APGI American Power Group Corporation (PK)

 Notes to Interim Consolidated Financial Statements

(Unaudited)

1. Nature of Operations, Risks, and Uncertainties

American Power Group Corporation (together with its subsidiaries “we”, “us” or “our”) was originally founded in 1992 and has operated as a Delaware corporation since 1995.

The information contained in this Form 10Q for the three and nine months ended June 30, 2017 including our interim financial statements and notes to the interim financial statements have not been reviewed by our independent accountants using professional review standards and procedures, although such review is required by this Form 10Q.

Recent Developments

On June 2, 2017, we initiated a corporate wide realignment and material reduction in workforce in response to continuing significant operating losses and low oil prices. In conjunction with the realignment, our Chief Executive Officer, Lyle Jensen was terminated and Charles Coppa, our Chief Financial Officer assumed the additional title of Chief Executive Officer. Mr. Jensen also resigned from our Board of Directors. The realignment is expected to result in a reduction in annual operating costs of over $2 million.

Despite the reduction in annual operating costs, the fundamental conditions facing our dual fuel business over the last several years have not changed. With oil prices remaining below $50 per barrel, the price differential between oil and natural gas remains extremely tight. The resulting delays in customer orders have negatively impacted our dual fuel operations and have made them no longer sustainable. Our efforts since June to secure licensing relationships, master distributorship relationships and/or joint marketing relationships with several of the largest domestic natural gas retail/wholesale gas suppliers have not generated material traction. Despite favorable economic conditions in the Mexican market, delays in securing material orders as well as our limited access to working capital have forced us to discontinue operating as we have been in that market.

Market conditions for our flare capture and recovery services in the Bakken region of North Dakota continue to be very soft, again due to low oil prices and reduction in the number of drill rigs operating in the region. We do not foresee any material positive changes in flare capture market conditions in the near term and therefore, we announced on August 15, 2017 that we have elected to discontinue our flare capture initiative. As a result, we recorded a non-cash impairment loss of approximately $2.8 million associated with the write down of our flare capture and recovery equipment and license agreement to their estimated fair market value during the three months ended June 30, 2017.

As a result of the foregoing and our limited access to additional near term capital, our Board of Directors is evaluating several alternatives, including the immediate closure of operations.

During the period of January to June 2017, we issued $3.0 million of 10% Contingent Convertible Promissory Notes to several existing shareholders, members of management and investors affiliated with members of our Board of Directors. The notes are automatically convertible, subject to shareholder approval of an increase in the number of authorized shares of our Common Stock from 350 million to a minimum of 600 million, into shares of a new proposed Series E 12.5% Convertible Preferred Stock at a conversion price of $100,000 per share. Each share of Series E Convertible Preferred Stock would be convertible into shares of our Common Stock at a conversion price of $0.10 per share. Upon the conversion of the notes into shares of Series E Preferred Stock, we will issue to each investor a ten-year warrant to purchase a number of shares of Common Stock equal to ten times the number of shares issuable upon conversion of the Series E Preferred Stock, exercisable at $0.10 per share.

Concurrent with the initial closing of the financing in January 2017, Neil Braverman became our new Chairman of the Board of Directors replacing Maurice Needham, who will remain as a Director. Matthew Van Steenwyk was appointed by the Board of Directors as Lead Strategic Director with more direct focus on helping to optimize the strategic marketing initiatives for the Company.

In connection with this financing, WPU Leasing, LLC agreed on January 27, 2017 to defer all current and future cash interest and principal payments due under approximately $1.8 million of notes until such time as our Board of Directors determines we are in a position to resume normal payments, but no later than such time as we are EBITDA positive at a Corporate level for two consecutive quarters. In addition, WPU amended its notes, effective as of December 1, 2016, to reduce the current normal interest rate from 22.2% to 15% and eliminate the penalty interest provision. On January 27, 2017, in consideration of WPU agreements and waivers, we issued WPU’s members ten year warrants to purchase an aggregate of 3,538,172 shares of our Common Stock at an exercise price of $.10 per share.

On May 24, 2017, our shareholders approved an amendment to our Restated Certificate of Incorporation to increase the number of authorized shares of Common Stock from 350,000,000 to 700,000,000 and an amendment to the 2016 Stock Option Plan to increase the number of shares of our Common Stock reserved for issuance from 21,000,000 to 50,000,000.

On May 26, 2017, the holders of our Contingent Convertible Promissory Notes agreed to defer the automatic conversion of the notes into the Series E Convertible Preferred Stock until such time as written notice is received from the holders of the notes requesting us to file said Certificate of Designation for the Series E Convertible Preferred Stock. In addition, on July 26, 2017, the holders also agreed to extend the maturity of the notes from July 27, 2017 until October 27, 2017.

As of August 21, 2017, we have an industry-leading 503 overall approvals from the Environmental Protection Agency (“EPA”) including 47 approvals for engine families with SCR (selective catalytic reduction) technology. We believe that of the approximately 2 million Class 8 trucks operating in North America, an estimated 600,000 to 700,000 Class 8 trucks fall into the Inside Useful Life designation. We have also received State of California Air Resources Board (“CARB”) Executive Order Certifications for Volvo/Mack D-13/MP8 (2010-2013), Cummins ISX (2010-2012) and Detroit Diesel DD15 (2010-2012) engine models for the heavy-duty diesel engine families ranging from 375HP to 600HP.

Nature of Operations, Risks, and Uncertainties

Dual Fuel Technology Subsidiary - American Power Group, Inc.

