As filed with the Securities and Exchange Commission on March 25, 2010

Registration No. 333-164915

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

 

 

 

Amendment No. 1

to

Form S-1

 

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

 

 

Fallbrook Technologies Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

 

 

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:

 

 

 

 

 

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):

 

(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.

 

 

Subject to Completion, dated March 25, 2010

 

          Shares

 

 

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 9.

 

 

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.

 

 

 

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.

 

 

Prospectus dated          , 2010

 

Table of Contents

 

 

 

 

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.

 

 

Until          , 2010 (the 25th day after the date of this prospectus), all dealers, whether or not participating in this offering, that effect transactions in these securities may be required to deliver a prospectus. This is in addition to the dealer’s obligation to deliver a prospectus when acting as an underwriter in this offering and when selling previously unsold allotments or subscriptions.

 

Prospectus Summary

 

	•	Improved efficiency and performance;
	•	Adaptable platform technology; and
	•	Simple, durable and cost-effective design.

End Market		Application		Key Benefits
Automotive Accessory Drives		Alternators, air conditioning compressors and superchargers		•   Improved accessory performance •   Improved fuel economy
Electric Vehicles		Primary transmissions		•   Increased operating range •   Improved acceleration and top speed •   Improved battery life •   Reduced manufacturing cost
Bicycles		Primary transmissions (rear wheel hubs)		•   Improved ride experience •   Unlimited available speeds within its range •   Smooth, seamless shifting
Small Wind Turbines (<100kW)		Primary transmissions		•   Increased power production •   Improved reliability •   Lower cost of energy
Lawn Care Equipment		Primary transmissions		•   Improved efficiency •   Noise reduction •   Improved performance

End Market Application		Addressable Market Opportunity
Automotive Accessory Drives(1)		$	2.4 billion
Electric Vehicle(2)		$	1.2 billion
Bicycle		$	1.1 billion
Small Wind Turbine (<100kW)(2)		$	1.0 billion
Lawn Care Equipment		$	65 million

(1)		This includes a one time revenue opportunity of $1.0 billion, which represents potential sales into the existing installed base of vehicles (or pre-owned vehicle market).

(2)		The addressable market opportunity provided is based on projected market size for 2015.

	•	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.

	•	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 strategic 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 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.

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 750,000 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.

	•	the conversion, immediately prior to the closing of this offering, of all of our outstanding shares of preferred stock into 101,106,785 shares of our common stock;

	•	the issuance of          shares issuable upon the exercise of warrants to be exercised 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.

		Year Ended December 31,
		2007(1)				2008(1)				2009
		($ in thousands)
Revenues		$	714			$	2,283			$	1,044
Cost of revenues			1,892				2,048				7,260
Gross (loss) profit			(1,178	)			235				(6,216	)
Operating expenses			5,827				10,321				10,523
Operating loss			(7,005	)			(10,086	)			(16,739	)
Other income (expense)			447				(470	)			(487	)
Net loss		$	(6,558	)		$	(10,556	)		$	(17,226	)

		As of December 31,
		2007(1)				2008(2)				2009
		($ in thousands)
Cash and cash equivalents		$	8,043			$	14,565			$	9,213
Total assets			10,855				25,314				13,526
Total liabilities			2,158				3,171				3,813
Total equity			8,697				22,143				9,713

		Year Ended December 31,
		2007(1)				2008(2)				2009
		($ in thousands)
Net cash (used in) provided by:
Operating activities		$	(5,860	)		$	(9,496	)		$	(12,118	)
Investing activities			8,073				(7,271	)			2,954
Financing activities			2,612				23,289				3,812
Net change in cash		$	4,825			$	6,522			$	(5,352	)

(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. 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.

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 over 350 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:

 

 

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

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 and $17,226,000 for 2009. We expect to incur a loss in 2010. We anticipate that we will continue to have negative cash flow in 2010 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.

 

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.

 

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. For example, Viryd Technologies Inc. has licensed our technology for use in wind energy applications and we have an agreement with Hydro-Gear to incorporate our technology into 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.

 

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 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.

 

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 OEMs is also required to determine the requirements for each specific application. Once our products are designed into an OEM or tier one supplier customer’s products or systems, the OEM or tier one supplier customer may depend on us to resolve issues relating to our products. If we do not effectively assist our OEM or tier one supplier 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.

 

In addition, 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 financial problems of the automobile industry might result in reduced spending on alternative or more efficient energy management systems for automobiles, delays in the introduction of new hybrid and electric vehicles and the elimination of other programs, which in each case would be candidates for the use of our technology. If this happens, 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 share of the market for internal hub bicycle transmissions 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. 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, 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.

We may not be able to successfully recruit and retain skilled employees, particularly scientific, technical and management professionals.

 

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. Additionally, among our employees are a number of highly skilled traction drive experts. These individuals 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.

 

Additionally, we believe that 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. The demand for 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.

 

Declines in product prices or increases in the cost of materials 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. At the same time, the cost to produce our products may increase, as rapid growth and consumption of raw materials by China may cause their prices to rise. Either a reduction in the price of our products or an increase in the costs of our products, or both, 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.

