S-1/A 1 a54842a4sv1za.htm FORM S-1/A sv1za
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As filed with the Securities and Exchange Commission on August 27, 2010
Registration No. 333-164915
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
 
 
 
Amendment No. 4
to
Form S-1
 
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
 
 
 
 
Fallbrook Technologies Inc.
(Exact Name of Registrant as Specified in Its Charter)
 
         
Delaware   3714   20-1027116
(State or Other Jurisdiction of
Incorporation or Organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification Number)
 
 
 
 
9444 Waples Street, Suite 410
San Diego, California 92121
(858) 623-9557
(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)
 
 
 
 
William G. Klehm III
Chairman and Chief Executive Officer
Fallbrook Technologies Inc.
9444 Waples Street, Suite 410
San Diego, California 92121
(858) 623-9557
(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent For Service)
 
 
 
 
with copies to:
 
     
Craig S. Andrews, Esq.    Kevin Morris, Esq.
Matthew W. Leivo, Esq.    Daniel P. Raglan, Esq.
C. Christopher Shoff, Esq.    Torys LLP
DLA Piper LLP (US)   237 Park Avenue
4365 Executive Drive, Suite 1100   New York, New York 10017
San Diego, California 92121   (212) 880-6000
(858) 677-1400    
 
 
 
 
Approximate date of commencement of proposed sale to the public:  As soon as practicable after this registration statement becomes effective.
 
If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  o
 
If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o
(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 or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), shall determine.
 


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The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.
 
Subject to Completion, dated August 27, 2010
 
          Shares
 
(FALLBROOK TECHNOLOGIES LOGO)
 
Fallbrook Technologies Inc.
 
Common Stock
 
 
This is Fallbrook Technologies Inc.’s initial public offering. We are selling           shares of our common stock.
 
We expect the public offering price to be between $      and $      per share. Currently, no public market exists for the shares. After pricing of the offering, we expect that the shares will trade on the           under the symbol “          ”.
 
 
Investing in our common stock involves risks. See “Risk Factors” beginning on page 10.
 
 
Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.
 
 
                         
        Underwriting
   
    Initial Public
  Discounts and
  Proceeds to Us,
    Offering Price   Commissions   Before Expenses
 
Per Share
  $           $           $        
Total
  $       $       $  
 
We have granted the underwriters a 30-day option to purchase up to a maximum of           additional shares of common stock from us at the public offering price, less underwriting discounts and commissions, to cover over-allotment of shares, if any.
 
 
Delivery of the shares of common stock will be made on or about          , 2010.
 
CIBC Mackie Research Capital
 
Prospectus dated          , 2010


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(GRAPHIC)
Electric Vehicles Application in Development Small Wind Turbines Application in Development Lawn Care Equipment Application in Development Automotive Accessory Drives Application in Development Bicycles Commercial Application NuVinci FALLBROOK TECHNOLOGIES Enabling Energy Efficient Applications.


 

 
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 EX-4.11
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 EX-23.2
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You should rely only on the information contained in this prospectus and any free writing prospectus we provide to you. We have not authorized anyone to provide you with information that is different. This document may only be used where it is legal to sell securities.
 
 


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Prospectus Summary
 
This summary highlights information contained elsewhere in this prospectus. As this is a summary, it does not contain all of the information that you should consider before investing in our common stock. You should read the entire prospectus carefully before making an investment decision, including the information under “Risk Factors”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included in this prospectus. Unless the context otherwise requires, the terms “we,” “us,” “our,” “Company,” “Fallbrook” and “Fallbrook Technologies” refer to Fallbrook Technologies Inc. and its wholly-owned subsidiary, Fallbrook Technologies International Co.
 
Overview
 
Fallbrook Technologies
 
We are a company that has developed and that markets, manufactures and distributes a patented technology, sold under the “NuVinci” brand. We have operations in California and Texas, as well as contract manufacturing capability in China. Our technology, which is currently only commercially available for bicycles, consists of a new type of continuously variable transmission (CVT) that we believe can be used in a wide variety of end market applications. A transmission is a mechanical device that provides speed and torque conversion from a rotating power source using gear ratios, or speeds. A CVT is a transmission that effectively has an infinite number of gear ratios, or speeds, between its lowest and highest speeds. Our NuVinci technology is designed to improve the overall efficiency and performance of vehicles and equipment that operate at various speeds, such as bicycles, automobile accessories, wind turbines and lawn mowers. Our NuVinci technology provides a smooth, continuous progression from one speed to another through its range with no breaks or jerks, allowing the transmission output speed to change, while the engine or motor speed stays at its speed of peak efficiency or power.
 
We sell or plan to sell our products directly to vehicle and equipment manufacturers and aftermarket products distributors. In some end markets, we license our products to other companies to manufacture and sell in their respective industries, from which we derive licensing fees or royalties on the sales of their products. In other end markets, we intend to enter joint ventures with development partners that would manufacture and market our products. We anticipate that we will share in the sales of such products. We also provide engineering and support services to vehicle and equipment manufacturers to help them implement our technology in their products.
 
Our technology is currently available in the global market for bicycle transmissions, through bicycle manufacturers, aftermarket equipment distributors and retailers, where it has been used to replace the rear wheel gear changing assembly, or derailleur, and is currently the only commercially available CVT for bicycles. We are also currently developing applications of our core technology for a number of other target end markets that we believe, based on our research, have near-term commercial potential. These include alternators, air conditioning compressors, power steering pumps and superchargers for the automotive accessory drive market where the CVT will allow the accessory to operate at a constant speed regardless of the varying engine speed, and primary transmissions for the electric vehicle, small wind turbine and lawn care equipment markets where the CVT will provide variable drive speed to the wind turbines or vehicles.
 
To date, we have primarily been an early stage development company focused on the development of our core technology and formation of initial commercial partnerships. We have raised approximately $62 million in financing to develop and patent our core technology, design and produce prototypes to test the application of our technology in products for our customers and develop the operational capabilities needed to support targeted sales of our products. We have developed a patent portfolio covering our core technology and end market applications of our technology that includes over 365 patents and pending applications around the world. We have established a sales presence in Europe, where we have a branch office for sales and customer support. We also have a contract manufacturing relationship with a manufacturer in China and have begun

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establishing an office in Shanghai to oversee the activities of that manufacturer and support exploration of other opportunities in China. We currently plan to expand our sales efforts to support increased sales in 2010 and 2011. In 2009, we earned $1,044,000 in total revenues from products sales and services at a total net loss of $17,226,000. During the six months ended June 30, 2010, we earned $460,000 in total revenues from product sales and services and had a total net loss of $6,726,000.
 
Our Strengths
 
In the end market applications we are focused on, we believe based on our knowledge and research of industry literature and internal testing, our NuVinci technology provides many advantages over existing transmission technology and addresses the limitations of other currently available CVTs by offering the following:
 
  •   Improved efficiency and performance;
 
  •   Adaptable platform technology; and
 
  •   Simple, durable and cost-effective design.
 
To date, we have invested significant resources developing applications for a selected set of end market applications that we believe offer the most attractive competitive advantages and potential for economic returns.
 
Markets
 
The applications for our NuVinci technology in each end market are at different stages of development and have different economic prospects. While we have spent several years developing our core technology, our past experience in launching our bicycle product and developing other products to date indicates that the product development process to apply our core technology to each of our target end market applications takes from 18 to 34 months from start to finish, depending on the complexity of the particular application. The key steps of the development cycle, which are discussed further below, include product design, prototyping and testing, production design validation, manufacturing tooling and process development, including supplier development, and manufacturing launch. Our technology is already being used in the bicycle market and we anticipate that we or our licensee will launch products in the automotive accessory drives and small wind turbines markets in 2011, in the lawn care equipment market in 2012 and in the electric vehicles market in 2013. We expect, in some cases with the assistance of licensees or joint venture partners, to fund the completion of the development of these end market applications through manufacturing launch with the net proceeds of this offering and our existing cash and cash equivalents.
 
Investment in Technology and Patents
 
As of August 25, 2010, we had raised approximately $62 million in financing to develop and commercialize our technology. In December 2008, we closed our largest financing round of $25 million from a consortium of private investors and two venture capital firms, NGEN Partners and Dutch investment firm Robeco, that are significantly involved in the cleantech sector — a market segment dedicated to reducing adverse environmental impact. Robeco is a wholly-owned subsidiary of Rabobank Group. This investment followed three previous private investment rounds. In August 2010, we closed a private financing round of $6 million to support our continued operations.
 
We have developed a patent portfolio covering our core technology as well as individual applications of it that, as of July 31, 2010, consisted of 95 U.S. patents, 52 U.S. pending patent applications, 81 foreign issued patents (including validated countries) and 137 pending foreign patent applications, the oldest of which will expire at the end of its 20-year term in 2018. Other patents, which were all filed since the oldest, will expire 20 years after their respective filing dates. Each of our foreign patents and applications originate from patents and applications filed in the U.S. and therefore are directed to the same or similar products and will expire at the same time as their respective U.S. counterpart. Our patent applications in the U.S. usually are granted as patents within about 3 years from filing, where in foreign countries it is usually longer, and often as long as 5-7 years. Our U.S. patent portfolio was ranked as the #1 patent portfolio in the automotive and transportation industry by The Patent Scorecardtm as reported in the Wall Street Journal on January 13, 2009. While this ranking was developed by an independent third


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party, such rankings are inherently subjective and therefore do not guarantee or provide any indication of success in protecting our products in the various marketplaces around the world. Further information regarding our patents can be found in the Business Section of this Prospectus.
 
Our NuVinci technology has also won several key industry awards including:
 
  •   R&D Magazine’s 2007 R&D 100 Award as one of the 100 most technically significant new products of 2007;
 
  •   Popular Science’s “Best of What’s New, Grand Award 2007”;
 
  •   The Dutch bicycle industry’s 2007 FietsVak “Innovation of the Year” award honoring the year’s best new bicycle product;
 
  •   2008 iF Design EUROBIKE Gold Award, one of ten Gold Awards awarded by iF International Forum Design, honoring the best in bicycle design; and
 
  •   The Guardian/Cleantech Group’s 2009 Global Cleantech 100 Award.
 
Our Growth Strategy
 
Our goal is to use our transmission and engineering expertise, commercial relationships and management team to identify and introduce a number of NuVinci applications into specific end markets. As we commercialize these applications, we will consider other end market applications for future development and launch that we believe would be well-suited to our NuVinci technology. We currently believe products such as automotive driveline transmissions, industrial equipment, and auxiliary power units may provide such opportunities and we are conducting preliminary market and product research and analysis on the potential opportunities represented by these end markets.
 
We intend to pursue the following strategies to attain this goal:
 
  •   Expand current markets through continued development and marketing;
 
  •   Pursue new markets where NuVinci technology has a clear competitive advantage;
 
  •   Leverage proven commercialization capabilities from the bicycle market into other markets;
 
  •   Establish relationships with industry leaders to adapt and commercialize our products;
 
  •   Pursue a flexible approach to manufacturing through the use of contract manufacturers or licensees; and
 
  •   Continue to invest in our NuVinci technology in order to develop additional applications and proprietary technologies that support a competitive advantage.
 
Our Management
 
Our senior management team is comprised of industry veterans. Our chief executive officer has over 20 years of automotive experience with multiple management positions in the automotive business. Our chief operating officer has over 30 years of automotive experience in operations, engineering and sales both domestically and internationally. Our chief technology officer previously headed the drivetrain group at the Southwest Research Institute in San Antonio, Texas, and has over 21 years of automotive and engineering experience. Our president of the bicycle division has over 20 years of sales, product development and business development experience in the automotive industry.
 
Recent Developments
 
On April 23, 2010, we executed a non-binding memorandum of understanding with Chengdu Bus Company (Chengdu) in Chengdu, China, which is located in the Sichuan province. The non-binding memorandum states that the two companies intend to enter an agreement for the development of a continuously variable accessory drive for application in Chengdu’s buses, which we currently believe will be an air conditioner or alternator application.


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On June 4, 2010, we entered a non-binding memorandum of understanding with a leading manufacturer of power steering pumps for commercial vehicles under which the parties agreed to review certain accessory drive applications to identify a target application and negotiate a joint development agreement for the development of a commercial product for that accessory drive application.
 
In June 2010, we launched the production of our second generation bicycle product, the N360, and shipped our first production units to customers in July 2010.
 
On August 26, 2010, we entered a non-binding memorandum of understanding with TEAM Industries, Inc. under which we mutually agreed to negotiate a joint venture for the manufacture of NuVinci CVTs for small residential and recreational vehicles including all-terrain vehicles and utility vehicles as well as low speed vehicles and neighborhood electric vehicles.
 
On August 26, 2010 we entered a non-binding memorandum of understanding with Shentong Automotive Decoration Co., which is located in Ningbo near Shanghai, China. Under the memorandum, we agreed to negotiate a joint venture for the manufacture of driveline transmissions for electric passenger cars.


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Risks Related to Our Business
 
Investing in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties summarized below, the risks described under “Risk Factors,” the other information contained in this prospectus and our consolidated financial statements and the related notes before you decide whether to purchase our common stock.
 
  •   Our patents and other protective measures may not adequately protect our proprietary intellectual property;
 
  •   It is difficult to evaluate our future prospects, as several of our products are still under development and we have a limited operating history with limited revenue generation to date;
 
  •   If the applications that we develop for our technology fail to gain market acceptance and adequate market share, our business will be adversely affected;
 
  •   Since our inception, we have never been profitable and we may be unable to achieve or sustain profitability;
 
  •   We use single suppliers for several components specifically qualified for use in our CVT products. If any of these suppliers become unable or unwilling to provide their respective components, we would be forced to qualify, over a period of two to three months, a different component from another manufacturer for use in our products, which would adversely impact our or our licensee’s ability to deliver products to customers;
 
  •   If we do not continue to form and maintain economic arrangements with original equipment manufacturers, or OEMs, to incorporate our technology into their products such that we derive revenue from licensing and royalties on product sales, our profitability will be impaired;
 
  •   Our ability to sell our products to our direct, OEM and tier one supplier customers depends in part on the quality of our engineering and customization capabilities. If we fail to offer high quality engineering support and services, our sales and operating results will be materially adversely affected; and
 
  •   The state of the economy affects each of our target end markets and a material downturn in the economy will have a materially adverse effect on these markets.
 
These risks and other risks described under “Risk Factors” could materially adversely affect our business, financial condition and results of operations.
 
Company Information
 
We were originally formed on December 11, 2000 as Motion Systems Technologies, LLC, which was subsequently converted into Fallbrook Technologies Inc., a Delaware corporation, on April 13, 2004.
 
Immediately prior to the closing of this offering, all of our outstanding shares of preferred stock will be converted into shares of our common stock. See “Conversion of Preferred Stock into Common Stock.” Following this offering, we will have one class of authorized common stock outstanding and no preferred stock outstanding.
 
Our corporate headquarters are located at 9444 Waples Street, Suite 410, San Diego, California 92121. The telephone number of our corporate headquarters is (858) 623-9557. Our website is www.fallbrooktech.com. The information on, or that may be accessed through, our website is not a part of this prospectus.


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Trademarks, Trade Names and Service Marks
 
“Fallbrook Technologies,” “NuVinci,” “CruiseController” and related trademarks, trade names and service marks of Fallbrook Technologies appearing in this prospectus are the property of Fallbrook Technologies. Solely for convenience, our trademarks referred to in this prospectus may appear without the® or tm symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights to these trademarks.
 
Industry and Market Data
 
Market data, industry statistics, forecasts and other statistical information used throughout this prospectus are based on independent industry publications (including CSM Worldwide’s Global Light Vehicle and Medium/Heavy Production Forecast — March 2010 and the 2009 AWEA Small Wind Turbine Global Market Study, for example), government publications, reports by market research firms and other published independent sources. Some data are also based on our good faith estimates, which are derived from our review of internal surveys and data or independent sources listed above. Although we believe these sources are credible, we have not independently verified the information obtained from these sources.


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The Offering
 
Common stock offered by us      shares
 
Common stock to be outstanding after this offering(1)      shares
 
Over-allotment option We have granted to the underwriters an option, exercisable upon notice to us, to purchase up to        additional shares of common stock at the offering price to cover over-allotments, if any, for a period of 30 days from the date of this prospectus.
 
Use of proceeds We intend to use the net proceeds from this offering for general corporate purposes, including the repayment of indebtedness. See “Use of Proceeds” on page 25 of this prospectus for more information.
 
Risk factors You should read the information set forth under “Risk Factors” beginning on page 9 of this prospectus for a discussion of factors you should carefully consider before deciding to invest in shares of our common stock.
 
Dividend policy We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.
 
Stock exchange symbol ‘‘     ”.
 
 
(1) The number of shares to be outstanding after this offering does not reflect          shares of common stock reserved or issuable pursuant to our 2010 Stock Plan,           shares of common stock issuable upon exercise of outstanding options under our 2004 Stock Plan, an outstanding warrant held by the Jacobs Family Trust to purchase 3,100,753 shares of our common stock and up to 650,000 shares of common stock issuable pursuant to contingent warrants that may be granted upon achievement of certain performance milestones. After the effective date of the 2010 Stock Plan, we will grant no further stock options or other awards under the 2004 Stock Plan.
 
Unless otherwise indicated, this prospectus reflects and assumes the following:
 
  •   the conversion, immediately prior to the closing of this offering, of all of our outstanding shares of preferred stock into           shares of our common stock;
 
  •   the issuance of          shares of our common stock upon the exercise of warrants that would otherwise expire immediately prior to the closing of the offering;
 
  •   no exercise by the underwriters of their option to purchase up to          additional shares from us; and
 
  •   an initial public offering price of $      per share, the midpoint of the estimated public offering price range set forth on the cover page of the prospectus.


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Summary Consolidated Financial Data
 
We derived the summary consolidated statement of operations data and consolidated statement of cash flows data for the years ended December 31, 2007 and 2008, as restated (see Note 16 to our audited consolidated financial statements), and December 31, 2009, and the summary consolidated balance sheet data as of December 31, 2008, as restated (see Note 16 to our audited consolidated financial statements), and December 31, 2009, from our audited consolidated financial statements included elsewhere in this prospectus. We derived the summary consolidated balance sheet data as of December 31, 2007, as restated (see Note 16 to our audited consolidated financial statements), from our audited consolidated financial statements, which are not included in this prospectus. We derived the summary consolidated statement of operations data and summary consolidated statement of cash flows data for the six months ended June 30, 2009 and 2010 and the summary consolidated balance sheet data as of June 30, 2010 from our unaudited condensed consolidated interim financial statements included elsewhere in this prospectus.
 
We have prepared the unaudited consolidated interim financial statements on the same basis as our audited consolidated financial statements and, in our opinion, have included all adjustments, which include only normal recurring adjustments necessary to present fairly, in all material respects, our financial position and results of operations. The results for any interim period are not necessarily indicative of the results that may be expected for the full year. Additionally, our historical results are not necessarily indicative of the results expected for any future period.
 
You should read the summary historical financial data below together with the consolidated financial statements and related notes appearing elsewhere in this prospectus, as well as “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the other financial information included elsewhere in this prospectus.


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Consolidated Statement of Operations Data:

                                         
          Six Months Ended
 
    Year Ended December 31,     June 30,  
    2007(1)     2008(1)     2009     2009     2010  
    ($ in thousands)  
 
Revenues
  $ 714     $ 2,283     $ 1,044     $ 672     $ 460  
Cost of revenues
    1,892       2,048       7,260       2,129       521  
Gross (loss) profit
    (1,178 )     235       (6,216 )     (1,457 )     (61 )
Operating expenses
    5,827       10,321       10,523       4,988       6,614  
Operating loss
    (7,005 )     (10,086 )     (16,739 )     (6,445 )     (6,675 )
Other income (expense)
    447       (470 )     (487 )     15       (51 )
                                         
Net loss
  $ (6,558 )   $ (10,556 )   $ (17,226 )   $ (6,430 )   $ (6,726 )
                                         
 
Consolidated Balance Sheet Data:
 
                                 
                      As of
 
    As of December 31,     June 30,
 
    2007(1)     2008(2)     2009     2010  
    ($ in thousands)  
 
Cash and cash equivalents(3)
  $ 8,043     $ 14,565     $ 9,213     $ 1,542  
Total assets
    10,855       25,314       13,526       9,290  
Total liabilities
    2,158       3,171       3,813       6,019  
Total equity
    8,697       22,143       9,713       3,271  
 
Consolidated Statement of Cash Flows Data:
 
                                         
          Six Months Ended
 
    Year Ended December 31,     June 30,  
    2007(1)     2008(2)     2009     2009     2010  
    ($ in thousands)  
 
Net cash (used in) provided by:
                                       
Operating activities
  $ (5,860 )   $ (9,496 )   $ (12,118 )   $ (6,472 )   $ (5,960 )
Investing activities
    8,073       (7,271 )     2,954       (6,551 )     (305 )
Financing activities
    2,612       23,289       3,812       (5 )     (1,404 )
Effect of exchange rate changes on cash
                            (2 )
                                         
Net change in cash
  $ 4,825     $ 6,522     $ (5,352 )   $ (13,028 )   $ (7,671 )
                                         
 
 
(1) On January 3, 2007, we formed a wholly-owned subsidiary, Viryd Technologies Inc. (Viryd), a Delaware corporation. On December 18, 2008, we completed a spin-off of our ownership of Viryd through a pro rata distribution of shares to our stockholders. The 2007 and 2008 consolidated financial statements include the accounts of the Fallbrook Technologies Inc. and Viryd through December 18, 2008. All intercompany transactions through December 18, 2008 have been eliminated.
 
(2) On December 18, 2008, we sold an aggregate of 63,607,402 shares of our Series D convertible preferred stock at a purchase price of $0.3992 per share for a total of $25.4 million, of which $20.6 million was in cash and $4.8 million was from the conversion of principal and accrued interest on our then outstanding convertible debt.
 
(3) As of August 25, 2010, cash and cash equivalents were $5.9 million.


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Risk Factors
 
Investing in our common stock involves a high degree of risk. Before making an investment in our common stock, you should carefully consider the risks and uncertainties described below and the other information contained in this prospectus, including our consolidated financial statements and the related notes. These risks could materially adversely affect our business, financial condition and results of operations. As a result, the market price of our common stock could decline, and you may lose part or all of your investment.
 
Risks Related to Our Business
 
Our patents and other protective measures may not adequately protect our proprietary intellectual property.
 
We regard our intellectual property, particularly our proprietary rights in our NuVinci technology, as critical to our success. We have 365 issued patents or pending applications worldwide for various applications and aspects of our technology or processes. In addition, we generally enter into confidentiality and invention assignment agreements with our employees and consultants as well as our development partners and licensees. Such patents and agreements and various other measures we take to protect our intellectual property from use by others may not be effective for various reasons, including the following:
 
  •   our pending patent applications may not be granted for various reasons, including the existence of previously available public information or other prior art, conflicting patents or defects in our applications;
 
  •   the patents we have been granted may be challenged or invalidated because of the pre-existence of prior art;
 
  •   the patents we have been granted may be circumvented depending upon the strength of the claims granted in each patent;
 
  •   parties to the confidentiality and invention agreements may have such agreements declared unenforceable or, even if the agreements are enforceable, may breach such agreements;
 
  •   the costs associated with enforcing patents, confidentiality and invention agreements or other intellectual property rights may limit our enforcement of our rights in them;
 
  •   even if we enforce our rights, injunctions, fines and other penalties may be insufficient to deter violations of our intellectual property rights; and
 
  •   other persons may independently develop proprietary information and techniques that are functionally equivalent or superior to our intellectual proprietary information and techniques but do not breach our patented or unpatented proprietary rights.
 
It is difficult to evaluate our future prospects, as several of our products are still under development and we have a limited operating history with limited revenue generation to date.
 
Efforts to expand our products beyond our existing bicycle market may never result in new products that achieve market acceptance, create additional revenue or become profitable. Several of our products targeted for use in the automotive industry are still under development, and it is difficult to determine the timing of our release of new products. The successful use of our technology in small wind turbines and lawn care equipment, and the associated licensing revenue, depends on the success of our licensees, Viryd Technologies Inc. and Hydro-Gear, respectively. With our limited operating history and the uncertainty of market dynamics for planned products, it is difficult to evaluate our future prospects.
 
If the applications that we develop for our technology fail to gain market acceptance and adequate market share, our business will be adversely affected.
 
The value proposition for the application of our technology to bicycles involves some factors such as ride feel/ride enjoyment, ease of shifting, ability for a rider to find his or her “own gear,” which factors are at least partially subjective. A well-funded competitor may be able to reduce the value of these advantages through


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marketing and public relations campaigns or through price cuts and thereby impact our ability to command a premium price or grow our market share, which in turn would impact our ability to achieve our planned revenue and profit levels.
 
The value proposition for other applications of our technology involves providing increased system efficiency, fuel economy, or cost reductions for manufacturers. If we are unable in a timely fashion, either directly or through licensees, to implement our technology and manufacture products that provide sufficient, demonstrable incremental value, we will be unable to achieve our business objectives.
 
Since our inception, we have never been profitable and we may be unable to achieve or sustain profitability.
 
We experienced net losses of $6,558,000 for 2007, $10,556,000 for 2008, $17,226,000 for 2009, and $6,726,000 for the six months ended June 30, 2010. We expect to incur a loss in 2010. We anticipate that we will continue to have negative cash flow in 2010 and for the foreseeable future as we invest resources in developing and commercializing our products for our target end markets. We expect selling, general and administrative expenses to also increase as we commercialize additional NuVinci CVT products, increase our business development and marketing efforts worldwide, and continue to build out the corporate infrastructure needed to support a public company. These additional expenses will likely involve increases to salaries and related expenses, legal and consultant fees, accounting fees, rent and utilities, director fees, increased directors’ and officers’ insurance premiums, and fees for investor relations services. These increased expenditures will make it harder for us to achieve and maintain future profitability. We may incur losses in the future for a number of reasons, including the other risks outlined in this prospectus. Additionally, there may be unanticipated expenses, difficulties, complications, delays and other unknown events that may impact our ability to achieve or maintain profitability.
 
If we are unable to enter into commercial agreements with third parties on acceptable terms to assist in the development of our products, our business will be adversely affected and we will be unable to achieve our profit goals.
 
Our business plan depends on licensing our technology to others and entering joint ventures with others such that those partners would bear some of the costs of bringing those products to market. From time to time we enter into memorandums of understanding (MOUs) with those commercial partners. These MOUs are usually non-binding, although they may include immaterial obligations that are binding for the negotiation of the contemplated business, and while we would anticipate being able to negotiate definitive agreements with such parties, we may be unable to do so. If we are unable to enter into such licenses or joint ventures, our costs and our capital needs will significantly increase, and our timeline of bringing our products to market may be extended, which would have a material adverse effect on our ability to achieve or sustain profitability.
 
We use single suppliers for several components specifically qualified for use in our CVT products. If any of these suppliers become unable or unwilling to provide their respective components, we would be forced to qualify, over a period of two to three months, a different component from another manufacturer for use in our products, which would adversely impact our or our licensee’s ability to deliver products to customers.
 
We use single suppliers for several components in our CVT products. The component parts for our products are qualified for production through a rigorous validation process prior to approval for use. If we were required to utilize another supplier for some key components that are not readily available from other sources, we would need to spend some significant time qualifying the parts from the alternative supplier, which would require both time and substantial expense. Any resulting delays in our ability or the ability of our licensees to deliver products containing such component parts would affect our profitability, could lead to a loss of future business, and would harm our reputation.


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If we do not continue to form and maintain economic arrangements with original equipment manufacturers, or OEMs, to incorporate our technology into their products such that we derive revenue from licensing and royalties on product sales, our profitability will be impaired.
 
Part of our business strategy is to license our NuVinci technology to OEMs for use in various application areas. We currently have licenses with two OEMs — Viryd Technologies Inc. has licensed our technology for use in wind energy applications and Hydro-Gear has licensed our technology for lawn care equipment products. The development process for our customers to incorporate our technology not only requires considerable lead time between the start of design efforts and commercial availability but also typically involves our providing engineering services for a fee prior to the negotiation of licensing and royalty arrangements. Currently, we have two development agreements for the development of products for our target end market applications.
 
If our customers are unable to successfully implement our technology and develop successful commercial products, we will not obtain licensing and royalty revenue, which would adversely affect our revenue and profitability levels. If we are unable to enter into additional agreements for the use of our technology in various applications, we will not receive revenue from engineering services, from the licensing of our technology for additional application areas, or from royalties on the sales of resulting commercial products. Consequently both our growth and profitability could be adversely affected.
 
Our ability to sell our products to our customers depends in part on the quality of our engineering and customization capabilities.
 
A high level of support is critical for the successful marketing and sale of our products. The sale or licensing of our technology involves significant co-development and customization work in certain applications. This development process may require substantial lead time between the commencement of design efforts for a transmission or the incorporation of a transmission into an end product and the commencement of volume shipments of products to customers. The cooperation and assistance of our customers is also required to determine the requirements for each specific application. Once our products are designed for an end market application, customers may depend on us to resolve issues relating to integrating that design into their products. If we do not effectively assist our customers in customizing, integrating and deploying our products in their own systems or products, or if we do not succeed in helping them quickly resolve post-deployment issues and provide effective support, our ability to sell our products would be adversely affected.
 
If we fail to offer high quality engineering support and services, our sales and operating results will be materially adversely affected.
 
While we may have supply and co-development agreements with customers located in different regions of the world, we do not have a globally distributed engineering support and services organization. Currently, issue resolution related to our products, system deployment or integration is directed to our engineering and product development group in Cedar Park, Texas from which we deploy engineers and support personnel. As we grow our business with our existing customers and beyond the markets into which we currently sell our products, we may need to increase the size of our engineering support teams and deploy them closer to our customers. Any inability to deliver a consistent level of engineering support and overall service as we expand our operations would have a material adverse effect on our business and operating results. Moreover, our products may contain manufacturing or design defects or exhibit performance problems at any stage of their lifecycle. These problems could result in expensive and time-consuming design modifications and impose additional needs for engineering support and maintenance services as well as significant warranty charges.
 
The state of the economy affects each of our target end markets and a material downturn in the economy will have a materially adverse effect on these markets.
 
The state of the economy as a whole affects each of our target end markets and a material downturn or economic problems in any of these industries will have a materially adverse effect on our business. For example, the effects of the current economic downturn included a delay in winning additional engineering services agreements with customers in the automobile industry because they increased their scrutiny on


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spending for new technology and we incurred more marketing and business development expenses. Additionally, we have had to reduce our engineering services fees in order to win engineering services business during this period. The financial problems for the automobile industry have led to a significant decrease in the amount of automobiles sold worldwide, but have not yet affected our product sales revenue because the products for that end market are still in development. Should the decrease in automobile sales persist as we develop and then launch our products, our business would be materially adversely affected.
 
