AEMETIS, INC - Quarter Report: 2009 June (Form 10-Q)

 UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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, 2009

¨  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: 00-51354

AE BIOFUELS, INC.

(Exact name of registrant as specified in its charter)

20400 Stevens Creek Blvd., Suite 700

Cupertino, CA 95014

(Address of principal executive offices)

(408) 213-0940

(Registrant'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 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 ¨

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. (Check one):

Large accelerated filer ¨     Accelerated filer  þ     Non-accelerated filer  ¨     Smaller reporting company þ

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

The number of shares outstanding of the registrant’s Common Stock on August 4, 2009 was 86,171,532.

AE BIOFUELS, INC.

FORM 10-Q

Quarterly Period Ended June 30, 2009

INDEX

2

SPECIAL NOTE REGARDING FORWARD—LOOKING STATEMENTS

On one or more occasions, we may make forward-looking statements in this Quarterly Report on Form 10-Q regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events. Words or phrases such as “anticipates,” “may,” “will,” “should,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “targets,” “will likely result,” “will continue” or similar expressions identify forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, under “Part II — Other Information, Item 1A. Risk Factors” and elsewhere, and in other reports we file with the Securities and Exchange Commission (“SEC”), specifically the most recent Annual Report on Form 10-K and 10-K/A. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. However, your attention is directed to any further disclosures made on related subjects in our subsequent annual and periodic reports filed with the SEC on Forms 10-K, 10-Q and 8-K and Proxy Statements on Schedule 14A.

Unless the context requires otherwise, references to “we,” “us,” “our,” the “Company” and “the Company” refer specifically to AE Biofuels, Inc.

3

PART I - FINANCIAL INFORMATION

Item 1 - Financial Statements.

AE BIOFUELS, INC.

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of the financial statements

4

AE BIOFUELS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

The accompanying notes are an integral part of the financial statements

5

AE BIOFUELS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

The accompanying notes are an integral part of the financial statements

6

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Nature of Activities and Summary of Significant Accounting Policies.

Nature of Activities. These consolidated financial statements include the accounts of AE Biofuels, Inc., a Nevada corporation, and its wholly owned subsidiaries: (i) American Ethanol, Inc. (“American”), a Nevada corporation and its subsidiaries; Sutton Ethanol, LLC (“Sutton”), a Nebraska limited liability company, Illinois Valley Ethanol, LLC (“Illinois Valley”), an Illinois limited liability company; Danville Ethanol Inc, an Illinois corporation; AE Biofuels, Inc., (“AEB-DE”), a Delaware corporation and its subsidiary AE Renova, LLC (“AE Renova”), a Delaware limited liability company, (ii) Biofuels Marketing, a Delaware corporation; (iii) International Biodiesel, Inc., a Nevada corporation and its subsidiary AE International Biofuels, Ltd., a British Virgin Islands company, AE DAABON, Ltd., a British Virgin Islands company, International Biofuels, Ltd, a Mauritius corporation and its subsidiary Universal Biofuels Private Ltd, an India company; and (iv) AE Biofuels Americas, a Delaware corporation, and (v) AE Biofuels Technologies, Inc., a Delaware corporation and its subsidiary Energy Enzymes LLC, a Delaware limited liability company, collectively, (“AE Biofuels” or the “Company”).

The Company is an international biofuels company focused on the development, acquisition, construction and operation of next-generation fuel grade ethanol and biodiesel facilities, and the distribution, storage, and marketing of biofuels. The Company began selling fuel grade biodiesel from its production facility in Kakinada, India in November 2008 and began operating a cellulosic ethanol commercial demonstration facility in Butte, Montana in August 2008.

Development Stage Enterprise. The Company prepared its statements in accordance with the Development Stage Enterprise guidance as specified in SFAS No. 7 “Accounting and Reporting by Development Stage Enterprises” (“SFAS 7”) until October 1, 2008, when planned principal operations commenced.

Basis of Presentation and Consolidation. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The accompanying consolidated balance sheets as of June 30, 2009, the consolidated statements of operations for the three and six months ended June 30, 2009 and 2008, and the consolidated statements of cash flows for the six months ended June 30, 2009 and 2008 are unaudited. The consolidated balance sheet as of December 31, 2008 was derived from the 2008 audited consolidated financial statements and notes thereto. The consolidated financial statements in this report should be read in conjunction with the 2008 audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2008.

The accompanying unaudited interim consolidated financial statements as of June 30, 2009 and 2008 and for the three and six months ended June 30, 2009 and 2008 have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP) pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations.

In the opinion of management, the unaudited interim consolidated financial statements for the three and six months ended June 30, 2009 and 2008 have been prepared on the same basis as the audited consolidated statements as of December 31, 2008 and reflect all adjustments, consisting primarily of normal recurring adjustments, necessary for the fair presentation of its statement of financial position, results of operations and cash flows. The results of operations for the three and six months ended June 30, 2009 are not necessarily indicative of the operating results for any subsequent quarter, for the full fiscal year or any future periods.

Use of Estimates. The preparation of financial statements in conformity with U.S. GAAP 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 revenues and expenses during the reporting period. Significant estimates, assumptions and judgments made by management include the determination of impairment of long-lived assets, the valuation of equity instruments such as options and warrants, the recognition and measurement of current taxes payable and deferred tax assets or liabilities, and the accrual for the payments under the Company's registration rights agreement with certain of its shareholders and management’s judgment about contingent liabilities. Management believes that the estimates and judgments upon which they rely are reasonable based upon information available to them at the time that these estimates and judgments are made. To the

7

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

extent there are material differences between these estimates and actual results, the Company’s consolidated financial statements will be affected.

Reclassifications. Certain prior year amounts were reclassified to conform to current year presentation. These reclassifications had no impact on previously reported net loss or accumulated deficit.

Revenue Recognition. The Company recognizes revenue when products are delivered, the price is fixed or determinable and collection is reasonably assured. This typically occurs upon shipment as payments are generally made in advance and products are sold without the right of return.

Cost of Goods Sold. Cost of goods sold include those costs directly associated with the production of revenues, such as raw material purchases, factory overhead, and other direct production costs.

Research and Development. Research and development costs are expensed as incurred, unless they have alternative future uses to the Company.

General and Administrative. General and administrative expenses include those costs associated with the general operations of our business such as: compensation, rent, consultants, and travel related to executive, legal and financial functions.

Cash and Cash Equivalents. The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The Company maintains cash balances at various financial institutions domestically and abroad. Domestic accounts are insured by the FDIC. The Company’s accounts at these institutions may exceed federally insured limits. The Company has not experienced any losses in such accounts.

Inventories. Inventories are stated at the lower of cost, using the first-in and first-out (FIFO) method, or market.

Property, Plant and Equipment. Property, plant and equipment are carried at cost less accumulated depreciation after assets are placed in service and are comprised primarily of land acquired for development of production facilities, and the biodiesel plant in India. The estimated useful life of this plant is 20 years. The estimated useful life for office equipment and computers is three years and the useful life of machinery and equipment is seven years. Depreciation is computed using the straight line method over the useful life of the assets.

Intangible Assets. Intangible assets are carried at initial fair value less accumulated amortization over the estimated useful life. Amortization is computed over the estimated useful lives of the underlying assets using a method that reflects their utilization pattern.

Income Taxes. The Company recognizes income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes” (“SFAS 109”), using an asset and liability approach. This approach requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. The measurement of current and deferred taxes is based on provisions of enacted tax law.

SFAS 109 provides for recognition of deferred tax assets if the realization of such assets is more likely than not to occur. Otherwise, a valuation allowance is established for the deferred tax assets which may not be realized. As of December 31, 2008, the Company recorded a full valuation allowance against its net deferred tax assets due to operating losses incurred since inception. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets were fully offset by a valuation allowance.

The Company is subject to income tax audits by the respective tax authorities in all of the jurisdictions in which it operates. The determination of tax liabilities in each of these jurisdictions requires the interpretation and application of complex and sometimes uncertain tax laws and regulations. The recognition and measurement of current taxes payable or refundable and deferred tax assets and liabilities requires that the Company make certain estimates and judgments. Changes to these estimates or a change in judgment may have a material impact on the Company’s tax provision in a future period.

8

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation on FASB Statement No. 109” ("FIN 48") which requires a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. The Company records a liability for the difference between the benefit recognized and measured pursuant to FIN 48 and the tax position taken or expected to be taken on its tax return. To the extent that the Company’s assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. With the adoption of FIN 48, the Company also began reporting tax-related interest and penalties as a component of income tax expense.

Long-Lived Assets. The Company evaluates the recoverability of long-lived assets with finite lives in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) which requires recognition of impairment of long-lived assets wheneverevents or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. When events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable based on estimated undiscounted cash flows, the impairment loss would be measured as the difference between the carrying amount of the assets and its fair value based on the net present value of estimated future cash flows.

Basic and Diluted Net Loss per Share. Basic loss per share is computed by dividing loss attributable to common shareholders by the weighted average number of common shares outstanding for the period, net of shares subject to repurchase. Diluted net loss per share reflects the dilution of common stock equivalents such as options, convertible preferred stock and warrants to the extent the impact is dilutive. Basic loss per share includes the vested portion of restricted stock grants. Unvested restricted stock grants are included only in the fully diluted net loss per share calculation. As the Company incurred net losses for the three months ended June 30, 2009 and 2008, potentially dilutive securities have been excluded from the diluted net loss per share computations as their effect would be anti-dilutive.

The following table shows the weighted-average number of potentially dilutive shares excluded from the diluted net loss per share calculation for the three months ended June 30, 2009 and 2008:

Comprehensive Income. Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), requires that an enterprise report, by major components and as a single total, the change in its net assets from non-owner sources. The Company’s other comprehensive income consists solely of cumulative foreign currency translation adjustments resulting from the translation of the financial statements of its India subsidiary. The investment in this subsidiary is considered indefinitely invested overseas and, as a result, deferred income taxes are not recorded related to the currency translation adjustments.