Our patented dual fuel conversion system is a unique external fuel delivery enhancement system that converts existing diesel engines into more efficient and environmentally friendly engines that have the flexibility, depending on the circumstances, to run on:

Our proprietary technology seamlessly displaces up to 75% (average displacement ranges from 40% to 65%) of the normal diesel fuel consumption with various forms of natural gas. Installation requires no engine modification, unlike the more expensive fuel injected alternative fuel systems in the market.

By displacing highly polluting and expensive diesel fuel with inexpensive, abundant and cleaner burning natural gas, a user can:

Primary end market applications include both primary and back-up diesel generators as well as heavy-duty vehicular diesel engines.

Wellhead Gas Flare Capture and Recovery Services Division - NGL Services, a division of American Power Group, Inc.

When oil is extracted from shale, a mixture of hydrocarbon gases (methane, ethane, propane, butane, pentane and other heavy gases) reach the surface at each well site. These gases are either gathered in low-pressure pipelines for downstream natural gas liquids (“NGL”) and methane extraction by large mid-stream processing companies or flared into the atmosphere when the gas-gathering infrastructure is too far away (remote well sites) or the pipeline is insufficient to accommodate the volumes of associated gas (stranded well sites). Many areas in North America are facing significant state imposed penalties and restrictions associated with the elimination of flared well head gas by oil and gas production companies.

In August 2015, we entered the flare gas capture and recovery business through a relationship with Trident Resources. NGL’s can be sold to a variety of end markets for heating, emulsifiers, or as a combined NGL liquid called Y Grade that can be sold to midstream companies who separate the liquids into their final commodities.

Market conditions for our flare capture and recovery services in the Bakken region of North Dakota where our equipment is located continues to be very soft, again due to low oil prices and reduction in the number of drill rigs operating in the region. We do not foresee any material positive changes in flare capture market conditions in the near term and have therefore elected to discontinue our flare capture initiative.

During the nine months ended June 30, 2017 and 2016, revenues from our NGL Division were $0 and $29,983, respectively. We announced on August 15, 2017 that we have elected to discontinue our flare capture initiative.

Liquidity and Management’s Plans

As of June 30, 2017, we had $212,166 cash and cash equivalents and a working capital deficit of $5,053,549, which includes $3,000,000 of Subordinated Contingent Convertible Promissory Notes due on October 27, 2017, and $500,000 under our working capital line of credit with Iowa State Bank, which expires on September 14, 2017. As of August 21, 2017, we had we had approximately $60,000 of cash and cash equivalents and approximately $150,000 of accounts receivable.

The fundamental conditions facing our dual fuel business over the last several years have not changed. With oil prices remaining below $50 per barrel, the price differential between oil and natural gas remains extremely tight. The resulting delays in customer orders have negatively impacted our dual fuel operations and have made them no longer sustainable. Our efforts since June to secure licensing relationships, master distributorship relationships and/or joint marketing relationships with several of the largest domestic natural gas retail/wholesale gas suppliers have not generated material traction.

As a result of the June 2017 corporate realignment, we have reduced our employee head count from 20 to 8 employees and terminated a majority of our third party consulting agreements which is expected to result in an estimated annual savings of over $2 million per year. Our primary focus going forward has been on our North American stationary dual fuel business as well as vehicular dual fuel business in Latin America where the economics are very favorable for using dual fuel. Thus far, neither has yet to generate any measureable revenue since June.

We are currently managing our business on a week to week basis based on limited access to financial resources and are pursuing several financing options to fund and continue our dual fuel operations. No assurances can be given, however that additional capital will be available on terms acceptable to the Company or at all which raises substantial doubt about our ability to continue as a going concern. As a result of the foregoing and our limited access to additional near term capital, our Board of Directors is evaluating several alternatives, including the possible sale of the company or the immediate closure of operations.

The accompanying financial statements have been prepared on a basis that assumes we will continue as a going concern and that contemplates the continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business.

2. Basis of Presentation

The consolidated financial statements include the accounts of American Power Group Corporation and our wholly-owned subsidiary, American Power Group, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying interim financial statements at June 30, 2017 are unaudited and should be read in conjunction with the financial statements and notes thereto for the fiscal year ended September 30, 2016 included in our Annual Report on Form 10-K. The information contained in this Form 10Q for the three and nine months ended June 30, 2017 including our interim financial statements and notes to the interim financial statements have not been reviewed by our independent accountants using professional review standards and procedures, although such review is required by this form 10Q.

The balance sheet at September 30, 2016 has been derived from the audited financial statements as of that date; certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the Securities and Exchange Commission rules and regulations, although we believe the disclosures which have been made herein are adequate to ensure that the information presented is not misleading. The results of operations for the interim periods reported are not necessarily indicative of those that may be reported for a full year. In our opinion, all adjustments which are necessary for a fair statement of our financial position as of June 30, 2017 and the operating results for the interim periods ended June 30, 2017 and 2016 have been included.

