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EX-10.8 - DIRECTOR NOTE - ECOSPHERE TECHNOLOGIES INCesph_ex108.htm
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EXCEL - IDEA: XBRL DOCUMENT - ECOSPHERE TECHNOLOGIES INCFinancial_Report.xls


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 June 30, 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
Smaller reporting company  
o  
(Do not check if a smaller reporting company)        

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 August 5, 2011
Common Stock, $0.01 par value per share
 
145,063,817 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
    28  
           
Item 3.
Qualitative and Quantitative Disclosures about Market Risk
    39  
           
Item 4.
Controls and Procedures
    40  
           
           
PART II – OTHER INFORMATION
         
Item 1.
Legal Proceedings
    41  
           
Item 1A.
Risk Factors
    41  
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    42  
           
Item 3.
Defaults Upon Senior Securities
    42  
           
Item 4.
(Removed and Reserved)
    42  
           
Item 5.
Other Information
    42  
           
Item 6.
Exhibits
    43  
           
SIGNATURES
    44  
 
 
2

 
  
PART I – FINANCIAL INFORMATION
 
ITEM 1.
FINANCIAL STATEMENTS.
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
             
    June 30,     December 31,  
   
2011
    2010  
    (Unaudited)        
Current Assets
           
Cash
  $ 439,453     $ 46,387  
Restricted cash
    323,125       -  
Accounts receivable
    757,028       703,475  
Prepaid expenses and other current assets
    151,363       46,151  
Total current assets
    1,670,969       796,013  
Property and equipment, net
    7,208,777       7,729,721  
Construction in progress
    4,074,353       389,558  
Patents, net
    44,154       46,145  
Deposits
    27,645       22,205  
Total assets
  $ 13,025,898     $ 8,983,642  
                 
Liabilities, Redeemable Convertible Cumulative Preferred Stock and Stockholders’ Deficit                
Current Liabilities
               
Accounts payable
  $ 1,377,111     $ 1,953,798  
Accounts payable - related parties
    -       15,093  
Accrued liabilities
    612,462       917,872  
Vehicle financing
    62,629       69,566  
Insurance premium financing contract
    67,861       -  
Equipment financing - current portion
    32,957       -  
Due to affiliate
    2,000       2,000  
Customer deposit
    4,300,000       -  
Notes payable – related parties (net of discount) – current portion
    2,073,375       2,636,093  
Notes payable – third parties (net of discount) – current portion
    -       50,000  
Fair value of liability for warrant derivative instruments
    607,490       610,642  
Total current liabilities
    9,135,885       6,255,064  
Restructuring reserve
    145,534       181,119  
Equipment financing - less current portion
    156,547       -  
Notes payable - related parties - less current portion
    136,676       136,676  
Notes payable - third parties – less current portion
    1,591,578       313,722  
Total Liabilities
    11,166,220       6,886,581  
                 
Redeemable convertible cumulative preferred stock series A                
11 shares authorized; 6 shares issued and outstanding at June 30, 2011 and December 31, 2010, $25,000 per share redemption amount plus dividends in arrears ($1,147,244 at June 30, 2011)     1,147,244       1,135,994  
                 
Redeemable convertible cumulative preferred stock series B
               
484 shares authorized; 322 shares issued and outstanding at June 30, 2011 and December 31, 2010, $2,500 per share redemption amount plus dividends in arrears ($2,782,052 at June 30, 2011)
    2,782,052       2,741,802  
                 
Commitments and Contingencies (Note 13)
               
                 
Ecosphere Technologies, Inc. Stockholders’ Deficit
               
Common stock, $0.01 par value; 300,000,000 shares authorized; 144,506,497 and 137,430,786 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively
    1,445,065       1,374,307  
Common stock issuable, $0.01 par value, 407,320 and 1,347,915 issuable at June 30, 2011 and December 31, 2010, respectively
    4,073       13,480  
Additional paid-in capital
    101,723,045       96,778,394  
Accumulated deficit
    (115,633,905 )     (110,025,222 )
Total Ecosphere Technologies, Inc. stockholders’ deficit
    (12,461,722 )     (11,859,041 )
Noncontrolling interest in consolidated subsidiary
    10,392,104       10,078,306  
Total stockholders' deficit
    (2,069,618 )     (1,780,735 )
Total liabilities, redeemable convertible cumulative preferred stock, and stockholders’ deficit
  $ 13,025,898     $ 8,983,642  
 
The accompanying unaudited notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
3

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 
 
 
 
 
 
 
 
   
For The Three Months Ended
June 30,
   
For The Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Revenues
  $ 2,367,543     $ 2,138,386     $ 4,595,184     $ 4,239,253  
                                 
Cost of revenues
    802,558       792,236       1,424,257       1,538,770  
                                 
Gross profit
    1,564,985       1,346,150       3,170,927       2,700,483  
                                 
Operating expenses
                               
Selling, general and administrative
    3,100,049       3,082,364       8,036,199       5,887,410  
Total operating expenses
    3,100,049       3,082,364       8,036,199       5,887,410  
                                 
Loss from operations
    (1,535,064 )     (1,736,214 )     (4,865,272 )     (3,186,927 )
                                 
Other income (expense):
                               
Other income
    290       152       433       242  
Gain (loss) on conversion, net
    -       (115,505 )     (94,662 )     (133,604 )
Interest expense
    (189,084 )     (327,394 )     (311,496 )     (845,330 )
Change in fair value of derivative instruments
    174,873       7,009,612       (23,888 )     (14,035,239 )
Total other income (expense)
    (13,921 )     6,566,865       (429,613 )     (15,013,931 )
                                 
Net income (loss)
    (1,548,985 )     4,830,651       (5,294,885 )     (18,200,858 )
                                 
Preferred stock dividends
    (25,750 )     (26,250 )     (51,500 )     (53,750 )
                                 
Net income (loss) applicable to common stock
    (1,574,735 )     4,804,401       (5,346,385 )     (18,254,608 )
                                 
Less: Net (income) loss applicable to non-controlling interest in consolidated subsidiary
    (285,786 )     (83,315 )     (313,798 )     (192,710 )
                                 