We rely on contract manufacturers and licensees to produce and sell products that generate product sales revenue and royalties for us. If revenue from contract manufacturers and licensees is less than anticipated, we will be unable to achieve our projected revenue and profit goals.
 
We rely on contract manufacturers and licensees to produce products incorporating our technology. If the demand for our manufacturers’ and licensees’ products declines, they may reduce production and the revenue we receive from our related license agreements with these manufacturers and licensees may also decline. This could cause us to fail to achieve our projected revenue and profit goals. Additionally, our success depends on entering into agreements with new manufacturers and licensees who are able to acquire or manufacture, incorporate, and successfully market products utilizing our technology in a reasonable timeframe. While we assist contract manufacturers and licensees in various ways in their ability to incorporate our technology, there are many factors affecting their success or failure over which we have no control.
 
Our principal competitors have, and any future competitors may have, greater financial and marketing resources than we do, and they may therefore develop products or other technologies similar or superior to ours or otherwise compete more successfully than we do.
 
The industries in which we compete and will be competing include major domestic and international companies, most of which have existing relationships in the markets into which we sell as well as name recognition, financial, technical, marketing, sales, manufacturing, growth capacity, distribution and other resources that are substantially greater than ours. Some of our competitors have existing and evolving relationships with our target customers. For example, Shimano has the major market share of the internal hub bicycle transmissions market and has a significant relationship with all of our current and projected future customers in that business.
 
Potential customers may also choose to do business with our more established competitors because of their perception that our competitors are more stable, are more likely to complete various projects, can grow their operations more quickly, have greater manufacturing capacity and are more likely to continue as a going concern. If we are unable to compete successfully against manufacturers of other products or technologies in any of our targeted applications, our business will suffer, and we could lose or be unable to gain market share.
 
Our failure to raise additional capital necessary to expand our operations and invest in our products and manufacturing facilities could reduce our ability to compete successfully.
 
Throughout the global credit and economic crisis, it has been expensive for us to raise private capital. If we are unable to raise capital from this public offering, in order to continue to expand our operations and invest in our products and manufacturing facilities, we believe we would need to raise approximately $16.0 million within the next twelve months through one or more private equity offerings. We would also draw on the $0.5 million that remains available as of August 25, 2010 under our existing $3.0 million revolving line of credit. We do not currently have other abilities to borrow, and our ability to increase the amount of available borrowings under our existing line of credit or renew our existing line of credit, which expires on December 31, 2010, could be subject to negotiations with the financial institution and could entail some form of guarantee. Accordingly, we may require additional capital in the future and we may be unable to obtain additional debt or equity financing on favorable terms, if at all. If we raise additional equity financing, our stockholders may experience significant dilution of their ownership interests, and the per share value of our common stock could decline. With respect to debt financing, the credit markets have experienced extreme volatility during the last year, and worldwide credit markets have remained illiquid despite injections of capital by the federal government and foreign governments. Despite these capital injections and government actions,


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banks and other lenders (including equipment leasing companies) have significantly increased credit requirements and reduced the amounts available to borrowers. For our activities requiring substantial debt capital or other credit instruments, if current credit market conditions do not improve, we may not be able to access debt or leasing markets to finance our growth. Further, even if we are able to engage in debt financing, we may be required to accept terms that restrict our ability to incur additional indebtedness and force us to maintain specified liquidity or other ratios. If we need additional capital and cannot raise or otherwise obtain it on acceptable terms, our ability to expand our business will be severely constrained.
 
Our working capital requirements involve estimates based on demand expectations and may decrease or increase beyond those currently anticipated, which could harm our operating results and financial condition.
 
It is difficult to accurately predict how much capital our anticipated product launches will require. Inaccurate forecasts as to our working capital requirements could delay or prevent effective rollouts of products and interfere with our ability to market and sell existing products. Additionally, in order to fulfill the future product delivery requirements of our customers, we plan for working capital needs in advance of customer orders. For example, under a manufacturing and supply agreement with Tri Star Group for the manufacture of our next generation bicycle CVT (N360) we are required to purchase certain inventory Tri Star has on hand based on our forecasts of future demand. As long as the agreement is effective, we may be required to use working capital to pay for this inventory. If demand for our products does not increase as quickly as we have estimated or drops off sharply, our inventory and expenses could rise, and our business and operating results could suffer. Alternatively, if we experience sales in excess of our estimates, our working capital needs may be higher than those currently anticipated. Our ability to meet this excess customer demand depends on our ability to arrange for additional financing for any ongoing working capital shortages, since it is likely that cash flow from sales will lag behind these investment requirements.
 
Our future success depends on our ability to retain key personnel.
 
Our success will depend, to a significant extent, on the continued services of our senior management team. The loss or unavailability of one or more members of senior management could adversely impact our ability to execute our business plan, maintain important business relationships and complete certain product-development initiatives. Employment agreements with members of our senior management team do not require them to remain with our company. Any one of them could terminate his or her relationship with us on 30 days notice, and we may be unable to enforce any applicable employment or non-compete agreements.
 
We may not be able to successfully recruit and retain skilled technical personnel, particularly those employees with certain technical skills, such as experience in traction drives, for which demand exceeds the number available.
 
Our future success will depend in large part on our ability to attract and retain highly skilled technical, managerial and marketing personnel. We plan to continue to expand our work force both domestically and internationally. These employees will require specialized skills including, for example, mechanical and other types of engineering for both designing and manufacturing products, specialized operational skills in managing suppliers and customers and also in quality assurance and control. The demand for certain of such employees, particularly those with experience in traction drives, however, exceeds the number of personnel available, and the competition for attracting and retaining these employees will intensify as the use of and applications for continuously variable transmissions increases. As this competition increases, it could require us to increase compensation for current employees over time. We compete in the market for personnel against numerous companies, including larger, more established firms who have significantly greater financial resources than we do and may be in a better financial position to offer higher compensation packages to attract and retain human capital. We cannot be certain that we will be successful in attracting and retaining the skilled personnel necessary to operate our business effectively in the future. Because of the highly technical nature of our products, the loss of any significant number of our existing engineering and project management personnel could adversely affect our business and operating results.


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Additionally, among our employees are a number of highly skilled traction drive experts. These individuals have unique and specialized mechanical engineering experience in the design and development of particular mechanical devices and are not easily replaced and if one or more of these individuals is incapacitated or leaves us, our ability to address problems in existing products or develop new products will be affected beyond the impact of normal attrition.
 
Declines in product prices may adversely affect our financial results.
 
If our NuVinci technology becomes recognized by others as a competitive threat to their sales or anticipated sales, there may be increased price pressure as a competitive response, which could force us to reduce the price of our products. In periods of decreased demand, such as the current economic recession, the pressure for us to reduce prices may be even greater. A reduction in the price of our products would adversely affect our gross margins and ability to achieve profitability, especially during periods of decreased demand for our products as we would expect to occur during a recession.
 
Increases in the cost of materials may have a negative impact upon our ability to achieve profitability.
 
If the cost of the materials we use to produce our products increases then our results of operations might be adversely impacted. For example, China’s rapid growth and its increased consumption of raw materials may result in increased pressure on prices of raw materials, causing them to rise. An increase in the costs of raw materials would make it more difficult for us to maintain our gross margins and would negatively affect our ability to achieve profitability.
 
Our inability to effectively and quickly transfer, replicate and scale new product manufacturing processes from low volume prototype production to high volume, cost effective manufacturing, could adversely affect our results of operations.
 
Regardless of whether we use contract manufacturers or licensees, manufacturing processes and systems for new products are initially established and developed for relatively low volume production (primarily prototype quantities) and initial profit margins may be below target levels. As demand increases for a product, various processes and systems must be used to support higher volume manufacturing. If we, our contract manufacturers or our licensees are unable to effectively and quickly scale manufacturing processes and systems, customers’ product quality and quantity requirements may not be met and we may not be able to attain the anticipated cost benefits from higher volume and achieve target gross margins. Consequently, our business and results of operations could be adversely affected.
 
We currently depend on a sole source contract manufacturer to build bicycle transmissions incorporating our NuVinci technology. If that contract manufacturer or contract manufacturers engaged by us for other products are unable to fulfill orders of finished goods of appropriate quality in a timely fashion, we will be unable to meet our revenue and profit goals.
 
We currently rely on a single contract manufacturer for bicycle transmissions and we intend to rely on future contract manufacturers for certain of our other products. Our contract manufacturer relies, in turn, on obtaining raw materials, parts and components, manufacturing equipment and other supplies from reliable suppliers in a timely manner. It may be difficult for our contract manufacturer to substitute one supplier for another, increase the number of its suppliers or change one component for another in a timely manner or at all due to the interruption of supply or increased industry demand. This may adversely affect our contract manufacturer’s ability to supply our product. The prices of raw materials, parts and components and manufacturing equipment may increase due to changes in supply and demand. In addition, currency fluctuations may affect both our and our contract manufacturer’s purchasing power. We are dependent on the ability of our contract manufacturers to manufacture products at a reasonable schedule and at acceptable cost and quality levels. Failure to meet our expectations could result in the cost of our product exceeding the purchase price paid to us by our customers. Delays in meeting demand and quality requirements could damage our customer relationships and result in significant lost business opportunities for us.


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Our restatement of our consolidated financial statements, and possible future restatements, may have a material adverse effect on us.
 
We have effected restatements of prior period financial results. Since inception through December 31, 2008, we valued our common stock, options, and warrants by a method that was not in accordance with generally accepted accounting principles in the United States, or GAAP. We had determined fair value based on Internal Revenue Code Section 409A, using a probability-weighted expected return valuation method. With the assistance of an unrelated valuation specialist, we have since reassessed the fair value of our common stock in accordance with GAAP by determining the total enterprise value and then allocating a portion of that total enterprise value to the common stock. This reassessment caused us to restate our consolidated financial statements as of December 31, 2008 and for each of the years ended December 31, 2007 and 2008.
 
Management’s previous election to value our common stock using a method not in accordance with GAAP was a material weakness that resulted in a qualified audit opinion. A material weakness is a significant deficiency, or combination of significant deficiencies, that result in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. We have remediated this material weakness by establishing an internal policy to assess the fair value of our common stock only in accordance with GAAP, by reassessing the prior years’ fair values of our common stock in accordance with GAAP and by making the necessary adjustments to our financial statements included in this prospectus.
 
If we are required to restate our consolidated financial statements in the future, we may be the subject of negative publicity focusing on financial statement inaccuracies and resulting restatement. In addition, our financial results as restated may be more adverse than originally reported. In the past, certain publicly traded companies that have restated their consolidated financial statements have been subject to shareholder actions. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our common stock to decline after this offering. Further, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate consolidated financial statements may have a material adverse effect on our stock price.
 
If we fail to maintain proper and effective internal controls, our ability to produce accurate consolidated financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and the trading price of our common stock.
 
As a public company, our management will be responsible for certifying the design of our internal control over financial reporting. Internal control over financial reporting is intended to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with applicable generally accepted accounting principles. Our efforts to institute effective internal control over financial reporting are likely to result in increased general and administrative expenses and the commitment of significant financial and personnel resources. The restatement of our consolidated financial statements relating to the valuation of our common stock prior to 2009 evidenced a material weakness in our internal control over financial reporting, which we have remediated by reassessing the fair value of our common stock in accordance with GAAP. Additionally, prior to having quarterly reporting requirements, we recorded an impairment loss on certain manufacturing assets during the fourth quarter of 2009. Subsequent to initiating interim reporting requirements, we recorded an adjustment to recognize a portion of this impairment in the third quarter of 2009, which evidenced a material weakness in our internal control over interim financial reporting. Although we have since instituted internal controls to support interim reporting requirements that would remediate this material weakness, we cannot be sure that we will not have other weaknesses in our internal controls in the future. Any failure to adequately maintain effective internal control over our financial reporting or, consequently, our inability to produce accurate consolidated financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate consolidated financial statements will likely have a negative effect on the trading price of our common stock.


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We will incur increased costs and demands upon management as a result of complying with the laws and regulations affecting public companies, which could harm our operating results.
 
As a public company, we will incur significant additional legal, accounting and other expenses that we did not incur as a private company, including costs associated with public company reporting requirements. We also have incurred and will incur costs associated with current corporate governance requirements, including requirements under Section 404 and other provisions of the Sarbanes-Oxley Act, as well as rules implemented by the Securities and Exchange Commission, or SEC, and other applicable regulators and stock exchanges. The expenses incurred by public companies for reporting and corporate governance purposes have increased dramatically in recent years. We expect these rules and regulations to substantially increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We are unable to currently estimate these costs with any certainty. We also expect these new rules and regulations will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage previously available. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our Board of Directors or as our executive officers.
 
Our international operations subject us to a number of risks, including unfavorable political, regulatory, labor and tax conditions.
 
We have manufacturing operations in China and expect to sell a significant portion of our products to customers located in other countries. Risks inherent to international operations and sales include, but are not limited to, the following:
 
  •   difficulty in enforcing agreements and intellectual property rights, particularly in China;
 
  •   fluctuations in exchange rates may affect product demand and our costs;
 
  •   fluctuations in exchange rates may cause foreign currency losses;
 
  •   impediments to the flow of foreign exchange capital payments and receipts;
 
  •   changes in general economic and political conditions;
 
  •   changes in foreign government regulations and technical standards;
 
  •   requirements or preferences of foreign nations for domestic products;
 
  •   compliance with the U.S. Foreign Corrupt Practices Act;
 
  •   diversion of management attention;
 
  •   trade barriers such as export requirements, tariffs and taxes;
 
  •   tax consequences from operating in multiple jurisdictions; and
 
  •   longer payment cycles typically associated with international sales and potential difficulties in collecting accounts receivable.
 
Our business in foreign jurisdictions will require us to respond to rapid changes in market conditions in these countries. Our overall success will depend on our ability to succeed in different legal, regulatory, economic, social and political situations and conditions. We may not be able to develop and implement effective policies and strategies in each foreign jurisdiction where we do business. Also, each of the foregoing risks will likely take on increased significance as we implement plans to expand foreign manufacturing operations.
 
Foreign exchange rate fluctuations may have a material impact on our operating revenue and product costs.
 
While to date all of our sales and costs are in U.S. dollars, in the future foreign exchange rate fluctuations may have a material impact on our operating and product costs. Our results of operations will be particularly sensitive to the fluctuation of the Chinese Renminbi against the U.S. dollar because while our sales are in U.S. dollars, most of our products will be manufactured in China. On July 21, 2005, the Chinese government changed its decade-old policy of pegging the value of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 17.5% appreciation of the Renminbi against the U.S. dollar


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between July 21, 2005 and December 31, 2009. While the international reaction to the Renminbi revaluation has generally been positive, there remains significant international pressure on the Chinese government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the Renminbi against the U.S. dollar. If the Renminbi were to appreciate against the U.S. dollar, the cost of our products manufactured in China would increase, which would have a negative impact on our margins, profitability and cash flows. If the U.S. dollar appreciates against the currencies of the other markets in which we sell, such as Europe, it may be harder to sell applications with our NuVinci technology and our product sales revenue may decrease. We do not currently hedge against foreign exchange risks.
 
Our ongoing manufacturing operations in China are complex and it may be difficult to establish adequate management and financial controls in China.
 
Currently, most of our manufacturing operations are based in China and are provided by a contract manufacturer. Our contractor requires our assistance in developing the skills, processes and knowledge necessary to manufacture and test our products. Any problems or disruptions requiring significant assistance from our company will require additional time for travel to support those operations in China. This may divert management’s attention, lead to disruptions in operations and delay implementation of our business strategy, all of which could negatively impact our profitability.
 
China has only recently begun to adopt management and financial reporting concepts and practices like those with which investors in North America are familiar. We may have difficulty in ensuring our manufacturer in China has the experience necessary to implement the kind of management and financial controls that are common for a North American company. If our contract manufacturer cannot establish and implement appropriate controls, we may experience great difficulty collecting relevant data necessary to manage our business effectively.
 
If our products fail to perform as expected, we could lose existing and future business and our ability to develop, market and sell our products and technology could be harmed.
 
Our products could have unknown defects or errors, which may give rise to claims against us, diminish the reputation of our brand or divert our resources. Despite testing, our existing products may contain defects and errors. In addition, future products may contain manufacturing or design defects, errors or performance problems when first introduced, when new versions or enhancements are released, or even after these products have been used by our customers for a period of time. These problems could result in expensive and time-consuming design modifications or warranty charges, delays in the introduction of new products or enhancements, significant increases in our service and maintenance costs, exposure to liability for damages, damaged customer relationships and harm to our reputation, any of which may adversely affect our business and our operating results.
 
Our success depends on our ability or that of our licensees to develop and successfully manufacture and commercialize products that are recognized as adding significant value. Significant value would include, with respect to the automotive industry for example, increased fuel economy, more effective power generation, longer range, or lower production costs compared to alternative products or technologies. In the automotive industry in particular, the design and development of a product or use is complex, expensive, time-consuming and subject to rigorous quality and performance requirements. If we are unable to design, develop and commercially manufacture products that are accepted for use in all of our target end markets, and in particular the automotive industry, our business and operating results may be adversely affected.
 
Product liability or other claims could cause us to incur losses.
 
We may be exposed to product liability claims for the products we manufacture and market as well as for products that our licensees manufacture and market. Although we have product liability insurance for our products, this may be inadequate to cover all potential product liability claims. In addition, while we generally seek to limit our product liability in our contracts, such limits may be unenforceable or may be subject to


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exceptions. Any lawsuit seeking significant monetary damages either in excess of our coverage, or outside of our coverage, may have a material adverse affect on our business and financial condition.
 
We are subject to financial and reputational risks due to product recalls resulting from product quality and liability issues.
 
Product quality and liability issues present significant risks and may affect not only our own products but also the third-party products that incorporate our technology. Our efforts and the efforts of our contract manufacturers and licensees to maintain product quality may not be successful, and if they are not, we may incur expenses in connection with, for example, product recalls and lawsuits, and our brand image and reputation as a producer of high-quality products may suffer. Any product recall or lawsuit seeking significant monetary damages could have a material adverse effect on our business and financial condition. A product recall could generate substantial negative publicity about our products and business, interfere with our manufacturing plans and product delivery obligations as we seek to replace or repair affected products, and inhibit or prevent commercialization of other future product candidates. We do not have insurance to cover the costs associated with a product recall. In addition, the expenses and negative publicity we would incur in connection with a product recall would adversely affect our business and operating results.
 
Our facilities or operations could be damaged or adversely affected as a result of disasters or unpredictable events, including widespread public health problems.
 
Our corporate headquarters is located in San Diego, California. Some management personnel and the majority of our staff are located in Texas. If major disasters such as earthquakes, fires, floods, hurricanes, wars, terrorist attacks, computer viruses, pandemics or other events occur, or our information system or communications network breaks down or operates improperly, our facilities may be seriously damaged, or we may have to stop or delay production and shipment of our products. We may incur expenses relating to such damages. In addition, a widespread health problem, such as the H1N1 flu, in the United States, China, or elsewhere in the world could have a negative effect on our operations.
 
Our financial results may vary significantly from period-to-period because of the unpredictability of revenues associated with the launch of a new product by an early stage company and the seasonality of our target end markets, which may lead to volatility in our stock price.
 
Due to unpredictable demand by consumers, technical risks, competitive response and other factors associated with early stage companies, we expect to experience unpredictable sales in connection with the initial launch of our products in each of our target end markets.
 
In addition, we are exposed to the seasonality of our target end markets. In the bicycle transmission market, 50% of our unit sales are likely to occur in the period from December to March because of the model year timing of bicycle OEMs. Only 15% of unit sales are likely to occur in the period from April to July and the remaining 35% in the period from July to November. Additionally, there may be long and unpredictable sales cycles for some of our other products that we may sell directly or will be sold by our licensees. For instance, the lawn care equipment market is subject to substantial seasonal variation in sales, and also depends heavily on annual precipitation. In addition, since transmissions with our technology are incorporated into our customers’ products for sale into their respective end markets, the seasonality of our customers’ product sales will impact the seasonality of our business.
 
Because many of our expenses are based on anticipated levels of annual revenue, our business and operating results could also be adversely affected if we do not achieve revenue consistent with our expectations for this seasonal demand. Accordingly, our financial results could vary significantly from period to period and if our operating results do not coincide with the expectations of investors or equity research analysts, the trading price of our common stock could fall.


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If our warranty expense estimates differ materially from our actual claims, or if we are unable to estimate future warranty expense for new products, our business and financial results could be harmed.
 
Our warranty for our bicycle transmission is currently six years. We expect that the warranty for our next generation bicycle transmission, the N360, will be two years, which is comparable to that offered in the bicycle industry for other transmissions. Since the bicycle transmissions using our technology were first sold in the consumer market in 2007, we have a limited product history on which to base our warranty estimates. Other products utilizing our technology are not yet available commercially and there is no warranty history. Because of our limited operating history, our management is required to make assumptions and to apply judgment regarding a number of factors, including anticipated rate of warranty claims, the durability and reliability of our products, and service delivery costs. Our assumptions could prove to be materially different from actual performance, which could cause us to incur substantial expense to repair or replace defective products in the future and may exceed expected levels against which we have reserved. If our estimates prove incorrect, we could be required to accrue additional expenses from the time we realize our estimates are incorrect and also face a significant unplanned cash burden at the time our customers make a warranty claim, which could adversely affect our business and operating results.
 
In addition, with our new products and products that remain under development, we will be required to base our warranty estimates on historical experience of similar products, testing of our products and performance information learned during our development activities with the customer. If we are unable to estimate future warranty costs for any new product, we may realize a lower gross margin on such products than we have estimated, which might result in our financial results varying significantly from period-to-period.
 
While we have not yet been profitable, if we fail to manage our growth effectively, we may be unable to execute our business plan, maintain high levels of service or address competitive challenges adequately.
 
While there is no guarantee that we will achieve rapid growth, or any growth at all, we are planning for the possibility of rapid sales growth for our products. Expanding our sales rapidly will require increases in expenditures both for personnel and marketing programs and working capital. In addition, expanding our organization globally and managing a geographically dispersed workforce will require substantial management effort and significant additional investment in support systems. We will be required to continue to improve our operational, financial and management controls and reporting. We may not be able to do so effectively or as rapidly as desired, which could cause inefficiencies in managing our expenses effectively in the future, negatively impacting our operating results in any particular quarter.
 
We are currently implementing new software systems to support our business operations. If these implementations are not successful, our business and operations could be disrupted and our operating results could be harmed.
 
We are currently implementing new software systems to assist us in the management of our business. The implementation of new software systems require significant management time, support and cost. We expect the implementation and enhancements of these platforms to continue across new and existing sites worldwide. In addition, as our business continues to develop, we expect to add or enhance existing systems in the areas of engineering, sales, and customer support and warranty management. We cannot be sure that these systems will be fully or effectively implemented on a timely basis, if at all, and implementation may take more resources than expected, which could cause disruption in our operations and an unanticipated increase in our operating expenses.
 
Risks Related to Intellectual Property
 
Parties may bring intellectual property infringement claims against us that would be time-consuming and expensive to defend, and if any of our products or processes are found to be infringing, we will be required to attempt to license the necessary patent or redesign our products or processes, failing which we will be unable to manufacture, use or sell those respective products or processes that were found to be infringing.
 
Our success depends in part on avoiding the infringement of other parties’ patents and proprietary rights. We may inadvertently infringe existing third-party patents or third-party patents issued on existing patent


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applications. Around the world, most patent applications are confidential until they are published 18 months after filing. However, currently in the U.S. not all patent applications must be published prior to issuance even after 18 months of filing. With patent applications that have not been published, we would not have had an opportunity to try and perform any diligence, as we would be unaware of such pending applications.
 
Because of the sheer volume of patents in the U.S. and other jurisdictions and the various terminology used to describe components, we can never be sure we do not infringe third-party patents. Those holding ownership or exclusive rights in any patents could bring claims against us that, in any event, could cause us to incur substantial expenses and, if resolved against us, could also cause us to pay substantial damages. Under certain circumstances in the United States, these damages could be triple the actual damages the patent holder incurs. If we have supplied infringing products to third parties for marketing or licensed third parties to manufacture, use or market infringing products, we may be obligated to indemnify these third parties for any damages they may be required to pay to the patent holder and for any losses the third parties may sustain themselves as the result of lost sales or damages paid to the patent holder. In addition, we may have, and may be required to, make representations as to our right to supply intellectual property, license intellectual property and to our compliance with laws.
 
If a patent infringement suit were brought against us, we and our customers, development partners and licensees could be forced to stop, delay or modify research, development, manufacture or sales of products based on our technologies in the country or countries covered by the patent or patents we infringe, unless we can obtain a license from the patent holder. Such a license may not be available on acceptable terms, or at all, particularly if the third party is developing or marketing a product competitive with products based on our technologies. Even if we were able to obtain a license, the rights may be nonexclusive, which could give our competitors access to the same intellectual property acquired under such a license.
 
Any successful infringement action brought against us may also adversely affect marketing of products based on our technologies in other markets not covered by the infringement action. Furthermore, even if we are successful in defending or settling a patent infringement action against, it could be costly to defend, require significant time and attention of our key management and technical personnel, and could harm our reputation and competitive position.
 
We may be involved in lawsuits to protect or enforce our patents, which would be expensive and time consuming.
 
Competitors or third parties may infringe our patents. We may be required to file patent infringement claims, which can be expensive and time-consuming. Patent litigation requires the use of expert legal counsel and witnesses who are experts in the field of technology. This litigation is subject to time consuming processes and because of the complexity involved, there is a significant amount of uncertainty and cost involved.
 
This is particularly the case in countries outside the U.S. due to multiple factors. U.S. patents are only enforceable in the U.S. — in a foreign country we must have patents issued by that country’s government to enforce against infringers in that country. We will be subject to different laws and procedures in that country such as service of process against a defendant, the requesting and issuance of temporary or permanent injunctions of infringement, standing to file an infringement case, and whether jury trials are available, as examples. Similarly, our foreign patents are not enforceable in the U.S. and we must therefore rely on U.S. patents against infringers in the U.S. Due to the high complexity and cost inherent in any patent litigation, initiating or defending such actions in foreign countries where these differences in procedures, the law and languages add additional strain and uncertainty is even more costly and time consuming.
 
In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or that the third party’s technology does not in fact infringe upon our patents. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly and could put our related pending patent applications at risk of not issuing. Even if successful, litigation may result in substantial costs and be a distraction to our management.


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Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential or sensitive information could be compromised by disclosure in the event of litigation. In addition, during the course of litigation there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.
 
Our patent applications may not result in issued patents, which may have a material adverse effect on our ability to prevent others from commercially exploiting products similar to ours.
 
Patent applications in the United States are maintained in secrecy until the patents are published or, in some cases, are issued. We cannot be certain that we are the first creator of inventions covered by pending patent applications or the first to file patent applications on these inventions. We also cannot be certain that our pending patent applications will result in issued patents or that any of our issued patents will afford protection against a competitor. In addition, patent applications filed in foreign countries are subject to laws, rules and procedures that differ from those of the United States, and thus we cannot be certain that foreign patent applications related to issued United States patents will be issued. Furthermore, if these patent applications issue, some foreign countries provide significantly less effective patent enforcement mechanisms than in the United States.
 
The patent application process involves complex legal and factual questions and it is difficult to definitively determine whether any claimed invention in a patent application will go on to issue. Accordingly, we cannot be certain that the patent applications that we file will result in issued patents, or that our patents and any patents that may be issued to us in the near future will afford protection against competitors with similar technology.
 
Challenges to our patent rights can result in costly and time-consuming legal proceedings that may prevent or limit development of our products.
 
Outside of the United States, certain jurisdictions, including in Europe, permit oppositions to be filed against the granting of patents within a certain period of their grant. Because our intent is to commercialize products internationally and specifically in Europe, securing both proprietary protection and freedom to operate outside of the United States is important to our business. While we are not currently involved in any opposition proceedings, it is not uncommon for market incumbents to seek and institute opposition proceedings against emerging market companies to gain competitive advantage. European opposition and appeal proceedings can take several years to reach final decision and are therefore costly and not expedient and can cast doubt on the status of the patent during those proceedings. Patent opposition proceedings are not currently available in the United States patent system, but are likely to be instituted in the near future under proposed legislation.
 
While opposition proceedings as they exist in Europe do not currently exist in the United States, issued United States patents can be reexamined by the Patent and Trademark Office (PTO), at the request of a third party. While we are currently not involved in any such proceedings, our competitors may decide to request reexamination by the PTO with respect to any or all of our issued United States patents if they are in possession of prior art in relation to an issued patent that represents a substantial new question of its patentability. Patent reexamination proceedings, like opposition proceedings, are long and complex and therefore costly and, as in any legal proceeding, the outcome of patent reexaminations is uncertain. A decision adverse to our interests could result in the loss of valuable patent rights.
 
Where more than one party seeks United States patent protection for the same technology, the PTO may declare an interference proceeding in order to ascertain the party to which the patent should be issued. Patent interferences are typically complex, highly contested legal proceedings, subject to appeal, that are lengthy and expensive and an adverse decision in interference can result in the loss of important patent rights. As more groups become engaged in scientific research and product development related to our NuVinci CVT technology, the risk of our patents being challenged through patent interferences, oppositions, reexaminations or other means will likely increase, and our pending patent applications, or our issued patents, may be drawn


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into interference proceedings that may delay or prevent the issuance of patents, or result in the loss of issued patent rights.
 
Successful challenges to our patents through oppositions, reexamination proceedings or interference proceedings could result in a loss of patent rights in the relevant jurisdiction. If we are unsuccessful in actions we bring against the patents of other parties and it is determined that we infringe the patents of third-parties, we may be subject to litigation, or otherwise prevented from commercializing potential products in the relevant jurisdiction, or may be required to obtain licenses to those patents or develop or obtain alternative technologies, any of which could harm our business. Furthermore, if such challenges to our patent rights are not resolved promptly in our favor, our existing business relationships may be jeopardized and we could be delayed or prevented from entering into new collaborations or from commercializing certain products, which could adversely affect our business and results of operations.
 
We may be unable to adequately prevent disclosure of trade secrets and other proprietary information.
 
We rely on trade secrets to protect some aspects of our proprietary technology, especially where we do not believe patent protection is appropriate or obtainable. Confidentiality agreements with our employees, contractors, consultants, development partners and other advisors to protect our trade secrets and other proprietary information may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover our trade secrets or independently develop processes or products that are similar or identical to our trade secrets, and courts outside the United States may be less willing to protect trade secrets. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
 
Risks Related to this Offering and Ownership of Our Common Stock
 
Our management will have broad discretion over the use of the proceeds we receive in this offering and might not apply the proceeds in ways that increase the value of your investment.
 
