U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
OR
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
For the transition period from __________ to __________.
 
For the period ended September 30, 2007
 
Commission file number 001-31972
 
TELKONET, INC.

(Exact name of Issuer as specified in its charter)
 
 Utah
 87-0627421
 (State of Incorporation)
 (IRS Employer Identification No.)
 
20374 Seneca Meadows Parkway, Germantown, MD 20876
(Address of Principal Executive Offices)
 
(240) 912-1800
Issuer's Telephone Number
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 x  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, and accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act, (check one).
 
Large Accelerated Filer  o
   Accelerated Filer  x
  Non-Accelerated Filer  o
 
Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act.  o Yes   x No
 
Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 67,786,342 shares of Common Stock ($.001 par value) as of November 1, 2007.




TELKONET, INC.
FORM 10-Q for the Quarter Ended September 30, 2007
 
Index
 
 
Page 
PART I. FINANCIAL INFORMATION
 
 
 
Item 1. Financial Statements (Unaudited)
 
 
 
Condensed Consolidated Balance Sheets:
2
September 30, 2007 and December 31, 2006
 
 
 
Condensed Consolidated Statements of Operations:
 3
Three and Nine months Ended September 30, 2007 and 2006
 
 
 
Condensed Consolidated Statement of Stockholders’ Equity
 4
January 1, 2007 through September 30, 2007
 
 
 
Condensed Consolidated Statements of Cash Flows:
 5
Nine months Ended September 30, 2007 and 2006
 
 
 
Notes to Unaudited Condensed Consolidated Financial Statements:
 7
September 30, 2007
 
 
 
Item 2. Management’s Discussion and Analysis
 32
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 46
 
 
Item 4. Controls and Procedures
 46
 
 
PART II. OTHER INFORMATION
 47
 
 
Item 1. Legal Proceedings
 47
 
 
Item 1A. Risk Factors
 47
 
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 48
 
 
Item 3. Defaults Upon Senior Securities
 48
 
 
Item 4. Submission of Matters to a Vote of Security Holders
 48
 
 
Item 5. Other Information
 48
 
 
Item 6. Exhibits
 48
 



TELKONET, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
 
(Unaudited)
September 30, 2007
   
December 31,
2006
 
ASSETS
 
 
   
 
 
Current Assets:
 
 
   
 
 
Cash and cash equivalents
  $
1,582,586
    $
1,644,037
 
Accounts Receivable: net of allowance for doubtful accounts of $207,000 and $60,000 at September 30, 2007 and December 31, 2006, respectively
   
2,616,205
     
295,116
 
Income tax receivable
   
291,000
     
291,000
 
Note receivable
   
17,876
     
-
 
Inventories
   
2,125,082
     
1,306,593
 
Deposits - Inventory     379,281       -  
Other
   
585,239
     
229,333
 
Total current assets
   
7,597,269
     
3,766,079
 
 
               
Property and Equipment:
               
Furniture and equipment, at cost
   
1,616,058
     
1,370,780
 
Less: accumulated depreciation
   
741,856
     
577,759
 
Total property and equipment, net
   
874,202
     
793,021
 
 
               
Cable Equipment, Installation and Equipment under Operating Leases:
               
Capitalized equipment, at cost
   
5,773,229
     
4,026,255
 
Less: accumulated depreciation
   
1,130,731
     
568,721
 
Total cable equipment, installation and equipment under operating leases, net
   
4,642,498
     
3,457,534
 
 
               
Other Assets:
               
Long-term investments
   
193,847
     
193,847
 
Intangible assets, net of accumulated amortization of $693,229 and $282,325 at September 30, 2007 and December 31, 2006, respectively
   
6,552,591
     
2,181,602
 
Financing costs, net of accumulated amortization of $101,663
   
764,151
     
-
 
Goodwill
   
16,877,978
     
1,977,768
 
Note receivable
   
17,974
      -  
Deposits and other
   
154,357
     
146,665
 
Total other assets
   
24,560,898
     
4,499,882
 
Total Assets
  $
37,674,867
    $
12,516,516
 
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities:
               
Accounts payable and accrued liabilities
  $
4,850,231
    $
2,859,863
 
Notes payable - officer
   
-
     
80,444
 
Income tax refund due to officer
   
291,000
     
291,000
 
Deferred revenue
   
218,076
     
160,125
 
Senior note payable, net of discount for warrant feature of $125,058
   
1,374,942
     
-
 
Registration Rights Liability of subsidiary
   
500,000
     
-
 
Note payable under subsidiary acquisition
   
-
     
900,000
 
Customer deposits and other
   
195,241
     
5,281
 
Total current liabilities
   
7,429,490
     
4,296,713
 
 
               
Long Term Liabilities:
               
Deferred Revenue
   
13,903
     
42,019
 
Deferred lease liability & other
   
61,841
     
42,561
 
Convertible debentures, net
   
4,605,920
     
-
 
Total long term liabilities
   
4,681,664
     
84,580
 
                 
Total Liabilities
   
12,111,154
     
4,381,293
 
 
               
Commitments and Contingencies
               
Minority Interest
   
3,783,829
     
-
 
 
               
Stockholders’ Equity :
               
Preferred stock, par value $.001 per share; 15,000,000 shares authorized;
none issued and outstanding at September 30, 2007 and December 31, 2006
   
-
     
-
 
Common stock, par value $.001 per share; 100,000,000 shares authorized;
67,736,342 and 56,992,301 shares issued and outstanding at September 30,
2007 and December 31, 2006, respectively
   
67,736
     
56,992
 
Additional paid-in-capital
   
107,078,791
     
78,502,900
 
Accumulated deficit
    (85,366,643 )     (70,424,669 )
Stockholders’ equity
   
21,779,884
     
8,135,223
 
Total Liabilities And Stockholders’ Equity
  $
37,674,867
    $
12,516,516
 
 
See accompanying footnotes to the unaudited condensed consolidated financial information 

2


TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

 
 
For The Three months Ended
September 30,
   
For The Nine months Ended
September 30,
 
 
 
2007
   
2006
   
2007
   
2006
 
Revenues, net:
                       
Product
  $
3,005,144
    $
585,535
    $
6,269,079
    $
2,697,424
 
Rental
   
1,583,633
     
557,562
     
3,232,574
     
1,542,056
 
Total Revenue
   
4,588,777
     
1,143,097
     
9,501,653
     
4,239,480
 
 
                               
Cost of Sales:
                               
Product
   
2,139,034
     
345,244
     
4,503,983
     
2,349,056
 
Rental
   
1,229,985
     
714,804
     
3,177,386
     
1,019,404
 
Total Cost of Sales
   
3,369,019
     
1,060,048
     
7,681,369
     
3,368,460
 
 
                               
Gross Profit
   
1,219,758
     
83,049
     
1,820,284
     
871,020
 
 
                               
Costs and Expenses:
                               
Research and Development
   
646,848
     
447,092
     
1,736,656
     
1,411,791
 
Selling, General and Administrative
   
4,553,161
     
3,551,569
     
13,057,979
     
10,390,864
 
Impairment write-down in investment in affiliate
   
-
     
-
     
-
     
38,000
 
Non-Employee Stock Based Compensation
   
400,220
     
-
     
400,220
     
277,344
 
Employee Stock Based Compensation
   
425,800
     
230,991
     
1,115,867
     
815,809
 
Depreciation and Amortization
   
275,611
     
141,548
     
638,131
     
412,267
 
Total Operating Expense
   
6,301,640
     
4,371,200
     
16,948,853
     
13,346,075
 
 
                               
Loss from Operations
    (5,081,882 )     (4,288,151 )     (15,128,569 )     (12,475,055 )
 
                               
Other Income (Expenses):
                               