3. Recently Issued Accounting Pronouncements

Revenue from Contracts with Customers . In May 2014, the Financial Accounting Standards Board (FASB) issued new revenue recognition guidance for recognizing revenue from contracts with customers that provides a five-step analysis of transactions to determine when and how revenue is recognized. The guidance states that a company should recognize revenue which depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to receive in exchange for those goods or services. The new standard will also result in enhanced disclosures about revenue related to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The standard also requires quantitative and qualitative disclosures about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. Additionally, the FASB has provided guidance for transactions that were not previously addressed comprehensively, and improved guidance for multiple-element arrangements. The original pronouncement was effective for the Company beginning in fiscal 2018 (October 1, 2017), and early adoption was not permitted. On July 9, 2015, FASB approved a one-year deferral of the effective date for the revenue recognition standard. As a result of the one-year deferral, the revenue recognition standard is effective for us beginning in fiscal 2019 (October 1, 2018), however, we may adopt this guidance as of the original effective date. This guidance can be adopted by us either retrospectively (October 1, 2016) or as a cumulative-effect adjustment as of the date of adoption. We are currently evaluating the impact that the adoption of this new accounting guidance will have on our results of operations, cash flows and financial position.

Going Concern . In August 2014, FASB issued Accounting Standard Update No. 2014-15, “ Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern ” (“ASU No. 2014-15”), which amends FASB Accounting Standards Codification 205 “Presentation of Financial Statements.” This update requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. ASU No. 2014-15 is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter.

Debt Issuance Costs. In April 2015, FASB issued a standard that simplifies the presentation of debt issuance costs with the requirement that debt issuance costs related to a debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The standard is effective for fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016. We have implemented this standard early with the filing of our Form 10-K for the fiscal year ended September 30, 2016. The adoption did not have a material impact on our financial position, results of operation or cash flows.

Inventory Measurement. In July 2015, FASB issued a new topic on simplifying the measurement of inventory. The current standard is to measure inventory at lower of cost or market; where market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. This topic updates this guidance to measure inventory at the lower of cost and net realizable value; where net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This update is effective for annual reporting periods beginning after December 15, 2016, which would be our fiscal year ending September 30, 2018. The amendments should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The adoption of this guidance is not expected to have a material impact on our consolidated financial position or results of operations.

Leases. In February 2016, FASB issued ASU No. 2016-02, Leases (Topic 842) , which requires, among other things, a lessee to recognize a liability representing future lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. For operating leases, a lessee will be required to recognize at inception a right-of-use asset and a lease liability equal to the net present value of the lease payments, with lease expense recognized over the lease term on a straight-line basis. For leases with a term of twelve months or less, ASU 2016-02 allows a reporting entity to make an accounting policy election to not recognize a right-of-use asset and a lease liability, and to recognize lease expense on a straight-line basis. ASU No. 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted. Upon adoption, a reporting entity should apply the provisions of ASU 2016-02 at the beginning of the earliest period presented using a modified retrospective approach, which includes certain optional practical expedients that an entity may elect to apply. We are currently evaluating the impact that the adoption of this new accounting guidance will have on our results of operations, cash flows and financial position.

Revenue Standard’s Principal-Versus-Agent Guidance. In March 2016, FASB issued ASU No. 2016-08, Revenue Recognition: Clarifying the new Revenue Standard’s Principal-Versus-Agent Guidance (“ASU 2016-18”). The standard amends the principal-versus-agent implementation guidance and illustrations in the FASB’s new revenue standard (ASU 2014-09). ASU 2016-08 clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. As defined in the ASU, a specified good or service is “a distinct good or service (or a distinct bundle of goods or services) to be provided to the customer”. Therefore, for contracts involving more than one specified good or service, the Company may be the principal in one or more specified goods or services and the agent for others. The new standard has the same effective date as ASU 2014-09, as amended by the one-year deferral and early adoption provisions in ASU 2015-14. In addition, entities are required to adopt ASU 2016-08 by using the same transition method they used to adopt the new revenue standard. We are currently evaluating the impact that the adoption of this new accounting guidance will have on our results of operations, cash flows and financial position.

Share-Based Compensation . In April 2016, the FASB issued ASU No. 2016-09, “ Compensation-Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting ” (“ASU 2-16-09”). Under ASU 2016-09, companies will no longer record excess tax benefits and certain tax deficiencies in additional paid-in capital (“APIC”). Instead, they will record all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement and the APIC pools will be eliminated. In addition, ASU 2016-09 eliminates the requirement that excess tax benefits be realized before companies can recognize them. ASU 2016-09 also requires companies to present excess tax benefits as an operating activity on the statement of cash flows rather than as a financing activity. Furthermore, ASU 2016-09 will increase the amount an employer can withhold to cover income taxes on awards and still qualify for the exception to liability classification for shares used to satisfy the employer’s statutory income tax withholding obligation. An employer with a statutory income tax withholding obligation will now be allowed to withhold shares with a fair value up to the amount of taxes owed using the maximum statutory tax rate in the employee’s applicable jurisdiction(s). ASU 2016-09 requires a company to classify the cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation as a financing activity on the statement of cash flows. Under current GAAP, it was not specified how these cash flows should be classified. In addition, companies will now have to elect whether to account for forfeitures on share-based payments by (1) recognizing forfeitures of awards as they occur or (2) estimating the number of awards expected to be forfeited and adjusting the estimate when it is likely to change, as is currently required. The Amendments of this ASU are effective for reporting periods beginning after December 15, 2016, with early adoption permitted but all of the guidance must be adopted in the same period. We are currently evaluating the impact that the adoption of this new accounting guidance will have on our results of operations, cash flows and financial position.

4. Receivables

Accounts Receivable

Accounts receivable are carried at original invoice amount less an estimate made for doubtful accounts. Management determines the allowance for doubtful accounts by regularly evaluating past due individual customer receivables and considering a customer’s financial condition, credit history, and the current economic conditions. Individual accounts receivable are written off when deemed uncollectible, with any future recoveries recorded as income when received.