Our management will have broad discretion to use our net proceeds from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. We expect to use the net proceeds from this offering for general corporate purposes, including the repayment of indebtedness. However, our management might not apply our net proceeds from this offering in ways that increase the value of your investment, and you will not have the opportunity to influence our decisions on how to use our net proceeds from this offering.
 
Our 5% or greater stockholders and executive officers could have substantial influence over us, and they may act to the detriment of other stockholders.
 
Our 5% or greater stockholders, directors and executive officers, as a group, beneficially own approximately 63.6% of our outstanding common stock on an as-converted basis as of August 25, 2010. However, none of these parties individually own more than 25% of the voting interests of the Company and none of these parties individually has control over our management’s operating policies or business decisions. Following this offering, this group will beneficially own approximately     % of our outstanding common stock. While there is no voting agreement among this group that provides it control, this group could have substantial influence over our business and affairs, including the ability to influence elections of our directors and any other actions that may require stockholder approval, such as amendments to our charter documents and significant corporate transactions. This concentration of ownership could also have the effect of delaying or preventing a change in control that could be beneficial to the other stockholders.


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An active trading market for our common stock may not develop, and you may not be able to resell your shares at or above the initial public offering price.
 
Prior to this offering, there has been no public market for shares of our common stock and we cannot assure you that one will develop or be sustained after the offering. If a market does not develop or is not sustained, it may be difficult for you to sell your shares of our common stock at an attractive price or at all. The initial public offering price of our common stock will be determined through negotiations between us and the underwriters. This initial public offering price may not be indicative of the market price of our common stock after the offering. In the absence of an active trading market for our common stock, investors may not be able to sell their common stock at or above the initial public offering price or at the time that they would like to sell.
 
Our stock price may be volatile, and the market price of our common stock after this offering may drop below the price you pay.
 
The market price of our common stock could be subject to significant fluctuations after this offering, and it may decline below the initial public offering price. Market prices for securities of early stage companies have historically been particularly volatile. As a result of this volatility, you may not be able to sell your common stock at or above the initial public offering price. In addition, if the market for technology stocks or the stock market in general experiences a loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, financial condition or results of operations. If any of the foregoing occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management. In the past, securities class action litigation has often been instituted against companies following periods of volatility in their stock price. This type of litigation even if it does not result in liability for us, could result in substantial costs to us and divert management attention and resources.
 
A significant portion of our total outstanding shares may be sold into the public market in the near future, which could cause the market price of our common stock to drop significantly, even if our business is doing well.
 
Sales of a substantial number of shares of our common stock in the public market could occur at any time after the expiration of the lock-up agreements described in the “Underwriting” section of this prospectus. These sales, or the market perception that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock. Based on shares outstanding as of          , upon completion of this offering we will have outstanding          shares of common stock, assuming no exercise of the underwriters’ over-allotment option. This includes          shares, which may be resold in the public market immediately. Of the remaining shares,          shares of common stock will be subject to a 180-day contractual lock-up with the underwriters. These shares will be able to be sold, subject to any applicable volume limitations under applicable securities laws, after the earlier of the expiration of, or release from, the 180-day lock-up period. CIBC World Markets Inc. and Mackie Research Capital Corporation, on behalf of the underwriters, may permit our officers, directors, employees and current stockholders who are subject to the contractual lock-up to sell shares prior to the expiration of the lock-up agreements.
 
Purchasers in this offering will experience immediate and substantial dilution in the book value of their investment.
 
The assumed initial public offering price of our common stock is substantially higher than the net tangible book value per share of our outstanding common stock immediately after this offering. Therefore, if you purchase our common stock in this offering, you will incur immediate dilution of $     in net tangible book value per share from the price you paid. Moreover, we issued options in the past to acquire common stock. As of June 30, 2010, 12,971,571 shares of common stock are issuable upon exercise of outstanding stock options with a weighted average exercise price of $0.24 per share, of which 6,221,566 are vested as of such date. To the extent that these outstanding options are ultimately exercised, you will incur further dilution.


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If securities or industry analysts do not publish or cease publishing research or reports about us, our business or our market, or if they change their recommendations regarding our stock adversely, our stock price and trading volume could decline.
 
The trading market for our common stock will be influenced by the research and reports that industry or securities analysts may publish about us, our business, our market or our competitors. If any of the analysts who may cover us change their recommendation regarding our stock adversely, or provide more favorable relative recommendations about our competitors, our stock price would likely decline. If any analyst who may cover us were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.
 
Anti-takeover provisions contained in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could impair a takeover attempt.
 
Delaware law and our certificate of incorporation and bylaws that will be adopted in connection with the completion of this offering contain provisions that could have the effect of rendering more difficult or discouraging an acquisition deemed undesirable by our Board of Directors. These provisions include:
 
  •   authorizing blank check preferred stock, which could be issued with voting, liquidation, dividend and other rights superior to our common stock;
 
  •   limiting the liability of, and providing indemnification to, our directors and officers;
 
  •   prohibiting our stockholders from taking any action by written consent in lieu of a meeting;
 
  •   prohibiting our stockholders from calling and bringing business before special meetings; and
 
  •   the filling of vacancies or newly created seats on the board to our Board of Directors then in office.
 
As a Delaware corporation, we are also subject to provisions of Delaware law, including Section 203 of the Delaware General Corporation law, which prevents some stockholders holding more than 15% of our outstanding common stock from engaging in certain business combinations without approval of the holders of substantially all of our outstanding common stock.
 
Any provision of our amended and restated certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also affect the price that some investors are willing to pay for our common stock.


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Special Note Regarding Forward-Looking Statements
 
This prospectus contains estimates and forward-looking statements, principally in “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Business.” Our estimates and forward-looking statements are mainly based on our current expectations and estimates of future events and trends, which affect or may affect our businesses and operations. Although we believe that these estimates and forward-looking statements are based upon reasonable assumptions, they are subject to several risks and uncertainties and are made in light of information currently available to us. Many important factors, in addition to the factors described in this prospectus, may adversely affect our results as indicated in forward-looking statements. You should read this prospectus and the documents that we have filed as exhibits to the registration statement of which this prospectus is a part completely and with the understanding that our actual future results may be materially different from what we expect.
 
Our estimates and forward-looking statements may be influenced by the following factors, among others:
 
  •   the factors discussed in this prospectus set forth under the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”;
 
  •   the depth and duration of the current economic downturn;
 
  •   lack of acceptance of new products or technology;
 
  •   projected expenditures and other costs;
 
  •   the ability to obtain financing;
 
  •   our dependence on our key management personnel and our ability to attract and retain qualified personnel; and
 
  •   changes in the competitive environment in our industry and the markets where we operate.
 
The words “believe,” “may,” “will,” “aim,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan” and similar words are intended to identify estimates and forward-looking statements.
 
Estimates and forward-looking statements speak only as of the date they were made and, except to the extent required by applicable laws, we undertake no obligation to update or to review any estimate and/or forward-looking statement because of new information, future events or other factors. Estimates and forward-looking statements involve risks and uncertainties and are not guarantees of future performance. As a result of the risks and uncertainties described above, the estimates and forward-looking statements discussed in this prospectus might not occur and our future results and our performance may differ materially from those expressed in these forward-looking statements due to, including, but not limited to, the factors mentioned above. Because of these uncertainties, you should not place undue reliance on these forward-looking statements when making an investment decision.


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Use of Proceeds
 
We estimate that the net proceeds to us from the sale of           shares of common stock in this offering will be approximately $      million, assuming an initial public offering price of $      per share, which is the midpoint of the range set forth on the cover page of this prospectus, and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.
 
We intend to use the net proceeds from this offering for general corporate purposes and for the repayment of indebtedness on our line of credit, the proceeds of which $2.0 million was borrowed on April 2, 2008 to purchase manufacturing assets and $0.5 million was borrowed on August 2, 2010 to fund working capital. The revolving line of credit expires December 31, 2010 and bears interest at a fluctuating rate equal to the highest of the prime rate, LIBOR plus 1.5%, or the Federal Funds Rate plus 1.5%. The highest rate was 3.25% under the prime rate as of June 30, 2010. As a result, management will retain broad discretion over the allocation of the net proceeds from this offering. Pending use of the net proceeds from this offering, we intend to invest the net proceeds in short-term, interest-bearing, investment-grade securities.
 
An increase or decrease of           shares from the expected number of shares to be sold by us in the offering, assuming no change in the assumed initial public offering price per share, would increase or decrease our net proceeds from this offering by $      . A $1.00 increase or decrease in the assumed public offering price of $      per share, the midpoint of the range set forth on the front cover of this prospectus, would increase or decrease our expected net proceeds by approximately $      , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. We expect to use any additional net proceeds from this offering for general corporate purposes.


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Dividend Policy
 
We have never declared or paid cash dividends on our common stock. However, in connection with the Series E Preferred Stock private financing that closed in August 2010, dividends shall accrue on a cumulative annual basis on each share of Series E Preferred Stock at an annual rate of $0.09160 per share (10% of original issuance price) whether or not declared. If the Series E Preferred Stock has not been converted to common stock on or prior to the two-year anniversary date of issuance, the annual dividend rate shall increase to $0.11908 per share. Accumulated dividends are payable in the form of common stock upon conversion of the Series E Preferred Stock. If the Series E Preferred Stock has not converted on or before August 13, 2012, then, at the request of the shareholder, the shares can be redeemed for cash. We currently intend to retain all of our future earnings, if any, generated by our operations for the development and growth of our business. The payment of any dividends in the future will be at the discretion of our Board of Directors and will depend upon our financial condition, results of operations, earnings, capital requirements, contractual restrictions, outstanding indebtedness, and other factors deemed relevant by our board. Additionally, our revolving line of credit restricts the declaration or payment of dividends without the bank’s prior written consent. As a result, you may need to sell your shares of common stock to realize a return on your investment, and you may not be able to sell your shares at or above the price you paid for them.


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Conversion of Preferred Stock into Common Stock
 
We currently have five series of outstanding preferred stock:
 
                         
    Number of Shares Outstanding
    Conversion
    Equivalent Shares of
 
Preferred Stock
  as of August 25, 2010     Ratio     Common Stock  
 
Series A
    3,887,577       1.4424       5,607,441  
Series B
    4,786,444       2.0868       9,988,351  
Series C
    3,012,765       3.9444       11,883,550  
Series D
    73,627,442       1.0000       73,627,442  
Series E
    6,550,218       1.0000 (1)     6,550,218 (2)
                         
 Total
    91,864,446               107,657,002  
                         
 
 
(1) The initial conversion ratio for the Series E Preferred Stock is 1.0000 based on the original issuance price of $0.9160 divided by the conversion price of $0.9160, subject to adjustment for certain events, such as an initial public offering. In the event of an initial public offering with aggregate net proceeds of not less than $20 million or a reverse take-over of a company listed on an internationally recognized securities exchange immediately followed by a minimum $20 million equity financing, the conversion price will be an amount equal to the lesser of (A) a 20% discount to the common stock offering price, and (B) a per share price equal to $120 million divided by the total number of outstanding shares of common stock deemed to be outstanding immediately prior to the qualifying event.
 
(2) The number of equivalent shares of common stock does not include dividends, which shall accrue on a cumulative annual basis on each share of Series E Preferred Stock at an annual rate of $0.09160 per share (10% of original issuance price) whether or not declared. If the Series E Preferred Stock has not been converted to common stock on or prior to the two-year anniversary date of issuance, the annual dividend rate shall increase to $0.11908 per share. Accumulated dividends are payable in the form of common stock upon conversion of the Series E Preferred Stock. If the Series E Preferred Stock has not converted on or before August 13, 2012, then, at the request of the shareholder, the shares can be redeemed for cash.
 
Effective immediately prior to this offering, all of our outstanding preferred stock will be converted into           shares of our common stock.
 
Indebtedness
 
We have a $3,000,000 revolving line of credit with Wells Fargo Bank, National Association, of which $2,500,000 is outstanding as of August 25, 2010. The line of credit is fully collateralized by assets held on account with the lender by a stockholder and director of our company. The line of credit imposes no restrictive financial covenants on the Company. The outstanding principal balance bears interest at a fluctuating rate equal to the highest of the prime rate, LIBOR plus 1.5%, or the Federal Funds Rate plus 1.5%. The highest rate was 3.25% under the prime rate as of June 30, 2010. The line of credit provides for a quarterly unused commitment fee of 0.375% per annum on the average daily unused amount. Up to $2,000,000 of the line of credit may be used to finance standby letters of credit, with maximum maturities of one year. The line of credit expires December 31, 2010.
 
We intend to repay the outstanding balance under this revolving line of credit with the net proceeds of this offering.


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Capitalization
 
The following table sets forth our capitalization as of June 30, 2010:
 
  •   On an actual basis;
 
  •   On a pro forma basis, to give effect to the automatic conversion of all outstanding shares of our convertible preferred stock into 101,106,784 shares of common stock (as of June 30, 2010) upon the closing of this offering, which we refer to as the “Conversion”; and
 
  •   On an as adjusted basis, giving effect to:
 
  •   the Conversion;
 
  •   the issuance of          shares of our common stock upon the exercise of warrants that would otherwise expire immediately prior to the closing of the offering;
 
  •   our sale of           shares of our common stock in this offering (at an assumed initial public offering price of $      per share, which is the midpoint of the range set forth on the cover page of this prospectus and after deducting underwriting discounts and commissions and estimated offering expenses payable by us); and
 
  •   our repayment of $2.0 million in short-term debt with the net proceeds from this offering.
.
 
                         
    As of June 30, 2010  
    Actual     Pro Forma     As Adjusted(1)  
    ($ in thousands)  
 
Cash and cash equivalents
  $ 1,542     $ 1,542          
                         
Short-term debt
  $ 2,000     $ 2,000          
Equity:
                       
Series A convertible preferred stock: $0.001 par value; 3,887,577 shares authorized, issued and outstanding, actual
    479                
Series B convertible preferred stock: $0.001 par value; 4,786,444 shares authorized, issued and outstanding, actual
    8,202                
Series C convertible preferred stock: $0.001 par value; 3,012,765 shares authorized, issued and outstanding, actual
    16,040                
Series D convertible preferred stock: $0.001 par value; 78,637,462 shares authorized, 73,627,442 shares issued and outstanding, actual
    27,735                
Common stock: $0.001 par value; 140,000,000 shares authorized, 11,660,855 shares issued and outstanding, actual;           shares authorized,           shares issued and outstanding, as adjusted
    12       113          
Additional paid-in capital
    3,018       55,373          
Accumulated other comprehensive loss — foreign transaction loss
    (2 )     (2 )        
Accumulated deficit
    (52,213 )     (52,213 )        
                         
Total equity
    3,271       3,271          
                         
Total capitalization
  $ 5,271     $ 5,271          
                         
 
 
 
(1) A $1.00 increase or decrease in the assumed initial public offering price per share would increase or decrease cash and cash equivalents by $      million, would increase or decrease additional paid-in capital by $      million, and would increase or decrease total stockholders’ equity and total capitalization by $      million, after deducting the underwriting discount and the estimated offering expenses payable by us. Similarly, any increase or decrease in the number of shares that we sell in the offering will increase or decrease our net proceeds by such increase or decrease, as applicable, multiplied by the offering price per share, less underwriting discounts and commissions and offering expenses.


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The table above does not include:
 
  •   $6,000,000 in gross cash proceeds from the issuance of 6,550,218 shares of Series E redeemable convertible preferred stock, $0.001 par value, issued in August 2010, which will be classified as temporary equity;
 
  •              shares of common stock reserved or issuable pursuant to our 2010 Stock Plan;
 
  •              shares of common stock issuable upon the exercise of outstanding options to purchase common stock under our 2004 Stock Plan;
 
  •   3,100,753 shares of common stock issuable upon the exercise of an outstanding warrant held by the Jacobs Family Trust;
 
  •   up to 650,000 shares of common stock issuable pursuant to contingent warrants that may be granted upon achievement of certain performance milestones; and
 
  •   the exercise by the underwriters of their option to purchase up to           additional shares from us.
 
You should read this capitalization table together with “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Selected Consolidated Financial Data,” and our consolidated financial statements and related notes included elsewhere in this prospectus.


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Dilution
 
Purchasers of the common stock in the offering will suffer an immediate and substantial dilution in net tangible book value per share. Dilution is the amount by which the initial public offering price paid by purchasers of shares of common stock in this initial public offering exceeds the net tangible book value per share of our common stock immediately after completion of the offering. Net tangible book value per share represents the amount of our total tangible assets (calculated as total assets minus intangible assets and deferred costs) reduced by our total liabilities, divided by the number of shares of common stock outstanding.
 
As of June 30, 2010, our net tangible book value was approximately ($3,627,000), or ($0.31) per share, based on 11,660,855 shares of common stock outstanding.
 
After giving effect to (a) the automatic conversion of all outstanding shares of our convertible preferred stock into           shares of common stock, (b) the issuance of           shares of common stock upon the exercise of warrants that would otherwise expire immediately prior to the closing of the offering, (c) our repayment of $2.0 million in short-term debt with the net proceeds from this offering, and (d) the sale of           shares of common stock in this offering at an assumed public offering price of $      per share, which is the midpoint of the estimated price range set forth on the cover page of this prospectus and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, our as adjusted net tangible book value as of June 30, 2010 would have been approximately $     , or $      per share. This represents an immediate increase in as adjusted net tangible book value per share of $      to existing stockholders and an immediate dilution of $      per share to new investors. The following table illustrates this per share dilution:
 
                 
Assumed initial public offering price
              $        
                 
Net tangible book value per share as of June 30, 2010
  ($ 0.31 )        
Increase per share attributable to this offering
               
                 
As adjusted net tangible book value per share after giving effect to this offering
               
                 
Dilution per share to new investors in this offering
          $    
                 
 
A $1.00 increase or decrease in the assumed initial public offering price of $      per share would increase or decrease, as applicable, our as adjusted net tangible book value per share of common stock by $     , and increase or decrease, as applicable, the dilution per share of common stock to new investors by $     , assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. Similarly, any increase or decrease in the number of shares that we sell in the offering will increase or decrease our net proceeds in proportion to such increase or decrease, as applicable, multiplied by the offering price per share, less underwriting discounts and commissions and offering expenses.
 
The following table sets forth, as of June 30, 2010, on the as adjusted basis described above, the differences between existing stockholders and new investors with respect to the total number of shares of common stock purchased from us, the total consideration paid, and the average price per share paid before deducting underwriting discounts and commissions and estimated offering expenses payable by us, at an assumed initial public offering price of $      per share of common stock, which is the midpoint of the range set forth on the cover page of this prospectus:
                                         
                            Average
 
    Shares Purchased     Total Consideration     Price per
 
    Number     Percent     Amount     Percent     Share  
 
Existing stockholders
                %   $             %   $        
New investors
                                       
                                         
Total
            100.00 %             100.00 %        


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The foregoing tables and calculations do not include:
 
  •   $6,000,000 in gross cash proceeds from the issuance of 6,550,218 shares of Series E redeemable convertible preferred stock, $0.001 par value, issued in August 2010, which will be classified as temporary equity;
 
  •              shares of common stock reserved or issuable pursuant to our 2010 Stock Plan;
 
  •              shares of common stock issuable upon the exercise of outstanding options to purchase common stock under our 2004 Stock Plan;
 
  •   3,100,753 shares of common stock issuable upon the exercise of an outstanding warrant held by the Jacobs Family Trust;
 
  •   up to 650,000 shares of common stock issuable pursuant to contingent warrants that may be granted upon achievement of certain performance milestones; and
 
  •   the exercise by the underwriters of their option to purchase up to           additional shares from us.


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Selected Consolidated Financial Data
 
We derived the selected consolidated statement of operations data and the selected consolidated statement of cash flows data for the years ended December 31, 2007 and 2008, as restated (see Note 16 to our audited consolidated financial statements), and December 31, 2009, and the selected consolidated balance sheet data as of December 31, 2008, as restated (see Note 16 to our audited consolidated financial statements), and December 31, 2009, from our audited consolidated financial statements included elsewhere in this prospectus. We derived the selected consolidated statement of operations data and the selected consolidated statement of cash flows data for the years ended December 31, 2005 and 2006 and the selected consolidated balance sheet data as of December 31, 2005, 2006 and 2007 from our audited consolidated financial statements, as restated, which are not included in this prospectus and include restatement adjustments for similar items as discussed in Note 16 to our audited consolidated financial statements. We derived the selected consolidated statement of operations data and selected consolidated statement of cash flows data for the six months ended June 30, 2009 and 2010 and the selected consolidated balance sheet data as of June 30, 2010 from our unaudited condensed consolidated interim financial statements included elsewhere in this prospectus.
 
We have prepared the unaudited consolidated interim financial statements on the same basis as our audited consolidated financial statements and, in our opinion, have included all adjustments, which include only normal recurring adjustments necessary to present fairly, in all material respects, our financial position and results of operations. The results for any interim period are not necessarily indicative of the results that may be expected for the full year. Additionally, our historical results are not necessarily indicative of the results expected for any future period.
 
You should read the selected historical financial data together with the consolidated financial statements and related notes appearing elsewhere in this prospectus, as well as “Prospectus Summary — Summary Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the other financial information included elsewhere in this prospectus.
 
Consolidated Statement of Operations Data:
 
                                                         
          Six Months Ended
 
    Year Ended December 31,     June 30,  
    2005     2006     2007(1)     2008(1)     2009     2009     2010  
    ($ in thousands, except per share data)  
 
Revenues
  $ 40     $ 97     $ 714     $ 2,283     $ 1,044     $ 672     $ 460  
Cost of revenues
    12       283       1,892       2,048       7,260       2,129       521  
Gross (loss) profit
    28       (186 )     (1,178 )     235       (6,216 )     (1,457 )     (61 )
Operating expenses
    4,961       6,558       5,827       10,321       10,523       4,988       6,614  
Operating loss
    (4,933 )     (6,744 )     (7,005 )     (10,086 )     (16,739 )     (6,445 )     (6,675 )
Other income (expense)
    122       490       447       (470 )     (487 )     15       (51 )
                                                         
Net loss
    (4,811 )     (6,254 )     (6,558 )     (10,556 )     (17,226 )     (6,430 )     (6,726 )
                                                         
Less: Discount related to beneficial conversion feature on Preferred Stock
                      (1,376 )                  
                                                         
Net loss attributable to Fallbrook Technologies Inc. common stockholders
  $ (4,811 )   $ (6,254 )   $ (6,558 )   $ (11,932 )   $ (17,226 )   $ (6,430 )   $ (6,726 )
                                                         
Net loss per share—basic and diluted
  $ (0.42 )   $ (0.55 )   $ (0.57 )   $ (1.04 )   $ (1.48 )   $ (0.55 )   $ (0.58 )
Weighted average shares outstanding—basic and diluted
    11,422       11,422       11,437       11,462       11,656       11,654       11,661  
Pro forma net loss per share—basic and diluted (unaudited)(2)
                                  $               $    
Pro forma weighted average shares outstanding—basic and diluted (unaudited)(2)
                                                       


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Consolidated Balance Sheet Data:
 
                                                 
    As of December 31,     June 30,
 
    2005     2006(3)     2007(1)     2008(4)     2009     2010  
    ($ in thousands)  
 
Cash and cash equivalents
  $ 4,195     $ 3,218     $ 8,043     $ 14,565     $ 9,213     $ 1,542  
Total assets
    11,153       14,105       10,855       25,314       13,526       9,290  
Total liabilities
    505       1,764       2,158       3,171       3,813       6,019  
Convertible preferred stock
    17,091       24,721       24,721       48,566       52,456       52,456  
Accumulated deficit
    (7,252 )     (13,506 )     (20,064 )     (28,261 )     (45,487 )     (52,213 )
Total equity
    10,648       12,341       8,697       22,143       9,713       3,271  
 
Consolidated Statement of Cash Flows Data:
 
                                                         
          Six Months Ended
 
    Year Ended December 31,     June 30,  
    2005     2006(3)     2007(1)     2008(1)(4)     2009     2009     2010  
    ($ in thousands)  
 
Net cash (used in) provided by:
                                                       
Operating activities
  $ (3,796 )   $ (4,564 )   $ (5,860 )   $ (9,496 )   $ (12,118 )   $ (6,472 )   $ (5,960 )
Investing activities
    (6,393 )     (4,034 )     8,073       (7,271 )     2,954       (6,551 )     (305 )
Financing activities
    8,351       7,621       2,612       23,289       3,812       (5 )     (1,404 )
Effect of exchange rate changes on cash
                                        (2 )
                                                         
Net change in cash
  $ (1,838 )   $ (977 )   $ 4,825     $ 6,522     $ (5,352 )   $ (13,028 )   $ (7,671 )
                                                         
 
 
(1) On January 3, 2007, we formed a wholly-owned subsidiary, Viryd Technologies Inc. (Viryd), a Delaware corporation. On December 18, 2008, we completed a spin-off of our ownership of Viryd through a pro rata distribution of shares to our stockholders. The 2007 and 2008 consolidated financial statements include the accounts of Fallbrook Technologies Inc. and Viryd through December 18, 2008.
 
(2) The pro forma basic and diluted net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding for the period plus the weighted average number of common shares resulting from the assumed conversion of the outstanding shares of convertible preferred stock and the exercise of           warrants prior to the closing of the offering. The assumed conversion is calculated using the if-converted method, as if such conversion had occurred as of the beginning of the period presented or as of the original issuance date, if later.
 
(3) In 2006, we issued 1,429,487 shares of Series C convertible preferred stock for cash in the amount of $7,636,000, recorded net of issuance costs of $6,000.
 
(4) On December 18, 2008, we sold an aggregate of 63,607,402 shares of our Series D convertible preferred stock at a purchase price of $0.3992 per share for a total of $25.4 million, of which $20.6 million was in cash and $4.8 million was from the conversion of principal and accrued interest on our then outstanding convertible debt.


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Management’s Discussion and Analysis of
Financial Condition and Results of Operations
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Prospectus Summary—Summary Consolidated Financial Data,” “Selected Consolidated Financial Data” and our consolidated financial statements included elsewhere in this prospectus. In addition to historical data, this discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including but not limited to those discussed in the sections entitled “Risk Factors” and “Special Note Regarding Forward-Looking Statements” included elsewhere in this prospectus.
 
Overview
Our NuVinci Technology
 
We have developed patented transmission technology, sold under the “NuVinci” brand. It is designed to improve the overall efficiency and performance of mechanical systems that require variation between the speed of a primary drive and the speed required to operate the mechanical system.
 
Our NuVinci technology is a new type of continuously variable transmission (CVT) that can be used in a wide variety of end market applications. A CVT is a transmission that effectively has an infinite number of gear ratios within its range. Our technology is currently available in the global market for bicycle transmissions, where it has been used to replace the rear wheel gear assembly. We are also currently developing applications for a number of other target end markets. These include alternators, air conditioning compressors and superchargers for the automotive accessory drives market, and primary transmissions for the electric vehicles, wind turbines, and lawn care equipment markets.
 
We were originally formed in 2000, and to date have raised approximately $62 million in financing to develop and commercialize our technology. We have focused on developing applications for a group of target end markets that offer the most attractive competitive advantages and potential for economic returns. As of July 31, 2010, we invested in the development and protection of intellectual property resulting in a worldwide portfolio of 176 patents (including validated countries) and 189 patent applications.
 
Commercialization
 
Our first commercial product, a CVT for bicycles, was introduced in January 2007, under a development and manufacturing license agreement with Aftermarket Technologies Corp. (ATC) for the development, manufacturing and sale of our bicycle CVT. Our revenue from that agreement consisted of royalties on ATC’s product sales, license fees, and revenue from engineering services. In February 2008, to gain greater control of manufacturing and sales, we ended our relationship with ATC, and transitioned to a contract manufacturing arrangement with MTD Products Inc. (MTD). The contract manufacturing agreement with MTD was signed in March 2008. At the same time, we assumed direct responsibilities for sales and marketing. As part of the transition to MTD, we purchased the manufacturing line and associated equipment from ATC and moved the manufacturing line to MTD’s facilities. MTD spent approximately six months setting up and testing the manufacturing line and production of the bicycle CVT resumed in September 2008. Before manufacturing resumed at MTD, we sold the bicycle CVTs out of the inventory that had been built up by ATC. After September 2008, we purchased bicycle CVTs from MTD and sold them directly to original equipment manufacturers (OEMs) and distributors. However, the per unit cost of the bicycle CVTs manufactured by MTD was prohibitive because the manufacturing process used a long lead time supply chain. We have determined that it would be most cost effective and would provide for the largest growth opportunity to concentrate the supply base in one off-shore region or location.
 
In 2009, we began the process of phasing out production of our existing bicycle CVTs to prepare for the manufacturing launch of the next generation bicycle CVT, called the N360, which launch occurred in June 2010. We terminated our contract manufacturing agreement with MTD in October 2009, after building


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2,600 units of inventory for us to continue to deliver products to customers while our next contract manufacturer prepares for production of the N360. We have engaged a contract manufacturer, Tri Star Group, located in Shanghai, China, to manufacture the N360. The production of prototypes began in December 2009 and we launched manufacturing of the N360 in June 2010 and shipped initial products to customers in July 2010. The N360 will have many improvements over the current bicycle CVT including a weight reduction of at least 35%, a size reduction of at least 10%, improved shift feel and responsiveness, and the CVT will be easier to assemble with over 50% fewer parts. We believe the improved design of the N360 will have a much broader appeal in the marketplace. In addition, as Tri Star is located in China and is near most of the component suppliers, inbound logistics costs will be lower and coordination will be easier. Through the combination of the fixed-priced manufacturing agreement with Tri Star, new component suppliers, and improved design, we expect the N360 will have a per unit cost that is at least 50% less than the per unit cost of the N171 bicycle CVT.
 
The end markets for our NuVinci technology on which we are currently focusing are automotive accessory drives, electric vehicles, bicycles, small wind turbines and lawn care equipment. We are at different stages of development of the products for each of these end markets. While we have spent several years developing our core technology, our past experience in launching our bicycle product and developing other products to date indicates that the product development process to apply our core technology in each of our target end market applications takes from 18 to 34 months from start to finish, depending on the complexity of the particular application. The key steps of the development cycle include product design, prototyping and testing, production design validation, manufacturing tooling and process development, including supplier development and manufacturing launch. Manufacturing of the N360 launched in June 2010. The NuVinci CVT for the automotive accessory drive, lawn care equipment, and small wind turbines end markets is in the prototyping and testing stage of development. We anticipate that we or our licensee will launch production of our products into the automotive accessory drive and small wind turbines end markets in 2011 and lawn care equipment market in 2012. The application for the electric vehicles end market is in the design stage of development and production is expected to launch in 2013. Other than for certain applications where we will rely on the assistance of licensees or joint venture partners, we expect the net proceeds from this offering and our existing cash and cash equivalents will provide us with sufficient resources to fund the development of these product applications.
 
