As Previously
		Reported				Adjustment				As Restated
Net loss		$	(1,550,958	)		$	-			$	(1,550,958	)
Net loss attributable to noncontrolling interests		$	670,297			$	(290,502	)		$	379,795
Net loss attributable to KL Energy Corporation		$	(880,661	)		$	(290,502	)		$	(1,171,163	)
Net loss per share, basic and diluted		$	(0.02	)		$	(0.01	)		$	(0.03	)

 

Significant Accounting Policies

Use of Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  The following estimates are significant to the Company’s consolidated financial statements: costs to complete long-term contracts, useful lives of property, plant and equipment, impairment of long-lived assets, valuation of share based compensation, going concern analysis, valuation allowance on deferred tax assets and the allowance for doubtful accounts.

Principles of Consolidation

The accompanying consolidated financial statements include the results of operations and financial position of the Company, KL Energy Services LLC (“KLES”, a wholly-owned subsidiary, as well as its wholly-owned KLHC LLC (formerly known as KL Energy LLC, “KLHC”) and majority-owned KL Management, LLC (“KLM”), Patriot Motor Fuels LLC (“Patriot”) and Western Biomass Energy LLC (“WBE”).  Until September 30, 2008, KLHC and KLM were 53% owned by KLPDG and the remaining 47% was owned by three other individuals; Patriot was 50% owned by KLPDG and two other owners held the remaining 50% interest.   At September 30, 2008, the Company ownership interest increased to 75% for KLHC, KLM and Patriot. WBE is 64% owned by the Company and 36% owned by various unrelated investors.  All significant intercompany accounts and transactions have been eliminated in consolidation.

 

Basis of Presentation

The accompanying unaudited consolidated financial statements and related notes have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Results for interim periods should not be considered indicative of results for a full year. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of the results for interim periods have been included.

We have reclassified certain data in the financial statements of the prior period to conform to the current period presentation.  Specifically, in the statement of operations, we reclassified approximately $251,000 and $432,000 of expenses in the three and six months ended June 30, 2009, respectively, that were previously included in general and administrative expenses but that were more appropriately includable in research and development expenses.

 

- 8 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 1 – Nature of Business and Significant Accounting Policies (continued)

Significant Accounting Policies (continued)

 

Recently Issued Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board, or FASB, issued guidance requiring additional fair value disclosures for significant transfers between levels of the fair value hierarchy and gross presentation of items within the Level 3 reconciliation. This guidance also clarifies that entities need to disclose fair value information for each class of asset and liability measured at fair value and that valuation techniques need to be provided for all non-market observable measurements. Our adoption of this guidance on January 1, 2010, did not impact our consolidated financial statements as we have no items classified as Level 3.

In August 2009, the FASB issued new accounting guidance to provide clarification on measuring liabilities at fair value when a quoted price in an active market is not available. This guidance became effective for us on October 1, 2009. The Company adopted this guidance on October 1, 2009, and it had no material impact on our consolidated financial statements.

In April 2009, the FASB issued additional guidance regarding fair value measurements and impairments of securities which makes fair value measurements more consistent with fair value principles, enhances consistency in financial reporting by increasing the frequency of fair value disclosures, and provides greater clarity and consistency in accounting for and presenting impairment losses on securities.  The additional guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  The Company adopted the provisions for the period ending March 31, 2009.  The adoption did not have a material impact on our financial position or results of operations.

In April 2009, the FASB issued new accounting guidance related to interim disclosures about the fair values of financial instruments. This guidance requires disclosures about the fair value of financial instruments whenever a public company issues financial information for interim reporting periods. This guidance is effective for interim reporting periods ending after June 15, 2009. The Company adopted this guidance upon its issuance, and it had no material impact on our consolidated financial statements.

 

Revenue and Cost Recognition

 

Revenue from fixed price contracts is recognized on the percentage-of-completion method, measured by the percentage of costs incurred to date to estimated total costs for each contract.  This method is used because management considers expended costs to be the best available measure of progress on these contracts.  Due to uncertainties inherent in the estimation process, it is at least reasonably possible that the completion costs for contracts in progress at June 30, 2010 and December 31, 2009 will be revised significantly in the near term.  Contract costs include all direct material, subcontract and labor costs, and those indirect costs related to contract performance, such as labor, supply, tool, and depreciation costs.  Operating costs are charged to expense as incurred.  Revenue is reported net of sales tax collected.  Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined.  Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and income and are recognized in the period in which the revisions are determined.

Revenue from feedstock testing results from agreements with third parties for the Company to perform extensive tests to determine if the customer’s feedstock is a viable candidate for use in the production of cellulosic ethanol.  The standard agreement requires that the customer pay 50% of the testing fee upon signing the feedstock testing agreement and the remaining 50% when the Company delivers a final report to the customer explaining the test results and conclusions.  Feedstock testing revenues, and related expenses, are only recognized when this report is delivered.

