Attached files

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EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER - ECOSPHERE TECHNOLOGIES INCesph_ex312.htm
EX-32.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER AND PRINCIPAL FINANCIAL OFFICER - ECOSPHERE TECHNOLOGIES INCesph_ex321.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER - ECOSPHERE TECHNOLOGIES INCesph_ex311.htm
EX-10.6 - EES SIDE LETTER AGREEMENT - HYDROZONIX - ECOSPHERE TECHNOLOGIES INCesph_ex106.htm
EX-10.3 - HYDROZONIX EXCLUSIVE PRODUCT PURCHASE AND SUBLICENSE AGREEMENT - ECOSPHERE TECHNOLOGIES INCesph_ex103.htm
EX-10.7 - SECOND AMENDMENT TO EES LLC AGREEMENT - ECOSPHERE TECHNOLOGIES INCesph_ex107.htm
EX-10.1 - SUMMARY OF EMPLOYMENT ARRANGEMENT - VINICK - ECOSPHERE TECHNOLOGIES INCesph_ex101.htm


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

FORM 10-Q

þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended March 31, 2011
   
OR
   
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from ________________ to ________________

Commission file number 000-25663
 
 Ecosphere Technologies, Inc.
 (Exact name of registrant as specified in its charter)
 
Delaware
 
20-3502861
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
     
3515 S.E. Lionel Terrace, Stuart, Florida
 
34997
(Address of principal executive offices)
 
(Zip Code)

Registrant’s telephone number, including area code: (772) 287-4846

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No   o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes No   o

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes No þ

Class
 
Outstanding at May 6, 2011
Common Stock, $0.01 par value per share
 
142,421,093 shares



 
 

 
TABLE OF CONTENTS
 
   
Page
 
PART I – FINANCIAL INFORMATION
     
       
Item 1.
Condensed Consolidated Financial Statements (unaudited)
    3  
           
 
Condensed Consolidated Balance Sheets
    3  
           
 
Condensed Consolidated Statements of Operations (unaudited)
    4  
           
 
Condensed Consolidated Statements of Cash Flows (unaudited)
    5  
           
 
Notes to Condensed Consolidated  Financial Statements (unaudited)
    7  
         
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    20  
           
Item 3.
Qualitative and Quantitative Disclosures about Market Risk
    27  
           
Item 4.
Controls and Procedures
    27  
           
PART II – OTHER INFORMATION
       
         
Item 1.
Legal Proceedings
    28  
           
Item 1A.
Risk Factors
    28  
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    38  
           
Item 3.
Defaults Upon Senior Securities
    38  
           
Item 4.
(Removed and Reserved)
    38  
           
Item 5.
Other Information
    38  
           
Item 6.
Exhibits
    39  
           
SIGNATURES
    40  
  
 
2

 
 
PART I – FINANCIAL INFORMATION
 
ITEM 1.
FINANCIAL STATEMENTS.
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
    March 31,
2011
    December 31,
2010
 
   
(Unaudited)
       
Current Assets
           
Cash
  $ 365,218     $ 46,387  
Restricted cash
    2,140,000       -  
Accounts receivable
    689,891       703,475  
Prepaid expenses and other current assets
    238,550       46,151  
Total current assets
    3,433,659       796,013  
Property and equipment, net
    7,293,358       7,729,721  
       Construction in progress
    521,386       389,558  
       Patents, net
    45,150       46,145  
       Deposits
    27,645       22,205  
Total assets
  $ 11,321,198     $ 8,983,642  
Liabilities, Redeemable Convertible Cumulative Preferred Stock and Stockholders’ Deficit                
Current Liabilities
               
Accounts payable
  $ 1,228,772     $ 1,953,798  
Accounts payable - related parties
    -       15,093  
Accrued liabilities
    803,702       917,872  
Vehicle financing
    66,001       69,566  
Insurance premium financing contract
    117,998       -  
Due to affiliate
    2,000       2,000  
Customer deposit
    2,140,000       -  
Notes payable – related parties (net of discount) – current portion
    2,291,311       2,636,093  
Notes payable – third parties (net of discount) – current portion
    -       50,000  
Fair value of liability for warrant derivative instruments
    809,403       610,642  
Total current liabilities
    7,459,187       6,255,064  
       Restructuring reserve
    157,934       181,119  
       Notes payable - related parties - less current portion
    136,676       136,676  
       Notes payable - third parties – less current portion
    1,519,153       313,722  
Total Liabilities
    9,272,950       6,886,581  
Redeemable convertible cumulative preferred stock series A                
           11 shares authorized; 6 shares issued and outstanding at March 31, 2011 and December 31, 2010,
                $25,000 per share redemption amount plus dividends in arrears ($1,141,619 at March 31, 2011)
    1,141,619       1,135,994  
Redeemable convertible cumulative preferred stock series B                
           484 shares authorized; 322 shares issued and outstanding at March 31, 2011 and December 31, 2010,
                $2,500 per share redemption amount plus dividends in arrears ($2,761,926 at March 31, 2011)
    2,761,926       2,741,802  
                 
Commitments and Contingencies (Note 13)
               
                 
Ecosphere Technologies, Inc. Stockholders’ Deficit
               
Common stock, $0.01 par value; 300,000,000 shares authorized; 141,967,359 and 137,430,786 shares issued
and outstanding at March 31, 2011 and December 31, 2010, respectively
    1,420,772       1,374,307  
Common stock issuable, $0.01 par value, 453,733 and 1,347,915 issuable at March 31, 2011
and December 31, 2010, respectively
    4,538       13,480  
Additional paid-in capital
    100,412,209       96,778,394  
Accumulated deficit
    (113,799,134 )     (110,025,222 )
Total Ecosphere Technologies, Inc. stockholders’ deficit
    (11,961,615 )     (11,859,041 )
Noncontrolling interest in consolidated subsidiary
    10,106,318       10,078,306  
Total stockholders' deficit
    (1,855,297 )     (1,780,735 )
Total liabilities, redeemable convertible cumulative preferred stock,
  $ 11,321,198     $ 8,983,642  
 and stockholders’ deficit
 
The accompanying unaudited notes are an integral part of these condensed consolidated financial statements.
 
 
3

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
For the Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Revenues
  $ 2,227,641     $ 2,100,867  
                 
Cost of revenues
    621,699       746,534  
                 
Gross profit
    1,605,942       1,354,333  
                 
Operating expenses
               
Selling, general and administrative
    4,936,150       2,805,046  
Total operating expenses
    4,936,150       2,805,046  
                 
Loss from operations
    (3,330,208 )     (1,450,713 )
                 
Other income (expense):
               
Other income
    143       90  
Gain (loss) on settlement, net
    -       18,099  
Gain (loss) on conversion, net
    (94,662 )     -  
Interest expense
    (122,412 )     (517,936 )
Change in fair value of derivative instruments
    (198,761 )     (21,044,851 )
Total other income (expense)
    (415,692 )     (21,544,598 )
                 
Net  loss
    (3,745,900 )     (22,995,311 )
                 
Preferred stock dividends
    (25,750 )     (27,500 )
                 
Net loss applicable to common stock
    (3,771,650 )     (23,022,811 )
                 
Less: Net (income) applicable to noncontrolling interest in consolidated subsidiary
    (28,012 )     (109,395 )
                 
Net (loss) applicable to Ecosphere Technologies, Inc. common stock
  $ (3,799,662 )   $ (23,132,206 )
                 
                 
Net income (loss) per common share applicable to common stock
               
Basic and diluted
  $ (0.03 )   $ (0.19 )
 
               
Weighted average number of common shares outstanding
               
Basic and diluted
    141,672,563       119,544,476  
 
The accompanying unaudited notes are an integral part of these condensed consolidated unaudited financial statements.

 
4

 

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
For the Three Months Ended March 31,
 
   
2011
   
2010
 
OPERATING ACTIVITIES:
           
Net (loss) applicable to Ecosphere Technologies, Inc. common stock
  $ (3,799,662 )   $ (23,132,206 )
Adjustments to reconcile net (loss) to net cash provided by (used in) operating activities:
               
Accrued preferred stock dividends
    25,750       27,500  
Depreciation and amortization
    528,045       443,196  
Accretion of discount on notes payable
    46,182       143,142  
Loss on settlement of note and accrued interest for common stock
    93,762       -  
Stock-based compensation expense
    2,398,474       1,005,212  
Stock options issued for services
    97,450       -  
Increase in fair value of warrant derivative liability
    198,761       16,391,765  
Increase in fair value of embedded conversion option derivative liability
    -       4,653,085  
Restricted stock vesting expense
    53,748       -  
Changes in operating assets and liabilities
    -       -  
Decrease in accounts receivable
    13,584       96,167  
(Increase ) in prepaid expenses and other current assets
    (41,347 )     (22,772 )
(Increase)  in deposits
    (5,440 )     (5,085 )
(Increase) in restricted cash
    (2,140,000 )     -  
Increase  in accounts payable
    (725,026 )     (357,129 )
Increase (decrease) in accounts payable - related parties
    (15,093 )     -  
(Decrease) in restructuring reserve
    (23,185 )     (17,535 )
Increase in customer deposits
    2,140,000       -  
Increase (decrease) in deferred revenue
    -       (288,000 )
Increase (decrease)  in accrued liabilities
    (97,932 )     7,969  
Noncontrolling interest in income (loss) of consolidated subsidiary
    28,012       109,395  
Net cash provided by (used in) operating activities
    (1,223,917 )     (945,296 )
                 
