Filed with the Securities and Exchange Commission on February 16, 2017.

 

Registration Statement No. 333-211048

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Post-Effective Amendment No. 1

to

Form S-1
REGISTRATION STATEMENT UNDER
THE SECURITIES ACT OF 1933 

 

ENER-CORE, INC.
(Exact name of registrant as specified in its charter)

 

Delaware   3511   46-0525350
(State or other jurisdiction of
incorporation or organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification Number)

 

9400 Toledo Way
Irvine, California 92618

(949) 616-3300

 

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

Alain J. Castro

Chief Executive Officer
9400 Toledo Way

Irvine, California 92618

(949) 616-3300 

 

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

Copies of all communications to:

 

Shoshannah D. Katz

Matthew A. Susson

K&L Gates LLP

1 Park Plaza, Twelfth Floor

Irvine, CA 92614

(949) 253-0900

 

Approximate date of commencement of proposed sale to the public:
As soon as practicable after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. ☒

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐

 

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

 

Large accelerated filer ☐ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☒
  (Do not check if a smaller reporting company)

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 

 

 

 

EXPLANATORY NOTE

 

This Post-Effective Amendment No. 1, or Post-Effective Amendment, relates to the Registration Statement on Form S-1 of Ener-Core, Inc. pertaining to 937,500 shares of our common stock, par value $0.0001 per share, which was initially filed with the Securities and Exchange Commission on May 2, 2016 (File No. 333-211048), as amended, and was declared effective by the Securities and Exchange Commission on June 28, 2016, or the Registration Statement. This Post-Effective Amendment is being filed to update certain financial and other information contained in the prospectus and includes the financials and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 and Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2016 and certain other updated information contained in the Registration Statement.

 

No additional securities are being registered under this Post-Effective Amendment. All applicable registration fees were paid at the time of the original filing of the Registration Statement.

 

 

 

 

PROSPECTUS

 

 

 

Ener-Core, Inc.

 

Up to 937,500 Shares of Common Stock

 

This prospectus relates to the offer and sale from time to time by the selling stockholders identified in this prospectus of up to an aggregate of 937,500 shares of our common stock, par value $0.0001 per share. The selling stockholders acquired an aggregate of 625,000 shares of common stock and warrants to purchase up to an aggregate of 312,500 shares of common stock pursuant to that certain securities purchase agreement, dated as of December 31, 2015, by and between such selling stockholders and the Company.

 

The shares of common stock registered hereby may be offered and sold by our selling stockholders through one or more underwriters, broker-dealers or agents. If the shares of common stock are sold through underwriters or broker-dealers, the selling stockholders will be responsible for underwriting discounts or commissions or agent’s commissions. The shares of common stock may be sold in one or more transactions at fixed prices, at prevailing market prices at the time of the sale, at varying prices determined at the time of sale, or at negotiated prices. See “Plan of Distribution.”

 

We are not selling any shares of common stock under this prospectus, and we will not receive any of the proceeds from the offer and sale of shares of our common stock by the selling stockholders.

 

This prospectus describes the general manner in which shares of common stock may be offered and sold by any selling stockholder. When the selling stockholders sell shares of common stock under this prospectus, we may, if necessary and required by law, provide a prospectus supplement that will contain specific information about the terms of that offering. Any prospectus supplement may also add to, update, modify or replace information contained in this prospectus. We urge you to read carefully this prospectus, any accompanying prospectus supplement and any documents we incorporate by reference into this prospectus and any accompanying prospectus supplement before you make your investment decision.

 

Our common stock is currently quoted on the OTCQB Marketplace under the symbol “ENCR.” On February 7, 2017, the last reported sale price of shares of our common stock on the OTCQB Marketplace was $2.01.

 

On May 6, 2013, we effected a 30-for-1 forward split of our issued and outstanding shares of common stock by way of a stock dividend. On July 8, 2015, we effected a 1-for-50 reverse split of our issued and outstanding shares of common stock. All share and per share information in this prospectus gives effect to the 30-for-1 forward split and 1-for-50 reverse split, retroactively.

 

We are an “emerging growth company” as defined under the Jumpstart Our Business Startups Act of 2012, and applicable Securities and Exchange Commission rules, and have elected to comply with certain reduced public company reporting requirements. Please refer to the discussions under “Summary—Implications of Being an Emerging Growth Company” and “Risk Factors” below concerning how and when we may lose emerging growth company status and the various exemptions that are available to us. 

 

Investing in our securities involves a high degree of risk. See “Risk Factors” beginning on page 12 of this prospectus.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

The date of this prospectus is       , 2017. 

 

 

 

 

TABLE OF CONTENTS

 

  Page
Prospectus Summary 1
Risk Factors 12
Special Note Regarding Forward-Looking Statements 30
Use of Proceeds 31
Private Placements of Common Shares and Warrants 32
Selling Stockholders 33
Plan of Distribution 36
Dividend Policy 38
Management’s Discussion and Analysis of Financial Condition and Results of Operations 39
Business 73
Management 98
Executive and Director Compensation 103
Certain Relationships and Related Party Transactions 120
Principal Stockholders 122
Description of Capital Stock 125
Legal Matters 130
Experts 130
Information Incorporated by Reference 130
Where You Can Find More Information 130
Index to Financial Statements F-1

 

You should rely solely on the information contained in this prospectus. We have not authorized anyone to provide any information or make any representations other than those contained in this prospectus. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. We are offering to sell, and seeking offers to buy, securities only in jurisdictions where such offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus.

 

Unless otherwise indicated, information contained in this prospectus concerning our industry, including our market opportunity, is based on information from independent industry analysts, market research, publicly available information and industry publications. The third-party sources from which we have obtained information are generally believed to be reliable, but we cannot assure you that such information is accurate or complete. Management estimates contained in this prospectus are based on assumptions made by us using our internal research data and our knowledge of such industry and market, including reference to publicly available information released by independent industry analysts and third party sources, which we believe to be reasonable. In addition, while we believe the market opportunity information included in this prospectus is generally reliable and is based on reasonable assumptions, such data involves risks and uncertainties and is subject to change based on various factors, including those discussed under the heading “Risk Factors.” These and other factors could cause our future performance to differ materially from our assumptions and estimates. See “Special Note Regarding Forward-Looking Statements.”

 

For investors outside the U.S.: We have not and the selling stockholders have not done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the U.S. You are required to inform yourselves about and to observe any restrictions relating to the offering of the shares of common stock and the distribution and possession of this prospectus outside of the U.S.

 

The Ener-Core, Inc. logo and other trademarks or service marks of Ener-Core, Inc., including, but not limited to “ENER-CORE”, appearing in this prospectus are the property of Ener-Core, Inc.

 

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PROSPECTUS SUMMARY

 

This summary highlights certain information contained in other parts of this prospectus. Because it is a summary, it does not contain all of the information you should consider before investing in our securities. You should read the entire prospectus carefully, including “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and our consolidated financial statements and related notes before deciding to invest in our common stock. References in this prospectus to “Ener-Core,” “the Company,” “we,” “our,” “ours,” “us,” or similar terms refer to Ener-Core, Inc. and its wholly-owned subsidiary, Ener-Core Power, Inc., taken together, unless the context indicates otherwise.

 

Overview

 

Our proprietary and patented Power Oxidation technology is designed to create greater industrial efficiencies by converting low-quality waste gases generated from industrial processes into usable on-site energy, therefore decreasing both operating costs and significantly reducing environmentally harmful gaseous emissions. We design, develop, license, manufacture and market our Power Oxidizers, which, when bundled with an electricity generating turbine in the 250 kilowatt, or kW, and 2 megawatt, or MW, sizes, are called Powerstations. We currently partner and are pursuing partnerships with large established manufacturers to integrate our Power Oxidizer with their gas turbines, with the goal to open substantial new opportunities for our partners to market these modified gas turbines to industries for which traditional power generation technologies were not technically feasible previously. We currently manufacture our Powerstations in the 250 kW size and manufacture just the Power Oxidizer for the 2MW size. Beginning in 2017, contingent upon the successful completion of certain field testing, our 2MW partner, Dresser-Rand a.s., a subsidiary of Dresser-Rand Group Inc., a Siemens company, or Dresser-Rand, will manufacture the 2MW Power Oxidizers under a manufacturing license and will pay us a non-refundable license fee for each unit manufactured.

 

Historically, basic industries such as Petroleum, Plastics, Steel and Paper have consumed electricity in their manufacturing processes and created heat for their manufacturing processes through the burning of fossil fuels in a combustion chamber. Nearly all such combustion chambers use high quality premium fuels and burn those fuels at high temperatures, while low-quality waste gases were typically destroyed or vented into the atmosphere. Worldwide, these industrial processes collectively contribute approximately 32% of total global greenhouse gas emissions. Our technology utilizes these waste gases by modifying turbines with our gradual oxidation vessel. Inside this vessel, pressure and temperature are applied over time to destroy contaminants and return a substantially low emission source of energy in the form of heat. This heat then powers a turbine, spinning a generator and creating electricity. This technology can potentially unlock a new, global source of clean power generation (electricity, steam and/or heat energy) while reducing harmful emissions. Our goal is to enable industrial process facilities to generate clean energy from their existing waste gases, thereby reducing the amount of energy they purchase from their regional utilities, and simultaneously reducing the cost of compliance with local, state, and federal air quality regulations by avoiding the chemicals, catalysts and complex permitting required by existing pollution abatement systems.

 

We have experienced losses since inception and anticipate that we will continue to incur losses and negative cash flows for the foreseeable future as we continue to further develop and deploy our power products.

 

Our Opportunity

 

The creation and release of waste gases, which lead to air pollution, is a byproduct of many modern industries. Industrial waste gases take many forms and are often subject to governmental or regulatory oversight via air quality or air standards boards. The rules and guidelines implemented by these boards lead to compliance costs for companies with industrial facilities that emit the waste gases. With the worldwide concerns over the atmospheric emissions of greenhouse gases, air quality standards have become increasingly stringent. For areas with industrial air pollution abatement regulations, industrial polluters currently have the following choices:

 

  (i) continue to pollute and thereby pay substantial fines imposed by regulatory authorities,
     
  (ii) reduce their air pollution through existing abatement solutions such as scrubbing or flaring, or
     
  (iii) institute some combination of these solutions.

  

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Each industrial location must choose the most economic mix of the available solutions, but each of these solutions represents both a financial operating cost as well as an environmental cost.

 

Our technology provides an alternative to the typical economic and environmental costs of hydrocarbon pollution abatement by providing the ability for industrial facilities to productively utilize their waste gases to generate power, which can be sold or used internally, while at the same time reducing both the atmospheric pollution resulting from those waste gases and any resulting pollution abatement costs.

  

Our Technology

 

Our technology involves the acceleration of a naturally occurring, gas oxidation process by injecting hydrocarbon gases into a controlled, high temperature, high pressure, and oxygen rich environment. Oxidation is a natural and commonly observed chemical reaction that occurs when a substance comes into contact with oxygen over a prolonged period of time, approximately 10 to 20 years for the waste gases that we have targeted. The reaction is exothermic, which generates heat. By accelerating the reaction to 0.5–1.25 seconds within the controlled, steady state environment of our Power Oxidizers, the heat generated from the reaction is compounded and we are able to capture and utilize the heat output within the heat profile ranges necessary to operate standard gas turbines or steam boilers without actually igniting the gas.

 

Our Products and Value Proposition

 

We have developed a 250 kW Power Oxidizer that we integrate with a 250 kW gas turbine to produce 250 kW Powerstations. We have two Powerstations currently in operation at a landfill site in the Netherlands and at the Irvine campus of the University of California, Irvine, or UCI, and one additional Powerstation currently in the production phase expected to be installed at a landfill in southern California. We have built a Power Oxidizer of a significantly larger size, capable of generating sufficient heat and airflow to power a KG2 turbine produced by Dresser-Rand. Together, the Power Oxidizer and KG2 turbine comprise a 2MW Powerstation. The initial unit was constructed in the first quarter of 2016, and is currently being used in field tests that were substantially completed in the fourth quarter of 2016, at a third party location in Southern California. We have sold two 2MW Power Oxidizers to Dresser-Rand, each of which were delivered to the customer site in October 2016 and were combined with KG2 turbines and installed at Pacific Ethanol’s facility in Northern California in 2016. We believe this scaled-up version of our Power Oxidizer, combined with the KG2 turbine, will result in a Powerstation product that is better aligned with the scale of emissions (and energy requirements) observed at the industrial facilities that we believe stand to benefit most from this technology. As with the 250 kW Powerstation, the larger Powerstations are designed to provide an alternative to typical combustion-based power generation and enable industries to utilize their own waste gases to generate power.

 

We also expect to integrate our Power Oxidizer technology into additional sized gas turbines as well as other applications that can use the heat generated by our Power Oxidizers to power other industrial applications. We believe other industrial grade waste gas-to-heat opportunities, powered by an ultra-low pollution Power Oxidizer, include: (i) the generation of steam from coupling a Power Oxidizer with a traditional steam boiler, (ii) use in industrial grade dryers for kilns or industrial drying customer requirements, and (iii) use in industrial chiller units for customers requiring cold air or water in their processes.

 

We believe our Power Oxidizers provide a significantly lower fuel cost per kilowatt hour since they can operate using both premium, refined natural gas as well as a wide variety of lower quality, low hydrocarbon gases, traditionally considered to be “waste” gases, as well as certain volatile organic compounds, or VOCs, such as paint solvents. These gases and compounds are typically seen as a waste by-product of industrial processes and which often represent a source of pollution which in turn often requires expensive waste abatement equipment and significant recurring operating costs. Our Power Oxidizers can utilize many of these waste gases and VOC compounds as fuels for our Powerstations, which we intend to serve as a fuel cost reduction for our industrial customers.

 

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We also believe our Power Oxidizers provide a superior air pollution waste abatement solution for industrial customers. A typical industrial customer historically requires electricity, steam and generates industrial gases as a by-product of their facility operations. Prior to our Powerstation solution, these customers would purchase energy or produce energy with a traditional gas turbine. Traditional gas turbines use a combustion chamber to ignite the natural gas and result in air pollution such as carbon dioxide, carbon monoxide, and nitrogen oxides. The gas turbine and by-product gases generally require pollution control equipment and recurring costs in order to comply with existing pollution standards, which vary by geography with different regulations. Since both the natural gas fuel and the industrial by-product gases oxidize in our Power Oxidizers over a much longer time than combustion heat sources, the Power Oxidizer eliminates both the gas fuels and by-products to levels below significantly all of the existing and proposed air quality emission standards in most areas of the world.

 

Licensing Approach

 

On November 14, 2014, we entered into a global commercial licensing agreement with Dresser-Rand, or the CLA, through our wholly-owned subsidiary, Ener-Core Power, Inc., which granted Dresser-Rand the right to market and sell the Dresser-Rand KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer, or a Combined System. The CLA grants Dresser-Rand exclusive rights to commercialize the Ener-Core Power Oxidizer, within ranges of 1–4 MW of power capacity, bundled with the Dresser-Rand KG2 gas-turbine product line. As part of the CLA, Dresser-Rand agreed to pay us a $1.6 million initial license fee, under the condition that we were able to successfully scale up the technology to a size of 2 MW. Dresser-Rand also agreed to achieve annual sales thresholds agreed to by both companies in order to retain the exclusivity of the commercial license. Upon payment of the initial license fee in full, Dresser-Rand obtained an exclusive license to sell the Ener-Core Power Oxidizer within ranges of 1–4 MW of power capacity, bundled with a gas-turbine to generate electricity.

 

On June 29, 2016, we entered into a Commercial and Manufacturing License Agreement, or the CMLA, with Dresser-Rand, through Ener-Core Power, Inc., intended to supersede and replace the CLA. Upon successful completion of the FSAT, the CLA will terminate and the CMLA will provide the terms of the commercial relationship between us and Dresser-Rand. Once the FSAT is completed, the effective date of the CMLA will be deemed November 14, 2014. In the event we are unable to successfully complete the FSAT, the CLA will continue to govern our commercial relationship with Dresser-Rand. As of December 31, 2016, we had performed the testing protocols of substantially all of the required tests, the results of which remain subject to verification by Dresser-Rand, which is currently underway.

 

Under the new CMLA, Dresser-Rand will have a worldwide license to manufacture, market, commercialize and sell the Power Oxidizer as part of the Combined System within the 1 MW to 4 MW range of power capacity, or the License. Initially, the License will be exclusive, even as to us, and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System in each calendar year beginning in 2017, or the Sales Threshold, subject to certain conditions and exceptions. If Dresser-Rand does not meet the Sales Threshold in any calendar year and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the License by making a true-up payment to us for each unit that is in deficit of the Sales Threshold, or a True-Up Payment; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive calendar year periods. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver and elects not to make the True-Up Payment, the License will convert to a nonexclusive License.

 

Upon a sale by Dresser-Rand of a Combined System unit to a customer, the CMLA requires Dresser-Rand to make a license fee payment to us equal to a percentage of the sales price of the Combined System purchased, in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $600,000 per Combined System unit sold, or the License Fee. Payment terms to us from Dresser-Rand will be 50% of each License Fee within 30 days of order and 50% upon the earlier of the Combined System commissioning or twelve months after the order date.

 

Dresser-Rand may also request that we undertake design and development work on modifications to the Combined Systems, each referred to as a Bespoke Development. We and Dresser-Rand will negotiate any fees resulting from any such Bespoke Development on a case-by-case basis. Further, any obligation by us to undertake such Bespoke Development will be conditioned upon the execution of mutually agreed-upon documentation. 

 

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As long as the exclusive License remains in effect, we will provide certain ongoing sales and marketing support services, at no additional cost to Dresser-Rand, subject to certain restrictions. Any additional sales and marketing services agreed upon by us and Dresser-Rand will be compensated at an hourly rate to be upwardly adjusted annually.

 

If we and Dresser-Rand so elect, we will manufacture a certain number of Power Oxidizers as part of a certain number of Combined System projects during a transition period, or the Transition Phase, beginning after execution of the CMLA and prior to the period in which Dresser-Rand manufactures its first three Power Oxidizers as part of at least two individual Combined System projects, or the Initial Manufacturing Phase, as mutually agreed by the parties. So long as the License remains exclusive during the Transition Phase, if any, and the Initial Manufacturing Phase, we will provide a mutually agreed upon number of hours of engineering support services. After the conclusion of the Initial Manufacturing Phase, we will, for so long as the License remains exclusive, continue providing up to an agreed upon number of hours of such support services on an annual basis at no additional cost to Dresser-Rand, subject to certain conditions. Any additional engineering support services agreed upon by us and Dresser-Rand will be compensated at an hourly rate, to be upwardly adjusted annually. During the Transition Phase, we must also develop the spare parts list pertaining to the scope of supply to allow Dresser-Rand to offer service agreements for the Combined System.

 

We must maintain our existing backstop security, or the Backstop Security, under the CLA in favor of Dresser-Rand in support of all products manufactured, supplied or otherwise provided by us during the period beginning on the execution date of the CMLA, or the Execution Date, and continuing through the expiration of the warranty period for the Combined System units sold to customers as of the Execution Date; however, if we and Dresser-Rand mutually agree to engage in a Transition Phase, then such Backstop Security must be extended to support all products manufactured, supplied or otherwise provided by us during such Transition Phase.

 

Dresser-Rand must also: (i) develop the controls strategy for the Dresser-Rand gas turbine control system and integrate it with the Power Oxidizer control system; (ii) with support from us, manufacture and commercialize the Combined System following the Transition Phase; (iii) with support from us, develop and prioritize sales opportunities for the Combined System; (iv) assume the sales lead role with respect to each customer; and (v) take commercial lead in developing sales to customers. In addition, Dresser-Rand will be primarily responsible for overall warranty and other commercial conditions to Combined System customers, as well as sole project and service provider and interface with customers. Dresser-Rand will also be responsible for warranty, service and after-sales technical assistance for all portions of Combined Systems that comprise Dresser-Rand products. We, however, will be responsible for warranty and service for all products manufactured or otherwise provided by us prior to or during the Transition Phase.

 

The CMLA prohibits us from, without the prior written consent of Dresser-Rand, permitting the creation of any encumbrance, lien or pledge of its intellectual property which would result in any modification to, revocation of, impairment of or other adverse effect on Dresser-Rand’s rights with respect to the exclusive License. In addition, all intellectual property rights that are owned by either us or Dresser-Rand as of the Execution Date will remain the sole property of such party, subject to the licenses described in the CMLA. The CMLA also contains provisions that govern the treatment of process and technology developments and any joint inventions that (i) relate to the subject matter of the CMLA and (ii) occur after the Execution Date and during the term thereof.

 

The CMLA also contains certain restrictions on publicity and obligates Dresser-Rand to use its commercially reasonable efforts to include our name and logo and otherwise promote our brand and Power Oxidizers in a mutually agreed-upon manner. We and Dresser-Rand have also mutually agreed to withhold disclosure of certain commercial and technologically sensitive terms of the CMLA including technical specifications, License Fee percentages, and the Sales Threshold minimum annual quantities to maintain exclusivity.

 

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Commercial Sales Efforts

 

We are entering the combined heat and power, or CHP, market that is highly competitive and historically conservative in its acceptance of new technologies. To date, we have sold and delivered one 250 kW commercial PowerStation unit to the Netherlands and have sold one additional 250 kW PowerStation unit to a landfill site in Southern California scheduled for delivery in 2017. We have also sold two initial 2MW Power Oxidizers to Dresser-Rand for installation at their end user customer, Pacific Ethanol, which were delivered in the second half of 2016 but which remain subject to acceptance conditions which may not have been met as of December 31, 2016 and which remain subject to further review or deferral, depending in part on the results of the final FSAT test results. These three systems, combined with the Dresser-Rand license fees of $1.6 million, represent our $4.6 million order backlog as of February 7, 2017. To date, we have billed $4.2 million and collected $4.1 million of our existing backlog.

 

In May 2016, we received a conditional purchase order for four 250 kW Powerstations expected to be installed on a landfill site in Southern California and scheduled for delivery in late 2017. This order is valued at approximately $4.0 million and is subject to additional pre-sales engineering and permitting requirements.

 

Markets

 

We see our total potential market consisting of industrial facilities with permanent waste gas emissions sufficient to operate our units on a constant basis. We evaluate our potential markets in two methods, geographically and vertically. Our most significant sales opportunities are those where a customer’s demand for power, heat energy, and pollution abatement intersect as presented in the schematic diagram below (opportunities not to scale):

 

 

 

We believe the total addressable U.S. market size is at least $5 billion for our Power Oxidizer technology, based on our assumption that our 333 kW Power Oxidizer is most appropriate for landfills and our 2 MW Power Oxidizer is most appropriate for our other targeted markets. We also believe the total addressable market size in Europe, Japan and China provides us with potentially meaningful opportunities.

 

Geographic Target Markets

 

We initially identified our geographic target markets to consist of North America, Europe, Japan and China, with selective evaluations of other regions on a case-by-case basis. While we intend to focus primarily on the North American and European geographic markets over the next year, we expect and intend to evaluate commercial opportunities in other geographic markets.

 

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In the United States, we are focused on opportunities where our low-quality fuels configuration and our ultra-low emissions configuration provide competitive advantages. We are also focused on specific states where the wholesale electricity prices are the highest, as this typically results in the most attractive return on investment scenarios for prospective customers. These states include California, New Jersey, New York, Maine, New Hampshire, Massachusetts, Connecticut, Rhode Island and Vermont.

 

Internationally, we have identified similar opportunities in Canada and western European countries with similar environmental and regulatory laws as the United States, such as the Netherlands, Belgium, the United Kingdom, Germany, Italy, France and Spain.

 

Vertical Markets

 

We believe that our current products provide a superior value proposition for two customer types: (i) open and closed existing landfills, and (ii) industrial facilities that could benefit from on-site combined heat/power, or CHP, generation coupled with waste gas pollution abatement. In general, the projected economics seen to date indicate that sales into existing landfill plants will primarily represent EC250 and EC333 sales opportunities and sales into other industrial facilities will typically involve our larger products. We believe that our future steam product will primarily represent an attractive alternative to industrial facilities that value on site steam production higher than on site electricity production. We also believe that larger sized Power Oxidizer turbines of 5 MW and above, once developed, will likely be met with demand from large industrial facilities such as oil and gas refineries and petrochemical plants.

 

Initially, we will target the following markets:

 

  Landfills;
     
  Fuel-grade and beverage ethanol/alcohol distilleries and related products production;
     
  Rendering and animal processing byproducts;
     
  Wastewater and sewage treatment;
     
  Coal mines;
     
  “High tech” aerospace and defense instruments and materials; semiconductor and electronics manufacturing; and
     
  Petroleum and petrochemical storage, distillation and petroleum production.

 

Competitive Advantages

 

As compared to alternative technologies, Power Oxidation provides certain advantages over alternative energy-generation technologies, including the following:

 

  Operates on a wider range of fuels. Our system is designed to operate on gases with energy densities as low as 50 BTU/scf (1700 kJ/m3). By comparison, most turbine, engine, and fuel cell systems require fuel quality of significantly higher energy densities. 

 

  Lower air emissions. Our Power Oxidizer technology produces substantially lower emissions of Nitrogen Oxides (NOx) and Carbon Monoxide (CO) (CO) (< 1ppm) than, and destroys up to 99% of Volatile Organic Compounds (VOCs) compared to, combustion-based systems like gas engines or gas turbines or other commonly deployed pollution abatement systems.

 

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  No chemicals or catalysts for pollution abatement or control. Today, most of the low-quality waste gases produced by industries are processed through pollution abatement technologies that do not generate energy from the gases and are solely in place to reduce the volume of emissions to the atmosphere. Unlike other pollution abatement systems, such as selective catalytic reduction, our Power Oxidizer does not use chemicals or catalysts and, thus, cannot be rendered inactive from catalyst poisoning or degradation.

 

  Requires less fuel conditioning. Our system is capable of running on fuels with high levels of contaminants and is designed to require substantially less fuel pre-treatment than competing systems. In most cases, our system is able to process the waste gases from industrial processes without any of the fuel pre-treatment processes that are typically required by combustion-based methods to remove impurities and contaminants prior to generating energy from gases.

 

Selected Risks Associated with Our Business and Industry

 

Our Power Oxidation technologies also have certain disadvantages over alternative energy-generation technologies, including the following:

 

  New and unproven technology. Our Power Oxidation technologies have only been demonstrated commercially in a 250 kW product and our technology has only been commercially available since 2013. Although we have received a purchase order for two of our larger 2 MW Power Oxidizers, we currently have no commercial deployments of these larger units and have not demonstrated their full commercial viability outside of our test facility.

 

  Commercial viability. Our Power Oxidation products have had limited commercial installation and to date have been produced on a limited scale.

 

  Unproven and early stage value proposition. Our Power Oxidation solutions and our value proposition are not fully demonstrated in multiple real world installations and to date have not been communicated widely among our potential customers. While we believe that our value proposition is sound, the industries in which we are attempting to sell our products are conservative and may discount, or not accept, our value proposition.

 

  Competes with existing mature technologies. Our Power Oxidation products often cannot compete on a standalone cost basis solely on either alternative power generation or pollution abatement solutions. Our product solutions currently make economic sense in limited customer applications when pollution abatement and power generation are both required by a customer.

 

In addition, our business is subject to a number of other risks and uncertainties, including those highlighted in the section titled “Risk Factors” immediately following this prospectus summary. These risks include, but are not limited to, the following:

 

  we have experienced losses since inception and anticipate that we will continue to incur losses;
     
  we expect to require substantial additional financing;
     
  our independent registered public accounting firm has expressed substantial doubt about our ability to continue as a going concern; and
     
  we have identified material weaknesses in our internal control over financial reporting and ineffective disclosure controls and procedures.

  

Product Commercialization to Date

 

  Initial Commercial Unit—250 kW Unit: In June 2014, our first commercial EC250 Powerstation was installed at a landfill in the Netherlands that is owned and operated by Attero, one of the leading waste management companies in the Netherlands.

 

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  First Licensing Agreement: On November 14, 2014, we entered into the CLA to develop and market Dresser-Rand’s KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer. The CLA and ongoing integration provides for a scale-up of our technology into the larger utility grade sized turbines requested by our customers. Under the CLA, Dresser-Rand agreed to pay an initial license fee of $1.6 million, which was initially placed in escrow, and to commercialize the technology through its sales and distribution channels. In July 2015, we successfully completed the first of two technical milestones, which enabled Dresser-Rand to begin commercialization of the KG2-3GEF/PO turbines.

 

  Initial Order—2 MW Unit into Distillery Market: On January 12, 2015, Pacific Ethanol, Inc. publicly announced that it had placed an order with Dresser-Rand that included two KG2-3GEF/PO units. The order represents the first two commercial KG2 units that are designed to include our Power Oxidizer units. In August 2015, after the completion of the first technical test, we received a formal purchase order for $2.1 million for two Power Oxidizer units. We delivered the units associated with this initial order to the Stockton Biorefinery site owned by Pacific Ethanol in October 2016.

 

  Additional 250 kW Commercial Unit: In May 2015, the Orange County Board of Supervisors approved a project to install an EC250 Powerstation at the Santiago Canyon landfill in Orange County, California, and in August 2015, we received a purchase order for $900,000 for the EC250 Powerstation unit. The order represents an entry into a closed landfill opportunity that we believe has the potential for additional sales in the future.  In 2016, it was determined that the Santiago Canyon landfill site did not have sufficient power infrastructure in situ. Alternative locations for the EC250 Powerstation are currently being evaluated.

 

Over the next two years, we expect to continue our product commercialization efforts with the following expected deliverables and projects:

 

  Completion of Full Scale Acceptance Test—2 MW Unit: Under the CLA, the second technical test is the full-scale acceptance test, or FSAT, which is required after achievement of the first technical milestone. The FSAT consists of the building and installation of a full prototype of a working 2 MW KG2 unit at a site in Southern California, and then testing the prototype under different operating conditions for performance and life cycle validation. We completed construction of the 2 MW Power Oxidizer in 2016 and began the field testing of the 2 MW unit in the first half of 2016. In September 2016, after initial testing results were received, the $1.6 million license fee payment was released from escrow, from which we received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. We substantially completed field testing in the fourth quarter of 2016 and are awaiting final testing reports, which we expect later in the first quarter of 2017.

 

  Fulfillment and Delivery of Existing Customer Order Backlog of Approximately $4.6 Million: As of February 7, 2017, and prior to recognition of revenues associated with these orders, we had a backlog of approximately $3.0 million for our Power Oxidizers and approximately $1.6 million of Dresser-Rand license fees. During 2016, we (i) assembled, shipped and installed the first two Power Oxidizers for the two KG2 units sold by Dresser-Rand to Pacific Ethanol, and (ii) received the $1.6 million license fee payment from Dresser-Rand that was previously paid into escrow, less $500,000 paid to Dresser-Rand for engineering services. We are currently evaluating the revenue recognition on these orders in conjunction with the FSAT testing process described above. We expect to commission the Pacific Ethanol units in the first half of 2017. While we received payments on the EC250 Powerstation unit for which we received a purchase order in August 2015, delivery of this unit (originally sourced to delivery at the Santiago Canyon landfill location) has been delayed pending a change of the delivery location by the customer. We expect the unit to be installed at an alternative site in 2017.

 

  Commercialization of EC250 Powerstations and Additional KG2 Power Oxidizers: We have a pipeline of additional opportunities through Dresser-Rand for KG2 Power Oxidizers and directly sold units for our EC250 Powerstations. We expect to receive additional purchase orders for these products in 2017.

  

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Corporate Information

 

Ener-Core was incorporated in Nevada in April 2010 under the name “Inventtech Inc.” Our operating subsidiary, Ener-Core Power, Inc., was incorporated in Delaware in July 2012 under the name “Flex Power Generation, Inc.” Ener-Core Power, Inc. became our subsidiary in July 2013 by way of a reverse merger transaction, or the Merger, as further described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Reverse Merger.”

 

Effective as of September 3, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware, or the Reincorporation, pursuant to a plan of conversion dated September 2, 2015, following approval by our stockholders of the Reincorporation at our 2015 Annual Meeting of Stockholders held on August 28, 2015. In connection with the Reincorporation, we filed articles of conversion with the State of Nevada and a certificate of conversion and certificate of incorporation with the State of Delaware. Upon effectiveness of the Reincorporation, the rights of our stockholders became governed by the Delaware General Corporation Law, the certificate of incorporation filed in Delaware and newly adopted bylaws. As a Delaware corporation following the Reincorporation, which we refer to as Ener-Core Delaware, we are deemed to be the same continuing entity as the Nevada corporation prior to the Reincorporation, which we refer to as Ener-Core Nevada. As such, Ener-Core Delaware continues to possess all of the rights, privileges and powers of Ener-Core Nevada, all of the properties of Ener-Core Nevada and all of the debts, liabilities and obligations of Ener-Core Nevada, including all contractual obligations, and continues with the same name, business, assets, liabilities, headquarters, officers and directors as immediately prior to the Reincorporation. Upon effectiveness of the Reincorporation, all of the issued and outstanding shares of common stock of Ener-Core Nevada automatically converted into issued and outstanding shares of common stock of Ener-Core Delaware without any action on the part of our stockholders.

 

The address of our corporate headquarters is 9400 Toledo Way, Irvine, California 92618, and our telephone number is (949) 616-3300. Our website address is www.ener-core.com. The information that is contained on, or that may be accessed through, our website is not a part of this prospectus. We have included references to our website in this prospectus solely as inactive textual references.