Pre-contract costs directly associated with a specific contract are deferred as incurred in anticipation of that contract if recovery of these costs is determined to be probable.    Conversely, if it appears unlikely that we will obtain the contract, all previously deferred costs are expensed.  Such costs include consultant expenses for project development, technology improvements, facility engineering and feedstock evaluation expenses.     

 

Based on our percentage-of-completion revenue recognition policy, revenues and costs associated with approved change orders are adjusted when Company and customer approvals of the change order are obtained.  For unpriced or unapproved change orders, recovery must be deemed probable, if the future event or events necessary for recovery are likely to occur, at which time revenues and costs associated with the unpriced or unapproved change orders are adjusted. If change orders are in dispute or are unapproved in regard to both scope and price, they are evaluated as claims.

 

Claims are amounts in excess of the agreed contract price (or amounts not included in the original contract price) that a contractor seeks to collect from customers or others for customer-caused delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated additional costs.

 

Recognition of amounts of additional contract revenue relating to claims is made only if it is probable that the claim will result in additional contract revenue and if the amount can be reliably estimated. Those two requirements are satisfied by the existence of all of the following conditions:

a.) The contract or other evidence provides a legal basis for the claim; or a legal opinion has been obtained, stating that under the circumstances there is a reasonable basis to support the claim.

b.) Additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor's performance.

c.) Costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed.

d.) The evidence supporting the claim is objective and verifiable, not based on management's feel for the situation or on unsupported representations.

If the foregoing requirements are met, revenue from a claim is recorded only to the extent that contract costs relating to the claim have been incurred. Costs attributable to claims are treated as costs of contract performance as incurred.

The asset, "Costs and estimated earnings in excess of billings on uncompleted contracts," represents revenue recognized in excess of amounts billed.  The liability, "Billings in excess of costs and estimated earnings on uncompleted contracts," represents billings in excess of revenue recognized.

 

Patriot provided blended fuel on consignment to service stations.  Revenue related to the sale of blended fuel by Patriot was recorded when the ethanol was sold by the service station to the end customer.  This operation was discontinued in January 2009.

 

 

- 9 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

 

Note 1 – Nature of Business and Significant Accounting Policies (continued)

Significant Accounting Policies (continued)

Long-Lived Assets

 

The Company assesses the realizable value of long-lived assets for potential impairment at least annually or when events and circumstances warrant such a review.  The net carrying value of a long-lived asset is considered impaired when the anticipated fair value is less than its carrying value.  Approximately 96% of the Company’s property, plant and equipment is attributable to the WBE facility in Upton, WY which was completed in August 2007.

The Company continually monitors conditions that may indicate a potential impairment of long-lived assets.  These conditions include current-period operating losses combined with a history of losses and a projection of continuing losses, and significant negative industry or economic trends.  When these conditions exist, we test for impairment.  

We group our long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are independent of the cash flows of other assets and liabilities for the purpose of testing for impairment loss.  In the event of an impairment loss the carrying amount of only the long-lived assets within the group is reduced.  Currently, our long-lived assets do not have identifiable cash flows that are independent of the cash flows of other assets and liabilities and, therefore, our long-lived assets are assessed for impairment as one asset group.

Our un-discounted cash flows are used to determine if the carrying value of the Company’s long-lived assets is not recoverable.  In this event, we determine the fair value of our long-lived assets using internal cash flow projections, outside financing activity, historical financial information, current market conditions and forecasted future market conditions.  These assessments are used to calculate the present value of our long-lived assets which we believe is the best estimate of their fair value.   An impairment charge is recognized for the amount by which the carrying value of the asset group exceeds its estimated fair value.  The assumptions and methodologies used in our 2009 impairment analysis were substantially the same as we used in our 2008 impairment analysis.

As of December 31, 2009, based on these analyses as well as the continuing operational value of the WBE facility to our research and development efforts, management concluded that the fair value of these long-lived assets exceeded their $2.4 million net book value and. no impairment charge was recognized.

 

Note 2 - Property, Plant, and Equipment

Property, plant, and equipment consist of the following as of:

 

		June 30,				December 31,
		2010				2009
Plant and Plant Equipment		$	7,410,262			$	7,402,413
Office Furnishings and Equipment			373,156				274,103
Vehicles			51,698				51,698
			7,835,116				7,728,214
Less Accumulated Depreciation			(5,191,268	)			(4,227,017	)
Total Property, Plant, and Equipment, Net		$	2,643,848			$	3,501,197

Construction costs associated with the WBE demonstration plant are stated at cost (including direct construction costs, and capitalized interest).  The Company has also capitalized approximately $471,000 of professional engineering and construction services provided by the Company through June 30, 2010.