Foreign Currency Translation/Transactions. Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment, where that local currency is the functional currency, are translated into U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments directly recorded to a separate component of accumulated other comprehensive income. Income and expense accounts are translated at average exchange rates during the year. Gains and losses from foreign currency transactions are recorded in other income (loss), net. The functional currency is the local currency for all non-U.S. subsidiaries.

Restricted Stock. The Company has granted restricted stock awards, restricted by a service condition, with vesting periods of up to three years. Restricted stock awards are valued using the fair market value of the Company’s common stock as of the grant date. The Company recognizes compensation expense on a straight line basis over the requisite service period of the award. The remaining unvested shares are subject to forfeitures and restrictions on sale, or transfer, up until the vesting date.

9

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Stock-Based Compensation Expense. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”), requiring us to recognize expense related to the fair value of our stock-based compensation awards adjusted to reflect only those shares that are expected to vest. Our implementation of SFAS 123(R) used the modified-prospective-transition method.

We made the following estimates and assumptions in determining fair value of stock options as prescribed by SFAS 123(R):

·

Valuation and Amortization Method — We estimate the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

·

Expected Term — The expected term represents the weighted-average period that our stock-based awards are expected to be outstanding. We applied the “Simplified Method” as defined in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 and 110.

·

Expected Volatility — The Company’s expected volatilities are based on the historical volatility of comparable public companies’ stock for a period consistent with our expected term.

·

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

·

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

Recent Accounting Pronouncements.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used in measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measurements. However, the application of this statement may change current practice. On January 1, 2008, the Company adopted SFAS 157 and the adoption of this statement had no material effect on the Company’s financial statements. On February 12, 2008, the FASB issued FASB Staff Position (FSP) No. 157-2, “Effective Date of FASB Statement No. 157.” FSP 157-2 delays the effective date of adoption for non-financial assets and liabilities to fiscal years beginning after November 15, 2008. As such, the Company adopted the provisions of SFAS 157 with respect to non-recurring fair value measurements for non-financial assets and liabilities as of January 1, 2009. Adoption of this statement did not have a material effect on the Company’s financial statements.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141R”). This statement changes the accounting for acquisition transaction costs by requiring them to be expensed in the period incurred, and also changes the accounting for contingent consideration, acquired contingencies and restructuring costs related to an acquisition. Also in December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements-an amendment of ARB No. 51” (“SFAS 160”). This statement changes the accounting and reporting for minority interests, which are re-characterized as non-controlling interests, classified as a component of equity and accounted for at fair value. SFAS 141(R) and SFAS 160 are effective for the Company’s 2009 financial statements. Early adoption is prohibited. The effect the adoption of SFAS 141(R) has had and will have on the Company’s financial statements will depend on the nature and size of acquisitions we complete after we adopt SFAS 141(R). We adopted SFAS 160 as of January 1, 2009. As a result, we reclassified the 49% non-controlling interest in our subsidiary Energy Enzymes, Inc., prospectively. Had we continued to apply the prior method of accounting for noncontrolling interests, losses incurred by this entity would have been fully attributed to us.

10

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In April 2009, the Financial Accounting Standards Board (FASB) issued Staff Position SFAS 107-1 and Accounting Principles Board (APB) Opinion No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (FSP 107-1 and APB 28-1). FSP 107-1 amends FASB Statement No. 107, “Disclosures about Fair Values of Financial Instruments,” to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. APB 28-1 amends APB Opinion No. 28, “Interim Financial Reporting,” to require those disclosures in all interim financial statements. FSP 107-1 and APB 28-1 are effective for interim periods ending after June 15, 2009 and the Company has adopted them during the period ended June 30, 2009. Adoption of this statement did not have a material effect on the Company’s financial statements. See Note 17 Fair Value Measurement.

In April 2009, the FASB issued Staff Position SFAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (FSP 157-4). FSP 157-4 provides additional guidance in estimating fair value under statement No. 157, “Fair Value Measurements” (SFAS 157), when the volume and level of transaction activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability. FSP 157-4 also provides additional guidance on circumstances that may indicate a transaction is not orderly. FSP 157-4 is effective for interim periods ending after June 15, 2009, and the Company has adopted its provisions during the period ended June 30, 2009. Adoption of this statement did not have a material effect on the Company’s financial statements.

In April 2009, the FASB issued Staff Position SFAS 115-2 and SFAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (FSP 115-2). FSP 115-2 provides guidance in determining whether impairments in debt securities are other than temporary, and modifies the presentation and disclosures surrounding such instruments. FSP 115-2 is effective for interim periods ending after June 15, 2009, and the Company has adopted its provisions during the period ended June 30, 2009. Adoption of this statement did not have a material effect on the Company’s financial statements.

In May 2009, the FASB issued SFAS 165, “Subsequent Events.” SFAS 165 modifies the definition of what qualifies as a subsequent event to be those events or transactions that occur following the balance sheet date, but before the financial statements are issued, or are available to be issued, and requires companies to disclose the date through which it has evaluated subsequent events and the basis for determining that date. The Company adopted the provisions of SFAS 165 for the period ended June 30, 2009. See Note 18.

In June 2009, the FASB issued SFAS No. 168, "The FASB Accounting Standards Codification(TM) ("Codification") and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No. 162" ("SFAS No. 168"). SFAS No. 168 establishes the Codification as the single official source of authoritative United States accounting and reporting standards for all non-governmental entities (other than guidance issued by the SEC). The Codification changes the referencing and organization on financial standards and is effective for interim and annual periods ending on or after September 15, 2009. We will apply the Codification to our disclosures beginning with our report for the period ended September 30, 2009. As Codification is not intended to change the existing accounting guidance, its adoption will not have an impact on our financial statements.

2. Ability to Continue as a Going Concern.

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has experienced losses and negative cash flow since inception and currently has an accumulated deficit. These factors raise substantial doubt about its ability to continue as a going concern. The Company’s ability to continue as a going concern is dependent on several factors, including the ability to raise a significant amount of capital for operating expenses and capital expenditures.

The Company has produced minimal gross profit, has less than one month of cash, has incurred losses from inception through June 30, 2009 and has negative working capital (current assets less current liabilities) of $15,399,243. The Company has raised approximately $31.8 million to date through the sale of preferred stock and approximately $11.5 million through debt facilities. An additional $2 million of cash has been generated through the sale of its subsidiary, Wahoo Ethanol, LLC, with an additional $8 million through the dissolution of the Sutton Ethanol Joint venture. The Company will have to raise significantly more capital and secure a significant amount of debt to complete its business plan and continue as a going concern. The Company has one biodiesel production facility in operation that began selling biodiesel into the domestic Indian market in November 2008. Although the biodiesel plant provides some cash flow to the Company it will likely be insufficient to allow for the completion of our business plan in fiscal 2009.

11

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Management believes that it will be able to raise additional capital through equity offerings and debt financings. Should the Company not be able to raise enough capital it may be forced to sell all or a portion of its existing biodiesel facility or other assets at a discount to market value and incur impairment related to these assets to generate cash to continue the Company’s business plan or possibly discontinue our operations. Until such additional capital is raised, the Company is dependent on financing from a related party. The Company has also arranged extended terms with our trade creditors. The Company’s goal is to raise additional funds needed to construct and operate next generation ethanol and biodiesel facilities through stock offerings and debt financings. There can be no assurance that additional financing will be available on terms satisfactory to the Company. The accompanying financial statements do not include any adjustments that may result should the Company be unable to continue as a going concern.  

3. Inventory.

Inventory consists of the following:

For the three and six months ended June 30, 2009 the Company expensed $196,406 and $234,173, respectively, in connection with the write-down of inventory to reflect market value below cost. During the three and six months ended June 30, 2008 the Company incurred no expense in connection with write down of inventory to reflect market value below cost.

4. Property, Plant and Equipment.

Property, plant and equipment consist of the following:

For the three and six months ended June 30, 2009 the Company recorded $190,293 and $359,715, respectively, in depreciation expense. During the three and six months ended June 30, 2008 the Company recorded $5,660 and $8,719, respectively in depreciation expense.

Components of construction in progress include $2,870,425 related to our India biodiesel pretreatment and glycerin facility (expected to be placed in service during 2009) and $2,053,949 related to the development of our Sutton property (held for future development of a next generation cellulosic ethanol facility). The estimated cost to complete construction of the pretreatment and glycerin facility is $1,000,000. Commitments for approximately $22,328 under construction contracts, purchase orders and other short term contracts were outstanding at June 30, 2009.

12

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. Other Assets.

Other assets consists of foreign input tax credits, restricted cash, payments for land options for possible future ethanol plants, supplier deposits and other prepayments.

The Company acquired options to purchase land in various locations in Nebraska and Illinois. These options gave the Company the right to buy specific property for a set price per acre and typically ended in one to two years. As of December 31, 2008, the Company had one option to purchase land in Illinois for $934,000. This option expired in May 2009, and was expensed during the three months ended March 31, 2009 upon management’s determination not to renew. For the three and six months ended June 30, 2009, the Company expensed options that ended or were released in the amount of $40,000. For the three and six months ended June 30, 2008, the Company expensed options that ended or were released in the amount of $124,536.

6. Intangible Assets.

Intangible assets consist of purchased customer lists (acquired in 2007 in connection with the acquisition of Biofuels Marketing, Inc. discussed in Note 12 below), which have been amortized over an estimated useful life of 18 months. The intangible assets have a cost basis of $300,000 and a net carrying amount of $0 and $33,334 at June 30, 2009 and December 31, 2008, respectively. For the three and six months ended June 30, 2009, the Company recorded amortization of $0 and $33,334, respectively. For the three and six months ended June 30 2008, the Company recorded amortization of $50,000 and $100,000, respectively.