We expect to manufacture NuVinci CVTs for automotive accessory drives, electric vehicles, bicycles and small wind turbines primarily through a contract manufacturer and to sell these products to distributors, OEMs, or directly to customers. Starting in 2011, we will manufacture and sell the NuVinci CVTs to Viryd Technologies Inc. (Viryd). We have also licensed to Viryd the rights to manufacture and sell the NuVinci CVTs for the small wind turbines market and we will receive royalties from Viryd should they manufacture the CVTs. In the near term, we anticipate this revenue will be primarily from product sales, but over the longer term it may be primarily from royalties. We have licensed the rights to manufacture and sell NuVinci CVTs for lawn care equipment to Hydro-Gear in that end market and will receive royalties from them. We may also opportunistically license the manufacturing of products of other end market applications to certain manufacturers or OEMs that will commercialize products utilizing our NuVinci technology. We will receive revenue through the sale of engineering services, license fees, and royalties on product sales. In all licensing and development arrangements, we own all patentable improvements to our NuVinci CVT. In our view, the use of contract manufacturing to manufacture our NuVinci CVTs and licensing our technology to OEMs has several advantages over in-house manufacturing. These advantages include lower capital requirements, less operational complexity, the need for fewer permanent employees and faster commercialization of new applications.
 
Financial Overview
 
Revenues
 
We primarily derive our revenues from product sales, license fees and royalties, engineering services, and related party revenues.
 
Product sales. These revenues to date consist primarily of sales of our bicycle CVTs. We started to earn product sales revenue when we transitioned from the licensing business model for the bicycle CVTs to a


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manufacturing model. As part of the transition plan, in February 2008 we purchased finished bicycle CVTs from our licensee manufacturer (ATC) for inventory so that we could continue to fulfill customer orders. In March 2008, we began outsourcing physical manufacturing to a contract manufacturer and started selling the NuVinci CVTs directly to OEMs and distributors. We have been working with a new manufacturer, Tri Star Group (Tri Star), located in Shanghai, China, to design and prepare for production of the N360. We believe the improved design of the N360 bicycle CVT will have a much broader appeal in the marketplace and that product sales will increase accordingly. We launched manufacturing of the N360 in June 2010 and shipped initial products to customers in July 2010.
 
We expect to launch our product for the automotive accessory drives market in 2011 and electric vehicles market in 2013 using one or more contract manufacturers.
 
License fees and royalties. We receive license fees and royalties from the licensing of our NuVinci technology to manufacturers and OEMs. We receive license fees up front from customers upon or shortly after the signing of our licenses and we recognize license fee revenues when the license term commences and there are no future performance obligations or requirements. When the contract requires us to provide engineering development services during the license term, license fee revenue is deferred and recognized over the term of the contract or the remaining estimated period of continuing involvement. We also receive royalties from product sales by our licensees. Lawn care equipment CVT production is expected to be launched in 2012 by Hydro-Gear, who licensed the rights to manufacturer and sell NuVinci CVTs for that end market.
 
As we develop and commercialize NuVinci technology, additional manufacturers and OEMs may sign license agreements for those products and we would generate additional license fees and royalty revenue.
 
Engineering services. These revenues consist primarily of fees for engineering services that we provide to manufacturers and OEMs associated with applying the NuVinci CVT technology to their products. We own all of the intellectual property that results from our engineering work. In some engineering services agreements, we may receive partial payments from manufacturers or OEMs upfront before the project or pre-determined milestones are completed. Such pre-payments are recorded as revenue when we meet pre-determined milestones.
 
Development under engineering services agreements is intended to lead to commercialization of NuVinci CVTs. For example, the development performed under the engineering services agreements with Viryd in 2008 and 2009 for the small wind turbine end market will result in the launch of the product in 2011. We expect that the engineering services agreements for the automotive accessory drive for superchargers will lead to commercialization and manufacturing in 2011 as well as lawn care equipment CVTs by 2012.
 
As we advance the development of the NuVinci CVT technology, we expect other manufacturers and OEMs to sign engineering services agreements to develop the NuVinci CVTs for their specific products.
 
Related-party revenues. These revenues are earned from providing administrative, operations and engineering support services to Viryd subsequent to its spin-off on December 18, 2008. We expect administrative support services to Viryd to decline as they hire additional administrative staff. However, we expect to continue to provide operations and engineering support services as they prepare to manufacture and sell their products. The engineering support services that we have provided to Viryd have led to the development of a product we expect Viryd to launch, under the license from us, for the small wind turbine end market in 2010. We expect product sales revenue to increase when we begin to manufacture and sell our NuVinci CVT for the small wind turbine end market in 2011.
 
Cost of revenues
 
The cost component for each of our main sources of revenues consists primarily of cost of product sales, license fees and royalties, engineering services and related-party revenues.
 
Cost of product sales. Since March 2008, when we started the contract manufacturing business model, cost of product sales represent costs of purchasing the NuVinci CVTs from contract manufacturers that we then sell to OEMs and distributors. Prior to March 2008, we employed a licensing model for the production of the bicycle CVTs when we earned royalties from sales of the bicycle CVTs by our licensed manufacturer (ATC). Through


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the combination of the fixed-priced manufacturing agreement with Tri Star, new component suppliers, and improved design, we expect the N360 will have a per unit cost that is at least 50% less than the per unit cost of the N171 bicycle CVT.
 
Also included in cost of product sales are depreciation of assembly line equipment that we purchased from ATC as part of the transition to MTD and provisions for estimated future warranty claims expense. Because our cost of product sales has, to date, exceeded our product selling price, our cost of product sales also includes provisions to write down the carrying value of inventories to their net realizable value.
 
In 2011, we expect our licensee, Viryd, to launch the production of the NuVinci CVTs for the small wind turbine end market. We will be selling NuVinci CVTs manufactured by Tri Star to Viryd. We expect to launch the manufacturing and sales of automotive accessory drives in 2011 and CVTs for electric vehicles in 2013. We will be providing these NuVinci products to our customers through one or more contract manufacturers.
 
Cost of license fees and royalties. These represent the costs of support provided to our licensees. For example, certain of our license agreements require that we provide engineering support to the manufacturer for a period of time as it commences production of our NuVinci bicycle CVTs. If we enter into additional licensing agreements that will require us to provide engineering support to the customers, we expect our costs will increase proportionally with the increases in revenue.
 
Cost of engineering services. These represent the costs of our development, primarily engineering labor and related expenses, incurred as we perform our obligations under the engineering services agreements between us and the manufacturer or OEMs.
 
In 2009, we signed an engineering services agreement for an automotive accessory drive for superchargers and another agreement for the lawn care equipment CVT. Engineering services revenue and cost of engineering services will be recorded when we achieve pre-determined milestones.
 
As we advance the development of the NuVinci CVT technology, we expect other manufacturers and OEMs to sign engineering services agreements to develop the NuVinci CVTs for their specific products. Thus the cost of engineering services will increase along with engineering services revenue.
 
Cost of related-party revenues. These represent the costs of providing administrative, operations and engineering support services to Viryd. We expect administrative support services to Viryd to decline as they hire additional administrative staff. However, we expect to continue to provide operations and engineering support services as they prepare to manufacture and sell their products.
 
Operating expenses
 
Our operating expenses consist primarily of development expenses and selling, general and administrative expenses.
 
Research and development expenses. These costs include salaries and related expenses for engineering personnel, cost of building and testing product prototypes, rent expense for our facilities in Cedar Park, Texas and depreciation of machinery, furniture, and equipment used by the engineering personnel.
 
Development expenses will increase as we continue to develop NuVinci technology. We expect our investment in development expenses for existing and future potential applications may lead to future engineering services and license agreements and ultimately commercialization.
 
Selling, general and administrative expenses. These costs consist primarily of salaries and related expenses for personnel in the business development, administration, intellectual property and finance departments. Other expenses include trade show costs, advertising and marketing, professional fees for legal and accounting, general office expenses, facility rent for our corporate offices in San Diego, California, utilities, various insurance expenses, amortization of capitalized patent costs and intangibles, depreciation of various furniture and equipment, and other general administrative expenses.
 
We expect selling, general and administrative expenses to increase as we commercialize additional NuVinci CVT products, increase our business development and marketing efforts worldwide and as we begin to operate


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as a public company and continue to build our corporate infrastructure. These increases will likely include salaries and related expenses, legal and consultant fees, accounting fees, rent and utilities, director fees, increased directors’ and officers’ insurance premiums, and fees for investor relations services.
 
Interest income (expense)
 
Interest and dividend income. This consists of interest and dividend income earned on our cash, cash equivalents and short-term investments.
 
Interest expense. This consists primarily of interest paid on our line of credit, note payable, capital lease, and non-cash interest related to convertible unsecured promissory notes and warrants.
 
Results of Operations
 
Comparison of the Six Months Ended June 30, 2009 and 2010
 
                                 
    Six Months Ended
             
    June 30,     Increase
    Percentage
 
    2009     2010     (Decrease)     Change  
    ($ in thousands)        
 
Revenues:
                               
Product sales
  $ 327     $ 36     $ (291 )     (89 )%
License fees and royalties
    6       6              
Engineering services
    53       227       174       328 %
Related party revenues
    286       191       (95 )     (33 )%
                                 
Total revenues
    672       460       (212 )     (32 )%
                                 
Cost of revenues:
                               
Cost of product sales
    1,697       330       (1,367 )     (81 )%
Cost of engineering services
    37       97       60       162 %
Cost of related party revenues
    395       94       (301 )     (76 )%
                                 
Total cost of revenues
    2,129       521       (1,608 )     (76 )%
                                 
Gross loss
    (1,457 )     (61 )     1,396       (96 )%
                                 
Operating expenses:
                               
Research and development
    2,656       3,046       390       15 %
Selling, general and administrative
    2,332       3,568       1,236       53 %
                                 
Total operating expenses
    4,988       6,614       1,626       33 %
                                 
Operating loss
    (6,445 )     (6,675 )     (230 )     4 %
                                 
Other income (expense):
                               
Interest and dividend income
    64       4       (60 )     (94 )%
Interest expense
    (49 )     (44 )     5       (10 )%
Transaction loss on foreign currency exchange
          (11 )     (11 )     N/A  
                                 
Total other income (expense)
    15       (51 )     (66 )     (440 )%
                                 
Net loss
  $ (6,430 )   $ (6,726 )   $ (296 )     5 %
                                 


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Revenues
 
                                 
    Six Months Ended
             
    June 30,     Increase
    Percentage
 
    2009     2010     (Decrease)     Change  
    ($ in thousands)        
 
Product sales
  $ 327     $ 36     $ (291 )     (89 )%
License fees and royalties
    6       6              
Engineering services
    53       227       174       328 %
Related party revenues
    286       191       (95 )     (33 )%
                                 
Total revenues
  $ 672     $ 460     $ (212 )     (32 )%
                                 
 
Total revenues for the six months ended June 30, 2010 decreased by $212,000, or 32%, compared to the six months ended June 30, 2009.
 
Product sales decreased by $291,000, or 89%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This decrease was primarily attributable to the decrease in the sales volume of the bicycle CVT, while the unit sales price remained relatively stable. The decrease in CVT sales volume was the direct result of the phasing out of the N171 bicycle CVT model, in anticipation of the next generation N360 bicycle CVT, which commercially launched in July 2010. We expect that sales of the N171 model will continue to decline, while sales of the N360 commences. As the N360 is different than the N171 because the N360 is smaller, lighter and more efficient, we believe that the N360 will attract more and different customers in the bicycle market as they are now able to integrate the N360 in their various bicycle models. As such, we do not expect to have high levels of customer concentration with N360 sales compared to N171 sales in 2009.
 
Engineering services revenue increased by $174,000, or 328%, during the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This increase was the result of the recognition of $227,000 for engineering services revenue derived from the successful completion of two milestones on the development of a supercharger for the automotive market using our continuously variable accessory drive (CVAD) for one customer, as compared to $53,000 recognized in the first quarter of 2009 related to engineering services for the collaborative exploration of using an accessory drive for motorcycle applications for a different customer in a different market.
 
Related party revenues are primarily comprised of support services and engineering services for Viryd (a subsidiary that was spun-off in December 2008), which decreased by $95,000, or 33%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. Related party revenues from accounting and administrative support services decreased by $151,000 during the six months ended June 30, 2010 compared to the six months ended June 30, 2009 due to additional support services provided in 2009 following the December 2008 spin-off of Viryd, which required support for its transition into a newly operating, stand-alone entity. As demonstrated in the first and second quarters of 2010, we expect support services to decline going forward as Viryd has hired a chief financial officer, accounting manager, and administrative assistant to handle accounting and administration on their own, thereby no longer requiring support services from us. The decrease of accounting and administrative support services was offset by the increase in related party revenues for engineering services. Related party revenues for engineering services increased by $54,000 during the six months ended June 30, 2010 compared to the six months ended June 30, 2009, as we performed engineering and component design services on the CVT units for use in a full Viryd prototype wind turbine, while engineering services during the six months ended June 30, 2009 were minimal.


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Cost of revenues
 
                                 
    Six Months Ended
             
    June 30,     Increase
    Percentage
 
    2009     2010     (Decrease)     Change  
    ($ in thousands)        
 
Cost of product sales
  $ 1,697     $ 330     $ 1,367 )     (81 )%
Cost of engineering services
    37       97       60       162 %
Cost of related party revenues
    395       94       (301 )     (76 )%
                                 
Total cost of revenues
  $ 2,129     $ 521     $ 1,608 )     (76 )%
                                 
 
Total cost of revenues for the six months ended June 30, 2010 decreased by $1,608,000, or 76%, compared to the six months ended June 30, 2009.
 
Cost of product sales decreased $1,367,000, or 81%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This decrease was primarily attributable to $673,000 in lower-of-cost-or-market inventory write-downs that were recognized during the six months ended June 30, 2009 because the CVT unit cost exceeded the sales price. This decrease was offset by a $260,000 inventory write-down on developer kits during the six months ended June 30, 2010, which resulted from a Professional Services Agreement entered into in May 2010 that will begin the development of an auto-shifting system equipped with the N360 CVT, which will essentially replace our existing developer kits. The decrease in cost of product sales was also due to a $446,000 decrease in depreciation and amortization of manufacturing line assets during the six months ended June 30, 2010, compared to the six months ended June 30, 2009, due to the disposal of manufacturing equipment in the fourth quarter of 2009 and the write-off of intangible assets associated with the trade secrets and manufacturing processes used by MTD in third quarter of 2009. The remaining decrease in cost of product sales was due to the decrease in the total number of N171 CVT units sold during the six months ended June 30, 2010 compared to the six months ended June 30, 2009 as a result of the anticipated release of the next generation N360 bicycle CVT.
 
Cost of engineering services increased by $60,000, or 162%, during the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This increase was due to $97,000 in cost of engineering services provided during the six months ended June 30, 2010 for the development of a supercharger for the automotive market using our CVAD under an engineering services agreement that commenced in June 2009. This increase was offset by $37,000 of costs incurred in the first quarter of 2009 for an engineering services agreement entered into in October 2008 for a collaborative exploration of using an accessory drive for motorcycle applications that did not recur in the six months ended June 30, 2010.
 
Cost of related party revenues decreased by $301,000, or 76%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 due primarily to the $228,000 decrease in cost of engineering services provided to Viryd. Cost of related party revenues for engineering services in the six months ended June 30, 2009 were higher than the six months ended June 30, 2010 because we incurred higher engineering costs associated with the design and development of a NuVinci CVT for the small wind turbine end market under the engineering services agreement that we signed with Viryd in April 2008. In addition, the cost of related party revenues for accounting and administrative support services decreased by $75,000 in the six months ended June 30, 2010 as compared to the six months ended June 30, 2009 due to the decrease in support services provided to Viryd. We expect cost of related party revenues for support services to decline going forward, as Viryd has begun handling accounting and administration on their own.


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Operating expenses
 
Research and development
 
                                 
    Six Months Ended
       
    June 30,   Increase
  Percentage
    2009   2010   (Decrease)   Change
    ($ in thousands)    
 
Research and development
  $ 2,656     $ 3,046     $ 390       15 %
 
Research and development expense increased by $390,000, or 15%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.
 
Research and development expense increased due to a $241,000 increase in prototype costs, shop supplies and the associated freight in the six months ended June 30, 2010 as part of our development of the N360 in preparation for production launch in July 2010 and our internal continuous development of the NuVinci technology for the automotive accessory drives end-market. There was also a $144,000 increase in travel expense in the six months ended June 30, 2010 compared to the six months ended June 30, 2009 primarily relating to engineers traveling to China as they work with Tri Star on the N360 production launch.
 
Selling, general and administrative
 
                                 
    Six Months Ended
       
    June 30,   Increase
  Percentage
    2009   2010   (Decrease)   Change
    ($ in thousands)    
 
Selling, general and administrative
  $ 2,332     $ 3,568     $ 1,236       53 %
 
Selling, general and administrative expense for the six months ended June 30, 2010 increased by $1,236,000, or 53%, compared to the six months ended June 30, 2009.
 
The increase in selling, general and administrative expense was primarily due to a $511,000 increase in salaries and payroll related expenses in the six months ended June 30, 2010 compared to the six months ended June 30, 2009 due to the addition of seven new positions, including chief operating officer and vice president of operations. There was also a $42,000 increase in share-based compensation expense in the six months ended June 30, 2010 compared to the six months ended June 30, 2009 resulting from stock options that were granted during 2009. There were no stock options granted during the six months ended June 30, 2010. Additionally, there was a $171,000 increase during the six months ended June 30, 2010 compared to the six months ended June 30, 2009 for accounting expenses related to the audit work performed for the restatement of our 2004 through 2008 financial statements, as well as completion of the audit of our 2009 financial statements.
 
The increase in selling, general and administrative expense was also the result of a $386,000 increase in business and marketing consulting expense and business development expense during the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This increase was primarily attributable to an increase in travel, meals, and tradeshow expenses resulting from an increase in trade show activity to promote the new N360 product, which began commercial sales in July 2010. We have attended twice as many tradeshows during the six months ended June 30, 2010 compared to the six months ended June 30, 2009, which also caused a $42,000 increase in freight expense.
 
As we commercialize additional NuVinci CVT products, increase our business development and marketing efforts worldwide, and continue to build out the corporate infrastructure needed to support a public company, we expect selling, general and administrative expenses to continue to increase in the near term.


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Interest income (expense)
 
Interest and dividend income
 
                                 
    Six Months Ended
       
    June 30,   Increase
  Percentage
    2009   2010   (Decrease)   Change
    ($ in thousands)    
 
Interest and dividend income
  $ 64     $ 4     $ (60 )     (94 )%
 
Interest and dividend income decreased by $60,000, or 94%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. This decrease was attributable to the fact that we did not invest in any debt or equity securities during the six months ended June 30, 2010, whereas we held $9,825,000 in investments as of March 31, 2009.
 
Interest expense
 
                                 
    Six Months Ended
       
    June 30,   Increase
  Percentage
    2009   2010   (Decrease)   Change
    ($ in thousands)    
 
Interest expense
  $ 49     $ 44     $ (5 )     (10 )%
 
Interest expense remained relatively consistent with a $5,000, or 10%, decrease during the six months ended June 30, 2010 compared to the six months ended June 30, 2009. There were no borrowings or repayments on the $2,000,000 outstanding on our revolving line of credit during the six months ended June 30, 2010 or the six months ended June 30, 2009. The average interest rate during the six months ended June 30, 2010 was relatively consistent with the average interest rate during the six months ended June 30, 2009.


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Comparison of the Years Ended December 31, 2008 and 2009
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2008     2009     (Decrease)     Change  
    ($ in thousands)        
 
Revenues:
                               
Product sales
  $ 320     $ 467     $ 147       46 %
License fees and royalties
    914       12       (902 )     (99 )%
Engineering services
    998       53       (945 )     (95 )%
Related party revenues
    19       512       493       2,595 %
Other
    32             (32 )     (100 )%
                                 
Total revenues
    2,283       1,044       (1,239 )     (54 )%
                                 
Cost of revenues:
                               
Cost of product sales
    1,158       6,639       5,481       473 %
Cost of license fees and royalties
    368             (368 )     (100 )%
Cost of engineering services
    488       37       (451 )     (92 )%
Cost of related party revenues
    11       584       573       5,209 %
Cost of other revenues
    23             (23 )     (100 )%
                                 
Total cost of revenues
    2,048       7,260       5,212       254 %
                                 
Gross (loss) profit
    235       (6,216 )     (6,451 )     (2,745 )%
                                 
Operating expenses:
                               
Research and development
    5,939       5,426       (513 )     (9 )%
Selling, general and administrative
    4,382       5,097       715       16 %
                                 
Total operating expenses
    10,321       10,523       202       2 %
                                 
Operating loss
    (10,086 )     (16,739 )     (6,653 )     66 %
                                 
Other income (expense):
                               
Interest and dividend income
    127       87       (40 )     (31 )%
Interest expense
    (597 )     (574 )     23       (4 )%
                                 
Total other income (expense)
    (470 )     (487 )     (17 )     4 %
                                 
Net loss
  $ (10,556 )   $ (17,226 )   $ (6,670 )     63 %
                                 
 
Revenues
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2008     2009     (Decrease)     Change  
    ($ in thousands)        
 
Product sales
  $ 320     $ 467     $ 147       46 %
License fees and royalties
    914       12       (902 )     (99 )%
Engineering services
    998       53       (945 )     (95 )%
Related party revenues
    19       512       493       2,595 %
Other
    32             (32 )     (100 )%
                                 
Total revenues
  $ 2,283     $ 1,044     $ (1,239 )     (54 )%
                                 
 
Total revenues for the year ended December 31, 2009 decreased by $1,239,000, or 54%, compared to the year ended December 31, 2008.


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Product sales for 2009 increased by $147,000, or 46%, compared to 2008. In March 2008, we transitioned from a licensing business model for the bicycle CVT to a manufacturing model that outsources physical manufacturing to a contract manufacturer. At that time, we started selling the NuVinci bicycle CVT’s directly to OEMs and distributors. The increase in product sales in 2009 was the result of a full year of selling the bicycle CVT’s via contract manufacturing.
 
License fees and royalties decreased by $902,000, or 99%, in 2009 compared to 2008. The $914,000 in license fees and royalties revenue that were earned from our licensed manufacturer and OEM customers in 2008 were not replicated in 2009. In February 2008, we terminated our manufacturing license agreement with ATC, who had paid us $50,000 in May 2005 and $950,000 in August 2006, for a total of $1,000,000 in nonrefundable license fees. We were previously recognizing that license fee revenue over a period of five years. When the manufacturing license agreement terminated, $733,000 of unrecognized license fees were immediately recognized. The remaining $181,000 of license fees and royalties that were recognized in 2008 were from Valvoline, our trademark licensee, and royalties from ATC, which did not recur in 2009. In March 2008, we engaged a contract manufacturer for the bicycle CVT. As a result of replacing our licensed manufacturer with a contract manufacturer in 2008, there were no manufacturing license fees from bicycle CVT products in 2009.
 
Engineering services revenue decreased by $945,000, or 95%, in 2009 compared to 2008. The majority of the $998,000 engineering services revenue earned in 2008, were from agreements signed in 2007 with various manufacturers and OEMs. When we established the contract manufacturing arrangement for the NuVinci CVTs in March 2008, we primarily focused on manufacturing and selling the bicycle CVTs. Because of limited resources, we did not focus on selling additional engineering services to develop NuVinci CVTs for new applications other than those that were committed to customers in 2007. Nearly all of our engineering services agreements signed in 2007 were completed by the end of 2008. In 2009, we signed an engineering services agreement for an automotive accessory drive for superchargers and another agreement for the lawn care equipment CVT. Although we may receive partial payments upfront from these engineering services agreements, we will not recognize engineering services revenue until we meet the pre-determined milestones.
 
Related-party revenues were recognized for the first time in December 2008 and continued through 2009, because of contractual agreements for us to provide support services and engineering services to Viryd subsequent to the December 18, 2008 spin-off of Viryd.
 
Cost of revenues
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2008     2009     (Decrease)     Change  
    ($ in thousands)        
 
Cost of product sales
  $ 1,158     $ 6,639     $ 5,481       473 %
Cost of license fees and royalties
    368             (368 )     (100 )%
Cost of engineering services
    488       37       (451 )     (92 )%
Cost of related party revenues
    11       584       573       5,209 %
Cost of other revenues
    23             (23 )     (100 )%
                                 
Total cost of revenues
  $ 2,048     $ 7,260     $ 5,212       254 %
                                 
 
Total cost of revenues for the year ended December 31, 2009 increased by $5,212,000, or 254%, compared to the year ended December 31, 2008.
 
This increase was primarily due to the $5,481,000 increase in cost of product sales of the bicycle CVTs. In March 2008, we transitioned from a licensing business model for the bicycle CVT to a manufacturing model that outsources physical manufacturing to a contract manufacturer. We purchased manufacturing line equipment for $3,952,000 and intangible assets for $700,000 from ATC that included trade secrets and manufacturing processes used to manufacture the N171. We delivered the manufacturing line equipment to


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MTD for the manufacture of bicycle CVTs. Prior to the termination of the Manufacturing Supply Agreement in October 2009, our projected cost of the CVT over the term of the agreement was expected to decrease to an amount that would yield a positive margin and the total undiscounted cash flows at inception and as assessed over the term of the manufacturing supply agreement would be sufficient to recover the cost of the tangible and intangible assets associated with the manufacturing line. Per the terms of the agreement with MTD, there would be four cost reduction phases. Each phase lasted 120 days, with the first phase commencing on the day production began, which was in September 2008. MTD had presented to the Company its cost reduction production plan and based on the plan, we expected that the N171 would be sold at a negative gross margin for approximately the first eight months of production, as MTD stabilized the supply base and manufacturing processes, and would not achieve positive gross margin until the third phase, which would have been by August 2009. Since the period production commenced in September 2008, we monitored MTD’s progress against the production plan. By the third quarter of 2009, MTD was still utilizing costly parts, and the long supply chain lead time was contributing to the costly manufacturing process. Accordingly, MTD was not able to achieve the cost reductions specified in the production schedule in the time frame anticipated. In the third quarter of 2009, we had discussions with MTD regarding the continued high cost and unstable production levels and whether MTD would be interested in producing the next generation product. Unresolved negotiations about product cost, unstable production levels, and considerations relating to the production of the next generation product led management to believe that the carrying amounts of certain tangible and intangible assets associated with the production line used by MTD may not be recoverable. We then assessed our manufacturing line equipment and intangibles associated with trade secrets and manufacturing processes used by MTD for potential impairment and recorded an impairment loss of $1,537,000 in the third quarter of 2009 based upon the estimated fair value of the manufacturing equipment and $490,000 in the third quarter of 2009 for the intangible assets used by MTD as they would no longer provide future benefit. This was because of the decision to cease production of the N171 with which it was associated before the end of the intangible assets’ previously estimated useful life. Further, these unresolved negotiations about product cost and unstable production levels between the Company and MTD caused us to terminate the manufacturing supply agreement with MTD. In connection with the early termination of the manufacturing supply agreement with MTD, we agreed to transfer the manufacturing line equipment to MTD and as a result, recorded a loss on disposal of manufacturing line equipment of $1,455,000 in the fourth quarter of 2009.
 
The increase in cost of product sales was also due to a $952,000 lower of cost or market charge on inventory incurred during 2009. This charge was the result of the unit cost of the N171 model of the bicycle CVT being higher than the sales price and, as a result, we recorded a lower of cost or market charge relating to the inventory on hand. Through the combination of the fixed-priced manufacturing agreement with Tri Star, new component suppliers, and improved design, we expect the next generation bicycle CVT, the N360, will have a per unit cost that is at least 50% less than the per unit cost of the N171 bicycle CVT. In connection with the manufacturing launch of the N360 in June 2010, we recorded an obsolescence charge of $357,000 during 2009, for the excess inventory of the previous N171 bicycle CVTs on hand. Cost of product sales also increased because of an increase in depreciation of manufacturing equipment by $199,000, or 38%, compared to 2008. The remaining increase in cost of product sales in 2009 was due to a full year of selling the bicycle CVTs via contract manufacturing.
 
Costs of license fees and royalties in 2009 decreased by $368,000, or 100%, compared to 2008. This was the result of the termination of the manufacturing license agreement with our former bicycle CVT manufacturer, ATC, in February 2008. Under the manufacturing license agreement, we provided engineering support to the manufacturer as it commenced production of our bicycle CVTs.
 
Cost of engineering services for 2009 decreased by $451,000, or 92%, compared to 2008. The decrease was due to the decline in engineering services provided during 2009, as engineering services agreements signed in 2007 with various manufacturers and OEMs were completed by the end of 2008. In 2009, we signed an engineering services agreement for an automotive accessory drive for superchargers and another agreement for the lawn care equipment CVT. We are currently providing engineering services under those agreements. We expect to recognize cost of engineering services relating to those agreements in 2010 and 2011 when the predetermined engineering milestones are met and revenues are recognized.


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Cost of related-party revenues increased by $573,000, or 5,209%, as they were recognized for the first time starting in December 2008, for contractual agreements to provide support services and engineering services to Viryd subsequent to the December 18, 2008 spin-off of Viryd. The engineering services that we provided to Viryd during 2009 were to design and develop a NuVinci CVT for the small wind turbine end market. The NuVinci CVT that we are designing and developing for Viryd can also be used by other potential customers in industries outside of the wind turbine end market. We can either license or arrange contract manufacturing for the same-size NuVinci CVT for other end markets. We incurred higher development costs for the NuVinci CVT for Viryd than expected resulting in a negative gross margin for the engineering services that we provided to Viryd.
 
Operating expenses
 
Research and development
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2008   2009   (Decrease)   Change
    ($ in thousands)    
 
Research and development
  $ 5,939     $ 5,426     $ (513 )     (9 )%
 
Research and development expense for the year ended December 31, 2009 decreased by $513,000, or 9%, compared to the year ended December 31, 2008.
 
Prior to the spin-off of Viryd in December 2008, we consolidated Viryd’s research and development expenses. Included in the $5,939,000 of research and development expense incurred during 2008 was $874,000 of research and development expense incurred by Viryd to develop the NuVinci CVTs for the small wind turbine end market. Excluding Viryd’s research and development costs from 2008, our development expense for 2009 increased by $360,000, or 7%. The increase was primarily due to a $191,000 increase in prototype costs incurred as part of our internal continuous development of the next generation of the NuVinci bicycle CVT, as well as supporting the bicycle CVT that is currently being sold in the market. Salaries and payroll-related expenses increased by $91,000, as a result of our engineering team devoting some development efforts to improve and explore opportunities for the core NuVinci technology in the automotive accessory drives end market, which was recognized as research and development expense. In 2008, these labor costs were associated with license fees and engineering services revenue, which were recognized as costs of revenue. Engineering consulting expense for 2009 increased by $112,000, compared to 2008.
 