Note Receivable, Related Party

On June 30, 2015, we entered into a Loan and Security Agreement with Trident Resources, LLC, pursuant to which we loaned Trident $737,190 under the terms of a 6% senior secured demand promissory note due September 30, 2015. The note is secured by a first priority security interest in all of Trident’s assets and has been guaranteed on a secured basis by Trident’s sole owner. Trident has repaid $240,000 of the outstanding principal balance with $497,190 remains past due as of June 30, 2017.

We have commenced legal action against Trident and its owner who has personally guaranteed Trident’s obligations under the note to pursue collection of the outstanding balance of approximately $677,000 (including approximately $177,000 of interest). We have the right to offset any amounts due under Trident’s note receivable to us against our $1.716 million equipment note payable to Trident and therefore believe no reserve for uncollectibility is necessary as of June 30, 2017.

Seller’s Note Receivable, Related Party

In conjunction with the July 2009 acquisition of substantially all the American Power Group operating assets, we acquired a promissory note from the previous owners of American Power Group (renamed M&R Development, Inc.), payable to us, in the principal amount of $797,387. The note, which was subsequently amended, bears interest at the rate of 5.5% per annum and was based on the difference between the assets acquired and the consideration given.

M&R is not required to make any payments under the note until such time as we begin to make royalty payments under our technology license (see Note 6) and at that time, the aggregate principal amount due under the note is to be paid in eight equal quarterly payments plus interest. Those payments will be limited to a maximum of 50% of any royalty payment due M&R on a quarterly basis. No payments have been made under the note as of June 30, 2017. We have classified 100% of the balance as long term. We consider this a related party note as one of the former owners of American Power Group is now an employee of ours.

5. Inventory

Raw material inventory primarily consists of dual fuel conversion components. Work in progress includes materials, labor and direct overhead associated with incomplete dual fuel conversion projects. As of June 30, 2017 and September 30, 2016, we recorded an inventory valuation allowance of $369,397 and $279,580.

All inventory is valued at the lower of cost or market on the first-in first-out (FIFO) method. Inventory consists of the following:

6. Intangible Assets

We review intangibles for impairment annually, or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of our intangible assets below their carrying value.

In conjunction with the exclusive license agreement from Trident, we recognized $300,000 associated with the execution of the agreement. The value was being amortized on a straight line basis over an estimated useful life of 120 months. Amortization expense associated with the long term technology license agreement is $7,500 and $22,500 for the three and nine months ended June 30, 2017 and 2016, respectively. Based on a continuing lack of demand for our flare capture and recovery services in the Bakken region of North Dakota where our equipment is located and the fact we do not foresee any material positive changes in flare capture market conditions in the near term, we have elected to discontinue our flare capture initiative. As a result, we have written off the remaining unamortized balance of the license agreement and recorded a non-cash impairment loss of $242,500 during the three months ended June 30, 2017.

In conjunction with the American Power Group acquisition and license agreement, we recorded intangible assets of $500,000 associated with the execution of a long term technology license agreement and $500,000 associated with the purchase of the dual fuel conversion technology. Both values are being amortized on a straight line basis over an estimated useful life of 120 months. Amortization expenses associated with the long term technology license agreement and the purchased dual fuel conversion technology were $25,000 and $75,000 for the three and six months ended June 30, 2017 and 2016, respectively. Accumulated amortization was $791,667 and $716,667 at June 30, 2017 and September 30, 2016, respectively.

In conjunction with the 10% Convertible Preferred Stock financing in April 2012, we amended the M&R technology license agreement to modify the calculation and the timing of the royalty payments. Under this amendment, effective April 27, 2012, the monthly royalty due is the lesser of 10% of net sales or 30% of pre-royalty EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). No royalties will be earned or due until such time as our cumulative EBITDA commencing April 1, 2012 is positive on a cumulative basis. During the three and nine months ended June 30, 2017 and 2016, we incurred $0 royalties to M&R.

A critical component of our dual fuel aftermarket conversion solution is the internally developed software component of our electronic control unit. The software allows us to seamlessly and constantly monitor and control the various gaseous fuels to maximize performance and emission reduction while remaining within all original OEM diesel engine performance parameters. We have developed a base software application and EPA testing protocol for both our Outside Useful Life (“OUL”) and Intermediate Useful Life (“IUL”) engine applications, which will be customized for each engine family approved in order to maximize the performance of the respective engine family.

As of June 30, 2017, we have capitalized $4,577,223 of development costs associated with our OUL ($1,801,506) and IUL ($2,775,717) applications, which will be amortized on a straight line basis over an estimated useful life of 60 months for OUL applications and 84 months for IUL applications. Amortization costs for the three months ended June 30, 2017 and 2016 were $182,793 and $183,427, respectively. Amortization costs for the nine months ended June 30, 2017 and 2016 were $549,699 and $544,727, respectively. Accumulated amortization was $2,655,819 at June 30, 2017 and $2,106,120 September 30, 2016, respectively.

Amortization expense associated with intangibles during the next five years is anticipated to be:

7. Property, Plant and Equipment

Property, plant and equipment consist of the following:

Construction in progress relates to the flare capture and recovery processing units used in our flare capture and recovery business. Based on the decision to discontinue our flare capture initiative, we wrote down the value of our flare capture and recovery equipment to its estimated fair market value and as a result have recorded an impairment loss of $2,576,821. Our estimation of the fair market value of the equipment was based on market data research as well as discussions with the manufacturer of some of the equipment and with several parties interested in purchasing the equipment. Accordingly, we have reclassified assets with a net book value of approximately $832,000 as available for sale and are actively seeking buyers.