INVESTING ACTIVITIES:
               
Redemption of restricted cash
    -       350,000  
Construction in process purchases
    (131,828 )     (40,080 )
Purchase of property and equipment
    (90,687 )     (1,106,502 )
Net cash (used in) investing activities
    (222,515 )     (796,582 )
                 
FINANCING ACTIVITIES:
               
Proceeds from issuance of convertible notes payable and warrants
    1,575,000       -  
Proceeds from modifications of warrrants for cash
    -       617,168  
Proceeds from warrant and option exercises
    571,664       367,773  
Proceeds from vehicle financing
    -       42,000  
Repayments of notes payable and insurance financing
    (33,054 )     (58,596 )
Repayments of notes payable to related parties
    (344,782 )     -  
Repayments of vehicle financing
    (3,565 )     (2,754 )
Principal payments on capital leases
    -       (10,677 )
Net cash provided by financing activities
    1,765,263       954,914  
Net increase (decrease) in cash
    318,831       (786,964 )
Cash, beginning of period
    46,387       1,089,238  
Cash, end of period
  $ 365,218     $ 302,274  
 
The accompanying unaudited notes are an integral part of these condensed consolidated unaudited financial statements.
 
 
5

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
    For the Three Months Ended March 31,  
Supplemental Cash Flow Information:
 
2011
   
2010
 
             
Cash paid for interest
  $ 84,924     $ 215,576  
Cash paid for income taxes
  $     $  
                 
Non-Cash Investing and Financing Activities:
               
                 
Accrued preferred stock dividends
  $ 25,750     $ 27,500  
Conversion of convertible notes to common stock
  $     $ 1,552,778  
Conversion of related party debt to common stock
  $     $ 259,948  
Discount related to warrants issued with convertible debt
  $ 415,751     $  
Reduction of derivative liability for embedded conversion options from conversion of convertible notes and debentures
  $     $ 3,474,705  
Insurance premium finance contract recorded as prepaid asset
  $ 151,052     $  
Reduction of derivative liability for warrant derivative instruments from warrants exercises and modifications
  $     $ 517,334  
Common stock issued as settlement of note and accrued interest
  $ 66,328     $  
Series B Redeemable Convertible Cumulative Preferred Stock converted to common stock
  $     $ 50,000  
 
The accompanying unaudited notes are an integral part of these condensed consolidated unaudited financial statements.

 
6

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
1.
NATURE OF OPERATIONS, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS AND BASIS OF PRESENTATION

We were incorporated in April 1998 in Florida. We reincorporated on September 8, 2006, in Delaware under the name Ecosphere Technologies, Inc. (“Ecosphere”, “we”, “us”, “our” or the “Company”). Ecosphere is a diversified water engineering, technology licensing, manufacturing and environmental services company.  The Company’s environmental services and technologies can be used in large-scale and sustainable applications across industries, nations and ecosystems.
 
The accompanying unaudited condensed consolidated financial statements include the accounts of Ecosphere Technologies, Inc. (ETI), its 90%-owned subsidiary, Ecosphere Systems, Inc. (“ESI”), its 52.6% owned subsidiary Ecosphere Energy Services LLC (“EES”), and its wholly-owned subsidiaries Ecosphere Envirobotic Solutions, Inc. (“UES”) and Ecosphere Exploration and Mining Services LLC (“EEMS”).  ESI was formed during the first quarter of 2005 to market the Company’s mobile water filtration technologies for disaster relief, homeland security and military applications. UES was formed in October 2005 to pursue the sale of UHP robotic coating removal equipment and technology and to perform contract services in the maritime coating removal industry that demonstrated the capabilities of the underlying technology. Ecosphere Energy Solutions, Inc. (“EES Inc.”)  was organized in November 2006.  It developed and marketed water processing systems to the oil and gas exploration and production industry using the Company’s patented Ecosphere Ozonix ® process.  In November 2008, the Company changed the name of EES, Inc. to Ecosphere Energy Services, Inc.   In July 2009, the Company contributed the assets and liabilities of EES, Inc. in exchange for an initial 67% share of EES, a new LLC formed in July 2009, and EES Inc. ceased operations. In November 2009 EES sold additional ownership interests in EES reducing the Company’s holding to 52.6%.  EEMS was formed in March 2010 to treat mining superfund sites and related contaminated mining waters in the U.S. and globally using the Ecosphere Ozonix® technology.  The Company is currently pursuing funding opportunities for this entity.  Except for EES, all of the Company’s subsidiaries are currently inactive.
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and with the rules and regulations of the U.S Securities and Exchange Commission for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The unaudited condensed consolidated financial statements reflect all normal recurring adjustments, which, in the opinion of management, are considered necessary for a fair presentation of the results for the periods shown. The results of operations for the periods presented are not necessarily indicative of the results expected for the full fiscal year or for any future period. The information included in these unaudited condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis and Plan of Operation contained in this report and the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

PRINCIPALS OF CONSOLIDATION
 
The unaudited condensed consolidated financial statements include the accounts of Ecosphere Technologies, Inc. and its subsidiaries. All inter-company balances and transactions have been eliminated in the consolidation.
 
NON-CONTROLLING INTEREST
 
The Company accounts for its less than 100% interest in consolidated subsidiaries in accordance with ASC 810 and accordingly, the Company presents non-controlling interests as a component of equity on its condensed consolidated balance sheets and reports non-controlling interest net (income) loss under the heading “net (income) loss applicable to non-controlling interest in consolidated subsidiary” in the condensed consolidated statements of operations.
 
CASH AND CASH EQUIVALENTS
 
For the purposes of the statements of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. The Company’s cash equivalents consist of a money market account.
 
 
7

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Restricted cash, which amounted to $2,140,000 as of March 31, 2011, consists of amounts held in an escrow account with a bank to provide the funds necessary to pay for the manufacturing and overhead costs of building the first two EF 60 units for Hydrozonix LLC (Hydrozonix).
 
ACCOUNTING FOR DERIVATIVE INSTRUMENTS

In January 2009, the Company adopted the provisions of ASC 815-40 which was ratified by the Financial Accounting Standards Board on June 25, 2008 and became effective for financial statements issued after December 15, 2008.  Earlier application was not permitted.  Under the provisions of ASC 815-40, convertible instruments and warrants, which contain terms that protect holders from declines in the stock price (“reset provisions”), may no longer be exempt from derivative accounting treatment.   As a result, warrants and embedded conversion features of convertible notes are recorded as a liability and are revalued at fair value at each reporting date.  Further, under derivative accounting, the warrants are recorded at their fair value.  If the fair value of the warrants exceeds the face value of the related debt, the excess is recorded as change in fair value on the issuance date.  Embedded conversion features are valued at their fair value. The fair value of the embedded conversion feature is added to loan discount, in an amount which is the lesser of, the fair value of the embedded conversion feature or the excess of the face value of the debt over the fair value of the attached warrants or any other applicable debt discounts. If the amount of the fair value of embedded conversion feature applied to discount is less than the total fair value of the embedded conversion feature, the remainder will be recorded as change in fair value on the issuance date.

In April 2010, the Company offered holders of warrant derivative instruments the right to extend the expiration date of the warrants for an additional year in exchange for the removal of the repricing feature in the warrant agreement.  Holders of 6,517,186 availed themselves of this opportunity which resulted in a charge to interest expense of $93,735 representing the increase in the fair value of the warrants resulting from the one year extension of the expiration date.  In addition, holders of warrants to purchase 6,746,173 shares of common stock exercised their cashless exercise rights and were issued 5,834,188 shares of common stock.  Further, since January 1, 2010, holders of warrants to purchase an additional 1,941,044 shares of common stock exercised their warrants for cash.  As a result, the number of warrant derivative instruments has been reduced from 16,911,486 at December 31, 2009 to 1,707,083 as of March 31, 2011.
 
The Company calculated the estimated fair values of the liabilities for warrant derivative instruments at March 31, 2011with the Black-Scholes option pricing model using the closing price of the Company’s common stock, $0.62, volatility and an expected term and a risk free interest rate as indicated in Table 1 that follows.   The volatility was based on historical volatility, the expected term is equal to the remaining term of the warrants and the risk free rate is based upon rates for treasury securities with the same term.  During the three months ended March 31, 2011, based upon the estimated fair value, the Company increased the fair value of liability for warrant derivative instruments by $198,761which was recorded as change in derivative liability in other expense.  
 
Table 1
 
Black Scholes Inputs
 
Warrants
     
 
 
As of March 31, 2011
 
Volatility
    100.66 %
Expected Term
    0.69 - 3.03  
Risk Free Interest Rate
    0.21% - 1.29 %
 
FAIR VALUE ACCOUNTING
 
We measure our financial assets and liabilities in accordance with generally accepted accounting principles. For certain of our financial instruments, including cash, accounts receivable, accounts payable and accrued liabilities, the carrying amounts approximate fair value due to their short maturities. Amounts recorded for notes payable, net of discount, also approximate fair value because current interest rates available to us for debt with similar terms and maturities are substantially the same.
 