Loss on early extinguishment of debt
   
-
      (4,626,679 )    
-
      (4,626,679 )
Registration rights liquidated damages of subsidiary
    (500,000 )    
-
      (500,000 )    
-
 
Interest Income
   
37,883
     
106,074
     
110,343
     
294,614
 
Interest Expense
    (328,611 )     (1,665,030 )     (529,168 )     (5,515,378 )
Total Other Income (Expenses)
    (790,728 )     (6,185,635 )     (918,825 )    
(9,847,443
 
 
                               
Loss Before Provision for Income Taxes
    (5,872,610 )     (10,473,786 )     (16,047,394 )     (22,322,498 )
Provision for Income Taxes
   
-
     
-
     
-
     
-
 
 
                               
Loss Before Minority Interest
    (5,872,610 )     (10,473,786 )     (16,047,394 )     (22,322,498 )
Minority Interest
   
916,980
     
-
     
1,105,420
     
19,569
 
Net Loss
  $ (4,955,630 )   $ (10,473,786 )   $ (14,941,974 )   $ (22,302,929 )
 
                               
Loss per common share (basic and assuming dilution)
  $ (0.07 )   $ (0.20 )   $ (0.23 )   $ (0.46 )
 
                               
Weighted average common shares outstanding
   
67,520,571
     
52,602,757
     
64,324,325
     
48,784,948
 
 
See accompanying footnotes to the unaudited condensed consolidated financial information


3


TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (UNAUDITED)
FOR THE PERIOD FROM JANUARY 1, 2007 THROUGH SEPTEMBER 30, 2007

 
 
Preferred Shares
   
Preferred Stock Amount
   
Common Shares
   
Common Stock Amount
   
Additional Paid in Capital
   
Accumulated Deficit
   
Total
 
Balance at January 1, 2007
   
-
     
-
     
56,992,301
    $
56,992
    $
78,502,900
    $ (70,424,669 )   $
8,135,223
 
 
                                                       
Shares issued for employee stock options exercised at approximately $1.05 per share
   
-
     
-
     
118,500
     
119
     
124,342
             
124,460
 
 
                                                       
Shares issued in exchange for services rendered at approximately $2.63 per share
   
-
     
-
     
21,803
     
22
     
57,320
             
57,342
 
 
                                                       
Issuance of shares for purchase of subsidiary
   
-
     
-
     
2,227,273
     
2,227
     
5,997,773
             
6,000,000
 
 
                                                       
Issuance of shares for purchase of subsidiary
   
-
     
-
     
3,459,609
     
3,460
     
9,752,637
             
9,756,097
 
 
                                                       
Shares Issued in connection with Private Placement
   
-
     
-
     
4,000,000
     
4,000
     
9,606,000
             
9,610,000
 
 
                                                       
Issuance of shares for acquisition by subsidiary
                   
866,856
     
867
     
1,529,133
             
1,530,000
 
                                                         
Shares issued in exchange for services at $1.68 per share
                   
50,000
     
50
     
83,950
             
84,000
 
                                                         
Value of additional warrants issued in conjunction with exchange of convertible debentures
   
-
     
-
     
-
     
-
     
132,949
             
132,949
 
 
                                                       
Debt discount attributable to warrants attached to Note
                   
-
     
-
     
195,924
             
195,924
 
                                                         
Stock-based compensation expense related to employee stock options
   
-
     
-
     
-
     
-
     
941,900
             
941,900
 
 
                                                       
Stock-based compensation related to Stock option expenses accrued in prior period
   
-
     
-
     
-
     
-
     
153,963
             
153,963
 
 
                                                       
Net Loss
   
-
     
-
                                    (14,941,974 )     (14,941,974 )
 
                                                       
Balance at September 30, 2007
   
-
    $
-
     
67,736,342
   
67,736
   
107,078,791
    (85,366,643 )  
21,779,884
 
 
See accompanying footnotes to the unaudited condensed consolidated financial information

4

TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
For The Nine months
Ended September 30,
 
 
 
2007
   
2006
 
Cash Flows from Operating Activities:
           
Net loss
  $ (14,941,974 )   $ (22,302,929 )
Adjustments to reconcile net loss from operations to cash used in operating activities
               
Minority interest
    (1,105,420 )     (19,569 )
Amortization and write-off of financing costs in connection with conversion of convertible debentures
   
-
     
1,145,911
 
Amortization of financing costs
   
101,663
     
-
 
Write-off of fixed assets in conjunction with loss on sublease
   
64,608
     
-
 
Registration rights liquidated damages of subsidiary
   
500,000
     
-
 
Warrants issued for interest expense
   
319,495
         
Warrants issued with conversion of convertible debentures
   
-
     
2,921,023
 
Common stock issued in exchange for and penalty in connection with early extinguishment of debt
   
-
     
1,982,078
 
Common stock issued in exchange for interest expense
   
-
     
23,951
 
Amortization of debt discount
   
175,450
     
-
 
Amortization and write-off of debt discount - beneficial conversion feature of convertible debentures
   
-
     
1,390,137
 
Amortization and write-off of debt discount - value of warrants attached to convertible debentures
   
-
     
2,743,342
 
Stock options and warrants issued in exchange for services rendered
   
1,115,867
     
1,093,153
 
Common stock issued in exchange for services rendered
   
308,342
     
203,027
 
Impairment write-down in investment in Amperion
   
-
     
38,000
 
Depreciation, including depreciation of equipment under operating leases
   
1,181,149
     
699,268
 
Increase / decrease in:
               
Accounts receivable
    (1,573,744 )     (327,325 )
Inventory
   
474,432
     
172,041
 
Prepaid expenses and deposits
    (713,831 )     (425,359 )
Customer deposits and other
   
129,368
      (72,662 )
Accounts payable and accrued expenses
   
1,480,144
      (217,001 )
Deferred revenue
    (115,927 )    
87,467
 
Deferred lease liability and other
   
9,114
     
245
 
Net Cash (Used in) Operating Activities
    (12,591,264 )     (10,014,484 )
 
               
Cash Flows from Investing Activities:
               
Costs of cable equipment, installation and equipment under operating leases
    (1,162,832 )     (1,576,980 )
Proceeds from sale of equipment under operating lease
   
-
     
350,571
 
Released funds from Restricted Certificate of Deposit
   
-
     
10,000,000
 
Investment in Newport
    (1,020,000 )    
-
 
Payment of note payable and investment in subsidiary
    (900,000 )     (1,017,822 )
Net cash acquired from MST
   
-
     
59,384
 
Investment in subsidiaries
    (3,150,557 )    
-
 
Investment in affiliate
   
-
      (44 )
Purchase of property and equipment, net
    (266,280 )     (708,598 )
Net Cash Provided by (Used in) Investing Activities
    (6,499,669 )     7,106,511  
 
               
Cash Flows from Financing Activities:
               
Proceeds from sale of common stock, net of costs
   
9,610,000
     
6,000,000
 
Proceeds from the issuance of senior note payable
   
1,500,000
     
-
 
Proceeds from subsidiaries’ sale of common stock, net of costs
   
2,694,020
     
-
 
Proceeds from the issuance of convertible debentures, net of costs and fees
   
5,303,238
     
-
 
Repayment of convertible debentures
   
-
      (7,750,000 )
Repayment of senior notes
   
-
      (100,000 )
Proceeds from exercise of stock options and warrants
   
124,460
     
2,371,300
 
Repayment of subsidiary loans
    (202,236 )     (412,119 )
Net Cash Provided by Financing Activities
   
19,029,482
     
109,181
 
 
               
Net (Decrease) in Cash and Cash Equivalents
    (61,451 )     (2,798,792 )
 
               
Cash and cash equivalents at the beginning of the period
   
1,644,037
     
8,422,079
 
 
               
Cash and cash equivalents at the end of the period
  $
1,582,586
    $
5,623,287
 
See accompanying footnotes to the unaudited condensed consolidated financial information
5


TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
 
 
For The Nine months
Ended September 30,
 
 
 
2007
   
2006
 
Supplemental Disclosures of Cash Flow Information
           
Cash paid during the period for interest
  $
3,995
    $
1,014,797
 
Income taxes paid
   
-
     
-
 
                 
Non-cash transactions:
               
Note payable under subsidiary acquisition
   
-
     
900,000
 
Common stock issued in exchange for convertible debentures
   
-
     
12,250,000
 
Common stock issued in exchange for interest expense and penalty in connection with early extinguishment of debt
   
-
     
2,006,029
 
Registration rights liquidated damages of subsidiary
   
500,000
     
-
 
Issuance of shares for purchase of subsidiary
   
17,286,097
     
2,700,000
 
Employee stock-based compensation
   
1,095,863
     
815,809
 
Issuance of stock options and warrants in exchange for services rendered
   
-
     
277,344
 
Common stock issued for services rendered
   
141,342
     
203,026
 
Value of stock options issued for accrued expenses     153,963       -  
                 
Acquisition of subsidiaries (Note B):
               
Assets acquired
   
3,052,880
     
1,656,673
 
Subscriber lists
   
4,781,893
     
2,463,927
 
Goodwill (including purchase price contingency)
   
15,096,922
     
6,477,767
 
Minority Interest
   
-
      (19,569 )
Liabilities assumed
    (1,356,415 )     (1,460,976 )
Common stock issued
    (17,286,097 )     (2,700,000 )
Notes payable issued
   
-
      (900,000 )
Purchase price contingency
   
-
      (4,500,000 )
Direct acquisition costs
    (394,183 )     (117,822 )
Cash paid for acquisition
  (3,895,000 )   (900,000 )
 
See accompanying footnotes to the unaudited condensed consolidated financial information

6

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)


NOTE A - SUMMARY OF ACCOUNTING POLICIES

General
 
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
 
In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Accordingly, the results from operations for the three and nine-month period ended September 30, 2007, are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 2006 financial statements and footnotes thereto included in the Company's Form 10-K for the year ended December 31, 2006.

Basis of Presentation
 
Telkonet, Inc. (the "Company"), formerly Comstock Coal Company, Inc., was formed on November 3, 1999 under the laws of the state of Utah. The Company was a “development stage enterprise” (as defined by Statement of Financial Accounting Standards No. 7) until December 31, 2003. The Company is engaged in the business of developing, producing and marketing proprietary equipment enabling the transmission of voice and data over electric utility lines.

In January 2006, following the acquisition of Microwave Satellite Technologies (MST) (Note B), the Company began offering complete sales, installation, and service of VSAT and business television networks, and became a full-service national Internet Service Provider (ISP). The MST solution offers a complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision Broadband  Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.

In March 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada.

In March 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition will enable Telkonet to provide installation and support for PLC products and third party applications to customers across North America.

In May 2007, Microwave Acquisition Corp., a newly formed, wholly-owned subsidiary of MSTI Holdings Inc. (formerly Fitness Xpress-Software Inc.) merged with MST. As a result of the merger, the Company’s common stock in MST was exchanged for shares of common stock of MSTI Holdings Inc. Immediately following the merger, MSTI Holdings Inc. completed a private placement of its common stock for aggregate gross proceeds of $3,078,716 and sold senior convertible debentures in the aggregate principal amount of $6,050,000 (plus an 8% original issue discount added to such principal amount). As a result of these transactions, the Company’s 90% interest in MST became a 63% interest in MSTI Holdings Inc.

In July 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership. Pursuant to the terms of the acquisition, the total consideration paid was $2,550,000, consisting of unregistered shares of the Company’s common stock, equal to $1,530,000, and (ii) $1,020,000 in cash, subject to adjustments. The total consideration will be increased or decreased depending on the number of subscriber accounts acquired in the acquisition that were in good standing at that time.


7

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Telkonet Communications, Inc. and Ethostream, LLC and 63%-owned subsidiary MSTI Holdings Inc. (reported as the Company’s MST segment). Significant intercompany transactions have been eliminated in consolidation.

Investments in entities over which the Company has significant influence, typically those entities that are 20 to 50 percent owned by the Company, are accounted for using the equity method of accounting, whereby the investment is carried at cost of acquisition, plus the Company’s equity in undistributed earnings or losses since acquisition.

Reclassification
 
Certain reclassifications have been made to conform prior periods’ data to the current presentation. These reclassifications had no effect on reported losses.
 
Concentrations of Credit Risk
 
Financial instruments and related items, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents. The Company places its cash and temporary cash investments with credit quality institutions. At times, such investments may be in excess of the FDIC insurance limit. The Company periodically reviews its trade receivables in determining its allowance for doubtful accounts. The allowance for doubtful accounts was $207,000 and $60,000 at September 30, 2007 and December 31, 2006, respectively.

Liquidity
 
As shown in the accompanying consolidated financial statements, the Company incurred net loss of $14,941,974 and $22,302,929 for the nine months ended September 30, 2007 and 2006, respectively. Net loss included $1,161,216 and $5,304,765 of non-cash expense in connection with the convertible debentures, $0 and $4,626,769 of non-cash expense in connection with the early extinguishment of debt, and $1,516,087 and $1,093,153 of non-cash compensation to employees and non-employees in connection with stock options granted and vested for the nine months ended September 30, 2007 and 2006, respectively. The Company's current assets, on a consolidated basis, exceeded its current liabilities by $167,779 as of September 30, 2007.
 
Revenue Recognition
 
For revenue from product sales, the Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB104”), which superceded Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB101”). SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectibility of those amounts. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The Company defers any revenue for which the product has not been delivered or is subject to refund until such time that the Company and the customer jointly determine that the product has been delivered or no refund will be required. SAB 104 incorporates Emerging Issues Task Force 00-21 (“EITF 00-21”), Multiple-Deliverable Revenue Arrangements. EITF 00-21 addresses accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.
 
 
8

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

For equipment under lease, revenue is recognized over the lease term for operating lease and rental contracts. All of the Company’s leases are accounted for as operating leases. At the inception of the lease, no lease revenue is recognized and the leased equipment and installation costs are capitalized and appear on the balance sheet as “Equipment Under Operating Leases.” The capitalized cost of this equipment is depreciated from two to three years, on a straight-line basis down to the Company’s original estimate of the projected value of the equipment at the end of the scheduled lease term. Monthly lease payments are recognized as rental income. For sales-type leases, we record the discounted present values of minimum rental payments under sales-type leases as sales. 

MST accounts for the revenue, costs and expense related to residential cable services as the related services are performed in accordance with SFAS No. 51, Financial Reporting by Cable Television Companies. Installation revenue for residential cable services is recognized to the extent of direct selling costs incurred. Direct selling costs have exceeded installation revenue in all reported periods. Generally, credit risk is managed by disconnecting services to customers who are delinquent. The capitalized cost of this equipment is depreciated from three to ten years, on a straight-line basis down to the Company’s original estimate of the projected value of the equipment at the end of the scheduled lease term and appears on the balance sheet in “Equipment Under Operating Leases.”.

Management identifies a delinquent customer based upon the delinquent payment status of an outstanding invoice, generally greater than 30 days past due date.  The delinquent account designation does not trigger an accounting transaction until such time the account is deemed uncollectible. Accounts are deemed uncollectible on a case-by-case basis, at management’s discretion based upon an examination of the communication with the delinquent customer and payment history.  Typically, accounts are only escalated to “uncollectible” status after multiple attempts have been made to communicate with the customer.

Guarantees and Product Warranties

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.