Note 3 - Financing

 

On June 4, 2010, the Company received the final installment of an equity financing pursuant to Securities Purchase Agreement with an accredited investor.  Pursuant to the terms of the purchase agreement, the Company issued to this investor 681,818 shares of the Company’s common stock, at $1.10 per share, for net proceeds to the Company of $675,000.  The shares were issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

 

 

- 10 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 3 – Financing (continued)

On May 3, 2010, the Company received the final installment of a Securities Purchase Agreement with an accredited investor.  Pursuant to the terms of the Purchase Agreement, the Company issued to this investor 545,455 shares of the Company’s common stock, at $1.10 per share, for net proceeds to the Company of $540,000.  The shares will be issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

Effective April 6, 2010, pursuant to the terms of a Securities Purchase Agreement with an accredited investor executed on January 6, 2010 and which agreement required pricing of these shares to be reduced to $1.10 per share based on the absence of an investment by an additional institutional investor within 90 days after the date of the agreement, the Company issued to this investor an additional 363,636 shares of the Company’s common stock at $1.10 per share.  The shares were issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

On March 30, 2010, the Company received the final installment of the December 2009 Securities Purchase Agreement with an accredited investor.  Pursuant to the terms of the Purchase Agreement, the Company issued to the investor 454,545 shares of the Company’s common stock, at $1.10 per share, for net proceeds to the Company of $450,000.  The shares will be issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

On January 6, 2010, the Company entered into a Securities Purchase Agreement with an accredited investor.  Pursuant to the terms of the Purchase Agreement, the Company received $1.5 million before expenses on that date, representing 50% of this investor’s commitment to purchase 2,000,000 shares of the Company’s common stock, and will pay the remaining $1.5 million within 14 days of receiving a written demand from the Company.  The pricing of these shares may be reduced based on certain subsequent events.  (See Note 13 for additional details.)  This Purchase Agreement provides for: (i) piggyback registration rights allowing the Investor to participate in registration statements filed by the Company and (ii) participation rights allowing the Investor to purchase its pro rata share of equity securities issued by the Company for cash, with certain exceptions including, without limitation, issuances relating to compensation, commercial credit arrangements, and strategic transactions involving ongoing business relationships. The shares will be issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

 

Note 4 – Net Loss Per Common Share

Basic EPS includes no dilution and is computed by dividing income or (loss) applicable to common stock by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted EPS.   For the three and six months ended June 30, 2010 and 2009, stock warrants for 3,125 shares were not included in the computation of diluted loss per share because their effect was anti-dilutive.  For the three and six months ended June 30, 2010, stock options for 83,333 shares of common stock were not included in the computation of diluted loss per share because their effect was anti-dilutive.  There were no other stock warrants or options issued or outstanding as of June 30, 2010.

Note 5 - Operations

Continuing Operations

During the period from its inception to June 30, 2010, the Company has incurred significant annual net losses and at June 30, 2010 and December 31, 2009, the Company had negative working capital (i.e. current assets less current liabilities) of approximately $6.1 million and $6.4 million, respectively.  At June 30, 2010, total liabilities exceeded total assets by approximately $3.5 million.  The first generation ethanol industry, in which the Company has historically operated, continues to face significant challenges including increased construction costs, limited availability of debt and equity financing and a reduction in public and governmental support.

These factors, among others, indicate the Company may be unable to meet its current obligations and may be unable to continue as a going concern unless it raises additional capital.  Management is continuing its efforts to raise additional capital through various methods and has refocused its business to cellulosic ethanol.

 

- 11 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 5 – Operations (continued)

Discontinued Operations

In January 2009, the Company determined that its majority-owned subsidiary, Patriot Motor Fuels LLC (“Patriot”), should be discontinued as a result of pricing and other competitive factors.  Patriot distributed ethanol blended fuel.  In June 2009, the Company also discontinued two additional businesses in which it held a majority interest:  KL Management LLC (“KLM”), which managed ethanol facilities for third parties, and KLHC LLC (formerly known as KL Energy LLC, “KLHC”), which sold wholesale ethanol. Both businesses were discontinued as a result of the severe change in the economics of the first generation ethanol industry but especially due to the Company’s re-focus on cellulosic second generation ethanol commercialization.

Operating results from discontinued operations were income (loss) of approximately $5,000 and ($20) during the three months ended June 30, 2010 and 2009, respectively, and income (loss) of approximately $31,000 and ($12,000) during the six months ended June 30, 2010 and 2009, respectively.   At June 30, 2010 and 2009, these businesses had no assets and the only liabilities were accounts payable of $316,431 and $356,970, respectively.

Note 6 –Debt

Short-Term Borrowing Arrangements

The Company had available a $250,000 revolving line of credit with Wells Fargo Bank, N.A. that was personally guaranteed by certain Company shareholders, and collateralized by their personal property, with accrued interest payable monthly at the prime rate plus 0.5% (3.75% at December 31, 2008). This line of credit matured and was paid off in June 2009.