 
8

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Effective January 1, 2008, we adopted accounting guidance for financial assets and liabilities. The adoption did not have a material impact on our results of operations, financial position or liquidity. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements. This guidance does not apply to measurements related to share-based payments. This guidance discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). The guidance utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:
 
Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.
 
Level 2: Inputs other than quoted prices that are observable, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
 
Level 3: Unobservable inputs in which little or no market data exists, therefore developed using estimates and assumptions developed by us, which reflect those that a market participant would use.
 
We currently measure and report at fair value the liability for warrant and embedded conversion option derivative instruments.  The fair value liabilities for price adjustable warrants and embedded conversion options have been recorded as determined utilizing Black-Scholes option pricing model.  The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2011:
 
   
Balance at
 March 31, 2011
 
Quoted Prices in
Active Markets
for Identical
Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
       
(Level 1)
 
(Level 2)
 
(Level 3)
 
Fair value of liability for warrant derivative instruments
  $ 809,403     $     $     $ 809,403  
Fair value of liability for embedded conversion option derivative instruments
                       
Total Financial Liabilities
  $ 809,403     $     $     $ 809,403  
 
The following is a roll-forward for the three months ended March 31, 2011 of the fair value liability of warrant derivative instruments and embedded conversion option derivative instruments:

   
Fair Value of Liability For Warrant Derivative Instruments
 
Balance at December 31, 2010
  $ 610,642  
Fair value of new warrants
    -  
Fair value of warrants exercised
    -  
Impact on fair value of warrant modifications
    -  
Change in fair value included in other (income) loss
    198,761  
Balance at March 31, 2011
  $ 809,403  
 
The Company had no non-financial assets or liabilities measured at fair value as of March 31, 2011.
 
USE OF ESTIMATES
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Significant estimates in the accompanying unaudited condensed consolidated financial statements include the allowance for doubtful accounts receivable,  estimates of depreciable lives, valuation of property and equipment, valuation of construction in progress, estimates of amortization periods and impairment for intangible assets, restructuring charges,  valuation of discounts on debt, valuation of beneficial conversion features in convertible debt, valuation of equity based instruments issued for other than cash, valuation of derivatives and the valuation allowance on deferred tax assets.

REVENUE RECOGNITION
 
In accordance with ASC 605-10, revenue from the sale of equipment is recognized when persuasive evidence of an arrangement exists, products are delivered to and accepted by the customer, economic risk of loss has passed to the customer, the price is fixed or determinable, collection is reasonably assured, and any future obligations of the Company are insignificant.
 
 
9

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Revenue from water-filtration contracts is earned based upon the volume of water processed plus additional period based contractual charges and is recognized in the period the service is provided. Payments received in advance of the performance of services or of the delivery of goods are deferred as liabilities until the services are performed or the goods are delivered.
 
Revenue from technology license royalties are recorded as the royalties are earned in accordance with ASC 952-605-25-12.

Some projects we undertake are based upon our providing water processing services for fixed periods of time.  Revenue from these projects is recognized based upon the number of days the service has been provided during the reporting period.

The Company includes shipping and handling fees billed to customers as revenues and handling costs as cost of revenues.
 
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Any ASUs which are not effective until after March 31, 2011 are not expected to have a significant effect on the Company’s consolidated financial position or results of operations.
 
2.           GOING CONCERN
 
The accompanying unaudited condensed consolidated financial statements were prepared assuming that the Company will continue as a going concern. This basis of accounting contemplates the realization of assets and the satisfaction of liabilities in the normal course of operations. During the three months ended March 31, 2011, the Company incurred a net loss of approximately $3.75 million and used cash in operations of $1,223,917. At March 31, 2011, the Company had a working capital deficiency of approximately $4 million, a stockholders’ deficit of approximately $1.9 million and had outstanding convertible preferred stock that is redeemable under limited circumstances for approximately $3.9 million (including accrued dividends).  The Company’s continued existence is dependent upon its ability to generate sufficient additional revenue to support operations. During the three months ended March 31, 2011, the Company received $2,140,000 in customer deposits, $571,664 from the exercise of options and warrants for cash and $1,575,000 from the issuance of convertible notes and warrants.  In addition, the Company’s 52.6% owned subsidiary had revenues of $2.2 million for the three months ended March 31, 2011.
 
In March 2011, the Company entered into an Exclusive Product Purchase and Sub-License Agreement (the “Agreement”) with Hydrozonix, LLC (“Hydrozonix”) to deploy its patented Ecosphere Ozonix technology in the U.S. oil and gas exploration and production industries on-shore only. As part of the Agreement, Hydrozonix agreed to advance the direct costs and the manufacturing overhead for each EF60 unit it orders. Additionally, it will pay a manufacturing fee and a license fee to EES. In turn, ETI will be the exclusive manufacturer of the EF60s and will receive its costs on a pass-through basis from EES. Also, EES will pay ETI a manufacturing fee. In addition, ETI will receive profit distributions from EES relating to its ownership of EES which will be derived from the fees and royalty payments EES receives from Hydrozonix if the first two units are accepted and additional unit orders are placed. Management believes the Agreement will provide the Company with the working capital to meet most if not all of the Company’s working capital needs. Management is currently exploring several alternatives for additional equity or debt financing either at the Parent company level or through investments into new applications of the Ozonix technology.
 
Although, the Company has not attained a level of revenues sufficient to support recurring expenses as of this report, based on the anticipated cash flow, revenues and profits from the Hydrozonix contract, the Company expects to have the resources to settle all previously incurred obligations. These factors, among others, have considerably reduced the substantial doubt about the Company’s ability to continue as a going concern expressed in previous filings, albeit that some doubt will remain pending the acceptance of and payment by Hydrozonix for the first two EF60s currently in production.
 
The unaudited condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the inability of the Company to continue as a going concern. There are no assurances that the Company will be successful in achieving the above plans, or that such plans, if consummated, will enable the Company to obtain profitable operations or continue as a going concern.
 
 
10

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
3.     PROPERTY AND EQUIPMENT

During the three months ended March 31, 2011, the Company invested $90,687 in leasehold improvements and new manufacturing equipment in anticipation of the Agreement with Hydrozonix.  Depreciation for the three months ended March 31, 2011 amounted to $527,050.

4.      NOTES PAYABLE

During the three months ended March 31, 2011, the Company received $1,075,000 in exchange for convertible notes with a total principal balance of $1,075,000, plus five-year warrants to purchase 767,857 shares of common stock at an exercise price of $0.70 per share. The notes have a conversion rate of $0.70 per share and bear interest of 10% payable at the earlier of maturity or conversion.  The warrants were valued using the Black-Scholes option pricing model with expected terms of 5 years, volatility ranging from 100.73% to 112.55% and discounts rates from 1.95% to 2.06%.  The relative fair value of these warrants, $270,259, was recorded as a debt discount and is being amortized to interest expense over the term of the notes. Because the conversion rate of the note exceeded the trading price of the Company’s common stock, there was no intrinsic value for the embedded conversion feature.

The Company also received $500,000 in exchange for a convertible original issue discount note in the amount of $550,000 plus five year warrants to purchase 392,857 shares of the Company’s common stock at an exercise price of $0.70 per share.  The note has a conversion rate of $0.70 per share. The warrants were valued using the Black-Scholes option pricing model with an expected term of 5 years, a volatility of 105.08% and a discount rate of 1.97%. The relative fair value of these warrants, $145,492, plus the original issue discount of $50,000 was recorded as debt discount and is being amortized to interest expense over the term of the note. Because the conversion rate of the notes exceeded the trading price of the Company’s common stock, there was no intrinsic value for the embedded conversion feature.

As of March 31, 2011, a note payable to a former director in the amount of $291,311 is in default for failure to make payments as agreed.  The Company is currently working with the former director to cure the default.  As of March 31, 2011, accrued interest due on this note amounted to $40,776.
 
A summary of notes outstanding as of March 31, 2011 is as follows:
 
   
Principal
   
Unamortized Discount
   
Debt, Net of Discount
 
Unrelated parties
                 
Convertible and non-convertible note payable
  $ 2,050,000     $ (530,847 )   $ 1,519,153  
Less current portion
    -       -       -  
Convertible and non-convertible note payable, net of current portion
  $ 2,050,000     $ (530,847 )   $ 1,519,153  
                         
Related parties
                       
Convertible and non-convertible note payable
  $ 2,427,987     $ -     $ 2,427,987  
Less current portion
    2,291,311       -       2,291,311  
Convertible and non-convertible note payable, net of current portion
  $ 136,676     $ -     $ 136,676  
 
5.     RESTRUCTURING RESERVE
 
In June 2009, the Board of Directors approved an exit strategy to close the Company’s New York office in order to reduce operating costs. The Company recognized aggregate restructuring charges related to the office closing in the amount of $548,090 consisting of future lease commitments and employee severance costs in the amount of $246,920 and $301,170, respectively.
 