7. Debt.

Debt consists of the following:

Senior secured note. On May 16, 2008, Third Eye Capital ABL Opportunities Fund (“Purchaser”) purchased a 10% senior secured note in the amount of $5 million along with 5 year warrants exercisable for 250,000 shares of common stock at an exercise price of $3.00 per share. The note is secured by first-lien deeds of trust on real property located in Nebraska and Illinois, by a first priority security interest in equipment located in Montana, and a

13

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

guarantee of $1 million by McAfee Capital LLC (owned by Eric McAfee and his wife). Interest on the note accrues on the unpaid principal balance and is payable on the first business day of each quarter beginning on July 1, 2008. The Company may prepay all or any portion of the outstanding principal amount of the note at any time. Prior to the note maturing on May 15, 2009, the Company entered into an amendment and limited waiver (the “Amendment”) with Third Eye Capital Corporation (“Agent”) on behalf of itself and the Purchaser dated March 31, 2009. Subject to satisfaction of certain conditions, which have not been met as of June 30, 2009, the Amendment will become effective as of March 31, 2009. As the Amendment is not effective as of June 30, 2009 as we were unable to execute the conditions of effectiveness of the Amendment, the interest rate under this facility has been accrued at the default interest rate, which is 18% through June 30, 2009. Once the Amendment becomes effective, the Amendment provides for the extension of the maturity date of the note to December 31, 2009 and for the waiver of certain covenant defaults for a fee. Under the Amendment, the Company has also agreed to provide Agent additional collateral as security for the note and has agreed to amend the exercise price of the warrants issued to a price equal to the volume weighted average trading price of a share of Common Stock of the Company for the twenty trading days immediately preceding the date of this Amendment.

Under the note, the Company has two financial covenants, a stock market capitalization covenant and a current ratio covenant. The stock market capitalization covenant requires the Company to maintain an aggregate dollar market value of at least $100,000,000 as of the end of each month through March 31, 2009 and under the Amendment, at least $5,000,000 as of the end of April and May 2009 and $7,000,000 as of the end of June 2009. This calculation is performed by multiplying the stock price at the end of each month by the aggregate shares outstanding. The current ratio covenant requires the Company to maintain a ratio of at least 1.10:1 exclusive of the indebtedness under the note and the registration rights liability. This calculation is performed by first adjusting the current liabilities by the amount of the note and the registration rights liability, then by applying this denominator to the current assets numerator. The calculations as of June 30, 2009 are as follows:

The Company was not in compliance with the current ratio or stock market capitalization covenant for the months of November 2008 through June 2009 under the loan agreement.

Once the Amendment becomes effective, we are able to obtain waivers for the covenant default by remitting a waiver fee of $10,000 per occurrence of default. The Amendment was not effective as of June 30, 2009 as we were unable to execute the conditions of effectiveness of the Amendment; accordingly, the interest rate under this facility has been accrued at the default interest rate, which is 18%, during the period of default. The Company has no cross default provisions in this or any other debt agreement. As a result, our inability to execute the conditions of effectiveness of the Amendment will have no adverse impact on our other debt obligations. Nevertheless, the failure to execute the effectiveness of the Amendment may have an adverse impact on our ability to obtain additional borrowings. There is no assurance that the Company will be able to obtain alternative funding in the event the Amendment does not become effective. Immediate acceleration would have a significant adverse impact on the Company’s near term liquidity.

14

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

A discount to the note was recorded based on the relative fair value of the 250,000 warrants issued with the note. For purposes of the relative fair value allocation, the warrants were valued using a Black-Scholes valuation with the following assumptions: five year term, volatility of 58.7%, no dividends and a risk free interest rate of 3.66%. The fair value of the note was estimated using a discounted cash flow analysis. The resulting relative fair value of the warrants of $822,500, combined with a discount of $500,000 related to cash issuance costs, will be amortized over one year, the term of the note. For the three and six months ended June 30, 2009, the Company recorded amortization of this discount in the amount of $165,312 and $495,938, respectively.

Secured term loan. On July 17, 2008, Universal Biofuels Private Limited (“UBPL”), a wholly-owned subsidiary, entered into a six year secured term loan with the State Bank of India with an overall limit in the amount of approximately $6 million. The term loan matures in March 2014 and is secured by UBPL’s assets, consisting of the biodiesel plant and land in Kakinada. In July 2008 we drew approximately $4.6 million against the secured term loan. The loan principal amount is repayable in 20 quarterly installments of approximately $250,000, using exchange rates on June 30, 2009, with the first installment due in June 2009 and the last installment payment due in March 2014. The interest rate under this facility is subject to adjustment every two years, based on 0.25% above the Reserve Bank of India advance rate and is currently 12.50%.

The first principal payment scheduled for June 2009 was not made and in the event of default of payment of any installment of principal payments, the term loan provides for liquidating damages at a rate of 2% per annum for the period of default. The default period began on July 1, 2009 when the principal payment was deemed past due; therefore, we have accrued for the liquidating damages for the period of default in July and August. Additional provisions of default include the bank having the unqualified right to disclose or publish our company name and our directors names as defaulter in any medium or media. At the bank’s option, it may also demand payment of the balance of the loan since the principal payments are in default in July 2009 so we have classified the entire loan amount as current. As of the date of this filing, we have not received notice of demand payment of the balance of the loan.

Revolving line of credit – related party. On November 16, 2006, the Company entered into a short-term loan agreement with a former member of the Company’s board of directors. In 2008 this short-term loan agreement was amended to convert the facility into a revolving line of credit with a credit limit of $3,000,000. In addition, the maturity date of the credit facility was extended to January 31, 2011. At June 30, 2009, a total of $2,978,816, including accrued interest, was outstanding under this credit facility which accrues interest at 10% interest per annum. All outstanding principal and accrued interest is due and payable on January 31, 2011.

8. Operating Leases.

The Company, through its subsidiaries, has non-cancelable operating leases for office space in various worldwide locations and the property housing our cellulosic demonstration facility in Butte, Montana. These leases expire at various dates through May 31, 2012. The operating lease for the cellulosic demonstration facility grants the Company the right to purchase the underlying land and building at the end of each lease year. The Company records rent expense on a straight line basis.

Future minimum operating lease payments as of June 30, 2009, are:

For the three and six months ended June 30, 2009, the Company recorded $65,732 and $133,295, respectively, in rent expense.  During the three and six months ended June 30, 2008, the Company recorded $72,132 and $163,286, respectively in rent expense.

15

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9. Stockholders’ Equity.

The Company is authorized to issue up to 400,000,000 shares of common stock, $0.001 par value and 65,000,000 shares of preferred stock, $0.001 par value, of which 7,235,565 shares were designated Series B preferred stock, 3,330,725 shares of which were outstanding as of June 30, 2009.

Convertible Preferred Stock

Significant terms of the Series B preferred stock are as follows:

Voting. Holders of our Series B preferred stock are entitled to the number of votes equal to the number of shares of Common Stock into which the shares of Series B preferred stock held by such holder could be converted as of the record date. Cumulative voting with respect to the election of directors is not allowed. Currently each share of Series B preferred stock is entitled to one vote per share of Series B preferred stock. In addition, without obtaining the approval of the holders of a majority of the outstanding preferred stock, the Company cannot:

·

Increase or decrease (other than by redemption or conversion) the total number of authorized shares of Series B preferred stock;

·

Effect an exchange, reclassification, or cancellation of all or a part of the Series B preferred stock, including a reverse stock split, but excluding a stock split;

·

Effect an exchange, or create a right of exchange, of all or part of the shares of another class of shares into shares of Series B preferred stock; or

·

Alter or change the rights, preferences or privileges of the shares of Series B preferred stock so as to affect adversely the shares of such series.

Dividends. Holders of all of our shares of Series B preferred stock are entitled to receive non-cumulative dividends payable in preference and before any declaration or payment of any dividend on common stock as may from time to time be declared by the board of directors out of funds legally available for that purpose at the rate of 5% of the original purchase price of such shares of preferred stock. No dividends may be made with respect to our common stock until all declared dividends on the preferred stock have been paid or set aside for payment to the preferred stock holders. To date, no dividends have been declared.

Liquidation Preference. In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company, the holders of the Series B preferred stock are entitled to receive, prior and in preference to any payment to the holders of the common stock, $3.00 per share plus all declared but unpaid dividends (if any) on the Series B preferred stock. If the Company’s assets legally available for distribution to the holders of the Series B preferred stock are insufficient to permit the payment to such holders of their full liquidation preference, then the Company’s entire assets legally available for distribution are distributed to the holders of the Series B preferred stock in proportion to their liquidation preferences. After the payment to the holders of the Series B preferred stock of their liquidation preference, the Company’s remaining assets legally available for distribution are distributed to the holders of the common stock in proportion to the number of shares of common stock held by them. A liquidation, dissolution or winding up includes (a) the acquisition of the Company by another entity by means of any transaction or series of related transactions to which the Company is party (including, without limitation, any stock acquisition, reorganization, merger or consolidation but excluding any sale of stock for capital raising purposes) that results in the voting securities of the Company outstanding immediately prior thereto failing to represent immediately after such transaction or series of transactions (either by remaining outstanding or by being converted into voting securities of the surviving entity or the entity that controls such surviving entity) a majority of the total voting power represented by the outstanding voting securities of the Company, such surviving entity or the entity that controls such surviving entity, or (b) a sale, lease or other conveyance of all or substantially all of the assets of the Company.

16

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Conversion. Holders of Series B preferred stock have the right, at their option at any time, to convert any shares into common stock. Each share of preferred stock will convert into one share of common stock, at the current conversion rate. The conversion ratio is subject to adjustment from time to time in the event of certain dilutive issuances and events, such as stock splits, stock dividends, stock combinations, reclassifications, exchanges and the like. In addition, at such time as the Registration Statement covering the resale of the shares of common stock is issuable, then all outstanding Series B preferred stock shall be automatically converted into common stock at the then effective conversion rate. For the three months ended June 30, 2009, no shares of Series B preferred stock were converted into shares of common stock.

