claim that our technology infringes on their intellectual property or proprietary rights and commence legal proceedings against us which could be time-consuming and expensive and could result in our being prohibited from developing, marketing, selling or distributing our products.
Because of the complex and difficult legal and factual questions that relate to patent positions in our industry, we cannot assure you that our products or technology will not be found to infringe upon the intellectual property or proprietary rights of others. Third parties may claim that our products or technology infringe on their patents, copyrights, trademarks or other proprietary rights and demand that we cease development or marketing of those products or technology or pay license fees. We may not be able to avoid costly patent infringement litigation, which will divert the attention of management away from the development of new products and the operation of our business. We cannot assure investors that we would prevail in any such litigation. If we are found to have infringed on a third party's intellectual property rights, we may be liable for money damages, encounter significant delays in bringing products to market or be precluded from manufacturing particular products or using particular technology.
Other parties may challenge certain of our foreign patent applications. If such parties are successful in opposing our foreign patent applications, we may not gain the protection afforded by those patent applications in particular jurisdictions and may face additional proceedings with respect to similar patents in other jurisdictions, as well as related patents. The loss of patent protection in one jurisdiction may influence our ability to maintain patent protection for the same technology in another jurisdiction.
New technology may lead to our competitors developing superior products which would reduce demand for our products.
Research into the electrochemical applications for carbon nanotechnology and other storage technologies is proceeding at a rapid pace and many private and public companies and research institutions are actively engaged in the development of new battery technologies based on carbon nanotubes, nanostructured carbon materials and other non-carbon materials. These new technologies may, if successfully developed, offer significant performance or price advantages when compared with our PbC technology. There is no assurance that our existing patents or our pending and proposed patent applications will offer meaningful protection if a competitor develops a novel product based on a new technology.
Risks relating to our common stock
The number of shares of common stock we are obligated to register could depress our stock price.
Effective August 5, 2008, we registered 2,782,837 shares of our common stock for resale by certain Selling Stockholders. These shares represent approximately 7.3% of our capitalization assuming the exercise of certain warrants and options and conversion of preferred stock. The sale of a significant number of these shares may cause the market price of our common stock to decline.
We have issued a large number of convertible securities, warrants and options that may increase, perhaps significantly, the number of common shares outstanding.
We had 26,414,437 shares of common stock outstanding on the date of this report, and (a) our Series A Convertible Preferred Stock is presently convertible into 7,618,569 shares of common stock, (b) our shares of Cumulative Convertible Senior Preferred Stock is presently convertible into 1,084,527 shares of common stock, (c) we have warrants outstanding that, if exercised, would generate proceeds of $42,015,303 and cause us to issue up to an additional 14,278,772 shares of common stock and (d) we have options to purchase common stock that, if exercised, would generate proceeds of $10,513,018 and result in the issuance of an additional 2,460,885 shares of common stock.
We have provided and intend to continue offering compensation packages to our management and employees that emphasize equity-based compensation.
As a key component of our growth strategy, we have provided and intend to continue offering compensation packages to our management and employees that emphasize equity-based compensation. In particular:
| · | Our incentive stock plan authorized incentive awards for up to 2,000,000 shares of our common stock; we have issued incentive awards for an aggregate of 652,950 shares at the date of this report; and we have the power to issue incentive awards for an additional 1,347,050 shares without stockholder approval; |
| · | Our independent directors’ stock option plan authorized options for up to 500,000 shares of our common stock; we have issued options for an aggregate of 169,600 shares at the date of this report; and have the power to issue options for an additional 330,400 shares without stockholder approval; |
| · | We have issued contractual options for an aggregate of 1,943,000 shares of our common stock, of which 1,503,000 are currently outstanding, to executive officers under the terms of their employment agreements with us; and |
| · | We have issued contractual options for an aggregate of 965,200 shares of our common stock, of which 765,900 are currently outstanding, to certain attorneys and consultants under the terms of their agreements with us. |
We believe our equity compensation policies will allow us to provide substantial incentives while minimizing our cash outflow. Nevertheless, we will be required to account for the fair market value of equity compensation awards as operating expenses. As our business matures and expands, we expect to incur increasing amounts of non-cash compensation expense, which may materially and adversely affect our future operating results.
We may issue stock to finance acquisitions.
We may wish to acquire complementary technologies, additional facilities and other assets. Whenever possible, we will try to use our stock as an acquisition currency in order to conserve our available cash for operations, but use of stock as an acquisition currency will also dilute the ownership of then current existing stockholders. Future acquisitions may give rise to substantial charges for the impairment of goodwill and other intangible assets that would materially and adversely affect our reported operating results. Any future acquisitions will involve numerous business and financial risks, including:
| · | difficulties in integrating new operations, technologies, products and staff; |
| · | diversion of management attention from other business concerns; and |
| · | cost and availability of acquisition financing. |
We will need to be able to successfully integrate any businesses we may acquire in the future, and the failure to do so could have a material adverse effect on our business, results of operations and financial condition.
Because of factors unique to us, the market price of our common stock is likely to be volatile.
Because of the relatively small number of shares currently available for resale, the large number of shares that we are in the process of registering on behalf of Quercus, the development stage of our business and numerous other factors, the trading price of our common stock has been and is likely to continue to be highly volatile. In addition, actual or anticipated variations in our quarterly operating results; the introduction of new products by competitors; changes in competitive conditions or trends in the battery industry; changes in governmental regulation and changes in securities analysts’ estimates of our future performance or that of our competitors or our industry in general, could adversely affect our future stock price. Investors should not purchase our shares if they are unable to suffer a complete loss of their investment.
Our stock price may not stabilize at current levels.
Our stock is quoted on the OTCBB. Since trading in our common stock began in January 2004, trading has been sporadic, trading volumes have been low and the market price has been volatile. The closing price reported as of October 31, 2008 [the latest practicable date] was $1.28 per share. Current quotations are not necessarily a reliable indicator of value and there is no assurance that the market price of our stock will stabilize at or near current levels.
Our common stock is subject to the “penny stock” rules.
Rule 3a51-1 promulgated under the Securities Exchange Act of 1934, as amended, defines a “penny stock” as any equity security that is not listed on a national securities exchange or the Nasdaq system and has a bid price of less than $5 per share. We presently are subject to the penny stock rules. Our market price has been highly volatile since trading in our common stock began in January 2004 and there is no assurance that the penny stock rules will not continue to apply to our shares for an indefinite period of time. Before effecting a transaction that is subject to the penny stock rules, a broker-dealer must make a decision respecting the suitability of the purchaser; deliver certain disclosure materials to the purchaser and receive the purchaser’s written approval of the transaction. Because of these restrictions, most broker-dealers refrain from effecting transactions in penny stocks and many actively discourage their clients from purchasing penny stocks. Therefore, both the ability of broker-dealers to recommend our common stock and the ability of our stockholders to sell their shares in the secondary market could be adversely affected by the penny stock rules.
| 31.1 | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) |
| 31.2 | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) |
| 32.1 | Statement of Chief Executive Officer Pursuant to Section 1350 of Title 18 of the United States Code |
| 32.2 | Statement of Chief Financial Officer Pursuant to Section 1350 of Title 18 of the United States Code |
SIGNATURES
In accordance with the requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AXION POWER INTERNATIONAL, INC.
Thomas Granville,
Chief Executive Officer
Dated: November 10, 2008
/s/ Donald T. Hillier
Donald T. Hillier, Principal Financial Officer andPrincipal Accounting Officer
Dated: November 10, 2008