In addition, the Company had approximately $39,000 and $44,000 in credit card liability at June 30, 2010 and December 31, 2009, respectively, which are also guaranteed by certain shareholders. These credit card liability balances are included in accounts payable in the accompanying consolidated balance sheets.  These liabilities are being reduced monthly.

Subordinated Debt – Related Parties

The Company has a subordinated secured note payable to a Company shareholder totaling $506,461and $560,000 at June 30, 2010 and December 31, 2009, respectively.  This note includes interest at a variable rate, which was 5.0% at June 30, 2010 and December 31, 2009, respectively, with interest paid quarterly.  Prior to February 2009, this note was unsecured and did not have a specified due date. In February 2009, the note was modified to include principal payments of $10,000 per month, beginning in September 2009, over a 60-month term. The principal payments are scheduled to be $120,000 in 2010, 2011, 2012, 2013, respectively, and $56,461 in 2014.  Payments of $120,000 are due on this note in the next twelve months and therefore have been classified as current at June 30, 2010.  As security for our obligations under this note, we granted to the lender a security interest in our current and future accounts receivable.  In addition, if the Company receives additional equity financing, the Company is obligated to pay 5% of the proceeds towards principal payments on this note.  Based on equity financing since February 2009, an additional $310,000 has been classified as currently payable. Total current maturities and the balance on this note as of June 30, 2010 were $436,461 and $506,461, respectively

 

- 12 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

 Note 6 –Debt (continued)

Long-Term Debt

Long-term debt consists of the following as of:

 

		June 30, 2010				December 31, 2010
Note payable to bank with interest at 6.5%. The note is payable in twelve monthly installments of $17,560 of principal and interest beginning March 2010 with any remaining unpaid principal and interest due March 2011, with additional maturity extensions available. This note is secured by substantially all assets of WBE and guaranteed by the Company and certain WBE members.		$	1,332,028			$	1,394,043
Payable to Hermanson Egge to replace overdue payables for construction services with unsecured agreement, interest at 0% with payments of $70,000 in July 2009, $15,000 monthly from July 2009 to April 2010, $10,000 monthly from May 2010 to August 2010, $20,000 monthly for September 2010 to November 2010 and $15,000 in December 2010.			85,000				160,000
Note payable to Lansing Securities Corp., interest at 10% and the maturity date has passed and has been temporarily waived by the note holder until further notice.			250,000				250,000
Note payable to Universal Premium Acceptance Corp. for payment of insurance premiums, interest at 9.24%, payable in monthly principal and interest installments of $5,239.			–				30,605
Note payable to Avid Solutions for centrifuge equipment of $195,000, payable in monthly principal and interest installments of $10,000, including interest at 10% secured by equipment.			–				6,767
Note payable to Shimadzu for lab equipment of $32,114, payable in monthly principal and interest installments of $1,072, including interest at 13.6% secured by equipment.			14,71 4				19,095
Note payable to First Insurance Funding Corporation for payment of direct or and officer insurance premiums, payable in monthly installments of $3,692, including interest at 8.4%.			32,671				–
Subordinated note payable to Randy Kramer and assigned to First National Bank, interest at 5.0%, secured by accounts receivable of the Company, payable in monthly installments of $10,000 per month plus interest beginning September 2009 and 5% of equity financings after February 2009.			506,461				560,000
Subtotal		$	2,220,874			$	2,420,510
Less current maturities of long-term debt			(2,149,027	)			(2,113,889	)
Total Long-Term Debt		$	71,847			$	306,621

 

- 13 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 7 – Common Stock Activity

Pursuant to the terms of a Securities Purchase Agreement executed in January 2010, which agreement required pricing of these shares to be reduced to $1.10 per share based on the absence of an investment by an additional institutional investor within 90 days after the date of the agreement, the Company issued to this investor 363,636 shares of the Company’s common stock at $1.10 per share. The shares were issued in reliance on the exemption provided by Regulation S of the Securities Act of 1933, as amended.

Note 8 - Segment Information

As of June 30, 2010, the Company manages its business and aggregates its operational and financial information in accordance with two reportable segments. Its engineering and management contracts segment provides contracted engineering and project development to third party customers. Despite the lack of activity in this segment during the first three months of 2010, during which time the Company focused its resources on biofuel research and development, management believes this will be a viable business segment in the near future. The biofuel segment is focused on developing unique technical and operational capabilities designed to enable the production and commercialization of biofuel, in particular ethanol from cellulosic biomass, and is expected to begin operations starting in 2010.

Management assesses performance and allocates resources based on specific financial information for the business segments. For the biofuel segment, performance is assessed based on total operating expenses and capital expenditures. Operating expenses for each segment include direct costs of that segment. Expenses and assets shared by the segments require the use of judgments and estimates in determining the allocation of expenses to the segments. Different assumptions or allocation methods could result in materially different results by segment.