The Company’s guarantees were issued subject to the recognition and disclosure requirements of FIN 45 as of September 30, 2007 and December 31, 2006. The Company records a liability for potential warranty claims. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made. During the nine months ended September 30, 2007 and the year ended December 31, 2006, the Company experienced approximately three percent of units returned under its product warranty policy. As of September 30, 2007 and December 31, 2006, the Company recorded warranty liabilities in the amount of $58,817 and $47,300, respectively, using this experience factor.

Registration Payment Arrangements

The Company accounts for registration payment arrangements under Financial Accounting Standards board (FASB) Staff Position EITF 00-19-2, “Accounting for Registration Payment Arrangements” (FSP EITF 00-19-2). FSP EITF 00-19-2 specifies that the contingent obligation to make future payments under a registration payment arrangement should be separately recognized and measured in accordance with SFAS No. 5, Accounting for Contingencies. FSP EITF 00-19-2 was issued in December, 2006.  As of September 30, 2007, the Company had accrued an estimated penalty (see Note E).

New Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits entities to choose to measure many financial instruments, and certain other items, at fair value. SFAS 159 applies to reporting periods beginning after November 15, 2007. The adoption of SFAS 159 is not expected to have a material impact on the Company’s financial condition or results of operations.


9

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

NOTE B - ACQUISITION OF SUBSIDIARY
 
Acquisition of Microwave Technologies, Inc .

On January 31, 2006, the Company acquired a 90% interest in Microwave Satellite Technologies, Inc. (“MST”) from Frank Matarazzo, the sole stockholder of MST, in exchange for $1.8 million in cash and 1.6 million unregistered shares of the Company’s common stock for an aggregate purchase price of $9,000,000. The purchase price of $9,000,000 was increased by $117,822 for direct costs related to the acquisition. These direct costs included legal, accounting and other professional fees. The cash portion of the purchase price was payable in two installments, $900,000 at closing and $900,000 payable in January 2007. The stock portion is payable from shares held in escrow, 400,000 shares at closing and the remaining 1,200,000 “purchase price contingency” shares issued based on the achievement of 3,300 “Triple Play” subscribers over a three year period. During the quarter ended September 30, 2006, the Company issued 200,000 shares of the purchase price contingency valued at $900,000 as an adjustment to Goodwill.
 
The purchase price contingency shares are price protected for the benefit of the former owner of MST. In the event the Company’s common stock price is less than $4.50 per share upon issuance of the shares from escrow, a pro rata adjustment in the number of shares will be required to support the aggregate consideration of $5.4 million. The price protection provision provides a cash benefit to the former owner of MST if the as-defined market price of the Company’s common stock is less than $4.50 per share at the time of issuance from the escrow. The issuance of additional shares or distribution of other consideration upon resolution of the contingency based on the Company’s common stock prices will not affect the cost of the acquisition. When the contingency is resolved or settled, and additional consideration is distributable, the Company will record the current fair value of the additional consideration and the amount previously recorded for the common stock issued will be simultaneously reduced to the lower current value of the Company’s common stock.
 
MST is a communications technology company that offers complete sales, installation, and service of Very Small Aperture Terminal (VSAT) and business television networks, and is a full-service national Internet Service Provider (ISP).  Management believes that the MST acquisition will enable Telkonet to provide a complete “Quad-play” solution to subscribers of HDTV, VoIP telephony, NuVision Broadband  Internet access and wireless fidelity (“Wi-Fi”) access, to commercial multi-dwelling units and hotels.

The acquisition of MST was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the average price of the Company's common stock for several days before and after the acquisition of MST. The results of operations for MST have been included in the Consolidated Statements of Operations since the date of acquisition. The components of the purchase price were as follows:
 
 
 
As Reported
   
Including
Purchase Price Contingency
(*)
 
Common stock
  $
2,700,000
    $
7,200,000
 
Cash (including note payable)
   
1,800,000
     
1,800,000
 
Direct acquisition costs
   
117,822
     
117,822
 
Purchase price
   
4,617,822
     
9,117,822
 
Minority interest
   
19,569
     
19,569
 
Total
  $
4,637,391
    $
9,137,391
 
 
 
10

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:
 
 
 
As Reported
   
Including
Purchase Price
Contingency
(*)
 
Cash and other current assets
  $
346,548
    $
346,548
 
Equipment and other assets
   
1,310,125
     
1,310,125
 
Subscriber lists
   
2,463,927
     
2,463,927
 
Goodwill and other intangible assets
   
1,977,767
     
6,477,767
 
Subtotal
   
6,098,367
     
10,598,367
 
Current liabilities
   
1,460,976
     
1,460,976
 
Total
  $
4,637,391
    $
9,137,391
 
 
(*) At the date of the acquisition, the effect of the “purchase price contingency” shares valued at approximately $5.4 million had not been recorded in accordance with FAS 141. During the quarter ended September 30, 2006, the Company issued 200,000 shares of the purchase price contingency valued at $900,000 as an adjustment to Goodwill. The remaining shares, when issued, will reflect an adjustment to Goodwill and Other Intangibles.

Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. The Company used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a period of eight years. Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. The subscriber list was independently valued at $2,463,927 with an estimated useful life of eight years.
 
At December 31, 2006, the Company performed an impairment test on the goodwill and intangibles acquired, it was determined that there were no changes in the carrying value of goodwill and intangibles acquired.

On May 24, 2007, MST completed a merger transaction pursuant to which it became a wholly-owned subsidiary of MSTI Holdings, Inc. (formerly Fitness Xpress, Inc. ("FXS")), an inactive publicly registered shell corporation with no significant assets or operations. As a result of the merger, there was a change in control of the public shell corporation. In accordance with SFAS No. 141, MST was the acquiring entity. While the transaction is accounted for using the purchase method of accounting, in substance the transaction represented a recapitalization of MST’s capital structure. For accounting purposes, the Company accounted for the transaction as a reverse acquisition and MST is the surviving entity. MST did not recognize goodwill or any intangible assets in connection with the transaction. In connection with the acquisition, the Company’s 90% interest in MST was converted to a 63% interest in MSTI Holdings, Inc.
 
11

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)
 
Acquisition of Smart Systems International, Inc.

On March 9, 2007, the Company acquired substantially all of the assets of Smart Systems International (SSI), a leading provider of energy management products and solutions to customers in the United States and Canada for cash and Company common stock having an aggregate value of $6,875,000. The purchase price was comprised of $875,000 in cash and 2,227,273 shares of the Company’s common stock. The Company is obligated to register the stock portion of the purchase price on or before May 15, 2007 and 1,090,909 shares are being held in an escrow account for a period of one year following the closing from which certain potential indemnification obligations under the purchase agreement may be satisfied. The aggregate number of shares held in escrow is subject to adjustment upward or downward depending upon the trading price of the Company’s common stock during the one year period following the closing date.

The acquisition of SSI was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's common stock on the day immediately preceding the acquisition date. The results of operations for SSI have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

 
 
As Reported
 
Common stock
 
$
6,000,000
 
Cash
 
 
875,000
 
Direct acquisition costs
 
 
131,543
 
Total Purchase Price
 
$
7,006,543
 


In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
 
$
1,416,299
 
Property, plant and equipment
 
 
36,020
 
Other assets 
 
 
8,237
 
Goodwill 
 
 
6,103,771
 
Total assets acquired 
 
 
7,564,327
 
 
 
 
 
 
Accounts payable and accrued liabilities 
 
 
(557,784
)
Total liabilities assumed 
 
 
(557,784
)
Net assets acquired
 
$
7,006,543
 
 
Due to its recent date of acquisition, the purchase price allocation to Goodwill is based upon preliminary data that is subject to adjustment and could change significantly. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually.
 