Registration Rights Agreement liquidated damages for certain common and Series B preferred shareholders. Certain holders of shares of our common stock and holders of shares of our Series B preferred stock were entitled to have their shares of common stock (including common stock issuable upon conversion of Series B preferred stock) registered under the Securities Act within but no later than 30 days after December 7, 2007, pursuant to the terms and subject to the conditions set forth in a Registration Rights Agreement entered into among the Company and such holders. Registration of these shares under the Securities Act would result in these shares becoming freely tradable without restriction under the Securities Act.

In February 2009, in full settlement of the $1,807,748 registration right liability, the Company issued a total of 406,656 shares of its common stock to eligible shareholders resulting in a reduction of the liability and a corresponding increase in additional paid in capital and common stock.

Mandatorily Redeemable Series B preferred stock. In connection with the election of dissenters’ rights by the Cordillera Fund, L.P., at December 31, 2008 the Company reclassified 583,334 shares of Series B preferred stock with an original purchase price of $1,750,002 out of shareholders’ equity to a liability called “mandatorily redeemable Series B preferred stock” and accordingly reduced stockholders equity by the same amount to reflect the Company’s estimate of its obligations with respect to this matter. See Note 16 – Contingent Liabilities.

Common Stock

On October 6, 2008, the Company and TIC cancelled their Strategic Alliance Agreement and TIC agreed to return 4,000,000 shares of the Company’s common stock for a total payment of $500,000 by the Company of which $234,419 was paid to TIC upon the parties’ entry into the agreement and $265,581 was payable on or before December 30, 2008. Upon cancellation of the agreement, TIC returned 1,880,000 shares and will return the remaining 2,120,000 shares upon the receipt of the final payment. In the event the final payment is not received on or before December 30, 2008, interest shall begin to accrue at the annual rate of 18% until paid in full. At June 30, 2009, the Company had not made the payment required under the agreement. As of June 30, 2009, the Company accrued interest of $24,561 related to this obligation.

10. Private Placement of Preferred Stock and Warrants.

In connection with the sale of our Series A and B preferred stock, we issued to our placement agent warrants to purchase a number of shares of our common stock representing up to 8% of the shares of Series A and Series B preferred stock sold. The warrants are exercisable for a period of seven years from the date of issuance, have a net exercise provision and are transferable. Further, subject to certain conditions, the Company has indemnified the placement agents and affiliated broker-dealers against certain civil liabilities, including liabilities under the Securities Act.

A summary of warrant activity for placement warrants for 2009 is as follows:

17

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The warrants are considered equity instruments. Since they were issued as a cost of the issuance of the Series A and B preferred stock, the fair value of these warrants has effectively been netted against the preferred stock sale proceeds.

One former member of the Company’s board of directors and a significant shareholder of the Company was a registered representative of the placement agent. He received a portion of the compensation paid to the placement agent and received 976,721 of the warrants issued from the Series A and B financing. During 2008, he exercised warrants for 801,721 shares of our common stock and transferred 175,000 warrants to another individual.

Warrants

In May 2008, we issued 250,000 common stock warrants to Third Eye Capital in connection with the sale of a 10% senior secured note. These warrants are immediately exercisable at $3.00 per share. Upon effectiveness of the May 6, 2009 amendment and limited waiver, the Company has agreed to amend the exercise price of the warrants issued to a price equal to the volume weighted average trading price of a share of Common Stock of the Company for the twenty trading days immediately preceding the date of this Amendment. See Note 7 above.

In February 2007, we issued 5,000 warrants to a consultant as compensation for services rendered. These warrants are immediately exercisable at $3.00 per share.

11. Stock-Based Compensation.

Common Stock Reserved for Issuance

We authorized the issuance of 4,882,410 shares under the 2007 Stock Plan for stock option awards, which includes both incentive and non-statutory stock options. Options granted under the Plan generally expire five years from the date of grant and are exercisable at any time after the date of the grant, subject to vesting. Shares issued upon exercise before vesting are subject to a right of repurchase, which lapses according to the vesting schedule of the original option.

The following is a summary of options granted under the 2007 Stock Plan:

At June 30, 2009, the weighted average remaining contractual term is 4.70 years. The aggregate intrinsic value of the shares outstanding at June 30, 2009 is $0. The aggregate intrinsic value represents the total pretax intrinsic value, based on the excess of the Company’s closing stock price at June 30, 2009 of $0.16, over the options holders’ strike price, which would have been received by the option holders had all option holders exercised their options as of that date. The weighted average grant date fair value of these awards at June 30, 2009 is $1.85. Options vested and exercisable at June 30, 2009 were 2,650,423 with a weighted average exercise price of $1.41.

Included in the table above are 627,000 options issued to consultants in November 2007, June 2008 and May 2009. These options had an exercise price of $3.00, $3.70 and $0.16, respectively, and generally vest over 3 years. At June 30, 2009 the weighted average remaining contractual term was 3.64 years. The Company recorded an expense for the three and six months ended June 30, 2009 in the amount of $27 and $3,270, respectively, which reflects periodic fair value remeasurement of outstanding consultant options under Emerging Issues Task Force, or EITF, No. 96-18, “Accounting for Equity Instruments that are issued to Other Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” (“EITF 96-18”). The valuation using the Black-Scholes-Merton model is based

18

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

upon the current market value of our common stock and other current assumptions, including the expected term (contractual term for consultant options). The Company records the expense related to consultant options using the accelerated expense pattern prescribed in EITF 96-18.

Valuation and Expense Information under SFAS 123(R)

The Company incurred non-cash stock compensation expense of $284,287 and $452,274 for the three and six months ended June 30, 2009, respectively, for options granted to our general and administrative employees and consultants. Of the non-cash stock compensation expense for the three and six months ended June 30, 2009, $37,500 and $75,000, respectively, was attributable to stock granted to an officer pursuant to the acquisition of Biofuels Marketing, Inc. discussed in Note 12 – Acquisitions, Divestitures and Joint Ventures below. Therefore all stock option expense was classified as general and administrative expense.

As of June 30, 2009, total unrecognized compensation expense under FAS 123R was $591,219, net of estimated forfeitures, which the Company will amortize over the next five fiscal years.

In January 2006, the Company issued certain employees 4,400,000 shares of common stock at $0.0025 per share in the form of restricted stock awards in connection with employment agreements under restricted unit purchase agreements. These shares were issued as an incentive to retain key employees and officers and vest over 3 years.

The following table summarizes the Company’s repurchase rights under these agreements:

12. Acquisitions, Divestitures and Joint Ventures.

Marketing Company Acquisition. On September 1, 2007, we acquired Biofuels Marketing, Inc., a Nevada corporation, in exchange for 200,000 shares of common stock valued at $3.00 per share. Of the shares issued, 50% were contingent upon the continued employment of the President of Biofuels Marketing through August 31, 2009, and are accounted for as compensation expense as earned. Of the purchase price, $300,000 was assigned to the primary asset acquired, which was a customer list, which was amortized over 18 months.

Technology Company Formation. On February 28, 2007, we acquired a 51% interest in Energy Enzymes, Inc. We have the right to acquire the remaining 49% for 1,000,000 shares of our common stock upon the fulfillment of certain performance milestones. The performance milestones had not been met as of June 30, 2009. In accordance with SFAS 160, we attributed net loss to Energy Enzymes, Inc. beginning at the date of adoption of SFAS 160 in our consolidated statement of operations and recorded the minority interest to non-controlling interest in the stockholders equity section of our balance sheet. The equity attributable to the Company and to the noncontrolling interest in Energy Enzymes, Inc. are as follows:

19

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Operating Agreement. In November 2008, we entered into an operating agreement with Secunderabad Oils Limited. Under this agreement Secunderabad agreed to provide us with plant operational expertise on an as-needed basis and working capital, on an as needed basis, to fund the purchase of feedstock and other raw materials for our Kakinada biodiesel facility. Working capital advances bear interest at the actual bank borrowing rate of Secunderabad. In return, we agreed to pay Secunderabad an amount equal to 30% of the plant’s monthly net operating profit. In the event that our biodiesel facility operates at a loss, Secunderbad owes the Company 30% of the losses.  The agreement can be terminated by either party at any time without penalty. During the three and six months ended June 30, 2009 the Company paid Secunderabad approximately $10,427 and $80,134, respectively, under the agreement and approximately $6,240 and $7,446, respectively, in interest for working capital funding. At June 30, 2009 and December 31, 2008 the Company had $792,324 and $0 outstanding under this agreement, respectively, and included as current short term borrowings on the balance sheet.

13. Segment Information.

Summarized financial information by reportable segment for the three and six months ended June 30, 2009, based on the internal management system, is as follows:

During the three and six months ended June 30, 2009 all of our revenues were from sales to external customers in our India segment.

Two customers represented 37% of our sales for the three months ended June 30, 2009. One customer represented 23% of our sales for the six months ended June 30, 2009. No other single customer represented more than 10% of our revenues during this period.

20

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

14. Related Party Transactions.

Laird Cagan, a former member of the Company’s board of directors and a significant stockholder, provides the Company a $3,000,000 revolving line of credit. At June 30, 2009, a total of $2,753,492 plus accrued interest of $225,325 was outstanding under this credit facility which accrues interest at 10% interest per annum. All outstanding principal and accrued interest is due and payable on January 31, 2011.

The Company and Eric A. McAfee, the Company's Chief Executive Officer and Chairman of the board of directors, are parties to an agreement pursuant to which the Company pays Mr. McAfee a monthly salary of $10,000 per month for services rendered to the Company as its President and CEO. For each of the three and six months ended June 30, 2009 and 2008, the Company paid or accrued Mr. McAfee $30,000 and $60,000, respectively, pursuant to this agreement. As of June 30, 2009, the Company owes Mr. McAfee $100,000 under the terms of this agreement.