Net income (loss) applicable to Ecosphere Technologies, Inc. common stock
  $ (1,860,521 )   $ 4,721,086     $ (5,660,183 )   $ (18,447,318 )
                                 
Net income (loss) per common share applicable to Ecosphere Technologies, Inc. common stock
                               
Basic
  $ (0.01 )   $ 0.04     $ (0.04 )   $ (0.15 )
Diluted
  $ (0.01 )   $ 0.03     $ (0.04 )   $ (0.15 )
                                 
Weighted average number of common shares outstanding
                               
Basic
    143,472,955       130,212,522       142,577,732       124,907,969  
Diluted
    143,472,955       170,733,321       142,577,732       124,907,969  
 
The accompanying unaudited notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
4

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
For the Six Months Ended June 30,
 
   
2011
   
2010
 
OPERATING ACTIVITIES:
           
Net (loss) applicable to Ecosphere Technologies, Inc. common stock
  $ (5,660,183 )   $ (18,447,318 )
Adjustments to reconcile net (loss) to net cash (used in) operating activities:
         
Accrued preferred stock dividends
    51,500       53,750  
Depreciation and amortization
    1,062,142       922,345  
Accretion of discount on notes payable
    118,607       538,712  
Loss on settlement of note and accrued interest for common stock
    93,762       19,604  
Shares issued for setttlement
    -       114,000  
Stock-based compensation expense
    3,645,597       1,896,553  
Stock options issued for services
    97,450       -  
Expense of warrant modification
    -       93,735  
Increase in fair value of warrant derivative liability
    23,888       10,020,019  
Increase in fair value of embedded conversion option derivative liability
    -       4,015,220  
Restricted stock vesting
    107,500       -  
Changes in operating assets and liabilities
    -       -  
(Increase) decrease in accounts receivable
    (53,553 )     27,624  
Decrease in prepaid expenses and other current assets
    45,840       43,355  
(Increase) in deposits
    (5,440 )     (12,006 )
(Increase) in restricted cash
    (323,125 )     -  
(Increase in construction in progress
    (3,684,795 )     -  
Increase in accounts payable
    (576,687 )     80,687  
Increase (decrease) in accounts payable - related parties
    (15,093 )     32,082  
(Decrease) in restructuring reserve
    (35,585 )     (44,337 )
Increase in customer deposits
    4,300,000       -  
Increase (decrease) in deferred revenue
    -       (576,000 )
Increase (decrease) in accrued liabilities
    (240,083 )     45,782  
Noncontrolling interest in income (loss) of consolidated subsidiary
    313,798       192,710  
Net cash (used in) operating activities
    (734,460 )     (983,483 )
                 
INVESTING ACTIVITIES:
               
Redemption of restricted cash
    -       425,000  
Construction in process purchases
    -       (100,128 )
Purchase of property and equipment
    (539,207 )     (1,800,828 )
Net cash (used in) investing activities
    (539,207 )     (1,475,956 )
                 
FINANCING ACTIVITIES:
               
Proceeds from issuance of convertible notes payable and warrants
    1,575,000       -  
Proceeds from modifications of warrrants for cash
    -       756,968  
Proceeds from warrant and option exercises
    604,164       1,020,321  
Proceeds from vehicle financing
    -       42,000  
Proceeds from equipment financing
    189,504       -  
Repayments of notes payable and insurance financing
    (83,191 )     (96,882 )
Repayments of notes payable to related parties
    (611,807 )     (286,258 )
Repayments of vehicle financing
    (6,937 )     (5,697 )
Principal payments on capital leases
    -       (13,080 )
Net cash provided by financing activities
    1,666,733       1,417,372  
Net increase (decrease) in cash
    393,066       (1,042,067 )
Cash, beginning of period
    46,387       1,089,238  
Cash, end of period
  $ 439,453     $ 47,171  
 
The accompanying uaudited notes are an integral part of these unaudited condensed consolidated financial statements.
 
 
5

 
 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
    For the Six Months Ended June 30,  
Supplemental Cash Flow Information:
  2011     2010  
             
Cash paid for interest
  $ 124,835     $ 124,388  
Cash paid for income taxes
  $     $  
                 
Non-Cash Investing and Financing Activities:
               
                 
Accrued preferred stock dividends
  $ 51,500     $ 53,750  
Conversion of convertible notes to common stock
  $     $ 1,986,667  
Converion of related party accrued interest to note principal
  $ 49,089     $  
Conversion of related party debt to common stock
  $     $ 539,948  
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
  $     $ 5,100,128  
Insurance premium finance contract recorded as prepaid asset
  $ 151,052     $  
Reduction of derivative liability for warrant derivative instruments from warrants exercises and modifications
  $ 27,040     $ 14,571,170  
Common stock issued as settlement of note and accrued interest
  $ 66,328     $ 30,462  
Common stock issued in payment of services and accounts payable
  $     $ 60,518  
Series A Redeemable Convertible Cumulative Preferred Stock converted to common stock
  $     $ 25,000  
Series B Redeemable Convertible Cumulative Preferred Stock converted to common stock
  $     $ 62,500  
 
 
The accompanying unaudited notes are an integral part of these unaudited consolidated financial statements.
 
 
6

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 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 that designs, develops and manufactures wastewater treatment solutions for industrial markets.  The Company’s environmental services and technologies can be licensed for use  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 ultimately demonstrated the capabilities of the underlying water treatment technologies the Company continues to develop. 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 wastewaters and related contaminated mining waters in the U.S. and globally using the Ecosphere Ozonix® technology.  The Company is currently pursuing funding and licensing opportunities for this entity.  Except for EES, all of the Company’s subsidiaries are 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.
 
 
7

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
 
NON-CONTROLLING INTEREST
 
The Company accounts for its less than 100% interest in consolidated subsidiaries in accordance with ASC 810-10 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.
 
Restricted cash, which amounted to $323,125 as of June 30, 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 EcosFrac 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 2,007,710 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 1,640,417 as of June 30, 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.  
 
 
8

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
 The Company calculated the estimated fair values of the liabilities for warrant derivative instruments at June 30, 2011 with the Black-Scholes option pricing model using the closing price of the Company’s common stock, $0.54, 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 June 30, 2011, based upon the decrease in the estimated fair value, the Company decreased the fair value of liability for warrant derivative instruments by $174,873 which was recorded as change in derivative liability in other income.  
 