12

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

Acquisition of Ethostream LLC

On March 15, 2007, the Company acquired 100% of the outstanding membership units of Ethostream, LLC, a network solutions integration company that offers installation, sales and service to the hospitality industry. The Ethostream acquisition will enable Telkonet to provide installation and support for PLC products and third party applications to customers across North America. The purchase price of $11,756,097 was comprised of $2.0 million in cash and 3,459,609 shares of the Company’s common stock. The entire stock portion of the purchase price is being held in escrow to satisfy certain potential indemnification obligations of the sellers under the purchase agreement. The shares held in escrow are distributable over the three years following the closing.  If during the twelve months following the Closing, the common stock has a volume-weighted average trading price of at least $4.50, as reported on the American Stock Exchange, for twenty (20) consecutive trading days, the aggregate number of shares of common stock issuable to the sellers shall be adjusted such that the number of shares of common stock issuable as the stock consideration shall be determined assuming a per share price equal to $4.50.

The acquisition of Ethostream was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the most recent price of the Company's common stock prior to the acquisition date. The results of operations for Ethostream have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

 
 
As Reported
 
Common stock
 
$
9,756,097
 
Cash
 
 
2,000,000
 
Direct acquisition costs
 
 
164,346
 
Total Purchase Price
 
$
11,920,443
 

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
 
$
949,308
 
Property, plant and equipment
 
 
51,724
 
Other assets 
 
 
21,602
 
Subscriber lists
 
 
2,900,000
 
Goodwill 
 
 
8,796,440
 
Total assets acquired 
 
 
12,719,074
 
Accounts payable and accrued liabilities 
 
 
(798,631
)
Total liabilities assumed 
 
 
(798,631
)
Net assets acquired
 
$
11,920,443
 
 
Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. Due to its recent date of acquisition, the purchase price allocation to Intangibles and Goodwill is based upon preliminary data that is subject to adjustment and could change significantly pending the completion of management’s valuation to accurately evaluate this allocation. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. The subscriber list was preliminarily valued and could also change significantly pending the completion of management’s appraisal at $2,900,000 with an estimated useful life of twelve years.
 
 
13

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

 
Acquisition of Newport Telecommunications Co. by Subsidiary

On July 18, 2007, Microwave Satellite Technologies, Inc., the wholly-owned subsidiary of the Company’s majority owned subsidiary MSTI Holdings Inc., acquired substantially all of the assets of Newport Telecommunications Co., a New Jersey general partnership (“NTC”), relating to NTC’s business of providing broadband internet and telephone services at certain residential and commercial properties in the development known as Newport in Jersey City, New Jersey. Pursuant to the terms of the NTC acquisition, the total consideration paid was $2,550,000, consisting of (i) 866,856 unregistered shares of the Company’s common stock, equal to $1,530,000 (which is based on the average closing prices for the Company common stock for the ten trading days immediately prior to the closing date), and (ii) $1,020,000 in cash, subject to adjustments. The total consideration will be increased or decreased depending on the number of subscriber accounts acquired in the NTC acquisition that were in good standing at that time. The number will be determined within 120 days of the closing. The stock certificates representing the Company common stock, and $510,000 of the cash consideration were paid to an escrow agent to be released after the final determination of the number of subscriber accounts in good standing acquired at closing.

The acquisition of Newport was accounted for using the purchase method in accordance with SFAS 141, “Business Combinations.” The value of the Company’s common stock issued as a part of the acquisition was determined based on the average closing prices for the Company common stock for the ten trading days immediately prior to the closing date. The results of operations for Newport have been included in the Consolidated Statements of Operations since the date of acquisition.  The components of the purchase price were as follows:

 
 
As Reported
 
Common stock
 
$
1,530,000
 
Cash
 
 
1,020,000
 
Direct acquisition costs
 
 
98,294
 
Total Purchase Price
 
$
2,648,294
 

In accordance with Financial Accounting Standard (SFAS) No. 141, Business Combinations, the total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The fair value of the assets acquired was based on management’s best estimates. The purchase price was allocated to the fair value of assets acquired and liabilities assumed as follows:

Current assets
 
$
-
 
Property, plant and equipment
 
 
668,107
 
Other assets 
 
 
98,294
 
Subscriber lists
 
 
1,881,893
 
Goodwill 
 
 
-
 
Total assets acquired 
 
 
2,648,294
 
Accounts payable and accrued liabilities 
 
 
-
 
Total liabilities assumed 
 
 
-
 
Net assets acquired
 
$
2,648,294
 

Goodwill and other intangible assets represent the excess of the purchase price over the fair value of the net tangible assets acquired. Due to its recent date of acquisition, the purchase price allocation to Intangibles and Goodwill is based upon preliminary data that is subject to adjustment and could change significantly pending the completion of management’s valuation to accurately evaluate this allocation. In accordance with SFAS 142, goodwill is not amortized and will be tested for impairment at least annually. The subscriber list was preliminarily valued and could also change significantly pending the completion of management’s appraisal at $1,881,893 with an estimated useful life of eight years.


15

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

 
The following unaudited condensed combined pro forma results of operations reflect the pro forma combination of the Telkonet, MST, SSI and Ethostream businesses as if the combination had occurred at the beginning of the periods presented compared with the actual results of operations of Telkonet for the same period. The unaudited pro forma condensed combined results of operations do not purport to represent what the companies’ combined results of operations would have been if such transaction had occurred at the beginning of the periods presented, and are not necessarily indicative of Telkonet’s future results.

 
 
Nine months Ended
 
 
 
September 30,
 
 
 
Proforma
   
Proforma
 
 
 
2007
   
2006
 
 
 
 
   
 
 
Product revenue
  $
7,185,105
    $
5,636,119
 
Rental revenue
   
4,739,867
     
3,666,301
 
Total revenues
   
11,924,972
     
9,302,420
 
 
               
Net (loss)
  $ (15,855,515 )   $ (23,185,452 )
Basic (loss) per share
  $ (0.25 )   $ (0.39 )
Diluted (loss) per share
  $ (0.25 )   $ (0.39 )

NOTE C - INVENTORIES
 
Inventories are stated at the lower of cost or market determined by the first-in, first-out (FIFO) method. Inventories primarily consist of Gateways, eXtenders, Couplers and iBridges, which are the significant components of the Telkonet solution. Components of inventories as of September 30, 2007 and December 31, 2006 are as follows:
 
 
 
September 30, 2007
   
December 31, 2006
 
Raw Materials
  $
1,050,880
    $
516,604
 
Finished Goods
   
1,074,202
     
789,989
 
 
  $
2,125,082
    $
1,306,593
 

NOTE D - INTANGIBLE ASSETS AND GOODWILL

As a result of the MST acquisition at January 31, 2006 and the Ethostream acquisition on March 15, 2007 and MSTI Holdings, Inc.’s acquisition of Newport on July 18, 2007, the Company had intangibles totaling $7,245,820 at September 30, 2007 (Note B).

In accordance with SFAS 142, Goodwill and Other Intangible Assets (SFAF No. 142), an impairment test will be performed on these assets at least annually. The consolidated statement of operations for the three and nine months ended September 30, 2007 includes only charges for amortization of these intangibles.
 
We used a discounted cash flow model to determine the value of the intangible assets and to allocate the excess purchase price to the intangible assets and goodwill as appropriate. In this model, expected cash flows from subscribers were discounted to their present value at a rate of return of 20% (incorporating the risk-free rate, expected inflation, and related business risks) over a determined length of life year. Expected costs such as income taxes and cost of sales were deducted from expected revenues to arrive at after tax cash flows.


16

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

We have applied the same discounted cash flow methodology to the assessment of value of the intangible assets of Ethostream, LLC, during the acquisition completed on March 15, 2007, for purposes of determining the purchase price.

The MST subscriber list was determined to have an eight-year life. This intangible was amortized using that life and amortization from the date of the acquisition through September 30, 2007 was taken as a charge against income in the consolidated statement of operations. MST's goodwill of $1,977,767, excluding the purchase price contingency, represented the excess of the purchase price over the fair value of the net tangible and intangible assets acquired.