 

- 14 -

---

 

 KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 8 - Segment Information (continued)

Financial information for the Company’s business segments was as follows (in thousands):

		As of				As of
		June 30,				December 31,
		2010				2009
Identifiable Fixed Assets:
Engineering and management contracts		$	425			$	326
Biofuel research and development			7,410				7,402
Total			7,835				7,728
Accumulated depreciation			(5,191	)			( 4,227	)
Total Identifiable Fixed Assets		$	2,644			$	3,501

		For the Three Months Ended								For the Six Months Ended
		June 30,								June 30,
		2010				2009				2010				2009
Revenues:
Engineering and management contracts		$	-			$	-			$	-			$	-
Biofuel			-				-				120				-
Total Revenues		$	-			$	-			$	120			$	-
Depreciation:
Engineering and management contracts		$	14			$	14			$	29			$	30
Biofuel			473				467				941				937
Total Depreciation		$	487			$	481			$	970			$	967
Interest Expense:
Engineering and management contracts		$	26			$	20			$	44			$	61
Biofuel			15				6				37				40
Total Interest Expense		$	41			$	26			$	81			$	101
Net Loss:
Engineering and management contracts		$	(767	)		$	(481	)		$	(1,766	)		$	(2,717	)
Biofuel			(475	)			(690	)			(954	)			(1,202	)
Net Loss		$	(1,242	)		$	(1,171	)		$	(2,720	)		$	(3,919	)
Reconciliation to Reported Amounts
Revenue - Reportable Segments		$	-			$	-			$	120			$	-
Eliminations/Other			-				-				-				-
Total Consolidated Revenues		$	-			$	-			$	120			$	-
Net Loss - Reportable Segments		$	(1,242	)		$	(1,171	)		$	(2,720	)		$	(3,919	)
Eliminations/Other			-				-				-				-
Total Consolidated Net Loss		$	(1,242	)		$	(1,171	)		$	(2,720	)		$	(3,919	)

Note 9 – Noncontrolling Interests

On January 1, 2009, the Company adopted changes issued by the FASB to consolidation accounting and reporting. These changes establish accounting and reporting for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This guidance defines a noncontrolling interest, previously called a minority interest, as the portion of equity in a subsidiary not attributable, directly or indirectly, to a parent. These changes require, among other items, that (a) noncontrolling interests to be included in the consolidated statement of financial position within equity separate from the parent’s equity, (b) consolidated net income to be reported at amounts inclusive of both the parent’s and noncontrolling interest’s shares and, separately, the amounts of consolidated net income attributable to the parent and noncontrolling interest all on the consolidated statement of operations, and (c) if a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary should be measured at fair value and a gain or loss be recognized in net income based on such fair value. Other than the change in presentation of noncontrolling interests, the adoption of these changes had no impact on the consolidated financial statements. The presentation and disclosure requirements of these changes were applied retrospectively.

 

- 15 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 9 – Noncontrolling Interests (continued)

Components of noncontrolling interests are as follows:

 

		June 30,				December 31,
		2010				2009
		(unaudited)
Beginning of period		$	(1,058,456	)		$	193,399
Net loss attributable to noncontrolling interests			(554,919	)			(1,251,855	)
End of period		$	(1,613,375	)		$	(1,058,456	)

Note 10 - Contingencies

Litigation

 

On March 21, 2007 in the District Court of Douglas County, Nebraska, the Company was named in a personal injury lawsuit as wells as Midwest Renewable Energy, U.S. Water Services Utility Chemicals (the plaintiffs employer), and a company employee. The plaintiff claims that the defendants were negligent in not assuring that the manhole cover to the boiler being serviced by the plaintiff was depressurized so that the plaintiff could open the manhole cover in a safe manner.  The Company was performing services at Midwest Renewable Energy. The plaintiff is seeking reimbursement of $64,000 of medical bills, plus interest, plus punitive damages.  Due to the number of defendants and the difficulty of imputing liability by the plaintiff to the defendant, any losses incurred by the Company cannot be reasonably estimated.  Accordingly, the Company has not recorded an accrual for such potential loss but plans to vigorously defend its position. The jury trial, originally scheduled for March 2010, is now expected to take place in the third quarter of 2010 or later.

 

On November 12, 2008 in Circuit Court, Second Judicial Circuit, South Dakota, County of Minnehaha, the Company was named in a pending action, which is captioned Dakota Supply Group, Inc. (“DSG”) v. KL Process Design Group, LLC (“KL”), and Midwest Renewable Energy, LLC, (“MRE”).  The action was commenced in 2008 for the collection of a debt of approximately $524,000 plus interest for electrical supplies and materials furnished by DSG to MRE.  DSG alleges that KL and MRE are responsible for the debt because KL executed the purchase order without clarifying that the debt was the responsibility of MRE and that credit was extended directly to KL rather than MRE.  Depositions have taken place between all parties. At this time, the Company is unable to predict the outcome of the case, and accordingly has not recorded an accrual for such potential loss, but plans to vigorously defend its position.