8. Product Warranty Costs

We provide for the estimated cost of product warranties for our dual fuel products at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs, and the cost per repair. We assess the adequacy of the warranty provision and we may adjust this provision if necessary. During the six months ending June 30, 2017, costs charged and product warranty claims have remained consistent with prior year costs and claims. Warranty accrual is included in accrued expenses.

The following table provides the detail of the change in our product warranty accrual relating to dual fuel products as of:

9. Notes Payable/Credit Facilities

The following summarizes our notes payable as of June 30, 2017 and September 30, 2016.

Refinancing of Credit Facility

On September 14, 2016, we entered into a new $3 million term loan agreement and new $500,000 working capital line of credit with Iowa State Bank in which we refinanced approximately $2,835,000 due to the bank under existing loan agreements.

Under the terms of the new term loan we will make (i) 36 consecutive monthly payments of $30,659, beginning on December 14, 2016, which includes interest at the rate of 4.0% per annum, followed by (ii) 84 consecutive monthly payments of $30,659, beginning on December 14, 2019, adjusted to reflect an interest rate equal to the Wall Street Journal U.S. Prime Rate plus 0.5%. The final payment of all principal and accrued interest on the term loan is due on November 14, 2026.

In addition, Iowa State Bank has provided a new $500,000 working capital line of credit which has an initial expiration of September 14, 2017 and bearing interest at a rate equal to the Wall Street Journal U.S. Prime Rate plus 0.5% (4.5% as of June 30, 2017). The maximum amount we may borrow from time to time under the line of credit remains equal to lesser of (i) the sum of 70% of our eligible accounts receivable, other than accounts receivable outstanding for more than 90 days, and 50% of the value of our inventory, or (ii) $500,000. As of June 30, 2017, the balance on the line of credit was $500,000 and we had no additional availability under the line. We are currently in discussions with Iowa State Bank regarding the renewal of our working capital line of credit which expires on September 14, 2017. We cannot, however, be assured of the success of these efforts.

Our obligations under this credit facility are secured by the grant of a first priority security interest in all of our assets, and the limited personal guarantees of two of our Directors. Amounts borrowed under the credit facility are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the facility; (ii) any failure to keep the collateral insured; (iii) any attempt by any other creditor of ours to collect any indebtedness through court proceedings; (iv) any assignment for the benefit of creditors by us, or our insolvency; (v) the institution of certain bankruptcy proceedings by or against us; (vi) any breach by us of any covenant in the documents related to the credit facility; and (vii) any other occurrence that either significantly impairs the value of the collateral or causes Iowa State Bank to reasonably believe that they will have difficultly collecting the amounts borrowed under the credit facility.

As a result of refinancing the credit facility, we recorded a $497,492 loss on modification of debt during the fiscal year ended September 30, 2016. This amount includes $718,161 recorded as a discount to the principal amount of the Credit Facility, which is being accreted to interest expense over the term of the facility using the effective interest method, $22,055 of original debt issuance costs expensed at the time of the refinancing, and $1,143,598 in warrants issued to the Guarantors as consideration for their guarantee. The warrants were valued using the Black-Scholes pricing model with the following assumptions; dividend yield 0%; risk-free interest rate of 1.2%; volatility of approximately 73%, and expected term of 5 years. See Note 13, “Fair Value Measurements,” for further discussion regarding the recorded value of the credit facility.

Agreements with the Guarantors

As described above, two of our Directors have each agreed, severally and not jointly, to guaranty the payment of up to $1,750,000 of our obligations under the credit facility, including the payment of principal, interest and all costs of collection.

We entered into a Credit Support Agreement with these Directors pursuant to which, in consideration of the guarantees, we issued each of these Directors a ten year warrant to purchase up to 6,950,000 shares of our Common Stock, at an initial exercise price of $.20 per share. Each warrant may be exercised at any time during the term for up to 5,560,000 shares with the remaining 1,390,000 additional shares becoming exercisable based on any the following conditions: (i) if Iowa State Bank initiates any action to enforce the Director’s guaranty, (ii) if the Directors, elect to repay, on our behalf, all of the obligations due under the credit facility before September 13, 2019 or (iii) in the absence of either of the foregoing events if their guarantees have not been released by Iowa State Bank prior to September 13, 2019.

The guarantors have agreed that if they payoff Iowa State Bank prior to September 13, 2019, they will succeed to all of the rights and interests of Iowa State Bank as the lender and secured party under all agreements, promissory notes and other instruments which comprise the credit facility. Unless otherwise agreed by us, no other term or condition of the credit facility will be deemed to amended or restated. If the guarantor’s payoff Iowa State Bank after September 13, 2019, they have the right to receive shares of our Common Stock (valued at the 20 day volume weighted average price prior to payment) equal to the amount paid plus a warrant to purchase a number of shares (at the same 20 day volume weighted average price) equal to the shares of Common Stock issued in payment of the bank obligations.

10. Notes Payable, Related Parties

The following summarizes our related party notes payable as of June 30, 2017 and September 30, 2016.