As of March 31, 2011, the restructuring reserve liability of $157,934 consists of the total initial restructuring cost of $548,090 plus an additional $50,000 reserve for future rental payments due recorded during the third quarter of 2010, less the severance costs paid to date and the net amount of lease payments made to date.  The Company entered into a sublease agreement with a tenant that provides for monthly sublease payments of approximately $10,300 through April 2013, which are being added to the reserve since the initial reserve included a reduction for estimated sub-lease income.
 
 
11

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
The following table summarizes the activity in the restructuring reserve during the three months ended March 31, 2011 and 2010:
 
Restructuring Reserve
 
For the Three Months Ended March 31,
 
   
2011
   
2010
 
Balance, beginning of period
  $ 181,119     $ 123,436  
Rent payments
    (44,755 )     (43,207 )
Sublease payment received
    21,570       25,672  
Balance, end of period
  $ 157,934     $ 105,901  

6.     REDEEMABLE CONVERTIBLE CUMULATIVE PREFERRED STOCK

Series A

As of March 31, 2011 and December 31, 2010, there were six shares of Series A Redeemable Convertible Cumulative Preferred Stock outstanding. The shares are redeemable at the option of the Company at $27,500 per share plus accrued dividends, and the shares became redeemable at the option of the holder in September 2002 at $25,000 per share plus accrued dividends.  The shares may be redeemed at the option of the holder upon the occurrence of a change in control of the Company, by the transfer of greater than 50% of the Company’s common stock.  The shares are convertible each into 24,000 common shares. Accrued dividends totaled $991,619 and $985,994 at March 31, 2011 and December 31, 2010, respectively. During the three months ended March 31, 2011 no Series A preferred shares were converted into common stock.

Series B

As of March 31, 2011 and December 31, 2010, there were 322 shares of Series B Redeemable Convertible Cumulative Preferred Stock outstanding, respectively. The shares are redeemable at the option of the Company at $3,000 per share plus accrued dividends, and the shares became redeemable at the option of the holder in September 2002 at $2,500 per share plus accrued dividends.  The shares may be redeemed at the option of the holder upon the occurrence of a change in control of the Company, by the transfer of greater than 50% of the Company’s common stock.  The shares are convertible each into 835 common shares.  Accrued dividends totaled $1,956,926 and $1,936,801 at March 31, 2011 and December 31, 2010. During the three months ended March 31, 2011 no Series B preferred shares were converted into common stock.
 
7.
COMMON STOCK

The Company is authorized to issue up to 300,000,000 shares of its $0.01 par value common stock as of March 31, 2011.

Shares issued

Issuances of the Company’s common stock during the three months ended March 31, 2011 included the following:

Shares Issued Upon Settlement of  a Note and Accrued Interest

a)  
333,333 shares of common stock were issued to settle a note and accrued interest in the amount of $66,238.  The trading value of the stock on the date of settlement was $0.48 resulting in a loss on settlement of $93,762.

Shares Issued Upon Exercise of Warrants and Options

b)  
2,119,039 shares of common stock were issued upon exercise of warrants and options at exercise prices ranging from $0.15 to $0.28 per share resulting in proceeds to the Company of $571,664.
c)  
1,219,137 shares of common stock were issued upon the cashless exercise of 2,080,000 warrants with an exercise price of $0.28 per share based upon market prices of the Company’s common stock ranging from $0.60 to $0.68 per share.

The Company recognized share-based compensation expense related to restricted stock grants, issued per the terms of the 2006 Equity Incentive Plan of $53,750 for the three months ended March 31, 2011. The following table summarizes non-vested restricted stock and the related activity as of March 31, 2011:
 
   
Shares
   
Weighted
 Average
 Grant-Date
 Fair-Value
 
Non-vested at January 1, 2011
    269,504     $ 0.89  
Granted
    ---     $ ---  
Vested
    ---     $ ---  
Forfeited
    ---     $ ---  
Unvested at March 31, 2011
    269,504     $ 0.89  
 
Total unrecognized share-based compensation expense from unvested restricted stock as of March 31, 2011 was $91,250 which is expected to be recognized over the next 1.8 years.

8.
NET INCOME (LOSS) PER SHARE

The Company’s outstanding options and warrants to acquire common stock, shares of common stock which may be issued upon conversion of outstanding redeemable convertible cumulative preferred stock, unvested shares of restricted stock and  shares of common stock which may be issued upon conversion of convertible notes and convertible original issue discount notes which total 85,759,690 as of March 31, 2011, are not included in the computation of net loss per common share for the three months ended March 31, 2011 because the effect of their inclusion would be anti-dilutive.  These common stock equivalents may dilute future earnings per share.

 
12

 

ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
9.
STOCK OPTIONS AND WARRANTS

The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. This model incorporates certain assumptions for inputs including a risk-free market interest rate, expected dividend yield of the underlying common stock, expected option life and expected volatility in the market value of the underlying common stock. We used the following assumptions for options issued in the following periods:
 
   
For the Three Months Ended
March 31,
   
2011
 
2010
Expected volatility
   
104.79% - 112.58%
 
104.5%
Expected lives
   
3.0 – 5.0
 
2.5 years
Risk-free interest rate
   
1.05% - 2.06
 
1.22%
Expected dividend yield
   
None
 
None

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options and warrants have characteristics different from those of its traded stock, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of such stock options. The risk free interest rate is based upon quoted market yields for United States Treasury debt securities. The expected dividend yield is based upon the Company’s history of having never issued a dividend and management’s current expectation of future action surrounding dividends. Expected volatility in 2011 and 2010 is based on historical volatility for the expected term as it is a reasonable estimate of expected future volatility. Implied volatility was not considered as the Company does not have any traded options or warrants.  The expected terms of the options and warrants are estimated using either the option term, for non-employee options and warrants, or the simplified method for employee and director grants.

During the three months ended March 31, 2011 the Company increased the number of shares authorized under the 2006 Incentive Compensation Plan to 30 million shares and modified all outstanding options under the plan to include a cashless exercise feature.
 
 
13

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Stock-based compensation expense related to options and warrants for the three months ended March 31, 2011 was $2,495,924.  As of March 31, 2011 there was $5,297,091 of total unrecognized compensation cost related to unvested options granted under the Company’s option plans. This unrecognized compensation cost is expected to be recognized over the next 27 months.
 
Activity in the Company’s options for the three month periods ended March 31, 2011 and 2010 were as follows:
 
Employee Fixed Plan
                       
   
For the Three Months Ended March 31, 2011
   
For the Three Months Ended March 31, 2010
 
   
Shares
   
Weighted Average Exercise Price
   
Shares
   
Weighted Average Exercise Price
 
                         
Outstanding at beginning of period
    11,730,805     $ 0.58       11,468,736     $ 0.58  
                                 
Granted
    -     $ -       -     $ -  
                                 
Exercised
    (584,000 )   $ 0.28       (340,000 )   $ 0.29  
                                 
Forfeited
    -     $ -       -     $ -  
                                 
Expired
    (97,000 )   $ 0.75       -     $ -  
                                 
Outstanding at end of period
    11,049,805     $ 0.58       11,128,736     $ 0.59  
                                 
Exercisable at end of period
    10,705,685     $ 0.57       7,199,317     $ 0.68  
                                 
Outstanding
                               
   Weighted average remaining contractual term
            2.40               3.66  
   Aggregate intrinsic value
          $ 1,171,123             $ 10,172,273  
   Weighted average grant date fair value
            N/A               N/A  
                                 
Exercisable
                               
   Weighted average remaining contractual term
            2.35               3.07  
   Aggregate intrinsic value
          $ 1,149,030             $ -  
 
During the three months ended March 31, 2011, the Company issued 544,000 shares of common stock in exchange for $152,320 in connection with the exercise of options with exercise prices of $0.28 per share.  In addition, the Company issued 21,333 shares of common stock in connection with the cashless exercise of options to purchase 40,000 shares of common stock at an exercise price of $0.28 per share and based upon a market price of the Company’s common stock of $0.60 per share.

Employee Fixed Non-Plan
                       
   
For the Three Months Ended March 31, 2011
   
For the Three Months Ended March 31, 2010
 
   
Shares
   
Weighted Average Exercise Price
   
Shares
   
Weighted Average Exercise Price
 
                         
Outstanding at beginning of period
    42,719,462     $ 0.50       33,115,414     $ 0.45  
                                 
Granted
    10,000,000     $ 0.48       200,000     $ 0.43  
                                 
Exercised
    (554,239 )   $ 0.24       (166,667 )   $ 0.23  
                                 
Forfeited
    (750,000 )   $ 0.82       -     $ -  
                                 
Expired
    -     $ -       -     $ -  
                                 
Outstanding at end of period
    51,415,223     $ 0.53       33,148,747     $ 0.45  
                                 
Exercisable at end of period
    40,048,557     $ 0.50       18,965,412     $ 0.43  
                                 
Outstanding
                               
   Weighted average remaining contractual term
            3.22               3.62  
   Aggregate intrinsic value
          $ 8,630,157             $ 34,631,268  
   Weighted average grant date fair value
          $ 0.33             $ 0.26  
                                 
Exercisable
                               
   Weighted average remaining contractual term
            2.94               3.42  
   Aggregate intrinsic value
          $ 7,435,157             $ 14,231,266  

 
14

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
On January 2, 2011, the Company granted its Chief Technology Officer five-year options to purchase 9,000,000 shares of common stock at an exercise price of $0.4799 per share.  The options vested one-third upon the signing of the Hydrozonix agreement, with the remainder vesting in equal installments on each June 30th and December 31st until either the Company has delivered 16 EF 60 units to Hydrozonix  or on the second anniversary of the agreement.