 

- 16 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 10 - Contingencies (continued)

Litigation (continued)

On June 30, 2009, a lawsuit was brought against the Company, certain subsidiaries, and certain current and past officers in the District Court of Lincoln County, Nebraska.  The plaintiff is Midwest Renewable Energy, LLC, a Nebraska limited liability company ("MRE").  MRE previously engaged the Company to manage its existing ethanol facility, oversee its expansion construction and market the ethanol produced at its facilities.  The plaintiff alleged, among other things, that the named individuals and entities engaged in breaches of fiduciary duties owed to MRE, breaches of contract, fraud, interference with contract, conversion and negligence relating to the management and expansion of its corn-based ethanol facilities in Nebraska.  In August 2009, Company filed a motion to compel MRE to arbitrate its claims, and also separately filed three arbitration demands for claims relating to the three agreements between the Company and its affiliates and MRE that were at issue in the lawsuit.  In November 2009, the Court ruled for the Company and issued an order to compel arbitration. The Company has claimed $2.8 million in these proceedings, and MRE has counterclaimed $42.1 million, which counterclaim we believe has absolutely no merit and which we intend to defend vigorously. The arbitration proceedings for two of the three arbitrations have begun and are expected to conclude in the fourth quarter of 2010. No arbitrator has been selected for the arbitration of claims and counterclaims arising out of or relating to the third arbitration.  The schedule for this arbitration will be established when an arbitrator is selected and proceedings will commence thereafter. Any losses incurred by the Company cannot be reasonably estimated. Accordingly, the Company has not recorded an accrual for such potential loss but plans to vigorously defend its position. The Company and MRE are currently waiting for the third arbitration claim and demand to begin.

 

The Company may be subject to various claims and legal actions arising in the ordinary course of business from time to time. The Company maintains insurance to cover certain such actions.

Note 11 – Related Parties

Pursuant to its agreement with the Company, Pelly Management, Inc. (“Pelly”) received fees of $135,000 and $335,000 for the three and six months ended June 30, 2010, respectively and $0 and $400,000 for the three and six months ended June 30, 2009, respectively.  These amounts represent fees for financial advisor services.

In March 2010, the Company entered into a consulting agreement with add blue Consultoria Ltda., a Brazilian consulting company, for the provision of services by Peter Gross as CEO and President of the Company and its subsidiaries.  During the three and six months ended June 30, 2010, fees paid to add blue Consultoria Ltda.  were approximately $48,000 and $72,000, respectively.

In February 2009 and April 2009, the Company entered into a consulting contract with Thomas Schueller, for the position of Executive Chairman of the Board, and Thomas Bolan, for the position of Chief Financial Officer, respectively.  In July 2009, the Company also entered into a consulting services contract with Alan Rae, a Director.  During the three months ended June 30, 2010 and 2009, fees paid to Messrs. Schueller, Bolan and Rae were approximately $37,000 and $36,000, $ 35,000 and $38,000, and $42,000 and $0, respectively.  During the six months ended June 30, 2010 and 2009, fees paid to Messrs. Schueller, Bolan and Rae were approximately $73,000 and $56,000, $73,000 and $38,000, and $77,000 and $0, respectively.

As approved by the Board of Directors on March 2, 2010, a Director’s fee of $18,000 per annum will be awarded to all serving non-executive and non-consulting directors.  However, payment of such fees will be deferred until approved by the Board. As of the date of this report, Alain Vignon was the only Non-Executive, Non-Consulting director and $31,500 has been accrued for his services from his appointment in October 2008 through June 2010.

 

- 17 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 12 – Share Based Compensation

On March 2, 2010, the Company issued to a former executive an option to purchase 83,333 shares of the Company’s common stock at an exercise price of $1.10 which became fully vested on April 2, 2010 and is exercisable for three years.  The options were issued to Mr. Corcoran pursuant to Regulation D of the Securities Act of 1933, as amended.  The fair value of this option, based on volatility of 232%, and dividend and risk-free interest rates of 0% and 1.51%, respectively, was $87,500 and this amount is included in general and administrative expense in the consolidated statements of operations.

The Company adopted accounting guidance that sets accounting requirements for share-based compensation to employees and non-employee directors and consultants, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity based compensation expensed over the requisite service and vesting period. For the purpose of determining the fair value of stock option awards, the Company uses the Black-Scholes option-pricing model. The estimation of forfeitures is required when recognizing compensation expense which is then adjusted over the requisite service period should actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative adjustment to compensation in the period of change.   As of June 30, 2010, the Company has not experienced any forfeitures.