Notes Payable-Related Party-Trident Resources, LLC

On August 12, 2015, we purchased two processing systems from Trident Resources, LLC for $1,716,500. We issued Trident a promissory note for $832,000, which was payable in 12 equal monthly installments of principal and interest at 6.75% commencing September 20, 2015 and a second secured promissory note for $884,500, which was payable in 36 equal monthly installments of principal and interest at 6% commencing September 20, 2016. These notes are secured by liens on the purchased equipment. As of December 1, 2015, we amended and restated these two secured promissory notes and combined the obligations of the original notes into a new note for $1,716,500 which bears interest at 6% per year with 48 monthly payments of principal and interest estimated to initially begin on August 31, 2016 assuming the Trident NGL Services division meets specified production goals in the preceding month. If these production goals are not met, the new note provides that we may defer payments otherwise due in any month following a month in which the production goals are not met to the maturity date, without incurring any additional interest. The amended and restated note also permits us, at our discretion, to offset against amounts otherwise due under such note in the event of any default by Trident under its promissory note to the Company. As of June 30, 2017, no principal or interest payments have been made on this note and we have accrued interest of $198,446 associated with this note, which is included in accrued expenses.

Financing Agreement –WPU Leasing, LLC

In January 2016, WPU Leasing agreed to defer cash payments on approximately 70% of the $1.9 million of debt outstanding. The deferral of payments reduced our cash outflow commitments by approximately $500,000 during fiscal 2016 and as noted below, WPU has agreed to defer subsequent payments due after fiscal 2016. WPU Leasing had the option, starting June 30, 2016, of taking deferred and current payments in shares of our Common Stock (based on the 20 day volume weighted average price prior to conversion) which would positively impact our cash flow position going forward. At June 30, 2016, a member of WPU Leasing, LLC which is affiliated with one of our Directors agreed to accept 1,209,857 shares of Common Stock (valued at $.14 per share) in lieu of cash for deferred principal and interest payments due as of June 30, 2016 of $169,379. No other payments have been made since June 30, 2016. As of June 30, 2017 and September 30, 2016, we have accrued interest associated with this note of $464,143 and $238,953, respectively. These amounts are included in accrued expenses.

In consideration of WPU Leasing’s commitment under our financing agreement, we issued to WPU Leasing’s members warrants to purchase up to the lesser of (i) an aggregate of 3,250,000 shares of our Common Stock or (ii) one share of Common Stock for each dollar borrowed by us under the agreement. During the fiscal year ended September 30, 2016, we terminated warrants to purchase 1,325,000 shares of Common Stock due to the fact WPU Leasing had not provided the remaining $1.325 million of its commitment. The warrants are exercisable at a price of $.20 per share for a period of four years from the date of issue and may be exercised on a cashless basis. We determined the value of these warrants using the Black-Scholes option pricing model and recorded deferred financing costs of $86,923, which are being amortized over the term of the finance agreement.

In connection with the January 2017 private placement, WPU Leasing agreed to defer all current and future cash interest and principal payments due under approximately $1.8 million of notes until such time as our Board of Directors determines we are in a position to resume normal payments but no later than such time as we are EBITDA positive at a Corporate level for two consecutive quarters. In addition, WPU amended its notes, effective as of December 1, 2016, to reduce the current normal interest rate from 22.2% to 15% and eliminate the penalty interest provision. On January 27, 2017, in consideration of WPU Leasing’s agreements and waivers, we issued WPU’s members ten year warrants to purchase an aggregate of 3,538,172 shares of our Common Stock at an exercise price of $.10 per share. Using the Black-Scholes model, we determined the fair value of the warrants to be $371,961. We evaluated the debt amendment according to ASC 470 guidance, and determined the difference between the original and new debt instruments to not be substantially different under the 10% test; therefore, the fair value of the warrants was recorded as a reduction against the WPU notes and an increase in Additional Paid in Capital.

As a result of the warrant issuance, we recorded a $400,024 debt discount during the quarter ended March 31, 2017. This discount is being accreted to interest expense over the term of the facility using the effective interest method, and includes $28,063 of the remaining debt issuance costs expensed at the time of the refinancing, and $371,961 in warrants issued in consideration of the interest rate reduction. The warrants were valued using the Black-Scholes pricing model with the following assumptions; dividend yield 0%; risk-free interest rate of 2.49%; volatility of approximately 73%, and expected term of 10 years. See Note 13, “Fair Value Measurements,” for further discussion regarding the recorded value of the Note Payable to WPU Leasing.

10% Subordinated Contingent Convertible Promissory Notes

During the nine months ended June 30, 2017, we issued $3.0 million of 10% Subordinated Contingent Convertible Promissory Notes to several existing shareholders, members of management and investors affiliated with members of our Board of Directors. Under their original terms, these notes are automatically convertible into shares of a new proposed Series E 12.5% Convertible Preferred Stock at a conversion price of $100,000 per share, subject to shareholder approval of an increase in the number of authorized shares of our Common Stock from 350 million to a minimum of 600 million and the filing of a Certificate of Designation for the Series E Convertible Preferred Stock,. Each share of Series E Convertible Preferred Stock would be convertible into shares of our Common Stock at a conversion price of $0.10 per share. Upon the conversion of the notes into shares of Series E Preferred Stock, we will issue to each investor a ten-year warrant to purchase a number of shares of Common Stock equal to ten times the number of shares issuable upon conversion of the Series E Preferred Stock, exercisable at $0.10 per share.

On May 26, 2017, the holders agreed to defer the automatic conversion of the notes into the Series E Convertible Preferred Stock until such time as written notice is received from the holders requesting us to file the Certificate of Designation for the Series E Convertible Preferred Stock. In addition, on July 26, 2017, the holders also agreed to extend the maturity of the notes from July 27, 2017 until October 27, 2017.