Additionally, the MST subscriber list includes the acquisition of subscribers from Newport Telecommunications.  This subscriber list was determined to have an eight-year life. This intangible was amortized using that life and amortization from the date of the acquisition through September 30, 2007 was taken as a charge against income in the consolidated statement of operations.

The Ethostream subscriber list was estimated to have a twelve-year life. This intangible was amortized using that life and amortization from the date of the acquisition through September 30, 2007 was taken as a charge against income in the consolidated statement of operations. Ethostream's goodwill of $8,796,440 represented the excess of the purchase price over the fair value of the net tangible and intangible assets acquired.

Total identifiable intangible assets acquired and their carrying values at December 31, 2006 are:

 
 
Gross
Carrying Amount
   
Accumulated Amortization
   
Net
   
Residual
Value
   
Weighted
Average
Amortization
Period
(Years)
 
Amortized Identifiable intangible Assets:
 
 
   
 
   
 
   
 
   
 
 
Subscriber lists
  $
2,463,927
    $ (282,325 )   $
2,181,602
    $
-
     
8.0
 
 
                                       
Total Amortized Identifiable Intangible Assets
   
2,463,927
      (282,325 )    
2,181,602
    $
-
     
8.0
 
Unamortized Identifiable Intangible Assets:
 
None
                                 
Total
  $
2,463,927
    $ (282,325 )   $
2,181,602
    $
-
     
8.0
 

Total identifiable intangible assets acquired and their carrying values at September 30, 2007 are:

 
 
Gross Carrying Amount
   
Accumulated Amortization
   
Net
   
Residual
Value
   
Weighted Average Amortization Period (Years)
 
Amortized Identifiable Intangible Assets:
 
 
   
 
   
 
   
 
   
 
 
Subscriber lists – MST
  $
4,345,820
    $ (562,326 )    
3,783,494
   
 
     
8.0
 
Subscriber lists - Ethostream
   
2,900,000
    $ (130,903 )    
2,769,097
    $
-
     
12.0
 
 
                                       
Total Amortized Identifiable Intangible Assets
   
7,245,820
    $ (693,229 )    
6,552,591
     
-
     
9.6
 
Unamortized Identifiable Intangible Assets:
 
None
                                       
Total
  $
7,245,820
    $ (693,229 )    
6,552,591
    $
-
     
9.6
 



17

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

Total amortization expense charged to operations for the nine months ended September 30, 2007 and 2006 was $413,508 and $209,958, respectively. Estimated amortization expense as of September 30, 2007 is as follows:

Fiscal
 
 
 
 
October 1 - December 31, 2007
 
 
196,223
 
2008
 
 
784,894
 
2009
 
 
784,894
 
2010
 
 
784,894
 
2011
 
 
784,894
 
2012 and after
 
 
3,216,792
 
Total
 
$
6,552,591
 

The Company does not amortize goodwill. As a result of the acquisition of MST, Ethostream, and SSI, the Company recorded goodwill in the amount of $16,877,978 as of September 30, 2007. There were no changes in the carrying amount of goodwill for the nine months ended September 30, 2007.

NOTE E - SENIOR CONVERTIBLE DEBENTURES AND SENIOR NOTES PAYABLE

A summary of convertible promissory notes payable at September 30, 2007 and December 31, 2006 is as follows:

 
 
2007
   
2006
 
Senior Convertible Debentures, accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the debentures, payable quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010
  $
6,576,350
    $
-
 
Original Issue Discount - net of accumulated amortization of $175,450 and $0 at September 30, 2007 and December 31, 2006, respectively.
    (350,900 )    
-
 
Debt Discount - beneficial conversion feature, net of accumulated amortization of $57,840 and $0 at September 30, 2007 and December 31, 2006, respectively.
    (809,765 )        
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $57,840 and $0 at September 30, 2007 and December 31, 2006, respectively.
    (809,765 )    
-
 
 
               
Total
  $
4,605,920
    $
-
 
Less: current portion
   
-
     
-
 
 
  $
4,605,920
    $
-
 

Aggregate maturities of long-term debt as of September 30, 2007 are as follows:

For the twelve months ended September 30
 
Amount
 
2007
   
-
 
2008
   
-
 
2009
   
-
 
2010
   
6,576,350
 
 
  $
6,576,350
 


18

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

During the nine months ended September 30, 2007, MSTI Holdings Inc., a majority owned subsidiary of Telkonet, Inc., issued senior convertible debentures (the "Debentures") having a principal value of $6,576,350 to investors, including an original issue discount of $526,350, in exchange for $6,050,000 from investors, exclusive of placement fees. The original issue discount to the Debentures is amortized over 12 months. The Debentures accrue interest at 8% per annum commencing on the first anniversary of the original issue date of the Debentures, payable quarterly in cash or common stock, at MSTI Holdings Inc.’s option, and mature on April 30, 2010. The Debentures are not callable and are convertible at a conversion price of $0.65 per share into 10,117,462 shares of MSTI Holdings Inc. common stock, subject to certain limitations.
  
In accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with a Beneficial Conversion Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an imbedded beneficial conversion feature present in the notes. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to the MST additional paid in capital included in the Company’s minority interest. The Company recognized and measured an aggregate of $867,605 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Notes issued during the period ended September 30, 2007. The debt discount attributed to the beneficial conversion feature is amortized over the Notes maturity period (three years) as interest expense.
 
In connection with the placement of the Debentures, MSTI Holdings, Inc. has also agreed to issue to the Noteholders, five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per share. MSTI Holdings Inc. valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 54%. The $867,605 of debt discount attributed to the value of the warrants issued is amortized over the Notes maturity period (three years) as interest expense.

In connection with the issuance of the Debentures, MSTI Holdings Inc. incurred placement fees of $423,500. Additionally, MSTI Holdings Inc. issued such agents five-year warrants to purchase 708,222 shares of MSTI Holdings Inc. common stock at an exercise price of $1.00.

The Company amortized the original issue discount, the beneficial conversion feature and the value of the attached warrants, and recorded non-cash interest expense in the amount of $175,450, $57,840 and $57,840, respectively, for the period ended September 30, 2007.

Registration Rights Liquidated Damages

On May 24, 2007, the Company’s majority-owned subsidiary, MSTI Holdings, Inc. completed a private placement, pursuant to which 5,597,664 shares of common stock and five-year warrants to purchase 2,798,836 shares of common stock were issued at an exercise price of $1.00 per share, for total proceeds of $2,694,020.  Additionally, MSTI Holdings, Inc. also sold senior convertible debentures for total proceeds of $6,050,000.  The debentures bear interest at a rate of 8% per annum, commencing on the first anniversary of the original issue date of the debentures, payable quarterly in cash or common stock, at MSTI Holdings, Inc. option, and mature on April 30, 2010. The debentures are not callable and are convertible at a price of $0.65 per share into 10,117,462 shares of common stock.  In addition, holders of the debentures received five-year warrants to purchase an aggregate of 5,058,730 shares of MSTI Holdings, Inc. common stock at an exercise price of $1.00 per share.

MSTI Holdings, Inc. agreed to file a “resale” registration statement with the SEC within 60 days after the final closing of the private placement and the issuance of the debentures covering all shares of common stock sold in the private placement and underlying the debentures, as well as the warrants attached to the private placement. MSTI Holdings, Inc. has agreed to its our best efforts to have such “resale” registration statement declared effective by the SEC as soon as possible and, in any event, within 120 days after the initial closing of the private placement and the issuance of the debentures.
 