Selling, general and administrative
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2008   2009   (Decrease)   Change
    ($ in thousands)    
 
Selling, general and administrative
  $ 4,382     $ 5,097     $ 715       16 %
 
Selling, general and administrative expense for the year ended December 31, 2009 increased by $715,000, or 16%, compared to the year ended December 31, 2008.
 
Salaries and payroll-related expenses increased by $175,000 due to the addition of three employees in 2009, including the Chief Operating Officer. Share-based compensation expense increased by $196,000, from $160,000 in 2008 to $356,000 in 2009. During 2009, we incurred an additional $258,000 in accounting expenses associated with the restatement of our prior year financial statements. In addition, business and marketing consulting expense increased by $318,000 and travel expenses increased by $67,000 in 2009. These increases were offset by a $329,000 decrease in 2009 because of the spin-off of Viryd in December 2008.


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Interest income (expense)
 
Interest and dividend income
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2008   2009   (Decrease)   Change
    ($ in thousands)    
 
Interest and dividend income
  $ 127     $ 87     $ (40 )     (31 )%
 
Interest and dividend income for the year ended December 31, 2009, decreased by $40,000, or 31%, compared to the year ended December 31, 2008.
 
The decrease of $40,000 was attributable to lower interest rates in 2009 as compared to 2008 on certificates of deposit, money market funds, auction rate securities, and checking accounts, as well as the shorter term investments in which we invested. This decrease was offset by an increase in average cash, cash equivalents and short-term investments of $5,584,000 in 2008 to $12,652,000 in 2009 because of $20,594,000 in cash proceeds from the Series D Preferred Stock financing that closed in December 2008 and $4,000,000 in cash proceeds from the Series D Preferred Stock financing that closed in December 2009.
 
Interest expense
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2008   2009   (Decrease)   Change
    ($ in thousands)    
 
Interest expense
  $ 597     $ 574     $ (23 )     (4 )%
 
Interest expense for the year ended December 31, 2009 decreased by $23,000, or 4%, compared to the year ended December 31, 2008.
 
Various financing activities generated the interest expense in 2008. During 2008, we recorded $180,000 of non-cash interest expense and $49,000 for a beneficial conversion charge in connection with the $4,618,000 convertible unsecured promissory note dated August 8, 2008, which was converted into Series D Preferred Stock in December 2008. We also recorded non-cash interest expense of $212,000 during 2008 for the value of the detachable warrants that were associated with the $4,618,000 convertible unsecured promissory note. Also included in interest expense for 2008 was $98,000 of interest expense related to an April 2008 promissory note for $1,952,000. The remaining interest expense recorded in 2008 was related to the $2,000,000 that was drawn down from the line of credit on April 2, 2008. Proceeds from the April 2008 promissory note and draw down on the line of credit were used to purchase the manufacturing assets from our former bicycle CVT manufacturer, ATC. We paid off the promissory note and accrued interest in December 2008.
 
Interest expense incurred during 2009 was primarily related to $476,000 in non-cash interest expense associated with a warrant issued in connection with a guarantee on our line of credit and interest expense from the $2,000,000 balance that remained outstanding throughout the year on our line of credit.


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Comparison of the Years Ended December 31, 2007 and 2008
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2007     2008     (Decrease)     Change  
    ($ in thousands)        
 
Revenues:
                               
Product sales
  $     $ 320     $ 320       N/A  
License fees and royalties
    295       914       619       210 %
Engineering services
    327       998       671       205 %
Related party revenues
          19       19       N/A  
Other
    92       32       (60 )     (65 )%
                                 
Total revenues
    714       2,283       1,569       220 %
                                 
Cost of revenues:
                               
Cost of product sales
          1,158       1,158       N/A  
Cost of license fees and royalties
    1,005       368       (637 )     (63 )%
Cost of engineering services
    822       488       (334 )     (41 )%
Cost of related party revenues
          11       11       N/A  
Cost of other revenues
    65       23       (42 )     (65 )%
                                 
Total cost of revenues
    1,892       2,048       156       8 %
                                 
Gross (loss) profit
    (1,178 )     235       1,413       120 %
                                 
Operating expenses:
                               
Research and development
    2,985       5,939       2,954       99 %
Selling, general and administrative
    2,842       4,382       1,540       54 %
                                 
Total operating expenses
    5,827       10,321       4,494       77 %
                                 
Operating loss
    (7,005 )     (10,086 )     (3,081 )     (44 )%
                                 
Other income (expense):
                               
Interest and dividend income
    447       127       (320 )     (72 )%
Interest expense
          (597 )     (597 )     N/A  
                                 
Total other income (expense)
    447       (470 )     (917 )     (205 )%
                                 
Net loss
  $ (6,558 )   $ (10,556 )   $ (3,998 )     61 %
                                 


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Revenues
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2007     2008     (Decrease)     Change  
    ($ in thousands)        
 
Product sales
  $     $ 320     $ 320       N/A  
License fees and royalties
    295       914       619       210 %
Engineering services
    327       998       671       205 %
Related party revenues
          19       19       N/A  
Other
    92       32       (60 )     (65 )%
                                 
Total revenues
  $ 714     $ 2,283     $ 1,569       220 %
                                 
 
Total revenues for the year ended December 31, 2008 increased by $1,569,000, or 220%, compared to the year ended December 31, 2007.
 
This increase of $1,569,000 was primarily a result of a $619,000 increase in license fees and royalties and a $671,000 increase in engineering services. The majority of the $998,000 engineering services revenue earned in 2008 was from agreements signed in 2007 with various manufacturers and OEMs. We recognize engineering services revenue when we have completed our services and met certain pre-determined development milestones under the engineering services agreements. In 2007, we recognized revenue for one engineering service project, compared to 2008, when we recognized engineering services revenue from four different projects.
 
In 2008, we recorded $733,000 of license fee revenue when our manufacturing license agreement with ATC terminated in February 2008. Per our manufacturing license agreement, ATC paid us $50,000 in May 2005 and $950,000 in August 2006, for a total $1,000,000 nonrefundable license fee. We were recognizing that license fee over a period of five years. When the manufacturing license agreement terminated, $733,000 of unrecognized license fee was recognized immediately. In 2008, we also recorded $107,000 fee from Valvoline for a trademark license. The remaining license fees of $12,000 that were recognized in 2008 were from OEMs, and royalties of $59,000 and $3,000 recognized in 2008 were from the sale of NuVinci bicycle CVTs by ATC and for fluid sales by Valvoline, respectively.
 
We started to earn product sales revenue when we began the contract manufacturing arrangement for the NuVinci bicycle CVT after March 2008. Production of the NuVinci bicycle CVT was launched in January 2007, by ATC under a manufacturing license agreement. We received royalties from ATC for all bicycle CVTs it sold from January 2007 through February 2008. In March 2008, we began outsourcing physical manufacturing to a contract manufacturer, started selling the NuVinci bicycle CVTs directly to OEMs and distributors, and recorded product sales revenue for the first time. Total product sales recorded in 2008 was $320,000.
 
Other revenue decreased by $60,000, or 65%, in 2008, compared to 2007, because of the termination of the license agreement with ATC in February 2008. The majority of the other revenue in 2007 was from miscellaneous parts and services sold to ATC.
 
We earned $19,000 of related-party revenues from the support services and engineering services provided to Viryd subsequent to the December 18, 2008 spin-off of Viryd.


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Cost of revenues
 
                                 
    Year Ended
             
    December 31,     Increase
    Percentage
 
    2007     2008     (Decrease)     Change  
    ($ in thousands)        
 
Cost of product sales
  $     $ 1,158     $ 1,158       N/A  
Cost of license fees and royalties
    1,005       368       (637 )     (63 )%
Cost of engineering services
    822       488       (334 )     (41 )%
Cost of related party revenues
          11       11       N/A  
Cost of other revenues
    65       23       (42 )     (65 )%
                                 
Total cost of revenues
  $ 1,892     $ 2,048     $ 156       8 %
                                 
 
Total cost of revenues for the year ended December 31, 2008 increased by $156,000, or 8%, compared to the year ended December 31, 2007.
 
The increase of $156,000 was primarily due to the $1,158,000 increase in cost of product sales. The increase was offset by the decrease of $637,000 and $334,000 in cost of license fees and royalties and cost of engineering services, respectively. Production of the NuVinci bicycle CVT was launched in January 2007, by ATC under a manufacturing license agreement. We received royalties from ATC for all bicycle CVTs it sold from January 2007 through February 2008, and did not incur any cost of product sales. In March 2008, we transitioned from a licensing business model for the bicycle CVT to a manufacturing model that outsources physical manufacturing to a contract manufacturer. At that time, we started selling the NuVinci bicycle CVTs directly to OEMs and distributors and recorded related cost of product sales. In addition to the cost of the N171 bicycle CVTs we purchased from our contract manufacturer (MTD), included in cost of product sales were $518,000 of depreciation expense of the manufacturing equipment we purchased from ATC and $16,000 of warranty reserve expense. Through the combination of the fixed-priced manufacturing agreement with Tri Star, new component suppliers, and improved design, we expect the N360 will have a per unit cost that is at least 50% less than the per unit cost of the N171 bicycle CVT.
 
Cost of license fees was from the engineering support we were required to provide to ATC. According to the terms of the manufacturing license agreement, we were to provide engineering support to ATC for a period of time while it commercialized the NuVinci bicycle CVTs. In order for us to successfully launch the first commercial product, the N360, for which we launched manufacturing in June 2010, we provided as much engineering support as reasonably necessary for that manufacturer to develop and sell the bicycle CVTs. Because of a long lead and unstable component supply base, we provided more engineering support than expected and incurred a negative gross margin from the license fees. We terminated the manufacturing license agreement with ATC in February 2008. In 2008, we recognized $368,000 of cost of license fees associated with the manufacturing license agreement.
 
The majority of the engineering services revenues earned and expenses incurred in 2007 was from services provided to ATC in support of ATC’s intent to develop the NuVinci technology for a high-powered application, such as automobile primary transmissions. We were willing to provide engineering services for this project at a negative gross margin because it was an opportunity to demonstrate the NuVinci technology in an application beyond bicycle. In 2007, this engineering services project required many more engineering hours than the other engineering projects in 2008. Commercializing the automobile primary transmission would require extensive capital, development and testing over a period of several years. When we terminated the relationship with ATC in February 2008, we considered the costs, barriers to entry and opportunity for this application. Following these deliberations, we chose not to proceed with the project further, choosing instead to focus our resources on the development and commercialization of other near-term revenue opportunities that require significantly less capital, such as products for the automotive accessory drive end market. Notwithstanding this decision, as a result of our development work under the engineering services agreement with ATC, we were able to apply for various patents relating to automobile primary transmissions and we build a fully demonstrable working prototype with performance test results should we choose to pursue the project at a later


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date. We may license the technology for this application to a manufacturer or OEM in the automotive industry and sign additional engineering services agreements to further develop and test the automobile primary transmission.
 
The majority of the other revenue in 2007 was from miscellaneous parts and services sold to ATC. Cost of other revenue decreased in 2008 because of the termination of the relationship with ATC in February 2008.
 
Operating expenses
 
Research and development
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2007   2008   (Decrease)   Change
    ($ in thousands)    
 
Research and development
  $ 2,985     $ 5,939     $ 2,954       99 %
 
Research and development expense for the year ended December 31, 2008 increased by $2,954,000, or 99%, compared to the year ended December 31, 2007.
 
The increase of $2,954,000 was primarily due to an increase in research and development activities by Viryd. Viryd’s research and development was $133,000 and $1,385,000 in 2007 and 2008, respectively. Viryd had one employee (Vice President of Engineering) at the end of July 2007. As of December 31, 2007 and 2008, Viryd increased its headcount (all engineers) to three and five, respectively. Excluding the increase from Viryd’s activities, the increase in our development expense in 2008, was $1,702,000, or 60%, compared to 2007. In 2007, $1,827,000 of development labor costs were incurred as cost of license fees and cost of engineering services revenue. In 2008, $971,000 of those development labor costs were incurred as part of our internal continuous development of the next generation of the NuVinci bicycle CVT, as well as supporting the bicycle CVT that is currently being sold in the market. Our engineering team also devoted some development efforts to improve and explore opportunities for our NuVinci technology in the automotive accessory drive end market. Total engineering salaries and payroll related expenses increased by $612,000 in 2008, compared to 2007. We increased the size of our engineering staff by five in 2007 and an additional five engineers in 2008. Rent, utilities and related expenses for the year ended December 31, 2008 increased by $168,000, compared to 2007 as we leased additional space to accommodate additional test stands and work space.
 
Selling, general and administrative expense
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2007   2008   (Decrease)   Change
    ($ in thousands)    
 
Selling, general and administrative
  $ 2,842     $ 4,382     $ 1,540       54 %
 
Selling, general and administrative expense for the year ended December 31, 2008, increased by $1,540,000, or 54%, compared to the year ended December 31, 2007.
 
Included in total selling, general and administrative expense in 2007 and 2008 were Viryd’s activities of $108,000 and $280,000, respectively. Excluding Viryd’s activities, our selling, general and administrative expenses in 2008 increased by $1,368,000, or 50%, compared to 2007. The increase was primarily due to costs incurred as part of becoming a manufacturer in March 2008. Total advertising, marketing, and trade show expenses increased by $387,000, salaries, bonuses and payroll related expenses increased by $335,000, business and marketing consulting expenses increased by $383,000, legal expenses increased by $191,000, and office, insurance, travel related, and other administrative expenses increased by $160,000. We added three employees in selling, general, and administrative in 2007 and two more employees in 2008.


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Interest income (expense)
 
Interest and dividend income
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2007   2008   (Decrease)   Change
    ($ in thousands)    
 
Interest and dividend income
  $ 447     $ 127     $ (320 )     (72 )%
 
Interest and dividend income for the year ended December 31, 2008 decreased by $320,000, or 72%, compared to the year ended December 31, 2007.
 
The decrease of $320,000 was attributable to lower average cash, cash equivalents, and short-term investment balances during the year ended December 31, 2008. Prior to the closing of the sale of Series D Preferred Stock on December 18, 2008, our average cash, cash equivalents, and short-term investment balances in 2008 was $6,347,000. During 2007, the average cash, cash equivalents, and short-term investment cash balances was $8,891,000. In addition, due to lower cash balances during the first half of 2008, we primarily invested our cash in money-market and certificate of deposits with shorter terms such as thirty days. In 2007, we invested our excess cash in longer term certificate of deposits and thus earned higher yields.
 
Interest expense
 
                                 
    Year Ended
       
    December 31,   Increase
  Percentage
    2007   2008   (Decrease)   Change
    ($ in thousands)    
 
Interest expense
  $     $ 597     $ 597       N/A  
 
We recognized interest expense for the first time in 2008 in the amount of $597,000.
 
Beginning in March 2008, we received proceeds from bridge loans in the amount of $4,618,000 and effective August 8, 2008 entered into a Convertible Note and Warrant Purchase Agreement and issued Convertible Unsecured Promissory Notes, with interest at an annual rate of 6%, and detachable warrants to purchase a certain number of shares in new securities (Series D Preferred Stock) equal to 20% of the original principal amount of the applicable Notes. We recorded approximately $180,000 of interest expense incurred from these Notes from the effective date to December 18, 2008, when they were converted into Series D Preferred Stock. We also recorded a non-cash interest expense of $261,000 for the value of the detachable warrants and beneficial conversion feature that were associated with the $4,618,000 promissory note.
 
We recorded $98,000 of interest that was attributable to a note payable by us in April 2008 in the amount of $1,952,000, with an interest rate of 8% per annum, to purchase an assembly line from ATC so that we could become an outsourced manufacturer. We paid the note in full in December 2008. In consideration of prepayment, the interest rate on the note was amended to 7% per annum. The remaining interest expense was incurred from the outstanding $2,000,000 balance of the note drawn from the line of credit in April 2008. As of December 31, 2008, a balance of $2,000,000 remains outstanding.


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Liquidity and Capital Resources
 
Overview
 
Since 2000, we have funded our operations primarily through the private placement of approximately $62 million in the aggregate of our equity securities. We have also financed our business through cash generated from our operations and by borrowing cash under our revolving line of credit or other third party resources.
 
To date, we have invested significant resources developing products for a selected set of end markets. We have also invested in the development and protection of intellectual property resulting in a worldwide portfolio of 176 patents (including validated countries) and 189 pending applications as of July 31, 2010. We plan to continue to invest in developing and commercializing the NuVinci CVTs for the automotive accessory drives, electric vehicles, bicycle, lawn care equipment and small wind turbine end markets.
 
While we have spent several years developing our core technology, our past experience in launching our bicycle product and developing other products to date indicates that the product development process to apply our core technology in each of our target end market applications takes from 18 to 34 months from start to finish, depending on the complexity of the particular application. The key steps of the development cycle include: product design, prototyping and testing; production design validation; manufacturing tooling and process development, including supplier development; and manufacturing launch. The NuVinci CVT for the automotive accessory drive, lawn care equipment, electric vehicles and small wind turbines end markets is in the design, prototyping and testing stage of development. In some of these end markets, we license our products to other companies to manufacture and sell in their respective industries, from which we derive licensing fees or royalties on the sales of their products. In other end markets, we intend to enter joint ventures with development partners that would manufacture and market our products, from which we would share in the sales of such products. If we choose not to enter joint ventures for such products, we may elect to use third party contract manufacturers to produce those products.
 
Our bicycle product has been commercially available since 2007 and we launched our next generation product, the N360, for the bicycle end market in June 2010 and shipped initial products to customers in July 2010. We anticipate that we or our licensees will launch products in the small wind turbines and automotive accessory drives markets in 2011, lawn care equipment market in 2012 and for the electric vehicle market in 2013.
 
Over the next twelve months, we expect to fund our operations through the proceeds of this offering and the proceeds of one or more private equity offerings.
 
We believe that the net proceeds from this public offering and our existing cash and cash equivalents, together with interest thereon, will provide us with sufficient resources to pay off our existing revolving line of credit and fund our operations through at least 2012. While we intend to pay off our existing line of credit with the proceeds from the public offering, we may choose to maintain a revolving line of credit for working capital requirements. In order to fund our operations beyond 2012, we may need to raise additional funds through the issuance of equity, equity-related or debt securities. This capital will be necessary to fund our ongoing operations, continue research, development and design efforts and launch our products. We cannot be certain that additional funds will be available to us on favorable terms when required, or at all.
 
If we choose to develop and commercialize additional products or make any strategic investments outside of our current plan, we may need additional funds. We may obtain additional capital from:
 
  •   Internally generated funds;
 
  •   Equity, debt financings and borrowings on our line of credit; and
 
  •   Collaborations such as joint development or joint ventures.
 
As of August 25, 2010, we had cash and cash equivalents of approximately $5.9 million and borrowing capacity under a revolving line of credit of $0.5 million. Assuming no change in present trends, our estimated monthly cash burn rate is approximately $1.5 million. If we are unable to raise capital from this public


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offering, in addition to the $6.0 million raised in a private equity offering in August 2010, we would need to raise approximately $16.0 million through private equity offerings from our existing and new investors, which we believe would be sufficient for us to continue operations through August 2011. If the closing of the private equity round is delayed, we may curtail our development efforts to only focus on the development and commercialization of the bicycle and small wind turbine end markets. We would also attempt to renew the existing revolving line of credit that expires on December 31, 2010. If we are not able to renew the revolving line of credit, the capital raise from the potential $16.0 million private equity offering would be sufficient to pay off the outstanding balance under the revolving line of credit. There is no guarantee that we would be successful in raising any or all of the $16.0 million through a private equity offering.
 
Recent Transactions Affecting our Liquidity and Capital Resources
 
Throughout the global credit and economic crisis, it has been expensive for us to raise private capital. In order to purchase the manufacturing tangible and intangible assets from ATC in February 2008, we drew $2.0 million from our $5.0 million line of credit (which was amended in March 2010 to be a $3.0 million line of credit), and issued a promissory note for $2.0 million. Collateral for the line of credit consisted of the personal guarantee of, but now consists of assets held on account with the lender by Gary Jacobs, a stockholder and director of our company. In December 2009, we issued a warrant to purchase 3,100,753 shares of common stock at a price of $0.3992 in exchange for the personal guarantee of our line of credit.
 
Beginning in March 2008, we received proceeds from bridge loans from existing and new private investors in the amount of $4.6 million and effective August 2008, entered into a Convertible Note and Warrant Purchase Agreement and issued Convertible Unsecured Promissory Notes with interest at an annual rate of 6%, and detachable warrants to purchase a certain number of shares in new securities (Series D Preferred Stock) equal to 20% of the original principal amount of the applicable Notes. The bridge loans provided us the capital required to continue operations until we closed the Series D Preferred Stock financing in December 2008.
 
In December 2008, we were able to close a private placement of new securities and issued 51,589,191 shares of Series D Preferred Stock, at a price of $0.3992 per share in exchange for gross proceeds of approximately $20.6 million. The principal of the Convertible Note and accrued interest of $4.8 million were converted into 12,018,211 shares of Series D Preferred Stock and the detachable warrants were canceled in exchange for 672,050 shares of Viryd Series A Preferred Stock that was held by us. The transaction fees in connection with the Series D Preferred Stock financing include warrants to purchase 2,004,000 shares of common stock at a price of $0.3992.
 
On December 31, 2008, we paid off the $2.0 million promissory note in full. As of December 31, 2009 and June 30, 2010, $2.0 million remains outstanding under the revolving line of credit. On August 2, 2010, we borrowed an additional $0.5 million against the revolving line of credit to fund working capital requirements.
 
In November 2009, we raised $4.0 million by issuing 10,020,040 shares of Series D Preferred Stock. The transaction fees included warrants to purchase 112,726 shares of common stock at a price of $0.3992 per share.
 
In August 2010, we closed a private placement of new securities by issuing 6,550,218 shares of Series E Redeemable Convertible Preferred Stock at a price of $0.9160 per share in exchange for cash proceeds of $6,000,000.
 
Sources and Uses of Cash
 
At June 30, 2010, we had cash and cash equivalents of $1.5 million, compared to $9.2 million at December 31, 2009, $14.6 million at December 31, 2008, and $8.0 million at December 31, 2007.
 


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          Six Months Ended
 
    Year Ended December 31,     June 30,  
    2007     2008     2009     2009     2010  
    ($ in thousands)  
 
Net cash (used in) provided by:
                                       
Operating activities
  $ (5,860 )   $ (9,496 )   $ (12,118 )   $ (6,472 )   $ (5,960 )
Investing activities
    8,073       (7,271 )     2,954       (6,551 )     (305 )
Financing activities
    2,612       23,289       3,812       (5 )     (1,404 )
Effect of foreign currency transactions
                            (2 )
                                         
Net change in cash
  $ 4,825     $ 6,522     $ (5,352 )   $ (13,028 )   $ (7,671 )
                                         
 
Cash Flows from Operating Activities
 
Cash flows used in operating activities totaled $6.0 million during the six months ended June 30, 2010 compared to $6.5 million during the six months ended June 30, 2009. Net cash used in operating activities was primarily generated from the net loss as adjusted for lower-of-cost-or-market write-downs and inventory obsolescence, depreciation and amortization, and share-based compensation expense. Net loss totaled $6.7 million for the six months ended June 30, 2010 compared to $6.4 million for the six months ended June 30, 2009. We incurred lower-of-cost-or-market write-downs and inventory obsolescence expense of $0.3 million during the six months ended June 30, 2010 relating to a provision for obsolescence on developer kits compared to $0.7 million during the six months ended June 30, 2009 relating to lower-of-cost-or-market write-downs because the N171 CVT unit cost exceeded the sales price. Depreciation and amortization expense decreased from $0.7 million during the six months ended June 30, 2009 to $0.2 million during the six months ended June 30, 2010. The decrease in depreciation and amortization was the result of the disposal of manufacturing equipment and write-off of intangible assets associated with the trade secrets and manufacturing processes used by MTD in 2009. As such, there was no depreciation or amortization on these assets during the six months ended June 30, 2010. Share-based compensation expense increased by $91,000 as a result of stock options granted during 2009 that continue to vest in 2010.
 
In January 2010, we signed a manufacturing and supply agreement with Tri Star Group, a manufacturer located in Shanghai, China, to manufacture the next generation bicycle CVT. Under that agreement, we are responsible for certain finished goods, work in process, and raw materials inventory relating to our bicycle CVT that Tri Star has on hand. As long as the manufacturing and supply agreement with Tri Star is effective, we may be required to use working capital to pay for this inventory.
 
In 2009, cash flows used by operating activities totaled $12.1 million, compared to $9.5 million in 2008. The increase in cash used in operations in 2009 was due primarily to an increase in the net loss of $6.6 million offset by a noncash impairment of $1.5 million and loss on disposal of $1.5 million on machinery and equipment, as well as a $0.5 million impairment loss on the write-off of intangible assets from ATC that included trade secrets and manufacturing processes used to manufacture the N171. Additionally, there was a $1.3 million lower of cost or market write-down and obsolescence charge on inventory on hand. This was offset by a $1.7 million increase in cash used to build product inventory for future sales and product replacements, if any, and to further develop the core NuVinci technology for our target end markets.
 
In 2008, cash flows used by operating activities totaled $9.5 million, compared to $5.9 million in 2007. The increase in cash flows used by operating activities was driven primarily by costs associated with becoming a contract manufacturer and development efforts to improve and further develop the core NuVinci technology for the automotive accessory drive and small wind turbine end markets.
 
Cash Flows from Investing Activities
 
Cash flows used in investing activities totaled $0.3 million during the six months ended June 30, 2010 compared to $6.6 million during the six months ended June 30, 2009. During the six months ended June 30,

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2009, cash used in investing activities primarily consisted of $8.1 million in purchases of held-to-maturity investments, offset by $2.0 million in sales of held-to-maturity investments; whereas during the first quarter of 2010, we elected to maintain liquidity in cash and cash equivalents instead of investing in debt or equity securities.
 
In 2009, cash flows provided by investing activities totaled $3.0 million, compared to $7.3 million used in investing activities in 2008. In 2009, cash provided by investing activities primarily consisted of proceeds from sales of investments, while cash used in investing activities in 2008 consisted of purchases of equipment and leasehold improvements, purchases of intangible assets and costs incurred for patents, and purchases of investments.
 
In 2008, cash flows used in investing activities totaled $7.3 million, compared to $8.1 million that was provided by investing activities in 2007. In 2008, we primarily used cash to purchase manufacturing equipment, intangible assets and to pay for patent costs. In 2007, proceeds from the sale of investments exceeded cash flows used to purchase investments.
 
Cash Flows from Financing Activities
 
Cash flows used in financing activities of $5,000 during the six months ended June 30, 2009 was for repayments of a capital lease obligation, compared to $1.4 million during the six months ended June 30, 2010 in cash used for accounting, legal, underwriting, and other miscellaneous costs associated with the proposed initial public offering.
 
In 2009, cash flows provided by financing activities totaled $3.8 million, compared to $23.3 million in 2008. Financing activities in 2009 primarily included $4.0 million in proceeds from the issuance of Series D Preferred Stock, as compared to $20.1 million in proceeds from the issuance of Series D Preferred Stock in 2008. In 2008, financing activities also included borrowings of $4.6 million in Convertible Unsecured Promissory Notes and borrowings of $2.0 million on the line of credit, offset by $2.0 million in repayments of notes payable.
 
In 2008, cash flows provided by financing activities totaled $23.3 million, compared to $2.6 million in 2007. Cash provided by financing activities in 2008 was primarily from the issuance of Series D Preferred Stock in exchange for gross cash proceeds of $20.6 million and borrowings of $4.6 million Convertible Unsecured Promissory Notes and $2.0 million on the line of credit. The cash inflows were reduced by repayments of $2.0 million note payable, Series D Preferred Stock issuance cost of $1.4 million, and spin-off of Viryd of $0.9 million.
 
Capital Expenditures
 
Our capital expenditures include machinery and equipment, furniture and fixtures, computer equipment, and leasehold improvements. Under our business model of contract manufacturing and licensing, one of the several advantages over in-house manufacturing is lower capital expenditures. We do not expect to invest significant amounts of capital in facilities and equipment; however, we do expect to share some tooling costs with the contract manufacturer of our products. In 2008, we paid $2.7 million in cash and issued a promissory note in the amount of $2.0 million to ATC in connection with the purchase of ATC’s manufacturing line equipment. In 2009, we spent $0.4 million in cash for machinery and equipment.
 
Revolving Line of Credit
 
At December 31, 2008 and 2009, we had $2.0 million of borrowings outstanding under our revolving line of credit. As of December 31, 2008 and 2009, we had $3.0 million available under the revolving line of credit.
 
In March 2010, we amended the line of credit to remove restrictive financial covenants. The amendment also decreased the available credit from $5.0 million to $3.0 million. At June 30, 2010, we had $2.0 million outstanding under our revolving line of credit with $1.0 million remaining available.
 
On August 2, 2010, we borrowed an additional $0.5 million against the revolving line of credit to fund working capital requirements.


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Off-Balance Sheet Arrangements
 
We do not have any off-balance sheet arrangements, except for operating leases for our facilities.
 
Contractual Obligations
 
The following table summarizes our contractual obligations and commitments as of December 31, 2009:
 
                                         
    Payments by Year  
    Total     2010     2011     2012     Thereafter  
    ($ in thousands)  
 
Operating leases
  $ 439     $ 308     $ 108     $ 23     $  
Debt(1)
    2,000       2,000                    
                                         
Total
  $ 2,439     $ 2,308     $ 108     $ 23     $  
                                         
 
 
(1) As of December 31, 2009, debt obligation includes short-term debt of $2.0 million of outstanding balance on the revolving line of credit, but excludes related interest payments on the line of credit. The outstanding principal balance bears interest at a rate of 1.0% per annum above the base rate, which is a fluctuating rate equal to the highest of the prime rate (5.0% at December 31, 2009 and 3.25% as of June 30, 2010), LIBOR plus 1.5%, or the Federal Funds Rate plus 1.5%; but in no case shall the interest rate be less than 5.0%. Debt obligation also excludes the quarterly unused commitment fee of 0.375% per annum on the average daily unused line of credit.
 
We had no long-term debt as of December 31, 2009. Our current debt as of December 31, 2009 was comprised of $2.0 million drawn on a revolving line of credit scheduled to expire on December 31, 2010. Our long-term liabilities include deferred revenue of $0.3 million as of December 31, 2009.
 