Table 1
   Black Scholes Inputs  
Warrants
           
    As of March 31, 2011     As of June 30, 2011  
             
Volatility
    100.66 %     74.24 %
Expected Term
    0.69 - 3.03       0.44 - 2.78  
Risk Free Interest Rate
    0.21% - 1.29 %     0.08% - 0.73 %
 
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.

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.
 
 
9

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
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 June 30, 2011:
 
   
Balance at
 June 30, 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
  $ 607,490     $     $     $ 607,490  
Fair value of liability for embedded conversion option derivative instruments
                       
Total Financial Liabilities
  $ 607,490     $     $     $ 607,490  
 
The following is a roll-forward for the six months ended June 30, 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
    (27,040 )
Impact on fair value of warrant modifications
    -  
Change in fair value included in other loss
    23,888  
Balance at June 30, 2011
  $ 607,490  
 
The Company had no non-financial assets or liabilities measured at fair value as of June 30, 2011.
 
 
10

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
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 and sub-license fee revenue 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.
 
Revenue from water-treatment 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 June 30, 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 six months ended June 30, 2011, the Company incurred a net loss of approximately $5.7 million and used cash in operations of $734,460.  At June 30, 2011, the Company had a working capital deficiency of approximately $7.5 million, a stockholders’ deficit of approximately $2.1 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 six months ended June 30, 2011, the Company received $4.3 million in deposits by a customer, $604,164 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 approximately $4.6 million for the six months ended June 30, 2011.
 
11

 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
In March 2011, the Company entered into an Exclusive Product Purchase and Sub-License Agreement (the “Agreement”) with Hydrozonix LLC (a strategic alliance between the principals of Ely & Associates, Inc., Phillips and Jordan, Inc., and Siboney Contracting Company) (“Hydrozonix”) to deploy its patented Ecosphere Ozonix® technology in the U.S. onshore 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 EF 60 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 EF 60s and will receive its costs on a pass-through basis from EES. Also, EES will pay ETI a manufacturing fee. In May 2011, Hydrozonix approved a change order to increase the flow rate of the units being produced.  The new units will be called EF 80s as each unit will be capable of processing 80 barrels per minute as compared to the 60 barrels per minute processed by the EF 60's. 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 when the first two units are accepted and additional unit orders are placed. Since the EF 80 employs the same Ozonix® technology as the units that have successfully processed water for oil and gas exploration companies over the past two years on over 400 wells, EES believes the likelihood of Hydrozonix accepting the EF 80 units is good, but not certain. 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 in subsidiaries formed to apply the Ozonix® technology to new industrial wastewater applications.

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 EF80s currently in production.  It is anticipated that such acceptance and payment of final amounts due will occur in September 2011 after the units are tested in the field.
 
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.

3. 
PROPERTY AND EQUIPMENT

During the six months ended June 30, 2011, the Company invested approximately $350,000 in leasehold improvements and new manufacturing equipment to support the manufacturing process for the new Agreement with Hydrozonix, plus approximately $190,000 for other equipment upgrades. The Company obtained equipment financing of $189,504 for the new manufacturing equipment which bears annual interest of 6.5% to 6.75% and is payable over 5 years. Depreciation for the six months ended June 30, 2011 amounted to $1,060,152.

4. 
NOTES PAYABLE

During the six months ended June 30, 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 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.
 
 
12

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
In May 2011, the Company renegotiated a note payable with a former director, which removed the previous interest rate and extended the maturity date of the prior note, resulting in a new note agreement. Under the new agreement, the Company made an initial payment of $17,025 and is required to make quarterly payments of $17,025 until the amount due, $340,400 (consisting of original principal of $291,311 plus accrued interest of $49,089), is paid in full.  The renegotiation of the note was accounted for as a troubled debt restructuring in accordance with ASC 470-60-15.  The carrying amount of the note was not affected as it did not exceed the total future cash payments.
 
A summary of notes outstanding as of June 30, 2011 is as follows:
 
   
Principal
   
Unamortized Discount
   
Debt, Net of Discount
 
Unrelated parties
                 
Convertible and non-convertible notes payable
  $ 2,050,000     $ (458,422 )   $ 1,591,578  
Less current portion
    -       -       -  
Convertible and non-convertible notes payable, net of current portion
  $ 2,050,000     $ (458,422 )   $ 1,591,578  
                         
Related parties
                       
Convertible and non-convertible notes payable
  $ 2,210,051     $ -     $ 2,210,051  
Less current portion
    2,073,375       -       2,073,375  
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 June 30, 2011, the restructuring reserve liability of $145,534 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.
 
 
13

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
The following table summarizes the activity in the restructuring reserve during the six months ended June 30, 2011 and 2010:
 
Restructuring Reserve   For the Six Months Ended June 30,  
   
2011
   
2010
 
Balance, beginning of period
  $ 181,119     $ 123,436  
Rent payments
    (100,298 )     (100,815 )
Sublease payment received
    64,713       56,478  
Balance, end of period
  $ 145,534     $ 79,099  
 
6.
REDEEMABLE CONVERTIBLE CUMULATIVE PREFERRED STOCK

Series A

As of June 30, 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 only 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 $997,244 and $985,994 at June 30, 2011 and December 31, 2010, respectively. During the six months ended June 30, 2011 no Series A preferred shares were converted into common stock.

Series B

As of June 30, 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 only 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 $1,977,501 and $1,936,801 at June 30, 2011 and December 31, 2010. During the six months ended June 30, 2011 no Series B preferred shares were converted into common stock.
 
 
14

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
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 June 30, 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 to a related party upon the cashless exercise of 2,080,000 options 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.

Issuances of the Company’s common stock during the three months ended June 30, 2011 included the following:

Shares Issued Upon Exercise of Warrants and Options

a)  
216,666 shares of common stock were issued upon exercise of warrants and options at an exercise price of $0.15 per share resulting in proceeds to the Company of $32,500.
b)  
2,122,833 shares of common stock were issued to a related party upon the cashless exercise of 3,997,000 options with exercise prices of between $0.15 and $0.30 per share based upon a market price of the Company’s common stock of $0.54 per share.
 