On January 18, 2011, coinciding with his appointment as Chief Executive Officer, the Company issued five-year options to purchase 1,000,000 shares of the Company’s common stock with an exercise price of $0.48 per share.  The options vested 500,000 immediately, and the remainder vest in equal installments on June 30, 2011 and December 31, 2011, subject to the continued employment of the CEO on those dates.  In connection with the issuance, the CEO forfeited five-year options to purchase 750,000 shares of common stock at an exercise price of $0.82 which were granted to him upon his appointment as full-time Executive Chairman in August 2010.

During the three months ended March 31, 2011, the Company issued 514,239 shares of common stock in exchange for $122,320 in connection with the exercise of options with exercise prices ranging from $0.15 to $0.28 per share.  In addition, the Company issued 21,334 shares of common stock in connection with the cashless exercise of options to purchase 40,000 shares of common stock at an exercise price of $0.28 per share and based upon a market price of the Company’s common stock of $0.60 per share.

Non-Employee Fixed Non-Plan
                       
                         
   
For the Three Months Ended March 31, 2011
   
For the Three Months Ended March 31, 2010
 
   
Shares
   
Weighted Average Exercise Price
   
Shares
   
Weighted Average Exercise Price
 
                         
Outstanding at beginning of period
    2,353,714     $ 0.33       3,803,714     $ 0.59  
                                 
Granted
    700,000     $ 0.64       -     $ -  
                                 
Exercised
    (1,618,000 )   $ 0.28       -     $ -  
                                 
Forfeited
    -     $ -       -     $ -  
                                 
Expired
    -     $ -       (300,000 )   $ 1.02  
                                 
Outstanding at end of period
    1,435,714     $ 0.53       3,503,714     $ 0.55  
                                 
Exercisable at end of period
    1,185,714     $ 0.51       3,360,856     $ 0.56  
                                 
Outstanding
                               
   Weighted average remaining contractual term
            3.87               1.32  
   Aggregate intrinsic value
          $ 139,143             $ 3,318,531  
   Weighted average grant date fair value
          $ 0.50               N/A  
                                 
Exercisable
                               
   Weighted average remaining contractual term
            3.67               1.20  
   Aggregate intrinsic value
          $ 139,143             $ 3,166,744  
 
On January 5, 2011, the Company issued five-year options to purchase 200,000 shares of common stock at an exercise price of $0.61 per share to its legal counsel for past services. The options vested immediately.

On January 20, 2011, the Company issued five-year options to purchase 500,000 shares of common stock at an exercise price of $0.65 per share to an individual as a finder’s fee related to the Hydrozonix agreement.  The options vested 50% upon the signing of the definitive agreement and the remainder vesting upon the completion of the eighth EF 60 unit, approximately one year.
 
During the three months ended March 31, 2011, the Company issued 418,000 shares of common stock in exchange for $117,040 in connection with the exercise of options with exercise prices of $0.28 per share.  In addition, the Company issued 705,883 shares of common stock in connection with the cashless exercise of options to purchase 1,200,000 shares of common stock at an exercise price of $0.28 per share and based upon a market price of the Company’s common stock of $0.68 per share.

 
15

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Warrants

Activity in the Company’s warrants for the three month periods ended March 31, 2011 and 2010 were as follows:
 
Warrants
 
For the Three Months Ended March 31, 2011
   
For the Three Months Ended March 31, 2010
 
   
Shares
   
Weighted Average Exercise Price
   
Shares
   
Weighted Average Exercise Price
 
                         
Outstanding at beginning of period
    19,179,489     $ 0.43       32,588,207     $ 0.51  
                                 
Granted
    1,160,714     $ 0.70       -     $ -  
                                 
Exercised
    (1,442,800 )   $ 0.28       (1,018,445 )   $ 0.23  
                                 
Forfeited
    -     $ -       -     $ -  
                                 
Exchanged, net
    -     $ -       1,558,000     $ 0.67  
                                 
Expired
    (649,400 )   $ 0.51       (1,080,000 )   $ 1.12  
                                 
Outstanding at end of period
    18,248,003     $ 0.46       32,047,762     $ 0.45  
                                 
Exercisable at end of period
    18,248,003     $ 0.46       32,047,762     $ 0.45  
                                 
Outstanding and exercisable
                               
   Weighted average remaining contractual term
            1.86               2.29  
   Aggregate intrinsic value
          $ 3,792,184             $ 33,588,847  
 
During the three months ended March 31, 2011, the Company issued five-year warrants to purchase 1,160,714 shares of common stock at an exercise price of $0.70 per share in connection with the issuance of convertible notes and a convertible original issue discount note to accredited investors.  The warrants are fully vested.
 
During the three months ended March 31, 2011, the Company issued 642,800 shares of common stock in exchange for $179,984 in connection with the exercise of warrants with exercise prices of $0.28 per share.  In addition, the Company issued 470,588 shares of common stock in connection with the cashless exercise of options to purchase 800,000 shares of common stock at an exercise price of $0.28 per share and based upon a market price of the Company’s common stock of $0.68 per share.
 
10.        INCOME TAXES
 
The Company and one of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various states. The Company is no longer subject to U.S. federal or state income tax examinations by tax authorities for years before 2004. None of the tax years subject to examination are currently under examination by a tax authority and the Company has not received notice of the intent by any tax authority to commence an examination.

The Company did not recognize any liability for unrecognized tax benefits, since the Company has concluded that all of its tax positions are highly certain of being upheld upon examination by federal or state tax authorities. 
 
11.
OPERATING SEGMENTS

Pursuant to ASC 280-10, the Company defines an operating segment as:

 
·
A business activity from which the Company may earn revenue and incur expenses;

 
·
Whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and

 
·
For which discrete financial information is available.

In 2005, the Company expanded its business offerings to include the water filtration technology business. Recognizing that each business offering applied to different markets, the Company established three operating entities or segments, which are defined as each business line that it operates. This however, excludes corporate headquarters, which does not generate revenue.
 
 
16

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
Our operating entities are defined as follows:

 
·
ESI which we organized in April 2005 to operate our non-Ozonix water filtration system business;
 
 
·
Ecosphere Envirobotic Solutions, Inc., formerly UltraStrip Envirobotic Solutions, Inc., which we organized in October 2005 to operate our coating removal business; and,

 
·
EES, Inc., which we organized in November 2006, conducted our water processing for the oil and gas industry using the Ecosphere Ozonix® technology until July 2009, when the assets and liabilities of EES, Inc. were contributed in the formation of EES.  As of March 31, 2011, the Company has a 52.6% ownership position in EES.
 
Presently, our operations consist of a manufacturing facility operated within Ecosphere and our oil and gas services company which is processing water for the oil and gas industry using the Ecosphere Ozonix® technology.  This activity is conducted by EES, a 52.6% owned subsidiary that is managed by Ecosphere.
 
The table below presents certain financial information by business segment for the three months ended March 31, 2011:
 
   
Ecosphere
Systems Inc.
   
Ecosphere
Envirobotic 
Solutions, Inc.
   
  Ecosphere
Energy
Services LLC
   
 Segment 
Totals
   
Corporate
   
Consolidated 
Totals
 
                                     
Revenue from external customers
  $ -     $ -     $ 2,227,641     $ 2,227,641     $ -     $ 2,227,641  
Interest expense and amortization of debt discount
  $ -     $ -     $ (63,468 )   $ (63,468 )   $ (58,944 )   $ (122,412 )
Change in fair value of liability for derivative instruments
  $ -     $ -     $ -     $ -     $ (198,761 )   $ (198,761 )
Depreciation and amortization
  $ -     $ -     $ (501,907 )   $ (501,907 )   $ (26,138 )   $ (528,045 )
Income Tax Expense
  $ -     $ -     $ -     $ -     $ -     $ -  
Net income (loss) applicable to common stock
  $ -     $ -     $ 28,012     $ 28,012     $ (3,799,662 )   $ (3,771,650 )
                                                 
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $ 9,878,900     $ 10,770,099     $ 1,813,757     $ 12,583,856  
Fixed asset additions (disposals) (net)
  $ -     $ -     $ 464     $ 464     $ 90,223     $ 90,687  
Total Assets
  $ -     $ -     $ 10,008,923     $ 10,008,923     $ 1,312,275     $ 11,321,198  
 
The table below presents certain financial information by business segment for the three months ended March 31, 2010:
 
   
Ecosphere
 Systems,
Inc.
   
Ecosphere
Envirobotic
Solutions, Inc.
   