In January 2010, we entered into a two year consulting agreement with Advanced Strategic Leadership Limited (ASL), an unrelated Shanghai company, under which ASL will provide consulting and market development services in exchange for a monthly fee of $10,000 per month, 2% of net sales procured by ASL each calendar quarter during the term of the agreement, a warrant to purchase 50,000 shares of common stock, and, upon reaching certain performance milestones, warrants to purchase up to 750,000 shares of common stock at an exercise price of $0.3992. In August 2010, the Company issued a warrant to purchase 100,000 shares of common stock due to successful achievement of certain milestones, thereby leaving contingent warrants to purchase up to 650,000 shares of common stock available to ASL. Under the consulting agreement, services and deliverables that ASL will provide include a China electric vehicle market analysis and future forecast; support for the establishment of an electric vehicle business; and support for building brand/product introduction.
 
Effective January 30, 2010, we entered into a manufacturing supply agreement with Tri Star Group (Tri Star) under which Tri Star will manufacture the next generation bicycle transmission, the N360, on a contract basis and will participate with us in the sale of the N360 in China. Tri Star will provide the manufacturing facility and general purpose equipment, Tri Star and the Company will share the cost of tooling, and we will bear the cost of dedicated special purpose equipment needed for assembly of the product. We issued a blanket purchase order in the range of $8.0 million to $12.0 million for forecasted production requirements from May 2010 through August 2011. Regular orders against this blanket purchase order will be provided to Tri Star based on orders received and forecasted demand.
 
Qualitative and Quantitative Disclosures About Market Risk
 
Our exposure to market risk for changes to interest rates relates primarily to our cash and cash equivalents and revolving line of credit.
 
We have a $3,000,000 revolving line of credit, which expires December 31, 2010, with Wells Fargo Bank, National Association, of which $2,000,000 was outstanding at December 31, 2009 and June 30, 2010. The line of credit provides for a quarterly unused commitment fee of 0.375% per annum on the average daily unused


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amount. As of December 31, 2009, the outstanding principal balance bore interest at a rate of 1.0% per annum above the base rate, which was a fluctuating rate equal to the highest of the prime rate, LIBOR plus 1.5%, or the Federal Funds Rate plus 1.5%; but in no case would the interest rate be less than 5.0%. The resultant effective interest rate on the outstanding principal was 5.0% from the date the interest rate on the revolving line of credit was amended on June 1, 2009 through December 31, 2009. On March 23, 2010, the revolving line of credit was amended to decrease the interest rate to the base rate, which is a fluctuating rate equal to the highest of the prime rate, LIBOR plus 1.5%, or the Federal Funds Rate plus 1.5%. The highest rate was 3.25% under the prime rate as of June 30, 2010. This amendment eliminated the former 5.0% floor rate. If market interest rates increase, this variable-rate debt will create higher debt service requirements, which could adversely affect our cash flow. For example, based on an outstanding balance of $2,000,000 as of June 30, 2010, a 10% increase in a 5.0% interest rate would result in interest expense of $110,000 per annum based on 5.5% as compared to $100,000 per annum based on 5.0%. A 10% increase in a 3.25% interest rate would result in interest expense of $71,500 per annum based on 3.6% as compared to $65,000 per annum based on 3.25%. We do not enter into agreements to limit our exposure to higher interest rates.
 
Our cash, cash equivalents, and short-term investments as of June 30, 2010, consisted primarily of cash and money market funds. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of United States interest rates. However, because of the short-term nature of the instruments in our portfolio, a sudden change in market interest rates would not be expected to have a material impact on our financial condition or results of operation.
 
We are exposed to foreign currency exchange rate risk inherent in expenses, assets and liabilities denominated in currencies other than the U.S. dollar, principally the Euro. The potential change in foreign currency exchange rates represents a minimal risk to us and is not material given the size of our operations in those jurisdictions in the periods included in this prospectus. We also view our investment in our foreign operations as long-term and, therefore, have not entered into any derivative transactions to mitigate the currency effect on our operating results. We have no intention of hedging our foreign exchange risk at this time; however, such exposure to foreign currency exchange rate fluctuations in the future will be evaluated on an ongoing basis. We do not enter into derivatives for trading or other speculative purposes.
 
Accounting Restatements
 
Since inception through December 31, 2008, we elected to value our common stock, options, and warrants by a method not in accordance with GAAP. We had previously determined fair value based on Internal Revenue Code Section 409A, using a probability-weighted expected return valuation method. We have since reassessed the fair value of our common stock, through the engagement of a third-party valuation specialist, using methodologies in accordance with GAAP based our total enterprise value, which is defined as the market value of equity plus interest bearing debt less cash and cash equivalents.
 
We have restated the accompanying consolidated financial statements as of December 31, 2008 and for each of the years ended December 31, 2007 and 2008, to correct the recognition of share-based compensation expense, warrants, and debt discounts. The net effects of the restatement on our financial statements are disclosed in Note 16 to the consolidated financial statements.
 
In connection with the anticipated filing of the registration statement in connection with our initial public offering, certain expenses as originally reported have been reclassified in the consolidated statements of operations to be consistent with the classifications adopted in 2009, with no net impact on the 2007 and 2008 reported net loss, stockholders’ equity, and cash flows. These reclassifications allocated certain research and development and selling, general and administrative expenses to cost of revenues expense categories. Revenues were disaggregated into more detailed revenue lines. Stock-based compensation expense and depreciation and amortization were allocated to cost of revenues, research and development, and selling, general and administrative expenses.
 
Additionally, certain balance sheet reclassifications within current assets have been made, including consolidating a nominal interest receivable amount into prepaid expenses and other current assets, as well as


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reclassing certain certificates of deposit out of cash and cash equivalents and into short-term investments based on their original maturity dates. Reclassifications between liability accounts have also been made to properly classify long-term liabilities, such as reclassing deferred rent and deferred revenue to long-term liabilities based on their long-term nature.
 
Critical Accounting Policies and Estimates
 
Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are more fully described in Note 2 to our audited consolidated financial statements included in this prospectus, we believe that the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our consolidated financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of the Board of Directors.
 
Inventory
 
All items in inventory are finished goods and are stated at the lower of cost, determined on a first-in-first-out basis, or market. The Company regularly reviews inventory quantities on-hand and adjusts inventory values for excess and obsolete inventory based on overall inventory levels, the current and projected sales levels for such products, the projected markets for such products, and the overall projected demand for products once the next generation of products is scheduled for release.
 
The Company recognized $952,000 in write-downs of inventory based on monthly lower-of-cost-or-market assessments throughout the year ended December 31, 2009. These monthly assessments were based on actual sales prices of units sold during the month compared to actual unit costs of units purchased during that month, considering the fact that the unit cost of the N171 model of the bicycle CVT was higher than its sales price. We also took into account the effect the expected launch of, and preliminary marketing effort for, the N360 product may have on the sales price of the existing N171 product. If we changed the assumption used for unit sales price by 10%, the write-down of inventory for lower-of-cost-or-market would have either increased or decreased by approximately $97,000 for the year ended December 31, 2009.
 
The Company also recognized $357,000 in write-downs of inventory during the year ended December 31, 2009 as a result of evaluations of inventory obsolescence, which were based on the number of units on hand as compared to management’s best estimates of the timing and volume of future sales of the existing N171 model, considering the impending launch of the next generation N360 product. If we increased or decreased the forecasted sales volume by 10%, the write-down of inventory for obsolescence would have increased or decreased by approximately $5,000.
 
Evaluation of long-lived assets
 
The Company assesses its long-lived assets for potential impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Estimated future cash flows are based upon, among other things, assumptions about expected future operating performance and may differ from actual cash flows. Long-lived assets evaluated for impairment are grouped with other assets to the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. If the sum of the projected undiscounted cash flows (excluding interest) is less than the


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carrying value of the assets, the assets will be written down to the estimated fair value in the period in which the determination is made.
 
During the third quarter of 2009, the Company recognized an impairment loss of $1,537,000 on manufacturing equipment and a $490,000 impairment loss equal to the net book value of certain intangible assets relating to the manufacturing of the bicycle CVT. While MTD was manufacturing the bicycle CVT, management continually assessed, among other criteria, the likelihood and time period of when the anticipated cost decrease from MTD would be achieved, the estimated undiscounted cash flows from sales of units over the course of the manufacturing agreement, and how the cost reductions were tracking to production and cost reduction milestones. During the third quarter of 2009, management determined that the cost reductions would not happen within the anticipated timeframe and, as a result, the projected undiscounted cash flows were less than the carrying value of the assets, which then required management to assess the fair value of the CVT machinery and equipment. Management utilized the market approach to estimate fair value of the manufacturing equipment. The market approach was applied by obtaining quoted market prices for selected similar assets (based on make, model, and serial number) and applying the results to the remaining value of the manufacturing assets. If the quoted market values obtained had differed by 10%, the impairment recognized during the third quarter of 2009 would have either increased or decreased by approximately $154,000, which would have conversely increased or decreased the loss recognized in the fourth quarter of 2009 when the manufacturing equipment was transferred to MTD upon termination of the Manufacturing Supply Agreement.
 
Intangible Assets
 
As discussed in the previous policy regarding our evaluation of long-lived assets, we have assessed the recoverability of the patent portfolio based on the associated projected undiscounted future cash flows derived from our projections of the number of units sold and their respective selling prices. The projection of future net cash flows from sales or licenses of products using the Company’s patented technology requires significant management estimates and judgments, including the timing, volume, cost and pricing of future product sales, the expected rollout date of our next generation products, and expected demand based on discussions with customers. Although we have limited sales history, management believes that this information provides it with a reasonable basis to forecast future cash flows sufficient to support the recoverability of its patent costs. We believe that a 25% reduction in the associated projected undiscounted future cash flows would not affect the recoverability of the patent portfolio. As such, we have determined that no impairment exists for the years ended December 31, 2008 and 2009.
 
Share-based compensation
 
We measure all share-based compensation arrangements using a fair value method and to record the expense in our consolidated financial statements over the requisite service period.
 
The fair value of each employee option granted during the year ended December 31, 2009 was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:
 
     
    Year Ended December 31, 2009
 
Expected volatility
  56%-63%
Expected dividends
  None
Expected term (in years)
  5.25-6.08
Risk-free interest rate
  2.02%-2.77%
 
Expected volatility—The expected volatility rate used to value stock option grants is based on volatilities of a peer group of similar companies whose share prices are publicly available. The peer group was developed based on observed comparable companies’ historical common equity volatility for the applicable time periods. For 2009 employee awards, increasing the volatility assumption by 10% to a 62%-69% range or decreasing the volatility assumption by 10% to a 51%-56% would have resulted in an approximately $157,000 ($77,000 increase or $80,000 decrease) or 13% change in fair value. These changes in fair value would have been recognized over the three to four year vesting period of such awards.


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Expected term—The Company elected to utilize the “simplified” method to estimate the expected term of stock option grants because the Company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term. Under this approach, the weighted average expected life is presumed to be the average of the vesting term and the contractual term of the option. For 2009 employee awards, increasing the expected term assumption by 10% to 6.05—6.69 years or decreasing the expected term assumption by 10% to 4.95—5.47 years would have resulted in an approximately $92,000 ($44,000 increase or $48,000 decrease) or 7% change in fair value. These changes in fair value would have been recognized over the three to four year vesting period of such awards. It should be noted that a change in the expected term would cause other changes, since the risk-free rate and volatility assumptions are specific to the term; we did not attempt to adjust those assumptions in performing the sensitivity analysis above.
 
Common stock fair value—For purposes of estimating the fair value of its common stock for stock option grants, the Company reassessed the estimated fair value of its common stock, with the assistance of an unrelated valuation specialist, on selected dates during the years ended December 31, 2007 through 2009. Prior to this reassessment, the Company concluded that stock options granted had exercise prices equal to the then estimated fair value of common stock at the date of grant. Subsequent to reassessment, the Company determined certain stock options granted during 2007 through 2009 had an exercise price different than the estimated fair value of the common stock at the date of grant.
 
The Company’s reassessment was based on a methodology that first estimated the fair value of the Company as a whole, or enterprise value, and then allocated a portion of the enterprise value to its common stock. This approach is consistent with the methods outlined in the AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The valuation methodology utilized in the reassessment of fair value relied primarily on the income approach and the market approach to estimate enterprise value. The market approach gave consideration to the total financing amount received, the implied enterprise value of the Company based on the convertible preferred stock transactions, pricing of comparable publicly traded companies, and market-based private company transactions. Pursuant to the guidance under ASC Topic 820, the inputs used in the market approach over the various valuation dates were primarily Level 2 and Level 3 inputs. The income approach incorporated the expectations of future cash flows of the Company as of the valuation dates and market expectations for an estimated discount rate. The inputs used under the income approach were primarily Level 3 inputs with some Level 2 inputs related primarily to the derivation of the estimated appropriate market participant discount rate. Once the enterprise value was established, the Company used a method consistent with the guidance in AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, to determine the value of the underlying common shares. Specifically, the Company used the Option Pricing Method to determine the fair of the underlying common stock. The Company used these fair value estimates derived from its valuations to determine share-based compensation expense recorded in the consolidated financial statements.
 
Given the absence of an active market for our common stock, the Company estimated the fair value of our common stock, with assistance from an unrelated valuation specialist, by performing retrospective valuations for the valuation dates prior to 2009 and contemporaneous valuations during 2009. These estimates of the fair value of our common stock were made as of the following dates:
 
         
    Fair Value
Common Stock Valuation Date
  Per Share
 
June 30, 2007
  $ 0.67  
December 31, 2007
    0.47  
December 31, 2008
    0.22  
August 31, 2009
    0.11  
December 8, 2009
    0.26  


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The following table sets forth all stock options granted during the 12 months prior to June 30, 2010:
 
                         
    Number of
       
    Options
  Exercise
  Fair Value
Grant Date
  Granted   Price   Per Share
    (In thousands)        
 
August 26, 2009
    193     $ 0.22     $ 0.22  
October 22, 2009
    2,449       0.10       0.11  
December 3, 2009
    102       0.10       0.26  
December 5, 2009
    105       0.25       0.26  
 
In order to determine the fair value of our common stock on the date of grant for purposes of calculating the fair value of our stock option grants under ASC Topic 718, we utilized the most current valuation, primarily obtained on the last day of the fiscal year. If there was a material change in the business or in the business plan, we obtained an independent valuation prior to granting stock options.
 
Accounting Standards Updates
 
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. (FIN) 46(R), (codified in ASC Topic 810), as amended by ASU 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities, which amends the consolidation guidance that applies to variable interest entities (VIE). The amendments will significantly affect the overall consolidation analysis under FIN 46 (revised December 2003), Consolidation of Variable Interest Entities, or FIN 46(R), to improve financial reporting by enterprises involved with VIE’s and to provide more relevant and reliable information to users of financial statements. ASC Topic 810, as amended by ASU 2009-17 carries forward the scope of FIN 46(R), with the addition of entities previously considered qualifying special-purpose entities, as the concept of these entities was eliminated in SFAS No. 166, Accounting for Transfers of Financial Assets (ASC Topic 860). The principal objectives of these new disclosures are to provide financial statement users with an understanding of:
 
  •   The significant judgments and assumptions made by an enterprise in determining whether it must consolidate a VIE and/or disclose information about its involvement in a VIE;
 
  •   The nature of restrictions on a consolidated VIE’s assets and on the settlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities;
 
  •   The nature of, and changes in, the risks associated with an enterprise’s involvement with the VIE; and
 
  •   How an enterprise’s involvement with the VIE affects the enterprise’s financial position, financial performance, and cash flows.
 
We adopted the new accounting literature specified in ASC Topic 810, Consolidation, on January 1, 2010. The adoption of this new literature did not have a material effect on the consolidated financial statements.
 
In October 2009, ASU 2009-13, Multiple-Deliverable Revenue Arrangements, codified the consensus in Emerging Issues Task Force (EITF) Issue 08-1, which supersedes EITF Issue 00-21 (codified in ASC Topic 605-25). The ASU was issued in response to practice concerns related to the accounting for revenue arrangements with multiple deliverables under Issue 00-21 and applies to all deliverables in contractual arrangements in all industries in which a vendor will perform multiple revenue-generating activities, except when some or all deliverables in a multiple-deliverable arrangement are within the scope of other, more specific sections of the Codification and other sections of ASC 605 on revenue recognition. Specifically, the ASU addresses the unit of accounting for arrangements involving multiple deliverables. It also addresses how arrangement consideration should be allocated to the separate units of accounting, when applicable. However, guidance on determining when the criteria for revenue recognition are met and on how an entity should recognize revenue for a given unit of accounting are located in other sections of the Codification (e.g., Staff Accounting Bulletin Topic 13). Although the ASU retains the criteria from Issue 00-21 for when delivered items in a multiple-deliverable arrangement should be considered separate units of


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accounting, it removes the previous separation criterion under Issue 00-21 that objective and reliable evidence of the fair value of any undelivered items must exist for the delivered items to be considered a separate unit or separate units of accounting. The final consensus is effective for fiscal years beginning on or after June 15, 2010. Entities can elect to apply this ASU (1) prospectively to new or materially modified arrangements after the Issue’s effective date or (2) retrospectively for all periods presented. We do not believe the adoption of ASU 2009-13 will have a material impact on the consolidated financial statements.
 
In April 2010, the FASB issued ASU 2010-17, Milestone Method of Revenue Recognition, which establishes a revenue recognition model for contingent consideration that is payable upon the achievement of an uncertain future event, referred to as a milestone. The scope of the ASU is limited to research or development arrangements and requires an entity to record the milestone payment in its entirety in the period received if the milestone meets all the necessary criteria to be considered substantive. However, entities would not be precluded from making an accounting policy election to apply another appropriate accounting policy that results in the deferral of some portion of the arrangement consideration. The ASU is effective for fiscal years (and interim periods within those fiscal years) beginning on or after June 15, 2010. We will apply this guidance prospectively to milestones achieved after adoption on January 1, 2011 for research or development arrangements involving deliverables or units of accounting in which we satisfy performance obligations over time and all or a portion of the arrangement consideration is contingent upon the achievement of a milestone. We do not believe the adoption of ASU 2010-17 will have a material impact on the consolidated financial statements.


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Business
 
Overview
 
Our NuVinci Technology
 
We have developed products that incorporate our core patented technology, sold under the “NuVinci” brand. Our core technology is a type of transmission — a device that transmits power while converting the rotating input speed into one of multiple possible output speeds. Our NuVinci technology is designed to improve the overall efficiency and performance of vehicles and equipment that operate at various speeds, such as bicycles, automobile accessories, wind turbines and lawn mowers.
 
Our NuVinci technology is a new type of continuously variable transmission (CVT) that we believe can be used in a wide variety of end market applications. A CVT is a transmission that effectively has an infinite number of gear ratios, or speeds, between its lowest and highest speeds. Our NuVinci technology provides a smooth, continuous progression from one speed to another through its range with no breaks or jerks, allowing the transmission output speed to change, while the engine or motor speed stays at its speed of peak efficiency or power.
 
Our technology is currently available in the global market for bicycle transmissions, where it has been used to replace the rear wheel gear changing assembly, or derailleur. We are also currently developing applications of our core technology for a number of other target end markets that we believe, based on our research, to have near term commercial potential. These include accessory drives for automotive air conditioners, alternators, power steering pumps and superchargers and primary transmissions for electric vehicles, lawn care equipment and small wind turbines.
 
Based on our research and testing, we believe that the design and manufacturing cost of the NuVinci technology make it scalable across multiple applications in various industries, which we feel makes it a “platform technology.” Through our internal testing, we have shown that the NuVinci CVT improves overall efficiency, performance and functionality in many existing vehicles and equipment and, as discussed below, enables functions that currently do not exist in such systems.
 
Benefits of our NuVinci Technology
 
We believe, based on testing performed internally at our test facilities and on prototype vehicles and equipment, that our NuVinci technology provides the following benefits to specific applications in our target markets:
 
•  Automotive Accessory Drives:  Enables accessories to maintain an optimal operating speed, even as engine speed increases or decreases. This is important for vehicle engine accessories such as air conditioners and alternators, because it allows them to provide optimal cooling and electric power, respectively, even when the engine is at its lowest speed. For power steering pumps, this allows sufficient steering assistance, even when the engine speed is low or at idle. For superchargers, this improves engine performance and facilitates the use of smaller engines, or “engine downsizing,” to reduce fuel consumption and emissions without sacrificing performance.
 
•  Electric Vehicles:  Enhances the commercial potential of electric vehicles by creating mechanical efficiencies that increase vehicle driving range and top speed in typical day to day driving conditions, improving battery life and potentially reducing the need for certain inefficient, high cost power electronics, which would lower manufacturing costs.
 
•  Bicycles:  Optimizes ride experience by providing an unlimited number of speeds between low and high with smooth, seamless shifting throughout so the rider can select the exact pedaling speed the rider desires for any particular riding condition.
 
•  Lawn Care Equipment:  Reduces fuel consumption, emissions and noise of lawn care equipment, while providing the same or improved performance.


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•  Small Wind Turbines:  Improves the energy capture and improves reliability of small wind turbines, while lowering the cost of the wind turbine and thereby reducing the cost of energy produced.
 
Our Products
 
We have developed or are developing several products to address each of these end markets, some of which we will license to other manufacturers to make and sell into those markets (as described below). While we have spent several years developing our core technology, our past experience in launching our bicycle product and developing other products to date indicates that the product development process to apply our core technology to each of our target end market applications takes from 18 to 34 months from start to finish, depending on the complexity of the particular application. The key steps of the development cycle, which are discussed further below, include: product design, prototyping and testing; production design validation; manufacturing tooling and process development, including supplier development; and manufacturing launch. The products we are currently selling as well as those under development and the corresponding stage in the development process are as follows:
 
                 
            Anticipated
 
            Product
 
Product   End Market   Development Stage   Launch Year(1)  
 
Alternator drive
  Automotive accessory drives   Design, prototyping and testing     2011  
                 
Air conditioner drive
  Automotive accessory drives   Design, prototyping and testing     2011  
                 
Power steering pump
  Automotive accessory drives   Design, prototyping and testing     2011  
                 
Supercharger drive
  Automotive accessory drives   Design, prototyping and testing     2012  
                 
Primary transmission
  Electric vehicles   Design, prototyping and testing     2013  
                 
N171
  Bicycles   Production completed; ongoing sales of inventory     2007 (2)
                 
N360
  Bicycles   Manufacturing launch     2010 (2)
                 
Primary transmission
  Small wind turbines   Design, prototyping and testing     2011 (3)
                 
Primary transmission
  Lawn care equipment   Design, prototyping and testing     2012 (3)
 
Notes:
 
(1) Anticipated Product Launch Year refers to the particular year identified that we believe, based on development and planning, a particular product should be launched in the marketplace. We are unable to predict at this stage the particular quarter of any given year in which a product might be launched.
 
(2) Launched original version in 2007 and next generation version was launched in June 2010.
 
(3) Although this is the currently anticipated product launch date, the precise timing is at the discretion of our licensees.
 
Regarding the development process, the product design, prototyping and testing stage consists of the engineering design to generate part and assembly drawings, as well as the prototype manufacturing and testing to test the engineering design. This stage typically takes 6 to 9 months to complete. The production design validation stage consists of design revisions based on testing and validation of those design changes through repeated testing and typically takes 6 to 15 months to complete. The next stage is the manufacturing tooling and process development and supplier development stage, in which all the processes for manufacturing the individual parts and the assemblies are established and all tooling and equipment is manufactured and set up


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for manufacturing and qualified. This stage typically takes 3 to 6 months to complete. The final step is manufacturing launch, where each step in the manufacturing process is qualified and products made through the manufacturing process are tested to validate the entire process for launch of production, which typically takes 3 to 4 months to complete. As we have found in launching our prior commercial product, the entire development process takes roughly 18 months from beginning of design through production launch, but can take up to 34 months for complex designs.
 
Our bicycle product has been commercially available since 2007 and, in June 2010, we launched manufacturing of our next generation bicycle product, the N360, shipping initial products to customers in July 2010. We anticipate launching products in each of the small wind turbines and automotive accessory drives end markets in 2011, lawn care equipment end market in 2012 and for the electric vehicles market in 2013. For the products under development in the table above, and other than those for which we rely on the assistance of our licensees or joint venture partners, we believe that the net proceeds from this offering and our existing cash and cash equivalents will be sufficient to fund their product development.
 
Our test facilities are capable of applying a number of testing protocols on equipment ranging from as low as 200W up through and beyond 93kW. Our test personnel have designed and built 18 specialized test stands for component-level durability, fatigue testing, end-of-line production test, long term transmission-level durability test, and complete transmission developmental test. We have also built or assisted development partners in building prototype demonstration vehicles incorporating our NuVinci technology, including light electric vehicles, lawn and garden tractors, pedal assist bicycles, a light utility vehicle, a military medium tactical vehicle, a full size American SUV and a medium size Asian SUV, among others. With our test stands and prototypes, we have conducted tests that simulate a variety of conditions including, among others, real world simulation, harsh environmental testing, accelerated life testing and, for products that are on sale or near production, durability testing.
 
Our Markets
 
We believe that, due to its strengths, our NuVinci technology can improve the overall efficiency and performance of mechanical systems that require variation between the speed of a primary drive and the speed required to operate the system, and that our NuVinci technology provides a substantial platform for growth as we seek to commercialize applications in each of our target markets.
 
To date, we are developing or have developed applications for a selected set of end markets that based on our research and experience we believe offer the most attractive competitive dynamics and potential for economic returns, namely automotive accessory drives for air conditioners, alternators, power steering pumps and superchargers, primary transmissions for electric vehicles and lawn care equipment, drivetrains for the wind power systems markets and rear wheel hubs for bicycles.
 
To help us adapt our technology to the relevant application and to facilitate market access, we have established commercial relationships with industry members in each of our target markets. Our commercial relationships take the form of sales and support arrangements (under which we agree to sell products and aid in the marketing efforts of the products with our customer), manufacturing licenses (under which they gain the right to make the product), engineering services agreements (under which we adapt our technology for a specific application) and joint development agreements (under which we agree to work together with another company to develop a specific application of our technology).
 
In the automotive accessory drive market, we are working under an engineering services agreement with a major automotive supplier to develop a supercharger product. We entered into a memorandum of understanding with a leading manufacturer of power steering pumps for commercial vehicles for a power steering pump accessory drive. We also entered into a memorandum of understanding with Chengdu Bus Company for development and testing of accessory drives, which we currently believe will be an air conditioner or alternator application.
 
In the bicycle market, we have partnered with leading bicycle manufacturers through sales and support arrangements to drive sales of our product. In the electric vehicle market, we have partnered with a strategic


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automotive industry consultant through a consulting services contract for market development and consulting services for the Chinese EV market. In the wind and lawn and garden equipment markets we have provided manufacturing licenses to key industry members, enabling them to manufacture and distribute our technology, thereby increasing our growth prospects, brand awareness, and short term cash flow.
 
The following table summarizes the competitive advantages of our products and the state of the commercial relationships for each of our target end market applications:
 
Table 1: End Markets*
 
 
Note:
 
* There can be no guarantee that we will ever be able to successfully access any of these markets.
 
As we commercialize the end market applications in Table 1, we will consider addressing other end market applications that we believe would be well-suited to our NuVinci technology. Currently, we believe products such as automotive transmissions, industrial equipment, and auxiliary power units may provide such opportunities, and we are conducting preliminary market and product research and analysis on the potential opportunities represented by these end markets. If after further analysis, or if a potential development partner presents us with a business opportunity, there is an attractive business case, we will continue to invest in research and development to develop these applications and to expand into the associated markets on a commercial basis.
 
Our Patents and Technology Awards
 
We have developed a patent portfolio covering our core technology as well as individual applications of it that, as of July 31, 2010, consisted of 95 U.S. patents, 52 U.S. pending patent applications, 81 foreign issued patents (including validated countries) and 137 pending foreign patent applications, the oldest of which will expire at the end of its 20-year term in 2018. The rest of our U.S. patents and applications will expire at the end of their respective 20-year terms as well, with 19 others expiring in 2018, 5 expiring in 2019, 5 expiring in 2020, 14 expiring in 2022 and 38 expiring in 2024, among others. Each of our foreign patents and


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applications originate from the patents and applications filed in the U.S. and therefore are directed to the same or similar products and will expire at the same time as their respective U.S. counterpart. We currently have issued patents in Australia, Austria, Belgium, Canada, China, Denmark, Europe, Finland, France, Germany, Great Britain, Hong Kong, Ireland, Italy, Japan, Korea, Mexico, Russia, Spain, Sweden, Switzerland, Taiwan and The Netherlands with pending patent applications in those countries as well as Brazil and India. Our pending applications in these and other countries, however, can take up to 5 years or longer from the date they are filed to mature into patents depending on various factors by country including the subject matter and the examiner.
 
Our U.S. patent portfolio was ranked as the #1 patent portfolio in the automotive and transportation industry by The Patent Scorecardtm as reported in the Wall Street Journal on January 13, 2009. While this ranking was developed independently by a third party with whom we do not have and have not ever had any relationship, such rankings are inherently subjective and therefore do not guarantee or provide any indication of success in protecting our products in the various marketplaces around the world. We continue to file patent applications internationally as our development yields new patentable improvements to our technology.
 
Our NuVinci technology has also won several key industry awards including:
 
  •   R&D Magazine’s 2007 R&D 100 Award, awarded by an independent panel of experts and by the editors of R&D magazine recognizing the 100 most technically significant new products of 2007 worldwide.
 
  •   Popular Science’s “Best of What’s New, Grand Award 2007” for the recreational category, honoring innovations that made a positive impact on life.
 
  •   The Dutch bicycle industry’s 2007 FietsVak “Innovation of the Year” award honoring the year’s best new bicycle product.
 
  •   2008 iF Design EUROBIKE Gold Award, one of ten Gold Awards awarded by iF International Forum Design, honoring the best in bicycle design, considered one of the industry’s most prestigious design competitions. In 2008, more than 360 entries from 22 countries competed in 19 categories. The NuVinci CVT and CruiseControllertm, the trade name of the shifter for the bicycle hub, were given a Gold Award with judges citing the excellence of the NuVinci product’s engineering, its simplicity, and its ease of use as major factors in their decision.
 
  •   The Guardian/Cleantech Group’s 2009 Global Cleantech 100 Award. This award reflects the collective opinion of a panel of over 100 cleantech experts and venture capital companies around the world in evaluating companies with the greatest potential to achieve high growth and high market impact.
 
Our Strengths
 
Traditional transmission systems are limited to a fixed number of discrete gears and utilize complex shifting mechanisms. CVTs in general provide continuous variation, that is smooth transition without jerks or shocks, between the speed of the primary drive, such as an engine or electric motor, and the operating speed of the vehicle or equipment, from low up through high and any speed in between. In our target end market applications, we believe, based on our experience, research and testing, that our NuVinci technology provides many advantages over traditional transmissions and addresses the limitations of other currently available CVTs by offering the following:
 
  •   Improved efficiency and performance. Improves the overall efficiency and performance of existing mechanical systems, reducing the energy required for operation.
 