 
15

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
The Company recognized share-based compensation expense related to restricted stock grants, issued per the terms of the 2006 Equity Incentive Plan of $107,500 for the six months ended June 30, 2011. The following table summarizes non-vested restricted stock and the related activity for the six months ended June 30, 2011:
 
   
Shares
   
Weighted
 Average
 Grant-Date
 Fair-Value
 
Non-vested at January 1, 2011
    269,504     $ 0.89  
Granted
    ---     $ ---  
Vested
    153,225     $ 1.24  
Forfeited
    ---     $ ---  
Non-vested at June 30, 2011
    116,279     $ 0.43  
 
Total unrecognized share-based compensation expense from unvested restricted stock as of June 30, 2011 was $37,500 which is expected to be recognized over the next 1.5 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 78,672,423 as of June 30, 2011, are not included in the computation of net loss per common share for the six months ended June 30, 2011 because the effect of their inclusion would be anti-dilutive.  These common stock equivalents may dilute future earnings per share.

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 Six Months Ended
June 30,
 
   
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
 
 
 
16

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
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.
 
Stock-based compensation expense related to options and warrants for the six months ended June 30, 2011 was $3,743,048.   As of June 30, 2011 there was $4,049,967 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 24 months.
 
Activity in the Company’s options for the six month periods ended June 30, 2011 and 2010 were as follows:
 
Employee Fixed Plan            
   
For the Six Months Ended June 30, 2011
   
For the Six Months Ended June 30, 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       (448,667 )   $ 0.31  
                                 
Forfeited
    -     $ -       -     $ -  
                                 
Expired
    (2,847,376 )   $ 0.75       -     $ -  
                                 
Outstanding at end of period
    8,299,429     $ 0.50       11,020,069     $ 0.59  
                                 
Exercisable at end of period
    8,183,150     $ 0.50       10,845,650     $ 0.60  
                                 
Outstanding
                               
Weighted average remaining contractual term
            2.94               3.4  
Aggregate intrinsic value
          $ 654,236             $ 7,574,741  
Weighted average grant date fair value
            N/A               N/A  
                                 
Exercisable
                               
Weighted average remaining contractual term
            2.92               3.38  
Aggregate intrinsic value
          $ 652,957             $ 7,433,462  
 
 
17

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
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 Six Months Ended June 30, 2011
   
For the Six Months Ended June 30, 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       6,200,000     $ 0.99  
                                 
Exercised
    (4,701,239 )   $ 0.25       (850,423 )   $ 0.34  
                                 
Forfeited
    (750,000 )   $ 0.82       (202,020 )   $ 1.00  
                                 
Expired
    -     $ -       -     $ -  
                                 
Outstanding at end of period
    47,268,223     $ 0.55       38,262,971     $ 0.55  
                                 
Exercisable at end of period
    37,518,223     $ 0.53       27,214,082     $ 0.45  
                                 
Outstanding
                               
Weighted average remaining contractual term
            3.10               3.48  
Aggregate intrinsic value
          $ 4,237,909             $ 26,303,300  
Weighted average grant date fair value
          $ 0.33             $ 0.26  
                                 
Exercisable
                               
Weighted average remaining contractual term
            2.90               3.16  
Aggregate intrinsic value
          $ 3,860,409             $ 18,996,011  
 
18

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
On January 2, 2011, as part of a new employment contract the Company granted its founder and 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 performanced based 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 80 units to Hydrozonix  or on the second anniversary of the agreement.

On January 18, 2011, coinciding with the appointment of a new 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.

During the three months ended June 30, 2011, the Company issued 150,000 shares of common stock upon the exercise of options with an exercise price of $0.15 per share resulting in proceeds to the Company of $22,500.  In addition the Company issued 2,122,833 shares of common stock upon the cashless exercise of 3,997,000 options with exercise prices of between $0.15 and $0.30 per share based upon a market price of the Company’s common stock of $0.54 per share.
 
Non-Employee Fixed Non-Plan
                       
                         
   
For the Six Months Ended June 30, 2011
   
For the Six Months Ended June 30, 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       (193,548 )   $ 1.00  
                                 
Forfeited
    -     $ -       (806,452 )   $ 1.00  
                                 
Expired
    -     $ -       (300,000 )   $ 1.02  
                                 
Outstanding at end of period
    1,435,714     $ 0.53       2,503,714     $ 0.37  
                                 
Exercisable at end of period
    1,185,714     $ 0.51       2,488,832     $ 0.37  
                                 
Outstanding
                               
Weighted average remaining contractual term
            3.62               1.50  
Aggregate intrinsic value
          $ 78,286             $ 2,167,565  
Weighted average grant date fair value
          $ 0.50               N/A  
                                 
Exercisable
                               
Weighted average remaining contractual term
            3.42               1.49  
Aggregate intrinsic value
          $ 78,286             $ 2,149,112  
 
 
19

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
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.
 
Warrants

Activity in the Company’s warrants for the six month periods ended June 30, 2011 and 2010 were as follows:
 
Warrants
 
For the Six Months Ended June 30, 2011
   
For the Six Months Ended June 30, 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
    (1,509,466 )   $ 0.28       (10,226,771 )   $ 0.25  
                                 
Forfeited
    -     $ -       (2,508,734 )   $ 0.81  
                                 
Exchanged, net
    -     $ -       2,063,000     $ 0.67  
                                 
Expired
    (619,400 )   $ 0.52       (1,957,272 )   $ 1.10  
                                 
Outstanding at end of period
    18,211,337     $ 0.46       19,958,430     $ 0.46  
                                 
Exercisable at end of period
    18,211,337     $ 0.46       19,958,430     $ 0.46  
                                 
Outstanding and exercisable
                               
Weighted average remaining contractual term
            1.63               2.00  
Aggregate intrinsic value
          $ 3,007,563             $ 15,532,067  
 
 
 
20

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
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.

During the three months ended June 30, 2011, the Company issued 66,666 shares of common stock upon the exercise of warrants with an exercise price of $0.15 per share resulting in proceeds to the Company of $10,000. 

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.
 
 
21

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 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 June 30, 2011, the Company has a 52.6% ownership position in EES.
 