Ecosphere
 Energy
Services LLC
   
Segment Totals
   
Corporate
   
Consolidated
Totals
 
Revenue from external customers
  $ -     $ -     $ 2,100,867     $ 2,100,867     $ -     $ 2,100,867  
Interest expense and amortization of debt discount
  $ -     $ -     $ (119,438 )   $ (119,438 )   $ (398,498 )   $ (517,936 )
Change in fair value of liability for derivative instruments
  $ -     $ -     $ -     $ -     $ (21,044,851 )   $ (21,044,851 )
Depreciation and amortization
  $ (28,564 )   $ (245 )   $ (397,612 )   $ (426,421 )   $ (16,775 )   $ (443,196 )
Income Tax Expense
  $ -     $ -     $ -     $ -     $ -     $ -  
Net income (loss) applicable to common stock
  $ (28,564 )   $ (245 )   $ 109,395     $ 80,586     $ (23,212,792 )   $ (23,132,206 )
                                                 
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $ 8,564,946     $ 9,456,145     $ 1,978,523     $ 11,434,668  
Fixed asset additions (disposals) (net)
  $ -     $ -     $ 1,012,580     $ 1,012,580     $ 131,367     $ 1,143,947  
Total Assets
  $ 169,731     $ 823     $ 8,251,341     $ 8,421,895     $ 1,497,021     $ 9,918,916  
 
 
17

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
12.
RELATED PARTY TRANSACTIONS

The Company has not made its scheduled quarterly payments of $25,000 related to an unsecured note payable to a former director, bearing interest at 7%, since March 2010.  As such, the remaining balance under this note of $291,311 is in default and interest is accumulating at the default rate of 14%.   As of March 31, 2011, the Company owes accrued interest of $40,776 on this note.

On January 4, 2011, the Company issued 1,176,471 shares of common stock in connection with the cashless exercise of options to purchase 2,000,000 shares of the Company’s common stock exercisable at $0.28 per share and based upon the market value of the Company’s common stock of $0.68 per share.  The options were collateral for a loan from a third party to the Company’s then Chief Executive Officer and were exercised by the lender to secure repayment of the loan.  Of the shares issued, 800,000 shares were issued to the lender and 376,471 shares were issued to the Company’s Chief Executive Officer.

On January 31, 2011, the Company’s Vice President of Administration was issued 42,667 shares of common stock in connection with the cashless exercise of options to purchase 80,000 shares of common stock at an exercise price of $0.28 per share and based upon a market value of the Company’s common stock of $0.60 per share.

During the three months ended March 31, 2011, the Company repaid $344,782 of notes payable to a related party that holds a noncontrolling interest in EES.

13.
COMMITMENT AND CONTINGENCIES

From time to time, we may be involved in litigation relating to claims arising out of our operations in the normal course of business.  To our knowledge, except as described below, no legal proceedings, government actions, administrative actions, investigations or claims are currently pending against us or involve us that, in the opinion of our management, could reasonably be expected to have a material adverse effect on our business and financial condition.

The Company had a long term relationship with Kamimura International Associates (KIA), a Washington D.C. based organization, whereby the principals at KIA agreed to assist the Company in developing the coating removal market in the Far East. The relationship resulted in the establishment of UltraStrip Japan, Ltd. (USJ), a company whose purpose was to market and deliver ship stripping services in Japan. The agreement with KIA was never formalized. In February 2007, KIA filed a lawsuit against the Company. In March 2007, the Company filed a Motion to Dismiss, Motion to Strike, and Motion for More Definite Statement. The Company intends to vigorously defend itself in this litigation; the Company believes that the plaintiff will not prevail. In 2008, the Company filed a counter claim to which KIA responded by filing a motion to dismiss.  The motion to dismiss was rejected by the court.  Depositions are scheduled for the Spring of 2011, but have not, as yet, occurred. The Company has expensed and accrued an amount it reasonably estimates may be required to resolve any outstanding issues between the Company and KIA and management does not expect this matter to have any future impact on the liquidity or results of operations of the Company.
 
 
18

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2011
(UNAUDITED)
 
14.  
NONCONTROLLING INTEREST
 
In July 2009, the Company formed EES and contributed the assets and liabilities of EES Inc. in exchange for a 67% ownership interest in EES.  In November 2009 EES received $7,850,000 in exchange for a 21.5% interest in EES.  After the November transaction, the Company owns 52.6% of EES.  EES reported a net loss of $1,271,694 during the period from inception, July 16, 2009 through December 31, 2010, which was allocated to the other EES members in accordance with the LLC operating agreement.  During the three months ended March 31, 2011, EES reported net income of $28,012 which has been allocated entirely to the non-controlling interest in accordance with the LLC operating agreement.
 
The following provides a summary of activity in the noncontrolling interest in consolidated subsidiary account for the three months ended March 31, 2011 and 2010:

Noncontrolling Interest in Consolidated Subsidiary
 
   
For the Three Months Ended March 31,
 
   
2011
   
2010
 
Balance, beginning of period
  $ 10,078,306     $ 10,606,583  
Contributions from noncontrolling members
    -       -  
Noncontrolling interest in (income) loss
    28,012       109,395  
Distributions to noncontrolling members
    -       -  
Balance, end of period
  $ 10,106,318     $ 10,715,978  
 
Concurrently with entering into the  Hydrozonix agreement, the EES operating agreement was amended to defer the Company’s right to preferential distributions, outlined under the original operating agreement, until such time as the noncontrolling members have received distributions equal to their original investments.
 
In addition, so long as Hydozonix maintains its exclusivity, the EES minority members will receive 25% of the royalties paid by Hydrozoniz before the remainder of the royalties are distributed to the Company and the  monority members in accordance to their percentage interests in EES.
 
15.  
CONCENTRATIONS
 
The Company maintains its cash in bank and financial institution deposits that at times may exceed federally insured limits. The Company has not experienced any losses in such accounts through March 31, 2011.  As of March 31, 2011, there were no cash equivalent balances held in corporate money market funds that are not insured.  The restricted cash balance of $2,140,000 was held in an escrow account.
 
At March 31, 2011, 81% of accounts receivable was from one customer and 19% was due from one other customer.
 
During the three months  ended March 31, 2011, two customers accounted for 83% and 17% of revenues.
 
During the three months ended March 31, 2011, 17% of revenues resulted from processing frac flowback water for one customer and 83% resulted from pretreating water that is being used in fracturing wells for one company.
 
16.  
SUBSEQUENT EVENTS
 
On May 9, 2011, the Company entered into a new note agreement with its former director. Under the new agreement, the Company made an initial payment of $17,025 and is to make quarterly payments of $17,025 until the amount due, $340,400, is paid in full.
 
 
 
19

 
 
ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
ITEM 2:     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
 
The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors” in Part II, Item 1A of this Report.
 
Company Overview
 
Ecosphere Technologies, Inc. (“Ecosphere” or the “Company”) is a diversified engineering, technology development and manufacturing company dedicated to identifying, creating, building and marketing innovative technology solutions that provide for responsible, sustainable stewardship of the world’s natural resources.  Companies that use our patented technologies are able to improve their financial metrics while also reducing their ecological and environmental footprint.  The Company’s business model is to invent, develop, commercialize and sell green technologies using water as a key component.
 
At present, Ecosphere is focusing its efforts on EES, its 52.6% owned subsidiary. EES is engaged in operating high volume mobile water filtration equipment to treat energy exploration related wastewaters.  EES is successfully providing water recycling services to major energy operating companies utilizing our patented Ecosphere Ozonix® technology.  The industry acceptance of this technology is demonstrated by the multi-year agreements the Company secured with two oil  and gas operating companies and the Exclusive Sublicense and Manufacturing Agreement signed with Hydrozonix. These agreements prove the Ecosphere Ozonix® technology is commercially viable and have fueled the continuing development of the technology and the identification of additional applications of our technologies which will allow energy companies to optimize the revenues generated from a well site.
 
Ecosphere’s patented Ozonix® technology has the ability to clean water without chemicals in a variety of industries.  While EES has an exclusive license for energy, Ecosphere owns 100% of all other applications.  These industries include mining, municipal wastewater, industrial wastewater, food processing, agriculture and shipping.  The Company is beginning to seek financial partners to expand its Ozonix® technology to other applications.

2011 Highlights
 
We began 2011 by announcing the signing of a non-binding terms sheet for the sub-license and sale of up to 16 EF 60 units to a new oil and gas service company for use onshore in the United States.
 
 In March 2011, the Company signed the definitive agreements related to the non-binding terms sheet with Hydrozonix.  Highlights of the agreement include:
 
o   
An initial purchase of two EF 60 units, which upon acceptance will permit Hydrozonix to place orders for an additional 14 EF 60 units during the initial two years.
 
o   
Hydrozonix will have the exclusive license to use the Ecosphere Ozonix® technology onshore oil and gas exploration field of use in the United States.  In order to maintain their exclusivity, in subsequent years Hydrozonix must meet certain minimum equipment purchase quantities which averages at least eight per year.
  
Revenues for the three months ended March 31, 2011 increased by $126,774 or 6% over revenues for the three months ended March 31, 2010.  Gross profit increased $251,609 or 18.6%.
 