 

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.

 

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.

 

The restatement also evidenced a material weakness in our internal control over financial reporting. 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.

 

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.

 

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:

 

 

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. This is because, while our sales are in U.S. dollars, most of our products will be manufactured in China. Our results of operations will be particularly sensitive to the fluctuation of the Chinese renminbi against the U.S. dollar. For example, if the Chinese 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 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.

 

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.

 

We are planning rapid sales growth for our products. 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.

 

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 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. 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.

 

Litigation may fail and, even if successful, may result in substantial costs and be a distraction to our management. We may not be able to prevent misappropriation of our proprietary rights, particularly in countries outside the U.S. where patent rights may be more difficult to enforce.

 

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 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 will continue to have substantial influence and control 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 75.7% of our outstanding common stock as of December 31, 2009 and, following this offering will beneficially own approximately     % of our outstanding common stock. As a result, they will, as a group, 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.

 

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 December 31, 2009, 12,994,466 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 2,933,065 are vested as of such date. To the extent that these outstanding options are ultimately exercised, you will incur further dilution.

 

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:

 

 

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.

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 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.

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, including the repayment of indebtedness. 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.

We have never declared or paid cash dividends on our common stock. 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. 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.

We currently have four series of outstanding preferred stock:

 

 

Effective immediately prior to this offering, all of our outstanding preferred stock will be converted into 101,106,785 shares of our common stock.

We have a $3,000,000 revolving line of credit with Wells Fargo Bank, National Association, of which $2,000,000 was outstanding as of March 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 base rate, which is a fluctuating rate equal to the highest of the prime rate (5.0 percent at December 31, 2009), LIBOR plus 1.5 percent, or the Federal Funds Rate plus 1.5 percent. The line of credit provides for a quarterly unused commitment fee of 0.375 percent 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.

The following table sets forth our capitalization as of December 31, 2009:

 

 

 

 

 

 

 

.

 

 

 

 

 

The table above does not include:

 

 

 

 

 

 

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.

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 and par value of preferred stock, divided by the number of shares of common stock outstanding.

 

As of December 31, 2009, our actual net tangible book value was approximately $6,229,000, or $0.53 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 101,106,785 shares of common stock, (b) the issuance of           shares of common stock upon the exercise of warrants to be exercised 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 December 31, 2009 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:

 

 

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 December 31, 2009, 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:

 

The foregoing tables and calculations assume no exercise of the underwriters’ option to purchase additional shares and exclude:

 

 

 

 

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.

 

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:

 

 

Consolidated Balance Sheet Data:

 

 

Consolidated Statement of Cash Flows Data:

 

 

 

 

 

 

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, 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 $55 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 December 31, 2009, we invested in the development and protection of intellectual property resulting in a worldwide portfolio of 156 patents (including validated countries) and 208 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 launch of the next generation bicycle CVT, called the N360. We terminated our contract manufacturing agreement with MTD in October 2009, after building 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 expect to launch production of the N360 in 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.

 

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 2010, 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.

 

Production of the N360 and NuVinci CVT for small wind turbine will be launched in 2010. We anticipate that we or our licensee will launch production of our products into the automotive accessory drive, electric vehicle, and lawn care equipment end markets in 2011.

 

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 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 expect to launch production of the N360 in 2010.

 

We expect to launch our product for the automotive accessory drives and electric vehicles end markets in 2011 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 2011 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 2010. We expect that the engineering services agreements for the automotive accessory drive for superchargers and lawn care equipment CVTs will lead to commercialization and manufacturing of these products in 2011.

 

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 2010.

 

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 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 2010, 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 and CVTs for electric vehicles in 2011. 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 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 Years Ended December 31, 2008 and 2009

 

 

Revenues

 

 

Total revenues for the year ended December 31, 2009 decreased by $1,239,000, or 54%, compared to the year ended December 31, 2008.

 

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

 

 

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 $5,472,000 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 MTD for the manufacture of bicycle CVTs. However, in 2009, events and changes in circumstances associated with the manufacturing agreement with MTD 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. Unresolved negotiations about product cost and unstable production levels between the Company and MTD caused us to terminate the contractual relationship on October 30, 2009. In connection with the early termination of the manufacturing supply agreement, we agreed to transfer the machinery and equipment to MTD. As a result, we recorded an impairment of $1,537,000 and loss on disposal of $1,455,000 on machinery and equipment in 2009. We also determined that the associated trade secrets and manufacturing processes used by MTD would no longer provide future benefit due to the decision to cease production of the N171 to which it was associated before the end of the intangible assets’ previously estimated useful life. Accordingly, in 2009, we recorded a $490,000 impairment loss on the write-off of the intangible assets.

 

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. As the N360 is expected to launch in 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.

 

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

 

 

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

 

 

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.

 

Interest income (expense)

 

Interest and dividend income

 

 

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

 

 

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.

Comparison of the Years Ended December 31, 2007 and 2008

 

Revenues

 

 

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.