The Company and CM Consulting are parties to an agreement pursuant to which the Company reimbursed CM Consulting for a minimum of 20 hours per month of time on an aircraft owned by CM Consulting until February 2008. The Company paid an upfront fee of $360,000 in February 2006 for 24 months of usage. The contract expired in February 2008. The Company expensed $30,000 of this rental fee for the three months ended June 30, 2008. Eric A. McAfee, a director, officer and significant shareholder of the Company owns 50% of CM Consulting.

The Company and Cagan McAfee Capital Partners are parties to an agreement pursuant to which Cagan McAfee Capital Partners provides administrative and advisory services for a monthly fee of $15,000 plus expense reimbursement to the Company. For the three and six months ended June 30, 2009, the Company paid Cagan McAfee Capital Partners $45,418 and $101,089, respectively. For the three and six months ended June 30, 2008, the Company paid Cagan McAfee Capital Partners $10,995 and $89,327, respectively. Eric A. McAfee, an officer and member of the Company’s board of director and Laird Cagan, a former of the Company’s board of directors, together own 100% of Cagan McAfee Capital Partners. The contract expired in January 2009. As of June 30, 2009, the Company owes CMCP $209,866 under the terms of this agreement.

TIC - The Industrial Company (TIC) and Delta-T are companies involved in the design and construction of ethanol plants in the United States. In 2006 the Company paid TIC and Delta-T approximately $7.5 million for services related to the design and initial construction work on the Company’s Sutton ethanol plant facility. In August 2007, the Company and TIC ended their relationship, and the company wrote off approximately $5.2 million in design work and construction in progress. On October 6, 2008, the Company and TIC cancelled their Strategic Alliance Agreement and TIC agreed to return 4,000,000 shares of the Company’s common stock for a total payment of $500,000 by the Company. Upon cancellation of the agreement, TIC returned 1,880,000 shares and will return the remaining 2,120,000 shares upon the receipt of the final payment. The final payment was not made as required on December 30, 2008 and interest is accruing at the annual rate of 18% until paid in full.

15. Income Tax.

The Company files a consolidated federal income tax return. This return includes all corporate companies 80% or more owned by the Company as well as the Company’s pro-rata share of taxable income from pass-through entities in which Company holds an ownership interest. Energy Enzymes, Inc. is 51% owned by the Company, files a separate federal income tax return and is 100% consolidated for financial reporting. State tax returns are filed on a consolidated, combined or separate basis depending on the applicable laws relating to the Company and its subsidiaries.

We do not provide for U.S. income taxes on the undistributed earnings of our foreign subsidiaries, as we consider these to be permanently reinvested in the operations of such subsidiaries. At June 30, 2009, these undistributed losses totaled approximately $3,600,980. If any future earnings were distributed, some countries may impose withholding taxes. However, due to the Company’s overall deficit in foreign cumulative earnings and U.S. loss provision, we do not believe the net unrecognized U.S. deferred tax liability is material.

We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. The adoption of FIN 48 had no impact on our financial statements. FIN 48 clarifies the accounting for uncertainty in income tax positions. FIN 48 provides

21

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

that the tax effects from an uncertain tax position can be recognized in our financial statements only if the position is more-likely-than-not of being sustained on audit, based on the technical merits of the position. Tax positions that meet the recognition threshold are reported at the largest amount that is more-likely-than-not to be realized. This determination requires a high degree of judgment and estimation. We periodically analyze and adjust amounts recorded for our uncertain tax positions, as events occur to warrant adjustment, such as when the statutory period for assessing tax on a given tax return or period expires or if tax authorities provide administrative guidance or a decision is rendered in the courts.

We conduct business globally and, as a result, one or more of our subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. In the normal course of business, we are subject to examination by taxing authorities throughout the world, including such major jurisdictions as India, Mauritius, and the United States. With few exceptions, we incorporated in 2006 and we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations for years before 2006.

16. Contingent Liabilities.

On March 28, 2008, the Cordillera Fund, L.P. ("Cordillera") filed a complaint in the Clark County District Court of the State of Nevada against American Ethanol, Inc. and the Company. The complaint seeks a judicial declaration that Cordillera has a right to payment from the Company for its American Ethanol shares at fair market value pursuant to Nevada's Dissenters' Rights Statute, a judicial declaration that Cordillera is not a holder of Series B preferred stock in the Company under the provisions of the statute; and a permanent injunction compelling the Company to apply the Dissenters' Rights Statute to Cordillera's shares and reimburse Cordillera for attorneys fees and costs.

On June 2, 2008 the case was transferred to the Second Judicial Court of the State of Nevada, located in Washoe County, Nevada. On February 17, 2009, a jury trial commenced on the sole issue of whether Cordillera timely delivered its notice of Dissenters’ Rights to the Company. On February 17, 2009, the jury delivered its verdict in favor of Cordillera. The remaining issue in the lawsuit concerned the fair market value of the shares of stock held by Cordillera. On or about June 9, 2009, the Court entered an order as follows: "the parties are ordered to, within ninety (90) days, obtain an appraisal to determine the fair market value of the Plaintiff's stock at the time of the merger." As for the fair market value of the shares of stock held by Cordillera, the Court further stated that "the Court will make a decision after the appraisal reports have been filed." The deadline for the submission of the appraisals is September 6, 2009. Please see Note 9 – Stockholders Equity.

On May 1, 2009 our transfer agent, Corporate Stock Transfer, Inc. (“CST”), filed a Complaint for Interpleader in the United States District Court for the District of Colorado. The interpleader action is based on the Company’s and CST’s refusal to remove the restrictive legend from a certificate representing 5,600,000 shares of the Company's restricted common stock (the “Certificate”) held by Defendant Surendra Ajjarapu and seeks a judicial determination as to whether the legend can be lawfully removed from the Certificate. On July 1, 2009 Defendant Ajjarapu answered the Complaint for Interpleader, and Cross-Claimants and Counter-Claimants Surendra Ajjarapu and Sandhya Ajjarapu (the “Ajjarapus”) cross-claimed against the Company for breach of fiduciary duty, conversion, violation of Section 10(b) of the Exchange Act and Rule 10b-5 and injunctive relief. The Ajjarapus also counter-claimed against CST for declaratory judgment. On July 28, 2009 the Company answered the Complaint for Interpleader and filed a Motion to Dismiss the Ajjarapus’ cross-claims. The Company does not believe it has any liability for the matters described in this litigation and intends to defend itself vigorously. However, there can be no assurance regarding the outcome of the litigation. An estimate of possible loss, if any, or the range of loss cannot be made and therefore we have not accrued a loss contingency related to these actions.

In June, our India subsidiary exited from the Export Oriented Unit taxation status and became a domestic producer. As part of the governmental agreements, the Company is required to export approximately $4,000,000 of biodiesel into the international markets before June 2017 or pay the tax as though the exported biodiesel was sold within the country of India.

22

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

17. Fair Value Measurement.

Fair value, as defined in SFAS 157, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of an asset should reflect its highest and best use by market participants, whether using an in-use or an in-exchange valuation premise. The fair value of a liability should reflect the risk of nonperformance, which includes, among other things, the Company’s credit risk.

Valuation techniques are generally classified into three categories: the market approach; the income approach; and the cost approach. The selection and application of one or more of the techniques requires significant judgment and are primarily dependent upon the characteristics of the asset or liability, the principal (or most advantageous) market in which participants would transact for the asset or liability and the quality and availability of inputs. Inputs to valuation techniques are classified as either observable or unobservable within the following hierarchy:

Level 1 Inputs

These inputs come from quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 Inputs

These inputs are other than quoted prices that are observable, for an asset or liability. This includes: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3 Inputs

These are unobservable inputs for the asset or liability which require the Company’s own assumptions.

As required by SFAS 157, financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.

Our only financial asset carried at fair value is cash held in commercial bank accounts with short term maturities. We consider the statement we receive from the bank as a quoted price (Level 1 remeasurement) for cash and measure the fair value of these assets using the bank statement.  

The Company’s financial liabilities include short and long-term debt and long term debt (related party).  The carrying value of the Company’s short-term debt approximates fair value due to the short-term maturity of this instrument, which based on the pending amendment with Third Eye Capital ABL Opportunities Fund at the same interest rate as the current debt has a maturity date of December 2009 (Level 2 remeasurment) and which based on the operating agreement with Secunderabad Oils Limited at the actual borrowing rate of Secuderabad (Level 2 remeasurement). The Company’s long-term debt carrying value approximates fair value based upon the borrowing rates currently available to the Company for bank loans in India with similar terms and maturities (Level 2 remeasurement). The Company is unable to estimate the fair value of the long term debt (related party) due to the unsecured nature of this loan and the lack of comparable available credit facilities (Level 3 remeasurment).

23

AE BIOFUELS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The carrying amounts and fair values of the Company’s financial instruments at June 30, 2009, are as follows:

18. Subsequent Events.

Our Company has evaluated and disclosed any subsequent events that have occurred from June 30, 2009 through August 6, 2009, the date of filing of this Quarterly Report on Form 10-Q. We were not required to recognize the effect of our subsequent events in our financial statements, as they arose after our balance sheet date. The following is a summary of our nonrecognized subsequent events:

Revolving line of credit – related party. On July 23, 2009 this total amount of this credit facility was increased from $3,000,000 to $3,500,000. During July and August, 2009, the Company borrowed an additional $171,000 under the credit facility provided by Laird Cagan, a former director. See Notes 7 and 14 above.

24

Item 2.

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

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided in addition to the accompanying consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition, and cash flows. MD&A is organized as follows:

·

Overview. Discussion of our business and overall analysis of financial and other highlights affecting the Company to provide context for the remainder of MD&A.

·

Results of Operations. An analysis of our financial results comparing the three months ended June 30, 2009 to the three months ended June 30, 2008 and the six months ended June 30, 2009 to the six months ended June 30, 2008.

·

Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and discussion of our financial condition.