 
20

 
 
ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
CRITICAL ACCOUNTING ESTIMATES
 
In response to the SEC’s financial reporting release, FR-60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, the Company has selected its more subjective accounting estimation processes for purposes of explaining the methodology used in calculating the estimate, in addition to the inherent uncertainties pertaining to the estimate and the possible effects on the Company’s financial condition.  These accounting estimates are discussed below.  These estimates involve certain assumptions that if incorrect could create a material adverse impact on the Company’s results of operations and financial condition.
 
Revenue Recognition
 
Revenue from sales of equipment is recognized when products are delivered to and accepted by the customer, economic risk of loss has passed to the customer, price is fixed or determinable, collection is probable, and any future obligations of the Company are insignificant.  Revenue from the Ecosphere Ozonix® water-filtration contracts is earned based upon the volume of water processed plus additional contractual period based charges and is recognized in the period the service is provided.  Payments received in advance of the performance of services or of the delivery of goods are deferred as liabilities until the services are performed or the goods are delivered.  Revenue from technology license royalties are recorded as the royalties are earned.  The Company includes shipping and handling fees billed to customers as revenues and shipping and handling costs as cost of revenues.

Stock-Based Compensation

The Company follows the provisions of ASC 718-20-10 Compensation – Stock Compensation which establishes standards surrounding the accounting for transactions in which an entity exchanges its equity instruments for goods or services.  Under ASC 718-20-10, we recognize an expense for the fair value of our outstanding stock options as they vest, whether held by employees or others.

We estimate the fair value of each stock option at the grant date by using the Black-Scholes option pricing model based upon certain assumptions which are contained in Note 9 to our unaudited condensed consolidated financial statements contained in this report.  The Black-Scholes model requires the input of highly subjective assumptions including the expected stock price volatility.  Because our stock options and warrants have characteristics different from those of traded options, and because changes in the subjective input of assumptions can materially affect the fair value estimate, in our management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of such stock options.

Fair Value of Liabilities for Warrant and Embedded Conversion Option Derivative Instruments

We estimate the fair value of each warrant and embedded conversion option at the issuance date and at each subsequent reporting date by using the Black-Scholes option pricing model based upon certain assumptions which are contained in Note 1 to our unaudited consolidated financial statements contained in this report.  The Black-Scholes model requires the input of highly subjective assumptions including the expected stock price volatility.  Because our warrants and embedded conversion options have characteristics different from those of traded options, and because changes in the subjective input of assumptions can materially affect the fair value estimate, in our management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of such warrants and embedded conversion options.
 
 
21

 

ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
Comparison of the Three Months ended March 31, 2011 with the Three Months Ended March 31, 2010

The following table sets forth a modified version of our unaudited Condensed Consolidated Statements of Operations that is used in the following discussions of our results of operations:
 
   
For the Three Months Ended March 31,
             
               
Change
 
   
2011
   
2010
     $      %  
 
 
 
   
 
   
 
         
Revenues
  $ 2,227,641     $ 2,100,867     $ 126,774       6 %
Cost of revenues
    621,699       746,534       (124,835 )     -17 %
Gross profit (loss)
    1,605,942       1,354,333       251,609       19 %
Operating expenses
                               
       Salaries and employee benefits
    3,486,796       1,733,676       1,753,120       101 %
       Administrative and selling
    329,021       433,420       (104,399 )     -24 %
       Professional fees
    561,833       168,370       393,463       234 %
       Depreciation and amortization
    528,045       443,196       84,849       19 %
       Research and development
    30,455       26,384       4,071       15 %
           Total selling general and administrative
    4,936,150       2,805,046       2,131,104       76 %
Loss from operations
    (3,330,208 )     (1,450,713 )     (1,879,495 )     130 %
Other income (expense):
                               
Other income (expense)
    143       90       53       -59 %
Gain (loss) on settlement
    -       18,099       (18,099 )     100 %
Gain (loss) on conversion
    (94,662 )     -       (94,662 )     -100 %
Interest expense
    (122,412 )     (517,936 )     395,524       76 %
        Change in fair value of derivative instruments
    (198,761 )     (21,044,851 )     20,846,090       -99 %
Total other income (expense)
    (415,692 )     (21,544,598 )     21,128,906       -98 %
Net loss
    (3,745,900 )     (22,995,311 )     19,249,411       84 %
Preferred stock dividends
    25,750       27,500       (1,750 )     6 %
Net (loss) applicable to common stock
    (3,771,650 )     (23,022,811 )     19,251,161       84 %
Net (income) applicable to noncontrolling interest of consolidated subsidiary
    (28,012 )     (109,395 )     (81,383 )     74 %
Net loss applicable to Ecosphere Technologies, Inc. common stock
  $ (3,799,662 )   $ (23,132,206 )   $ 19,332,544       -84 %
 
 
22

 

ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
RESULTS OF OPERATIONS

Comparison of the Three Months Ended March 31, 2011 to the Three Months Ended March 31, 2010

The Company’s reported a net loss applicable to Ecosphere Technologies, Inc. common stock was $3,799,662 during the three months ended March 31, 2011 as compared to a net loss applicable to common stock of $23,132,206 for the three months ended March 31, 2010.  The Company’s net loss for the three months ended March 31, 2010 was significantly impacted by the accounting for derivative liabilities related to warrants and convertible notes issued by the Company.  On May 18, 2009 and May 17, 2010, the Company filed Form 8-Ks which highlighted the fluctuations in net income (loss) which may occur related to the accounting for these derivative instruments, stated that we believe an evaluation of our results should focus on our income or loss from operations and outlined steps the Company was taking to reduce the number of derivative instruments.

These derivative liabilities are recorded at fair value each reporting period.  A major component of this valuation is the market value of the Company’s common stock.  The periodic change in the value of the derivative liability is recorded in other income and expense.  As the market value of the Company’s common stock increases, so does the Company’s derivative liability.  This results in other expense.  As the market value of the Company’s common stock declines, the Company’s derivative liability decreases resulting in other income for the period.    

During the three months ended March 31, 2011, the market value of the Company’s common stock increased from $0.48 per share at December 31, 2010 to $0.62 per share at March 31, 2011 resulting in other expense of $198,761 related to the increase in the Company’s liability for warrant derivative instruments.    During the three months ended March 31, 2010, the market value of the Company’s common stock increased from $0.47 per share at December 31, 2009 to $1.50 per share at March 31, 2010, resulting in other expense of $21,044,851 related to the increase in the Company’s derivative liability.  The larger impact realized during the three months ended March 31, 2010 was due to a significantly larger number of derivative instruments outstanding as of March 31, 2010 as compared to March 31, 2011. The derivative liability at March 31, 2010 was based on 16,911,486 warrants outstanding plus 1,828,703 shares related to embedded conversion options as compared to 1,707,083 warrants outstanding as of March 31, 2011.

Revenues
 
Revenues for the three months ended March 31, 2011 increased $126,774 or 6% over the three months ended March 31, 2010.  Revenue for the three months ended March 31, 2011 consisted of 83% related to pretreating water prior to its use to fracture natural gas wells and 17% related to processing frac flowback water.  Revenue for the three months ended March 31, 2010 was generated 72% related to pretreating water prior to its use to fracture natural gas wells, 14%  from the processing of frac flowback water from natural gas wells and 14% from pilot projects processing flowback water from various oil and gas exploration sources.
 
Cost of Revenues
 
Cost of revenues amounted to $621,699 for the three months ended March 31, 2011 as compared to $746,534 for the three months ended March 31, 2010.  These costs consist of the payroll related costs of field personnel, plus parts, fuel and supplies used in support of the operations.  Cost of revenues as  percentage of revenues was 27.9% for the three months ended March 31, 2011 as compared to 35.5% for the three months ended March 31, 2010.  The higher percentage in 2010 resulted from higher support costs for pilot project operations as compared to the costs of recurring operations in 2011.
 
Operating Expenses
 
Operating expenses for the three months ended March 31, 2011 were $4,936,150 compared to $2,805,046 for the three months ended March 31, 2010.  This increase resulted  (1) from an increase in salaries and employee benefits of $1.8 million which resulted from an increase in non-cash employee option expense of $1.5 million resulting from new executive options granted in December 2010 and January 2011, plus an increase of $157,000 for the addition of a new Chief Executive Officer and additional support staff in anticipation of the Hydrozonix agreement and an increase in employee insurance costs of $43,000;  (2) an increase of $393,000 in professional fees related to legal expenses surrounding the preparation of the definitive Hydrozonix agreement and $97,000 of non-cash expense related to options granted to legal counsel and a $60,000 increase is accounting and auditing fees; and (3) an increase of 85,000 in depreciation expense due to an increase in the amount of equipment used in operations.  These increases were partially offset by a decrease of $104,000 in Administrative and Selling expenses due to decrease in travel expenses of $87,000 which decreased because there were no pilot projects during the three months ended March 31, 2011 and because there were fewer corporate, engineering and manufacturing personnel needed onsite to support field operations.  In addition, facilities expense was slightly lower due to the elimination of the temporary executive offices in Texas.
 