  

December 2015 Equity Financing

 

On December 30, 2015, we entered into a securities purchase agreement dated December 30, 2015, or the December 2015 Purchase Agreement, pursuant to which we issued to certain institutional and other accredited investors, or the December 2015 Investors, an aggregate of 625,000 shares of our common stock at a price of $4.00 per share, and five-year warrants to purchase an aggregate of 312,500 shares of our common stock at an exercise price of $5.00 per share, or the December 2015 Warrants, in exchange for aggregate gross proceeds of $2.5 million, which we refer to as the December 2015 Equity Financing. We also entered into a registration rights agreement with the December 2015 Investors, or the December 2015 Registration Rights Agreement, pursuant to which we are required to file one or more registration statements with the SEC to register for resale by the December 2015 Investors the shares of our common stock sold in the December 2015 Equity Financing and the shares of our common stock issuable upon exercise of the December 2015 Warrants. Pursuant to the terms of the December 2015 Registration Rights Agreement, we are registering 937,500 shares of our common stock under the Securities Act, which includes the 625,000 shares of common stock sold in the December 2015 Equity Financing and 312,500 shares of common stock issuable upon exercise of the December 2015 Warrants. All 937,500 shares of common stock are being offered for resale pursuant to this prospectus.

 

In addition, the December 2015 Purchase Agreement contains an anti-dilution adjustment provision, pursuant to which, in the event that we sell or issue shares of our common stock at a price lower than the $4.00 per share purchase price of the shares issued under the December 2015 Purchase Agreement, we will be required to issue to each December 2015 Investor, for no additional consideration, an additional number of shares of common stock in an amount equal to (1) the purchase price paid by such December 2015 Investor under the December 2015 Purchase Agreement divided by the price per share of common stock for the dilutive issuance, minus (2) the total number of shares of common stock purchased by such December 2015 Investor. Such adjustment is called a Share Dilution Adjustment. The Share Dilution Adjustment does not apply with respect to certain exempt issuances and will terminate on the earlier of: (i) thirty (30) days from the date of effectiveness of the registration statement of which this prospectus forms a part and (ii) six (6) months after December 31, 2015. Additionally, if, prior to such termination date, we issue or sell any warrants to purchase shares of common stock with an exercise price per whole share that is less than the exercise price per December 2015 Warrant share in effect at such time, the exercise price per December 2015 Warrant share will be adjusted, with no additional action required by the holder, to equal the exercise price per whole share of common stock as set forth in the warrants issued in such dilutive issuance, except in the case of certain exempt issuances. On June 30, 2016, the anti-dilution adjustment provision terminated.

 

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Implications of Being an Emerging Growth Company

 

We are an “emerging growth company,” as defined in Section 2(a) of the Securities Act of 1933, as amended, or the Securities Act, as amended and modified by the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. As such, we are eligible to take advantage of exemptions from various disclosure and reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to:

 

  not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002;
     
  being permitted to present only two years of audited financial statements and only two years of related Management’s Discussion and Analysis of Financial Condition and Results of Operations, in each case, instead of three years;
     
  being permitted to present the same number of years of selected financial data as the years of audited financial statements presented, instead of five years;

 

  reduced disclosure obligations regarding executive compensation, including the omission of a compensation disclosure and analysis;
     
  not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements; and
     
  exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved.

 

We may choose to take advantage of some or all of the available exemptions. We have taken advantage of some of the reduced reporting exemptions in this prospectus. Accordingly, the scope of the information contained herein may be different than the scope of the information you receive from other public companies in which you hold stock. We do not know if some investors will find our shares less attractive as a result of our utilization of these or other exemptions. The result may be a less active trading market for our shares and our share price may be more volatile.

 

In addition, Section 107 of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards, and therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

 

We will remain an “emerging growth company” until the earliest of (a) the last day of the first fiscal year in which our annual gross revenues exceed $1.0 billion, (b) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, or the Exchange Act, which would occur if the market value of our shares that are held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, (c) the date on which we have issued, during the previous three-year period, more than $1.0 billion in nonconvertible debt, or (d) the last day of our fiscal year containing the fifth anniversary of the date of our first sale of our common equity securities pursuant to an effective registration statement in the United States, which will occur on December 31, 2017.

 

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The Offering

 

Common stock outstanding before this offering: 3,844,660 shares(1)
   
Securities offered for resale to the public by the selling stockholders: 937,500 shares of common stock(2)
   
Common stock outstanding after this offering: 4,157,160 shares(3)
   
Use of proceeds: We will not receive any proceeds from the sale of our common stock offered by the selling stockholders under this prospectus. We may, however, receive proceeds from warrants exercised by selling stockholders in the event that such warrants are exercised for cash. See “Use of Proceeds” beginning on page 31 of this prospectus.
   
OTCQB Marketplace symbol: Shares of our common stock are currently quoted on the OTCQB Marketplace under the symbol “ENCR.”
   
Risk factors: Investing in our securities involves a high degree of risk. See “Risk Factors” beginning on page 12 of this prospectus for a discussion of factors you should consider before making a decision to invest in our securities.
   
Common stock splits: On May 6, 2013, we effected a 30-for-1 forward split of our issued and outstanding shares of common stock by way of a stock dividend. On July 8, 2015, we effected a 1-for-50 reverse split of our issued and outstanding shares of common stock. All share and per share information in this prospectus gives effect to the 30-for-1 forward split and 1-for-50 reverse split, retroactively.

 

(1) As of February 7, 2017.
   
(2) Consists of 625,000 shares of common stock sold in the December 2015 Equity Financing and 312,500 shares of common stock issuable upon exercise of the December 2015 Warrants.
   
(3) Assumes the sale of all of the shares of common stock offered by the selling stockholders pursuant to this prospectus.

 

The number of shares of common stock to be outstanding after this offering is based on 3,844,660 shares of common stock outstanding as of February 7, 2017. The number of shares of common stock to be outstanding after this offering does not include:

 

  5,108,881 shares of common stock issuable upon the exercise of warrants outstanding as of February 7, 2017, at a weighted average exercise price of $3.75 per share, which excludes the shares of common stock issuable upon exercise of the December 2015 Warrants registered herein;
     
  270,197 shares of common stock issuable upon the exercise of options outstanding as of February 7, 2017, at a weighted average exercise price of $13.73 per share;
     
  594,000 shares of common stock reserved for future issuance under the Ener-Core, Inc. 2015 Omnibus Incentive Plan, or the 2015 Plan, as of February 7, 2017;

 

  Securities issuable upon conversion of our outstanding convertible senior secured promissory notes issued in April and May 2015, or the 2015 Notes;
     
  Securities issuable upon conversion of our outstanding convertible senior secured promissory notes issued in December 2016, or the December 2016 Notes; and
     
  Securities issuable upon conversion of our outstanding convertible unsecured promissory notes issued in September 2016, or the Convertible Unsecured Notes.

 

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RISK FACTORS

 

Investing in our securities involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information contained in this prospectus, including our financial statements and the related notes thereto, before making a decision to invest in our securities. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us, or that we currently believe are not material, also may become important factors that affect us and impair our business operations. The occurrence of any of the events or developments discussed in the risk factors below could have a material and adverse impact on our business, results of operations, financial condition and cash flows, and in such case, our future prospects would likely be materially and adversely affected. If any of such events or developments were to happen, the trading price of our common stock and the value of the warrants could decline, and you could lose part or all of your investment. Further, our actual results could differ materially and adversely from those anticipated in our forward-looking statements as a result of certain factors.

 

All share and per share amounts have been adjusted to reflect the 30-for-1 forward split of our issued and outstanding shares of common stock by way of a stock dividend on May 6, 2013 and the 1-for-50 reverse split of our issued and outstanding shares of our common stock on July 8, 2015, retroactively.

 

Risks Relating to Our Financial Condition and Capital Requirements

 

We have experienced losses since inception and anticipate that we will continue to incur losses, which makes it difficult to assess our future prospects and financial results.

 

We have never been profitable and, as of September 30, 2016, we had an accumulated deficit of $38.8 million. We incurred net losses of $7.6 million in the nine months ended September 30, 2016 and net losses of $13.1 million, $10.5 million and $7.1 million in the years ended December 31, 2015, 2014 and 2013, respectively. We expect to continue to incur net losses for the foreseeable future as we continue to develop our products and seek customers and distribution for our products. Because of the risks and uncertainties associated with developing and commercializing our products, we are unable to predict the extent of any future losses or when we will become profitable, if at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unsuccessful in addressing these risks, our business may fail and investors may lose all of their investment.

 

Our limited operating history makes evaluating our business and future prospects difficult, and may increase the risk of your investment.

 

We design, develop, license, manufacture and market products based on proprietary technologies that aim to expand the power-generation range of gaseous fuels. While we shipped our first commercial product, the Ener-Core Powerstation EC250, in November 2013, to date, our other manufacturing efforts have been limited to our prototype units and the assembly of our Multi-Fuel Test Facility used in research and development. As such, we have a limited operating history with respect to designing and manufacturing systems for producing continuous energy from a broad range of sources, including previously unusable low quality waste gases, providing a limited basis for investors to evaluate our business, operating results, and prospects.

 

While the basic technology has been verified, we have only within the last several years begun offering the EC250 and EC333 as commercial systems and only received purchase orders for the KG2 Power Oxidizer system and 250 kW Powerstations within the last couple years. This limits our ability to accurately forecast the cost of producing and distributing our systems or technology or to determine a precise date on which our systems or technology will be widely released.

 

Our plan to complete the initial commercialization of our gas-to-heat and electricity conversion technology is dependent upon the timely availability of funds and upon our finalizing the engineering, component procurement, build out, and testing in a timely manner. Any significant delays would materially adversely affect our business, prospects, operating results, and financial condition. Consequently, it is difficult to predict our future revenues and appropriately budget for our expenses, and we have limited insight into trends that may emerge and affect our business. In the event that actual results differ from our estimates or we adjust our estimates in future periods, our operating results and financial position could be materially and adversely affected. If the market for transforming methane gas, especially low quality waste gases from landfills, coal mines, oil fields, and other low-quality methane sources into continuous electricity does not develop as we currently expect, or develops more slowly than we currently expect, our business, prospects, operating results, and financial condition will be materially harmed.

 

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We expect to require substantial additional financing. Failure to obtain such financing may require us to cease our business activities and result in our stockholders losing some or all of their investment in us.

 

There is no assurance that we will operate profitably or generate positive cash flow in the future. As of September 30, 2016 and December 31, 2015, we had approximately $0.6 million and $2.8 million, respectively, in cash and cash equivalents (including restricted cash). Although we raised approximately $3.4 million in December 2016, we will require additional financing in order to proceed with the manufacture, sale and distribution of our products, including our EC250, EC333, KG2 and other Power Oxidizer products. During the next 12 months, we currently project our cash needs to be in excess of $5.0 million, currently budgeted for employee, occupancy and related costs ($3.2 million), professional fees, corporate filings, and business development costs ($0.8 million), and working capital ($1.0 million). We will require additional financing if the costs of the development and operation of our existing technologies are greater than we have currently anticipated or if we are not successful in earning revenues. Our sales and fulfillment cycle can exceed 24 months, and we do not expect to generate sufficient revenue in the next 12 months to cover our operating costs.

 

We anticipate that we will rely on additional debt or equity capital in order to continue to fund our business operations until such time as we become profitable, which may never occur. Issuances of additional equity and/or convertible securities will result in dilution to our existing stockholders. Our ability to obtain additional financing will be subject to a number of factors, including market conditions, our operating performance and investor sentiment. We may not be able to obtain financing on commercially reasonable terms or terms that are acceptable to us when it is required. If we are unable to raise sufficient additional capital when required or on acceptable terms, we may have to significantly delay, scale back or discontinue the development or commercialization of one or more of our products, restrict our operations or obtain funds by entering into agreements on unattractive terms, which would likely have a material adverse effect on our business, stock price and our relationships with third parties with whom we have business relationships. Further, if we do not obtain sufficient funds to continue operations, our business could fail and investors could lose up to their entire investment.

 

Our independent registered public accounting firm has expressed substantial doubt about our ability to continue as a going concern, and if we are unable to continue as a going concern, our securities will have little or no value.

 

Since inception, we have experienced recurring operating losses and negative cash flows and we expect to continue to generate operating losses and consume significant cash resources for the foreseeable future. Without additional financing, these conditions raise substantial doubt about our ability to continue as a going concern, meaning that we may be unable to continue in operation for the foreseeable future or realize assets and discharge liabilities in the ordinary course of operations. As a result, the report of our independent registered public accounting firm that accompanies our audited consolidated financial statements for the years ended December 31, 2015 and 2014, respectively, contains going concern qualifications and our independent registered public accounting firm expressed substantial doubt about our ability to continue as a going concern. In addition to our history of losses, our accumulated deficits as of September 30, 2016, December 31, 2015, December 31, 2014 and December 31, 2013 were approximately $38.8 million, $31.1 million, $18.0 million and $7.5 million, respectively. At September 30, 2016, December 31, 2015, December 31, 2014 and December 31, 2013, we had cash and cash equivalents (including restricted cash) of $0.6 million, $2.8 million, $2.2 million and $1.3 million, respectively.

 

In order to continue as a going concern, we will need, among other things, additional capital resources. Our management’s plan is to obtain such resources by seeking additional equity and/or debt financing. During 2014, we raised a total of $4.6 million through debt financing and repaid $1.9 million of such debt financing and raised $4.0 million through equity financing. During 2015, we raised a total of $5.0 million through debt financing and $3.3 million through equity financing. During 2016, we raised a total of $3.7 million through debt financing and $3.0 million through equity financing. We may be required to raise capital on unfavorable terms, assuming opportunities to raise capital are even available to us. Our failure to obtain additional capital would have an adverse effect on our financial position, results of operations, cash flows, and business prospects, and ultimately on our ability to continue. 

 

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Any incurrence of additional indebtedness could adversely affect our ability to operate our business, remain in compliance with existing or future debt or commercial covenants, make payments on our debt and limit our growth.

 

As of February 7, 2017, we had $10.5 million of indebtedness outstanding, consisting of the principal balance and accrued interest on outstanding 2015 Notes, Convertible Unsecured Notes and December 2016 Notes, as well as balances due on capital lease financing.

 

Outstanding indebtedness could have important consequences for investors, including the following:

 

  if we are unable to comply with the obligations of any agreements governing our indebtedness, including financial and other restrictive covenants, such failure could result in an event of default under such agreements;
     
  the covenants contained in our debt and commercial agreements may limit our ability to borrow additional funds, including restrictions on use of certain of our intellectual property as collateral for future borrowings;
     
  we may need to use a portion of our cash flows to pay principal and interest on our debt, which will reduce the amount of money that we have for operations, working capital, capital expenditures, expansion, acquisitions or general corporate or other business activities;
     
  we may have a higher level of debt than some of our competitors, which could put us at a competitive disadvantage;
     
  we may be more vulnerable to economic downturns and adverse developments in our industry or the economy in general; and
     
  our debt level could limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate.

 

Our ability to meet our expenses and debt obligations will depend on our future performance, which will be affected by financial, business, economic, regulatory and other factors. We will not be able to control many of these factors. We cannot be certain that our cash flows will be sufficient to allow us to pay the principal and interest on our existing or future debt and meet our other obligations. If we do not have enough money to service our existing or future debt, we may be required to refinance all or part of our existing or future debt, sell assets, borrow more money or raise equity, which we may not be able to timely consummate on terms acceptable to us, if at all.

 

Risks Relating to Our Business and Industry

 

A sustainable market for our technology and products may never develop or may take longer to develop than we currently anticipate, which would materially adversely affect our results of operations and/or cause our business to fail.

 

Our products are being sold into mature markets and represent an emerging and unproven technology. We cannot be certain as to whether our targeted customers will accept our technology or will purchase our products in sufficient quantities to allow our business to grow. To succeed, demand for our current products must increase significantly in existing markets and there must be strong demand for products that we introduce in the future. If a sustainable market fails to develop or develops more slowly than we currently anticipate, we may be unable to recover the losses we have incurred to develop our products, we may have further impairment of assets, and we may be unable to meet our operational expenses. The development of a sustainable market for our systems may be hindered by many factors, including some that are out of our control. Examples include:

 

  customer reluctance to try a new product or concept;

 

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  the relaxing of regulatory requirements or policies regarding the environment;
     
  potential customers’ perception that our EC250, EC333, KG2 and other Power Oxidizer products that we may develop are not competitive on a cost basis;
     
  the costs associated with the installation and commissioning of our EC250, EC333, KG2 and other Power Oxidizer products that we may develop;
     
  maintenance and repair costs associated with our products;
     
  economic downturns and reduction in capital spending;
     
  customer perceptions of our products’ safety, quality and effectiveness;
     
  customer and potential customer awareness of our products;
     
  the emergence of newer, more competitive technologies and products;
     
  the financial and operational stability of our turbine partners;
     
  the inability of our turbine partners to fulfill orders in a timely manner;
     
  excessive warranty-related costs associated with parts replacement for Power Oxidizer or turbine components for Powerstations operating in the field; and
     
  the inability of our commercial partners to successfully sell and market our co-branded Power Oxidizer products.

 

If we are unable to develop effectively and promote our technology timely and gain recognition in our market segment, we may not be able to achieve acceptable sales revenue and our results of operations and financial condition would then suffer. We cannot predict the rate of adoption or acceptance of our technology by potential customers or prospective channel partners. While we may be able to effectively demonstrate the feasibility of our technology, this does not guarantee the market will accept it, nor can we control the rate at which such acceptance may be achieved. Failure to achieve productive relationships with a sufficient number of prospective partners who are established resellers in the market segments of our target customers may impede adoption of our solutions. Additionally, some potential customers in our target industries are historically risk-averse and have been slow to adopt new technologies. If our technology is not accepted in the industrial combustion and power generation market, we may not earn enough by selling or licensing our technology to support our operations, recover our research and development costs or become profitable and our business could fail.

 

Our products are unproven on a large-scale commercial basis and could fail to perform as anticipated.

 

The Power Oxidizer has never been utilized on a large-scale commercial basis and we cannot predict all of the difficulties that may arise when the technology is utilized on such scale. In addition, our technology has never operated at a profitable volume level. It is possible that the technology may require further research, development, design and testing prior to implementation of a large-scale commercial application. Accordingly, we cannot assure you that our technology will perform successfully on a large-scale commercial basis, that it will be profitable to us or that our products will be cost competitive in the market.

 

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We may not be able to maintain effective product distribution channels, which could limit sales of our products.

 

We may be unable to attract distributors, resellers and integrators, as planned, that can market our products effectively and provide timely and cost-effective customer support and service. There is also a risk that, after we have established such relationships, some or all of our distributors, resellers or integrators may be acquired, may change their business models or may go out of business, any of which could have an adverse effect on our business. Further, our potential distributors, integrators and resellers may carry competing products. The loss of important sales personnel, distributors, integrators or resellers could adversely affect us.

  

Our products involve a lengthy sales cycle and we may not anticipate sales levels appropriately, which could impair our results of operations. 

 

The sale of our products typically involves a significant commitment of capital by customers, and such purchase decisions often require substantial time, economic analysis, product testing and corporate approvals. Once a customer makes a formal decision to purchase our product, the fulfillment of the sales order by us and our turbine partners will require a substantial amount of additional time. For these reasons, the sales and fulfillment cycle associated with our products is typically lengthy and subject to a number of significant risks over which we have little or no control. We currently expect to plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially. If sales in any period fall significantly below anticipated levels, our financial condition, results of operations and cash flow would suffer. If demand in any period increases well above anticipated levels, we may have difficulties in responding, incur greater costs to respond, or be unable to fulfill the demand in sufficient time to retain the order, which would negatively impact our operations and our reputation. In addition, our operating expenses are based on anticipated sales levels, and a high percentage of our expenses are generally fixed in the short term. As a result of these factors, a small fluctuation in the timing of cash payments by our customers could result in additional capital being required to fund our operating and inventory needs. Further, our operating results may be subject to significant variations and, as such, our operating performance in one period may not be indicative of our future performance.

 

We may incur significant warranty related costs, which may result in decreased gross profit per unit sold and reduce our ability to achieve our profitability targets.

 

We have sold, and our business plan anticipates that we will continue to sell, products with warranties. There can be no assurance that the provision for estimated product warranty will be sufficient to cover our warranty expenses now or in the future. We cannot ensure that our efforts to reduce our risk through warranty disclaimers will effectively limit our liability. While we expect warranty costs to decrease significantly on a per unit basis, the limited operating time for our commercial units makes our warranty and other post-sale charges difficult to estimate. Further, we may, at times, undertake programs to enhance the performance of units previously sold. Such enhancements may be provided at no cost or below our cost. If we choose to offer such programs, such actions could result in significant additional costs to our business. For example, during 2014, we provided for a warranty reserve of $242,000 for our initial EC250 commercial unit to allow for full replacement of key components primarily related to sub-components furnished by our suppliers. If our commercial units have greater than expected warranty related expenses or if we experience warranty costs associated with our oxidizer units, we may experience lower gross margins on our products or we may be required to increase our expenses to re-engineer our Power Oxidizer products. Further, any significant incurrence of warranty expense in excess of estimates could have a material adverse effect on our operating results, financial condition, and cash flow.

 

We face intense competition and currently expect competition to increase in the future, which could prohibit us from developing a customer base and generating revenue.

 

The energy industry is characterized by intense competition. We compete with existing co-generation solutions and other power generation solutions for our current and future customers. Those existing solutions have typically more mature technology and have a lower equipment cost than our Power Oxidizer units. Our Power Oxidizers are typically more expensive per kilowatt of power capacity when compared to the initial cost of equipment, and competing products typically have lower upfront costs than our Power Oxidizers. Many of our existing and potential competitors have greater financial and commercial resources than us, and it may be difficult for us to compete against them. Many of our existing and potential competitors have better name recognition and substantially greater financial, technical, manufacturing, marketing, personnel, and/or research capabilities than we do. In addition, new competitors, some of whom may have extensive experience in related fields or greater financial resources, may enter the market.

 

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Although at this time we do not believe that any of our potential competitors have technology similar to ours, if and when we release products based on our technology, potential competitors may respond by developing and producing similar products. Many firms in the energy industry have made and continue to make substantial investments in improving their technologies and manufacturing processes. Our competitors may achieve substantial economies of scale and scope, thereby substantially reducing their fixed production costs and their marginal production costs. In addition, they may be able to price their products below the marginal cost of production in an attempt to establish, retain, or increase market share.

 

In addition to our efforts to replace existing combustion technologies, we face competition from other companies in two sectors, each with its distinct competitive landscape:

 

  Low-quality fuels—Where the gas source has an energy density (BTU/ft3) below the minimum level required by reciprocating engines and standard gas turbines, a prospective customer can elect to do nothing and allow low BTU gas to simply be emitted into the atmosphere or can purchase gas such as propane or natural gas, mix it with the low BTU gas to make combustion feasible, and then flare the mixture. Because this alternative results in the destruction of the low BTU gas instead of converting the gas into a form of energy that could be sold or monetized, we do not consider it to be a direct form of competition, however, potential customers may utilize this approach in lieu of investing in our products.
     
  Ultra-low emissions—Within applications where a customer is required to meet emissions regulations and controls limits, typically by national, regional or local legislation, our systems compete with pollution control technologies, such as Selective Catalytic Reduction, Dry-Low-NOx, or Dry-Low-Emissions systems, and in some cases, with low-emission flares and thermal oxidizers. As many of our competitors are large, well-established companies, they derive advantages from production economies of scale, worldwide presence, and greater resources, which they can devote to product development or promotion.

  

In light of the foregoing, it may be difficult for us to compete successfully in the energy market.

 

As an alternative energy technology, our products are subject to wavering interest and levels of investment arising from the volatility of traditional energy costs and pricing.

 

In addition to environmental concerns, the market for alternative energy technologies is driven in part by customers’ desire for stable, cost-effective energy production methods, including technologies that minimize waste or allow use of waste gases to capture more value from traditional energy production methods. Although increases or volatility in the costs of traditional energy production, including the cost of additives to flare or use waste gases, may drive some interest in our technology, significant drops in the costs of traditional energy production and resources could have the opposite effect, resulting in decreased willingness by customers to invest in comparatively unproven alternative energy technologies. If traditional energy production costs and pricing drop significantly for a sustained period of time, customers may not view our products as providing a comparative economic benefit and we may not be able to compete successfully in our target markets.

 

We anticipate the need to be able to provide a third party financing option to our current and future customers for our existing and future Power Oxidizer products in order to facilitate our planned growth. We have very limited operational history for our Power Oxidizer products, which may make financing these products very difficult. Any changes in business credit availability or cost of borrowing could adversely affect our business. 

 

We compete with products and solutions that have significantly longer operating histories than our Power Oxidizers. As such, traditional lending solutions such as capital lease providers or banks have access to a substantial amount of information regarding competing products and have established credit parameters for end user customers. Our Power Oxidizers are new to the market and lenders and potential lenders have not established credit parameters specific to our Power Oxidizer units, which puts us at a competitive disadvantage.  

 

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Declines in the availability of commercially acceptable business credit and increases in corporate borrowing costs could negatively impact the number of systems we can install. Substantial declines in the business and operations of our customers could have a material adverse effect on our sales and, therefore, our business, results of operations and financial condition. If our potential customers are unable to access credit or experience increases in borrowing costs, our operating results may be materially and adversely affected and our ability to grow our business may be impaired.

 

Turbine prices, sub-component availability and reliability factors impact our price competitiveness, warranty costs and rate of market acceptance.

 

Our Power Oxidizer products are currently commercialized in a manner that is fully integrated with a gas turbine, thus providing a complete Powerstation to the ultimate customer and operator. We purchase the turbines for the 250 kW and 333 kW Powerstations from an independent third party. The availability of these turbines is dependent on the current commercial backlog and financial stability of their manufacturers. A lengthy sub-component fulfillment timeframe could impact our ability to timely deliver a Powerstation and therefore could delay our revenues. The turbines are typically long lead time components and the pricing of these turbines could increase over time, causing the overall price of the integrated Powerstation to become commercially uncompetitive, which would hinder sales of our Power Oxidizer products or render them prohibitively expensive, which would result in decreased profit margins. Once operational, any issues in the reliability of the turbine, either due to issues with the Power Oxidizer or any inherent flaws in the turbine, could result in excessive warranty obligations for us and a level of operational reliability that is deemed unsatisfactory by our customers, which could hurt our relationships with our customers and materially and adversely affect our business, prospects, operating results and financial condition.

 

We are dependent on our suppliers, some of which are single or limited source suppliers, and the inability or refusal of these suppliers to deliver necessary components at prices, volumes, and schedules acceptable to us would have a material adverse effect on our business, prospects, operating results, and financial condition.

 

We are continually evaluating, qualifying, and selecting suppliers for our gas-to-heat and electricity conversion systems. For our Power Oxidizer units, our raw materials generally consist of readily available pipes, tanks and machined metal products made of steel and other readily available commercial metals. We also purchase an integrated controls system that is configured from off-the-shelf units. However, for certain proprietary components, we use parts that are single-sourced from certain suppliers for machined parts designed and built to our specifications. We expect to move away from single-sourced suppliers as our production levels increase and with future modifications to our products. We also intend to source globally from a number of suppliers, some of whom may, however, be single source suppliers for these components, in particular for the gas turbine sub-component. While we attempt to maintain the availability of components from multiple sources, it may not always be possible to avoid purchasing from a single source. To date, we have no qualified alternative sources for any of our single-sourced components.

 

While we believe that we may be able to establish alternate supply relationships and can obtain or engineer replacements for our single-source components, we may be unable to do so in the short term or at all at prices or costs that are favorable to us. In particular, qualifying alternate suppliers or developing our own replacements for certain highly customized components may be time consuming and costly.

 

Our supply chain exposes us to potential delivery failures or component shortages. If we experience significant increased demand, or need to replace our existing suppliers, there can be no assurance that additional supplies of component parts will be available if or when required, on terms that are favorable to us, or at all, or that any supplier would allocate sufficient supplies to us in order to meet our requirements or fill our orders in a timely manner. The loss of any single- or limited-source supplier or the disruption in the supply of components from these suppliers could lead to delayed deliveries to our customers, which could hurt our relationships with our customers, result in negative publicity and materially adversely affect our business, prospects, operating results, and financial condition.

 

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Commodity market factors impact our costs and availability of materials.

 

Our products contain a number of commodity materials from metals, including steel, special high temperature alloys, copper, nickel, and molybdenum, to computer components. The availability of these commodities could impact our ability to acquire the materials necessary to meet our production requirements. The cost of metals has historically fluctuated and we currently do not hedge against our materials inflation risk. An increase in materials pricing could impact the costs to manufacture our products. If we are not able to acquire commodity materials at prices and on terms satisfactory to us, or at all, our operating results may be materially adversely affected.

 

We may face risks from doing business internationally.

 

We have licensed, sold or distributed, and expect to continue to license, sell, or distribute, products outside of the United States and derive revenues from these sources. Our revenues and results of operations may be vulnerable to currency fluctuations, and we do not currently hedge any foreign currency. As of the date of this prospectus, we have shipped one of our EC250 systems to a customer in the Netherlands. We will report our revenues and results of operations in United States dollars, but, in future reporting periods, a significant portion of our revenues may be earned outside of the United States. In such a case, we cannot accurately predict the impact of future exchange rate fluctuations on our revenues and operating margins. Such fluctuations could have a material adverse effect on our business, results of operations, and financial condition.

 

Additionally, our business will be subject to other risks inherent in the international marketplace, many of which are beyond our control. These risks include:

 

  laws and policies affecting trade, investment, and taxes, including laws and policies relating to the repatriation of funds and withholding taxes, and changes in these laws;
     
  changes in local regulatory requirements, including restrictions on gas-to-heat and electricity conversions;
     
  longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
     
  increased financial accounting and reporting burdens and complexities;
     
  differing degrees of protection for intellectual property;
     
  instability of foreign economies and governments; and
     
  war and acts of terrorism.

 

Any of the foregoing could have a material adverse effect on our business, financial condition, and results of operations.

 

As our products remain under development, they may not meet quality and cost expectations or may require costly improvements.

 

In order to achieve our goal of improving the quality and lowering the total costs of ownership of our products, we may require engineering changes. Such improvement initiatives may render existing inventories obsolete or excessive and there is no guarantee such changes will meet our customers’ expectations. Any quality issues with our products or those of our turbine manufacturing partners could have a material adverse effect on our rate of product adoption, results of operations, financial condition, and cash flow. Moreover, as we develop new configurations for our gas-to-heat and electricity conversion systems and as our customers place existing configurations in commercial use, our products may perform below expectations. Any performance below expectations could materially and adversely affect our operating results, financial condition, and cash flow and affect the marketability of our products.

 

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If we are unable to adequately control the costs associated with operating our business, including our costs of sales and materials, our business, prospects, operating results, and financial condition will suffer.

 

If we are unable to achieve and/or maintain a sufficiently low level of costs for designing, marketing, selling and distributing our gas transforming systems relative to their selling prices, our business, prospects, operating results, and financial condition could be materially and adversely affected. We have made, and will be required to continue to make, significant investments for the design and sales of our system and technologies. There can be no assurances that our costs of producing and delivering our system and technologies will be less than the revenue we generate from sales, licenses and/or royalties or that we will achieve our currently expected gross margins.

 

We may be required to incur substantial marketing costs and expenses to promote our systems and technologies even though our marketing costs and expenses to date have been relatively limited. If we are unable to keep our operating costs aligned with the level of revenues we generate, our business, prospects, operating results, and financial condition will be harmed. Many of the factors that impact our operating costs are beyond our control. For example, the costs of our components could increase due to shortages if global demand for such components increases.

 

If we do not respond effectively and on a timely basis to rapid technological change, our business could suffer.

 

Our industry is characterized by rapidly changing technologies, industry standards, customer needs, and competition, as well as by frequent new product and service introductions. We must respond to technological changes affecting both our customers and suppliers. We may not be successful in developing and marketing, on a timely and cost-effective basis, new products that respond to technological changes, evolving industry standards or changing customer requirements. Our success will depend, in part, on our ability to accomplish all of the following in a timely and cost-effective manner:

 

  effective use and integration of new technologies;
     
  continual development of our technical expertise;
     
  enhancement of our engineering and system designs;
     
  retention of key engineering personnel, which have played a critical role in the development of our technology;
     
  development of products that meet changing customer needs;
     
  marketing of our products; and
     
  influence of and response to emerging industry standards and other changes.

 

In particular, we plan to upgrade or adapt our gas-to-heat and conversion systems and technology in order to continue to provide customers with the latest technology. However, our products may not compete effectively if we are not able to develop, source and integrate the latest technology into our gas-to-heat and electricity conversion systems at a cost structure or on a timeframe acceptable to our customers or potential customers. Other parties’ future research and discoveries may make our products and solutions less attractive or even obsolete compared to other alternatives that may emerge. Any failure to keep up with advances in gas-to-heat and electricity conversion systems and technology would result in a decline in our competitive position that would materially and adversely affect our business, prospects, operating results, and financial condition.

 

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Our customers operate in a highly regulated business environment, and non-compliance with such regulations or changes in regulations could impose significant costs on us or our customers.

 

Our customers are subject to federal, state, local and foreign laws, regulations and policies governing, among other things, emissions and occupational health and safety. Regulatory agencies may impose special requirements on our customers or on us for the implementation and operation of our products, some of which may significantly affect or even eliminate some of our target markets. We can provide no assurances that we or our customers will be able to obtain any approvals or permits that are or may become required in a timely manner, or at all. We may incur material costs or liabilities in complying with government regulations, whether applicable to our customers’ use of our products, due to additional development costs or indemnity costs, or to us directly. Potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future. Non-compliance of our products or their performance with laws, regulations and other requirements applicable to our customers or to us, could result in fines, disputes or other business disruptions, which would have a material adverse effect on our operating results.

 

Deregulation, restructuring or other fundamental changes affecting the energy industry may make our products less economically beneficial to our customers, thereby affecting demand for our products.