Presently, our operations consist of a manufacturing facility in Stuart, Florida operated within Ecosphere and our oil and gas services company operating out of Conway, Arkansas and Coalgate, Oklahoma which is processing water for two energy exploration companies in 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 six months ended June 30, 2011:
 
    Ecosphere Systems, Inc.     Ecosphere Envirobotic Solutions, Inc.    
Ecosphere
Energy
Services, Inc.
   
Ecosphere
Energy
Services LLC
   
Segment Totals
   
Corporate
   
Consolidated
Totals
 
                                           
Revenue from external customers
  $     $     $     $ 4,595,184     $ 4,595,184     $     $ 4,595,184  
Interest expense and amortization of debt discount
  $     $     $     $ (120,545 )   $ (120,545 )   $ (190,951 )   $ (311,496 )
                                                         
Change in fair value of liability for derivative instruments
  $     $     $     $     $     $ (23,888 )   $ (23,888 )
Depreciation and amortization
  $     $     $     $ (1,006,217 )   $ (1,006,217 )   $ (55,925 )   $ (1,062,142 )
Income tax expense
  $     $     $     $     $     $     $  
Net income (loss)
  $     $     $     $ 313,798     $ 313,798     $ (5,660,183 )   $ (5,346,385 )
                                                         
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $     $ 10,020,164     $ 10,911,363     $ 5,688,646     $ 16,600,009  
Fixed asset additions (disposals) (net)
  $     $     $     $ 139,603     $ 139,603     $ 399,604     $ 539,207  
Total Assets
  $     $     $     $ 7,098,484     $ 7,098,484     $ 5,927,414     $ 13,025,898  
 
 
22

 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
The table below presents certain financial information by business segment for the six months ended June 30, 2010:
 
   
Ecosphere
Systems,
Inc.
   
Ecosphere
Envirobotic
Solutions, Inc.
   
Ecosphere
Energy
Services, Inc.
   
Ecosphere Energy
Services LLC
   
Segment Totals
   
Corporate
   
Consolidated
Totals
 
                                           
Revenue from external customers
  $     $     $     $ 4,239,253     $ 4,239,253     $     $ 4,239,253  
Interest expense and amortization of debt discount
  $     $     $     $ (219,829 )   $ (219,829 )   $ (625,501 )   $ (845,330 )
Change in fair value of liability for derivative instruments
  $     $     $     $     $     $ (14,035,239 )   $ (14,035,239 )
Depreciation and amortization
  $ (57,128 )   $ (490 )   $     $ (829,640 )   $ (887,258 )   $ (35,087 )   $ (922,345 )
Income tax expense
  $     $     $     $     $     $     $  
Net income (loss)
  $ (57,128 )   $ (490 )   $     $ 192,710     $ 135,092     $ (18,582,410 )   $ (18,447,318 )
                                                         
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $     $ 8,505,844     $ 9,397,043     $ 2,655,813     $ 12,052,856  
Fixed asset additions (disposals) (net)
  $     $     $     $ 953,478     $ 953,478     $ 808,657     $ 1,762,135  
Total Assets
  $ 141,167     $ 578     $     $ 8,313,532     $ 8,455,277     $ 1,418,098     $ 9,873,375  
 
 
The table below presents certain financial information by business segment for the three months ended June 30, 2011:
 
    Ecosphere
Systems,
Inc.
    Ecosphere
Envirobotic
Solutions, Inc.
    Ecosphere Energy
Services, Inc.
    Ecosphere Energy
Services LLC
   
Segment Totals
    Corporate    
Consolidated
Totals
 
                                           
Revenue from external customers
  $     $     $     $ 2,367,543     $ 2,367,543     $     $ 2,367,543  
Interest expense and amortization of debt discount
  $     $     $     $ (57,077 )   $ (57,077 )   $ (132,007 )   $ (189,084 )
Change in fair value of liability for derivative instruments
  $     $     $     $     $     $ 174,873     $ 174,873  
Depreciation and amortization
  $     $     $     $ (504,310 )   $ (504,310 )   $ (29,787 )   $ (534,097 )
Income tax expense
  $     $     $     $     $     $     $  
Net income (loss)
  $     $     $     $ 285,786     $ 285,786     $ (1,860,521 )   $ (1,574,735 )
                                                         
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $     $ 10,020,164     $ 10,911,363     $ 5,688,646     $ 16,600,009  
Fixed asset additions (disposals) (net)
  $     $     $     $ 139,139     $ 139,139     $ 309,845     $ 448,984  
Total Assets
  $     $     $     $ 7,098,484     $ 7,098,484     $ 5,927,414     $ 13,025,898  
 
 
23

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
The table below presents certain financial information by business segment for the three months ended June 30, 2010:
 
    Ecosphere
Systems,
Inc.
    Ecosphere
Envirobotic
Solutions, Inc.
    Ecosphere
Energy
Services, Inc.
    Ecosphere
Energy
Services LLC
   
Segment Totals
   
Corporate
   
Consolidated
Totals
 
                                           
Revenue from external customers
  $     $     $     $ 2,138,386     $ 2,138,386     $     $ 2,138,386  
Interest expense and amortization of debt discount
  $     $     $     $ (100,391 )   $ (100,391 )   $ (227,003 )   $ (327,394 )
Change in fair value of liability for derivative instruments
  $     $     $     $     $     $ 7,009,612     $ 7,009,612  
Depreciation and amortization
  $ (28,564 )   $ (245 )   $     $ (432,028 )   $ (460,837 )   $ (18,312 )   $ (479,149 )
Income tax expense
  $     $     $     $     $     $     $  
Net income (loss)
  $ (28,564 )   $ (245 )   $     $ 83,315     $ 54,506     $ 4,666,580     $ 4,721,086  
                                                         
Segment fixed assets & construction in process
  $ 865,375     $ 25,824     $     $ 8,505,844     $ 9,397,043     $ 2,655,813     $ 12,052,856  
Fixed asset additions (disposals) (net)
  $     $     $     $ 56,236     $ 56,236     $ 638,090     $ 694,326  
Total Assets
  $ 141,167     $ 578     $     $ 8,313,532     $ 8,455,277     $ 1,418,098     $ 9,873,375  
 
 
24

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
12.
RELATED PARTY TRANSACTIONS
 
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 then 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.