·

Critical Accounting Estimates. Accounting estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results and forecasts.

The following discussion should be read in conjunction with the AE Biofuels, Inc. consolidated financial statements and accompanying notes included elsewhere in this report. The following discussion contains forward-looking statements that reflect the plans, estimates and beliefs of AE Biofuels, Inc. The actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Report, particularly under “Part II — Other Information, Item 1A. Risk Factors”, and in other reports we file with the Securities and Exchange Commission (“SEC”), specifically the most recent Annual Report on Form 10-K and 10-K/A.” All references to years relate to the calendar year ended December 31 of the particular year.

Overview

The Company’s goal is to be a leader in the production of next-generation fuels to meet the increasing demand for renewable transportation fuels, and to reduce dependence on petroleum-based energy sources in an environmentally responsible manner. We have raised approximately $31.8 million to date through the sales of our preferred stock and approximately $13 million through debt facilities to fund our operations since our inception in late 2005. To date, we have used these funds to (i) construct and operate a 50 MGY biodiesel manufacturing facility in Kakinada, India, (ii) purchase land and land options for the development of ethanol and/or next generation ethanol plants in the United States (iii) develop, draft and submit three patents on proprietary, patent-pending enzyme technology, (iv) construct a portion of a glycerin refining and vegetable oil pretreatment facility at our Kakinada plant, and (v) commercialize our proprietary, patent-pending enzyme technology, including the construction and operation of our next-generation cellulose ethanol demonstration facility in Butte, Montana.

We completed construction of both our biodiesel plant and our cellulosic ethanol demonstration plant in 2008 and we have been selling biodiesel since November 2008. We, however, currently do not have sufficient cash reserves to meet our anticipated operating and capital obligations. As a result, we are in the process of seeking additional capital for operation of our Kakinada refinery at full capacity, for continuing the construction of the glycerin refining and vegetable oil pretreatment plant, for funding development activities at our cellulosic ethanol demonstration plant and for paying ongoing corporate overhead expenses. Additional capital will have to be sufficient to fund the working capital of the biodiesel plant until the plant generates sufficient cash flow from operations, if ever. We may encounter unforeseen costs that could also require us to seek additional capital. Further, we have been operating at a loss and expect to increase our operating expenses significantly as we expand our operations.

The worldwide market for biofuels continued to grow in 2008 and 2009 and we have benefited from the growth of biodiesel use domestically in India as we began our operations and sales of biodiesel into the domestic Indian market in November 2008. Our sales transactions consist of sales of biodiesel to retail distributors of biodiesel in India. We receive the order and payment on the sale before distribution of the product. We sell our product primarily through outside sales brokers and partially through an outside sales force. We have not sold products on a consignment basis or to any international customers. We have the ability to generate additional revenue

25

through the sale of glycerin, the by-product from the biodiesel production process. Glycerin can be sold in crude or refined form. During the six months ended June 30, 2009 we sold 106 metric tons of crude glycerin. We are in the process of completing a glycerin refinery at our Kakinada plant and expect it to be completed in 2009 which will be financed by either our India banker or our India business partner. We had no sales of glycerin in fiscal 2008. Our cost of revenues consists of feedstock, chemicals and plant overhead. Depending upon the costs of these products in comparison to the sales price of the biodiesel, our gross margins can vary from positive to negative. Overhead expenses include direct and indirect costs associated with the biodiesel production at our Kakinada plant, plant utilities, maintenance, insurance, depreciation and freight. We produced 6,554 metric tons of biodiesel in 2009 and sold 5,749 metric tons of biodiesel which was 7.5% of our total plant capacity for the six months ended June 30, 2009.

In August 2008, we opened the first integrated cellulose and starch ethanol commercial demonstration facility in the United States. Our 9,000 square foot demonstration plant is capable of producing ethanol from a variety of feedstock sources, including wheat straw and corn stover. Our integrated technology addresses the immediate need for commercially viable uses of non-food feedstock to complement existing feedstock sources to meet the worldwide demand for ethanol. Our strategy for the commercialization of our integrated cellulose and starch process includes: (i) acquiring existing starch (corn) plants and retrofitting them with our technology; (ii) establishing joint ventures with existing ethanol plants (including corn ethanol plants in the U.S. and sugarcane ethanol plants in Brazil and India); (iii) constructing and operating standalone cellulosic ethanol facilities; and (iv) licensing our proprietary technology to ethanol plants in the U.S., Europe, Brazil and India.

During the three and six months ended June 30, 2009, we operated our biodiesel in India; however, our current operations are constrained by our limited working capital and the market acceptance of our biodiesel product in India. We believe that we can continue to increase sales of biodiesel in 2009; however, the biodiesel market must continue to accept our products and the margins between the feedstock costs and the biodiesel sales price must remain positive in order for us to have positive gross margins in 2009. We expect the market for next generation cellulosic ethanol to continue to grow due to a focus toward reducing reliance on petroleum based fuel and due to increased cellulosic ethanol mandates specified by the RFS II. We believe that we can begin generating revenues through the commercialization of our cellulosic ethanol technology and associated Renewable Identification Number (RIN’s) in 2009; however, we have not been able to generate revenues from this technology thus far.

Our cash and cash equivalents balance was $24,330 as of June 30, 2009, of which $7,493 was held in our domestic entities and $16,837 was held in foreign subsidiaries. Our current ratio as of June 30, 2009 was 0.16 compared to a current ratio of 0.13 as of December 31, 2008. We ended June 30, 2009 with limited working capital resources and we will need to raise additional working capital in 2009 in order to achieve our goals in India and the U.S. Due to the recent global financial crisis, obtaining working capital through commercial banks or through other means is a significant challenge and we cannot be assured we will be able to obtain additional working capital and therefore be successful in 2009. Should the Company not be able to raise enough equity or debt financing, it may be forced to sell all or a portion of its existing biodiesel facility or other assets to generate cash to continue the Company’s business plan or possibly discontinue operations.

Results of Operations

Three Months Ended June 30, 2009 Compared to Three Months Ended June 30, 2008

Revenues

For the three months ended June 30, 2009, $994,462 or 100% of our revenue was derived from the sale of biodiesel into the Indian domestic market. All revenue during 2009 is part of our India geographic segment. No revenues were recorded for the three months ended June 30, 2008.

We recognize revenue upon shipment of product as payments are generally made in advance and we do not offer any right of return. We had no accounts receivable as of June 30, 2009. Our average sales transaction consists of a customer taking delivery of several metric tons of biodiesel by loading it into their tanker truck at our plant site. We have several customers who take delivery of biodiesel on a daily basis. As a result, it is difficult to predict timing or size of product sales on a quarterly basis.

26

Cost of Revenues

Our cost of revenues consists of fixed costs, including utilities, supplies, insurance, property taxes, depreciation and indirect labor compensation. Variable costs include direct labor compensation and direct material costs. The largest component of the cost of revenues is the palm oil or palm stearin feedstock for the biodiesel production process. The price of palm oil and palm stearin is influenced by general economic, market and regulatory factors. These factors include local and global supply and demand, weather conditions, farmer planting decisions, government policies and subsidies with respect to agriculture and international trade. The price at which we sell our biodiesel in India is generally indexed to the price of petroleum diesel, which is set by the Indian government, the lack of correlation between production costs and product prices means that we are generally unable to pass increased feedstock costs on to our customers. The cost of palm oil or palm stearin has fluctuated significantly in recent periods; however, for the six months ended June 30, 2009, the commodity markets proved to be more stable than they were in fiscal 2008. In early January 2009, we sold through all the feedstock purchased in 2008 and we are buying feedstock as required to support current biodiesel production. During certain weeks of the three month period ended June 30, 2009 there was an increase in the price of palm oil or palm stearin to the point were the cost of production was higher than the cost of selling the biodiesel; therefore, we did not buy feedstock or produce and sell biodiesel for several weeks during the period. As a result of lower sales for the quarter than in the previous quarter, we did not sell amounts of biodiesel with a enough profit margin to cover our fixed costs of the biodiesel plant. Our cost of revenues for the three months ended June 30, 2009 was larger than our revenues and we incurred a negative gross margin of $103,295 or 10.4%.

We exited the quarter ended June 30, 2009 with 342 metric tons of feedstock, or about one week’s worth of biodiesel sales, at our current quarter’s sales levels. During the three months ended June 30, 2009, we recognized $196,406 in inventory adjustments attributable to lower of cost or market valuation. All of our cost of revenues was located in our India geographic segment. No revenues nor cost of revenues were recorded for the three months ended June 30, 2008.

Expenses

Research and Development Expenses. The principal area of spending for research and development is our integrated cellulose and starch ethanol commercial demonstration facility in Butte. We spent $49,960 and $387,708 in the three month periods ended June 30, 2009 and 2008, respectively. The largest component of expense for the three months ended June 30, 2009 was $19,674 we spend on rent, taxes and insurance on the facility as compared to $14,776 in the three month period of the prior year. We charged $17,571 of depreciation to research and development, as compared to $2,071 in the prior year. The balance of the expenses for the three months ended June 30, 2009 were related to professional services and supplies. In the three month period ended June 30, 2008, we incurred $302,668 in supplies and services related to the build-out of our research and development facility in Butte, which was completed and commissioned in August 2008. All of our research and development expenses were incurred in the North America segment.

Selling, General and Administrative Expenses. Principal areas of spending for general and administrative spending are in the areas of employee compensation, professional services, travel, depreciation and office expenses, including rent.

We summarize our spending within the North America segment into eight components as follows:

27

The single largest component of selling, general and administrative expense is employee compensation, including related stock compensation. For the three months ended June 30, 2009 and 2008, the number of United States employees remained flat at 12 employees. Compensation expense decreased from $1,646,123 for the three months ended June 30, 2008 to $708,348 for the three months ended June 30, 2009. The decrease was principally driven by a change in the mix of employees that includes fewer executive level employees and by lower non-cash, stock compensation of $281,017 for the three months ended June 30, 2009 compared to non-cash, stock compensation of $1,196,580 recorded during the same period of 2008.