 

We cannot determine how any deregulation or restructuring of the electric utility industry may ultimately affect the market for our products. Changes in regulatory standards or policies that currently support investment in more environmentally efficient power production could reduce the level of investment in the research and development of alternative power sources, including gas-to-heat and electricity conversion systems. Changes in the regulation or structure of the electric utility industry may result in rule changes that create challenges for our marketing and sales efforts. For example, as part of electric utility deregulation, federal, state, and local governmental authorities may impose transitional charges or exit fees, which would make it less economical for some potential customers to switch to our products, thereby materially adversely affecting our revenue and other operating results.

 

Our business depends substantially on the continuing efforts of certain personnel whose absence or loss could materially disrupt our business.

 

Our future success depends substantially on the continued services of our executive officers, especially our Chief Executive Officer, Alain J. Castro, our Chief Financial Officer, Domonic Carney, and our engineering vice president, Douglas Hamrin. If one or more of these persons were to become unable or unwilling to continue in their present positions, we may not be able to replace them readily or timely, if at all. Therefore, our business may be severely disrupted, and we may incur additional expenses to recruit and retain their replacements, if any acceptable persons may be found. In addition, if any of our executive or engineering officers joins a competitor or forms a competing company, we may lose some of our customers or potential customers.

 

If we are unable to attract, train, and retain engineering and sales personnel, our business may be materially and adversely affected.

 

Our future success depends, to a significant extent, on our ability to attract, train, and retain engineering and sales personnel. Recruiting and retaining capable personnel, particularly those with expertise in our industry, is vital to our success. There is substantial competition for qualified technical and sales personnel with experience in our industry, and there can be no assurance that we will be able to attract or retain them. If we are unable to attract and retain qualified employees, our business may be materially and adversely affected. 

  

We may not be able to effectively manage our growth, expand our production capabilities or improve our operational, financial and management information systems, which would impair our results of operations.

 

If we are successful in executing our business plan, we will experience growth in our business that could place a significant strain on our business operations, management and other resources. Our ability to manage our growth will require us to expand our production capabilities, continue to improve our operational, financial and management information systems, and to motivate and effectively manage our employees. We cannot provide assurance that our systems, procedures and controls or financial resources will be adequate, or that our management will be able to manage this growth effectively. 

 

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We have identified material weaknesses in our internal control over financial reporting and ineffective disclosure controls and procedures that will require additional resources to mitigate.

 

The Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, requires that we report annually on the effectiveness of our internal control over financial reporting and that our principal executive officer and principal financial officer conclude as to the effectiveness of our disclosure controls and procedures on a quarterly basis. Among other things, we must perform systems and processes evaluation and testing. We must also conduct an assessment of our internal controls to allow management to report on our assessment of our internal control over financial reporting, as required by Section 404 of Sarbanes-Oxley. We have identified material weaknesses in our internal control over financial reporting as of December 31, 2015. As defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, or the Exchange Act, a “material weakness” is a deficiency, or 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 consolidated financial statements will not be prevented or detected on a timely basis. Specifically, we determined that we had the following material weaknesses in our internal control over financial reporting: (i) we do not have written documentation of our internal control policies and procedures; (ii) we do not have sufficient segregation of duties within accounting functions, which is a basic internal control; (iii) for the year ended December 31, 2014, we did not have accounting and finance staff with sufficient technical accounting training and experience capable to manage and process our derivative equity accounting including stock options and warrants, and, in addition, we had 100% turnover during the year of accounting and finance management and staff, which resulted in periods of time where there was insufficient review of internal and external reports and proof of key internal controls; (iv) for the year ended December 31, 2014 and until May 2015, we did not have a majority of our directors considered to be independent directors and until July 2015 our Audit Committee consisted of the chairman of the committee only; (v) for the year ended December 31, 2015 we had inadequate controls over our costing and accounting for our capitalized inventory and project costing including a lack of a perpetual inventory system and (vi) for the years ended December 31, 2015 and 2014, management concluded that (a) our management information systems and information technology internal control design was deficient because the potential for unauthorized access to certain information systems and software applications existed during 2014 and 2015 in several departments, including corporate accounting, and (b) certain key controls for maintaining the overall integrity of systems and data processing were not properly designed and operating effectively, which increased the likelihood of potential material errors in our financial reporting.

 

As of December 31, 2015, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were ineffective at the reasonable assurance level. This conclusion was due to the presence of material weaknesses in our internal control over financial reporting, as described above.

 

Due to our size, we rely heavily on key management for day-to-day operations and for key cash and spending internal controls. Further, our size and correspondingly limited resources give rise to additional internal control weaknesses, including our information technology controls and disclosure controls.

 

We continue to review and develop controls and procedures that we believe to be sufficient to accurately report our financial performance on a timely basis, as well as mitigate our existing material weaknesses and significant deficiencies in our internal controls. As of the date hereof, however, while we have taken steps to remediate our material weaknesses, we have not remediated these material weaknesses in full. If we do not develop and implement effective controls and procedures, we may not be able to report our financial performance on a timely and materially accurate basis and our business and stock price may be adversely affected.

 

If product liability claims are brought against us, we may incur substantial costs if our insurance coverage for such claims is inadequate. 

 

We may be exposed to product liability claims, other claims and litigation in the event that the use of our products results, or is alleged to result, in bodily injury and/or property damage or our products actually or allegedly fail to perform as expected. Although we maintain insurance coverage with respect to certain product liability and other claims, such claims are expensive to defend and our insurance coverage may not be sufficient to cover all of our product liability-related expenses or losses, if it applies at all. Moreover, insurance coverage is becoming increasingly expensive, and, in the future, we may not be able to maintain insurance coverage at a reasonable cost, in sufficient amounts or upon adequate terms to protect us against losses due to product liability. Any damages that are not covered by insurance or are in excess of policy limits could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, product liability and other claims can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. Further, claims of this nature could cause our customers to lose confidence in our products and us. As a result, an unsuccessful defense of a product liability or other claim could have a material adverse effect on our financial condition, results of operations and cash flows.

 

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We may be vulnerable to disruption, damage and financial obligation as a result of information technology system failures.

 

Despite the implementation of security measures, any of the internal computer systems belonging to us or our third-party service providers are vulnerable to damage from computer viruses, unauthorized access, natural disasters, terrorism, war and telecommunication and electrical failure. Any system failure, accident or security breach that causes interruptions in our own or in third-party service vendors’ operations could result in a material disruption of our product development programs. Further, our information technology and other internal infrastructure systems, including firewalls, servers, leased lines and connection to the Internet, face the risk of systemic failure, which could disrupt our operations. To the extent that any disruption or security breach results in a loss or damage to our data or applications, or inappropriate disclosure of confidential or proprietary information, we may incur resulting liability, our product development programs and competitive position may be adversely affected and the further development of our products may be delayed. Furthermore, we may incur additional costs to remedy the damage caused by these disruptions or security breaches. We do not currently maintain insurance coverage that would potentially address such costs and are not certain whether we can obtain such coverage at an acceptable cost, if at all. Even if we were to obtain such insurance coverage, there can be no assurance that the policy obtained would cover some or all of the costs incurred by such disruptions or security breaches, and thus we may still incur significant financial losses upon such an event.

 

Additionally, certain confidential information, including nonpublic personal information and sensitive business data, including but not limited to data pertaining to certain public utilities, may be processed and stored on, and transmitted through, our computer systems and networks. In the event such information is jeopardized as a result of a disruption causing system failure, we may suffer significant losses, reputational damage, litigation, regulatory fines or penalties, or otherwise experience a material adverse effect on our business, financial condition or results of operations.

 

We are an “emerging growth company” and the reduced reporting requirements applicable to emerging growth companies may make our common stock less attractive to investors.

 

We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a non-binding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Investors may find our common stock less attractive because we may rely on these exemptions, there may be a less active trading market for our common stock and our stock price may be more volatile. 

 

In addition, Section 107 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we are choosing to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

 

As an emerging growth company, we have also chosen to take advantage of certain provisions of the JOBS Act that allow us to provide you with less information in this prospectus than would otherwise be required if we are not an emerging growth company. As a result, this prospectus includes less information about us than would otherwise be required if we were not an emerging growth company within the meaning of the JOBS Act, which may make it more difficult for you to evaluate an investment in us. 

 

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We would cease to be an emerging growth company upon the earliest of: (a) the last day of the first fiscal year in which our annual gross revenues exceed $1.0 billion, (b) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Exchange Act, which would occur if the market value of our shares that are held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, (c) the date on which we have issued, during the previous three-year period, more than $1.0 billion in nonconvertible debt, or (d) the last day of our fiscal year containing the fifth anniversary of the date of our first sale of our common equity securities pursuant to an effective registration statement in the United States, which will occur on December 31, 2017.

 

Risks Related to Our Intellectual Property

 

We may not be able to obtain, maintain, defend or enforce the intellectual property rights covering our products, which could adversely affect our ability to compete.

 

We utilize a variety of intellectual property rights in our products and technology. We use our portfolio of process and design technologies as part of our effort to differentiate our product offerings. Our commercial success depends, in large part, on our ability to obtain, maintain, defend or enforce our patents, trademarks, trade secrets and other intellectual property rights covering our technologies and products. We may not have sufficient resources or may otherwise be unable to preserve these intellectual property rights successfully in the future and such rights could be invalidated, circumvented, challenged, breached or infringed upon. If we are unable to protect and maintain our intellectual property rights, or if there are any successful intellectual property challenges or infringement proceedings against us, our ability to differentiate our product offerings would be substantially impaired. In addition, if our intellectual property rights or work processes become obsolete, we may not be able to differentiate our product offerings and some of our competitors may be able to offer more attractive products to our customers, which could materially adversely affect our competitive business position and harm our business prospects.

 

We may be unable to enforce our intellectual property rights throughout the world.

 

The laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. To the extent that we have obtained or are able to obtain patents or other intellectual property rights in any foreign jurisdictions, it may be difficult to stop the infringement of our patents or the misappropriation of other intellectual property rights. For example, some foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. In addition, some countries limit the availability of certain types of patent rights and enforceability of patents against third parties, including government agencies or government contractors. In these countries, patents may provide only limited benefit or no benefit. 

 

Proceedings to enforce our patent rights in foreign jurisdictions could result in substantial costs and divert our efforts and attention from other aspects of our business. Accordingly, efforts to protect our intellectual property rights in such countries may be inadequate. In addition, future changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain adequate protection for our technology and products and the enforcement of intellectual property. 

 

Developments or assertions by us or against us relating to intellectual property rights could materially impact our business.

 

We currently own or license significant intellectual property, including patents, and intend to be involved in future licensing arrangements. Patent laws afford only limited practical protection of our intellectual property rights.

 

Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others or to defend against claims of invalidity. As we create or adopt new technology, we will also face an inherent risk of exposure to the claims of others that we have allegedly violated their intellectual property rights.

 

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We might experience intellectual property claim losses in the future and we might also incur significant costs to defend such claims. Infringement or invalidity claims could materially adversely affect our business, results of operations and financial condition. Regardless of the validity or the success of the assertion of these claims, we could incur significant costs and diversion of resources in enforcing our intellectual property rights or in defending against such claims, which could have a material adverse effect on our business, results of operations and financial condition.

 

Confidentiality agreements with employees and others may not adequately prevent disclosure of our trade secrets and other proprietary information.

 

Our success depends upon the skills, knowledge, and experience of our technical personnel, our consultants and our advisors, as well as our licensees and contractors, and, as such, trade secrets are an important element of our overall intellectual property portfolio. However, trade secrets are difficult to protect. We enter, and currently expect that we will continue to enter, into confidentiality and intellectual property assignment agreements with our corporate partners, employees, consultants, outside scientific collaborators, developers, licensees and other advisors that may be breached or may not effectively assign intellectual property rights to us. Our trade secrets also could be independently discovered by our competitors, in which case we would not be able to prevent use of such trade secrets by these competitors. The enforcement of a claim alleging that a party illegally obtained and used our trade secrets could be difficult, expensive and time consuming, and we cannot predict the outcome. In addition, courts outside the United States may be less willing to protect trade secrets than will courts within the United States. The failure to obtain or maintain meaningful trade secret protection could adversely affect our competitive position.

 

Many of our competitors have significant resources and incentives to apply for and obtain intellectual property rights that could limit or prevent our ability to commercialize our current or future products in the United States or abroad.

 

Many of our existing and potential competitors, who have or may have significant resources and have made or may make substantial investments in competing technologies, have sought or may seek to apply for and obtain patents that prevent, limit or interfere or will prevent, limit or interfere with our ability to make, use or sell our products either in the United States or in international markets. Our current or future U. S. or foreign patents may be challenged or circumvented by competitors or others or may be found to be invalid, unenforceable or insufficient. Since patent applications are confidential until patents are issued in the United States or, in most cases, until after 18 months from filing of the application, or corresponding applications are published in other countries, and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to file patent applications for inventions or that we would have priority rights with respect to inventions covered by our pending applications.  

 

Risks Related to Our Securities

 

If an orderly and active trading market for our securities does not develop or is not sustained, the value and liquidity of your investment in our securities could be adversely affected.

 

An active or liquid market in our common stock or securities exercisable or convertible for our common stock does not currently exist and might not develop or, if it does develop, it might not be sustainable. The last reported sale price of our common stock on the OTCQB Marketplace on February 7, 2017 was $2.01 per share. The historic bid and ask quotations for our common stock, however, should not be viewed as an indicator of the current or historical market price for our common stock nor as an indicator of the market price for our common stock if our common stock were to be listed on a national securities exchange. The offering price for our securities as issued by the Company from time to time is determined through discussions between the Company and the prospective investor(s), with reference to the most recent closing price of our common stock on the OTCQB Marketplace, and may vary from the market price of our securities following any offering. Further, our trading volume on the OTCQB Marketplace has been generally very limited.

 

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If an active public market for our common stock develops, we expect the market price may be volatile, which may depress the market price of our securities and result in substantial losses to investors if they are unable to sell their securities at or above their purchase price.

 

If an active public market for our common stock develops, we expect the market price of our securities to fluctuate substantially for the foreseeable future, primarily due to a number of factors, including:

 

  our status as a company with a limited operating history and limited revenues to date, which may make risk-averse investors more inclined to sell their shares on the market more quickly and at greater discounts than would be the case with the shares of a seasoned issuer in the event of negative news or lack of progress;
     
  announcements of technological innovations or new products by us or our existing or future competitors;
     
  the timing and development of our products;
     
  general and industry-specific economic conditions;
     
  actual or anticipated fluctuations in our operating results;
     
  liquidity;
     
  actions by our stockholders;
     
  changes in our cash flow from operations or earnings estimates;
     
  changes in market valuations of similar companies;
     
  our capital commitments; and
     
  the loss of any of our key management personnel.

 

In addition, market prices of the securities of technology companies, particularly companies like ours without consistent revenues and earnings, have been highly volatile and may continue to be highly volatile in the future, some of which may be unrelated to the operating performance of particular companies. Further, our common stock is currently quoted on the OTCQB Marketplace, which is often characterized by low trading volume and by wide fluctuations in trading prices due to many factors that may have little to do with our operations or business prospects. The availability of buyers and sellers represented by this volatility could lead to a market price for our common stock that is unrelated to operating performance. Moreover, the OTCQB Marketplace is not a stock exchange, and trading of securities quoted on the OTCQB Marketplace is often more sporadic than the trading of securities listed on a national securities exchange like The NASDAQ Stock Market or the New York Stock Exchange. Even if we were to seek to list our securities on a national securities exchange, there is no assurance we will be able to do so, and if we do so, many of these same forces and limitations may still impact our trading volumes and market price in the near term. Additionally, the sale or attempted sale of a large amount of common stock into the market may also have a significant impact on the trading price of our common stock. 

 

Many of these factors are beyond our control and may decrease the market price of our common stock, regardless of our operating performance. In the past, securities class action litigation has often been brought against companies that experience high volatility in the market price of their securities. Whether or not meritorious, litigation brought against us could result in substantial costs, divert management’s attention and resources and harm our financial condition and results of operations.

 

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We have a substantial number of options, warrants and convertible notes outstanding, which could give rise to additional issuances of our common stock, potential dilution of ownership to existing stockholders and volatility in the price of our securities.

 

As of February 7, 2017, we have outstanding options and warrants to purchase an aggregate of 5,691,578 shares of our common stock at exercise prices ranging from $3.00 to $50.00 per share. Of these, 270,197 represent shares underlying employee options with exercise prices ranging from $4.31 to $24.00 per share and 5,421,381 represent shares underlying warrants at exercise prices ranging from $3.00 to $50.00 per share. As of February 7, 2017, we also have outstanding convertible notes with an aggregate principal amount of approximately $10.4 million, which are convertible into shares of our common stock at a price of $2.50 per share, subject to adjustment in accordance with the terms of such notes. To the extent any holders of options or warrants exercise such options and warrants or in the event the convertible notes are converted into shares of common stock, the issuance of shares of our common stock upon such exercise or conversion will result in dilution of ownership to existing stockholders.

 

Further, the trading price of our securities could decline if there are substantial sales of our common stock, particularly sales by our directors, executive officers, employees and significant stockholders, or when there is a large number of shares of our common stock available for sale, as would occur in the event of an exercise of outstanding options and/or warrants or conversion of outstanding convertible notes.

 

We expect to seek additional funding and may issue new securities with terms or rights superior to those of our shares of common stock, which could adversely affect the market price (if any) of our securities and our business.

 

Effective upon our reincorporation in Delaware on September 3, 2015, our certificate of incorporation authorizes up to 200,000,000 shares of common stock with a par value of $0.0001 per share, and 50,000,000 shares of preferred stock with a par value of $0.0001 per share. Our board of directors may choose to issue some or all of such shares to fund our overhead and general operating requirements or to acquire one or more companies or properties. The issuance of any such shares may reduce the book value per share and may contribute to a reduction in the market price (if any) of the outstanding shares of our common stock or preferred stock. If we issue any such additional shares, such issuance could reduce the proportionate ownership and voting power of all current stockholders. Further, such issuance(s) may result in a change of control of our Company.

 

Our leadership and principal stockholders own a large percentage of our voting stock, which will allow them to influence substantial control over matters requiring stockholder approval.

 

Currently, our executive officers, directors, Like Capital Limited, SAIL Exit Partners, LLC and its affiliates and Jeneration Capital Master Fund and its affiliates beneficially own approximately 48% of our outstanding common stock, based on the beneficial ownership at February 7, 2017. If these stockholders act together, they may be able to elect our board of directors, depending on stockholder participation at our annual meetings, and may significantly influence most other matters requiring approval by stockholders, including the approval of mergers, going private transactions, and other extraordinary transactions, as well as the terms of any of these transactions. This concentration of ownership could have the effect of delaying a change in our control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could in turn have an adverse effect on the market price of our common stock or prevent our stockholders from realizing a premium over the then-prevailing market price for their shares of common stock.

 

Certain provisions in our charter documents have anti-takeover effects.

 

Certain provisions of our certificate of incorporation and bylaws may have the effect of delaying, deferring or preventing a change in control of us. Such provisions, including those limiting who may call special stockholders’ meetings, together with the possible issuance of our preferred stock without stockholder approval, may make it more difficult for other persons, without the approval of our board of directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a stockholder might consider to be in such stockholder’s best interest. See “Description of Capital Stock” for additional information.

 

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Our operating results may fluctuate significantly, and these fluctuations may cause the price of our securities to fall.

 

Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of future performance. Factors that may affect our quarterly results include:

 

  market acceptance of our products and those of our competitors;
     
  the sales and fulfillment cycle associated with our products, which is typically lengthy and subject to a number of significant risks over which we have little or no control, and the corresponding delay in our receipt of the associated revenue;
     
  our ability to complete the technical milestone tests associated with our commercial agreements;
     
  our ability to attract and retain key personnel;
     
  development of new designs and technologies; and
     
  our ability to manage our anticipated growth and expansion.

 

Until our common stock is listed on a qualified national securities exchange or our common stock price exceeds $5 per share, our common stock will be considered a “penny stock” and will not qualify for exemption from the “penny stock” restrictions, which may make it more difficult for you to sell your securities.

 

Historically, shares of our common stock have traded on the OTCQB Marketplace at a price of less than $5.00 per share and, as a result, our common stock is considered a “penny stock” by the SEC and subject to rules adopted by the SEC regulating broker-dealer practices in connection with transactions in “penny stocks.” The SEC has adopted regulations which generally define a “penny stock” to be any equity security that is not listed on a qualified national securities exchange and that has a market price of less than $5.00 per share, or with an exercise price of less than $5.00 per share, subject to certain exceptions. Our securities are covered by the penny stock rules, which impose additional sales practice requirements on broker-dealers who sell to persons other than established customers and accredited investors. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document in a form prepared by the SEC which provides information about penny stocks and the nature and level of risks in the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market value of each penny stock held in the customer’s account. The bid and offer quotations, and the broker-dealer and salesperson compensation information, must be given to the customer orally or in writing prior to effecting the transaction and must be given to the customer in writing before or with the customer’s confirmation. In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from these rules; the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction. These disclosure requirements may have the effect of reducing the level of trading activity in the secondary market for the security that is subject to these penny stock rules. Consequently, these penny stock rules may affect the ability of broker-dealers to trade our securities. We believe that the penny stock rules discourage investor interest in and limit the marketability of our securities.

 

FINRA sales practice requirements may also limit a stockholder’s ability to buy and sell our securities.

 

In addition to the “penny stock” rules described above, the Financial Industry Regulatory Authority, or FINRA, has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer. Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer’s financial status, tax status, investment objectives and other information. Under interpretations of these rules, FINRA believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers. The FINRA requirements may make it more difficult for broker-dealers to recommend that their customers buy our securities, which may limit your ability to buy and sell our securities and have an adverse effect on the market for our securities.

 

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We are a former “shell company” and as such are subject to certain limitations not applicable to other public companies generally.

 

Prior to our reverse merger transaction in July 2013, we were a public reporting “shell company,” as defined in Rule 12b-2 under the Exchange Act. Although we are no longer a “shell company,” the Rule 144 safe harbor available for the resale of our restricted securities is only available to our stockholders if we have filed all reports and other materials required to be filed by Section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months, other than current reports on Form 8-K, at the time of the proposed sale, regardless of whether the restricted securities were initially issued at the time we were a shell company or subsequent to termination of such status. Other reporting companies that are not former shell companies and have been reporting for more than 12 months are not subject to this same reporting threshold for non-affiliate reliance on Rule 144.

 

As a result of the restrictions applicable to former shell companies, we may be less successful in offering registered securities to investors and investors may have less interest in obtaining restricted securities, which may materially and adversely affect our ability to efficiently and timely raise additional financing, if we are able to do so at all.

 

Further, as shell companies and reverse merger transactions have been, and remain to some degree, subject to additional scrutiny by the SEC, FINRA and the national securities exchanges, our prior shell company status and the reverse merger transaction that terminated it may result in delays in the completion of any offering and our attempt to qualify for and list on a national securities exchange. Specifically, as a former shell company and subject of a reverse merger transaction, we are required to demonstrate the ability to maintain a threshold per share market price for an extended trading period in order to qualify for listing on a national securities exchange. If we are unable to do so, we will breach certain contractual obligations and may need to complete additional securities issuances on terms and at pricing that would be materially adverse to our financial condition and dilutive to our stockholders.

 

The indemnification rights provided to our directors, officers and employees may result in substantial expenditures by our company and may discourage lawsuits against its directors, officers, and employees.

 

Our certificate of incorporation and bylaws contain provisions permitting us to enter into indemnification agreements with our directors, officers, and employees. We also have contractual obligations to provide such indemnification protection to the extent not covered by directors’ and officers’ liability insurance. The foregoing indemnification obligations could result in us incurring substantial expenditures to cover the cost of settlement or damage awards against directors and officers, which we may be unable to recoup. These provisions and resultant costs may also discourage us from bringing a lawsuit against our directors and officers for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our stockholders against our directors and officers even though such actions, if successful, might otherwise benefit us and our stockholders.

 

To date, we have not paid any cash dividends and we do not anticipate paying any such dividends in the foreseeable future.

 

We have never paid cash dividends on our capital stock. We do not currently anticipate paying cash dividends on our common stock in the foreseeable future and we may not have sufficient funds legally available to pay dividends. Even if the funds are legally available for distribution, we may nevertheless decide not to pay any dividends. We presently intend to retain all earnings for our operations. 

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This prospectus contains “forward-looking statements” that involve substantial risks and uncertainties. The forward-looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. These statements relate to future events or our future financial performance or condition and involve known and unknown risks, uncertainties and other factors that could cause our actual results, levels of activity, performance or achievement to differ materially from those expressed or implied by these forward-looking statements. These forward-looking statements include, but are not limited to, statements about:

 

  Our estimates regarding operating results, future revenues, capital requirements and the need for additional financing.
     
  Strategy for customer growth, retention, product development, market position, financial results and reserves.
     
  Customer acceptance of and demand for our products.
     
  Anticipated levels of capital expenditures and uses of capital for fiscal year 2017.
     
  Current or future volatility in the credit markets and future market conditions.
     
  Expectations of the effect on our financial condition of claims, litigation, contingent liabilities, warranty-related costs and stock price volatility.
     
  Strategy for risk management.
     
  Our ability to effectively manage growth and expansion.
     
  Economic and financial conditions, including volatility in interest and exchange rates, commodity and equity prices and the value of financial assets.
     
  The occurrence of hostilities, political instability or catastrophic events.
     
  Changes in customer demand or market opportunity.
     
  Changes in the price of key components and disruptions in supply chains for these components.
     
  Disruptions to our technology network, including computer systems and software, as well as natural events such as severe weather, fires, floods and earthquakes or man-made or other disruptions of our operating systems, structures or equipment.
     
  Our intellectual property position and the intellectual property positions of third parties.
     
  The impact of government laws, regulations and policies.
     
  Our ability to continue as a going concern.
     
  Other risk factors discussed under “Risk Factors.”

 

We caution you that the forward-looking statements highlighted above do not encompass all of the forward-looking statements made in this prospectus.

 

You should read this prospectus and the documents that we reference elsewhere in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual results may differ materially from what we expect as expressed or implied by our forward-looking statements. In light of the significant risks and uncertainties to which our forward-looking statements are subject, you should not place undue reliance on or regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified timeframe, or at all. We discuss many of these risks and uncertainties in greater detail under the section entitled “Risk Factors” and elsewhere in this prospectus. These forward-looking statements represent our estimates and assumptions only as of the date of this prospectus regardless of the time of delivery of this prospectus or any sale of our securities. Except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this prospectus.

 

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USE OF PROCEEDS

 

We are registering the shares of common stock covered by this prospectus pursuant to the registration rights granted to the selling stockholders in connection with our December 2015 Private Placement. We will not receive any proceeds from the offer and sale from time to time by the selling stockholders of the shares of our common stock covered by this prospectus. The selling stockholders will receive all of the net proceeds from any such offer and sale.

 

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Private Placement of COMMON SHARES AND WARRANTS

 

Securities Purchase Agreement

 

On December 30, 2015, we entered into a securities purchase agreement dated December 30, 2015, or the December 2015 Purchase Agreement, pursuant to which we issued to certain institutional and other accredited investors, or the December 2015 Investors, an aggregate of 625,000 shares of our common stock at a price of $4.00 per share, and five-year warrants to purchase an aggregate of 312,500 shares of our common stock at an exercise price of $5.00 per share, or the December 2015 Warrants, in exchange for aggregate gross proceeds of $2.5 million, which we refer to as the December 2015 Equity Financing.

 

The December 2015 Purchase Agreement contains representations, warranties and covenants made by us and the December 2015 Investors that are typical for transactions of this type. In addition, the December 2015 Purchase Agreement contains an anti-dilution adjustment provision, pursuant to which, in the event that we sell or issue shares of our common stock at a price lower than the per share purchase price of the shares issued under the December 2015 Purchase Agreement ($4.00 per share), we will be required to issue to each December 2015 Investor, for no additional consideration, an additional number of shares of common stock in an amount equal to (1) the purchase price paid by such December 2015 Investor under the December 2015 Purchase Agreement divided by the price per share of common stock for the dilutive issuance, minus (2) the total number of shares of common stock purchased by such December 2015 Investor. This anti-dilution provision does not apply with respect to certain exempt issuances and will terminate on the earlier of: (i) thirty (30) days from the date of effectiveness of the registration statement required to be filed by us pursuant to the December 2015 Registration Rights Agreement (as defined below), of which this prospectus is a part, and (ii) six months after December 31, 2015. The December 2015 Purchase Agreement prohibits December 2015 Investors from engaging in (or causing any person to engage in) any short sales or similar transactions with respect to the common stock from the date of the December 2015 Purchase Agreement ending on the 45th day following December 30, 2015. On June 30, 2016, the anti-dilution adjustment provision terminated.

 

Each December 2015 Warrant is exercisable immediately for cash. In addition, unless all of the shares of common stock underlying the December 2015 Warrants that are subject to an exercise notice with respect to any December 2015 Warrant are registered for resale pursuant to an effective registration statement and are issuable without any restrictive legend, such December 2015 Warrant may also be exercised by way of a cashless exercise. The December 2015 Warrants also contain provisions that protect their holders against dilution by adjustment of the exercise price in certain events such as stock dividends, stock splits and other similar events. Additionally, if, prior to the earlier of (i) thirty (30) days from the date of effectiveness of the registration statements required to be filed by us pursuant to the December 2015 Registration Rights Agreement, of which this prospectus is a part, and (ii) six months after the issuance date of the December 2015 Warrants, we issue or sell any warrants to purchase shares of common stock with an exercise price per whole share that is less than the exercise price per December 2015 Warrant share in effect at such time, the exercise price per December 2015 Warrant share will be adjusted, with no additional action required by the holder, to equal the exercise price per whole share of common stock as set forth in the warrants issued in such dilutive issuance, except in the case of certain exempt issuances.

 

The shares of common stock sold in the December 2015 Equity Financing and the December 2015 Warrants were not registered under the Securities Act, or the securities laws of any state, and were offered and sold in reliance on the exemption from registration under the Securities Act provided by Section 4(a)(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder. The December 2015 Warrant shares issuable to the December 2015 Investors upon exercise of the Warrants were not registered under the Securities Act, or the securities laws of any state, and were offered in reliance on the exemption from registration under the Securities Act provided by Section 4(a)(2) of the Securities Act and/or Rule 506 of Regulation D promulgated thereunder. Each December 2015 Investor was an accredited investor (as defined in Rule 501 of Regulation D under the Securities Act) at the time of the December 2015 Equity Financing.

 

Registration Rights Agreement

 

In connection with the Private Placement, we also entered into a registration rights agreement with the December 2015 Investors, or the December 2015 Registration Rights Agreement, pursuant to which we are required to file one or more registration statements with the SEC to register for resale by the December 2015 Investors the shares of our common stock sold in the December 2015 Equity Financing and the shares of our common stock issuable upon exercise of the December 2015 Warrants, and use our commercially reasonable efforts to maintain the effectiveness of such registration statement(s).

 

Pursuant to the terms of the December 2015 Registration Rights Agreement, we are registering 937,500 shares of our common stock under the Securities Act, which includes the 625,000 shares of common stock sold in the December 2015 Equity Financing and 312,500 shares of common stock issuable upon exercise of the December 2015 Warrants. All 937,500 shares of common stock are being offered for resale pursuant to this prospectus.

 

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SELLING STOCKHOLDERS 

 

The shares of common stock being offered by the selling stockholders are those previously issued to the selling stockholders and those issuable to the selling stockholders upon exercise of warrants. For additional information regarding the issuances of common stock and the warrants, see “Private Placement of Common Shares and Warrants” above. We are registering the shares of common stock in order to permit the selling stockholders to offer the shares for resale from time to time. Except for the ownership of the shares of common stock and the warrants, and in some cases as holders of our outstanding notes, the selling stockholders have not had any material relationship with us within the past three years.

 

The table below lists the selling stockholders and other information regarding the beneficial ownership of the shares of common stock by each of the selling stockholders. The second column lists the number of shares of common stock beneficially owned by each selling stockholder, based on its ownership of the shares of common stock and the warrants, as of May 24, 2016, assuming exercise of the warrants held by the selling stockholders on that date, without regard to any limitation on exercise.

 

The third column lists the shares of common stock being offered by this prospectus by the selling stockholders, which includes the shares of common stock purchased by each selling stockholder in the December 2015 Equity Financing, as well as the shares of common stock issuable upon exercise of the December 2015 Warrants held by such selling stockholder. The fourth column lists the percentage of shares of common stock beneficially owned by such selling stockholder after the completion of the offering, based on its ownership as of May 24, 2016, based on 3,844,660 shares of common stock outstanding as of February 7, 2017 and assuming the sale of all of the shares offered by the selling stockholders pursuant to this prospectus.

 

In accordance with the terms of registration rights agreements with the holders of the shares of common stock and the warrants, this prospectus generally covers the resale of that number of shares of common stock equal to the number of shares of common stock issued and the shares of common stock issuable upon exercise of the related warrants, determined as if the outstanding warrants were exercised, as applicable, in full, in each case as of the trading day immediately preceding the date this registration statement was initially filed with the SEC. The fourth column assumes the sale of all of the shares offered by the selling stockholders pursuant to this prospectus.

 

The selling stockholders may have sold or transferred some or all of their shares of common stock, or acquired additional shares of our common stock or securities convertible into or exercisable for shares of our common stock, since the date on which the information in the table below is presented. Information about the selling stockholders may change over time.