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.

In May 2011, the Company issued 2,122,833 shares of common stock to its Chief Technology Officer upon the cashless exercise of 3,997,000 options with exercise prices of between $0.15 and $0.30 per share based upon a market price of the Company’s common stock of $0.54 per share.

During the six months ended June 30, 2011, the Company repaid $594,782 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 were taken in the Spring and Summer of 2011. 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.
 
 
25

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 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 six months ended June 30, 2011, EES reported net income of $313,798 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 six months ended June 30, 2011 and 2010:
 
Noncontrolling Interest in Consolidated Subsidiary
           
   
For the Six Months Ended June 30,
 
   
2011
   
2010
 
Balance, beginning of period
  $ 10,078,306     $ 10,606,583  
Contributions from noncontrolling members
    -       -  
Noncontrolling interest in (income) loss
    313,798       192,710  
Distributions to noncontrolling members
    -       -  
Balance, end of period
  $ 10,392,104     $ 10,799,293  
 
     In a side agreement to 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 Hydrozonix maintains its exclusivity, the EES minority members will receive a 5% royalty while the remaining royalties of 15% are distributed to the Company and the minority members in accordance with their percentage interests in EES.
 
 
26

 
 
ECOSPHERE TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2011
(UNAUDITED)
 
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 June 30, 2011.  As of June 30, 2011, the Company had $182,000 of cash equivalent balances held in a corporate checking account that were not insured.  The restricted cash balance of $323,125 was held in an escrow account.
 
At June 30, 2011, 91.5% of accounts receivable was from one customer and 8.5% was due from one other customer.

During the six months ended June 30, 2011, two customers accounted for 83% and 17% of revenues.

During the six months ended June 30, 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

In July 2011, the Company issued 150,000 shares of the Company’s common stock in exchange for $22,500 upon the exercise of options with an exercise price of $0.15 per share.

In July 2011, the Company granted directors five-year options to purchase 287,037 shares of the Company’s common stock at an exercise price of $0.54 per share in connection with the 2007 Incentive Compensation Plan (the Plan) as compensation for their board service for the coming year.  In accordance with the Plan, the Company also granted the directors 138,889 restricted shares of the Company’s common stock. The options  and restricted stock vest on June 30, 2012, subject to the continued service as a director. The value of the options, $75,384, calculated using the Black-Scholes option pricing model and the value of the restricted stock, $75,000, based upon the market value of the Company’s common stock on the date of the grant, will be recognized as expense over the one year vesting period.

 In July 2011, the Company granted advisory board members five-year options to purchase 92,595 shares of the Company’s common stock at an exercise price of $0.54 per share in connection with the 2007 Incentive Compensation Plan (the Plan) as compensation for their advisory board service for the coming year.  In accordance with the Plan, the Company also granted the advisory board members 46,295 restricted shares of the Company’s common stock. The options  and restricted stock vest on June 30, 2012, subject to the continued service as an advisory board member.  The value of the options, $24,318, calculated using the Black-Scholes option pricing model and the value of the restricted stock, $25,000, based upon the market value of the Company’s common stock on the date of the grant, will be recognized as expense over the one year vesting period.
 
 
27

 

ECOSPHERE TECHNOLOGIES INC. 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 water engineering, technology licensing 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 license our patented technologies are able to improve their financial metrics while also reducing their ecological and environmental footprint.
 
The Company’s Innovation Network business model is to 1. Create and design a water centric solution to a major water environmental problem, 2. File patents on the process 3. Partner with industry leaders 4.Commercialize the technology by having the partners pay for the services of the technology invented on an ongoing basis. 5. License the patented commercialized technologies to well capitalized partners to bring to market. 6. Create reoccurring revenues and shareholder value.
 
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 exploration 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 exploration companies removing chemical biocides on over 400 natural gas wells 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 by allowing then to recycle their flowback and produced waters.
 
Ecosphere’s patented Ozonix® technology has the ability to clean water without using liquid chemicals in a variety of industries.  While EES has an exclusive license for global energy applications, Ecosphere Technologies owns 100% of all other applications.  These industries include mining, municipal drinking and wastewater, industrial wastewater, food processing, agriculture and marine ballast water.  The bottled water market is also a potentially huge market to license the chemical free Ozonix® technology to the major bottled water companies.  The Company is actively seeking financial partners and licensees 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 EcosFrac 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 (a strategic alliance between the principals of Ely & Associates, Inc., Phillips and Jordan, Inc., and Siboney Contracting Company).  Highlights of the agreement include:
 
 
28

 
 
ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
 
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.  In May 2011, the Company and Hydrozonix agreed to a change order to modify the units being manufactured to increase the flow rate of the units.  In connection with the change in the order, the units under production are now EF 80 units and the parties agreed to an increase in the price of each unit to reflect the added components necessary to increase the flow rate to 80 barrels per minute.
 
 
Hydrozonix will have the exclusive license to use the Ecosphere Ozonix® technology for the onshore oil and gas exploration field of use in the United States.  In order to maintain their exclusivity, in subsequent future years  Hydrozonix must meet certain minimum equipment purchase quantities which averages at least eight per year.
  
Revenues for the three months ended June 30, 2011 increased by $229,157 or 10.7% over revenues for the three months ended June 30, 2010.  Gross profit increased $218,835 or 16.3% for the three months ended June 30, 2011 as compared to the same period in 2010.

Revenues for the six months ended June 30, 2011 increased by $355,931 or 8.7% over revenues for the six months ended June 30, 2010.  Gross profit increased $470,444 or 17.3% for the six months ended June 30, 2011 as compared to the same period in 2010.
 
The Company has completed manufacturing, assembly and has shipped the first EF 80 unit for Hydrozonix and has completed certain sub-assemblies of the second EF 80 unit.