 
23

 
 
ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
Loss From Operations
 
Loss from operations for the three months ended March 31, 2011 was $3,330,208 compared to a loss of $1,450,713 for the three months ended March 31, 2010. The increase in the loss from operations in 2011 versus 2010 was due to the increase in operating expenses which was partially offset by the increase in gross profit as identified above.  Included in the loss from operations were non-cash expenses including stock based compensation of $2,549,672 plus depreciation and amortization of $528,045.
 
Interest Expense
 
Interest expense was $122,412 and $517,936 for the three months ended March 31, 2011 and 2010, respectively. The decline in 2011 is the result of a decrease in the average debt outstanding during Q1 2011 versus Q1 2010 and due to a reduction in the interest expense related to the current notes outstanding which resulted from a reduction in the warrant coverage, and the related debt discount, granted with the new notes. Interest expense for the three months ended March 31, 2011 included $46,000 related the accretion of discounts while interest expense for the three months ended March 31, 2010 included $143,142 related to the accretion of note discounts and $246,000 of note discount recognized upon the conversion of the notes.
 
Preferred Stock Dividends
 
Preferred stock dividends were $25,750 for the three months ended March 31, 2011 and $27,500 for the three months ended March 31, 2010. The dividends reflect Company obligations to preferred shareholders that have not been paid and decreased from 2010 because a number of holders chose to convert their preferred stock into common stock.
 
Change in Fair Value of Derivative Instruments
 
The Company adopted ASC 810-15 effective January 1, 2009.  Under ASC 810-15, the fair value of the liabilities for warrant derivative instruments and embedded conversion option feature derivative instruments are calculated at each reporting date with the change in liability recorded in other income or expense.  The Company estimated the fair value of these liabilities to be $809,403 as of March 31, 2011 using the Black-Scholes option pricing model.  As such, the Company recognized other expense of $198,761 for the three months ended March 31, 2011, representing the increase in the fair value of the derivative liability at March 31, 2011 as compared to the fair value at December 31, 2010.  The increase in the liability resulted primarily due to the increase in the market value of the Company’s common stock from $0.48 per share at December 31, 2010 to $0.62 per share at March 31, 2011.
 
The Company estimated the fair value of these liabilities to be $24,453,350 as of March 31, 2010 using the Black-Scholes option pricing model.  As a result, the Company recognized other expense of $21,044,851 for the three months ended March 31, 2010, representing the increase in the fair value of these liabilities.
 
If the Company’s common stock price at June 30, 2011 is higher than the $0.62 per share March 31, 2011 closing price, the Company may record a non-cash charge which may be material.  Conversely, if the Company’s common stock price at June 30, 2011 is lower than the March 31, 2011 closing price of $0.62, the Company may record other income which may be material.

Net Income (Loss) Applicable to Ecosphere Technologies, Inc. Common Stock
 
Net loss applicable to common stock was $3,799,662 for the three months ended March 31, 2011, compared to a net loss applicable to common stock of $23,132,206 for the three months ended March 31, 2010.  Net loss per share of common stock was $0.03  basic and diluted for the three months ended March 31, 2011 and the net loss per share of common stock was $0.19 basic and diluted for the three months ended March 31, 2010.  Weighted average shares outstanding were 141,672,563 and 119,544,476 for the three months ended March 31, 2011 and 2010.
 
 
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ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
LIQUIDITY AND CAPITAL RESOURCES
 
Net cash used in operating activities was $1,223,917 for the three months ended March 31, 2011, compared to net cash used in operations of $945,296 for the three months ended March 31, 2010.  Cash used resulted from the net loss applicable to common stock of $3,799,662 which was offset by non-cash charges for depreciation and amortization of $528,045,  accretion of note interest of $46,182, vesting of options and restricted stock of $2,452,222, options issued for services of $97,450, a loss on settlement of a note payable and accrued interest for stock of $93,762, an increase in derivative liabilities of $198,761 and an increase in customer deposits of $2,140,000 which was offset by an increase in restricted cash of $2,140,000 related to the first Hydrozonix equipment order.  The cash generated was used to reduce accounts payable and accrued expenses $822,958.  In 2010 net loss applicable to common stock of $23,132,206 was positively impacted by non-cash compensation of $1,005,212, accretion of loan discounts generated from convertible debt with attached warrants of $143,000, depreciation expense of 443,196, a decrease in accounts receivable of $ $96,167 and an increase in non-cash other expense of $21,044,851 related to the change in the fair value of the liabilities for derivative instruments.  These positive impacts were negatively affected by a decreased in deferred revenue of $288,000 and a reduction of accounts payable and accrued liabilities of $349,160.
 
The Company's net cash used by investing activities was $222,515 for the three months ended March 31, 2011 compared to net cash used in investing activities of $796,582 for the three months ended March 31, 2010. In 2011, the Company invested $90,687 in equipment and leasehold improvements related to its manufacturing facility and purchased approximately $132,000 of components and materials to begin manufacturing the EF 60 units for Hydrozonix.  In 2010, the Company completed the last three of its 24 EcosFrac Units for use on the Southwestern energy contract and purchased an additional service vehicle to support field operations.

The Company’s net cash provided by financing activities was $1,765,263 for the three months ended March 31, 2011 compared to net cash provided by financing activities of $954,914 for the three months ended March 31, 2010.  The amounts in 2011 consisted of proceeds from the exercise of warrants and options of $571,664, plus proceeds from the issuance of convertible debt and warrants of $1,575,000.  These proceeds were used to make payments on related party notes of $344,782 and to repay vehicle and insurance financings of $36,619.  In 2010, the Company received proceeds from the modification of warrants of $617,168, proceeds from the exercise of warrants and options of $367,773 and $42,000 from vehicle financing.  These proceeds were used to repay insurance and vehicle financing of $61,350 and to repay capital lease of $10,677.
 
In March 2011, EES and the Company signed a manufacturing and licensing agreement with Hydrozonix for an exclusive sublicensing of the Company’s Ecosphere Ozonix® technology in the onshore oil and gas exploration and production industry in the United States in exchange for minimum purchase commitments for the Company’s new EF60 units. Hydrozonix may purchase   up to 16 new EF60 units in the first twenty four months and will pay EES a continuing royalty based upon Hydrozonix income before interest and taxes from those units.  The Company has begun manufacturing the first two EF 60 units.

In September 2010, the board of directors approved a convertible note offering for up to $2,000,000. Under the offering, investors receive a two year note bearing annual interest of 10% and convertible into common stock at $0.70 per share plus five year warrants to purchase common stock at $0.70 per share. The number of warrants received is equal to 50% of the principal balance divided by the conversion rate. Through the date of this filing, the Company has received $1,975,000 from eight accredited investors for this financing which was intended to pay past due vendors.

Management believes that the Hydrozonix transaction will provide revenue sufficient to maintain operations for at least the next two years assuming Hydrozonix continues to purchase units in order to maintain its exclusivity.  In addition, the Company is working to identify potential investors for its Ecosphere Explorations and Mining Services subsidiary to apply the Ecosphere Ozonix® technology to the non-energy related mining industry.

The unaudited condensed consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the inability of the Company to continue as a going concern. There are no assurances that the Company will be able to achieve and sustain profitable operations or continue as a going concern.
 
 
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ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
RELATED PERSON TRANSACTIONS
 
For information on related party transactions and their financial impact, see Note 12 to the unaudited condensed consolidated financial statements.
 
RESEARCH AND DEVELOPMENT
 
In accordance with ASC 730-10 – Research and Development expenditures for research and development of the Company's products are expensed when incurred, and are included in operating expenses.  The Company recognized research and development costs of $30,455 and $26,384 for the three months ended March 31, 2011 and 2010, respectively.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
 
For information on recently issued accounting pronouncements, see Note 1 to the unaudited condensed consolidated financial statements.
 
CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

This report contains forward-looking statements including our liquidity.  Forward looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects” and similar references to future periods.

Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions.  Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict.  Our actual results may differ materially from those contemplated by the forward-looking statements.  We caution you therefore against relying on any of these forward-looking statements.  They are neither statements of historical fact nor guarantees or assurances of future performance.  Important factors that could cause actual results to differ materially from those in the forward-looking statements include the condition of the credit and financial markets, the effects of the global recession, the future price of natural gas, future legislation, markets for smaller public companies general reluctance of businesses to utilize new technology, continued positive results in the field, Hydrozonix’ acceptance of the initial two units and Hydrozonix’ placing additional orders for EF60 units.

Further information on our risk factors is contained in its filings with the Securities and Exchange Commission (the “SEC”) including those in Part II, Item 1A of this Report.   Any forward-looking statement made by us in this report speaks only as of the date on which it is made.  Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
 
 
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ECOSPHERE TECHNOLOGIES AND SUBSIDIARIES
 
ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our cash balance as of March 31, 2011 was held in insured depository accounts. Our restricted cash was held in an escrow account with a bank.

Contractual obligations:
                       
   
Amounts Due
 
   
April 2011 to March 2012
   
April 2012 to March 2013
   
Thereafter
   
Total
 
                         
Debt principal
  $ 2,085,125     $ 2,043,100     $ 187,175     $ 4,315,400  
Interest on debt
    206,654       456,676       -       663,330  
Operating leases
    298,911       209,532       14,983       523,426