 

Name of Selling Stockholder   Number of Shares Beneficially Owned Prior to Offering(1)     Maximum Number of Shares to be Sold Pursuant to this Prospectus(2)     Number of Shares Beneficially Owned After Offering(3)     Percentage of Shares Beneficially Owned After Offering(3)  
Anson Investments Master Fund LP     175,729 (4)     93,750       81,979       2.09 %
Thomas S. Bridges Revocable Trust     42,000 (5)     30,000       12,000        *    
Williams Family Limited Partnership     37,500 (6)     37,500       0        *    
Donald R. Kendall, Jr.     18,750 (7)     18,750       0        *    
The Gans Family Trust     14,167 (8)     7,500       6,667        *    
Intracoastal Capital LLC     203,896 (9)     187,500       16,396        *    
Empery Asset Master, Ltd.     166,151 (10)     27,909       138,242       3.54 %
Empery Tax Efficient, LP     100,125 (11)     14,406       85,719       2.20 %
Empery Tax Efficient II, LP     134,691 (12)     51,435       83,256       2.12 %
Jeneration Capital Master Fund     375,000 (13)     375,000       0        *  
Hudson Bay Master Fund Ltd.     200,322 (14)     93,750       106,572       2.70 %

 

* Less than 1%

 

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(1) The number of shares of common stock owned are those “beneficially owned” as determined under the rules of the SEC, including any shares of common stock as to which the selling stockholder has sole or shared voting or investment power and any shares of common stock that the selling stockholder has the right to acquire within 60 days of May 24, 2016 through the exercise of any option, warrant, or right.
   
(2) Includes both the shares of common stock purchased by each selling stockholder in the December 2015 Equity Financing and the shares of common stock issuable upon exercise of the December 2015 Warrants held by such selling stockholder.
   
(3) Assumes the sale of all of the shares offered by the selling stockholders pursuant to this prospectus.
   
(4) Includes 62,500 shares of common stock, 31,250 shares of common stock underlying the December 2015 Warrants and 81,979 shares of common stock underlying additional warrants held by Anson Investments Master Fund Ltd, or Anson. M5V Advisors Inc, or M5V, and Frigate Ventures LP, or Frigate, the Co-Investment Advisers of Anson, hold voting and dispositive power over the shares of common stock held by Anson. Bruce Winson is the managing member of Admiralty Advisors LLC, which is the general partner of Frigate. Moez Kassam and Adam Spears are directors of M5V. Mr. Winson, Mr. Kassam and Mr. Spears each disclaim beneficial ownership of these shares of common stock except to the extent of their pecuniary interest therein. The principal business address of Anson is 190 Elgin Ave; George Town, Grand Cayman.
   
(5) Includes 20,000 shares of common stock and 10,000 shares of common stock underlying the December 2015 Warrants. Thomas Bridges may be deemed to have sole voting and investment power over these securities.
   
(6) Includes 25,000 shares of common stock and 12,500 shares of common stock underlying the December 2015 Warrants. Douglas Williams may be deemed to have sole voting and investment power over these securities.
   
(7) Includes 12,500 shares of common stock and 6,250 shares of common stock underlying the December 2015 Warrants.
   
(8) Includes 5,000 shares of common stock and 2,500 shares of common stock underlying the December 2015 Warrants. Robert Gans and Melissa Gans may be deemed to have shared voting and investment power over these securities.
   
(9) Includes 125,000 shares of common stock, 62,500 shares of common stock underlying the December 2015 Warrants and 16,396 shares of common stock underlying additional warrants held by Intracoastal Capital, LLC, or Intracoastal. Mitchell P. Kopin and Daniel B. Asher, each of whom is a manager of Intracoastal, have shared voting control and investment discretion over the securities reported herein that are held by Intracoastal. As a result, each of Mr. Kopin and Mr. Asher may be deemed to have beneficial ownership (as determined under Section 13(d) of the Exchange Act) of the securities reported herein that are held by Intracoastal. Mr. Asher is also a control person of a broker-dealer. As a result of such common control, Intracoastal may be deemed to be an affiliate of a broker-dealer. Intracoastal acquired the shares of common stock being registered hereunder in the ordinary course of business, and at the time of the acquisition of the shares of common stock and warrants described herein, Intracoastal did not have any arrangements or understandings with any person to distribute such securities.

 

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(10) Includes 93,188 shares of common stock, 9,303 shares of common stock underlying the December 2015 Warrants and 63,660 shares of common stock underlying additional warrants held by Empery Asset Master, Ltd. Empery Asset Management LP, the authorized agent of Empery Asset Master Ltd., or EAM, has discretionary authority to vote and dispose of the shares held by EAM and may be deemed to be the beneficial owner of these shares. Martin Hoe and Ryan Lane, in their capacity as investment managers of Empery Asset Management LP, may also be deemed to have investment discretion and voting power over the shares held by EAM. EAM, Mr. Hoe and Mr. Lane each disclaim any beneficial ownership of these shares.
   
(11) Includes 37,293 shares of common stock, 4,802 shares of common stock underlying the December 2015 Warrants and 58,030 shares of common stock underlying additional warrants held by Empery Tax Efficient, LP. Empery Asset Management LP, the authorized agent of Empery Tax Efficient, LP, or ETE, has discretionary authority to vote and dispose of the shares held by ETE and may be deemed to be the beneficial owner of these shares. Martin Hoe and Ryan Lane, in their capacity as investment managers of Empery Asset Management LP, may also be deemed to have investment discretion and voting power over the shares held by ETE. ETE, Mr. Hoe and Mr. Lane each disclaim any beneficial ownership of these shares.
   
(12) Includes 34,290 shares of common stock, 17,145 shares of common stock underlying the December 2015 Warrants and 83,256 shares of common stock underlying additional warrants held by Empery Tax Efficient II, LP. Empery Asset Management LP, the authorized agent of Empery Tax Efficient II, LP, or ETE II, has discretionary authority to vote and dispose of the shares held by ETE II and may be deemed to be the beneficial owner of these shares. Martin Hoe and Ryan Lane, in their capacity as investment managers of Empery Asset Management LP, may also be deemed to have investment discretion and voting power over the shares held by ETE II. ETE II, Mr. Hoe and Mr. Lane each disclaim any beneficial ownership of these shares.
   
(13) Includes 250,000 shares of common stock and 125,000 shares of common stock underlying the December 2015 Warrants.
   
(14) Includes 62,500 shares of common stock, 31,250 shares of common stock underlying the December 2015 Warrants and 106,572 shares of common stock underlying additional warrants held by Hudson Bay Master Fund Ltd. Hudson Bay Capital Management LP, the investment manager of Hudson Bay Master Fund Ltd., has voting and investment power over these securities. Sander Gerber is the managing member of Hudson Bay Capital GP LLC, which is the general partner of Hudson Bay Capital Management LP. Each of Hudson Bay Master Fund Ltd. and Sander Gerber disclaims beneficial ownership over these securities.

 

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PLAN OF DISTRIBUTION

 

We are registering the shares of common stock previously issued and the shares of common stock issuable upon exercise of the warrants to permit the resale of these shares of common stock by the holders of the common stock and warrants from time to time after the date of this prospectus. We will not receive any of the proceeds from the sale by the selling stockholders of the shares of common stock. We will bear all fees and expenses incident to our obligation to register the shares of common stock.

 

The selling stockholders may sell all or a portion of the shares of common stock beneficially owned by them and offered hereby from time to time directly or through one or more underwriters, broker-dealers or agents. If the shares of common stock are sold through underwriters or broker-dealers, the selling stockholders will be responsible for underwriting discounts or commissions or agent’s commissions. The shares of common stock may be sold in one or more transactions at fixed prices, at prevailing market prices at the time of the sale, at varying prices determined at the time of sale, or at negotiated prices. These sales may be effected in transactions, which may involve crosses or block transactions,

 

  on any national securities exchange or quotation service on which the securities may be listed or quoted at the time of sale;
     
  in the over-the-counter market;
     
  in transactions otherwise than on these exchanges or systems or in the over-the-counter market;
     
  through the writing of options, whether such options are listed on an options exchange or otherwise;
     
  ordinary brokerage transactions and transactions in which the broker-dealer solicits purchasers;
     
  block trades in which the broker-dealer will attempt to sell the shares as agent but may position and resell a portion of the block as principal to facilitate the transaction;
     
  purchases by a broker-dealer as principal and resale by the broker-dealer for its account;
     
  an exchange distribution in accordance with the rules of the applicable exchange;
     
  privately negotiated transactions;
     
  short sales;
     
  sales pursuant to Rule 144;
     
  broker-dealers may agree with the selling securityholders to sell a specified number of such shares at a stipulated price per share;
     
  a combination of any such methods of sale; and
     
  any other method permitted pursuant to applicable law.

 

If the selling stockholders effect such transactions by selling shares of common stock to or through underwriters, broker-dealers or agents, such underwriters, broker-dealers or agents may receive commissions in the form of discounts, concessions or commissions from the selling stockholders or commissions from purchasers of the shares of common stock for whom they may act as agent or to whom they may sell as principal (which discounts, concessions or commissions as to particular underwriters, broker-dealers or agents may be in excess of those customary in the types of transactions involved). In connection with sales of the shares of common stock or otherwise, the selling stockholders may enter into hedging transactions with broker-dealers, which may in turn engage in short sales of the shares of common stock in the course of hedging in positions they assume. The selling stockholders may also sell shares of common stock short and deliver shares of common stock covered by this prospectus to close out short positions and to return borrowed shares in connection with such short sales. The selling stockholders may also loan or pledge shares of common stock to broker-dealers that in turn may sell such shares.

 

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The selling stockholders may pledge or grant a security interest in some or all of the convertible notes, warrants or shares of common stock owned by them and, if they default in the performance of their secured obligations, the pledgees or secured parties may offer and sell the shares of common stock from time to time pursuant to this prospectus or any amendment to this prospectus under Rule 424(b)(3) or other applicable provision of the Securities Act of 1933, as amended, amending, if necessary, the list of selling stockholders to include the pledgee, transferee or other successors in interest as selling stockholders under this prospectus. The selling stockholders also may transfer and donate the shares of common stock in other circumstances in which case the transferees, donees, pledgees or other successors in interest will be the selling beneficial owners for purposes of this prospectus.

 

The selling stockholders and any broker-dealer participating in the distribution of the shares of common stock may be deemed to be “underwriters” within the meaning of the Securities Act, and any commission paid, or any discounts or concessions allowed to, any such broker-dealer may be deemed to be underwriting commissions or discounts under the Securities Act. At the time a particular offering of the shares of common stock is made, a prospectus supplement, if required, will be distributed which will set forth the aggregate amount of shares of common stock being offered and the terms of the offering, including the name or names of any broker-dealers or agents, any discounts, commissions and other terms constituting compensation from the selling stockholders and any discounts, commissions or concessions allowed or reallowed or paid to broker-dealers.

 

Under the securities laws of some states, the shares of common stock may be sold in such states only through registered or licensed brokers or dealers. In addition, in some states the shares of common stock may not be sold unless such shares have been registered or qualified for sale in such state or an exemption from registration or qualification is available and is complied with.

 

There can be no assurance that any selling stockholder will sell any or all of the shares of common stock registered pursuant to the registration statement, of which this prospectus forms a part.

 

The selling stockholders and any other person participating in such distribution will be subject to applicable provisions of the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder, including, without limitation, Regulation M of the Exchange Act, which may limit the timing of purchases and sales of any of the shares of common stock by the selling stockholders and any other participating person. Regulation M may also restrict the ability of any person engaged in the distribution of the shares of common stock to engage in market- making activities with respect to the shares of common stock. All of the foregoing may affect the marketability of the shares of common stock and the ability of any person or entity to engage in market-making activities with respect to the shares of common stock.

 

We will pay all expenses of the registration of the shares of common stock pursuant to the registration rights agreement, estimated to be $50,000 in total, including, without limitation, Securities and Exchange Commission filing fees and expenses of compliance with state securities or “Blue Sky” laws; provided, however, that a selling stockholder will pay all underwriting discounts and selling commissions, if any. We will indemnify the selling stockholders against liabilities, including some liabilities under the Securities Act, in accordance with the registration rights agreements, or the selling stockholders will be entitled to contribution. We may be indemnified by the selling stockholders against civil liabilities, including liabilities under the Securities Act, that may arise from any written information furnished to us by the selling stockholder specifically for use in this prospectus, in accordance with the related registration rights agreement, or we may be entitled to contribution.

 

Once sold under the registration statement, of which this prospectus forms a part, the shares of common stock will be freely tradable in the hands of persons other than our affiliates.

 

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DIVIDEND POLICY

 

We have never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any dividends on our common stock in the foreseeable future. Any future determination to declare dividends will be made at the discretion of our board of directors and will depend on our financial condition, operating results, capital requirements, general business conditions and other factors that our board of directors may deem relevant. Additionally, our ability to pay dividends on our common stock is limited by restrictions under the terms of our existing debt covenants.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our results of operations and financial condition should be read in conjunction with our financial statements and the notes to those financial statements that are included elsewhere in this prospectus. This discussion contains forward-looking statements, such as our plans, objectives, expectations and intentions, that are based upon current expectations that involve risks and uncertainties. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the “Prospectus Summary,” “Risk Factors” and “Business” sections and elsewhere in this prospectus.

 

Overview

 

Our proprietary and patented Power Oxidation technology is designed to create greater industrial efficiencies by converting low-quality waste gases generated from industrial processes into usable on-site energy, therefore decreasing both operating costs and significantly reducing environmentally harmful gaseous emissions. We design, develop, license, manufacture and market our Power Oxidizers, which, when bundled with an electricity generating turbine in the 250 kilowatt, or kW, and 2 megawatt, or MW, sizes, are called Powerstations. We currently partner and are pursuing partnerships with large established manufacturers to integrate our Power Oxidizer with their gas turbines, with the goal to open substantial new opportunities for our partners to market these modified gas turbines to industries for which traditional power generation technologies were not technically feasible previously. We currently manufacture our Powerstations in the 250 kW size and manufacture just the Power Oxidizer for the 2MW size. Beginning later in 2016, contingent upon the successful completion of certain field testing, our 2MW partner, Dresser-Rand a.s., a subsidiary of Dresser-Rand Group Inc., a Siemens company, or Dresser-Rand, will manufacture the 2MW Power Oxidizers under a manufacturing license and will pay us a non-refundable license fee for each unit manufactured.

 

Historically, basic industries such as Petroleum, Plastics, Steel and Paper have consumed electricity in their manufacturing processes and created heat for their manufacturing processes through the burning of fossil fuels in a combustion chamber. Nearly all such combustion chambers use high quality premium fuels and burn those fuels at high temperatures, while low-quality waste gases were typically destroyed or vented into the atmosphere. Worldwide, these industrial processes collectively contribute approximately 32% of total global greenhouse gas emissions. Our technology utilizes these waste gases by modifying turbines with our gradual oxidation vessel. Inside this vessel, pressure and temperature are applied over time to destroy contaminants and return a substantially low emission source of energy in the form of heat. This heat then powers a turbine, spinning a generator and creating electricity. This technology can potentially unlock a new, global source of clean power generation (electricity, steam and/or heat energy) while reducing harmful emissions. Our goal is to enable industrial process facilities to generate clean energy from their existing waste gases, thereby reducing the amount of energy they purchase from their regional utilities, and simultaneously reducing the cost of compliance with local, state, and federal air quality regulations by avoiding the chemicals, catalysts and complex permitting required by existing pollution abatement systems.

 

Our Products and Value Proposition

 

We have developed a 250 kW Power Oxidizer that we integrate with a 250 kW gas turbine to produce 250 kW “Powerstations,” respectively. We have two Powerstations currently in operation at a landfill site in the Netherlands and at the Irvine campus of the University of California, Irvine, or UCI, and one additional Powerstation currently in the production phase expected to be installed at a landfill in southern California. We have built a Power Oxidizer of a significantly larger size, capable of generating sufficient heat and airflow to power a KG2 turbine produced by Dresser-Rand. Together, the Power Oxidizer and KG2 turbine comprise a 2MW Powerstation. The initial unit was constructed in the first quarter of 2016, and is currently being used in field tests that were substantially completed in 2016, at a third party location in Southern California. We have sold two 2MW Power Oxidizers to Dresser-Rand, each of which were delivered to the customer site in October 2016 and were combined with KG2 turbines and installed at Pacific Ethanol’s facility in Northern California in 2016. We believe this scaled-up version of our Power Oxidizer, combined with the KG2 turbine, will result in a Powerstation product that is better aligned with the scale of emissions (and energy requirements) observed at the industrial facilities that we believe stand to benefit most from this technology. As with the 250 kW Powerstation, the larger Powerstations are designed to provide an alternative to typical combustion-based power generation and enable industries to utilize their own waste gases to generate power.

 

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We also expect to integrate our Power Oxidizer technology into additional sized gas turbines as well as other applications that can use the heat generated by our Power Oxidizers to power other industrial applications. We believe other industrial grade waste gas-to-heat opportunities, powered by an ultra-low pollution Power Oxidizer, include: (i) the generation of steam from coupling a Power Oxidizer with a traditional steam boiler, (ii) use in industrial grade dryers for kilns or industrial drying customer requirements, and (iii) use in industrial chiller units for customers requiring cold air or water in their processes.

 

We believe our Power Oxidizers provide a significantly lower fuel cost per kilowatt hour since they can operate using both premium, refined natural gas as well as a wide variety of lower quality, low hydrocarbon gases, traditionally considered to be “waste” gases, as well as certain volatile organic compounds, or VOCs, such as paint solvents. These gases and compounds are typically seen as a waste by-product of industrial processes and which often represent a source of pollution which in turn often requires expensive waste abatement equipment and significant recurring operating costs. Our Power Oxidizers can utilize many of these waste gases and VOC compounds as fuels for our Powerstations, which we intend to serve as a fuel cost reduction for our industrial customers.

 

We also believe our Power Oxidizers provide a superior air pollution waste abatement solution for industrial customers. A typical industrial customer historically requires electricity, steam and generates industrial gases as a by-product of their facility operations. Prior to our Powerstation solution, these customers would purchase energy or produce energy with a traditional gas turbine. Traditional gas turbines use a combustion chamber to ignite the natural gas and result in air pollution such as carbon dioxide, carbon monoxide, and nitrogen oxides. The gas turbine and by-product gases generally require pollution control equipment and recurring costs in order to comply with existing pollution standards, which vary by geography with different regulations. Since both the natural gas fuel and the industrial by-product gases oxidize in our Power Oxidizers over a much longer time than combustion heat sources, the Power Oxidizer eliminates both the gas fuels and by-products to levels below significantly all of the existing and proposed air quality emission standards in most areas of the world. 

 

Reverse Merger

 

Prior to the reverse merger discussed below, pursuant to a contribution agreement dated November 12, 2012 by and among FlexEnergy, Inc., FlexEnergy Energy Systems, Inc., and Ener-Core Power, Inc., Ener-Core Power, Inc. (formerly Flex Power Generation, Inc.) was spun-off from FlexEnergy, Inc. as a separate corporation. As part of that transaction, Ener-Core Power, Inc. received all of the assets (including intellectual property) and liabilities pertaining to the Power Oxidizer business, which was the business carved out of FlexEnergy, Inc.

 

We were originally incorporated on April 29, 2010 in Nevada under the name Inventtech, Inc. On April 16, 2013, we entered into a merger agreement with Ener-Core Power, Inc. and a wholly-owned merger sub, pursuant to which the merger sub merged with and into Ener-Core Power, Inc., with Ener-Core Power, Inc. as the surviving entity. Prior to the merger, we were a public reporting “shell company,” as defined in Rule 12b-2 under the Exchange Act. On May 6, 2013, the pre-merger public shell company effected a 30-for-1 forward split of its common stock. All share amounts have been retroactively restated to reflect the effect of that stock split.

 

On July 1, 2013, we completed the reverse merger with Ener-Core Power, Inc., which remains our operating subsidiary. The merger was accounted for as a “reverse merger” and recapitalization. As part of the reverse merger, 120,520,000 shares of outstanding common stock of the pre-merger public shell company were cancelled (unadjusted for our July 8, 2015 reverse stock split). This cancellation has been retroactively accounted for as of the inception of Ener-Core Power, Inc. on November 12, 2012. Accordingly, Ener-Core Power, Inc. was deemed to be the accounting acquirer in the transaction and, consequently, the transaction was treated as a recapitalization of Ener-Core Power, Inc. Accordingly, the assets and liabilities and the historical operations that are reflected in the consolidated financial statements are those of Ener-Core Power, Inc. and are recorded at the historical cost basis of Ener-Core Power, Inc. Our assets, liabilities and results of operations were de minimis at the time of the reverse merger.

 

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Reverse Stock Split

 

Our April 2015 and May 2015 senior notes (see discussion below under “Financing Activities”) had three covenants, one of which was the requirement to enter into a reverse stock split in order to increase our share price above $5.00 per share in anticipation of an underwritten public offering. Our board of directors approved a reverse stock split of our authorized, issued and outstanding shares of common stock, as well as our authorized shares of preferred stock, par value $0.0001 per share, of which no shares are issued and outstanding, at a ratio of 1-for-50, or our Reverse Stock Split. On July 8, 2015, the Reverse Stock Split became effective and the total number of shares of common stock held by each stockholder converted automatically into the number of shares of common stock equal to: (i) the number of issued and outstanding shares of common stock held by each such stockholder immediately prior to the Reverse Stock Split divided by (ii) 50. We issued one whole share of the post-Reverse Stock Split common stock to any stockholder who otherwise would have received a fractional share as a result of the Reverse Stock Split, determined at the beneficial owner level by share certificate. As a result, no fractional shares were issued in connection with the Reverse Stock Split and no cash or other consideration was paid in connection with any fractional shares that would otherwise have resulted from the Reverse Stock Split.

 

Also on the effective date, all of our options, warrants and other convertible securities outstanding immediately prior to the Reverse Stock Split were adjusted by dividing the number of shares of common stock into which the options, warrants and other convertible securities are exercisable or convertible by 50 and multiplying the exercise or conversion price thereof by 50, all in accordance with the terms of the plans, agreements or arrangements governing such options, warrants and other convertible securities and subject to rounding to the nearest whole share. Such proportional adjustments were also made to the number of shares and restricted stock units issued and issuable under our equity compensation plans. The consolidated financial statements and notes to the consolidated financial statements included elsewhere in this prospectus give retroactive effect to the Reverse Stock Split for all periods presented.

 

Reincorporation

 

Effective as of September 3, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware, or the Reincorporation, pursuant to a plan of conversion dated September 2, 2015, following approval by our stockholders of the Reincorporation at our 2015 Annual Meeting of Stockholders held on August 28, 2015. In connection with the Reincorporation, we filed articles of conversion with the State of Nevada and a certificate of conversion with the State of Delaware. Upon effectiveness of the Reincorporation, the rights of our stockholders became governed by the Delaware General Corporation Law, the certificate of incorporation filed in Delaware and newly adopted bylaws. As a Delaware corporation following the Reincorporation, which we refer to as Ener-Core Delaware, we are deemed to be the same continuing entity as the Nevada corporation prior to the Reincorporation, which we refer to as Ener-Core Nevada. As such, Ener-Core Delaware continues to possess all of the rights, privileges and powers of Ener-Core Nevada, all of the properties of Ener-Core Nevada and all of the debts, liabilities and obligations of Ener-Core Nevada, including all contractual obligations, and continues with the same name, business, assets, liabilities, headquarters, officers and directors as immediately prior to the Reincorporation. Upon effectiveness of the Reincorporation, all of the issued and outstanding shares of common stock of Ener-Core Nevada automatically converted into issued and outstanding shares of common stock of Ener-Core Delaware without any action on the part of our stockholders.

 

Financing Activities

 

Our financing activities during 2015 consisted of the placement of $5 million of senior notes, or the 2015 Notes, and $3.3 million of common stock equity investments. We also committed significant resources during the year to raise capital through an underwritten public offering in the second half of 2015 in order to provide growth capital to finalize the KG2 integration and to facilitate sales of our products. The 2015 Notes entered into in April and May 2015 also had three covenants including: (i) a reverse split by July 22, 2015 (see above), (ii) an underwritten public offering by October 22, 2015 and (iii) a concurrent listing on a national securities exchange by October 22, 2015. The public offering and listing deadlines were extended in the fourth quarter of 2015 and were modified as described in greater detail below in March 2016. Additional related activities were undertaken as precursors to the underwritten public offering efforts including the April 2015 warrant exchange, the 1-for-50 reverse split in July 2015, and the reincorporation in Delaware effective September 2015. The underwritten public offering began with the filing of a registration statement in July 2015, continued with marketing the public offering in November 2015 and concluded with the withdrawal of the registration statement in March 2016 due to poor market conditions for public offerings. In lieu of the public offering financing, we concluded two PIPE transactions in December 2015 and April 2016. We incurred approximately $0.6 million in offering costs, primarily legal and accounting expenses related to the filing of the registration statement and amendments, which had been capitalized as prepaid expenses for the 2015 quarterly reporting periods. Accordingly, with the withdrawal of the registration statement in April 2016, those previously capitalized expenses were considered impaired and were expensed in the fourth quarter of 2015.

 

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In September 2016, we concluded a further financing transaction pursuant to which we issued the Convertible Unsecured Notes (as defined below) in exchange for gross proceeds of $1.25 million. Further, in December 2016, we amended and restated the 2015 Notes and issued the December 2016 Notes (as defined below) in exchange for gross proceeds of approximately $3.4 million.

 

April 2015 Warrant Exchange

 

On April 2, 2015, we entered into warrant exchange agreements, or the Exchange Agreements, with five accredited investors, or the April 2014 Investors, that held warrants for the purchase of up to an aggregate of 81,941 shares of our common stock that were issued on April 16, 2014, or the April 2014 Warrants, in connection with our April 2014 senior secured convertible notes and warrants financing transaction, or the April 2014 Financing. Pursuant to the Exchange Agreements, the April 2014 Investors agreed to surrender for cancellation all of their April 2014 Warrants in exchange for shares of our common stock, which in the aggregate totaled 73,747 shares of our common stock, or the Exchange Shares. Under the Exchange Agreements, we granted the April 2014 Investors a right of first refusal to participate in any future sale of our equity or equity equivalent securities on a pro rata basis up to 50% of the securities offered in such sale, from the closing of the exchange transaction until April 16, 2016, except for a registered underwritten public offering. In the event that we engage in a registered underwritten public offering of our common stock and the offering price per share in such registered offering is more than 85% of the closing sale price of our common stock on the date of pricing of such offering, then the participation right will be 20% of the securities offered in such registered offering. The April 2014 Investors waived their right to participate in our withdrawn public offering and the right of first refusal has since lapsed.

 

April 2015 and May 2015 Convertible Senior Secured Promissory Notes and Warrants Financing

 

On April 23, 2015, we sold senior secured promissory notes with an aggregate principal amount of $3.1 million, or the April 2015 Notes, and warrants for the purchase of up to 136,264 shares of our common stock, or the April 2015 Warrants. The investors in the offering paid $1,000 for each $1,000 of principal amount of April 2015 Notes and April 2015 Warrants. In connection with the offering, we agreed to effect a reverse stock split of our common stock initially yielding a post-split stock price of at least $4.00 per share of common stock within three months following the closing of the offering, to secure the listing of our common stock on a national securities exchange no later than six months following the closing of the offering, and to complete a firm commitment underwritten public offering registered under the Securities Act with aggregate gross proceeds to us equaling or exceeding $10,000,000 no later than six months following the closing of the offering.

 

On May 7, 2015, we sold senior secured promissory notes with an aggregate principal amount of $1.9 million, or the May 2015 Notes, and warrants for the purchase of up to 83,517 shares of our common stock, or the May 2015 Warrants. The investors in the offering paid $1,000 for each $1,000 of principal amount of May 2015 Notes and May 2015 Warrants. In connection with the offering, we agreed to covenants substantially identical to those described above relating to the April 2015 Notes financing.

 

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Originally, the April 2015 Notes provided for a maturity date of April 23, 2017, and the May 2015 Notes provided for a maturity date of May 7, 2017. The April 2015 Notes and the May 2015 Notes, which we collectively refer to as the 2015 Notes, each initially bore an interest rate of 12.00% per annum (which would have increased to 18% in the event of default) payable monthly in cash. The 2015 Notes are secured by a guaranty by Ener-Core Power, Inc. as well as current and future assets of the Company and Ener-Core Power, Inc. (excluding certain intellectual property assets described more fully below) pursuant to the pledge and security agreement entered into in connection with the 2015 Notes financings, as amended to date. The 2015 Notes and the related securities purchase agreements, or the 2015 SPAs, initially required our consummation of a firm commitment underwritten public offering registered under the Securities Act with aggregate gross proceeds to us equal to or in excess of $10,000,000, or a Qualified Public Offering, and a related listing of our common stock on a national securities exchange prior to October 22, 2015. Through a series of amendments to the 2015 Notes and related 2015 SPAs from October 2015 through December 2016, these requirements have been adjusted, extended or removed from the 2015 Notes. We and required holders also amended the 2015 Notes effective November 2, 2015 to include the Support Agreement and all related obligations, as well as the Convertible Unsecured Notes and December 2016 Notes, under the definitions of “Permitted Indebtedness” and “Permitted Liens.” Such amendments are binding upon all of the issued 2015 Notes and all parties to the 2015 SPAs pursuant to the terms thereof.

 

On November 23, 2016, we and certain investors holding 2015 Notes executed amendment agreements to amend and restate the 2015 Notes in order to (i) provide that the 2015 Notes will rank pari passu with the December 2016 Notes, (ii) adjust the terms of such 2015 Notes, including without limitation the initial conversion price per share, to conform to the December 2016 Notes and (iii) contemplate the issuance to the holders of the 2015 Notes of additional five-year warrants, or the December 2016 Additional Warrants, for the purchase of up to an aggregate of 2,222,217 shares of our common stock. On December 2, 2016, we issued to the holders of the 2015 Notes the December 2016 Additional Warrants. Upon the amendment and restatement thereof, the 2015 Notes provide that they will mature on December 31, 2018 and do not bear any ordinary interest, as the principal amount of the 2015 Notes includes an original issue discount of ten percent; provided that that 2015 Notes will bear interest at a rate of ten percent per annum immediately upon the occurrence of, and will continue to accrue during the continuance of, an Event of Default (as defined in the 2015 Notes).

 

As amended and restated through December 2, 2016, the 2015 Notes and related 2015 SPAs contain the following provisions: 

 

  We no longer must consummate a “Qualified Public Offering,” however remain obligated to commence trading of our common stock on a national securities exchange by no later than December 31, 2017.

  

  The 2015 Notes, as amended and restated on December 2, 2016:

 

  rank pari passu with the December 2016 Notes and senior to the Convertible Unsecured Notes;
     
  are convertible any time at a price per share of $2.50 per share;
     
  will automatically convert into shares of common stock on the fifth trading day immediately following the date on which (i) the Weighted Average Price (as defined in the 2015 Notes) of our common stock for each trading day during a twenty trading day period equals or exceeds $5.00 (as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction) and no Equity Conditions Failure (as defined in the 2015 Notes) has occurred;
     
  are subject to a limitation on any conversion if, following such conversion, a holder would beneficially own more than 4.99% or 9.99%, with such threshold determined by the holder prior to issuance, of the shares of our common stock after giving effect to such conversion; and
     
  contain a provision that prevents us from entering into or becoming party to a Fundamental Transaction (as defined in the 2015 Notes) unless the successor entity assumes all of our obligations under the 2015 Notes and the related transaction documents pursuant to written agreements in form and substance satisfactory to at least a certain number of holders of the 2015 Notes.
     
  Upon an Event of Default and delivery to the holder of the 2015 Note of notice thereof, such holder may require us to redeem all or any portion of its 2015 Note at a price equal to 115% of the Conversion Amount (as defined in the 2015 Notes) being redeemed.
     
  Upon a Change of Control (as defined in the 2015 Notes) and delivery to the holder of the 2015 Note of notice thereof, such holder may also require the Company to redeem all or any portion of its 2015 Note at a price equal to 115% of the Conversion Amount being redeemed

 

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  At any time from and after January 1, 2018 and provided that we have not received either (i) initial deposits for at least eight 2 MW Power Oxidizer units or (ii) firm purchase orders totaling not less than $3,500,000 and initial payment collections of at least $1,600,000, in each case during the period commencing on the issuance date of the 2015 Notes and ending on December 31, 2017, the holder of the 2015 Note may require us to redeem all or any portion of its 2015 Note at a price equal to 100% of the Conversion Amount being redeemed.
     
  At any time, we may redeem all or any portion of the then outstanding principal and accrued and unpaid interest with respect to such principal under the 2015 Notes at 100% of such aggregate amount; provided, however, that the aggregate Conversion Amount to be redeemed pursuant to all 2015 Notes must be at least $500,000, or such lesser amount as is then outstanding. The portion of the 2015 Note(s) to be redeemed shall be redeemed at a price equal to the greater of (i) 110% of the Conversion Amount of the 2015 Note being redeems and (ii) the product of (A) the Conversion Amount being redeemed and (B) the quotient determined by dividing (I) the greatest Weighted Average Price (as defined in the 2015 Notes) of the shares of common stock during the period beginning on the date immediately preceding the date of the notice of such redemption by us and ending on the date on which the redemption by us occurs by (II) the lowest Conversion Price (as defined in the 2015 Notes) in effect during such period.

 

The April 2015 Warrants and the May 2015 Warrants, which we collectively refer to as the 2015 Warrants, entitle their holders to purchase shares of our common stock at an exercise price of $12.50 per share and will expire on the 60-month anniversary of their issuance date. The 2015 Warrants may be exercised at any time and may be exercised on a “cashless” basis if a registration statement covering the resale of the shares underlying the 2015 Warrants is not then available; provided, however, that we may not effect any exercise if, following such exercise, a holder would beneficially own more than 4.99% of the shares of our common stock outstanding immediately after giving effect to such exercise. The December 2015 amendments to the 2015 SPAs provided for the issuance of additional five-year warrants, or Additional Warrants, exercisable for ten shares of common stock per $1,000 of outstanding principal of the 2015 Notes held by each buyer, each with an exercise price of $12.50 per share, subject to adjustment as set forth within the Additional Warrants, issuable in tranches triggered by certain Company actions. An initial tranche of 50,000 Additional Warrants became issuable and were issued in conjunction with the execution of the December Amendments. We issued a second tranche of 50,000 Additional Warrants on February 2, 2016, or the February 2016 Warrants. The March 2016 amendments to the 2015 SPAs further provided for the issuance of additional five-year warrants in substantially the same form as the Additional Warrants, or the March 2016 Warrants, to purchase an aggregate of 500,000 shares of common stock at a purchase price of $5.00 per share, exercisable for ten shares of common stock per $100 of outstanding principal of the 2015 Notes held by each buyer. In connection with the issuance of the March 2016 Warrants, the exercise price of the first and second tranche of Additional Warrants was adjusted from $12.50 per share to $5.00 per share. We accounted for the February 2016 Warrants and the March 2016 Warrants as derivative liabilities and recorded an additional $148,000 of debt discount upon the issuance of the February 2016 Warrants and $1,497,000 of debt discount upon the issuance of the March Warrants. The December 31, 2015 debt discount and the additional discounts recorded in February 2016 and March 2016 are amortized over the expected remaining life of the debt.