The signing of the Agreement with Hydrozonix signals the success of the Company's Innovation Network business model to license technology and transition the operations of its 52.6% owned subsidiary, EES, from a product and services demonstration oil and gas services provider to a oil and gas technology licensing and manufacturing company.  The new model will result in revenues from the sale of equipment, plus ongoing technology licensing royalties based upon the profits generated by the equipment.  It is anticipated that this transition will result in higher revenues due to the sales of the equipment, but at a lower gross profit margin percentage. The revenues generated from the technology licensing royalty are expected to grow steadily as the number of units of equipment are delivered and begin allowing energy companies to recycle 100% of their flowback and produced waters without the use of chemical biocides and scale inhibitors for use in oil and natural gas hydraulic fracturing operations.
 
 In addition, we are negotiating the lease of the existing equipment owned by EES.  The revenue generated from leasing the equipment is expected to be lower than the revenues over the past two years from providing services to oil and gas exploration companies, however the operating costs associated with providing the services will be significantly reduced, resulting in potentially higher income from operations.

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.
 
 
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ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
Revenue Recognition
 
Revenue from sales of equipment and sublicense fee revenue 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.
 
 
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ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
Comparison of the Six Months ended June 30, 2011 with the Six Months Ended June 30, 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 Six Months Ended June 30,
             
               
Change
 
   
2011
   
2010
          $   %
 
 
 
   
 
   
 
         
Revenues
  $ 4,595,184     $ 4,239,253     $ 355,931       8 %
Cost of revenues
    1,424,257       1,538,770       (114,513 )     -7 %
Gross profit (loss)
    3,170,927       2,700,483       470,444       17 %
Operating expenses
                               
       Salaries and employee benefits
    5,412,635       3,490,345       1,922,290       55 %
       Administrative and selling
    646,703       936,198       (289,495 )     -31 %
       Professional fees
    826,399       448,787       377,612       84 %
       Depreciation and amortization
    1,062,142       922,345       139,797       15 %
       Research and development
    88,320       89,735       (1,415 )     -2 %
           Total selling general and administrative
    8,036,199       5,887,410       2,148,789       36 %
Loss from operations
    (4,865,272 )     (3,186,927 )     (1,678,345 )     53 %
Other income (expense):
                               
Other income (expense)
    433       242       191       -79 %
Gain (loss) on conversion
    -       (133,604 )     133,604       100 %
Gain (loss) on settlement
    (94,662 )     -       (94,662 )     -100 %
Interest expense
    (311,496 )     (845,330 )     533,834       63 %
        Change in fair value of derivative instruments
    (23,888 )     (14,035,239 )     14,011,351       58654 %
Total other income (expense)
    (429,613 )     (15,013,931 )     14,584,318       -97 %
Net loss
    (5,294,885 )     (18,200,858 )     12,905,973       71 %
Preferred stock dividends
    51,500       53,750       (2,250 )     4 %
Net (loss) applicable to Ecosphere Technologies, Inc. common stock
    (5,346,385 )     (18,254,608 )     12,908,223       71 %
Net (income) applicable to noncontrolling interest of consolidated subsidiary
    (313,798 )     (192,710 )     121,088       -39 %
Net loss applicable to Ecosphere Technologies, Inc. common stock
  $ (5,660,183 )   $ (18,447,318 )   $ 12,787,135       69 %
 
 
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ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
RESULTS OF OPERATIONS

Comparison of the Six Months Ended June 30, 2011 to the Six Months Ended June 30, 2010

The Company’s reported net loss applicable to Ecosphere Technologies, Inc. common stock was $5,660,183 during the six months ended June 30, 2011 as compared to a net loss applicable to common stock of $18,447,318 for the six months ended June 30, 2010.  The Company’s net loss for the six months ended June 30, 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 six months ended June 30, 2011, the market value of the Company’s common stock increased from $0.48 per share at December 31, 2010 to $0.54 per share at June 30, 2011 resulting in other expense of $23,888 related to the increase in the Company’s liability for warrant derivative instruments.    During the six months ended June 30, 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 June 30, 2010, resulting in other expense of $14,035,239 related to the increase in the Company’s derivative liability.  The larger impact realized during the six months ended June 30, 2010 was due to a significantly larger number of derivative instruments outstanding as of June 30, 2010 as compared to June 30, 2011. The derivative liability at June 30, 2010 was based on 16,911,486 warrants outstanding plus 1,828,703 shares related to embedded conversion options.  There were  1,640,417 warrants outstanding and no shares related to embedded conversion options as of June 30, 2011.

Revenues
 
Revenue increased $355,931 or 8.4%, to $4,595,184 for the six months ended June 30, 2011 compared to revenue of $4,239,253 for the six months ended June 30, 2010.
 
Revenue is generated through the design, development, and manufacture of wastewater treatment solutions for industrial markets.  Currently we are focused on the market surrounding the fracture of natural gas wells.  Actual revenue billings are derived from the treatment of water used in the process of fracturing natural gas wells, which includes both the pretreatment of water used to fracture such wells, and to a lesser extent, the treatment of frac flowback water produced by the fracturing process.  In addition, 7% of revenue for the six months ended June 30, 2010 included incremental income from pilot projects processing flowback water from various oil and gas exploration sources.
 
As discussed in Note 2 of the Condensed Consolidated Financial Statements, 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. onshore oil and gas exploration and production industries.  As part of the Agreement, Hydrozonix agreed to advance the direct costs and the manufacturing overhead for each EF 60 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 EF 60s and will receive its costs on a pass-through basis from EES.  Also, EES will pay ETI a manufacturing fee.  In May 2011, Hydrozonix approved a change order to increase the flow rate of the units being produced.  The new units will be called EF 80s as each unit will be capable of processing 80 barrels per minute as compared to the 60 barrels per minute of the EF 60s.  In addition, ETI will receive a profit distribution from EES relating to its ownership of EES which will be derived from the fees and royalty payments EES receives from Hydrozonix when the first two units are accepted and additional unit orders are placed.  Since the EF80 technology is based on the same Ozonix technology that EES’s customers have been paying for the past two years on over 400 wells treated EES believes the likelihood of Hydrozonix accepting the new EF80 units is good, however no assurance can be given that such acceptance will occur.

Upon the anticipated acceptance of the first two EF 80 units, the Company will recognize $5.5 million in revenue from the sale of the units ($4.3 million of which has been advanced to the Company in the form of a customer deposit used to fund the building of the units) and believes it will receive future royalty payments based upon the operating profits of the units.  However, no assurance can be provided that the required financial operating parameters will be achieved thus resulting in royalty revenue pursuant to the terms of the Agreement.  As previously discussed, we anticipate that the revenue from pretreating water for oil and gas exploration companies will decline as we transition to a licensing business model.
 