  •   Adaptable platform technology. Its size, design, packaging and economic attributes enable its use in a variety of end market applications ranging in size from bicycle hubs to utility class wind turbine systems. Many of these end markets are currently employing transmission systems that provide lower overall system efficiency, that are more costly to manufacture, or that are limited to single-speeds due to technical, economic or space constraints.


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  •   Simple, durable and cost-effective design. Employs a simple design with a small number of components that are relatively simple to produce. This makes the manufacturing of our technology more reliable and less costly than that of other transmissions and results in a more durable product.
 
We believe this combination of strengths makes NuVinci technology capable of replacing existing transmissions or enabling its use in many of the applications in our target end markets.
 
Our Growth Strategy
 
The combination of a mechanical technology designed to improve efficiency and performance, an established research and product development team, an award winning portfolio of patents, and relationships with industry members, positions us to apply our NuVinci technology to a number of established end markets.
 
Our goal is to use our transmission and engineering expertise, strategic partnerships and experienced management team to commercialize applications where our NuVinci technology has a clear competitive advantage. We intend to pursue the following strategies to attain this goal:
 
  •   Expand current markets through continued development, sales and marketing. In order to expand our market and increase the demand for our NuVinci technology, we will continue to develop improvements to our existing products that address the needs of our OEM customers and the end user. We will also continue to develop our sales staff, participate in industry marketing events and conduct targeted marketing efforts to expand the knowledge and familiarity of the public with our products and our trademark.
 
  •   Pursue new markets and new applications where NuVinci technology has a clear competitive advantage. We will continue to focus our development efforts on applications in end markets where we believe NuVinci technology has competitive advantages over existing transmission system technology as well as markets that do not currently employ a transmission system.
 
  •   Continue to invest in research and development. We believe that our NuVinci technology provides us with a competitive advantage over existing CVTs and traditional gear-based transmissions. We intend to continue investing in research and development to improve and further develop the design of applications in our current end markets and continue developing proprietary technologies for other applications where our technology offers a competitive advantage.
 
We intend to implement these strategies through:
 
  •   Leveraging commercialization capabilities learned from the bicycle market into the development of other markets. We have completed the commercial development of a complete supply chain in the bicycle market. We intend to use this experience to commercialize and apply our NuVinci technology to subsequent end market applications.
 
  •   Partnering with industry members to adapt and commercialize our products. In each end market application, we intend to develop strategic relationships with industry members as development partners and customers. This approach should provide insights into the performance requirements of each market, increase the likelihood of successful commercialization and reduce development costs.
 
  •   Applying a flexible approach to manufacturing. In certain target markets, such as bicycle, EV’s and automotive accessory drives, we intend to engage high quality, cost effective contract manufacturers to make our products. In other target markets, such as wind and lawn and garden equipment, we intend to develop licensee relationships with key manufacturers to maximize our growth and cash flow prospects and further our brand awareness, while effectively managing our capital and human resources.
 
Our Management
 
Our senior management team is comprised of industry veterans with a wide range of experience in the development and commercialization of technology and products. Our chief executive officer has over 20 years of automotive-related experience with a number of management positions in the automotive business,


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including president of Visteon Climate Control System Ltd — at the time a subsidiary of Ford — with experience in growing successful organizations. Our chief operating officer brings over 30 years of automotive experience in operations, engineering and sales both domestically and internationally including management roles at General Motors and automotive suppliers. Our chief technology officer, a fellow of the Society of Automotive Engineers, previously headed the drivetrain group at the Southwest Research Institute in San Antonio, Texas. Our president of the bicycle division has over 20 years of sales, product development and business development experience in the automotive industry, both domestically and internationally serving in senior global roles with suppliers such as Visteon, Federal-Mogul and Echlin Inc.
 
Company History
 
We were originally formed on December 11, 2000 as Motion Systems Technologies, LLC, which was subsequently converted into Fallbrook Technologies Inc., a Delaware corporation, on April 13, 2004.
 
In 2002, we retained an independent design and testing laboratory serving automotive OEMs to conduct a series of tests to verify the potential of our NuVinci technology. The tests helped identify further development targets and indicated that our technology had the potential for use in a number of end market applications including variable speed gearboxes and generally within the automotive industry. We also separately confirmed analytically and then with prototypes our technology’s ability to support the implementation of an infinitely variable transmission (IVT), without additional shafts and gears—a feature we believe to be unique to NuVinci technology among CVTs.
 
Following these tests, we determined that additional engineering and management expertise was needed to commercialize our technology. In 2004, we hired auto industry veteran Mr. William (Bill) Klehm as President and CEO, converted to a Delaware corporation and changed our name to Fallbrook Technologies Inc. Bill Klehm assembled a team of senior engineers from the transmission field and several managers seasoned in development initiatives. We also accelerated our research and development initiatives resulting in our first manufacturing agreement later in 2004. In 2005, we signed a development agreement and license with Aftermarket Technologies Corp. for the development and manufacturing of our bicycle product.
 
In 2006, we entered into a number of commercial agreements, including a trademark licensing and development agreement with a transmission fluid manufacturer to design, test and market specialty fluids that improve the performance of the NuVinci CVT, a manufacturing license agreement with Aftermarket Technology Corp. (ATC) for the manufacture of NuVinci CVTs and OEM licensing agreements with Ellsworth International, Inc., Batavus BV, and Currie Technologies to design and market bicycles and electric scooters featuring the NuVinci technology.
 
On January 3, 2007, the Company formed a wholly-owned subsidiary, Viryd Technologies Inc. (Viryd) (formerly known as Fallbrook Wind Technology Inc.), a Delaware corporation, for the further development of applications specifically designed for the wind turbine market. On December 18, 2008, we completed a spin-off of Viryd through a pro rata distribution of shares to our stockholders.
 
In early 2008, in an effort to gain greater control of the manufacturing process, we agreed with ATC to terminate its license agreement and moved to a contract manufacturing platform by entering a manufacturing supply agreement with MTD Products Inc, a manufacturer of outdoor power equipment.
 
In December 2008, we closed our largest financing round of approximately $25 million from a consortium of private investors and two leading cleantech venture capital firms; NGEN Partners and Dutch investment firm Robeco, a wholly-owned subsidiary of Rabobank Group. In November 2009 we completed a subsequent closing of this same round for approximately $4 million, which included new and existing investors. This investment round followed three previous private investment rounds that in the aggregate provided approximately $55 million in financing for the development and commercialization of our NuVinci technology.
 
In 2009, we began the process of phasing out production of our existing bicycle product in order to prepare for the launch of our next generation bicycle product, the N360, for which we launched manufacturing in June 2010 and shipped initial products to customers in July 2010. We terminated our manufacturing supply


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agreement with MTD Products Inc. in October 2009. On January 30, 2010 we signed a supply agreement with Tri Star Group, a company located in Shanghai, for the manufacture of N360, thereby completing a selection process that began in 2008.
 
In August 2010, we closed a private placement financing round of $6.0 million to support continued operations.
 
Our Technology
 
Existing Technologies
 
Heightened concern for the environment and the desire for reduced dependence on fossil fuels have led to an increased demand for vehicles and equipment that operate more energy efficiently, with lower emissions and that provide the same or superior performance. Vehicle and equipment manufacturers continue to look for technological improvements that meet the increasing environmental standards without sacrificing performance. Increased regulatory standards for efficiency and reduced emissions also drive the pursuit of such improvements. For automobiles and other vehicles, improving the operating efficiency of the engine or motor can have the most significant impact on the overall efficiency of the vehicle.
 
Manufacturers of automobiles, other vehicles and equipment often focus on the transmission as an area in which to achieve such improvements. Transmissions take the operating speed of a motor or engine and convert it to the speed necessary for the operation of the vehicle or equipment. Since there are few instances where the motor or engine operates optimally at the same speed as the vehicle or equipment, transmissions are needed to take the speed of the engine or motor and produce an output speed that meets the operating speed requirements of the vehicle or equipment.
 
As an example, an automobile with a single gear is almost useless, because if geared low enough to start off or climb a hill, the car would have an unacceptably low top speed. If geared high enough to drive on a freeway, a single gear car would not be functional at startup or able to climb a hill. In contrast, the same car equipped with a five-speed transmission can stop and start while pulling a trailer over a mountain and it can cruise at high speeds on a freeway. The transmission makes the car functional. In addition, the multi-speed transmission enables the engine to operate more efficiently. For example, automobile engines typically operate most efficiently at a particular engine speed, or RPM. While the transmission is in each discrete gear, the engine must increase its speed from low to high before the car is travelling fast enough to allow a change to the next higher gear. As the engine’s speed increases within each discrete gear, the engine must rev up from a low RPM to a high RPM, thereby moving into and out of its most efficient operating range. In an automobile equipped with a five speed transmission, unless the automobile drives primarily at a fixed speed, the engine typically spends a large amount of driving time outside its most efficient operating speed and consequently the engine wastes energy and creates unnecessary, harmful emissions. By increasing the number of gears in a transmission, it is possible to increase the energy efficiency of the engine.
 
Unlike conventional transmissions that have a fixed number of gears or output speeds, a continuously variable transmission, or CVT, is a particular type of transmission that has an unlimited number of speed ratios between its high and low limits. This allows the engine or motor to stay within its peak efficiency or peak power operating speed more than the conventional transmission. For example, when used in an automotive transmission, CVTs improve performance by allowing the engine or motor to continuously deliver peak power and torque to the drivetrain while steadily allowing the speed of the car to increase through acceleration. This improves efficiency by allowing the car’s engine to remain in its most efficient speed as the car speeds up or slows down.
 
Therefore, because of the unlimited number of gears that allow engines to operate at their most efficient or highest power speed, while the speed of the rest of the mechanical system is allowed to vary, the CVT optimizes the overall system efficiency, reduces fuel consumption and emissions, thereby reducing the adverse effects of such mechanical systems on the environment. Besides automobiles, these benefits of CVTs are similarly achievable in many other mechanical systems that require variation between the speed of a primary drive and the speed required to operate the mechanical system.


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How Our NuVinci Technology Works
 
Our NuVinci technology is a CVT that is based on a set of rotating, tilting balls clamped between two rings. Figure 1 illustrates the basic components of the NuVinci CVT technology. As shown in Figure 1, our NuVinci technology has:
 
  •   an input disc, or ring, driven by the motor or engine that is in contact with and drives the balls on one side,
 
  •   a cylindrical support member, or idler, located in the middle of the balls that keeps the balls in their positions around the center of the CVT, and
 
  •   an output disc, or ring, in contact with and driven by the balls that forms, or is connected to, the output of the CVT.
(FIGURE 1 NUVINCI TECHNOLOGY)
 
Figure 1 – NuVinci Technology
 
Torque from an engine, motor or other input source (illustrated in Figure 1 by the lines with arrows going left to right) is transferred through the input disc to the balls via the contact between the balls and the input disc. The torque is then transmitted through the balls, each of which rotates about its own separate axle, and then to the output disc via the contact between the ball and the output disc. The input disc and output disc are clamped onto the balls tightly so that the requisite amount of clamping force is provided for the amount of torque being transmitted. A transmission fluid provides traction, and prevents metal to metal contact, between the balls and discs and provides lubrication for bearings and other components.
 
The speed of the input disc compared to the speed of the output disc, or speed ratio, is controlled by the angle of the ball axles relative to the axis of the transmission. Figure 2 illustrates that by tilting the ball axles, the transmission can be shifted from low to high (as shown left to right), or from high to low, or to any ratio in between. The number of balls used depends on several factors including torque and speed requirements, operational requirements and space considerations, among others.
 
(FIGURE 2 SHIFTING NUVINCI TECHNOLOGY)
 
Figure 2 – Shifting NuVinci Technology
 
Although we initially developed our NuVinci technology as a new type of CVT, we discovered after further development that the same components of the NuVinci technology could be configured as an IVT capable of forward, reverse and a “powered zero” state, where most other CVTs require extra shafts and gearing. In the “powered zero” state for vehicle main driveline transmissions, the NuVinci IVT will hold the wheels stopped on a vehicle even though the engine is running and the transmission is engaged, such as on a hill at a stop.


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NuVinci’s Competitive Advantages
 
We believe, based on our experience, research and internal testing, that our NuVinci technology provides enhanced performance and improved overall system efficiency for mechanical systems that require variation between the speed of a primary drive and the speed required to operate the mechanical system. Considering the pervasive use of mechanical systems, we believe that technologies, such as the NuVinci technology, that deliver improved performance, fuel or energy efficiency or design flexibility combined with reduced emissions should be of interest to consumers and manufacturers in today’s global climate of concern for emissions and efficiency improvement.
 
Compared to conventional transmissions, as with any CVT, our NuVinci CVT offers seamless and continuous transition to any ratio within its range, allowing motors and engines to operate at their most efficient speed thus maximizing overall efficiency, with no jarring or shocks from the shifting process. Consequently, NuVinci technology, like other CVTs, can improve acceleration and performance while providing system level efficiency improvement over conventional transmissions. Our NuVinci technology can be configured in several ways all in one compact package, providing flexible packaging. Due to its flexible packaging and scalable design, we have shown in commercial products, prototypes and test vehicles that it can enable the commercial use of CVTs in applications not currently using them, such as automotive accessory drives, wind turbines and bicycles.
 
Although they have a long history, CVTs have varied designs and, through our research we believe they have proven difficult or costly to manufacture to date. They have also been too difficult to apply, control or scale to the applications that could benefit from a smooth, quiet and gearless solution. In contrast to most other CVTs, we believe, based on our experience, research and internal testing that our NuVinci technology is less complex, more compact, provides more stable control, is easier to shift, offers more scalability across product lines, can be assembled and configured to suit a wider range of applications and is less expensive to manufacture and assemble. We believe, based on our experience, that our NuVinci technology can be viewed as the first truly “functional” CVT—one that is simple, versatile, relatively inexpensive and scalable.
 
Our NuVinci technology uses materials that are commonly available and widely used today in many industries. The primary materials used in our technology include steel and aluminum, both of which are available at commodity prices on mass production scale. Materials available as commodities are inexpensive and have more stable pricing than many special purpose materials that have relatively little, if any, mass production history. Unlike many “green” technologies that are dependent on rare raw materials with volatile pricing, we believe that our technologies offer a more sustainable economic proposition.
 
In summary, we believe NuVinci technology provides flexibility in design and configuration that makes it well suited for applications in many major industries including bicycles, light electric vehicles, agricultural equipment and tractors, automobiles, trucks, accessory drives, and wind turbines of all size classes. For many applications, we believe these advantages should be enabling, meaning that the application simply is not practical without the assembly and configuration flexibility of the NuVinci technology.
 
Market Opportunities
 
Overview
 
Our NuVinci technology is designed to improve the overall efficiency and performance of vehicles and equipment that operate at various speeds.
 
Automotive Accessory Drives
 
Background—Accessory drives
 
We believe the opportunity for our NuVinci technology within the transportation segment is substantial. While our technology could be applied as the primary vehicle transmission, our current development and initiatives


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are focused on improving the performance of automotive accessory drives, a market we believe should have fewer barriers and take less time to enter, as well as having lower capital requirements.
 
Figure 3 below is an illustration of the front end of a typical engine and various accessories that are driven off the engine’s crankshaft by a belt and a series of pulleys. As illustrated, numerous automotive accessory drives exist in a vehicular system, including an air conditioning compressor, alternator, water pump, power steering pump and, in some cases, a supercharger (not shown).
 
Continuously Variable Accessory Drive (CVAD) Applications
 
(FIGURE 3 ENGINE ACCESSORIES)
 
Figure 3 – Engine Accessories
 
These automotive accessory drives are powered directly from the engine and because the belt and pulleys that operate the accessories act as a single speed transmission, the operating speeds of the accessories are limited to going up and down as the engine’s speed changes. These accessories are typically sized to provide their required performance even in the worst case scenario—for instance, the AC compressor is sized to cool a car with the engine idling, sitting in traffic conditions, at a very high outside temperature. This means that anytime the engine is not operating in that worst case scenario, the accessories are over-performing and are wasting energy. In other situations, design constraints prevent the use of accessories sized large enough to meet the worst case conditions. In such cases the accessory cannot meet its basic performance requirements.
 
We are initially focusing on the performance and optimization of the alternator, supercharger, power steering pump and air conditioning compressor and will follow with products designed to improve the overall system by applying the technology to the crankshaft drive pulley to vary the speed of all the accessories independently of the engine speed. Based on a review of patents and technical papers arising from research conducted by other companies in the field, we believe a number of companies have spent significant resources attempting to use multi-speed drives to optimize automotive accessory drives in the quest for greater fuel economy. To date, there are few if any commercially successful products in the market addressing this need. We believe, based on our research and experience in the automotive industry, that this is due to key technological shortcomings of competing CVT Technologies.
 
We have developed the NuVinci continuously variable accessory drive (CVAD) in order to address the problems in the automotive accessory drive market. A CVAD is a NuVinci CVT used to drive automobile engine accessories. It can be applied to an engine’s crankshaft such that the operating speed of all the accessories is optimized together at all engine speeds.
 
Alternatively, our NuVinci CVAD can be mounted on an individual accessory to optimize its performance and efficiency. While we believe there are many accessories that could benefit from the application of our NuVinci CVAD technology, we are currently focusing our resources on applying our CVAD for the alternator,


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supercharger, power steering pump and air conditioner compressor end markets. Our NuVinci technology can be used by original equipment manufacturers, or OEMs, in new vehicles or can be applied to most vehicles through the aftermarket as a means to improve overall fuel efficiency and to enhance performance.
 
NuVinci Opportunity—Alternators
 
Alternators convert mechanical energy created by the engine into electrical energy to charge the battery and power the vehicle’s electric system when the engine is running. The speed of the alternator, and therefore its ability to generate electricity, is dependent on the speed of the engine because it is coupled directly to the engine crankshaft via a belt and pulleys. Therefore, when engine speed is at its lowest—when the engine is idling—the speed of the alternator is at its lowest and it generates the least amount of electrical power. In some cases, this prevents the alternator from creating sufficient electricity, resulting in excessive battery drain and reduced electric system function, such as when a bus’ lights dim when it stops. Conversely, as the alternator is designed for worst case conditions, that is at low engine speeds and high ambient temperatures, when the vehicle is accelerating and cruising, well above low engine speeds, the alternator operates at levels above that which is needed — resulting in increased fuel consumption and unnecessary emissions.
 
In heavy-duty vehicles, demands on alternators and batteries are increasing as a result of the addition of numerous electronic controls and devices that place a great deal of stress on the electrical system of the vehicle. In order to provide sufficient electrical power when the engine is idling, or at its lowest speed, the only current solution is to raise the idle speed of the engine to increase the alternator speed and associated electrical output. This is a poor solution due to the resulting increase in fuel consumption and emissions. Accordingly, we believe that there is a significant opportunity to upgrade existing vehicles using our NuVinci technology to improve performance and extend the life of batteries and alternators.
 
Our CVAD decouples the speed of the alternator from the speed of the engine, which we believe, based on our research and testing, enables the alternator output to meet the vehicle’s electric power needs regardless of driving conditions or engine speed. We demonstrated the potential improvement in alternator performance in a 2007 project conducted on a heavy duty government vehicle. The vehicle’s operators wanted to understand the potential of the NuVinci technology to improve the performance of its existing alternators.
 
(NUVINCI CVAD PERFORMANCE IMPROVEMENT)
 
Figure 4 – NuVinci CVAD Performance Improvement


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Figure 4 is a graph of the test results from our internal tests showing improved alternator performance with the NuVinci CVAD. The bottom line shows the electrical current the stock alternator delivers at various engine speeds. The top line shows the electrical current delivered at various engine speeds by the same alternator when its speed is controlled by the NuVinci CVAD. The shaded area shows the increased electrical current that is available at various engine speeds when using the NuVinci CVAD.
 
Testing of the tactical vehicle over a standardized EPA drive cycle, which simulates real world driving conditions for engine speed over time, showed what we consider to be dramatic improvement with the NuVinci CVAD. This test showed that the NuVinci CVAD delivered over 75% more current at idle than the stock alternator and over 34% more total energy over that same 1,200 second test. When that is extrapolated over an entire 7.5 hour workday the NuVinci CVAD helps deliver over 750% more energy. The 2007 project successfully demonstrated to our satisfaction the packaging, control responsiveness compatibility, proper current at any engine speed and improved total energy output of the CVAD-equipped alternator, even at high ambient temperatures, as we expected.
 
NuVinci Opportunity—Superchargers
 
A supercharger is an air compressor that increases the air flowing into the cylinders of an internal combustion engine. The increased level of oxygen in the cylinder in each combustion cycle results in more power output from each such combustion event than would be available without the supercharger. This increases the overall output power of the engine. Similar to the alternator, the speed at which the supercharger operates, and thus the amount of air it pumps into the engine, is determined by the speed of the engine.
 
Our NuVinci CVT technology can vary the speed of the supercharger independently of the engine speed to provide maximum boost or the most efficient performance at all engine speeds. We believe, based on tests performed with our prototypes, that the use of our technology shows great potential for improving vehicle performance and fuel economy when coupled to a supercharger. Specifically, we expect our NuVinci technology to reduce the fuel consumption of certain engines equipped with superchargers, or enable smaller engines with a supercharger to achieve similar performance to larger, less fuel efficient engines.
 
We believe there are significant benefits in decoupling superchargers from the crankshaft on existing engine systems. We believe, based on our research, that advanced engine designs using CVTs with superchargers are capable of increasing vehicle fuel economy by 30-50% through a 33% reduction in engine size while at the same time maintaining the power, top speed and acceleration of the vehicle.
 
(FIGURE 7 POTENTIAL SUPERCHARGER ENHANCEMENT)
 
Figure 5 – Potential Supercharger Enhancement
 
Figure 5 illustrates the results of a modeling analysis performed for us by an independent automotive industry consulting firm of the improvement that is possible when combining the NuVinci CVAD with a supercharger drive. These results demonstrate the opportunity to reduce the size of car engines to reduce fuel consumption


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and emissions without sacrificing performance. In the figure, as identified in the legend, the torque available from a standard 2.0 liter 4 cylinder (I4) engine, the torque output available from a 3.6 liter 6-cylinder (V6) engine, which is notably higher than the standard I4 engine, the higher torque available when a supercharger is added to the I4 engine, and the increased amount of torque available from the I4 engine equipped with a supercharger and a NuVinci CVAD are illustrated by their respective lines. The shaded area shows the increased amount of torque created by utilizing the NuVinci CVAD-driven supercharger. This graph shows that at some engine speeds the I4 engine with the CVAD-enhanced supercharger is actually outperforming the larger V6 engine illustrating the opportunity to downsize the engine without sacrificing performance.
 
We are currently working with a major automotive supplier under an engineering services agreement for the development of a NuVinci CVAD for automotive superchargers. This supplier has an option to enter into a commercialization agreement with us containing predetermined terms including the exclusive right to purchase NuVinci CVADs for superchargers, pricing and warranty requirements, among other things. The prototype we are currently testing is smaller than that tested for the heavy duty alternator drive, but is configured in a similar fashion and should provide valuable data on the durability of the design as we move to commercialization.
 
NuVinci Opportunity—Air Conditioner Compressors
 
Similar to alternators and superchargers, air conditioning compressor output is also determined by the engine speed. The compressor is designed to operate at necessary levels in the worst case operating conditions, which is low engine speeds and high ambient temperatures and cooling demand, meaning that the compressor is sized to provide required cooling during engine idle. However, as the engine speed increases, the compressor is overworked and consumes more fuel than is necessary. Furthermore, the automotive industry is attempting to adjust to increasingly stringent U.S. and European regulations, such as European Regulation (EC) No 842/2006, that phase out the use of certain automobile air conditioning system refrigerants in favor of new, more environmentally friendly system refrigerant formulations. These new refrigerants have thus far demonstrated significantly decreased cooling performance at low compressor speeds. We believe that optimizing the compressor performance with our NuVinci technology should provide automakers and suppliers with an economical solution for implementing the new refrigerant formulations.
 
Similar to the supercharger application, which is another type of compressor, our NuVinci CVAD can vary air conditioning compressor speed independently of the speed of the engine so that it can provide optimal cooling at all engine speeds. This allows system designers to optimize the speed of the air conditioning compressor to provide satisfactory cooling performance while maximizing fuel efficiency and reducing emissions.
 
We are currently working with Hodyon to develop a CVAD specifically designed to allow Hodyon to optimize the performance of their AC compressors. On March 5, 2010, we executed a joint development agreement with Hodyon to develop interface hardware to connect our CVAD to their AC compressor.
 
NuVinci Opportunity—Power Steering Pumps
 
Power steering pumps, which assist the driver’s steering by pumping power steering fluid, are typically designed to accommodate the system requirements at their most arduous situation, referred to as “dry park.” Dry park is the situation that occurs when the steering wheel is being turned significantly while the engine is at a low speed and the turning surface is dry. For example, when a driver is maneuvering into a tight parking space, the car or truck is stationary on a dry parking lot surface, the engine is at or near idle, and the driver is turning the steering wheel rapidly from one extreme of its travel to the other. This situation places by far the highest power demand on the power steering pump, but again the speed of the pump is tied to a low engine speed and thus must be sized to produce enough flow to properly steer the vehicle in this extreme condition. As a result, when the vehicle is going down the road at higher engine speeds with minimal steering input, the pump is pumping too much fluid, and more than can be bypassed through the system. This creates a great deal of heat in the system and wastes fuel. This predicament has led many automakers to switch to electric power steering systems that completely de-couple the power steering system from the engine. While this has shown


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to be viable on passenger cars, larger commercial vehicles do not have enough electrical power available to make such an electric system viable.
 
The adverse effects during high speed operations that are associated with an oversized power steering pump are most severe on larger vehicles that have the highest dry park loads imposed due to their large tires and high weight. We are currently working with a leading supplier of commercial truck power steering pumps under a memorandum of understanding to develop a NuVinci CVAD system for their power steering pumps. We believe, based on our research, that this application will reduce fuel consumption when compared to the conventional fixed displacement pump and fixed ratio engine to pump drive system used presently.
 
Market—Accessory drives
 
We define the global automotive vehicle market, based on our research, as consisting of two general categories: passenger car and light truck and heavy duty truck (including buses). We believe our NuVinci technology has broad applicability in both categories in both new and used vehicles. Table 2 below provides the unit volumes of the three vehicle categories and identifies annual new unit sales and the current installed base for the U.S.
 
Table 2—Automotive Vehicles by Segment
 
                         
    New Sales (2009)     Installed Base (2008)  
Vehicle Segment
  U.S. (000 units)     Global (000 units)     U.S. (000 units)  
 
Car & Light Truck
    10,432       56,000       234,067  
Heavy Duty Truck and Bus
    228       2,681       6,619  
 
We are targeting the heavy duty truck and bus aftermarket in the near term due to what we believe are low barriers to entry, the potential for fleet sales and the need in that market for solutions to the problems identified above make the opportunity attractive. We believe that the addressable number of these vehicles in the aftermarket, when considering vehicle types, engine compartment configurations and other factors, is about 1.5 million units. While we expect some penetration into the aftermarket for passenger cars and light trucks over the next five years, the projections of any penetration rates would involve significant speculation. Over a longer term, we expect OEM penetration on new sales in passenger car and light truck and in heavy duty trucks and buses. Due to the same factors as the aftermarket, we see the OEM market for passenger cars and light trucks as a 10.5 million annual vehicle market opportunity and for new heavy duty trucks and buses to be about 800 thousand units. While we are assuming the launch of each of our CVAD products, we are initially assuming only one CVAD product per vehicle in the target markets, and therefore we believe combined OEM sales for heavy duty trucks, bus and passenger cars and light trucks presents an addressable annual market of approximately $1.4 billion, while the total one-time aftermarket opportunity for heavy duty trucks currently on the market is approximately $1.0 billion.
 
Commercialization Plan— Accessory drives
 
To date, our efforts in the automotive accessory drive field have focused on developing and optimizing the design and system performance of our technology. In order to gain valuable industry, manufacturing and product insights, to further develop brand awareness and increase market acceptance, we have built and continue to build business relationships with established industry members in each of our target markets. For example, in the alternator market we have worked with a leading supplier of alternators and a niche supplier of military alternators. In the power steering pump market, we are working with a leading manufacturer of power steering pumps for commercial vehicles. Additionally, we are working with a leading automotive supplier under an engineering services agreement for the development of a NuVinci CVAD for automotive superchargers and we have entered a development agreement with an industry manufacturer and distributor of air-conditioning systems.
 
We expect to use the experience gained from our contract manufacturing arrangement in the bicycle market to develop commercial scale operations in the CVAD market for the alternator, air conditioner and supercharger


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applications. The products are at a pre-production design level, except for supercharger CVAD, which has undergone preliminary proof of concept testing with further design and concept testing required, and we have performed preliminary testing on prototypes. While there should likely be some difference in the mounting hardware, the alternator product and the air conditioner compressor product are very similar and we believe may be manufactured by the same manufacturer. The supercharger product will be a different sized product from the alternator and air conditioner products and therefore we may utilize a different manufacturer for its production. Similarly, due to its different size, the power steering pump product may be produced by a different manufacturer.
 
All of these products are currently in the design, prototyping and testing phase of development. The prototypes for all of these have been assembled internally from parts delivered primarily from Tri Star Group, our manufacturer for our bicycle CVT product, with some parts made internally. We have spent over a year working with Tri Star Group for the development of our initial CVAD products. Through a series of engineering service programs and production launch of the N360 bicycle CVT, we have developed an in-depth understanding of Tri Star’s manufacturing capabilities. We believe they could play a significant role in production of CVAD products. A pre-production prototype of an alternator CVAD has been delivered to an OEM customer and installed in its test vehicle and based on the unit’s performance, the customer has provided positive feedback. We continue to work with developmental partners to validate product durability in multiple applications. These tests and reviews are occurring with other OEM’s, independent global engineering services providers and fleets.
 
On April 23, 2010, we executed a memorandum of understanding with Chengdu Bus Company (Chengdu) in Chengdu, China, which is located in the Sichuan province. The non-binding memorandum states that the two companies intend to enter an agreement for the development of a continuously variable accessory drive for application in Chengdu’s buses. We have begun assembling hardware and testing equipment to run preliminary testing of an air conditioner drive in Chengdu’s buses.
 
The prototype testing these products are currently undergoing has resulted in design refinements. When the prototype testing is complete, changes will be made to the design to generate a production design and then additional testing will be performed to validate the production design. Following this production design validation, the manufacturing tooling and process development and supplier development will commence, the completion of which will lead these products to manufacturing launch.
 
We expect to begin negotiations in 2010 for the supply of products for this end market application with the intent to complete an initial production run in 2011 of the alternator CVAD product and commercial scale production in 2012.
 