 

May 2015 Equity Financing

 

On May 1, 2015, we sold 108,000 shares of our common stock at a purchase price of $7.50 per share and received gross proceeds of approximately $810,000 from the sale of such shares.

 

Support Agreement Obligations and Related Warrant

 

Effective November 2, 2015, we executed the Support Agreement pursuant to which an investor provided us with financial and other assistance (including the provision of sufficient and adequate collateral) in order to obtain a $2.1 million letter of credit in favor of Dresser-Rand in satisfaction of our backstop security requirement under the CLA. If the investor is required to make any payments on the letter of credit, then we are obligated to reimburse the investor the full amount of any such payment. Such payment obligation is secured by a pledge of certain collateral of the Company pursuant to a concurrently executed security agreement, or the Security Agreement, and the security interest in favor of and our payment obligations to the investor are subject to the terms of that certain Subordination and Intercreditor Agreement executed concurrently with the Support Agreement and the Security Agreement, by and among the investor, us and the collateral agent pursuant to the 2015 Notes.

 

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The term of our obligations under the Support Agreement commenced on November 2, 2015, the issuance date of the letter of credit in favor of Dresser-Rand, and will terminate on the earliest of: (a) replacement of the letter of credit with an alternative form of backstop security in favor of Dresser-Rand, (b) Dresser-Rand eliminating the backstop security requirement under the CLA, or (c) the last day of the twenty-fourth calendar month following the commencement of the term. In consideration of the investor’s support commitment, we will pay the investor a one-time fee equal to 4% of the amount of the letter of credit and a monthly fee equal to 1% of the amount of the letter of credit for the first twelve months. If the Support Agreement has not terminated after the initial twelve months, we are obligated to pay another one-time fee equal to 4% of the amount of the letter of credit, and a monthly fee equal to 2% of the amount of the letter of credit for up to another twelve months. We have also agreed to reimburse the upfront fee and expenses incurred by the investor in connection with obtaining the letter of credit, provided that if such upfront fee is less than 2% of the amount of the letter of credit, we will pay the investor an additional one-time fee equal to 50% of the reduction in such upfront fees. We retain the right to replace at any time, and in whole or in part, the collateral provided by the investor in connection with the letter of credit with an alternative solution, with or without notice to investor and with no penalty for the exchange, but with a related reduction in fees. As further consideration, we also issued the investor a five-year warrant to purchase 74,000 shares of our common stock, at an exercise price of $15.00 per share, subject to adjustment for stock splits or other similar changes to our capital structure, which will become exercisable on November 2, 2016.

 

December 2015 Equity Financing

 

On December 30, 2015, we entered into a securities purchase agreement dated December 30, 2015, or the December 2015 Purchase Agreement, pursuant to which we issued to certain institutional and other accredited investors, or the December 2015 Investors, an aggregate of 625,000 shares of our common stock at a price of $4.00 per share, and five-year warrants to purchase an aggregate of 312,500 shares of our common stock at an exercise price of $5.00 per share, or the December 2015 Warrants, in exchange for aggregate gross proceeds of $2.5 million, which we refer to as the December 2015 Equity Financing. We also entered into the December 2015 Registration Rights Agreement with the December 2015 Investors pursuant to which we are required to file one or more registration statements with the SEC to register for resale by the December 2015 Investors the shares of our common stock sold in the December 2015 Equity Financing and the shares of our common stock issuable upon exercise of the December 2015 Warrants, and use our commercially reasonable efforts to maintain the effectiveness of such registration statement(s). 

 

The December 2015 Purchase Agreement contains an anti-dilution adjustment provision, pursuant to which, in the event that we sell or issue shares of our common stock at a price lower than the $4.00 per share purchase price of the shares issued under the December 2015 Purchase Agreement, we will be required to issue to each December 2015 Investor, for no additional consideration, an additional number of shares of common stock in an amount equal to (1) the purchase price paid by such December 2015 Investor under the December 2015 Purchase Agreement divided by the price per share of common stock for the dilutive issuance, minus (2) the total number of shares of common stock purchased by such December 2015 Investor. Such adjustment is called a Share Dilution Adjustment. The Share Dilution Adjustment does not apply with respect to certain exempt issuances and will terminate on the earlier of: (i) thirty (30) days from the date of effectiveness of the registration statement of which this prospectus forms a part and (ii) six (6) months after December 31, 2015. Additionally, if, prior to such termination date, we issue or sell any warrants to purchase shares of common stock with an exercise price per whole share that is less than the exercise price per December 2015 Warrant share in effect at such time, the exercise price per December 2015 Warrant share will be adjusted, with no additional action required by the holder, to equal the exercise price per whole share of common stock as set forth in the warrants issued in such dilutive issuance, except in the case of certain exempt issuances. On June 30, 2016, the anti-dilution adjustment provision terminated.

 

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Each December 2015 Warrant is exercisable immediately for cash. In addition, unless all of the shares of common stock underlying the December 2015 Warrants that are subject to an exercise notice with respect to any December 2015 Warrant are registered for resale pursuant to an effective registration statement and are issuable without any restrictive legend, such December 2015 Warrant may also be exercised by way of a cashless exercise. The December 2015 Warrants also contain provisions that protect their holders against dilution by adjustment of the exercise price in certain events such as stock dividends, stock splits and other similar events. Additionally, if, prior to the earlier of (i) thirty (30) days from the date of effectiveness of the registration statements required to be filed by us pursuant to the December 2015 Registration Rights Agreement and (ii) six months after the issuance date of the December 2015 Warrants, we issue or sell any warrants to purchase shares of common stock with an exercise price per whole share that is less than the exercise price per December 2015 Warrant share in effect at such time, the exercise price per December 2015 Warrant share will be adjusted, with no additional action required by the holder, to equal the exercise price per whole share of common stock as set forth in the warrants issued in such dilutive issuance, except in the case of certain exempt issuances.

 

Underwritten Offering Withdrawal

 

On April 5, 2016, we formally requested that the Securities and Exchange Commission withdraw our registration statement, originally filed in July 2015. The underwritten public offering and a simultaneous listing on a national exchange was originally a requirement under our 2015 Notes. After negotiating the March Amendments (defined below), our board of directors determined, with the consultation of our professional advisors, that market conditions in early 2016 were not conducive to a marketed underwritten public offering.

 

March 2016 Debt Amendments

 

On March 31, 2016, we executed amendments to the 2015 Notes and related Securities Purchase Agreements, or, collectively, the March Amendments, each with certain investors holding the requisite number of conversion shares and warrant shares underlying the 2015 Notes and warrants issued in April 2015 and May 2015 pursuant to the referenced Securities Purchase Agreements, or the April and May Warrants. The March Amendments (i) removed the requirement that we consummate a “Qualified Public Offering”; (ii) extended the deadline for us to commence trading on a Qualified Eligible Market (as defined in the March Amendments) to no later than April 14, 2016; provided that if we consummated a private offering of its securities resulting in gross proceeds to us of at least $3,000,000 after June 30, 2016 and prior to or on April 14, 2016, or a Qualified Private Offering, such deadline would be automatically extended to October 15, 2016; (iii) provided for the issuance of warrants to purchase up to 500,000 shares of our common stock, each with an exercise price of $5.00 per share, subject to adjustment as set forth within the warrants, or the March Warrants; and (iv) added an additional covenant on behalf of us that, on or prior to April 14, 2016, we would cause our net monthly cash flow directly associated with the CLA, taken together with our monthly capital expenditure spending associated with the CLA, and excluding expenditures associated with the FSAT requirements defined in the CLA, to be neutral or positive, to be accomplished by re-negotiation or termination of such CLA. On April 11, 2016, we consummated a $3 million private offering and thereby satisfied condition (ii) above. On March 31, 2016, we issued warrants to purchase 500,000 shares of our common stock, as described in Note 11 to our unaudited condensed consolidated financial statements included elsewhere in this prospectus, or the March Warrants, and remained in compliance with the net monthly cash flow covenant listed in (iv) above during all relevant times. On June 29, 2016, we signed the CMLA, which will replace the CLA upon the successful completion of the technical tests associated with the KG2. Additionally, upon execution of the September Amendments (as defined below), the monthly cash flow covenant listed in (iv) above was removed.

 

The March Amendments amended the terms of the 2015 Notes to extend the conversion feature until the term of the 2015 Notes and to provide for the issuance of additional warrants. Additionally, in February 2016, pursuant to the terms of the December 2015 amendments to the 2015 Notes, we issued warrants to purchase up to 50,000 shares of our common stock at an exercise price of $12.50 per share, or the February Warrants, and subsequently adjusted the exercise price to $5.00 per share with the issuance of the March Warrants, to $4.00 per share upon the execution of the various warrant amendments on August 24, 2016 (as described below under “August Warrant Amendments”) and to $3.00 per share upon the execution of the amendment and restatement of the 2015 Notes. We accounted for the February Warrants and the March Warrants as derivative liabilities and recorded an additional $148,000 of debt discount upon the issuance of the February Warrants and $1,497,000 of debt discount upon the issuance of the March Warrants.  The December 31, 2015 debt discount and the additional discount recorded in February 2016 and March 2016 is amortized over the expected remaining life of the debt.

 

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April 2016 Equity Financing

 

On April 11, 2016, we entered into a stock purchase agreement, pursuant to which we issued to an accredited investor an aggregate of 696,056 shares of our common stock in exchange for gross proceeds of approximately $3.0 million, or the April 2016 Private Placement. The closing of the April 2016 Private Placement satisfied the Qualified Private Offering requirement described in the March Amendments described in Note 11 to our unaudited condensed consolidated financial statements included elsewhere in this prospectus under “March 2016 Amendment to 2015 Notes”.

 

August 2016 Warrant Amendments

 

On August 24, 2016, we executed amendments to the 2015 Warrants, the Additional Warrants, the December 2015 Warrants, the February 2016 Warrants and the March 2016 Warrants. The amendments reduced the exercise price of such warrants to $4.00 per share and removed all remaining net cash settlement provisions, as applicable, in each warrant. For the warrants accounted for as derivative liabilities, we marked the warrants to market immediately prior to the change in the strike price to a value of $1,719,000. The removal of the warrant agreement provisions that required derivative accounting resulted in a reclassification of $1,719,000 from derivative liabilities to Paid-in Capital. The reduction in exercise price to $4.00 resulted in an additional discount to the 2015 Notes of $206,000 which will be amortized to interest expense over the expected remaining life of the 2015 Notes.

 

September and October 2016 Debt Amendments

 

Effective as of September 1, 2016, we executed amendments to the 2015 Notes and related Securities Purchase Agreements, or the September Amendments, which are binding upon all of the 2015 Notes. The September Amendments (i) extend the deadline for us to commence trading on a Qualified Eligible Market (as defined in the September Amendments) to no later than December 31, 2016; (ii) provide that we may, on or prior to September 1, 2016, issue to one or more investors up to an aggregate of $1,500,000 principal amount of one-year term unsecured notes, as described in Note 9 to our condensed consolidated financial statements included elsewhere in this prospectus, and related warrants, and approve the forms of agreements to be executed in connection with the issuance of such unsecured notes and warrants; (iii) remove the covenant on behalf of us related to net monthly cash flow directly associated with the CLA; (iv) extend the earliest date on which the holders of the 2015 Notes may require us to redeem all or any portion of such 2015 Notes until December 31, 2016; and (v) extend the deadline for us to consummate a Further Private Offering (as defined in the 2015 Notes) to December 31, 2016. Effective as of October 21, 2016, we executed amendments to the 2015 Notes to clarify and conform the terms of such 2015 Notes to the terms of previous amendments to such 2015 Notes and the related Securities Purchase Agreements.

 

September 2016 Convertible Unsecured Notes

 

On September 1, 2016, we entered into a securities purchase agreement and related note agreements and warrant agreements whereby we issued $1,250,000 in convertible unsecured promissory notes, or the Convertible Unsecured Notes, and detachable five-year warrants to purchase an aggregate of 124,999 shares of our common stock at an exercise price of $4.00 per share, or the September 2016 Financing. We received total gross proceeds of $1,250,000, less transaction expenses of $20,000 consisting of legal costs for net proceeds of $1,230,000.

 

The Convertible Unsecured Notes bear interest at a rate of 12% per annum and mature on September 1, 2017. The Convertible Unsecured Notes are subordinate to the 2015 Notes described in Note 8 to our condensed consolidated financial statements included elsewhere in this prospectus. The Convertible Unsecured Notes were initially convertible at the option of the holder into common stock at an initial exercise price of $4.31and will automatically convert into shares of common stock in the event of a conversion of at least 50% of the then outstanding (i) principal, (ii) accrued and unpaid interest with respect to such principal and (iii) accrued and unpaid late charges, if any, with respect to such principal and interest, under the 2015 Notes. Upon the conversion of 50% or more of the 2015 Notes at a price per share less than $4.31, the conversion price of the Convertible Unsecured Notes will be reduced to the effective conversion price of the 2015 Notes. The Convertible Unsecured Notes also contain a blocker provision that prevents us from effecting a conversion in the event that the holder, together with certain affiliated parties, would beneficially own in excess of 9.99% of the shares of common stock outstanding immediately after giving effect to such conversion. At any time after the issuance date of the Convertible Unsecured Notes, we may, at its option, redeem all or any portion of the then outstanding principal and accrued and unpaid interest with respect to such principal, or the Company Optional Redemption Amount, at 100% of such aggregate amount; provided, however, that we may not redeem all or any portion of the Company Optional Redemption Amount so long as any of the 2015 Notes remain outstanding without the prior written consent of the collateral agent with respect to such 2015 Notes and certain investors holding the requisite number of conversion shares and warrant shares underlying the 2015 Notes and April 2015 Warrants and May 2015 Warrants.

 

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The securities purchase agreement for the Convertible Unsecured Notes calls for the issuance of additional five-year warrants to purchase an aggregate of 62,500 shares at an exercise price of $4.00 per share on each of the 61st, 91st, 121st and 151st days after the closing of the September 2016 Financing, or, in each case, an Additional Warrant Date, but only in the event we have not consummated a further financing consisting of the issuance of common stock and warrants for aggregate gross proceeds of at least $3,000,000 prior to such respective Additional Warrant Date. As of December 31, 2016, we had not consummated a further financing and, as a result, issued warrants to purchase an aggregate of 62,500 shares of our common stock on each of November 1, 2016, December 1, 2016 and December 31, 2016.

 

December 2016 Convertible Senior Secured Promissory Notes and Warrants Financing

 

On November 23, 2016, we entered into a securities purchase agreement, pursuant to which we issued to 21 accredited investors unregistered convertible senior secured promissory notes with an aggregate principal amount of approximately $3.7 million, or the December 2016 Notes, and five-year warrants, or the December 2016 Financing Warrants, to purchase an aggregate of 1,498,622 shares of our common stock at an exercise price of $3.00 per share, or the December 2016 Financing Warrant Shares, with aggregate net proceeds to us after a ten percent original issue discount and placement agent fee of approximately $3.2 million, or the December 2016 Financing. In connection with the December 2016 Financing, we agreed to secure the listing of our common stock on a national securities exchange by no later than December 31, 2017.

 

The December 2016 Notes bear no ordinary interest, as the principal amount of the December 2016 Notes will include an original issue discount. Upon an Event of Default (as defined in the December 2016 Notes), however, the December 2016 Notes will bear interest at a rate of 10% per annum. The December 2016 Notes will mature on December 31, 2018. The December 2016 Notes rank pari passu with the 2015 Notes and rank senior to the Convertible Unsecured Notes. The December 2016 Notes will be convertible at the option of the holder into common stock at an exercise price of $2.50 (as subject to adjustment therein) and will automatically convert into shares of common stock on the fifth trading day immediately following the date on which (i) the Weighted Average Price (as defined in the December 2016 Notes) of the common stock for each trading day during a twenty trading day period equals or exceeds $5.00 (as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction) and no Equity Conditions Failure (as defined in the December 2016 Notes) has occurred. The December 2016 Notes also contain a blocker provision that prevents us from effecting a conversion in the event that the holder, together with certain affiliated parties, would beneficially own in excess of either 4.99% or 9.99%, with such threshold determined by the holder prior to issuance, of the shares of common stock outstanding immediately after giving effect to such conversion.

 

Upon an Event of Default and delivery to the holder of the December 2016 Note of notice thereof, such holder may require us to redeem all or any portion of its December 2016 Note at a price equal to 115% of the Conversion Amount (as defined in the December 2016 Notes) being redeemed. Additionally, upon a Change of Control (as defined in the December 2016 Notes) and delivery to the holder of the December 2016 Note of notice thereof, such holder may also require us to redeem all or any portion of its December 2016 Note at a price equal to 115% of the Conversion Amount being redeemed. Further, at any time from and after January 1, 2018 and provided that we have not received either (i) initial deposits for at least eight 2 MW Power Oxidizer units or (ii) firm purchase orders totaling not less than $3,500,000 and initial payment collections of at least $1,600,000, in each case during the period commencing on the issuance date of the December 2016 Notes and ending on December 31, 2017, the holder of the December 2016 Note may require us to redeem all or any portion of its December 2016 Note at a price equal to 100% of the Conversion Amount being redeemed.

 

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At any time, we may redeem all or any portion of the then outstanding principal and accrued and unpaid interest with respect to such principal under the December 2016 Notes, at 100% of such aggregate amount; provided, however, that the aggregate Conversion Amount to be redeemed pursuant to all December 2016 Notes must be at least $500,000, or such lesser amount as is then outstanding. The portion of the December 2016 Note(s) to be redeemed shall be redeemed at a price equal to the greater of (i) 110% of the Conversion Amount of the December 2016 Note being redeems and (ii) the product of (A) the Conversion Amount being redeemed and (B) the quotient determined by dividing (I) the greatest Weighted Average Price (as defined in the December 2016 Notes) of the shares of common stock during the period beginning on the date immediately preceding the date of the notice of such redemption by us and ending on the date on which the redemption by us occurs by (II) the lowest Conversion Price (as defined in the December 2016 Notes) in effect during such period.

 

The December 2016 Notes contain a provision that prevents the Company from entering into or becoming party to a Fundamental Transaction (as defined in the December 2016 Notes) unless the successor entity assumes all of our obligations under the December 2016 Notes and the related transaction documents pursuant to written agreements in form and substance satisfactory to at least a certain number of holders of the December 2016 Notes.

 

In connection with the execution of the purchase agreement for the December 2016 Financing and the issuance of the December 2016 Notes, Ener-Core Power, Inc. entered into a Guaranty, pursuant to which it has agreed to guarantee all of our obligations under the purchase agreement, the December 2016 Notes and the related transaction documents.

 

The December 2016 Financing Warrants are exercisable immediately in exchange for cash. In addition, unless all of the December 2016 Financing Warrant Shares that are subject to an exercise notice with respect to any December 2016 Financing Warrant are registered for resale pursuant to an effective registration statement and are issuable without any restrictive legend, such December 2016 Financing Warrant may also be exercised by way of a cashless exercise. The December 2016 Financing Warrants also provide that the exercise price of each December 2016 Financing Warrant will be adjusted upon the occurrence of certain events such as stock dividends, stock splits and other similar events. The December 2016 Financing Warrants include a blocker provision that prevents us from effecting any exercise in the event that the holder, together with certain affiliated parties, would beneficially own in excess of either 4.99% or 9.99%, with such threshold determined by the holder prior to issuance, of the shares of common stock outstanding immediately after giving effect to such exercise.

 

December 2016 Amendments to 2015 Notes

 

On November 23, 2016, we and certain investors holding 2015 Notes executed amendment agreements, or the Amendment Agreements, to amend and restate the 2015 Notes in order to (i) provide that the 2015 Notes rank pari passu with the December 2016 Notes and (ii) adjust the terms of such 2015 Notes, including without limitation the initial conversion price per share, to conform to the December 2016 Notes. Additionally, the Amendment Agreements provide for the issuance to the holders of the 2015 Notes of additional warrants, or the December 2016 Additional Warrants, to purchase an aggregate of 2,222,217 shares of common stock at an exercise price of $3.00 per share, or the Additional Warrant Shares, in connection with the amendment and restatement of the 2015 Notes. The Amendment Agreements also adjusted the exercise price of certain warrants held by the investors holding 2015 Notes to $3.00 per share.

 

December 2016 Amendments to Convertible Unsecured Notes

 

On November 23, 2016, we and certain investors holding Convertible Unsecured Notes executed amendments to the securities purchase agreement for the Convertible Unsecured Notes, or the September 2016 SPA, to (i) extend the deadline for us to commence trading on a Qualified Eligible Market (as defined in the September 2016 SPA) to no later than December 31, 2017 and (ii) reduce the exercise price of certain warrants held by the investors holding Convertible Unsecured Notes to $3.00 per share. Additionally, we and certain investors holding Convertible Unsecured Notes executed amendments to such Convertible Unsecured Notes to reduce the initial conversion price per share of such Convertible Unsecured Notes to $2.50 and adjust certain definitions.

 

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Dresser-Rand 2 MW Integration

 

During the nine months ended September 30, 2016, we allocated a significant portion of our resources, including nearly all of our engineering staff and additional consultants, to the completion of our initial 2MW Power Oxidizer, which we subsequently integrated with the Dresser-Rand KG2-3GEF turbine to create a 2MW Powerstation that is currently undergoing final field testing.

 

On November 14, 2014, we entered into a Commercial License Agreement, or, as amended, the CLA, with Dresser-Rand, through our wholly-owned subsidiary, Ener-Core Power, Inc., which grants Dresser-Rand the right to market and sell the Dresser-Rand KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer, or a Combined System. The CLA grants Dresser-Rand exclusive rights to commercialize the Ener-Core Power Oxidizer, within ranges of 1–4 MW of power capacity, bundled with the Dresser-Rand KG2 gas-turbine product line. As part of the CLA, Dresser-Rand agreed to pay a $1.6 million initial license fee, under the condition that we were able to successfully scale up the technology from the current size of 250 kW to a size of 2 MW. Dresser-Rand also agreed to achieve annual sales thresholds agreed to by both companies in order to retain the exclusivity of the commercial license. Upon payment of the initial license fee in full, Dresser-Rand will have an exclusive license to sell the Ener-Core Power Oxidizer within ranges of 1–4 MW of power capacity, bundled with a gas-turbine to generate electricity.

 

The CLA calls for a series of technical milestones. The first technical milestone involved the completion of a “Sub-Scale Acceptance Test,” or SSAT, which we successfully completed in July 2015. The second technical milestone will be the “Full-Scale Acceptance Test,” or FSAT, that includes a multitude of tests using a full, working Combined System. During the second half of 2015 and continuing into the first quarter of 2016, we constructed the Combined System, which was substantially complete as of September 30, 2016. We commissioned the Combined System in the second quarter of 2016 and began the FSAT procedures. Both the SSAT and FSAT are required prior to the delivery of the first commercial 1.75 MW Combined System units.

 

The CLA also requires the satisfaction of certain binding conditions, all fully satisfied in 2015, in order for Dresser-Rand to be obligated to perform its covenants under the CLA, which covenants include the payment of license fees into escrow, the acceptance of binding purchase orders from its customers for KG2/PO units, the issuance of binding purchase orders to us for Power Oxidizer units and the performance of additional engineering services required for the FSAT. In March 2015, the CLA was amended to revise the second binding condition. The revised binding condition eliminates the need for a bond but requires the $400,000 quarterly cash payments due from Dresser-Rand to be paid into a cash escrow account. Funds may be released from the cash escrow as follows: (i) to Dresser-Rand for up to $500,000 to reimburse Dresser-Rand for certain engineering costs; (ii) to Dresser-Rand in the event of termination of the CLA as a result of a failed acceptance test; or (iii) to us upon the satisfaction of the FSAT. In September 2016, we and Dresser-Rand mutually agreed to waive the FSAT requirement for escrow cash release and, subsequently, Dresser-Rand released to us the $1.6 million license fee payment from escrow, from which we received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. In October 2016, the escrow account was closed. In October 2016, we shipped the first two KG2/PO Power Oxidizer units to the Pacific Ethanol location in Stockton, California for further implementation with the Dresser-Rand KG2 turbines.

 

Dresser-Rand Commercial and Manufacturing Agreement

 

On June 29, 2016, we entered into a Commercial and Manufacturing License Agreement, or the CMLA, with Dresser-Rand, through Ener-Core Power, Inc., intended to supersede and replace the CLA. Upon successful completion of the FSAT, the CLA will terminate and the CMLA will provide the terms of the commercial relationship between us and Dresser-Rand. Once the FSAT is completed, the effective date of the CMLA will be deemed November 14, 2014. In the event we are unable to successfully complete the FSAT, the CLA will continue to govern our commercial relationship with Dresser-Rand. As of December 31, 2016, we had performed the testing protocols of substantially all of the required tests, the results of which remain subject to verification by Dresser-Rand, which is currently underway.

 

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Under the new CMLA, Dresser-Rand will have a worldwide license to manufacture, market, commercialize and sell the Power Oxidizer as part of the Combined System within the 1 MW to 4 MW range of power capacity, or the License. Initially, the License will be exclusive, even as to us, and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System in each calendar year beginning in 2017, or the Sales Threshold, subject to certain conditions and exceptions. If Dresser-Rand does not meet the Sales Threshold in any calendar year and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the License by making a true-up payment to us for each unit that is in deficit of the Sales Threshold, or a True-Up Payment; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive calendar year periods. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver and elects not to make the True-Up Payment, the License will convert to a nonexclusive License.

  

Upon a sale by Dresser-Rand of a Combined System unit to a customer, the CMLA requires Dresser-Rand to make a license fee payment to us equal to a percentage of the sales price of the Combined System purchased, in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $600,000 per Combined System unit sold, or the License Fee. Payment terms to us from Dresser-Rand will be 50% of each License Fee within 30 days of order and 50% upon the earlier of the Combined System commissioning or twelve months after the order date.

 

Dresser-Rand may also request that we undertake design and development work on modifications to the Combined Systems, each referred to as a Bespoke Development. We and Dresser-Rand will negotiate any fees resulting from any such Bespoke Development on a case-by-case basis. Further, any obligation by us to undertake such Bespoke Development will be conditioned upon the execution of mutually agreed-upon documentation.

 

As long as the exclusive License remains in effect, we will provide certain ongoing sales and marketing support services, at no additional cost to Dresser-Rand, subject to certain restrictions. Any additional sales and marketing services agreed upon by us and Dresser-Rand will be compensated at an hourly rate to be upwardly adjusted annually.

 

If we and Dresser-Rand so elect, we will manufacture a certain number of Power Oxidizers as part of a certain number of Combined System projects during a transition period, or the Transition Phase, beginning after execution of the CMLA and prior to the period in which Dresser-Rand manufactures its first three Power Oxidizers as part of at least two individual Combined System projects, or the Initial Manufacturing Phase, as mutually agreed by the parties. So long as the License remains exclusive during the Transition Phase, if any, and the Initial Manufacturing Phase, we will provide a mutually agreed upon number of hours of engineering support services. After the conclusion of the Initial Manufacturing Phase, we will, for so long as the License remains exclusive, continue providing up to an agreed upon number of hours of such support services on an annual basis at no additional cost to Dresser-Rand, subject to certain conditions. Any additional engineering support services agreed upon by us and Dresser-Rand will be compensated at an hourly rate, to be upwardly adjusted annually. During the Transition Phase, we must also develop the spare parts list pertaining to the scope of supply to allow Dresser-Rand to offer service agreements for the Combined System.

 

We must maintain our existing backstop security, or the Backstop Security, under the CLA in favor of Dresser-Rand in support of all products manufactured, supplied or otherwise provided by us during the period beginning on the execution date of the CMLA, or the Execution Date, and continuing through the expiration of the warranty period for the Combined System units sold to customers as of the Execution Date; however, if we and Dresser-Rand mutually agree to engage in a Transition Phase, then such Backstop Security must be extended to support all products manufactured, supplied or otherwise provided by us during such Transition Phase.

 

Dresser-Rand must also: (i) develop the controls strategy for the Dresser-Rand gas turbine control system and integrate it with the Power Oxidizer control system; (ii) with support from us, manufacture and commercialize the Combined System following the Transition Phase; (iii) with support from us, develop and prioritize sales opportunities for the Combined System; (iv) assume the sales lead role with respect to each customer; and (v) take commercial lead in developing sales to customers. In addition, Dresser-Rand will be primarily responsible for overall warranty and other commercial conditions to Combined System customers, as well as sole project and service provider and interface with customers. Dresser-Rand will also be responsible for warranty, service and after-sales technical assistance for all portions of Combined Systems that comprise Dresser-Rand products. We, however, will be responsible for warranty and service for all products manufactured or otherwise provided by us prior to or during the Transition Phase.

 

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The CMLA prohibits us from, without the prior written consent of Dresser-Rand, permitting the creation of any encumbrance, lien or pledge of its intellectual property which would result in any modification to, revocation of, impairment of or other adverse effect on Dresser-Rand’s rights with respect to the exclusive License. In addition, all intellectual property rights that are owned by either us or Dresser-Rand as of the Execution Date will remain the sole property of such party, subject to the licenses described in the CMLA. The CMLA also contains provisions that govern the treatment of process and technology developments and any joint inventions that (i) relate to the subject matter of the CMLA and (ii) occur after the Execution Date and during the term thereof.

 

The CMLA also contains certain restrictions on publicity and obligates Dresser-Rand to use its commercially reasonable efforts to include our name and logo and otherwise promote our brand and Power Oxidizers in a mutually agreed-upon manner. We and Dresser-Rand have also mutually agreed to withhold disclosure of certain commercial and technologically sensitive terms of the CMLA including technical specifications, License Fee percentages, and the Sales Threshold minimum annual quantities to maintain exclusivity.

 

Commercial Sales Efforts

 

Our commercial sales and marketing focus during 2015 was to build from our first commercial success in 2014 and add to our sales team as we begin to roll out our technology. Shortly after signing the CLA with Dresser-Rand in November 2014, our existing sales team began to work with the international sales and marketing teams from Dresser-Rand to develop a go-to-market strategy. In parallel, our existing internal sales team has continued to advance commercial opportunities from 2014 and enter new industrial markets with our EC250 and EC333 products.

 

In 2015, we began to focus our sales resources and efforts toward the improved commercialization of our technology, and we increased our sales efforts through the hiring of two key sales and marketing executives with experience in the oil and gas, waste remediation and pollution control industries. In January 2015, we engaged the services of John Millard as Director of the Europe/Middle East Region. Mr. Millard is based out of Zurich, Switzerland and has been tasked with marketing our Power Oxidizer technology into Europe and the Middle East, both of which are markets that we believe have demonstrated a willingness and a desire to be early adopters of our technology. In March 2015, we hired Mark Owen as Director of Sales in North America. Mr. Owen brings years of industry experience including recent experience selling pollution control systems throughout North America, along with experience rolling out new technology solutions and building sales teams and processes.

 

During 2015, one of our international distributors, Holland Renewable Energy Technologies, added an additional distribution partner to its commercial agreements. This new distributor, Hofstetter B.V, will begin to distribute our Power Oxidizer solutions in 2015 in the European market. Hofstetter is a world leader in flaring technology systems and has installed over 1,600 flaring systems worldwide. We believe this partnership will result in increased market awareness in Europe, a market that we believe is increasingly receptive of our technology solutions. We believe that Hofstetter provides an immediate and established market presence in Europe.

 

We are entering the combined heat and power, or CHP, market that is highly competitive and historically conservative in its acceptance of new technologies. To date, we have sold and delivered one 250 kW commercial PowerStation unit to the Netherlands and have sold one additional 250 kW PowerStation unit to a landfill site in Southern California scheduled for delivery in 2017. We have also sold two initial 2MW Power Oxidizers to Dresser-Rand for installation at their end user customer, Pacific Ethanol, which were delivered in the second half of 2016 but which remain subject to acceptance conditions which may not have been met as of December 31, 2016 and which remain subject to further review or deferral, depending in part on the results of the final FSAT test results. These three systems, combined with the Dresser-Rand license fees of $1.6 million, represent our $4.6 million order backlog as of February 7, 2017. To date, we have billed $4.2 million and collected $4.1 million of our existing backlog.

 

In May 2016, we received a conditional purchase order for four 250 kW Powerstations expected to be installed on a landfill site in Southern California and scheduled for delivery in late 2017. This order is valued at approximately $4.0 million and is subject to additional pre-sales engineering and permitting requirements.

 

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Dresser-Rand Initial Commercial Activity

 

In January 2015, Pacific Ethanol announced the first sale of the new KG2-3GEF/PO unit, which placed a two unit order with Dresser-Rand. Pursuant to the terms of the CLA, we began working on the initial phase of these two systems immediately after the announcement of the order received by Dresser-Rand from Pacific Ethanol. After receipt of formal acceptance of the successful completion of the SSAT, in August 2015, we received a binding purchase order from Dresser-Rand for two 1.75MW Power Oxidizer units for a total purchase price of $2.1 million. We received the entire $2.1 million purchase price in the fourth quarter of 2015 after we satisfied the Dresser-Rand performance security requirement in November 2015. In September 2016, we secured the release of the license fees payable from Dresser-Rand, which had previously been placed in an escrow account and which were contingent upon satisfaction of the FSAT. We received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. We have not recognized the license fees as revenues as of September 30, 2016, since the required testing has not been completed.