One of our significant customers (who accounted for 87% of revenue in the current quarter) notified us they would like to use the new EF 80s in place of the existing EF10s on their frac sites going forward.  This customer was very instrumental in driving the design and development of the new EF 80 for better utilization and more wells completed per month with the higher flow rate and better utilization design.  The customer has notified EES that it will comply with the current arrangement and agreed upon two year contract to full term but will not renew a new contract strictly with the EF 10s and has expressed an interest in renegotiating with our new Hydrozonix licensee for the deployment of the EF 80s on frac sites and EF10s on produced water sites.  This customer is expected to be a Hydrozonix customer after Hydrozonix accepts the EF 80s.  The customer has provided for the test site.  One-half of the units will be removed in November 2011 and the balance in January 2012.  We are pursuing an agreement to lease the two EF 10 fleets currently in operation to Hydrozonix.  If we are able to complete the leasing arrangement, our revenue and the associated operating expenses will decline accordingly.  If we are unable to complete a leasing transaction for the EF 10s, the decline in revenue will be greater.
 
 
 
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ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
Cost of Revenues
 
Cost of revenues amounted to $1,424,257 for the six months ended June 30, 2011 as compared to $1,538,770 for the six months ended June 30, 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 31% for the six months ended June 30, 2011 as compared to 36.3% for the Six months ended June 30, 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 six months ended June 30, 2011 were $8,036,199 compared to $5,887,410 for the six months ended June 30, 2010.  This increase resulted  (1) from an increase in salaries and employee benefits of $1.9 million which resulted from an increase in non-cash employee option expense of $1.9 million resulting from new executive options granted in December 2010 and January 2011;  (2) an increase of $378,000 in professional fees of which $249,000 related to one-time legal expenses relating to the preparation of the definitive Hydrozonix agreement, and an increase of $11,000 in other legal expenses, $97,000 of non-cash expense related to options granted to legal counsel and a $21,000 increase is accounting and auditing fees; and (3) an increase of 140,000 in depreciation expense due to an increase in the amount of equipment used in operations.  These increases were partially offset by a decrease of $289,000 in Administrative and Selling expenses due to decrease in travel expenses of $147,000 which decreased because there were no pilot projects during the six months ended June 30, 2011 and because there were fewer corporate, engineering and manufacturing personnel needed onsite to support field operations.  In addition, facilities and administrative expense declined $120,000 due to the elimination of temporary executive offices in Texas and marketing expense declined $19,000 as we began to transition EES to a licensing business model.

Loss From Operations
 
Loss from operations for the six months ended June 30, 2011 was $4,865,272 compared to a loss of $3,186,927 for the six months ended June 30, 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 of $4,709,739 which  included stock based compensation of $3,645,597 and  depreciation and amortization of $1,062,142.
 
Interest Expense
 
Interest expense was $311,496 and $845,330 for the six months ended June 30, 2011 and 2010, respectively. The decline in 2011 is the result of a decrease in the average debt outstanding during the six months ended June 30, 2011versus the six months ended June 30, 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 six months ended June 30, 2011 included $118,607 related to the accretion of discounts while interest expense for the six months ended June 30, 2010 included $143,138 related to the accretion of note discounts and $395,574 of note discount recognized upon the conversion of the notes.
 
Preferred Stock Dividends
 
Preferred stock dividends were $51,500 for the six months ended June 30, 2011 and $53,750 for the six months ended June 30, 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 $607,490 as of June 30, 2011 using the Black-Scholes option pricing model.  As such, the Company recognized other expense of $23,888 for the six months ended June 30, 2011, representing the increase in the fair value of the derivative liability at June 30, 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 $0.54 per share at June 30, 2011.
 
 
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ECOSPHERE TECHNOLOGIES INC. AND SUBSIDIARIES
 
The Company estimated the fair value of these liabilities to be $1,858,215 as of June 30, 2010 using the Black-Scholes option pricing model.  As a result, the Company recognized other expense of $14,035,239 for the six months ended June 30, 2010, representing the increase in the fair value of these liabilities.
 
If the Company’s common stock price at September 30, 2011 is higher than the $0.54 per share June 30, 2011 closing price, the Company may record a non-cash charge which may be material.  Conversely, if the Company’s common stock price at September 30, 2011 is lower than the June 30, 2011 closing price of $0.54, 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 $5,660,183 for the six months ended June 30, 2011, compared to a net loss applicable to common stock of $18,447,318 for the six months ended June 30, 2010.  Net loss per share of common stock was $0.04 basic and diluted for the six months ended June 30, 2011 and the net loss per share of common stock was $0.15 basic and diluted for the Six months ended June 30, 2010.  Basic and diluted weighted average shares outstanding were 142,577,732 and 124,907,969 for the six months ended June 30, 2011 and 2010.
 
Comparison of the Three Months ended June 30, 2011 with the Three Months Ended June 30, 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 June 30,
             
               
Change
 
   
2011
   
2010
          $   %
 
 
 
   
 
   
 
         
Revenues
  $ 2,367,543     $ 2,138,386     $ 229,157       11 %
Cost of revenues
    802,558       792,236       10,322       1 %
Gross profit (loss)
    1,564,985       1,346,150       218,835       16 %
Operating expenses
                               
       Salaries and employee benefits
    1,926,535       1,756,669       169,866       10 %
       Administrative and selling
    317,046       502,778       (185,732 )     -37 %
       Professional fees
    264,506       280,417       (15,911 )     -6 %
       Depreciation and amortization
    534,097       479,149       54,948       11 %
       Research and development
    57,865       63,351       (5,486 )     -9 %
           Total selling general and administrative
    3,100,049       3,082,364       17,685       1 %
Loss from operations
    (1,535,064 )     (1,736,214 )     201,150       -12 %
Other income (expense):
                               
Other income (expense)
    290       153       137       -90 %
Gain (loss) on conversion
    -       (115,505 )     115,505       100 %
Interest expense
    (189,084 )     (327,394 )     138,310       42 %