The second largest component of selling, general and administrative expense is professional services, which include legal, accounting, financial advisory, board compensation, security filings, and transfer agent fees along with associated non-cash stock compensation expense. For the three months ended June 30, 2009, we spent $333,887 on professional services including a non-cash stock compensation charge of $3,270 for stock grants to key consultants and advisors. For the three months ended June 30, 2008, we spent approximately $1,387,694 on professional services of which $249,117 was non-cash stock-based compensation. The decrease from the prior year is attributable to a reduction in spending on all professional fees, including legal and financial advisory fees.

The third largest component of selling, general and administrative expense is taxes, insurance, rent and utilities. This category also includes licenses and permits as well as penalties and interest. The taxes included in this item are non-income based taxes. For the three months ended June 30, 2009 most of the $151,560 was spent on rent, utilities and insurance. This level of spending is slightly lower than the $207,885 spent during the three months ended June 30, 2008 due to a reduction in our insurance expenses in 2009 as compared to 2008.

During the three months ended June 30, 2009, we incurred some selling and marketing expenses related to our biodiesel sales, which consisted primarily of salaries, commissions and benefits related to sales and marketing personnel and sales brokers; travel and other out-of-pocket expenses, amortization of intangible assets related to our acquisition of Biofuels Marketing, Inc. and facilities costs and other related overhead. Commissions on biodiesel sales are typically accrued and expensed or paid when the respective products are sold. We intend to hire additional sales personnel, initiate additional marketing programs and build additional relationships with resellers and strategic partners on a global basis. Accordingly, we expect that our sales and marketing expenses will increase for the foreseeable future in absolute dollars. At this time, these costs are small and accordingly we have included them in general and administrative.

We summarize our spending within the India segment into eight components as follows:

During the early part of 2008, our India segment was fully engaged in the construction of the biodiesel plant in Kakinada, India. As such, substantially all costs associated with this segment were capitalized as costs associated with placing this asset in service. In October 2008, the plant was commissioned and operations commenced.

The largest component of selling, general and administrative expense is professional services associated with future fund raising activities. We spent $373,959 on legal fees in the three months ended June 30, 2009 principally for fund rasising activities. The second largest component is repairs and maintenance costs associated with our biodiesel plant. We spent $21,402 in the three months ended June 30, 2009 to maintain and make repairs to our operating plant. Another large component of selling, general and administrative expense was travel and entertainment, of which we spent $16,311 in the three months ended June 30, 2009. Other components of selling, general and

28

administrative expenses include professional services and taxes, insurance, rent and utilities. For the three months ended June 30, 2009, we spent $15,790 and $11,400 in these categories, respectively.

Other Income/Expense

Other income (expense) consisted of the following items:

·

Interest expense is the result of debt facilities acquired by both the Company and its India subsidiary. These debt facilities included warrant coverage and discount fees which are amortized as part of interest expense. We incurred interest expense of $602,694. During the same period of 2008 we incurred $253,019 of interest expense.

·

Interest income is earned on excess cash. Due to the decrease in our cash balances over the three months ended June 30, 2009, as compared to the same period of 2008, our interest income decreased from $6,089 to $18,945.

·

Other income, for both years, results from renting portions our land holdings in Sutton and Danville to local farmers.

Six Months Ended June 30, 2009 Compared to Six Months Ended June 30, 2008

Revenues

For the six months ended June 30, 2009, $3,497,953 or 100% of our revenue was derived from the sale of biodiesel into the Indian domestic market. All revenue during 2009 is part of our India geographic segment. No revenues were recorded for the six months ended June 30, 2008.

We recognize revenue upon shipment of product as payments are generally made in advance and we do not offer any right of return. We had no accounts receivable as of June 30, 2009. Our average sales transaction consists of a customer taking delivery of several metric tons of biodiesel by loading it into their tanker truck at our plant site. We have several customers who take delivery of biodiesel on a daily basis. As a result, it is difficult to predict timing or size of product sales on a quarterly basis.

Cost of Revenues

Our cost of revenues consists of fixed costs, including utilities, supplies, insurance, property taxes, depreciation and indirect labor compensation. Variable costs include direct labor compensation and direct material costs. The largest component of the cost of revenues is the palm oil or palm stearin feedstock for the biodiesel production process. The price of palm oil and palm stearin is influenced by general economic, market and regulatory factors. These factors include local and global supply and demand, weather conditions, farmer planting decisions, government policies and subsidies with respect to agriculture and international trade. The price at which we sell our biodiesel in India is generally indexed to the price of petroleum diesel, which is set by the Indian government, the lack of correlation between production costs and product prices means that we are generally unable to pass increased feedstock costs on to our customers. The cost of palm oil or palm stearin has fluctuated significantly in recent periods; however, for the six months ended June 30, 2009, the commodity markets proved to be more stable than they were in fiscal 2008. In early January 2009, we sold through all the feedstock purchased in 2008 and we are buying feedstock as required to support current biodiesel production. During the six months ended June 30, 2009 there was an increase in the price of palm oil or palm stearin to the point were the cost of production was higher than the cost of selling the biodiesel; therefore, we did not buy feedstock or produce and sell biodiesel for several weeks during the period. As a result of lower sales for the quarter, we did not sell amounts of biodiesel with enough profit margin to cover our fixed costs of the biodiesel plant. Therefore our cost of revenues for the three months ended June 30, 2009 was larger than our revenues due to the fact that our profit margins were not large enough to exceed our fixed cost of production for this three month period. For the six months period ended June 30, 2009 our biodiesel sales and gross margins exceeded our fixed and variable cost of revenues and we recognized a gross profit of $82,243 or 2.3%, this gross margin profit includes gross margin loss of $103,295 for the three month period ended June 30, 2009.

We exited the quarter ended June 30, 2009 with 342 metric tons of feedstock, or about one week’s worth of biodiesel sales, at our current quarter’s sales levels. During the six months ended June 30, 2009, we recognized $234,173 in inventory adjustments attributable to lower of cost or market valuation. All of our cost of revenues was located in our India geographic segment. Neither revenues nor cost of revenues were recorded for the six months ended June 30, 2008.

29

Expenses

Research and Development Expenses. The principal area of spending for research and development is our integrated cellulose and starch ethanol commercial demonstration facility in Butte. We spent $241,574 and $512,056 in the six month periods ended June 30, 2009 and 2008, respectively. The largest component of expense for the six months ended June 30, 2009 was the $132,215 we spent on professional services primarily related to the salaries for the small team of scientists working at the Butte facility and for legal services associated with our pending patents, compared to $120,190 for the same period of the prior year. We spent $38,908 on rent, taxes and insurance on the facility as compared to $29,747 in the six month period of the prior year. We charged $35,142 of depreciation to research and development, as compared to $4,141 in the prior year. For the six months ended June 30, 2008, we incurred $339,592 in supplies and services related to the build-out of our of our research and development facility in Butte, which was completed and commissioned in August 2008. The balance of the research and development expenses in both the six months ended June 30, 2009 and 2008 were for miscellaneous office expenses and travel. All of our research and development expenses were incurred in the North America segment.

Selling, General and Administrative Expenses. Principal areas of spending for general and administrative spending are in the areas of employee compensation, professional services, travel, depreciation, and office expenses, including rent.

We summarize our spending within the North America segment into eight components as follows:

The single largest component of selling, general and administrative expense is employee compensation, including related stock compensation. For the six months ended June 30, 2009 and 2008, the number of United States employees remained flat at 12 employees. Compensation expense decreased from $2,297,392 for the six months ended June 30, 2008 to $1,322,912 for the six months ended June 30, 2009. The decrease was driven by a change in the mix of employees that includes fewer executive level employees and a decrease in non-cash, stock compensation from $1,067,165 for the six months ended June 30, 2008 compared to non-cash, stock compensation of $448,976 recorded during the same period of 2009.

The second largest component of selling, general and administrative expense is professional services, which include legal, accounting, financial advisory, board compensation, security filings, and transfer agent fees along with associated non-cash stock compensation expense which arose from stock awards granted to consultants and advisors. For the six months ended June 30, 2009, we spent $787,876 on professional services including a non-cash stock compensation charge of $3,296 for stock grants to key consultants and advisors. For the six months ended June 30, 2008, we spent approximately $2,344,365 on professional services of which $493,878 was stock-based compensation. The decrease from the prior year is attributable to a reduction in spending on all professional fees, including legal and financial advisory fees and lower non-cash stock based compensation charges, due to a lower price of our common stock at June 30, 2009 as compared to June 30, 2008.

The third largest component of selling, general and administrative expense is taxes, insurance, rent and utilities. This category also includes licenses and permits as well as penalties and interest. The taxes included in this item are non-income based taxes. For the six months ended June 30, 2009 most of the $306,926 was spent on rent, utilities and insurance. This level of spending is relatively consistent with the $329,663 spent during the six months ended June 30, 2008.

30

During the six months ended June 30, 2009, we incurred some selling and marketing expenses related to our biodiesel sales, which consisted primarily of salaries, commissions and benefits related to sales and marketing personnel and sales brokers; travel and other out-of-pocket expenses, amortization of intangible assets related to our acquisition of Biofuels Marketing, Inc. and facilities costs and other related overhead. Commissions on biodiesel sales are typically accrued and expensed or paid when the respective products are sold. We intend to hire additional sales personnel, initiate additional marketing programs and build additional relationships with resellers and strategic partners on a global basis. Accordingly, we expect that our sales and marketing expenses will increase for the foreseeable future in absolute dollars. At this time, these costs are small and accordingly we have included them in general and administrative.

We summarize our spending within the India segment into eight components as follows:

During the early part of 2008, our India segment was fully engaged in the construction of the biodiesel plant in Kakinada, India. As such, substantially all costs associated with this segment were capitalized as costs associated with placing this asset in service. As of October 2008, the plant was commissioned and operations commenced.