The prescribed accounting guidance also requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows. As of June 30, 2010, the Company does not have any tax expense (benefits) resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes.

 

- 18 -

---

 

KL Energy Corporation

Notes to Consolidated Financial Statements

(unaudited)

Note 13 – Subsequent Events

On July 2, 2010, a lawsuit was brought against the Company and certain current directors and a Company investor in the Seventh Judicial District Court of Pennington County, South Dakota.  The plaintiff is Randy Kramer, a former CEO of the Company. The plaintiff alleges, among other things, that the Company violated the Severance Agreement signed by the Company and the Kramer.  The plaintiff also alleges that the named individuals engaged in conspiracy to have him removed as CEO and oppressed him to sign the Severance Agreement.  The plaintiff has not requested specific damages but seeks awards for all compensatory, consequential, and pecuniary damages allegedly sustained by him for breach of contract, fraud, and deceit, breach of fiduciary duty, tortuous interference, and oppression plus interest and punitive damages.  At this time, any losses incurred by the Company cannot be reasonably estimated.  Accordingly, the Company has not recorded an accrual for such potential loss but plans to vigorously defend its position.

 

On July 1, 2010, the Company received the final installment of the January 2010 Securities Purchase Agreement with John Buckens.  In lieu of issuing stock pursuant to that Purchase Agreement, the Company agreed to issue a $1.5 million Convertible Promissory Note for such investment which resulted in net proceeds to the Company of $1.425. This Note is non-interest bearing and is payable in full on February 11, 2020.  Pursuant to that Note, if the Company raises at least $15.0 million in equity financing prior to February 11, 2020, the outstanding Note principal will automatically convert into the Company’s common stock at a conversion rate of $1.10 per share (or 1,363,636 shares).

 

On June 30, 2010, the Board of Directors approved the issuance of awards, effective July 1, 2010, of incentive stock options on 119,518 shares of common stock to employees and 44,794 shares of restricted common stock to consultants.  These awards were made pursuant to the Company’s 2009 Equity Incentive Plan and are one-third vested on July 1, 2010, July 1, 2011 and July 1, 2012.  The exercise price per share was set at $1.10 per share on the date of grant.  This grant date and exercise price represents the effective price at which all recent private placement sales have been transacted since October 2009.

 

- 19 -

---

 

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

Business

While we have historically provided engineering, construction, operating and ethanol marketing services, for first generation grain based ethanol (“1st Gen” or “GBE”) our focus is now on owning and operating cellulose based ethanol ("CBE") second generation (“2nd Gen”) integrated facilities that utilize our proprietary technology, and designing these facilities for, and licensing our proprietary process technology to, third-parties seeking to participate in the renewable energy and advanced biofuel markets.

 

Initially, we created expansion and optimization programs for 1st Gen facilities. The experience in the design and operation of these GBE’s has given our company a significant advantage in the development and future operations of 2nd Gen facilities. While we are able to offer design and engineering services to optimize existing GBE facilities, our emphasis in the future will be on integrated CBE facilities.

The majority of 1st Gen ethanol is currently produced from sugar cane or grain-based feedstocks, predominantly corn in the United States, however it can also be produced from cellulose. The growth of first generation ethanol is limited due to the widespread opposition to using land and crops that can be used for food or feed, for the production of fuels. This is especially relevant now that technology has provided a solution that uses widely available cellulose as a feedstock for ethanol production.  Cellulose is the primary component of plant cell walls and is one of the most abundant organic compounds available. Advanced biofuels produced from cellulosic materials draws on non-food related and waste feedstock sources and has been proven to substantially reduce carbon dioxide emissions and improve engine efficiency.

Our scientists and engineers continue to optimize our technology both independently and in cooperation with the South Dakota School of Mines and Technology in Rapid City, South Dakota. Based on laboratory data, we have shown our process is capable of producing up to 90 gallons of ethanol from every dry metric ton of certain biomass feedstock. Using pretreated sugarcane bagasse and eucalyptus, we currently are achieving up to 75 gallons per dry metric ton at our bench scale facility.

A key part of our business model is the design of scalable, custom-designed fully integrated CBE plants, preferably with integrated Combined Heat and Power (CHP) and Bio-Lignin production, tailored to a project’s geographic area and locally available feedstock. Through Western Biomass Energy, LLC (“WBE”), a majority-owned subsidiary of ours, we have designed, constructed and operated what we believe to be one of the first second generation CBE demonstration plants in the United States. This plant was constructed to both facilitate research and validate our technology at a demonstration scale. This allows us to continue to research, and refine our cellulose conversion technology, while also demonstrating the commercial viability for this type of technology.