19

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

In addition, with respect to the shares of common stock sold in the private placement and underlying the warrants, MSTI Holdings, Inc. agreed to maintain the effectiveness of the “resale” registration statement from the effective date until the earlier of (i) 18 months after the date of the closing of the private placement or (ii) the date on which all securities registered under the registration statement (a) have been sold, or (b) are otherwise able to be sold pursuant to Rule 144, at which time exempt sales may be permitted for purchasers of the Units, subject to MSTI Holdings right to suspend or defer the use of the registration statement in certain events.

The registration rights agreement requires the payment of liquidated damages to the investors of approximately 1% per month of the aggregate proceeds of $9,128,717, or the value of the unregistered shares at the time that the liquidated damages are assessed, until the registration statement is declared effective, payable at the option of MSTI Holdings, Inc.  In accordance with EITF 00-19-2, the Company evaluated the likelihood of achieving registration statement effectiveness.  Accordingly, the Company has accrued an estimate of $500,000 as of September 30, 2007, to account for these potential liquidated damages until the expected effectiveness of the registration statement is achieved.

Senior Convertible Notes

During the year ended December 31, 2005, the Company issued convertible senior notes (the "Convertible Senior Notes") having an aggregate principal value of $20 million to sophisticated investors in exchange for $20,000,000, exclusive of $1,219,410 in placement costs and fees. The Convertible Senior Notes accrue interest at 7.25% per annum and call for monthly principal installments beginning March 1, 2006. The maturity date is 3 years from the date of issuance of the notes. At any time or times, the Noteholders shall be entitled to convert any portion of the outstanding and unpaid note amount into fully paid and nonassessable shares of the Company’s common Shares at $5 per share. At any time at the option of the Company, the principal payments may be paid either in cash or in common stock at the lower of $5 or 92.5% of the average recent market price. At any time after nine months should the stock trade at or above $8.75 for 20 of 30 consecutive trading days, the Company can cause a mandatory redemption and conversion to shares at $5 per share. At any time, the Company can pre-pay the notes with cash or common stock. Should the Company pre-pay the Notes other than by mandatory conversion, the Company must issue additional warrants to the Noteholders covering 65% of the amount pre-paid at a strike price of $5 per share. In addition to standard financial covenants, the Company has agreed to maintain a letter of credit in favor of the Noteholders equal to $10 million. Once the principal amount of the note declines below $15 million, the balance is reduced by $.50 for every $1 amortized. In accordance with Emerging Issues Task Force Issue 98-5, Accounting for Convertible Securities with a Beneficial Conversion Features or Contingently Adjustable Conversion Ratios ("EITF 98-5"), the Company recognized an imbedded beneficial conversion feature present in the notes. The Company allocated a portion of the proceeds equal to the intrinsic value of that feature to additional paid in capital. The Company recognized and measured an aggregate of $1,479,300 of the proceeds, which is equal to the intrinsic value of the imbedded beneficial conversion feature, to additional paid in capital and a discount against the Notes issued during the year ended December 31, 2005. The debt discount attributed to the beneficial conversion feature is amortized over the Notes maturity period (three years) as interest expense.
 
In connection with the placement of the Notes in October 2005, the Company has also agreed to issue to the Noteholders one million warrants to purchase company common stock exercisable for five years at $5 per share. The Company recognized the value attributable to the warrants in the amount of $2,919,300 to a derivative liability due to the possibility of the Company having to make a cash settlement, including penalties, in the event the Company failed to register the shares underlying the warrants under the Securities Act of 1933, as amended, within 90 days after the closing of the transaction. The Company accounted for this warrant derivative in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. The warrants were included as a liability and valued at fair market value until the Company met the criteria under EITF 00-19 for permanent equity. A registration statement covering shares issuable to the Noteholders upon conversion, amortization and/or redemption of the Convertible Senior Notes and upon exercise of the warrants was filed with the Securities and Exchange Commission on Form S-3 on November 23, 2005 and was declared effective on December 13, 2005. The warrant derivative liability was valued at the issuance date of the Notes in the amount of $2,919,300 and then revalued at $2,910,700 on December 13, 2005 upon effectiveness of the Form S-3. The Company charged $8,600 to Other Income and the derivative warrant liability was reclassified to additional paid in capital at December 13, 2005. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 4.00%, a dividend yield of 0%, and volatility of 76%. The $2,919,300 of debt discount attributed to the value of the warrants issued is amortized over the Notes maturity period (three years) as interest expense.


20

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

Principal Payments of Debt 

For the period of January 1, 2006 through August 14, 2006, the Company paid down principal of $1,250,000 in cash and issued an aggregate of 4,226,246 shares of common stock in connection with the conversion of $10,821,686 aggregate principal amount of the Senior Convertible Notes. Pursuant to the note agreement, the Company issued warrants to purchase 1,081,820 shares of common stock to the Noteholders, at a strike price of $5.00 per share, which represented 65% of the $8,321,686 accelerated principal at a strike price of $5 per share. The Company valued the warrants at $1,906,089 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 65%. The warrants are subject to anti-dilution protection in conjunction with the issuance of certain equity securities. The Company has warrants due the Noteholders as a result of the anti-dilution impact from a $6,000,000 private placement in September 2006 (Note J). The Company has accounted for the additional warrants issued as interest expense during the period ended September 30, 2006.

For the period of January 1, 2006 through August 14, 2006, the Company amortized the debt discount to the beneficial conversion feature and value of the attached warrants, and recorded non-cash interest expense in the amount of $251,759 and $500,353, respectively. The Company also wrote-off the unamortized debt discount attributed to the beneficial conversion feature and the value of the attached warrants in the amount of $708,338 and $1,397,857, respectively, in connection with paydown and conversion of the note.

The Company has warrants due the Noteholders as a result of the anti-dilution impact from a $10,000,000 private placement in February 2007 (Note I). The Company has accounted for the additional 76,230 warrants issued, valued at $131,009, as interest expense during the period ended September 30, 2007. The Company valued the warrants using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 4.75%, a dividend yield of 0%, and volatility of 70%.

Early Extinguishment of Debt

On August 14, 2006, the Company executed separate settlement agreements with the lenders of its Convertible Senior Notes. Pursuant to the settlement agreements the Company paid to the lenders on August 15, 2006 in the aggregate $9,910,392 plus accrued but unpaid interest of $23,951 and certain premiums specified in the Notes in satisfaction of the amounts then outstanding under the Notes. Of the amount to be paid to the lenders under the Notes, $6,500,000 was paid in cash through a drawdown on a letter of credit previously pledged as collateral for the Company’s obligations under the Notes. The remaining note balance of $1,428,314 and a Redemption Premium of $1,982,078, calculated as 25% of remaining principal, was paid to the lenders in shares of the Company’s common stock valued at the lower of $5.00 per share and 92.5% of the arithmetic average of the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days beginning on August 16, 2006. The Company also issued 862,452 warrants to purchase shares of the Company’s common stock at the exercise price of $2.58 per share (92.5% of the average trading price as described above). The Company valued the warrants at $1,014,934 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 5.00%, a dividend yield of 0%, and volatility of 65%. The Company has accounted for the Redemption Premium and the additional warrants issued as non-cash early extinguishment of debt expense during the year ended December 31, 2006. Registration statements covering the shares underlying the warrants, were filed with the Securities and Exchange Commission on Form S-3 on September 29, 2006 and October 13, 2006 and were declared effective on October 16, 2006 and October 24, 2006, respectively.  The achievement of permanent equity had been realized on October 16, 2006 and October 24, 2006 upon the declared effectiveness of the Form S-3. Upon the declared effectiveness of the Form S-3, the registration rights agreement requirements had been satisfied and achieved; therefore the warrants were accounted for as equity. The registration rights agreement required the payment of liquidated damages in the event of failure to achieve the registration with the SEC. 
 