Officer’s Promissory Note

In 2010, an officer loaned us $50,000 under an unsecured promissory note, the maturity of which has been extended several times. In September 2016, the officer agreed to extend the maturity of the outstanding $50,000 balance to September 30, 2017 and agreed to convert the outstanding balance into the 10% Subordinated Contingent Convertible Promissory Notes . This amount is included in the $3.0 million of 10% Subordinated Contingent Convertible Promissory Notes described above.

11. Commitments and Contingencies

Lease Settlement Obligations:

We are currently renting property located in Georgia relating to a former discontinued business. We have the right to terminate the Georgia lease with 6 months’ notice but are obligated to continue to pay rent until the earlier of (1) the sale by the landlord of the premises; (2) the date on which a new long term tenant takes over; or (3) 3 years from the date on which we vacate the property. As a result, we have recorded a lease settlement obligation. We currently sublease two portions of the property to an entity which is paying $8,000 per month on a tenant-at-will basis.

In March 2016, we notified the landlord of our intent to terminate the lease and are working with the landlord and our tenant towards a goal of our tenant leasing the entire facility from the landlord. In addition, we amended the existing lease with the landlord to reduce the monthly rental amount by $2,500 per month to $15,152 starting April 1, 2016. In October 2016, the landlord agreed to reduce the monthly cash payment to $10,500 with the difference accruing and payable in the future. During the three and nine months ended June 30, 2017, we had rental income of $24,000 and $72,000 respectively, associated with the Georgia property and rental expense of $6,896 and $26,032 respectively. During the three and nine months ended June 30, 2016, we had rental income of $24,000 and $72,000 respectively, associated with the Georgia property and rental expense of $12,663 and $138,530, respectively.

The total future minimum rental obligations at June 30, 2017, under the above real estate operating lease is as follows:

12. Warrants to Purchase Common Stock

In conjunction with the private placement of our 10% Convertible Preferred stock in April 2012 and November 2014, we issued warrants which contained a “down-round” provision that provides for a reduction in the warrant exercise price if there are subsequent issuances of additional shares of common stock for consideration per share less than the per share warrant exercise prices. In October 2012, FASB issued ASU No. 2012-04, Technical Corrections and Improvement (“ASU 2012-04”), which contained technical corrections to guidance on which we had previously relied upon in forming our initial conclusions regarding the accounting for warrants containing these reset provisions. Pursuant to this guidance and effective commencing October 1, 2013, we have recognized the fair value of these warrants as a liability and have re-measured the fair value of these warrants on a quarterly basis with any increase or decrease in the estimated fair value being recorded in other income or expense for the respective quarterly reporting period.

We have historically used the Black-Scholes option pricing model to determine the fair value of options and warrants. We have considered the facts and circumstances in choosing the Black-Scholes model to calculate the fair value of the warrants with a down-round price protection feature as well as the likelihood of triggering the down-round price protection feature, which, as described below, we have concluded is remote.

In determining the initial fair value of the warrants associated with the April 2012 Convertible Preferred Stock private placement as of October 1, 2013, we prepared a valuation simulation using the Black-Scholes option pricing model as well as additional models using a modified Black-Scholes option pricing model and a Binomial Tree option pricing model. We determined the initial fair value of the warrants associated with the November 2014 Convertible Preferred Stock private placement to be $694,631 based on a valuation simulation using the Black-Scholes option pricing model. Both additional simulations included various reset scenarios, different exercise prices, and other assumptions, such as price volatility and interest rates, that were kept consistent with our original Black-Scholes model. The resulting warrant values as determined under the modified Black-Scholes model and the Binomial Tree option model were not materially different from the values generated using the Black-Scholes model. We have therefore determined to use the Black-Scholes model as we believe it provides a reasonable basis for valuation and takes into consideration the relevant factors of the warrants, including the down round provision.

During the three and nine months ended June 30, 2017 and 2016, we recorded warrant valuation income of $5,156 and $36,952, and $5,890 and $207,211, respectively, associated with the change in the estimated fair value of all warrants containing the down round provision outstanding. Our warrant liability was $333 and $37,285 as of June 30, 2017 and September 30, 2016, respectively. The warrant liabilities were valued at June 30, 2017, using the Black-Scholes option-pricing model with the following assumptions.

Private Placement 1 – April 30, 2012, sale of 821.6 units of 10% Convertible Preferred Stock

Private Placement 2 – March 31, 2013, additional investment right from Private Placement 1, sale of approximately 274 units of 10% Convertible Preferred Stock.

As of June 30, 2017, approximately 3.6 million of warrants with down-round provision remained outstanding.

13. Fair Value Measurements

The carrying amount of our receivables and payables approximate their fair value due to their short maturities.

Accounting principles provide guidance for using fair value to measure assets and liabilities. The guidance includes a three level hierarchy of valuation techniques used to measure fair value, defined as follows:

We consider an active market as one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Conversely, we view an inactive market as one in which there are few transactions of the asset or liability, the prices are not current, or price quotations vary substantially either over time or amount market makers. When appropriate, non-performance risk, or that of counterparty, is considered in determining the fair values of liabilities and assets, respectively.

We have classified certain warrants related to the 10% Convertible Preferred Stock private placements noted in Note 10 as a Level 3 Liability. Assumptions used in the calculation require significant judgment. The unobservable inputs in our valuation model include the probability of additional equity financing and whether the additional equity financing would trigger a reset on the down-round protection.

The following table summarizes the financial liabilities measured a fair value on a recurring basis as of June 30, 2017 and September 30, 2016.

Level 3 Valuation

The following table provides a summary of the changes in fair value of our financial liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three month period ended June 30, 2017.