Biomass, unlike corn, includes all plants and plant-derived materials and is more evenly distributed among regions of the world.  The quantity of biomass available for a CBE plant can come from many different sources, including fuel wood harvesting, wood processing residue, urban wood residue, fuel treatment operations, municipal solid waste, crop residue, and perennial crops. The extensive biomass distribution facilitates co-locating CBE plants closer to plant feedstock, reducing transportation costs relating to feedstock. Locating CBE facilities near blending facilities and retail fuel outlets will reduce transportation costs related to the sale of ethanol. This has the potential to create a truly local and commercially viable energy source.  We believe that our CBE facilities provide a commercially viable alternative that may contribute to solving local communities’ energy and economic needs.

 

There is no assurance that we will operate profitably or will generate positive cash flow in the future. The Company has incurred losses since its inception.  There is no assurance that we will operate profitably or will generate positive cash flow in the future. Such losses have resulted from engineering and management contracts and fuel sales, with favorable gross margins, which were more than offset by research, development and administrative expenses.  As the engineering and management contracts expired, and the wholesale fuel business was discontinued, losses continued while the business focused on cellulosic research and development.  If we cannot generate positive cash flows in the future, or raise sufficient financing to continue our normal operations, then we may be forced to scale down or even close our operations.

 

 

- 20 -

---

 

Future Synergistic Projects

Our design also offers us better access to synergistic opportunities, such as co-locating   CBE facilities with combined heat and power plants, pulp & paper industries and first generation ethanol production plants.

As a natural consequence of converting the fermentable portion of the biomass feedstock to ethanol, the solid co-product left behind is rich in lignin, a high energy solid fuel component which is sulfate-free and can be used as a compound material in the chemicals industry.  Using a conventional wood pellet mill, this co-product can be formed into pellets that are more dense and durable than the typical wood pellet marketed today.  Our process minimizes chemical biomass pretreatment because the bio-lignin co-product chemistry is unaltered. This results in a clean-burning, high-energy premium bio-lignin pellet product.

We have identified several potential projects and locations for plants using our technology and are currently conducting multiple pre-feasibility studies.

Production Processes

Several technologies have been developed to produce ethanol from biomass.  Generally speaking, efforts to convert cellulose into ethanol follow one of two main processes:

•

Thermochemical conversion of biomass into synthesis gas or “syngas” (a process often referred to as “gasification”), followed by catalytic conversion of the syngas into mixed alcohols that include ethanol and/or alkaline via modified chemistry; or

•

Biomechanical conversion, which is the enzymatic or chemical breakdown of biomass into component sugars, followed by biological fermentation of the sugars into ethanol.

We have selected the enzymatic breakdown of biomass for producing ethanol from cellulose alternative because we believe it has distinct advantages over the thermochemical/gasification methods. Gasification methods present a number of challenges, including the capital intensity of the process, selectivity of the syngas conversion to ethanol, and alcohol tolerance of the organisms capable of converting syngas to ethanol. Furthermore, unlike other cellulosic ethanol technology, we use insignificant amounts of acid (up to .3%) in our process, eliminating the environmental hazards that result with acid, and producing valuable by-products from the resulting lignin. Our process has significantly reduced process water discharge. Other technologies discharge waste water back into local streams or municipal waste water systems.

In terms of reduction of greenhouse gases, cellulosic ethanol represents a significant advance over grain-based ethanol.  According to a report by Argonne National Laboratory, grain ethanol reduces greenhouse gas by 18% to 29% per vehicle mile traveled as compared to gasoline, while cellulosic ethanol reduces greenhouse gas emissions by approximately 85% per vehicle mile traveled. Other advantages may include additional revenues through the sale of carbon credits, federal and state tax incentives and other measures that result from governmental support of cellulosic ethanol.

Business Strategies

During the current year, we plan to continue to optimize our technology and to design our first commercial (and possibly second) CBE facility. In addition, we intend to license our technology and contract our design engineering to third parties.  We will focus on developing cellulosic ethanol projects integrated into existing industries like CHP plants, together with partners that will help us accelerate the commercialization of our cellulosic technology and expand our global market presence.  These strategic partners and alliances provide an important advantage in realizing success in commercializing our process technologies.  Key elements of our business strategy are:

 

- 21 -

---

 

· Developing and supplying the technologies for commercial production of cellulosic ethanol from certain biomass feedstocks like sugarcane bagasse, eucalyptus and other hard woods, soft woods and agricultural waste.  The design and production strategy involves developing scalable facilities preferably with integrated Combined Heat and Power (CHP) and Bio-Lignin production, based on available feedstock supplies and providing a commercially viable alternative for local energy and economic needs.

· Owning and operating our own CBE facilities.  We intend to own, or co-own, and operate fully industrially integrated CBE and CBE/CHP facilities that utilize our proprietary technology.   We intend to co-locate our plants with other industrial operations such as pulp and paper industries, wood processors, first generation ethanol and sugar plants that provide synergistic opportunities.