We currently expect to commence sales of our automotive CVADs for alternators and air conditioner compressors in 2011 through aftermarket distributors. This should allow us to demonstrate our capabilities in this market and develop brand awareness, which we will then use to drive distribution through OEMs for these products starting in 2012. We are working under an engineering services agreement for the development of our supercharger products with early prototype testing complete and further design and testing underway. We expect to begin OEM launch of the supercharger product through our customer in 2012. We receive partial funding for the development of the supercharger product from the engineering services agreement. However, we expect the majority of the funding for the development of the supercharger product, as well as all of the funding for the other CVAD products, to come from the net proceeds from this offering and our existing cash and cash equivalents or from licensees or joint venture partners.
 
Electric Vehicles
 
Background
 
Electric vehicles, or EVs, are two, three and four-wheeled vehicles powered solely by electric motors or by an electric motor in combination with an internal combustion engine, as in a hybrid vehicle. With increasing fuel costs and more stringent engine emissions requirements, EVs are becoming more popular around the world as


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consumers are increasingly looking for “green solutions.” However, current EV performance and range is less than that of competitive gasoline-powered vehicles.
 
The powertrain of a typical EV comprises a power source, usually a battery, an electric drive motor and controller, and power transmission devices such as sprockets, chains or gearing. Many EVs operate in a single speed configuration where the speed of the vehicle is directly linked to the speed of the drive motor, by a fixed gear ratio. Although the motor controller for an EV can direct the motor to operate at high or low speeds or to vary smoothly between them, the motor has a defined operational speed that maximizes its efficiency and similar to the gasoline engine, if the motor can be operated closer to this defined speed, then would be able to more efficiently provide torque and power to drive the vehicle, leading to increased vehicle range and reduced peak current draw among other advantages. As a result of this condition, achieving practical range compared to gas or diesel powered vehicles has challenged EV manufacturers, and their electrical systems have to endure high electrical current draw when climbing hills or starting from stop. These realities have led to significant research and development activities directed toward improved battery technology to support greater storage of energy in the vehicle and on the power electronics of such vehicles to meet the operational requirements of the vehicle.
 
Furthermore, power electronics, which are increasingly used in today’s vehicles, act as an additional drain on system power and reduce the overall system efficiency in EVs. Power electronics are used in electrical devices for many purposes such as varying voltage or frequency, converting AC to DC or vice versa, as well as changing the operating speed of motors. We believe, based on our research, that power electronics for hybrids represents 20% of the vehicle’s material costs and is larger for full electric EVs.
 
Current EVs are increasingly utilizing components made from rare earth materials for their operation and performance. However, our NuVinci technology does not rely on the use of these materials. Instead, the NuVinci technology uses common, readily available materials used in a wide array of industries today, which are available in mass quantities from multiple sources with generally less pricing volatility than is associated with special purpose materials.
 
NuVinci Opportunity—Electric Vehicles
 
Based on their relatively low sales and our research, we believe EVs suffer in their ability to effectively compete with gasoline powered vehicles as a viable source of reliable daily transportation because they do not generally have the range, top speed, hill climbing ability or the ability to pull significant loads. They therefore generally come up short on expectations placed on them to replace gasoline engines and thereby reduce fuel consumption and emissions. Testing we have conducted has shown that the NuVinci CVT allows EVs to accelerate, climb hills and pull loads at more efficient motor speeds to increase vehicle range and limit peak current levels, which typically improves battery life. Our NuVinci CVT allows the motor to operate at more efficient or optimal speeds for any vehicle speed to both improve performance of the EV and increase its efficiency. NuVinci CVTs will be integrated into the driveline of an EV as the primary transmission between the motor and the wheels to allow the motor to operate at a more optimal speed during different driving conditions and speeds. We have incorporated our NuVinci CVT into the rear wheel of a standard electric scooter and have demonstrated several improvements through empirical analysis and comparative testing. Specifically, through our demonstration and testing we have demonstrated to our satisfaction increased acceleration, higher top speeds, improved hill climbing, extended real world range and enhanced battery management when the NuVinci CVT is used as the primary transmission on such electric vehicles. While this was performed on a scooter, we believe that the results could be realized in larger vehicles as well. Table 3 provides an illustration of the actual improvements we have observed based on test results reported in our white paper published at the 2007 Ele-Drive Conference.


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Table 3—NuVinci CVT Performance Improvements
 
         
Operating Metric
    Empirical Improvements (1)
Acceleration(2)
    38 %
Steady State Velocity On A Hill(3)
    24 %
Maximum Speed(4)
    47 %
Range(5)
    20 %
 
 
(1) Results reflect the actual performance improvements in a 2006 model Currie IZIP 1000 scooter in an unmodified (stock) vehicle against a vehicle equipped with a NuVinci CVT.
 
(2) Acceleration is measured as the improvement in time to increase in speed from 0—19 KPH.
 
(3) Steady state velocity on a hill is measured as the improvement in speed while traveling up a hill.
 
(4) Maximum speed is the improvement in the maximum sustained speed.
 
(5) Range is measured as total kilometers driven in a city center.
 
We intend to leverage our existing applications and designs in adapting our NuVinci CVT to provide driveline transmissions for various vehicles in the EV market. We will initially focus on smaller vehicles with lower barriers and shorter time to entry and move towards hybrid automobiles and full electric automobiles. Our focus for the EV market is to provide products that can be easily incorporated in to the design of EVs so that designers can optimize the performance of electric motors and the vehicle resulting in EVs that are better able to compete with gasoline powered vehicles.
 
To date we have developed prototypes of the NuVinci CVT that demonstrated the performance and functionality necessary to successfully implement the NuVinci technology in the EV market. Our first development of a higher powered, higher torque driveline transmission with the NuVinci CVT was a driveline transmission for a medium sized agricultural tractor. The design had to meet several challenging performance characteristics in order to stand up to the demanding requirements of the medium agricultural sector. We designed and manufactured a prototype with which we were able to successfully demonstrate satisfactory levels of performance throughout the operating range of the transmission.
 
Through an engineering services agreement with our former licensee ATC, we also designed and developed a prototype of our technology for a medium sized sport utility vehicle. Through this project we, along with ATC, were able to demonstrate a fully functional prototype operated by the driver with a standard transmission control lever having the normal “PRNDL” shifter, representing the standard “park, reverse, neutral, drive and low” speeds to be selected by the driver. This prototype included a valve body and electronic control unit to automatically shift the transmission ratio according to the driving needs of the operator. Through these two programs we were able to demonstrate the applicability of the NuVinci technology to real world automotive applications thereby lending credibility to our calculations about the scalability of our technology. While both of these programs were designed for internal combustion engines in the target vehicles, they were tested on test stands operated by electric motors and from our testing of these prototypes and the smaller light electric vehicle prototypes, we expect the technology to perform well in real world EVs.
 
We believe the improved operating performance that can be achieved using our technology in EVs should increase their attractiveness as a practical option to gasoline powered vehicles and boost demand for our products. By allowing the motor to operate at optimal speeds as the vehicle’s driving conditions change, as multispeed transmissions do in other cars, EVs can realize the same benefit that gasoline powered cars do from implementing the NuVinci CVT. Furthermore, we believe that using a NuVinci CVT to optimize the speed of the motor while allowing for the vehicle’s varying driving conditions and speeds provides greater control flexibility and can be used to simplify the motor controller in either EVs or hybrid vehicles potentially reducing or eliminating the reliance on complex, relatively inefficient and expensive power electronics.


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Market—Electric Vehicles
 
EVs include categories ranging from full size utility or industrial vehicles, such as fork lifts, to passenger cars and all the way down in size to light electric vehicles (LEVs), such as scooters. They also range from full EVs to hybrid electric vehicles, to plug in hybrid vehicles. We believe the benefits realized during our testing on scooters applies equally to larger vehicles such as electric automobiles and electric industrial vehicles. A growing number of passenger car sized electric vehicles are being developed for production by existing automobile OEMs such as GM and Nissan, as well as new entrants solely focused on electric vehicles, such as Tesla and ZAP. Estimation of the growth in sales of EVs is still speculative at this point. Publicly available reports have estimated that globally, more than 17 million cars will be hybrid or electric in 2015. We believe the addressable market for electric cars and hybrid electric cars alone, not including LEVs, to be at least 4 million units annually by 2015 representing an addressable annual opportunity of $1.2 billion.
 
Commercialization Plan—Electric Vehicles
 
We expect to partner with vehicle manufacturers and their suppliers to adapt our existing CVT products to their EV. This application is currently in the design, prototyping and testing phase of development. We have tested prototypes of the transmission on automobiles as well as smaller electric vehicles. The product is currently going through further design refinement and will require further testing prior to moving to a production design. Under the current development schedule for this complex application, we currently expect to move to production design and validation in 2012 with an expected production launch in 2013. We believe that, with the assistance of joint venture partners, the net proceeds from this offering and our existing cash and cash equivalents will be sufficient to fund their product development for the electric vehicle products currently in development.
 
We have entered a consulting agreement with Advanced Strategic Leadership Limited (ASL), a Shanghai company, under which ASL will provide consulting and market development services for the Chinese EV market. ASL will provide market data and support sales and development of our NuVinci technology for EVs in China. We expect to manufacture our products for the EV market through a contract manufacturing relationship. We will select the appropriate contract manufacturer for the product when a target customer and vehicle is identified.
 
On August 26, 2010, we entered a memorandum of understanding with TEAM Industries, Inc. under which we mutually agreed to negotiate a joint venture for the manufacture of NuVinci CVTs for small residential and recreational vehicles including all-terrain vehicles and utility vehicles as well as low speed vehicles and neighborhood electric vehicles. Also, on August 26, 2010 we entered a memorandum of understanding with Shentong Automotive Decoration Co., which is located in Ningbo near Shanghai, China. Under this memorandum, we agreed to negotiate a joint venture for the manufacture of driveline transmissions for electric passenger cars. However, we cannot be sure that these business relationships will result in the formation of joint ventures.
 
Lawn Care Equipment
 
  Background
 
The lawn and garden equipment market encompasses a wide offering of products including lawnmowers, turf and grounds equipment, trimmers and edgers, among others. Powered ride-on mowers or lawn and garden tractors represent the largest market segment and include front engine lawn tractors and rear engine mounted zero turn radius (ZTR) products, which are further segregated into consumer and commercial use categories. In recent years, ZTRs have generated significant market share gains due to their low profile design and independent wheel controls that allow users to turn the mower a full 360-degrees in place. Furthermore, ZTRs, which include two IVTs per tractor, demonstrate superior performance. According to Hustler Turf, studies indicate that ZTRs can mow about 20-25% faster than regular lawn tractors on a U.S. football field size area.
 
By having an IVT dedicated to each rear wheel of the lawn tractor, each rear wheel can rotate forward or reverse independently of the other. This allows the driver to turn the vehicle in a circle that is the same size as


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the width of the vehicle by rotating one wheel forward and the other in reverse. This provides for the “zero turn radius” name these lawn tractors are given. The IVT technology presently used in lawn care equipment is the hydrostatic transmission. Hydrostatic transmissions use a hydraulic pump and motor to vary the speed ratio of the transmission. These transmission types can generally transmit more torque than inexpensive rubber belt transmissions, but can be sensitive to contamination. With efficiencies—that is the percentage of power provided by the engine to the transmission that is actually delivered out of the transmission to the drive shaft and wheels—ranging as low as 50%, the purely hydrostatic transmission is limited to low-end applications like lawn tractors, where its greater durability and absence of startup slip enables its use over more delicate rubber belt types. It is also used in some off-road construction equipment requiring the function of an IVT despite the fuel economy penalty. In addition to low efficiency and its high noise level, this transmission type also suffers from considerable heat generation and substantial fluid cleanliness requirements.
 
Technology innovation in the lawn and garden equipment market has historically focused on general performance improvements and ergonomic enhancements. However, due to increasing public and regulatory pressure, many companies are now looking for innovation to help reduce emissions and noise, to improve the utility of electric powered products, and to add user-friendliness features, like simple controls and improved handling.
 
  NuVinci Opportunity—Lawn Care Equipment
 
Under an engineering services agreement with a leading manufacturer of lawn and garden transmission equipment, we have developed an IVT that can be used in ZTRs. Preliminary testing indicates significant improvement in efficiency over existing hydrostatic transmissions.
 
Through testing and analysis, we have found the relative difference in efficiency between our NuVinci IVT and a hydrostatic transmission to be substantial. The lower efficiency of the hydrostatic transmission results in increased fuel consumption and increased vehicle emissions. As the Environmental Protection Agency has passed regulations in September 2008 limiting exhaust emissions from lawn and garden equipment, OEMs need to find ways to limit exhaust emissions while providing consumers with the same performance. Additionally, the mechanical connection between engine and drive wheels available using the NuVinci IVT, versus the fluid connection in hydrostatic transmissions, provides improved control and secure feel as well as improved performance for the rider. We have adapted our NuVinci IVT to enable the lawnmower to run forward, reverse and in a “powered-zero” state, that is the transmission maintains a zero output speed while engaged and with the engine running, with no additional shafts or gearing. We believe this feature is unique to NuVinci technology among mechanical IVTs and enables the transmission to be built with fewer components, thereby reducing overall packaging space and manufacturing costs. The powered-zero state has proven through testing to be advantageous as it will hold the mower steady on the side of the hill when the rider lets up off the control, whether a brake is engaged or not. We have found through testing that other IVTs will not hold the mower’s position and brakes must be engaged to prevent the mower from rolling. Finally, the packaging of our NuVinci IVT provides vehicle designers more options for vehicle powertrain layout to enhance rider position on the vehicle and vehicle setup.
 
  Market—Lawn Care Equipment
 
According to the Freedonia Group, the global lawn care equipment market in 2008 was estimated at approximately $16 billion, with an annual growth rate of approximately 2.8% and with about $9.7 billion of that market in the U.S. (Industry Study 2542, World Power Lawn & Garden Equipment, Freedonia Group, Aug 2009). The units sold were estimated to exceed 7.7 million units per year with the ride on lawn and garden vehicle market estimated to exceed 1.65 million units annually. Of this market, vehicles with automatic transmissions (including ZTRs) make up approximately 50%, and of that 50% hydrostatics have dominant market share. We have entered an exclusive manufacturing license arrangement for this end market application under which we should collect royalties from that licensee’s sales. We believe the royalties available from our licensee in this market, considering the unit sales opportunities available, represents an addressable annual opportunity of $65 million.


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  Commercialization Plan—Lawn Care Equipment
 
In August 2009, we entered into a manufacturing license agreement and a development agreement with Hydro-Gear Limited Partnership, which holds the leading market share for ride on automatic mowers with hydrostatic transmissions. Under the agreements, we plan to develop and commercialize NuVinci products within the lawn care equipment field and through this relationship we expect to receive a development fee upon reaching certain milestones and a royalty from future sales.
 
Under our development agreement with Hydro-Gear, this product is currently completing prototype testing and production design refinement, and with their current projections for product development, we expect to demonstrate the fully functional pre-production prototypes to key customers in 2011, beginning preparations for production shortly thereafter with production launch currently projected for later in 2012. The precise date of any launch however is at Hydro-Gear’s discretion. The funding for this development comes primarily from Hydro-Gear under the development agreement, with the remainder expected to come from the net proceeds of this offering along with our existing cash and cash equivalents on hand.
 
Wind Power
 
  Background
 
Over the last 20 years there have been many innovations in the wind turbine industry designed to increase power output capacity and lower the production and operating costs of wind farms. Variable speed turbines and power electronics represent a significant portion of the technology that wind turbines today utilize to control or increase their power output. However, power electronics are costly, representing a large portion of the cost for smaller turbines. For small wind turbines power electronics consist primarily of an inverter, which amounts to approximately 15% of the cost of an 8 kW system. According to the National Renewable Energy Laboratory (NREL), good inverters average about 86% efficiency, meaning the inverter is an expensive component that also reduces power output by at least 14%.
 
Another technical challenge for small wind turbines is how to handle high winds. Most small wind turbines employ passive furling, which turns the rotor out of the wind during periods of high wind speeds, a time when energy available from the wind is at its highest. Passive furl is a crude and very noisy method of regulating rotor speed, and results in suboptimal power generation at high wind speeds. Once a wind turbine has employed passive furling, power output will decrease, sometimes significantly. Maintaining peak power in high winds, a time when wind energy is abundant, is a technical challenge that small wind turbine manufacturers are striving to overcome.
 
Most wind turbines use a drivetrain that is a rigid system and prone to torque spikes from wind gusts. Many early wind turbines failed because of the effects of torque spikes damaging the drivetrain. Drivetrain components tend to be heavy, expensive, and now typically overbuilt.
 
  NuVinci Opportunity—Wind Power
 
We believe that our NuVinci technology can reduce the complexity and cost of wind turbines by maintaining an optimal speed into the generator as wind speed changes. By doing so, the NuVinci CVT-enabled wind turbine does not require the power electronics inverter needed to provide power acceptable to deliver to the grid. Furthermore, as demonstrated through testing by Viryd, our wind turbine licensee, the constant speed into the generator allows the use of simpler more cost-effective generators as well. Other CVT technologies generally lack the torque density (that is torque capacity for a given transmission package size), scalability, assembly and configuration flexibility, cost effectiveness and efficiency, or some combination of these factors, we believe are required to be feasible for use in wind turbines, whether utility class or small wind. Furthermore, we believe the NuVinci CVT can be used to control the speed of the turbine blades during high speed winds instead of employing passive furl, thereby generating power during the highest powered winds. This allows designers to use larger more optimized turbine blades to maximize wind capture.


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Our NuVinci technology’s ability to mechanically change speed of the turbine rotor to produce a stable input speed to the generator has been shown through testing in the field to expand maximum power production by allowing a turbine to operate at a higher rotor speed in high speed winds for a given maximum generator speed. Viryd, our licensee, has developed a prototype NuVinci CVT for an 8kW wind turbine drivetrain, which it has tested in Texas. Viryd’s current test data to date indicates a 34% improvement in energy generation. Furthermore, Viryd has also earned a U.S. Department of Energy grant for its wind turbine to be tested by the department’s National Renewable Energy Laboratory in Colorado under a DOE grant.
 
(ENHANCED WIND PERFORMANCE)
 
Figure 6 – Enhanced Wind Performance
 
Figure 6 is a graph provided to us by Viryd illustrating the improved performance available from wind turbines utilizing a NuVinci CVT drivetrain compared to traditional wind turbines, as determined from Viryd’s test data gathered from actual field testing. The bottom line with triangles illustrates the power available from a standard wind turbine at various wind speeds, and the middle line with circles illustrates the increased power available from the same turbine utilizing a NuVinci CVT. The light or top line with squares illustrates the improved performance available from the NuVinci-enabled wind turbine when also optimizing the turbine blades, as the CVT allows. We believe, based on our research and the described testing that our technology provides numerous advantages over existing designs of variable speed motors, electronics and transmissions for wind turbines that attempt to deliver the level of performance and system efficiencies required of current turbine technologies. By providing a solution that promises such improvements, our NuVinci technology is providing for power to be transferred in more efficient manner.
 
In summary, we believe the NuVinci technology offers the following benefits when used in a wind turbine:
 
  •   Enables variable rotor speed without an inverter, increasing energy production. NREL tests show that inverter efficiency averages about 86% when inverters on/off cycling at cut-in, cut-out, and standby time are included.
 
  •   Captures gusts and lulls. Much of the power in a wind gust is lost due to the fact that the rotor is not spinning at its optimal rate, and strong gusts can put the rotor into stall. Our NuVinci CVT can quickly increase rotor speed to capture gusts, and brake the rotor during lulls to extract the stored energy from the rotor, increasing energy production approximately 15%. We believe, based on research, that turbulent winds can reduce power output 20 to 40%.


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  •   Controls power production above peak power without blade pitching or passive furl. Rotor speed can be reduced precisely as wind speed increases, and peak power can be maintained until the wind turbine is shut down and thus avoiding noisy systems and passive furl.
 
  •   Use of a larger diameter rotor. NuVinci technology’s ability to slow the rotor above its peak power allows it to use a larger rotor. The larger rotor significantly increases annual energy production.
 
  •   Absorbs torque spikes, which can damage wind turbine drivetrains. Due to its multiple contact points and durable structure, NuVinci technology can provide mechanical buffer to allow for and absorb torque spikes by spreading their resulting force out over time.
 
  •   Reduces drivetrain cost to less than half of a typical small wind turbine drivetrain that uses a permanent magnet (PM) generator and an inverter. Our NuVinci technology eliminates the expensive PM generator typically used with small wind turbines and can be used with an inexpensive induction generator. It also eliminates the need for the very expensive inverter.
 
Market—Wind Power
 
Overall, we believe industry data indicates that U.S. wind-based electricity generation is expected to grow to 20% of total U.S. electricity generating capacity by 2030. Although the entire wind industry may be segmented into several smaller categories, traditionally, the industry has only defined two primary segments, small wind from 0 to 100 kW and large or utility class wind for turbines over 100 kW. We are currently scheduled to launch our product for the small wind turbine end market in 2010, which we currently believe to be an addressable annual opportunity of $40 million. However, as reported in the April 13, 2009 American Wind Energy Association Annual Wind Report, the small wind segment grew 96% in 2008, and the industry projects 30-fold growth in the small wind segment within as little as five years, despite the recent global recession. Given the projected growth in the segment over the next 5 years, we believe this represents an addressable annual opportunity for our NuVinci CVT of about $1 billion by 2015.
 
  Commercialization Plan—Wind Power
 
We have established a licensing agreement with Viryd, based in Austin, Texas. Viryd is a former subsidiary of ours and was formed as a separate company with a sole focus on the development and distribution of wind turbines and technologies for generating clean renewable energy.
 
Under an engineering services agreement for Viryd, we have designed, prototyped and tested a wind turbine CVT, on which prototype Viryd then performed further tests including field testing. This product is currently in the design, prototyping and testing stage of development and is undergoing further design refinement. We expect to work with Viryd to develop a production design for a limited production manufacturing launch currently scheduled by Viryd for 2011, but the launch date of this product is at Viryd’s discretion.
 
Viryd intends to both sell a complete product on its own and also to partner with other OEM’s to provide them wind turbine drivetrains that are not otherwise available in the market. While Viryd is currently scheduled to launch its 8 kW turbine in 2011, it is planning to develop a product for a larger wind turbine in the near future as well. We currently intend to sell Viryd the NuVinci CVTs it requires for its initial sales but we expect that Viryd will begin manufacturing themselves in the future and paying us royalties under its license. We believe our current addressable opportunity for the small wind turbine market to be $40M. However, given the projected growth by the industry over the next 5 years, we believe this represents an addressable annual opportunity for our NuVinci CVT of about $1 billion a year by 2015.
 
Current Commercial Application—Bicycles
 
Background
 
There are approximately one billion bicycles in operation worldwide today—twice as many as automobiles. Global economic conditions and the need to reduce dependence on fossil fuels favor the continued growth of bicycles for transportation. We believe, based on our research, that a person riding a bike once a week instead


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of driving can reduce his transportation carbon footprint by 20%—about the same amount as replacing a traditional vehicle with a hybrid, only less expensive.
 
Today the bicycle riding experience is heavily impacted by the process of shifting gears as the rider moves through traffic, stops and starts and adapts to changing terrain. The benefit of using different gears is optimizing performance of the human system, that is, the heart, lungs and legs, by varying or maintaining pedaling speed. Existing gear systems are seen by a large group of the population as being complex.
 
(N171 BICYCLE CVP & CRUISE CONTROLLER)
 
Figure 7 – N171 Bicycle
CVP & Cruise Controller
 
NuVinci Advantage
 
Our bicycle CVT transmission, shown in Figure 7, replaces the derailleur and multiple sprocket geared systems presently used in bicycles and, as our own consumer testing has shown, is much smoother and easier to operate. Simply by rotating a handle grip, which we refer to as the Cruise Controllertm, the rider may seamlessly shift the transmission until the desired gear ratio is attained. There is no temporary loss of power as experienced by the rider with geared systems that force the chain to jump from one sprocket to another. Our bicycle CVT transmission also decreases the effects of mistakes in shifting, which can lead a rider to slip off the pedals or stall going up a hill, creating less than satisfactory ride experience and potentially causing injury. Development of our bicycle CVT has occurred in phased steps over the past ten years with improvements in weight, configuration and performance.
 
Global Market—Bicycle
 
We estimate the global annual bicycle market to exceed 100 million units based on publicly available information from Bike Europe, Cycle Press, Japan Bicycle Promotion Institute and World Watch Society, COLIBI—European COmité de LIaison des Fabricants Européens de BIcyclettes, 2008 Bicycle Report, Danske Cykelhandlere estimate. However, due to the relatively low cost of bicycles sold in the China and India markets, we consider the realistic global market to be approximately 50 million units per year. Because our product is currently considered targeted to high end bicycles, we have reduced the target market size to include only those bicycles distributed through dealers. This yields a market potential of 14.6 million units. Finally, we further reduce the size of our addressable market by eliminating bicycles that fit into categories that are inappropriate, such as children’s bicycles, high end road bikes and triathlon bikes. Therefore, we estimate that the global bicycle market that is addressable by our NuVinci bicycle products to be approximately 8 million units per year. We believe that with the mix of products we are considering over the next few years that this market represents a total annual opportunity of $1.1 billion.
 
When considering which key geographic bicycle markets to launch our NuVinci technology in, we focused on countries and regions of the world where bicycle ownership per capita, percentage of trips made on bicycles, bicycle transportation infrastructure, and local bicycle industry advocacy is strong. As a result, we initially launched in The Netherlands, followed by Germany, Switzerland and Denmark, and have continued to leverage


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knowledge gained from this initial effort to expand into other key European countries as well as into North America and Asia, as increasing fuel prices drive up the interest in commuting bicycles.
 
Europe: The Netherlands is considered to be the most bicycle-centric country in the world, with annual bicycle sales exceeding 1.5 million units, primarily (80+%) sold by bicycle dealers. With the highest per capita bicycle ownership in the world, bicycles represent 34% of all modes of transportation for all trips. Dutch consumers ride an average 950 kilometers per year (#1 in world). The average value of bicycles sold by independent bike dealers in the Netherlands alone was €709. Germany is the EU country with the largest production of bicycles. We believe the 2008 total bicycle sales in Germany were 4.32 million per year at an average price of €386 with over 65% of bicycles sold through bicycle dealers. The German bicycle industry is planning a state-run program to promote inner-city cycling with a focus on reducing congestion and exhaust emissions in city centers.
 
North America: The North American market is dominated in unit sales by mass merchants. However, in terms of dollar value, mass merchants only have a 35% market share. Sporting goods retail chains had a 6% share in 2008 units sold and 9% in dollar value while Independent Bicycle Dealers (IBDs) had a 17% share in units and 50% of dollar value with an average per unit price of $422. The Canadian bicycle market of over 1.3 million units sold per year is dominated by the mass retailers with over 75% of unit sales through retailers such as Canadian Tire Corp, Wal-Mart, Zellers, and a variety of sporting goods chains. Over 2000 IBDs represent the balance of units sold in Canada.
 
Products—Bicycle
 
Our Bicycle Products Division markets NuVinci CVTs into the global bicycle and e-bicycle industry that currently use derailleur and internally geared hubs. The product includes a CVT transmission, a shifter, and a CVT interface that connects the cables between the controller and the CVT for a mechanical shift signal. We sell our bicycle products directly to original equipment manufacturers, or OEMs, that assemble or manufacture bicycles and e-bicycles, to wholesale distributors that sell bicycle components to independent bicycle retailers, or IBDs, to fleets that use bicycle for tourism and trade, and to national retail chains that source and sell private branded bicycles.
 
(NUVINCI CVT IMPROVEMENT)
 
Figure 8 – NuVinci CVT improvement
 
Figure 8 illustrates the development progress we have made with the NuVinci bicycle CVT. On the left, is the B15 Prototype, which represents the first commercially viable bicycle CVT. We currently market our commercial bicycle NuVinci CVT transmission, model N171, the successor to the initial product model N170, along with a developer kit. Our developer kit is an automatic shifting hub system that includes electronics and the N171 CVT. The N171 CVT is sold into the bicycle industry via OEMs and aftermarket dealers whereas the developer kit is sold directly to inventors and developers of light vehicles and equipment interested in implementing our NuVinci CVT technology in future vehicles or equipment.
 
We launched manufacturing of the N360, which is the next generation CVT for bicycles and e-bicycles. Production of the N360 began in June 2010 and shipments to customers began in July 2010. The N360 has many improvements over the N171 bicycle CVT including a weight reduction in over 35%, a size reduction of over 10%, improved shift feel and responsiveness, and we believe the CVT will be easier to assemble with


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over 50% fewer parts. We believe the improved design of N360 bicycle CVT will have a much broader appeal in the marketplace.
 
Following up on private demonstrations to selected bicycle manufacturers, we initiated official prelaunch marketing activities by introducing the N360 to the bicycle market on March 17 to 20, 2010 at the Taipei Cycle show in Taiwan, a major bicycle industry trade show with wide international attendance. Reaction to the N360 has been uniformly favorable. To date, over 40 bicycle manufacturers have tested pre-production prototypes of the N360 and have expressed interest in the product. We have launched manufacturing of the NuVinci N360 second generation commercial bicycle product and shipped the first production units in July 2010 to Simpel.ch, a premium Swiss city bicycle manufacturer. Response from the market on the N360 has been extremely positive and we have received purchase orders from customers representing several companies, even prior to receiving their production samples.
 
In addition, as Tri Star is located in China and is near most of the component suppliers, we expect that inbound logistics costs will be lower and coordination will be easier. Because of improved logistics, design and a fixed contracted unit price from Tri Star, we expect the cost per unit for the N360 should be at least 50% less than the first generation bicycle CVT. Furthermore, we have leveraged management’s experience in the automotive industry for the manufacturing of this product by implementing processes for quality and supply base management characteristic of the automotive industry. So far, more than 100 prototype versions of the N360 have been built for internal testing and customer demonstration. We continue to develop additional manufacturing sources for our components in order to ensure reliable supply of components and pursue cost reduction opportunities.
 
Customers—Bicycle
 
The demand for bicycles in Europe and North America is seasonal in nature with over 50% of the OEM demand ordered between November and March to prepare for bicycle assembly and shipment to the retail market in the spring season. The bicycle markets in China and Asia have less seasonal fluctuations, however, we anticipate that these markets should represent a relatively small (<10%) portion of our bicycle sales in the next three years.
 
All of our customer orders are placed with purchase order contracts that require shipment per order with no long term contracts that would require renegotiation. The Tri Star production line has a rated production capacity of over 300,000 units per year, to allow flexibility in planning and managing the growth of our sales.
 
Going forward, we plan to leverage commercial relationships to expand distribution in China, Japan and Korea. For China and Japan, these partners have been identified. We are in the early stages of reviewing Asian OEM and distribution partners.