 

Other Commercial Efforts

 

In May 2015, we received an award for our second commercial EC250 Powerstation as part of a California Energy Commission award of $1.5 million to the University of California, Irvine’s Advanced Power & Energy Program. We received a formal purchase order of approximately $900,000 in the third quarter of 2015 and through September 30, 2016 we have billed and collected $815,000. We anticipate that delivery and commission of this Powerstation will occur in 2017.

 

Our commercial sales and marketing focus during 2016 was to work with the domestic and international sales and marketing teams from Dresser-Rand to facilitate additional KG2 unit sales in order to drive Power Oxidizer sales. While we expect to close multiple KG2 opportunities in 2017, some of our potential orders for KG2 units require the successful completion of the FSAT, the testing protocols of which we substantially completed in the fourth quarter 2016 but which remain subject to verification by Dresser-Rand. In parallel, our existing internal sales team has continued to advance commercial opportunities and enter new industrial markets with our EC250 product. We have also expanded our understanding of our greater, integrated Powerstation solution and are working towards value-added partnership relationships with key providers of products which can use our ultra-low emissions heat. We also intend to sell the Combined System, a full working KG2 unit described above, upon completion of the FSAT procedures. Several parties have expressed interest and we view the possible sale of the Combined System as a potential cash recovery in 2017.

 

Revenue, Order-to-Cash Cycle and Customer Order Cash Flows

 

Our order-to-cash cycle is lengthy and requires multiple steps to complete. As such, we utilize and evaluate certain metrics such as bookings, backlog, and billed backlog. The initial commercial phase involves our sales team identifying a suitable project and evaluating each site to determine whether our value proposition fits the potential customer’s needs. We evaluate potential industrial sites based on the amount, density and quality of the waste gas produced, the impacts of air quality penalties and required pollution abatement, and the expected cost savings or sales value of on-site power production. We also evaluate with the potential customer whether there are other financial considerations that could further strengthen the economic payback to the potential customer (which could include revenue increases that may result from pollution abatement benefits or carbon/emission credits or tax avoidance). As part of this evaluation, we work with potential customers to produce financial models, which seek to capture and quantify all of the various benefits of the potential project to determine the overall economic payback to the potential customer. If the potential customer determines to proceed after this evaluation, we enter into an agreement with the customer, which typically includes purchase order arrangements.

 

Customer orders, which are defined as firm commitments to purchase with fixed and determinable prices and contracted delivery terms, are considered bookings and are included as backlog. From the date of booking until the projected shipping date, we follow the standard practices that are typically followed by other power equipment producers, which include payment terms that involve customer advance payments designed to mirror our cash inventory outlays for sourcing parts and materials necessary to assemble the power plants to achieve a neutral customer order cash flow until delivery. All customer advance payments are recorded as billings, are reported as billed backlog and are represented on our balance sheet as deferred revenue or customer advances. As the Power Oxidizer plant assets are built, the costs are capitalized as inventory.

 

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Powerstations are shipped to the customer locations and assembled on site. We supervise the assembly and commissioning of the Powerstations, which can take several months to complete. Once commissioning of the fully installed Powerstation(s) is/(are) concluded and title passes to the customer, we issue the final billings and recognize revenues and costs of revenues by decrementing deferred revenues and inventory respectively.

 

We also charge customers for commissioning services, post sale support, and post-warranty service and maintenance on our Power Oxidizer units. We provide a standard warranty, which typically ends between nine months and one year after commissioning.

 

Operating expense reduction

 

Beginning in the first quarter of 2016, we evaluated our cash spending, including the costs incurred with our withdrawn underwritten public offering. Beginning in the second quarter of 2016 and continuing into the third quarter of 2016, we identified and implemented cost reductions, primarily the reduction of employee and consulting headcount and professional services, and we expect to implement additional cost reductions in 2017, including a further reduction of service provider cash spending and a reduction in our fixed overhead costs. Excluding our debt service and excluding non-recurring costs related to the underwritten offering and testing of the FSAT, our quarterly cash spending for the three months ended September 30, 2016 was approximately $1,100,000, a reduction of approximately $400,000 from the first fiscal quarter of 2016.

 

Commercial Activity

 

During the quarter ended September 30, 2015, we closed orders for two KG2 Oxidizer systems and one EC 250 Powerstation system for a total unit backlog of $3.0 million. With our $1.6 million in license fees due from Dresser-Rand under the terms of the CLA, we consider our backlog at December 31, 2015 to be $4.6 million. We expect to collect the license fees and ship the three units in 2016.

 

In November 2015, we delivered to Dresser-Rand a $2.1 million letter of credit with an expiration date of June 30, 2017, which Dresser-Rand accepted as the backstop security required in support of the purchase order for the first two KG2 Power Oxidizer units. Under the terms of the Dresser-Rand purchase order, the backstop security enables us to collect 50% of the order value in cash immediately with additional payments over time as we purchase materials for the Power Oxidizer units. In order to obtain the letter of credit to serve as the required backstop security, we executed a Backstop Security Support Agreement, or the Support Agreement, pursuant to which an investor agreed to provide us with financial and other assistance (including the provision of sufficient and adequate collateral) as necessary to obtain the letter of credit. If the investor is required to make any payments on the letter of credit, we will reimburse the investor the full amount of any such payment, subject to the terms of a Security Agreement and Subordination and Intercreditor Agreement executed concurrently with the Support Agreement. The acceptance of the backstop security by Dresser-Rand allowed us to bill and collect on advance payment billings for the purchase order for the first two KG2 Power Oxidizer units.

 

During the second half of 2015, we began to bill and collect customer deposits on our existing $4.6 million backlog consisting of $2.4 million billed and collected for sales of our Power Oxidizers and Powerstations systems and $0.4 million billed and paid into escrow for our license fee arrangement with Dresser Rand.

 

Going Concern

 

Our consolidated financial statements are prepared using the accrual method of accounting in accordance with accounting principles generally accepted in the United States of America, or GAAP, and have been prepared on a going concern basis, which contemplates the realization of assets and settlement of liabilities in the normal course of business. Since our inception, we have made a substantial investment in research and development to develop the Power Oxidizer, have successfully deployed an EC250 field test unit at the U.S. Army base at Fort Benning, Georgia, and installed and commissioned our first commercial unit in the Netherlands in the second quarter of 2014. In November 2014, we signed the CLA to incorporate our Power Oxidizer into Dresser-Rand’s 1.75MW turbine. In August 2015, the CLA became a mutually binding agreement due to the satisfaction of certain binding conditions contained in the CLA.

 

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We have sustained recurring net losses and negative cash flows since inception and have not yet established an ongoing source of revenues sufficient to cover our operating costs and allow us to continue as a going concern. Despite capital raises of $2.5 million in December 2015, $3.0 million in April 2016, $1.25 in September 2016 and $3.4 million in December 2016, we expect to require additional sources of capital to support our growth initiatives. We must secure additional funding to continue as a going concern and execute our business plan.

 

Our plan is to obtain capital sufficient to meet our operating expenses by seeking additional equity and/or debt financing. The cash and cash equivalents balance (excluding restricted cash) on September 30, 2016, December 31, 2015 and December 31, 2014, was approximately$0.6 million, $2.6 million and $2.2 million, respectively. In April 2016, management began taking steps to reduce our operational cash burn through a combination of staff reductions and reductions of outside service providers. We expect to implement additional cost savings through reduced overhead costs later in 2016 as well as reduced non-recurring costs and capital expenditures related to our efforts to develop the 2MW KG2. We expect that the $0.6 million of cash and cash equivalents as of September 30, 2016, the $3.0 million of equity raised in April 2016, $1.25 million in September 2016, $3.4 million in December 2016 and receipts on customer billings, will continue to fund our working capital needs, general corporate purposes, and related obligations into the fourth quarter of 2016 at our reduced spending levels. However, we expect to require significantly more cash for working capital and as financial security to support our growth initiatives. We will not receive any of the proceeds from the sale by the selling stockholders of the shares of common stock pursuant to the registration statement of which this prospectus is a part.

 

 We will pursue raising additional equity and/or debt financing to fund our operations and product development. If future funds are raised through issuance of stock or debt, these securities could have rights, privileges, or preferences senior to those of our common stock and debt covenants that could impose restrictions on our operations. Any equity or convertible debt financing will likely result in additional dilution to our current stockholders. We cannot make any assurances that any additional financing, including the proposed registered offering, will be completed on a timely basis, on acceptable terms or at all.  Our inability to successfully raise capital in a timely manner will adversely impact our ability to continue as a going concern. If our business fails or we are unable to raise capital on a timely basis, our investors may face a complete loss of their investment.

 

The accompanying consolidated financial statements do not give effect to any adjustments that might be necessary if we were unable to meet our obligations or continue operations as a going concern.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Significant items subject to such estimates and assumptions include but are not limited to: collectability of receivables; the valuation of certain assets, useful lives, and carrying amounts of property and equipment, equity instruments and share-based compensation; provision for contract losses; valuation allowances for deferred income tax assets; valuation of derivative liabilities; and exposure to warranty and other contingent liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

 

While our significant accounting policies are more fully described in the notes to our consolidated financial statements included elsewhere in this prospectus, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our financial condition and results of operations. 

 

Basis of Presentation

 

The accompanying consolidated financial statements include our accounts and our wholly-owned subsidiary, Ener-Core Power, Inc. All significant intercompany transactions and accounts have been eliminated in consolidation. All monetary amounts are rounded to the nearest $000, except certain per share amounts.

 

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The accompanying financial statements have been prepared in accordance with GAAP.

 

Reclassifications

 

Certain amounts in the 2015 consolidated condensed financial statements have been reclassified to conform to the current year presentation. These reclassifications have no effect on previously reported net loss.

 

Segments

 

We operate in one segment. All of our operations are located domestically.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Significant items subject to such estimates and assumptions include but are not limited to: collectability of receivables; the valuation of certain assets, useful lives, and carrying amounts of property and equipment, equity instruments and share-based compensation; provision for contract losses; valuation allowances for deferred income tax assets; valuation of derivative liabilities; and exposure to warranty and other contingent liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. 

 

Foreign Currency Adjustments

 

Our functional currency for all operations worldwide is the U.S. dollar. Nonmonetary assets and liabilities are translated at historical rates and monetary assets and liabilities are translated at exchange rates in effect at the end of the year. Income statement accounts are translated at average rates for the year. At September 30, 2016 and 2015 and December 31, 2015 and 2014, we did not hold any foreign currency asset or liability amounts. Gains and losses resulting from foreign currency transactions are reported as other income in the period they occurred.

 

Concentrations of Credit Risk

 

Cash and Cash Equivalents

 

We maintain our non-interest bearing transactional cash accounts at financial institutions for which the Federal Deposit Insurance Corporation, or FDIC, provides insurance coverage of up to $250,000. For interest bearing cash accounts, from time to time, balances exceed the amount insured by the FDIC. We have not experienced any losses in such accounts and believe we are not exposed to any significant credit risk related to these deposits. At September 30, 2016 and December 31, 2015, we had $200,000 in deficit and $2.5 million in excess of the FDIC limit, respectively.

 

We consider all highly liquid investments available for current use with an initial maturity of three months or less and are not restricted to be cash equivalents. We invest our cash in short-term money market accounts.

 

Restricted Cash

 

Collateral Account

 

Under a credit card processing agreement with a financial institution that was entered in 2013, we are required to maintain funds on deposit with the financial institution as collateral. The amount of the deposit, which is at the discretion of the financial institution, was $50,000 on September 30, 2016 and December 31, 2015 and 2014.

 

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Dresser-Rand Escrow Account

 

Under the CLA, prepaid license fee payments of $400,000 per quarter were paid by Dresser-Rand into an escrow account with a financial institution beginning in August 2015. Dresser-Rand withdrew up to $125,000 per quarter from this escrow account for qualified engineering expenses incurred by Dresser-Rand under the terms and conditions of the CLA. Through September 30, 2016, Dresser-Rand funded $1,600,000 and withdrew $500,000. On September 26, 2016 substantially all of the remaining $1,100,000 was released to us from the escrow account and, in October 2016, the escrow account was closed. The balance in the escrow account was $5,000, $150,000 and $0 on September 30, 2016 and December 31, 2015 and December 31, 2014, respectively. See also Note 8—Deferred Revenues and Customer Advances to our condensed consolidated financial statements included elsewhere in this prospectus.

 

Accounts Receivable

 

Our accounts receivable are typically from credit worthy customers or, for international customers are supported by guarantees or letters of credit. For those customers to whom we extend credit, we perform periodic evaluations of them and maintain allowances for potential credit losses as deemed necessary. We generally do not require collateral to secure accounts receivable. We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in existing accounts receivable. We periodically review our accounts receivable to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt. Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.

 

As of September 30, 2016 and December 31, 2014, one customer accounted for 100% of net accounts receivable. We had no net accounts receivable as of December 31, 2015.

 

Accounts Payable

 

As of September 30, 2016, December 31, 2015 and December 31, 2014, three, five and six vendors, respectively, collectively accounted for approximately 45%, 50% and 54% of our total accounts payable. 

 

Inventory

 

Inventory, which consists of raw materials, is stated at the lower of cost or net realizable value, with cost being determined by the average-cost method, which approximates the first-in, first-out method. At each balance sheet date, we evaluate our ending inventory for excess quantities and obsolescence. This evaluation primarily includes an analysis of forecasted demand in relation to the inventory on hand, among consideration of other factors. Based upon the evaluation, provisions are made to reduce excess or obsolete inventories to their estimated net realizable values. Once established, write-downs are considered permanent adjustments to the cost basis of the respective inventories. At September 30, 2016, December 31, 2015 and 2014, we did not have a reserve for slow-moving or obsolete inventory.

 

Property and Equipment

 

Property and equipment are stated at cost, and are being depreciated using the straight-line method over the estimated useful lives of the related assets, ranging from three to ten years. Maintenance and repairs that do not improve or extend the lives of the respective assets are expensed. At the time property and equipment are retired or otherwise disposed of, the cost and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are reflected in the consolidated statements of operations.

 

Deposits

 

Deposits primarily consist of amounts incurred or paid in advance of the receipt of fixed assets or are deposits for rent and insurance.

 

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Accrued Warranties

 

Accrued warranties represent the estimated costs that will be incurred during the warranty period of our products. We make an estimate of expected costs that will be incurred by us during the warranty period and charge that expense to the consolidated statement of operations at the date of sale. We also reevaluate the estimate at each balance sheet date and if the estimate is changed, the effect is reflected in the consolidated statement of operations. We made our initial commercial sale to Efficient Energy Conversion TurboMachinery, B.V., or EECT, in the second quarter of 2014 with a six month warranty and later extended that warranty at our discretion. We had no warranty accrual at December 31, 2015 or September 30, 2016. We expect that most terms for future warranties of our Powerstations and Power Oxidizers will be depending on the warranties provided and the products sold. Accrued warranties for expected expenditures within one year are classified as current liabilities and as non-current liabilities for expected expenditures for time periods beyond one year.

 

Deferred Rent

 

We record deferred rent expense, included in accrued expenses, which represents the temporary differences between the reporting of rental expense on the financial statements and the actual amounts remitted to the landlord. The deferred rent portion of lease agreements are leasing inducements provided by the landlord. Also, tenant improvement allowances provided are recorded as a deferred rent liability and recognized ratably as a reduction to rent expense over the lease term. As of September 30, 2016, we had $4,000 of deferred rent, recorded in accrued liabilities.

 

Intangible Assets

 

Our intangible assets represent intellectual property acquired during the reverse merger. We amortize our intangible assets with finite lives over their estimated useful lives.

 

Impairment of Long-Lived Assets

 

We account for our long-lived assets in accordance with the accounting standards which require that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the historical carrying value of an asset may no longer be appropriate. We consider the carrying value of assets may not be recoverable based upon our review of the following events or changes in circumstances: the asset’s ability to continue to generate income from operations and positive cash flow in future periods; loss of legal ownership or title to the assets; significant changes in our strategic business objectives and utilization of the asset; or significant negative industry or economic trends. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset are less than its carrying amount. As of September 30, 2016 and December 31, 2015 and 2014, we do not believe there have been any impairments of our long-lived assets. There can be no assurance, however, that market conditions will not change or demand for our products will continue, which could result in impairment of long-lived assets in the future. 

 

Fair Value of Financial Instruments

 

Our financial instruments consist primarily of cash and cash equivalents, restricted cash, accounts receivable, accounts payable, convertible notes, derivative liabilities and capital lease liabilities. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of September 30, 2016 and December 31, 2015 and 2014. The carrying amounts of short-term financial instruments are reasonable estimates of their fair values due to their short-term nature or proximity to market rates for similar items.

 

We determine the fair value of our financial instruments based on a three-level hierarchy established for fair value measurements under which these assets and liabilities must be grouped, based on significant levels of observable or unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect management’s market assumptions. This hierarchy requires the use of observable market data when available. These two types of inputs have created the following fair-value hierarchy:

 

  Level 1: Valuations based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Currently, we classify our cash and cash equivalents as Level 1 financial instruments.

 

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  Level 2: Valuations based on observable inputs (other than Level 1 prices), such as quoted prices for similar assets at the measurement date quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability. We do not currently have any accounts under Level 2.
     
  Level 3: Valuations based on inputs that require inputs that are both significant to the fair value measurement and unobservable and involve management judgment (i.e., supported by little or no market activity). Currently, we classify our warrants and conversion options accounted for as derivative liabilities as Level 3 financial instruments.

 

If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement.

 

Derivative Financial Instruments

 

We issue derivative financial instruments in conjunction with its debt and equity offerings and to provide additional incentive to investors and placement agents. We use derivative financial instruments in order to obtain the lowest cash cost-source of funds. Derivative liabilities are recognized in the consolidated balance sheets at fair value based on the criteria specified in Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, topic 815-40 “Derivatives and Hedging—Contracts in Entity’s own Equity.” The estimated fair value of the derivative liabilities is calculated using either the Black-Scholes-Merton or Monte Carlo simulation model method. 

 

We issued detachable common stock warrants and convertible secured notes payable with conversion features in April 2014 and issued detachable common stock warrants and secured debt with a conversion feature in April and May 2015 and again in September 2016. We amended our existing debt to add a conversion feature in December 2015. We issued additional common stock warrants with price reset provisions in December 2015, February 2016 and March 2016. These embedded derivatives and detachable warrants were evaluated under ASC topic 815-40. We determined that the warrants and embedded conversion feature for the April 2014 issuance, the conversion feature for the 2015 issuances the conversion feature for the 2016 issuance should be accounted for as derivative liabilities. In August, 2016 all warrants issued that were previously determined to be accounted for as derivative liabilities were amended and we determined that after giving rise to the amendments, that the warrants were no longer required to be accounted for as derivative liabilities. We determined that the detachable warrants associated with the 2015 issuance on the issuance date and the detachable warrants associated with the 2016 issuance on the issuance date should not be accounted for as derivative liabilities. Warrants and the debt conversion features determined to be derivative liabilities were bifurcated from the debt host and are classified as liabilities on the consolidated balance sheet. Warrants not determined to be derivative liabilities were recorded to debt discount and paid in capital. We record the warrants and embedded derivative liabilities at fair value and adjust the carrying value of the common stock warrants and embedded derivatives to their estimated fair value at each reporting date with the increases or decreases in the fair value of such warrants and derivatives at each reporting date, recorded as a gain or (loss) in the consolidated statements of operations. The 2015 detachable warrants determined not to be derivative liabilities were recorded to debt discount with a corresponding entry to paid-in capital. The warrants amended in 2016 where the accounting was changed to eliminate derivative liability treatment were marked to market immediately prior to the amendment and the fair value was reclassified on the amendment date from derivative liabilities to paid in capital.

 

Revenue Recognition 

 

We generate revenue from the sale of our clean power energy systems and from consulting services. Revenue is recognized when there is persuasive evidence of an arrangement, product delivery and acceptance have occurred, the sales price is fixed or determinable and collectability of the resulting receivable is reasonably assured. Amounts billed to clients for shipping and handling are classified as sales of product with related costs incurred included in cost of sales.

 

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Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related revenue is recorded. We defer any revenue for which the services have not been performed or are subject to refund until such time that we and our customer jointly determine that the services have been performed or no refund will be required.

 

Revenues under long-term construction contracts are generally recognized using the completed-contract method of accounting. Long-term construction-type contracts for which reasonably dependable estimates cannot be made or for which inherent hazards make estimates difficult are accounted for under the completed-contract method. Revenues under the completed-contract method are recognized upon substantial completion—that is acceptance by the customer, compliance with performance specifications demonstrated in a factory acceptance test or similar event. Accordingly, during the period of contract performance, billings and costs are accumulated on the balance sheet, but no profit or income is recorded before completion or substantial completion of the work. Anticipated losses on contracts are recognized in full in the period in which losses become probable and estimable. Changes in estimate of profit or loss on contracts are included in earnings on a cumulative basis in the period the estimate is changed. As of September 30, 2016, December 31, 2015 and December 31, 2014, we had a $600,000, $600,000 and no provision for contract losses, respectively. 

 

Research and Development Costs

 

Research and development costs are expensed as incurred.  Research and development costs were $2,871,000 and $2,636,000 for the nine months ended September 30, 2016 and 2015, respectively, and were $3,412,000 and $3,156,000 for the years ended December 31, 2015 and 2014, respectively. 

 

Share-Based Compensation

 

We maintain an equity incentive plan and record expenses attributable to the awards granted under the equity incentive plan. We amortize share-based compensation from the date of grant on a weighted average basis over the requisite service (vesting) period for the entire award.

 

We account for equity instruments issued to consultants and vendors in exchange for goods and services at fair value. The measurement date for the fair value of the equity instruments issued is determined at the earlier of (i) the date at which a commitment for performance by the consultant or vendor is reached or (ii) the date at which the consultant’s 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.

 

In accordance with the accounting standards, an asset acquired in exchange for the issuance of fully vested, non-forfeitable equity instruments should not be presented or classified as an offset to equity on the grantor’s balance sheet once the equity instrument is granted for accounting purposes. Accordingly, we record the fair value of the fully vested, non-forfeitable common stock issued for future consulting services as prepaid expense in our consolidated balance sheets.

 

Income Taxes

 

We account for income taxes under the provisions of the accounting standards. Under the accounting standards, deferred tax assets and liabilities are recognized for the expected future tax benefits or consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided for significant deferred tax assets when it is more likely than not that such asset will not be realized through future operations. Our deferred tax assets and liabilities are primarily related to our Net Operating Losses and timing differences between book and tax accounting for depreciation and our net deferred tax assets were fully reserved as of December 31, 2015 and December 31, 2014. 

 

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The accounting guidance for uncertainty in income taxes provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. We recognize any uncertain income tax positions on income tax returns at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. As of December 31, 2015 and 2014 there were no unrecognized tax benefits included in the consolidated balance sheets that would, if recognized, affect the effective tax rate. Our practice is to recognize interest and/or penalties related to income tax matters in income tax expense. We had no accrual for interest or penalties on our consolidated balance sheets at December 31, 2015 and 2014 and have not recognized interest and/or penalties in the consolidated statements of operations for the years ended December 31, 2015 or 2014.

 

We are subject to taxation in the U.S. and various state and foreign jurisdictions.

 

We do not foresee material changes to our gross uncertain income tax position liability within the next twelve months.

 

Earnings (Loss) per Share 

 

Basic loss per share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares assumed to be outstanding during the period of computation. Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential shares had been issued and if the additional common shares were dilutive. Approximately 1.6 million, 0.5 million, 1.1 million and 0.5 million shares of common stock issuable upon full exercise of all options and warrants at September 30, 2016 and 2015 and December 31, 2015 and 2014, respectively, and all shares potentially issuable in the future under the terms of the Secured Notes Payable were excluded from the computation of diluted loss per share due to the anti-dilutive effect on the net loss per share.

 

All share and per share amounts in the table below have been adjusted to reflect the 1-for-50 reverse split of our issued and outstanding common stock on July 8, 2015, retroactively.

 

  

Three Months Ended

September 30,

   Year Ended
December 31,
 
   2016   2015   2015   2014 
Net loss  $(1,596,000)  $(3,310,000)  $(13,107,000)  $(10,534,000)
Weighted average number of common shares outstanding:                    
Basic and diluted   3,785,216    2,464,100    2,405,147    1,707,620 
Net loss attributable to common stockholders per share:                    
Basic and diluted  $(0.42)  $(1.34)  $(5.45)  $(6.17)

 

Comprehensive Income (Loss)

 

We have no items of other comprehensive income (loss) in any period presented. Therefore, net loss as presented in our Consolidated Statements of Operations equals comprehensive loss. 

 

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Results of Operations for the Three and Nine Months Ended September 30, 2016 and 2015

   

  

Three Months Ended

September 30,

  

Nine Months Ended

September 30,

 
   2016   2015   2016   2015 
                 
Revenues  $   $   $   $ 
Cost of goods sold:                
Gross profit                
                     
Operating expenses:                    
Selling, general, and administrative   941,000    1,165,000    3,255,000    3,475,000 
Research and development   1,170,000    928,000    2,871,000    2,636,000 
Total operating expenses   2,111,000    2,093,000    6,126,000    6,111,000 
Operating loss   (2,111,000)   (2,093,000)   (6,126,000)   (6,111,000)
                     
Other income (expenses):                    
Interest expense   (246,000)   (150,000)   (985,000)   (257,000)
Amortization of debt discount   (809,000)   (1,117,000)   (2,209,000)   (1,921,000)
Loss on exchange of warrants               (279,000)
Loss on modification of convertible debt           (1,429,000)    
Gain (loss) on valuation of derivative liabilities   1,570,000    50,000    3,124,000    (33,000)
Total other income (expenses), net   515,000    (1,217,000)   (1,499,000)   (2,490,000)
Loss before provision for income taxes   (1,596,000)   (3,310,000)   (7,625,000)   (8,601,000)
Provision for income taxes           3,000     
Net loss  $(1,596,000)  $(3,310,000)  $(7,628,000)  $(8,601,000)
                     
Loss per share—basic and diluted  $(0.42)  $(1.34)  $(2.12)  $(3.61)
Weighted average common shares—basic and diluted   3,785,216    2,464,100    3,591,233    2,385,500 

 

Revenue, Cost of Goods Sold and Gross Profit/(Loss)

 

We had no revenues for both the three and nine months ended September 30, 2016 or 2015, respectively, and, therefore, we had no cost of goods sold or gross profit or loss.

 

Selling, general and administrative expenses

 

Selling, general and administrative expenses costs include officer compensation, salaries and benefits, stock-based compensation expense, consulting fees, legal expenses, intellectual property costs, accounting and auditing fees, investor relations costs, insurance, public company reporting costs and listing fees, and corporate overhead related costs.  Total selling, general and administrative expenses for the three months ended September 30, 2016 decreased $228,000, or 19.5%, to $941,000 from $1,169,000 for the same period of the prior year. The decrease was primarily due to the cost savings measures we implemented beginning in April 2016, including a decrease in stock compensation of $36,000, a decrease in professional services of approximately $166,000 for lower legal and investor relations expenses, a decrease of $17,000 in overhead, and a decrease of $11,000 for travel expenses.

 

Total selling, general and administrative expenses for the nine months ended September 30, 2016 decreased $221,000, or 6.4%, to $3,254,000 from $3,475,000 for the same period of the prior year. The decrease was primarily due to the net effect of a decrease of headcount costs and stock compensation expenses of approximately $37,000, a reduction of approximately $62,000 in travel expenses, an expense decrease due to overhead allocated to research and development of $44,000, a reduction of professional services of $16,000 and a reduction of approximately $42,000 in non-recurring charges, including bad debt expense and bank charges.

 

Research and development

 

Research and development costs include development expenses for the Power Oxidizer and integration expenses related to our Power Oxidizer products with other partners such as Dresser-Rand and include salaries and benefits, consultant fees, cost of supplies and materials for samples and prototypes, depreciation, as well as outside services costs. Research and development expense for the three months ended September 30, 2016 increased $242,000, or 26.0%, to $1,170,000 from $928,000 for the same period of the prior year. The increase is due to the net effect of lower recurring expenses due to lower headcount, an expense reduction due to an allocation of headcount costs to Power Oxidizers carried in fixed assets and inventory, an increase in non-recurring charges due to the FSAT test unit in 2016 and a decrease in non-recurring charges due to the SSAT testing in 2015. See tabular presentation and greater detail below.

 

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Research and development expense for the nine months ended September 30, 2016 increased $235,000, or 8.9%, to $2,871,000 from $2,636,000 for the same period of the prior year.  he increase is due to the net effect of lower recurring expenses due to lower headcount, an expense reduction due to an allocation of headcount costs to Power Oxidizers carried in fixed assets and inventory, an increase in non-recurring charges due to the FSAT test unit in 2016 and a decrease in non-recurring charges due to the SSAT testing in 2015. See tabular presentation and greater detail below.

 

The following tabular presentation sets forth certain changes to research and development expenses for the three and nine months ended September 30, 2016 and 2015, respectively:

 

  

Three Months Ended

September 30,

  

Nine Months Ended

September 30,

 
   2016   2015   2016   2015 
Research and Development Expenses  (unaudited)   (unaudited)   (unaudited)   (unaudited) 
Recurring gross headcount, overhead, supplies and depreciation   669,000    766,000    2,370,000    2,459,000 
Less amount capitalized to FSAT and Inventory units   (186,000)       (186,000)    
Net recurring research and development expenses   483,000    766,000    2,184,000    2,459,000 
Non-recurring FSAT equipment related expenses   687,000        687,000     
Non-recurring SSAT related expenses       162,000        177,000 
Total Research and Development expenses  $1,170,000   $928,000   $2,871,000   $2,636,000 

 

The decrease in the recurring gross expenses of $97,000 to $669,000 for the three months ended September 30, 2016 and the decrease of $89,000 to $2,370,000 for the nine months ended September 30, 2016 is due to lower employee headcount, lower consulting, and lower stock compensation charges compared to the comparable 2015 reporting periods.

 

The three and nine months ended September 30, 2016 included a reduction of $186,000 related to salaries, benefits, and consulting costs associated with the buildout and completion of the FSAT unit and partial construction of the two Power Oxidizers delivered in October 2016 to Pacific Ethanol. We capitalized $45,000 to fixed assets for the FSAT unit and $141,000 into inventory for the Power Oxidizer units delivered to Pacific Ethanol in October 2016.

 

The three and nine months ended September 30, 2016 included $687,000 of non-recurring expenses and charges related to the FSAT conducted in the 2016 quarter, including $350,000 of assets capitalized in 2015 as fixed assets but not placed into service until the end of the second quarter of 2016. We determined that the underlying assets recorded in 2015 and certain similar assets recorded in 2016 were not likely to be recovered and therefore considered to be impaired. The three and nine months ended September 30, 2015 included non-recurring costs related to the SSAT, which was completed in 2015.

 

Other Income (Expenses):

 

Other income (expenses) for the three and nine months ended September 30, 2016 consisted primarily of cash and non-cash interest on the 2015 Notes, placed in April and May 2015 and the Convertible Unsecured Notes, placed in September 2016, the non-recurring charge for the modification of the 2015 Notes, cash and non-cash charges on the backstop security arrangement, and the mark to market adjustment for our derivative liabilities related to the 2015 and Convertible Unsecured Notes and the warrants issued in conjunction with our December 2015 private equity placement. Other income (expenses) for the three and nine months ended September 30, 2015 consisted of the mark to market adjustment for the December 2014 warrants, which were exchanged for common stock in April 2015, and cash and non-cash interest on the 2015 Notes, placed in late April and early May 2015. 

 

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Net Loss

 

For the three months ended September 30, 2016, our net loss was approximately $1.6 million, primarily from operating expenses of $2.1 million and $0.5 million of other income. Operating expenses include recurring cash basis expenses of $1.1 million, reduced by $0.2 million of recurring cash basis expenses capitalized to fixed assets and inventory, non-recurring expenses relating to the FSAT testing and equipment of $0.7 million, and non-cash expenses of $0.5 million, consisting of stock-based compensation expenses of $0.3 million and depreciation of $0.2 million. The $0.5 million of other income (net) consists of $0.3 million of cash interest expense and $0.8 million of non-cash interest expense, which is offset by a $1.6 million mark to market gain on derivative liabilities.

 

For the nine months ended September 30, 2016, our net loss was approximately $7.6 million, primarily from operating expenses of $6.1 million and other expenses (net) of $1.5 million. The operating expenses included $4.1 million of cash based expenses, a reduction of $0.2 million of recurring cash basis expenses capitalized to assets, non-recurring expenses relating to the FSAT testing and equipment charges of $0.7 million and $1.5 million of non-cash expenses including stock-based compensation of $1.0 million and depreciation of $0.5 million. Other expenses (net) consists of $1.0 million of interest on the 2015 Notes, Convertible Unsecured Notes and $2.1 million backstop security, $2.2 million of amortization of the discount on the 2015 Notes and Convertible Unsecured Notes, which is offset by a $3.1 million mark to market gain on derivative liabilities. 

 

Earnings per share

 

Earnings per share, basic and diluted were ($0.42) and ($1.34) for the three months ended September 30, 2016 and 2015, respectively, and were ($2.12) and ($1.34) for the nine months ended September 30, 2016 and 2015, respectively.