Balances Measured at Fair Value on a Nonrecurring Basis:

Effective September 14, 2016, we refinanced our debt agreement with Iowa State Bank to extend the term of the agreement and reduce the interest rate from 8.0% to 4.0%. As a result of this refinancing, it was determined that the original and new debt instruments were substantially different, and therefore, the new debt instrument was recorded at its fair value of $2,281,839 using Level 3 inputs. The fair value was determined using a discount rate of 10% and term of 120 months. See Note 9, Notes Payable, for further discussion regarding the modification of the terms of the credit facility. Our estimation of the fair market value of the equipment held for sale of approximately $832,000 was based on market data research as well as discussions with the manufacturer of some of the equipment and with several parties interested in purchasing the equipment. See Note 7, Property, Plant and Equipment.

14. Stockholders’ Equity

Authorized Shares

On May 24, 2017, our shareholder’s approved an amendment to the Restated Certificate of Incorporation to increase the number of authorized shares of Common Stock from 350,000,000 to 700,000,000.

Common Shares

During the three months ended June 30, 2017, holders of our 10% Convertible Preferred Stock converted approximately 11 shares into 291,028 shares of our Common Stock.

During the nine months ended June 30, 2017, two members of our Board of Directors agreed to accept 650,000 shares of our Common Stock valued at $65,000 in lieu of Board fees due them.

10% Convertible Preferred Stock Dividends

Our Board of Directors has determined that our cash resources are not currently sufficient to permit the payment of cash dividends with respect of our Convertible Preferred Stock and suspended the payment of cash dividends, commencing with the dividend payable on September 30, 2015. Since September 30, 2015, we have issued shares of our Common Stock valued at approximately $2.3 million in lieu of cash dividends.

During the nine months ended June 30, 2017, we recorded a dividend on our 10% Convertible Preferred Stock of $1,025,690, of which $848,266 remains in accrued dividends. During the nine months ended June 30, 2017, certain stockholders agreed to accept 3,894,099 shares of Common Stock in lieu of cash dividend payments of $358,368 due during that period and $140,748 due during previous fiscal years.

During the nine months ended June 30, 2016, we recorded a dividend on our 10% Convertible Preferred Stock of $959,128 and certain stockholders agreed to accept 7,140,654 shares of Common Stock (valued at $937,713) in lieu of cash dividend payments of $324,854 due for the current quarter and $612,859 due for previous quarters.

Stock Options

On May 24, 2017, our shareholders approved an amendment to the 2016 Stock Option Plan to increase the number of shares of our Common Stock reserved for issuance from 21,000,000 to 50,000,000.

In March 2017, we granted options under the 2016 Stock Option Plan to purchase 1,540,000 of our Common Stock to employees at exercise prices ranging from $0.10 to $0.11 per share, which represented the closing price of our stock on the date of the grants. The options have a ten year term and vest equally over a period of 60 months from date of grant. The fair value of the options at the date of grant in aggregate was $102,994, which was determined on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions; dividend yield of 0%; risk-free interest rates ranging from approximately 1.5% to 2.0%; expected volatility based on historical trading information ranging from 72% to 75% and expected term of 5 years.

In addition, in March 2017, we granted members of senior management and our Board of Directors options to purchase 8.75 million shares of our Common Stock with 7.15 million options vesting in varying installments over a four fiscal year period, beginning with fiscal 2017 based upon the grantee achieving certain annual performance milestones as determined annually by our Board of Director. The remaining 1.6 million options will vest immediate at the discretion of the Board based on individual performance.

During the three months ended June 30, 2017, options to purchase 10,000,000 shares of our Common Stock granted to former employees under the 2016 Stock Option Plan expired unexercised. The options were exercisable at prices ranging from $.10 to $.20 per share. In addition, during the three months ended June 30, 2017, options to purchase 705,000 shares of our Common Stock granted to former employees and a former director under the 2005 Stock Option Plan expired unexercised. The options were exercisable at prices ranging from $.10 to $.20 per share.

Amortization of stock compensation expense was $24,126 and $83,363, and $90,399 and $130,710 for the three and nine months ended June 30, 2017 and 2016, respectively.

The unamortized compensation expense at June 30, 2017 was $171,557 and will be amortized over a weighted average remaining life of approximately 4 years.

15. Segment Information

We have two reportable operating segments: (1) dual fuel conversion operations and (2) natural gas liquids operations. Each operating segment has its respective management team. Market conditions for our flare capture and recovery services (aka natural gas liquids operations) in the Bakken region of North Dakota continue to be very soft, again due to low oil prices and reduction in the number of drill rigs operating in the region. We do not foresee any material positive changes in flare capture market conditions in the near term and therefore, we announced on August 15, 2017 that we have elected to discontinue our flare capture initiative.

Our Chief Executive Officer has been identified as the chief operating decision maker (CODM) as he is responsible for assessing the performance of the segments and decides how to allocate resources to the segments. Income (loss) from operations is the measure of profit and loss that our CODM uses to assess performance and make decisions. Assets are a measure used to assess the performance of the company by the CODM; therefore we will report assets by segment in our disclosures. Income (loss) from operations represents the net sales less the cost of sales and direct operating expenses incurred within the operating segments as well as the allocation of some but not all corporate operating expenses. These unallocated costs include certain corporate functions (certain legal, accounting, wage, public relations and interest expense) and are included in the results below under Corporate in the reconciliation of operating results. Management does not consider unallocated Corporate in its management of segment reporting. There were no sales between segments for the three and nine months ending June 30, 2017 and 2016.