21

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)
 
As a result of the execution of the settlement agreements and the payments required thereby, the Company fully believes it repaid and satisfied all of its obligations under the Notes. The Company also agreed to pay the expenses of the lenders incurred in connection with the negotiation and execution of the settlement agreements. The settlement agreements were negotiated following the allegation by one of the lenders that the Company’s failure to meet the minimum revenue test for the period ending June 30, 2006 as specified on the Notes constituted an event of default under the Notes, which allegation the Company disputed.

The Settlement Agreement provides that the number of shares issued to the Noteholders shall be adjusted based upon the arithmetic average of the weighted average price of the Company’s common stock on the American Stock Exchange for the twenty trading days immediately following the settlement date.  The Company has concluded that, based upon the weighted average of the Company's common stock between August 16, 2006 and September 13, 2006, the Company is entitled to a refund from the two Noteholders.  One of the Noteholders has informed the Company that it does not believe such a refund is required.  As a result, the Company has declined to deliver to the Noteholders certain stock purchase warrants issued to them pursuant to the Settlement Agreement pending resolution of this disagreement. The Noteholder has alleged that the Company has failed to satisfy its obligations under the Settlement Agreement by failing to deliver the warrants. In addition, the Noteholder maintains that the Company has breached certain provisions of the Registration Rights Agreement and, as a result of such breach, such Noteholder claims that it is entitled to receive liquidated damages from the Company.

Senior Note Payable

A summary of the senior notes payable at September 30, 2007 and December 31, 2006 is as follows:

 
 
2007
   
2006
 
Senior Note Payable, accrues interest at 6% per annum, and mature on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008.
  $
1,500,000
    $
-
 
Debt Discount - value attributable to warrants attached to notes, net of accumulated amortization of $70,866 and $0 at September 30, 2007 and December 31, 2006, respectively.
    (125,058 )    
-
 
 
               
Total
  $
1,374,942
    $
-
 
Less: current portion
   
1,374,942
     
-
 
 
  $
-
    $
-
 

Aggregate maturities of senior note as of September 30, 2007 are as follows:

For the twelve months ended September 30
 
Amount
 
2007
  $
-
 
2008
   
1,500,000
 
2009
   
-
 
2010
   
-
 
 
  $
1,500,000
 
 
22


TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)
 
On July 24, 2007, Telkonet entered into a Senior Note Purchase Agreement with GRQ Consultants, Inc. (“GRQ”) pursuant to which the Company issued to GRQ a Senior Promissory Note (the “Note”) in the aggregate principal amount of $1,500,000. The Note is due and payable on the earlier to occur of (i) the closing of the Company’s next financing, or (ii) January 28, 2008, and bears interest at a rate of six (6%) percent per annum. The Company has incurred approximately $25,000 in fees in connection with this transaction. The net proceeds from the issuance of the Note will be for general working capital needs.

 In connection with the issuance of the Note, the Company also issued to GRQ warrants to purchase 359,712 shares of common stock at $4.17 per share. These warrants expire five years from the date of issuance. The Company valued the warrants in accordance with EITF 00-27 using the Black-Scholes pricing model and the following assumptions: contractual terms of 5 years, an average risk free interest rate of 4.00%, a dividend yield of 0%, and volatility of 76%. The $195,924 of debt discount attributed to the value of the warrants issued is amortized over the note maturity period (six months) as non-cash interest expense. The Company amortized the value of the attached warrants, and recorded non-cash interest expense in the amount of $70,866, respectively, for the period ended September 30, 2007.

NOTE F - STOCK OPTIONS AND WARRANTS
 
Employee Stock Options
 
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under a non-qualified employee stock option plan.
 
 
   
Options Outstanding
   
 
   
Options Exercisable
 
Exercise Prices
   
Number
Outstanding
   
Weighted Average
Remaining Contractual
Life (Years)
   
Weighted Average Exercise Price
   
Number
Exercisable
   
Weighted Average Exercise Price
 
$
1.00-$1.99
     
4,273,429
     
5.41
    $
1.04
     
4,083,429
    $
1.00
 
$
2.00-$2.99
     
1,995,750
     
7.37
    $
2.54
     
1,329,750
    $
2.49
 
$
3.00-$3.99
     
1,811,000
     
7.68
    $
3.27
     
1,177,750
    $
3.38
 
$
4.00-$4.99
     
   160,000
     
7.47
    $
4.44
     
     66,500
    $
4.44
 
$
5.00-$5.99
     
   146,750
     
7.36
    $
5.24
     
     70,250
    $
5.21
 
         
8,386,929
     
6.44
    $
2.01
     
6,456,179
    $
1.72
 

 Transactions involving stock options issued to employees are summarized as follows:
 
 
 
Number of Shares
   
Weighted Average
Price Per Share
 
Outstanding at January 1, 2005
   
9,614,767
    $
1.61
 
Granted
   
1,325,000
     
3.97
 
Exercised
    (415,989 )    
1.18
 
Canceled or expired
    (372,200 )    
3.74
 
Outstanding at December 31, 2005
   
10,151,078
    $
1.85
 
Granted
   
1,125,000
     
3.01
 
Exercised
    (2,051,399 )    
1.30
 
Canceled or expired
    (703,750 )    
2.67
 
Outstanding at December 31, 2006
   
8,520,929
    $
2.06
 
Granted
   
935,000
     
2.55
 
Exercised (Note J)
    (118,500 )    
1.05
 
Canceled or expired
    (950,500 )    
3.01
 
Outstanding at September 30, 2007
   
8,386,929
    $
2.01
 
 

23

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

The weighted-average fair value of stock options granted to employees during the period ended September 30, 2007 and 2006 and the weighted-average significant assumptions used to determine those fair values, using a Black-Scholes option pricing model are as follows:

 
 
2007
   
2006
 
Significant assumptions (weighted-average):
 
 
   
 
 
Risk-free interest rate at grant date
    4.8%       5.0%  
Expected stock price volatility
    70%       65%  
Expected dividend payout
   
-
     
-
 
Expected option life-years
   
5.0
     
5.0
 
Expected forfeiture rate
    12%       12%  
Fair value per share of options granted
  $
1.57
    $
1.94
 

The expected life of awards granted represents the period of time that they are expected to be outstanding. We determine the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures. We estimate the volatility of our common stock based on the calculated historical volatility of our own common stock using the trailing twenty-four months of share price data, measured daily, prior to the date of the award. We base the risk-free interest rate used in the Black-Scholes-Merton option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. We have not paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with SFAS No. 123R, we adjust share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.

The total intrinsic value of the options exercised during the nine months ended September 30, 2007 and 2006 is $73,470, and $2,510,591, respectively. Additionally, the total fair value of shares vested during these periods is $941,900 and $815,809, respectively.

Total stock-based compensation expense recognized in the consolidated statement of earnings for the nine months ended September 30, 2007 was $941,900, net of tax effect, excluding $173,967 of expense attributable to MST. Additionally, the aggregate intrinsic value of options outstanding and unvested at September 30, 2007 is $0.
 
Non-Employee Stock Options
 
The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to the Company consultants. These options were granted in lieu of cash compensation for services performed.
 
 
   
Options Outstanding
   
 
   
Options Exercisable
 
Exercise Price
   
Number
Outstanding
   
Weighted Average
Remaining Contractual
Life (Years)
   
Weighed Average Exercise Price
   
Number
Exercisable
   
Weighted Average Exercise Price
 
$
1.00
     
1,815,937
     
4.59
    $
1.00
     
1,815,937
    $
1.00
 


24

TELKONET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

Transactions involving options issued to non-employees are summarized as follows:
 
 
 
Number of Shares
   
Weighted Average
Price Per Share
 
Outstanding at January 1, 2005
   
1,999,169
    $
1.07
 
Granted
   
15,000
     
3.45
 
Exercised
    (172,395 )    
2.07
 
Canceled or expired
   
-
     
-
 
Outstanding at December 31, 2005
   
1,841,774
    $
1.00