 

Liquidity

  

Cash Flows used in Operating Activities

  

Our cash used in operating activities was approximately $5.4 million and $4.5 million for the nine months ended September 30, 2016 and 2015, respectively. Cash used in operating activities for the nine months ended September 30, 2016 resulted from a net loss of approximately $7.6 million, reduced by net non-cash charges of $2.5 million for stock-based compensation, gains on revaluation of derivative securities, non-cash interest expense due to amortization of debt discount and deferred financing charges, expense related to modification of debt, fixed asset impairment, and depreciation, offset by a change of $0.3 million of working capital, primarily due to a $1.9 million increase in inventory, accounts receivable and prepaid expenses offset by a $1.5 million increase in accounts payable and deferred revenue and a $0.1 million decrease in restricted cash. Cash used in operating activities for the nine months ended September 30, 2015 of $4.5 million resulted from a net loss of approximately $8.6 million reduced by $3.6 million of non-cash charges for stock based compensation, depreciation, and losses on revaluation of derivative securities and $0.5 million in additional working capital, primarily increases in accounts payable of $0.8 million and an increase of $0.3 million of restricted cash. 

 

Cash Flows from Investing Activities

 

Cash used in investing activities of $0.7 million for the nine months ended September 30, 2016 was attributable to the purchase of parts and equipment to build the FSAT unit for the KG2 product development. Cash used in investing activities of $1.8 million for the nine months ended September 30, 2015 was attributable to the purchase of property and equipment consisting primarily of the multi-fuel test facility, which was used to satisfy the initial SSAT for the CLA and early payments made to construct the full KG2 prototype to be used in the KG2 integration for the FSAT. 

 

Cash Flows from Financing Activities

 

Cash provided by financing activities for the nine months ended September 30, 2016 of $4.1 million consisted of a an equity investment of $2.9 million, net of $0.1 million in fees and the placement of $1.2 million, net of expenses of Convertible Unsecured Notes. Cash provided by financing activities for the nine months ended September 30, 2015 consisted of $4.7 million of proceeds from the $5.0 million 2015 Notes placement, net of $0.3 million in fees, and $0.7 million received from a private equity placement of $0.8 million net of $0.1 million of fees. 

 

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Capital Resources

 

Our principal capital requirements are to fund our working capital requirements, invest in research and development and capital equipment and fund the continued costs of public company compliance requirements.  We have historically funded our operations through debt and equity financings.  

 

From our inception, we have incurred losses from operations. For the nine months ended September 30, 2016, we have incurred losses from operations and have an accumulated deficit of approximately $38.7 million and a net loss of approximately $7.6 million. For the nine months ended September 30, 2016, we used cash in operations of approximately $5.4 million, which raises substantial doubt about our ability to continue as a going concern.

 

We expect to continue to incur substantial additional operating losses from costs related to the continuation of product and technology development and administrative activities.  Our cash on hand at September 30, 2016 was approximately $0.7 million (including restricted cash of $50,000). 

 

Our sales cycle can exceed 24 months and, except as noted below, we do not expect to generate sufficient revenue in the next twelve months to cover our operating costs. We anticipate that we will pursue raising additional debt or equity financing to fund new product development and execute on the commercialization of our product plans.  

 

Until we achieve our product commercialization plans and are able to generate sales to realize the benefits of the strategy and sufficiently increase cash flow from operations, we will require additional capital to meet our working capital requirements, research and development, capital requirements and compliance requirements and will continue to pursue raising additional equity and/or debt financing.

 

Our principal sources of liquidity are cash and receivables.  As of September 30, 2016, cash and cash equivalents (including restricted cash) were $0.7 million, or 9.1% of total assets, compared to $2.8 million, or 37.1% of total assets, at December 31, 2015.  The decrease in cash and cash equivalents was primarily attributable to cash used in operating activities of $5.4 million and $0.7 million of spending on fixed assets, primarily on the KG2 unit to be used for the FSAT testing. 

  

We have not yet achieved profitable operations and have yet to establish an ongoing source of revenue to cover operating costs and meet our ongoing obligations. During the three months ended September 30, 2016, we continued to reduce our cash operating expenses. Excluding one-time charges related to the FSAT unit testing, our September 2016 operational cash requirement decreased to approximately $1.1 million, down from approximately $1.5 million per quarter in the first quarter of 2016. In June 2016, we signed the CMLA with Dresser-Rand. The transition to the CMLA will decrease our cash needs for the next 12 months as compared to our projections for prior quarters due to lower working capital requirements. Since Dresser-Rand will begin manufacturing our Power Oxidizers and pay us a license fee of at least $370,000 per unit, our cash requirements is expected to decrease in future quarters. Our cash spending requirements, excluding debt repayment for the $6.25 million of debt due in 2017, are expected to be $7.0 million, consisting of: 

 

  Employee, occupancy and related costs: $3.2 million
     
  Professional fees and business development costs: $0.8 million
     
  Research and development programs: $0.5 million
     
  Corporate filings: $0.5 million
     
  Working capital: $1.0 million
     
  Debt service: $1.0 million

 

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We expect to reduce our cash spending requirement over the next year by further reducing our operating expenses, reducing our working capital requirement to zero, and eliminating most of our debt service cash spending.

 

Dresser-Rand license fee payments: Under the CMLA, beginning in the third quarter of 2016, Dresser-Rand is obligated to pay us a minimum of $370,000 per KG2 unit sold, of which 50% is due 30 days after order placement by the end customer to Dresser-Rand and 50% is payable within one year of order placement.

 

Sale or lease of FSAT KG2 unit: We constructed a functional KG2 production unit as part of the FSAT testing and intend to sell or lease this unit within the next nine months.

 

Results of Operations for the Fiscal Years Ended December 31, 2015 and 2014

 

  

Year Ended

December 31,

  

Year Ended

December 31,

 
   2015   2014 
         
Revenues  $   $868,000 
Cost of goods sold   600,000    1,170,000 
Gross profit (loss)   (600,000)   (302,000)
           
Operating expenses:          
Selling, general, and administrative   5,197,000    5,449,000 
Research and development   3,412,000    3,156,000 
Total operating expenses   8,609,000    8,605,000 
Operating loss   (9,209,000)   (8,907,000)
           
Other income (expenses):          
Interest income   2,000    1,000 
Loss on debt conversion       (2,414,000)
Loss on exchange of warrants   (279,000)    
Loss on debt extinguishment   (707,000)    
Gain (loss) on revaluation of derivative liabilities, net   (198,000)   1,574,000 
Interest expense   (2,716,000)   (787,000)
Total other income (expenses), net   (3,898,000)   (1,626,000)
Loss before provision for income taxes   (13,107,000)   (10,533,000)
Provision for income taxes       1,000 
Net loss  $(13,107,000)  $(10,534,000)
           
Loss per share—basic and diluted  $(5.45)  $(6.17)
Weighted average common shares—basic and diluted   2,405,147    1,707,620 

 

Revenue

 

Our revenue primarily consists of Power Oxidizer sales as well as engineering services. For the year ended December 31, 2014, we had revenue of $868,000. For the year ended December 31, 2015, we had no product sales, as compared to $868,000 for the prior year where we had $58,000 of waste gas testing consulting services and sold one unit to Attero in the Netherlands.

 

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Cost of Goods Sold

 

For the year ended December 31, 2014, cost of goods sold was $1,170,000. For the year ended December 31, 2015, we had $600,000 of cost of goods sold. Cost of goods sold for 2015 represents the estimated contract loss on the first two KG2 oxidizers sold to Dresser-Rand (a Siemens Company) for delivery expected in 2016. Cost of goods sold for the 2014 periods primarily consisted of the costs to build our Power Oxidizer unit shipped to Attero, including materials, labor, overhead costs and warranty costs, and materials costs related to the consulting services.

 

Gross profit (Loss)

 

Gross profit (Loss) increased from ($302,000) in 2014 to ($600,000) in 2015 representing the increase from $0.3 million in warranty driven losses in 2014 for the first commercial unit sold to Attero for a 250 kW Powerstation to a $0.6 million contract loss provision for the first two KG2 Oxidizers sold to Dresser-Rand (a Siemens company) for units expected to be shipped in 2016. 

 

Operating expenses:

 

Total operating expenses for the years ended December 31, 2015 and 2014 were $8.6 million and $8.6 million respectively. Our operating expenses consist of non-cash expenses including stock compensation charges and depreciation and cash-basis expenses, consisting of employee salaries and benefits paid in cash, rents and overhead, research and development materials, consulting expenses, professional services, and insurance.

 

From 2014 to 2015, despite the total expenses being consistent, the underlying activity is due to the net effect of a decrease of non-cash expenses of $1.7 million and cash basis expense increases of $1.7 million.

 

From 2014 to 2015, total expenses paid in cash increased by $1.7 million resulting from:

 

  $0.8 million increase in employee salaries and benefits due to increased staff in 2015 to support the engineering integration of for the KG2 Power Oxidizer and the increase sales and marketing headcount.
     
  $0.6 million increase in non-recurring professional fees primarily related to our S-1 filings and uplisting efforts.
     
  $0.2 million increase in research and development materials.
     
  $0.1 million increase in bad debt expense, fees, travel, and other miscellaneous expenses.

 

The non-cash expense reduction from $3.6 million in 2014 to $1.9 million in 2015 is due to a reduction in stock based compensation of $1.9 million, offset by a $0.2 million increase in depreciation, primarily associated with additional depreciation on our SSAT rig which was capitalized in July 2015.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses include officer compensation, salaries and benefits, stock-based compensation expense, consulting fees, legal expenses, intellectual property costs, accounting and auditing fees, investor relations costs, insurance, public company reporting costs and listing fees, and corporate overhead related costs. Total selling, general and administrative expenses for the year ended December 31, 2015 decreased $252,000 to $5,197,000 from $5,449,000 for the same period of the prior year.

 

The decrease for the year ended December 31, 2015 compared to 2014 is primarily due to the net effect of a decrease in stock-based compensation expense of $1.1 million and offset by a net increase in cash expenses of $0.9 million consisting of approximately $0.3 million of increased employee headcount related costs for additional sales and marketing staff and $0.6 million for increased legal and accounting fees in 2015 associated with costs for the public offering filings and corporate legal work.

 

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Research and Development Expenses

 

Research and development costs include development expenses for the Power Oxidizer and integration expenses related to our Power Oxidizer products with partners such as Dresser-Rand and include salaries and benefits, consultant fees, cost of supplies and materials for samples and prototypes, depreciation, as well as outside services costs. Research and development expenses for the fiscal year ended December 31, 2015 increased $256,000 to $3,412,000 from $3,156,000 for 2014. 

 

The increase was due to the net effect of a $0.8 million decrease in non-cash stock-based compensation expense offset by increases of $0.2 million for depreciation associated with the SSAT rig placed into service in mid-2015, an increase of $0.6 million for employee related costs due to higher headcount to support the Dresser-Rand integration, and an increase of $0.3 million for R&D materials, supplies, and natural gas consumed during the SSAT conducted in mid-2015. 

 

Other Income (Expenses)

 

Other income and expenses for the year ended December 31, 2015 of ($3,898,000) consisted primarily of combined interest expense and amortization of debt discount of ($2,716,000), loss on debt extinguishment of ($707,000), and a loss of ($198,000), all associated with our 2015 Notes entered into in April and May 2015 with a further loss of ($279,000) related to the April 2015 exchange of warrants issued in 2014 for shares of our common stock. 

 

Other income and expenses for the year ended December 31, 2014 of ($1,626,000) consisted primarily of combined interest expense and amortization of debt discount of ($787,000) and loss on debt conversion of ($2,414,000), offset by a gain on the fair value adjustment of our derivative liabilities of $1,574,000, all of which were associated with convertible secured notes issued in April 2014 and settled in August 2014. 

 

Net Loss

 

For the year ended December 31, 2015, our net loss was approximately $13.1 million, primarily from $600,000 in negative gross profit, operating expenses of $8.6 million, of which $1.5 million was for employee stock compensation, and other expense of $3.9 million related to the 2015 Notes issued in April and May 2015, as amended.

 

The increase from the net loss of $10.5 million for the year ended December 31, 2014 to $13.1 million for the year ended December 31, 2015 was due to an increase in other expenses of $2.2 million and the increase in operating loss of $0.3 million, as described above.

 

Liquidity

 

Cash Flows used in Operating Activities

 

Our cash used in operating activities were approximately $4.3 million and $4.5 million for the years ended December 31, 2015 and 2014, respectively. Cash used in operating activities for the year ended December 31, 2015 resulted from a net loss of approximately $13.1 million, reduced by non-cash charges of $6.0 million and $2.8 million of working capital. The non-cash charges consisted of $2.2 million in non-cash amortization of debt discounts and deferred financing fees, $1.5 million for stock-based compensation, a $0.7 million loss due to the modification of the 2015 Notes recorded as a debt extinguishment loss, a $0.6 million provision for estimated contract losses on our first two commercial KG2 units, $0.2 million for losses on revaluation of derivative securities, and $0.4 million for depreciation. The $2.8 million change in working capital was primarily due to $2.8 million increase in customer advances an increase of $0.9 million of accounts payable, offset by an increase of $0.7 million for purchased inventory.

 

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Cash used in operating activities for the year ended December 31, 2014 resulted primarily from a net losses of $10.5 million, reduced by non-cash charges of $5.9 million including $3.5 million of stock-based compensation expense, $2.5 million due to the accelerated amortization of debt discount on the conversion in August 2014 of the convertible secured notes issued in April 2014, $0.7 million of debt amortization, $0.4 million in fair value warrants issued for services and settlements, $0.2 million in warranty expenses, $0.2 million in depreciation and $0.1 million in working capital, offset by a $1.7 million gain on the reduction in fair value of our derivative liabilities.

 

Cash Flows from Investing Activities

 

Cash used in investing activities of $3.1 million for the year ended December 31, 2015 was attributable to the purchase of property and equipment consisting primarily of the MFTF, which was used to satisfy the SSAT for the CLA and payments made to construct the full KG2 prototype to be used in the KG2 integration for the FSAT. Cash used in investing activities for the year ended December 31, 2014 was attributable to purchases of research equipment and office equipment of $188,000.

 

Cash Flows from Financing Activities

 

Cash provided by financing activities of $7.8 million for the year ended December 31, 2015 was attributable to $3.3 million in equity placements and the $5.0 million of 2015 Notes sold in April and May 2015, net of offering costs and fees. Cash provided by financing activities was $5.7 million for the year ended December 31, 2014 consisting of a $3.8 million equity raise in September 2014, net and the net effect of $3.8 million in proceeds from the convertible secured notes issued in April 2014 and settled in August 2014 offset by a $1.9 million repayment. 

 

Capital Resources

 

Our principal capital requirements are to fund our working capital requirements, invest in research and development and capital equipment and fund the continued costs of public company compliance requirements. We have historically funded our operations through debt and equity financings. 

 

From our inception, we have incurred losses from operations. For the year ended December 31, 2015, we had a net loss of approximately $13.1 million and an accumulated deficit of approximately $31.1 million. For the year ended December 31, 2015, we used cash in operations of approximately $4.3 million, which raises substantial doubt about our ability to continue as a going concern.

 

We expect to continue to incur substantial additional operating losses from costs related to the continuation of product and technology development and administrative activities. Our cash on hand at December 31, 2015 was approximately $2.8 million (including restricted cash of $0.2 million). On April 23, 2015, we sold the April 2015 Notes with an aggregate principal amount of $3.1 million and the April 2015 Warrants for the purchase of up to 136,264 shares of our common stock. On May 1, 2015, we sold 108,000 shares of our common stock at a purchase price of $7.50 per share and received gross proceeds of approximately $810,000 from the sale of such shares. On May 7, 2015, we sold the May 2015 Notes with an aggregate principal amount of $1.9 million and the May 2015 Warrants for the purchase of up to 83,517 shares of our common stock. On December 31, 2015, we sold 625,000 shares of our common stock and warrants for the purchase of up to 312,500 shares of our common stock and received gross proceeds of $2.5 million from the sale of such securities. We paid $550,000 in costs and fees associated with these equity and debt financings.

 

Our sales cycle can exceed 24 months and we do not expect to generate sufficient revenue in the next twelve months to cover our operating costs. We anticipate that we will pursue raising additional debt or equity financing to fund new product development and execute on the commercialization of our product plans. We cannot make any assurances that our strategies will be effective or that any additional financing will be completed on a timely basis, on acceptable terms or at all. Our inability to successfully implement our strategies or to complete any other financing will adversely impact our ability to continue as a going concern.

 

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Until we achieve our product commercialization plans and are able to generate sales to realize the benefits of the strategy and sufficiently increase cash flow from operations, we will require additional capital to meet our working capital requirements, research and development, capital requirements and compliance requirements and will continue to pursue raising additional equity and/or debt financing.

 

Our principal source of liquidity is cash. As of December 31, 2015, cash and cash equivalents (including restricted cash) were $2.8 million or 37.2% of total assets compared to $2.2 million, or 67.6% at December 31, 2014. The increase in cash and cash equivalents was due to the receipt of $7.8 million of cash from debt and equity financings, offset by cash used in operating activities of $4.5 million and $3.1 million of spending on fixed assets, primarily on the MFTF and the prototype to be used for the FSAT.

 

We have not yet achieved profitable operations and have yet to establish an ongoing source of revenue to cover operating costs and meet our ongoing obligations. Our cash needs for the next 12 months are projected to be in excess of $10 million, which we estimate to include the following:

 

  Employee, occupancy and related costs: $4.3 million
     
  Professional fees and business development costs: $1.2 million

 

  Research and development programs: $1.5 million
     
  Corporate filings: $0.5 million

 

  Working capital: $2.5 million

  

During the quarter ended December 31, 2015, we began to bill and collect customer deposits on our existing $4.6 million backlog consisting of $2.4 million billed for sales of our Power Oxidizers and Powerstations and $0.4 million billed for our license fee arrangement with Dresser-Rand. Of the $2.8 million billed, we collected $2.4 million in cash, $0.4 million was placed into a restricted escrow account as described below.

 

Dresser Rand Restricted Cash Escrow Account. As of December 31, 2015, we had $150,000 in restricted cash held in an escrow account under the terms and conditions of the CLA. The escrowed funds represent 25% of the total $1,600,000 license fees due under the CLA, reduced by $250,000 of reimbursable engineering costs payable to Dresser-Rand. We expect to receive additional cash payments of $400,000 per quarter which will be placed into escrow until a gross total of $1,600,000 is placed into the escrow account. Dresser-Rand is allowed to draw up to $125,000 per quarter from the escrow account up to a maximum draw of $500,000. The remaining $1,100,000 will be released to us upon the satisfaction of the FSATs identified in the CLA. We expect the FSAT requirements to be completed in the second quarter of 2016.

 

Off-Balance Sheet Arrangements

 

In November 2015, we delivered to Dresser-Rand a $2.1 million letter of credit with an expiration date of June 30, 2017, which Dresser-Rand accepted as the backstop security required in support of the purchase order for the first two KG2 Power Oxidizer units. Under the terms of the Dresser-Rand purchase order, the backstop security enables us to collect 50% of the order value in cash immediately with additional payments over time as we purchase materials for the Power Oxidizer units. In order to obtain the letter of credit to serve as the required backstop security, we executed a Backstop Security Support Agreement, or the Support Agreement, pursuant to which an investor agreed to provide us with financial and other assistance (including the provision of sufficient and adequate collateral) as necessary to obtain the letter of credit. If the investor is required to make any payments on the letter of credit, we will reimburse the investor the full amount of any such payment, subject to the terms of a Security Agreement and Subordination and Intercreditor Agreement executed concurrently with the Support Agreement.

 

We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as stockholders’ equity that are not reflected in our financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

 

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Inflation

 

We believe that inflation has not had a material effect on our operations to date.

 

Recently Issued Accounting Pronouncements

  

In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). ASU 2014-09 provides a framework for addressing revenue recognition issues and, upon its effective date, replaces almost all existing revenue recognition guidance, including industry-specific guidance, in current U.S. generally accepted accounting principles. ASU 2014-09 is effective beginning with the calendar year ended December 31, 2017. We have not yet assessed the impact ASU 2014-09 will have upon adoption on its financial position, results of operations or cash flows. 

 

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. ASU 2014-15 requires that an entity’s management evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. Certain disclosures are necessary in the footnotes to the financial statements in the event that conditions or events raise substantial doubt about an entity’s ability to continue as a going concern. ASU 2014-15 is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter and early application is permitted. We have not yet assessed the impact ASU 2014-15 will have upon adoption. 

 

In November 2014, the FASB issued ASU 2014-16—Derivatives and Hedging: Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity. ASU 2014-16 clarifies how current GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. ASU 2014-16 is effected for the interim and annual periods beginning after December 15, 2015. We have not yet assessed the impact ASU 2014-16 will have upon adoption.

 

In April 2015, the FASB issued ASU 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 simplifies the presentation of debt issuance costs by requiring that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. ASU 2015-03 is effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2015 and interim periods within those fiscal years and early application is permitted. We elected to adopt ASU 2015-03 beginning with the interim period ended June 30, 2015. There was no impact to any prior periods presented as a result of adopting ASU 2015-03.

 

In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. ASU 2015-11 requires that entities measure inventory at the lower of cost and net realizable value. ASU 2015-11 is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years and early application is permitted. We have not yet assessed the impact ASU 2015-11 will have upon adoption.

 

In November 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. ASU 2015-17 requires that entities’ deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for fiscal years beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. We have not yet assessed the impact ASU 2015-17 will have upon adoption.

 

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In February 2016 the FASB issued ASU 2016-2, Leases (Topic 842). ASU 2016-2 affects any entity entering into a lease and changes the accounting for operating leases to require companies to record an operating lease liability and a corresponding right-of-use lease asset, with limited exceptions. ASU 2016-2 is effective for fiscal years beginning after December 15, 2019 and interim periods with annual periods beginning after December 15, 2010. Early adoption is allowed. We have not yet assessed the impact ASU 2016-2 will have upon adoption.

  

JOBS Act

 

Section 107 of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of new or revised accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies.

 

For as long as we remain an “emerging growth company” under the recently enacted JOBS Act, we will, among other things:

 

  be exempt from the provisions of Section 404(b) of the Sarbanes-Oxley Act, which requires that our independent registered public accounting firm provide an attestation report on the effectiveness of our internal control over financial reporting;
     
  be permitted to omit the detailed compensation discussion and analysis from proxy statements and reports filed under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and instead provide a reduced level of disclosure concerning executive compensation; and
     
  be exempt from any rules that may be adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report on the financial statements.

  

Although we are still evaluating the JOBS Act, we currently intend to take advantage of some or all of the reduced regulatory and reporting requirements that will be available to us so long as we qualify as an “emerging growth company,” except that we have irrevocably elected not to take advantage of the extension of time to comply with new or revised financial accounting standards available under Section 102(b) of the JOBS Act. Among other things, this means that our independent registered public accounting firm will not be required to provide an attestation report on the effectiveness of our internal control over financial reporting so long as we qualify as an emerging growth company, which may increase the risk that weaknesses or deficiencies in our internal control over financial reporting go undetected. Likewise, so long as we qualify as an emerging growth company, we may elect not to provide you with certain information, including certain financial information and certain information regarding compensation of our executive officers, that we would otherwise have been required to provide in filings we make with the SEC, which may make it more difficult for investors and securities analysts to evaluate us. As a result, investor confidence in us and the market price of our common stock may be materially and adversely affected.

 

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BUSINESS

 

Overview

 

Our proprietary and patented Power Oxidation technology is designed to create greater industrial efficiencies by converting low-quality waste gases generated from industrial processes into usable on-site energy, therefore decreasing both operating costs and significantly reducing environmentally harmful gaseous emissions. We design, develop, license, manufacture and market our Power Oxidizers, which, when bundled with an electricity generating turbine in the 250 kilowatt, or kW, and 2 megawatt, or MW, sizes, are called Powerstations. We currently partner and are pursuing partnerships with large established manufacturers to integrate our Power Oxidizer with their gas turbines, with the goal to open substantial new opportunities for our partners to market these modified gas turbines to industries for which traditional power generation technologies were not technically feasible previously. We currently manufacture our Powerstations in the 250 kW size and manufacture just the Power Oxidizer for the 2MW size. Beginning in 2017, contingent upon the successful completion of certain field testing, our 2MW partner, Dresser-Rand a.s., a subsidiary of Dresser-Rand Group Inc., a Siemens company, or Dresser-Rand, will manufacture the 2MW Power Oxidizers under a manufacturing license and will pay us a non-refundable license fee for each unit manufactured.

 

Historically, basic industries such as Petroleum, Plastics, Steel and Paper have consumed electricity in their manufacturing processes and created heat for their manufacturing processes through the burning of fossil fuels in a combustion chamber. Nearly all such combustion chambers use high quality premium fuels and burn those fuels at high temperatures, while low-quality waste gases were typically destroyed or vented into the atmosphere. Worldwide, these industrial processes collectively contribute approximately 32% of total global greenhouse gas emissions. Our technology utilizes these waste gases by modifying turbines with our gradual oxidation vessel. Inside this vessel, pressure and temperature are applied over time to destroy contaminants and return a substantially low emission source of energy in the form of heat. This heat then powers a turbine, spinning a generator and creating electricity. This technology can potentially unlock a new, global source of clean power generation (electricity, steam and/or heat energy) while reducing harmful emissions. Our goal is to enable industrial process facilities to generate clean energy from their existing waste gases, thereby reducing the amount of energy they purchase from their regional utilities, and simultaneously reducing the cost of compliance with local, state, and federal air quality regulations by avoiding the chemicals, catalysts and complex permitting required by existing pollution abatement systems.

 

We have experienced losses since inception and anticipate that we will continue to incur losses and negative cash flows for the foreseeable future as we continue to further develop and deploy our power products.

 

Our Opportunity

 

The creation and release of waste gases, which lead to air pollution, is a byproduct of many modern industries. Industrial waste gases take many forms and are often subject to governmental or regulatory oversight via air quality or air standards boards. The rules and guidelines implemented by these boards lead to compliance costs for companies with industrial facilities that emit the waste gases. With the worldwide concerns over the atmospheric emissions of greenhouse gases, air quality standards have become increasingly stringent. For areas with industrial air pollution abatement regulations, industrial polluters currently have the following choices:

 

  (i) continue to pollute and thereby pay substantial fines imposed by regulatory authorities,
     
  (ii) reduce their air pollution through existing abatement solutions such as scrubbing or flaring, or
     
  (iii) institute some combination of these solutions.

 

Each industrial location must choose the most economic mix of the available solutions, but each of these solutions represents both a financial operating cost as well as an environmental cost.

 

Our technology provides an alternative to the typical economic and environmental costs of hydrocarbon pollution abatement by providing the ability for industrial facilities to productively utilize their waste gases to generate power, which can be sold or used internally, while at the same time reducing both the atmospheric pollution resulting from those waste gases and any resulting pollution abatement costs.

 

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Our Technology

 

Our technology involves the acceleration of a naturally occurring, gas oxidation process by injecting hydrocarbon gases into a controlled, high temperature, high pressure, and oxygen rich environment. Oxidation is a natural and commonly observed chemical reaction that occurs when a substance comes into contact with oxygen over a prolonged period of time, approximately 10 to 20 years for the waste gases that we have targeted. The reaction is exothermic, which generates heat. By accelerating the reaction to 0.5–1.25 seconds within the controlled, steady state environment of our Power Oxidizers, the heat generated from the reaction is compounded and we are able to capture and utilize the heat output within the heat profile ranges necessary to operate standard gas turbines or steam boilers without actually igniting the gas.

 

In nature, methane and other greenhouse gases react with oxygen in the air and are eventually decomposed through an oxidation reaction over a period of 10 to 20 years. The speed of the reaction is dependent on three primary variables: the temperature, the pressure of the gases, and the abundance of oxygen. The oxidation reaction is exothermic (i.e., generates heat as a natural output of the chemical reaction), but since the reaction occurs slowly in natural, ambient conditions, the heat generated by the reaction is quickly dissipated and normally unnoticeable. Our Power Oxidizer accelerates the natural process by introducing a hydrocarbon-rich waste gas stream into a vessel with a high concentration of air, under pressure, and at high temperature. The combination of these factors results in an oxidation reaction occurring in 0.5–1.25 seconds. By accelerating the reaction within the controlled, steady state environment of our Power Oxidizers, the heat generated from the reaction is compounded and we are able to capture and utilize the heat output within the heat profile ranges necessary to operate standard gas turbines or steam boilers without actually igniting the gas.

 

Traditionally, industrial heat is provided by the combustion of a hydrocarbon which generates pollution such as nitrogen oxide (NO2), or NOX, as a byproduct. By comparison, our Power Oxidizers provide similar industrial grade heat at temperatures below when NOX is generated in a combustion reaction. The combination of our ability to utilize a low quality or “waste” fuel with the elimination of NOX generation (as compared to combustion heat sources) provides our Power Oxidizers with a superior alternative to traditional heat generation sources.

 

Our Power Oxidizers are designed to operate on gases with extremely low energy densities as compared to alternative chemical reactions, such as combustion. While the Power Oxidizers operate on waste gases, they may also be operated on commercially available natural gas or other high quality hydrocarbon gas products, or a combination of both waste gases and commercially available natural gas or other high quality hydrocarbon gas products. It should be noted, however, that the Power Oxidation technology is not useful for combustion exhaust gases emitted as the result of combustion reactions such as Carbon Dioxide or Carbon Monoxide. See Figure 1 below for the operating range of the Power Oxidizers.

 

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Figure 1

 

 

Our Products

 

We have developed a 250 kW Power Oxidizer that we integrate with a 250 kW gas turbine to produce 250 kW Powerstations. We have two Powerstations currently in operation at a landfill site in the Netherlands and at the Irvine campus of the University of California, Irvine, or UCI, and one additional Powerstation currently in the production phase expected to be installed at a landfill in southern California. We have built a Power Oxidizer of a significantly larger size, capable of generating sufficient heat and airflow to power a KG2 turbine produced by Dresser-Rand. Together, the Power Oxidizer and KG2 turbine comprise a 2MW Powerstation. The initial unit was constructed in the first quarter of 2016, and is currently being used in field tests that were substantially completed in the fourth quarter of 2016, at a third party location in Southern California. We have sold two 2MW Power Oxidizers to Dresser-Rand, each of which were delivered to the customer site in October 2016 and were combined with KG2 turbines and installed at Pacific Ethanol’s facility in Northern California in 2016. We believe this scaled-up version of our Power Oxidizer, combined with the KG2 turbine, will result in a Powerstation product that is better aligned with the scale of emissions (and energy requirements) observed at the industrial facilities that we believe stand to benefit most from this technology. As with the 250 kW Powerstation, the larger Powerstations are designed to provide an alternative to typical combustion-based power generation and enable industries to utilize their own waste gases to generate power.

 

We also expect to integrate our Power Oxidizer technology into additional sized gas turbines as well as other applications that can use the heat generated by our Power Oxidizers to power other industrial applications. We believe other industrial grade waste gas-to-heat opportunities, powered by an ultra-low pollution Power Oxidizer, include: (i) the generation of steam from coupling a Power Oxidizer with a traditional steam boiler, (ii) use in industrial grade dryers for kilns or industrial drying customer requirements, and (iii) use in industrial chiller units for customers requiring cold air or water in their processes.

 

Our first commercial products, or the EC Series, the Ener-Core Powerstation EC250, or EC250, previously called “FP250,” and the Ener-Core Powerstation EC333, or EC333, are products that combine our Power Oxidizer with a 250 kW and a 333 kW gas turbine, respectively. The gas turbines were initially developed by Ingersoll-Rand, plc, or Ingersoll-Rand, and subsequently enhanced by our predecessor, FlexEnergy, Inc., or FlexEnergy. The substitution of the Power Oxidizer for the combustor within a traditional turbine allows for the resulting, modified turbine to utilize low density waste gases as a fuel, in place of commercially purchased gases. The low energy density gases that the EC Series products can use as a fuel do not have an alternative commercial market as traditional combustion-based turbines require uncontaminated high energy fuels and thus cannot run on low energy density gases, and therefore such low energy density gases have no market value. The use of these waste gases results in a lower fuel cost to operate, in addition to providing a significant reduction in industrial air emissions.

 

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We are currently completing the scaling up of our Power Oxidizer, as well as the successfully combination thereof with Dresser-Rand’s KG2-3GEF turbine. The resulting product is currently being marketed and sold by Dresser-Rand’s international teams under the Dresser-Rand brand and is called the KG2-3GEF/PO (or KG2 with Power Oxidizer, or KG2/PO). We began the scale up and integration of our Power Oxidizer with Dresser-Rand’s KG2 turbine in late 2014 and continued to invest in engineering resources to support the integration and field testing of this unit throughout 2016. The final step of integration is the completion of the Full Scale Acceptance Test, or FSAT, which commenced in the second quarter of 2016 and was substantially completed in the fourth quarter of 2016, although the results of such tests remain subject to verification by Dresser-Rand. As of February 8, 2017 the results of all of the testing protocols required by the FSAT have not been received and are expected later in the first quarter of 2017.

 

We fulfilled the first Power Oxidizer units and sold them to Dresser-Rand at an estimated loss of $300,000 each in order to get our product into the field for proof of concept. After approval of the FSAT testing, Dresser-Rand is expected to manufacture the KG2/PO under a commercial and manufacturing license agreement which is expected to generate per unit license fees of between $370,000 and $650,000, calculated as a percentage of the total sales value of the KG2/PO. We will bear no requirement to source materials costs although we will be required to support Dresser-Rand’s sales efforts and installation of the KG2/PO systems. As a result, we expect our per unit margins to increase in future reporting periods.

 

As compared to alternative technologies, Power Oxidation provides certain advantages over alternative energy-generation technologies, including the following:

 

  Operates on a wider range of fuels. Our system is designed to operate on gases with energy densities as low as 50 BTU/scf (1700 kJ/m3). By comparison, most turbine, engine, and fuel cell systems require fuel quality of significantly higher energy densities.

 

  Lower air emissions. Our Power Oxidizer technology produces substantially lower emissions of Nitrogen Oxides (NOx) and Carbon Monoxide (CO) (< 1ppm) than, and destroys up to 99% of Volatile Organic Compounds (VOCs) compared to, combustion-based systems like gas engines or gas turbines or other commonly deployed pollution abatement systems.

  

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Figure 2

 

 

  No chemicals or catalysts for pollution abatement or control. Today, most of the low-quality waste gases produced by industries are processed through pollution abatement technologies that do not generate energy from the gases and are solely in place to reduce the volume of emissions to the atmosphere. Unlike other pollution abatement systems, such as selective catalytic reduction, our Power Oxidizer does not use chemicals or catalysts and, thus, cannot be rendered inactive from catalyst poisoning or degradation.

 

  Requires less fuel conditioning. Our system is capable of running on fuels with high levels of contaminants and is designed to require substantially less fuel pre-treatment than competing systems. In most cases, our system is able to process the waste gases from industrial processes without any of the fuel pre-treatment processes that are typically required by combustion-based methods to remove impurities and contaminants prior to generating energy from gases.

 

Our Power Oxidation technologies also have certain disadvantages over alternative energy-generation technologies, including the following:

 

  New and unproven technology. Our Power Oxidation technologies have only been demonstrated commercially in a 250 kW product and our technology has only been commercially available since 2013. Although we have received a purchase order for two of our larger 2 MW Power Oxidizers, we currently have no commercial deployments of these larger units and have not demonstrated their full commercial viability outside of our test facility.

 

  Commercial viability. Our Power Oxidation products have had limited commercial installation and to date have been produced on a limited scale.

  

  Unproven and early stage value proposition. Our Power Oxidation solutions and our value proposition are not fully demonstrated in multiple real world installations and to date have not been communicated widely among our potential customers. While we believe that our value proposition is sound, the industries in which we are attempting to sell our products are conservative and may discount, or not accept, our value proposition.

 

  Competes with existing mature technologies. Our Power Oxidation products often cannot compete on a standalone cost basis solely on either alternative power generation or pollution abatement solutions. Our product solutions currently make economic sense in limited customer applications when pollution abatement and power generation are both required by a customer.

 

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Licensing Approach

 

On November 14, 2014, we entered into a global commercial licensing agreement with Dresser-Rand, or the CLA, through our wholly-owned subsidiary, Ener-Core Power, Inc., which granted Dresser-Rand the right to market and sell the Dresser-Rand KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer, or a Combined System. The CLA grants Dresser-Rand exclusive rights to commercialize the Ener-Core Power Oxidizer, within ranges of 1–4 MW of power capacity, bundled with the Dresser-Rand KG2 gas-turbine product line. As part of the CLA, Dresser-Rand agreed to pay us a $1.6 million initial license fee, under the condition that we were able to successfully scale up the technology to a size of 2 MW. Dresser-Rand also agreed to achieve annual sales thresholds agreed to by both companies in order to retain the exclusivity of the commercial license. Upon payment of the initial license fee in full, Dresser-Rand obtained an exclusive license to sell the Ener-Core Power Oxidizer within ranges of 1–4 MW of power capacity, bundled with a gas-turbine to generate electricity.

 

On June 29, 2016, we entered into a Commercial and Manufacturing License Agreement, or the CMLA, with Dresser-Rand, through Ener-Core Power, Inc., intended to supersede and replace the CLA. Upon successful completion of the FSAT, the CLA will terminate and the CMLA will provide the terms of the commercial relationship between us and Dresser-Rand. Once the FSAT is completed, the effective date of the CMLA will be deemed November 14, 2014. In the event we are unable to successfully complete the FSAT, the CLA will continue to govern our commercial relationship with Dresser-Rand. As of December 31, 2016, we had performed the testing protocols of substantially all of the required tests, the results of which remain subject to verification by Dresser-Rand, which is currently underway.

 

Under the new CMLA, Dresser-Rand will have a worldwide license to manufacture, market, commercialize and sell the Power Oxidizer as part of the Combined System within the 1 MW to 4 MW range of power capacity, or the License. Initially, the License will be exclusive, even as to us, and will remain exclusive for so long as Dresser-Rand sells a minimum of number of units of the Combined System in each calendar year beginning in 2017, or the Sales Threshold, subject to certain conditions and exceptions. If Dresser-Rand does not meet the Sales Threshold in any calendar year and the Sales Threshold is not otherwise waived, Dresser-Rand may maintain exclusivity of the License by making a true-up payment to us for each unit that is in deficit of the Sales Threshold, or a True-Up Payment; provided, however, that Dresser-Rand may not maintain an exclusive License by making a True-Up Payment for more than two consecutive calendar year periods. In the event Dresser-Rand does not meet the Sales Threshold, does not qualify for a waiver and elects not to make the True-Up Payment, the License will convert to a nonexclusive License.

 

Upon a sale by Dresser-Rand of a Combined System unit to a customer, the CMLA requires Dresser-Rand to make a license fee payment to us equal to a percentage of the sales price of the Combined System purchased, in accordance with a predetermined fee schedule that is anticipated to result in a payment of between $370,000 and $600,000 per Combined System unit sold, or the License Fee. Payment terms to us from Dresser-Rand will be 50% of each License Fee within 30 days of order and 50% upon the earlier of the Combined System commissioning or twelve months after the order date.

 

Dresser-Rand may also request that we undertake design and development work on modifications to the Combined Systems, each referred to as a Bespoke Development. We and Dresser-Rand will negotiate any fees resulting from any such Bespoke Development on a case-by-case basis. Further, any obligation by us to undertake such Bespoke Development will be conditioned upon the execution of mutually agreed-upon documentation.

 

As long as the exclusive License remains in effect, we will provide certain ongoing sales and marketing support services, at no additional cost to Dresser-Rand, subject to certain restrictions. Any additional sales and marketing services agreed upon by us and Dresser-Rand will be compensated at an hourly rate to be upwardly adjusted annually.

 

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If we and Dresser-Rand so elect, we will manufacture a certain number of Power Oxidizers as part of a certain number of Combined System projects during a transition period, or the Transition Phase, beginning after execution of the CMLA and prior to the period in which Dresser-Rand manufactures its first three Power Oxidizers as part of at least two individual Combined System projects, or the Initial Manufacturing Phase, as mutually agreed by the parties. So long as the License remains exclusive during the Transition Phase, if any, and the Initial Manufacturing Phase, we will provide a mutually agreed upon number of hours of engineering support services. After the conclusion of the Initial Manufacturing Phase, we will, for so long as the License remains exclusive, continue providing up to an agreed upon number of hours of such support services on an annual basis at no additional cost to Dresser-Rand, subject to certain conditions. Any additional engineering support services agreed upon by us and Dresser-Rand will be compensated at an hourly rate, to be upwardly adjusted annually. During the Transition Phase, we must also develop the spare parts list pertaining to the scope of supply to allow Dresser-Rand to offer service agreements for the Combined System.

 

We must maintain our existing backstop security, or the Backstop Security, under the CLA in favor of Dresser-Rand in support of all products manufactured, supplied or otherwise provided by us during the period beginning on the execution date of the CMLA, or the Execution Date, and continuing through the expiration of the warranty period for the Combined System units sold to customers as of the Execution Date; however, if we and Dresser-Rand mutually agree to engage in a Transition Phase, then such Backstop Security must be extended to support all products manufactured, supplied or otherwise provided by us during such Transition Phase.

 

Dresser-Rand must also: (i) develop the controls strategy for the Dresser-Rand gas turbine control system and integrate it with the Power Oxidizer control system; (ii) with support from us, manufacture and commercialize the Combined System following the Transition Phase; (iii) with support from us, develop and prioritize sales opportunities for the Combined System; (iv) assume the sales lead role with respect to each customer; and (v) take commercial lead in developing sales to customers. In addition, Dresser-Rand will be primarily responsible for overall warranty and other commercial conditions to Combined System customers, as well as sole project and service provider and interface with customers. Dresser-Rand will also be responsible for warranty, service and after-sales technical assistance for all portions of Combined Systems that comprise Dresser-Rand products. We, however, will be responsible for warranty and service for all products manufactured or otherwise provided by us prior to or during the Transition Phase.

 

The CMLA prohibits us from, without the prior written consent of Dresser-Rand, permitting the creation of any encumbrance, lien or pledge of its intellectual property which would result in any modification to, revocation of, impairment of or other adverse effect on Dresser-Rand’s rights with respect to the exclusive License. In addition, all intellectual property rights that are owned by either us or Dresser-Rand as of the Execution Date will remain the sole property of such party, subject to the licenses described in the CMLA. The CMLA also contains provisions that govern the treatment of process and technology developments and any joint inventions that (i) relate to the subject matter of the CMLA and (ii) occur after the Execution Date and during the term thereof.

 

The CMLA also contains certain restrictions on publicity and obligates Dresser-Rand to use its commercially reasonable efforts to include our name and logo and otherwise promote our brand and Power Oxidizers in a mutually agreed-upon manner. We and Dresser-Rand have also mutually agreed to withhold disclosure of certain commercial and technologically sensitive terms of the CMLA including technical specifications, License Fee percentages, and the Sales Threshold minimum annual quantities to maintain exclusivity.

 

Commercial Sales Efforts

 

We are entering the combined heat and power, or CHP, market that is highly competitive and historically conservative in its acceptance of new technologies. To date, we have sold and delivered one 250 kW commercial PowerStation unit to the Netherlands and have sold one additional 250 kW PowerStation unit to a landfill site in Southern California scheduled for delivery in 2017. We have also sold two initial 2MW Power Oxidizers to Dresser-Rand for installation at their end user customer, Pacific Ethanol, which we delivered in October, 2016, but which remain subject to acceptance conditions which may not have been met as of December 31, 2016 and which remain subject to further review or deferral, depending in part on the results of the final FSAT test results. These three systems, combined with the Dresser-Rand license fees of $1.6 million, represent our $4.6 million order backlog as of February 7, 2017. To date, we have billed $4.2 million and collected $4.1 million of our existing backlog.

 

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In May 2016, we received a conditional purchase order for four 250 kW Powerstations expected to be installed on a landfill site in Southern California and scheduled for delivery in late 2017. This order is valued at approximately $4.0 million and is subject to additional pre-sales engineering and permitting requirements.

 

Product Commercialization to Date

 

  Initial Technology Development: In 1999, Edan Prabhu, the founder of FlexEnergy, our predecessor company, initially developed the “gradual oxidation” technology for use in catalytic engines and turbines. The first patent on catalytic gradual oxidation was granted to him in 2002. Several more years were spent after that on improving the technology to the level where it could be successfully demonstrated and commercialized.

 

  Initial Institutional Funding: In 2008, FlexEnergy received an initial round of institutional funding totaling approximately $3,000,000. The funding allowed FlexEnergy to purchase parts and materials necessary to begin field testing of the first development unit.

 

  F100 Development Test Unit: In November 2008, FlexEnergy began testing the first F100 development test unit in a San Diego, California test facility. This system was the first to combine the gradual oxidizer with a gas turbine, which was a 100 kilowatt gas turbine developed by Elliott Energy Systems, Inc. Through the process of designing proprietary software, hardware, and controls for the system, FlexEnergy learned how to effectively match the operating conditions of a gas turbine to the gradual oxidizer. In August 2010, FlexEnergy commissioned the first F100 field test unit at the Lamb Canyon Landfill in Beaumont, California with cooperation from the County of Riverside. This unit was the first to be evaluated for prolonged test periods, which led to significant improvements to our patented and proprietary key components and control processes.

 

  Prototype Evaluation—In-Field 250 kW Unit: In 2012, FlexEnergy’s technology underwent testing and verification by Southern Research Institute, or SRI, as part of a U.S. Department of Defense, or DoD, demonstration program. SRI commissioned the testing, which was performed by Integrity Air Monitoring, Inc. SRI is a not-for-profit 501(c)(3) scientific research organization that conducts advanced research in environmental, energy, and other fields, and FlexEnergy was one of its subcontractors. As part of that testing program, FlexEnergy shipped a prototype EC250 unit in 2012 for field tests for a one-year period and operations in 2012 and 2013. This test and verification project was a critical opportunity to operate FlexEnergy’s technology for an extended period of time within a true, industrial environment (as opposed to a controlled, laboratory environment), after a concerted 10-year research and development effort. The field tests were successful and proved that the technology and the accelerated oxidation reactions could be sustained in real world environments for extended periods of time. The field tests were completed in 2013 and represented a key step toward the commercialization of the Power Oxidation technology.

  

  Prototype for Controlled Testing: In 2013, through a partnership with UCI, we installed a fully operational EC250 unit at UCI’s campus. This facility location was chosen due to its proximity to our corporate headquarters, as well as on-going access to technical personnel who are collaborating with our engineering team to continue improving upon the technology and its various applications. The unit continues to operate and is used for in-field evaluations for research and development, as well as to showcase our technology to potential customers.

 

  Initial Commercial Unit—250 kW Unit: In June 2014, our first commercial EC250 Powerstation was installed at a landfill in the Netherlands that is owned and operated by Attero, one of the leading waste management companies in the Netherlands. With the exception of regular maintenance and in-warranty service related to turbine components, as well as down-time related to Attero’s refurbishment efforts on the underlying landfill during 2015, this system has continued to operate since it was commissioned.

 

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  Expansion Beyond Landfill Market into Oil and Gas Market: On September 9, 2014, we completed the first phase of a three phase commercial project with a major oil and gas producer located in Canada. Our prototype unit located at UCI successfully oxidized waste gases with an identical gas profile as waste gases currently being flared at petroleum production facilities in Alberta, Canada. We are currently working with the customer for the second phase of the project, which we expect will be to install a 250 kW commercial unit in a cold weather environment in Canada. Due to market conditions in the petroleum exploration industry and resulting reduced capital spending, this customer has temporarily placed the second phase on hold, but based on discussions with this customer, we expect the customer to proceed with the second phase over the next year.

 

  First Licensing Agreement: On November 14, 2014, we entered into the CLA to develop and market Dresser-Rand’s KG2-3GEF 2 MW gas turbine coupled with our Power Oxidizer. The CLA and ongoing integration provides for a scale-up of our technology into the larger utility grade sized turbines requested by our customers. Under the CLA, Dresser-Rand agreed to pay an initial license fee of $1.6 million, which was initially placed in escrow, and to commercialize the technology through its sales and distribution channels. In July 2015, we successfully completed the first of two technical milestones, which enabled Dresser-Rand to begin commercialization of the KG2-3GEF/PO turbines.

 

  Initial Order—2 MW Unit into Distillery Market: On January 12, 2015, Pacific Ethanol, Inc. publicly announced that it had placed an order with Dresser-Rand that included two of Dresser-Rand’s KG2-3GEF/PO units. The electrical output of each of these units was de-rated from 2.0 MW to 1.75 MW to allow for a portion of the generated heat to be used as steam, for a total 3.5 MW cogeneration plant at a location in California. The order represents the first two commercial KG2 units that are designed to include our Power Oxidizer units. In August 2015, after the completion of the first technical test, we received a formal purchase order for $2.1 million from Dresser-Rand, for two Power Oxidizers in the larger 1.5–2MW power capacity. The purchase order calls for an initial payment of 50% of the order value, or $1.05 million payable to us, with additional progress payments made over time under the purchase order until delivery of the Power Oxidizer units. The purchase order also requires us to create a $2.1 million performance security interest with an expected termination date of June 2017 by September 17, 2015, which date was extended until November 15, 2015. We satisfied the performance security requirement on November 2, 2015 and we received $2.0 million in cash from Dresser-Rand for the Pacific Ethanol units during 2015. The purchase order calls for the delivery of the Power Oxidizers to Dresser-Rand for subsequent integration into Dresser-Rand’s KG2-3G/PO Power-station, and represents the first commercial order of the system. In conjunction with the order from Dresser-Rand, we also received the initial license payment from Dresser-Rand under the CLA. We delivered the units associated with this initial order to the Stockton Biorefinery site owned by Pacific Ethanol in October 2016.

 

  Completion of Multi-Fuel Test Facility: In April 2015, we commissioned our self-constructed MFTF located at our corporate headquarters location in Irvine, CA. The MFTF will allow our development team to test, in a real world environment, different types and concentrations of gases and to configure tests for different heat output scenarios. We used the MFTF extensively to conduct the tests and analysis associated with the SSAT described below. We intend to use the MFTF in the future to test different waste gases, turbine configurations, steam applications, and specific gas concentrations to both enhance our existing technology as well as expand our potential addressable markets.

 

  Completion and Approval of SSAT: On August 3, 2015, we publicly announced the successful completion of the SSAT. The SSAT was a test conducted on the MFTF that involved verification of the heat output required by the KG2 unit but without the cost or risk of damage to a Dresser-Rand turbine unit. We believe that the successful completion of the SSAT provided Dresser-Rand with a significant level of assurance regarding the commercial viability of the Power Oxidizer technology, and we believe that the successful SSAT should enable Dresser-Rand to advance from its current preliminary commercial discussions with prospective customers to providing binding quotes and proposals and, ultimately, begin accepting additional binding purchase orders from customers that are interested in purchasing Dresser- Rand’s KG2-3GEF/PO Powerstations.

 

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  Additional 250 kW Commercial Unit: In May 2015, the Orange County Board of Supervisors approved a project that was awarded a research grant from the California Energy Commission. This project is a collaboration between us and UCI, through UCI’s Advanced Power & Energy Program, to install our EC250 Powerstation at the Santiago Canyon landfill in Orange County, California. In August 2015, we received a purchase order for $900,000 for the EC250 Powerstation unit.  In 2016, it was determined that the Santiago Canyon landfill site did not have sufficient power infrastructure in situ. Alternative locations for the EC250 Powerstation are currently being evaluated.

 

  Top Honors at Industry Conference: In June 2015, our presentation at POWER-GEN Europe, which is the largest power industry conference in Europe, won top honors. Our paper, “Extending Renewable Electricity for Decades at Closed Landfill Sites with Gas Below 30% Methane” was selected as the best paper within the category of Renewable Energy Strategy, Business & Integration from among the 122 submissions. 10,000 power executives, including 960 delegates from 103 countries, attended the conference.

 

Over the next two years, we expect to continue our product commercialization efforts with the following expected deliverables and projects:

 

  Completion of FSAT—2 MW Unit: Under the CLA, the second technical test is FSAT, which is required after achievement of the first technical milestone. The FSAT consists of the building and installation of a full prototype of a working 2 MW KG2 unit at a site in Southern California, and then testing the prototype under different operating conditions for performance and life cycle validation. We completed construction of the 2 MW Power Oxidizer in 2016 and began the field testing of the 2 MW unit in the first half of 2016. In September 2016, the $1.6 million license fee payment was released from escrow, from which we received $1.1 million in cash, representing the $1.6 million license fee net of $500,000 paid to Dresser-Rand for engineering services. We substantially completed field testing in the fourth quarter of 2016 and are awaiting final testing reports, which we expect later in the first quarter of 2017.
     
  Fulfillment and Delivery of Existing Customer Order Backlog of Approximately $4.6 Million: As of February 7, 2017, and prior to recognition of revenues associated with these orders, we had a backlog of approximately $3.0 million for our Power Oxidizers and approximately $1.6 million of Dresser-Rand license fees. During 2016, we (i) assembled, shipped and installed the first two Power Oxidizers for the two KG2 units sold by Dresser-Rand to Pacific Ethanol, and (ii) received the $1.6 million license fee payment from Dresser-Rand that was previously paid into escrow. We are currently evaluating the revenue recognition on these orders in conjunction with the FSAT testing process described above. We expect to commission the Pacific Ethanol units in the first half of 2017. While we received payments on the EC250 Powerstation unit for which we received a purchase order in August 2015, delivery of this unit (originally sourced to delivery at the Santiago Canyon landfill location) has been delayed pending a change of the delivery location by the customer. We expect the unit to be installed at an alternative site in 2017.

 

  Commercialization of EC250 Powerstations and Additional KG2 Power Oxidizers: We have a pipeline of additional opportunities through Dresser-Rand for KG2 Power Oxidizers and directly sold units for our EC250 Powerstations. We expect to receive additional purchase orders for these products in 2017.

 

  New Partnerships for 5.0 MW and Boiler Manufacturers, and Integration with Other Vertical Market Equipment Providers: We are in preliminary discussions with additional partners for a 5 MW Power Oxidizer and with boiler manufacturers that are interested in our 250/333 kW and 2 MW Power Oxidizers. We are also in discussion with providers of third party services for equipment such as industrial ovens, dryers, chillers, and anaerobic digesters which we believe will accelerate the sale of our products by expanding the vertical market opportunities. We intend to sign definitive agreements with one or more of these partners in 2017 for initial deliveries beginning in 2018.

 

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Key Parameters of Customer Value Proposition and Economic Payback

 

The value proposition, as well as the economic payback, of our products is based on the following parameters:

 

  (a) The industry in which the customer operates and the regulations and policies to which it is subject;

 

  (b) The cost of energy and the cost of fuels in the geographic region where the customer’s industrial facilities are located; and

 

  (c) The strictness of the air quality standards in the geographic region in which the customer’s industrial facilities are located.

 

  (d) The value to the customer of the residual industrial grade heat produced by our products.

 

The importance of a company’s industry, as it relates to our value proposition, is based on the following:

 

  The volume of waste gas that is produced as a byproduct of the core industrial processes within the industry: Industrial facilities with higher volumes of waste gases can better justify deploying our 2 MW system, while industries with less waste gas would be limited to deploying our smaller systems (250 kW or 333 kW). As is the case with most power generation equipment, due to economies of scale, the economic payback on the larger 2 MW systems will usually be substantially better than the economic payback on the smaller systems.

 

  The level of importance that the industry places on how they utilize or dispose of these waste gases: This is often linked to the environmental policies that are imposed on the industry. In many of our discussions with existing and prospective customers, the economic payback is measured as a function of savings on cost of energy as well as the avoided cost of environmental compliance (e.g., avoidance of fines imposed on industrial facilities that are not compliant with air quality standards, avoidance of costs of operating and maintaining standard pollution destruction equipment, etc.). In some cases, we have observed the avoidance of environmental compliance cost to represent as much as 20–30% of the aggregate economic benefits of our system. This does not imply that the avoidance of environmental compliance costs are a necessary element for achieving an attractive return on investment if a customer implements our system; in a number of cases the economic payback that is achievable through avoided energy costs alone is high enough to justify the investment in our system.

 

  The relative importance of energy costs within the overall cost structure of the industrial facilities: In certain industries, such as alcohol distilleries, the energy costs, consisting of both purchased electricity and consumed natural gas to provide heat or cooling, can be as high as 5–7% of the entire operating costs of a production facility. In other industries, such as steel production, the energy costs often amount to an even higher percentage of the overall cost structure. Industries in which energy costs represent a significant element of the overall cost structure will naturally be more sensitive to opportunities that involve reducing energy costs, as well as deploying projects that enable their industrial facilities to hedge against the potential of future increases in the cost of energy.

  

  The impact that pollution regulations have on our customers and potential customers in certain governmental jurisdictions: In certain governmental jurisdictions, such as in much of California, there are increasingly stringent pollution penalties, controls, and restrictions which may limit industrial production that uses traditional combustion to generate industrial heat. These regulations often limit the production of Nitrogen Oxide, which is a by-product of combustion chambers.

 

The cost of energy paid by industrial facilities within any particular geographic region also plays a critical role in the economic payback, and hence our value proposition. Usually, the most significant factor of the financial payback associated with an Ener-Core Powerstation is the avoided cost of energy that an industrial facility would typically purchase from its local or regional utility, and/or the additional revenue that an industrial facility can generate through selling the on-site power back to the local or regional utility. The higher the cost of energy in a particular region, the higher the return on investment associated with an Ener-Core Powerstation. The cost of energy consists both of the purchased or avoided electricity.

 

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For current and future projects, we target an internal rate of return of at least 15% for the customer, which includes only the value of the electricity generated by our Powerstations. Not included in this return is the value of pollution abatement, which can be substantial for certain customers in areas with high regulation of air pollution, and which is our largest competitive advantage over traditional combustion-based turbines. This generally results in a payback period of less than 5 years, but varies based on the price of electricity, installation costs, and any other customer-specific costs.

 

The air quality standards that are legislated and enforced in any particular region can also play a significant role in the value proposition of our solution and the calculation of the associated financial payback. In some regions of the world, such as California, the New England states, Western Europe, northern Europe and Japan, the air quality standards that are imposed on industrial facilities are rigorous and often difficult to meet in practical and economic ways. As a result, industrial facilities in a variety of industries find themselves spending an increasing percentage of operating budgets on sophisticated emissions destruction (pollution abatement) equipment, which often involves increased up-front costs as well as recurring costs on catalysts and other consumables, along with on-going maintenance costs. In addition, the failure to comply with air quality standards can result in significant penalties or fines. In most regions of the world, it is difficult to forecast the pace at which the air quality standards (and associated penalties for non-compliance) will change, but we believe that the general view is that the costs associated with environmental compliance will continue to increase over time. As a result, we believe that current and prospective customers consider, as part of their overall investment decision, the near-term and long-term environmental compliance savings that can be achieved by installing a Power Oxidizer.

 

Markets

 

We see our total potential market consisting of industrial facilities with permanent waste gas emissions sufficient to operate our units on a constant basis. We evaluate our potential markets in two methods, geographically and vertically. Our most significant sales opportunities are those where a customer’s demand for power, heat energy, and pollution abatement intersect as presented in Figure 3 below (opportunities not to scale).

 

Figure 3

 

 

 

We believe the total addressable U.S. market size is at least $5 billion for our Power Oxidizer technology, based on our assumption that our 333 kW Power Oxidizer is most appropriate for landfills and our 2 MW Power Oxidizer is most appropriate for our other targeted markets. We also believe the total addressable market size in Europe, Japan and China provides us with potentially meaningful opportunities. 

 

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Geographic Target Markets

 

We initially identified our geographic target markets to consist of North America, Europe, Japan and China with selective evaluations of other regions on a case-by-case basis. While we intend to focus primarily on the North American and European geographic markets over the next year, we intend to evaluate commercial opportunities in other geographic markets.

 

In the United States, we are focused on opportunities where our low-quality fuels configuration and our ultra-low emissions configuration provide competitive advantages, such as the South Coast Air Quality Management District, San Joaquin Air Pollution Control District, and other areas in air quality nonattainment as defined by the federal Clean Air Act. We are also focused on specific states where the wholesale electricity prices are the highest, as this typically results in the most attractive return on investment scenarios for prospective customers. These states include California, New Jersey, New York, Maine, New Hampshire, Massachusetts, Connecticut, Rhode Island and Vermont.

 

Internationally, we have identified similar opportunities in Canada and western European countries with similar environmental and regulatory laws as the United States, such as the Netherlands, Belgium, the United Kingdom, Germany, Italy, France, and Spain.

 

We believe that Japan provides a near term market opportunity since it is highly industrialized and has a multitude of industrial facilities that produce waste gases and could benefit from installing their own on-site source of power. Japan’s island geography, air quality initiatives, and recent movement away from nuclear power all indicate that new technologies such as our Power Oxidizers could be well received.

 

We believe that our potential opportunities in China are substantial based solely on the quantity of waste gases produced by industrial facilities. However, we have neither fully evaluated specific industries based in China, nor do we have the business partner relationships typically required to successfully enter the Chinese market.

 

We evaluate our market opportunities by performing feasibility studies, financial payback analyses and in some cases deploying pilot projects for potential customers, prior to producing a proposal for a full-scale solution deployment. We see this information as an integral part of our sales and marketing approach as each study provides our team with additional information on the wide range of waste gases produced and allows our team to better evaluate the specific return on investment scenarios, sales opportunities and overall value proposition that is most relevant to each geographic market.

 

Vertical Markets

 

We believe that our current products provide a superior value proposition for two customer types: (i) open and closed existing landfills, and (ii) industrial facilities that could benefit from on-site combined heat/power, or CHP, generation coupled with waste gas pollution abatement, or collectively CHP+A. In general, the projected economics seen to date indicate that sales into existing landfill plants will primarily represent EC250 and EC333 sales opportunities and sales into other industrial facilities will typically involve our larger products. We believe that our future steam product will primarily represent an attractive alternative to industrial facilities that value on site steam production higher than on site electricity production. We also believe that larger sized Power Oxidizer turbines of 5 MW and above, once developed, will likely be met with demand from large industrial facilities such as oil and gas refineries and petrochemical plants. After we have integrated and demonstrated our 2 MW Power Oxidizer to be commercially viable, we intend to increase the size of our Power Oxidizer and subsequently integrate it into larger turbines. 

 

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Landfills

 

When solid waste is deposited in landfills, the organic materials within the waste decompose slowly over time, resulting in the generation and emissions of methane-based waste gases. Historically, the quality of gases that has been emitted by landfills during their open phase (i.e., while trash is still being added) has been high enough for the generation of power through the installation and operation of reciprocating engines. However, the increasing prevalence of recycling and the diversion of organic materials are resulting in a reduction in the quality of the gas that is emitted from newer landfills. In addition, as landfills reach their maximum allowable size, they are eventually closed and deemed inactive. Once a landfill becomes inactive, and trash is no longer being added, the quality of the emitted gas typically falls to levels that are well below the quality thresholds (~30% methane) that are required as an inlet fuel for combustion-based power generating equipment such as reciprocating engines or standard gas turbines. For this reason, the viable power generation phase of a landfill’s life-cycle is typically limited to the years of operation when the landfill is active, and then for a few years after the landfill is closed. However, even after a landfill is closed, methane gas continues to be emitted for an additional 50 to 70 years, just at lower concentration levels than required to run combustion-based power generating equipment.

 

Our technology enables operators of existing landfill projects that utilize reciprocating engines and gas turbines for the collection and disposal of landfill-generated gases, or LFGs, to generate electricity beyond the normal operating range of their engines and turbines. In newer landfills that begin their life with less organic material, and therefore produce less methane, our technology also enables the generation of electricity where it might have been otherwise uneconomic to do so. Closed (inactive) landfills continue to emit waste gases for 50 to 70 years after the closure of the landfill, but the predictable reduction in gas quality makes it difficult (and in most cases, impossible) to generate energy from the waste gases, unless the waste gases are supplemented/enriched with a premium fuel such as natural gas or propane in order to raise their energy density. In either case, our low-quality fuel capability allows a greater percentage of the LFGs created from landfill-waste to be used for local electricity generation, as can be seen in Figure 4.

 

Figure 4

 

 

Typical gas emissions profile of a landfill throughout its entire life-cycle. The entire shaded area (yellow and green) represents the Ener-Core Power Oxidizer’s operational range to use methane at varying percentage levels. The yellow area represents the operational range of traditional combustion based turbines relating to landfill gas.

 

Utilizing the market data that is available through the U.S. Environmental Protection Agency’s, or EPA, Landfill Methane Outreach Program,” or LMOP, a voluntary assistance program that helps to reduce methane emissions from landfills by encouraging the recovery and beneficial use of landfill gas as a renewable energy source, we have been able to compile the data shown in Figure 5 regarding the age of the current closed landfills in California. 

 

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Figure 5

 

 

 

Closed California landfills as of March 2015, based on data provided by Landfill Methane Outreach Program (LMOP) available at www.epa.gov/lmop/.

 

Pollution abatement technologies (thermal oxidizers) appear to be one of the few alternative technologies for these older landfill sites once the hydrocarbon density in the LFG drops below the thresholds required by engines or other combustion technologies. Thermal oxidizers eliminate or treat waste gases but do not generate power. Closed landfills represent a large opportunity for us. We enable these older landfills to solve the pollution abatement problem and allows these sites to continue generating power (and hence revenue) from the LFG for several decades after traditional power generation technologies (reciprocating engines and gas turbines) are no longer able to operate due to the decrease in the quality of the gases.

 

Industrial Target Markets (excluding landfills)

 

Most industrial processes use heat energy in the form of heat, steam, or electricity for their operation. Many of these processes also generate byproduct waste gases with many embedded contaminants and impurities that are then either vented directly into the atmosphere or put through a “pollution abatement” or treatment process prior to release into the atmosphere. For industries where pollution abatement is mandated by applicable air pollution regulations, the facility typically purchases abatement equipment (scrubbers, thermal abatement, carbon absorber, etc.) separately from power production equipment, and such equipment destroys the waste gases, but does not monetize them. Our Power Oxidizers provide both functions in one unit and typically use waste gases as a partial or complete replacement of purchased commercial-grade gases. In applications where the waste gases have extremely low usable hydrocarbon content (or relatively low volumes of waste gases), significant values may still exist resulting from the coupling of power generation and pollution abatement that the Power Oxidizer provides, i.e., our CHP+A solution. 

  

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Figure 6

 

 

 

We reviewed the industries where we believe the combination of pollution abatement requirements, power consumption requirements, and the generation of waste gases provides the potential for superior economic returns with our products. Using these key attributes, we have identified twelve targeted vertical markets, aside from landfill opportunities, in California that we believe may result in sales. According to the EPA, these twelve markets represent in excess of 1,100 facilities in California and over 8,000 facilities in the United States that we believe have the combination of attributes that may indicate a superior economic return from a Power Oxidizer installation.

 

In addition to landfill opportunities, we intend to first pursue the following six general vertical industrial markets, representing nearly 5,000 potential installation sites across the US, as we believe they are the most likely to benefit from the Power Oxidizer in its current sizes. We have begun to market to these six vertical industrial markets, primarily for those facilities located in California, through direct contact from our sales department, tradeshow representation, and internet outreach. Each is discussed in greater detail below:

 

  Fuel-grade ethanol and beverage ethanol/alcohol distilleries and related products production (>500 facilities throughout the U.S.)

 

  Rendering and animal processing byproducts (>600 facilities)

 

 

Wastewater and sewage treatment (>3,500 facilities)

 

  Coal mines (>1,000 mines)

 

  “High tech” aerospace and defense instruments and materials; semiconductor and electronics manufacturing (>2,200 facilities)