The largest component of selling, general and administrative expense is professional services, which include legal, accounting, financial advisory and technical services. For the six months ended June 30, 2009, we spent $483,263 on professional services, which includes $73,017 paid to consultants in connection with our application for a change in taxation status of our biodiesel plant from an export oriented unit to a domestic production unit (the “Domestication”) and $358,169 to a legal firm in connection with fund raising.

The second largest component of selling, general and administrative expense is supplies and services, which include payments under the agreement with Secunderabad (see Note 12 – Acquisitions, Divestitures and Joint Ventures in the Notes to Consolidated Financial Statements), and office supplies and expenses. For the six months ended June 30, 2009, we spent $104,483 in this category of which $87,580 was paid to Secunderabad.

The third largest component of selling, general and administrative expense is taxes, insurance, rent and utilities. For the six months ended June 30, 2009, we spent $ 88,316 in this category, of which $50,643 was for duties related to the Domestication of the biodiesel plant.

Other Income/Expense

Other income (expense) consisted of the following items:

·

Pursuant to the terms of its Amended and Restated Registration Rights Agreement, beginning in January 2008 the Company was obligated to file a registration statement to register shares of common stock issued or issuable upon conversion of the Company's for Series A and B preferred stock or pay in cash or shares of stock to these investors an amount equal to 0.5% per month of their investment amount. The expense related to this payment from the period from January through December 2008 of $2,274,402 is reflected in our Statement of Operations as a registration rights payment.

·

During the six months ended June 30, 2008, we purchased and resold glycerin. These sales resulted in profits of $26,534 on sales of $205,270. As we had not commenced commercial operations as of June 30, 2008, the profits from these sales are classified in other income.

31

·

On January 23, 2008, we agreed to end the joint venture with Acalmar Oils and Fats, Ltd. (“Acalmar”) including termination of Acalmar’s right to own or receive any ownership interest in the joint venture. The total cancellation price of $900,000 is reflected in our Statement of Operations as a shareholder agreement cancellation payment.

·

Interest expense is the result of debt facilities acquired by both the Company and its India subsidiary. These debt facilities included warrant coverage and discount fees which are amortized as part of interest expense. For the six months ended June 30, 2009 we incurred interest expense of $1,444,498. During the same periods of 2008 we incurred $253,019 of interest expense.

·

Interest income is earned on excess cash. Due to the decrease in our cash balances over the six months ended June 30, 2009, as compared to the same period of 2008, our interest income decreased from $32,486 to $12,961.

·

Other income for both periods also arose from renting portions of our land holdings in Sutton and Danville to local farmers.

Income Taxes

Provision for income taxes is calculated in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes” (“SFAS 109”), using an asset and liability approach. This approach requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. The measurement of current and deferred taxes is based on provisions of enacted tax law.

SFAS 109 provides for recognition of deferred tax assets if the realization of such assets is more likely than not to occur. Otherwise, a valuation allowance is established for the deferred tax assets which may not be realized. As of December 31, 2008 and 2007, the Company recorded a full valuation allowance against its net deferred tax assets due to operating losses incurred since inception. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets were fully offset by a valuation allowance.

The Company is subject to income tax audits by the respective tax authorities in all of the jurisdictions in which it operates. The determination of tax liabilities in each of these jurisdictions requires the interpretation and application of complex and sometimes uncertain tax laws and regulations. The recognition and measurement of current taxes payable or refundable and deferred tax assets and liabilities requires that the Company make certain estimates and judgments. Changes to these estimates or a change in judgment may have a material impact on the Company’s tax provision in a future period.

We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007, and there was no impact to our financial statements. FIN 48 clarifies the accounting for uncertainty in income tax positions. FIN 48 provides that the tax effects from an uncertain tax position can be recognized in our financial statements only if the position is more-likely-than-not of being sustained on audit, based on the technical merits of the position. Tax positions that meet the recognition threshold are reported at the largest amount that is more-likely-than-not to be realized. This determination requires a high degree of judgment and estimation. We periodically analyze and adjust amounts recorded for our uncertain tax positions, as events occur to warrant adjustment, such as when the statutory period for assessing tax on a given tax return or period expires or if tax authorities provide administrative guidance or a decision is rendered in the courts. Furthermore, we do not reasonably expect the total amounts of unrecognized tax benefits to significantly increase or decrease within the next 12 months. As of June 30, 2009 and December 31, 2008, our unrecognized tax benefits were not significant.

Liquidity and Capital Resources

Contractual Obligations

In June 2009, our India subsidiary exited from the Export Oriented Unit taxation status and became a domestic producer. As part of the governmental agreements, the Company is required to export approximately $4,000,000 of biodiesel into the international markets before June 2017 or pay the tax as though the exported biodiesel was sold within the country of India. We do not have any other material off-balance sheet arrangements nor do we have any other material changes with respect to our contractual obligations.

32

Liquidity

Cash and cash equivalents, current assets, current liabilities and debt at the end of each period were as follows:

The Company has experienced losses and continues to have negative cash flows from its operations through June 30, 2009. As noted in the table above, the Company has negative working capital (current assets less current liabilities). To date, our operating biodiesel plant has provided us with only minimal cash flow, and it will likely be insufficient to allow for the completion of our business plan in 2009. As the development of our business plan has taken longer to develop than we had forecasted, we may have to review our long lived assets for impairment at a future date. Funds available at June 30, 2009 are sufficient to cover less than one month of our domestic operating costs.

In order for us to continue as a going concern, we require a significant amount of additional working capital to fund our ongoing operating expenses and future capital requirements. The use of additional working capital is primarily for general and administrative expenses, the purchase of feedstock and other raw materials to operate our existing facilities and debt interest and principal payments. Our ability to identify and enter into commercial arrangements with feedstock suppliers in India depends on maintaining our operations agreement with Secunderabad, who is currently providing us with working capital for our Kakinada facility. If we are unable to maintain this strategic relationship, our business may be negatively affected. In addition, the ability of Secunderabad to continue to provide us with working capital depends in part on the financial strength of Secunderabad and its banking relationships. If Secunderabad is unable or unwilling to continue to provide us with working capital, our business may be negatively affected.

With regards to our $5,000,000 senior secured note held by Third Eye Capital ABL Opportunities Fund (which had a carrying value at June 30, 2009 of $5,562,179), we were not in compliance with the current ratio covenant for the months of November 2008 through June 2009 under the loan agreement nor were we in compliance with the stock market capitalization covenant for December 2008 through June 2009. Prior to the note maturing on May 15, 2009, the Company entered into an amendment and limited waiver (the “Amendment”) with Third Eye Capital Corporation (“Agent”) on behalf of itself and the Purchaser dated March 31, 2009. Subject to satisfaction of certain conditions, which have not been met as of June 30, 2009, the Amendment will become effective as of March 31, 2009. As the Amendment is not effective as of June 30, 2009 as we were unable to execute the conditions of effectiveness of the Amendment, the interest rate under this facility has been accrued at the default interest rate, which is 18%, during the period of default. Once the Amendment becomes effective, the Amendment provides for the extension of the maturity date of the note to December 31, 2009 and for the waiver of certain covenant defaults for a fee. The Company has also agreed to provide Agent additional collateral as security for the note and has agreed to amend the exercise price of the warrants issued to a price equal to the volume weighted average trading price of a share of Common Stock of the Company for the twenty trading days immediately preceding the date of this Amendment.

The Company was not in compliance with the current ratio or stock market capitalization covenant for the months of November 2008 through June 2009 under the loan agreement. Due to the fact that our non-compliance with covenants have put our note into default, we have increased the interest rate on the note to the default interest rate of 18%, through June 30, 2009. The Company has no cross default provisions in this or any other debt agreement. As a result, our inability to execute the conditions of effectiveness of the Amendment will have no adverse impact on our other debt obligations. Nevertheless, the failure to execute the effectiveness of the Amendment may have an adverse impact on our ability to obtain additional borrowings. There is no assurance that the Company will be able to obtain alternative funding in the event the Amendment does not become effective. Immediate acceleration would have a significant adverse impact on the Company’s near term liquidity.

33

Planned capital expenditures in 2009 include an expected $1,000,000 to complete the pre-treatment facility and glycerin refinery at our Kakinada plant. Commitments for approximately $22,328 under construction contracts, purchase orders and other short term contracts were outstanding at June 30, 2009. We anticipate that the cash flow from our India operations will fulfill the current commitments and we expect to obtain an additional line of credit in India to provide us with the $1,000,000 required to complete our pre-treatment facility and glycerin refinery.

We may continue to deploy our management team’s combined industry, technical, merger and acquisition (“M&A”), restructuring and corporate finance expertise to target and acquire undervalued and/or distressed assets, and then apply our technology to improve the performance of those assets. We believe that our strategy offers substantial opportunity to build capital value in the current climate, particularly given (a) the present opportunity to acquire undervalued and/or underperforming assets and improve them; and (b) the medium to longer term outlook for ethanol and cellulosic ethanol as an alternative form of energy is likely to lead to under supply in 2010. To effect the planned M&A strategy in full, the Company requires access to substantial further acquisition and development finance and it is currently working with advisers with a view to securing additional financing. This may be made available through industry and/or financial partnerships and joint ventures, special purpose financing vehicles, structured acquisition finance arrangements, private placements of equity, debt and blended debt and equity instruments. In addition, the Company anticipates that it may issue share and/or loan capital to vendors as a means of securing target acquisitions and to fund development.

We intend to raise additional working capital in 2009 through some of all of the following: operating cash flows, working capital lines of credit, long-term debt facilities, joint venture arrangements and the sale of additional equity by the Company or its subsidiaries. We continue to explore different funding sources, but because of the continued unsettled state of the capital markets around the globe, the Company lacks any defined capital raising projects or specific sources of capital or commitments for the required capital. The Company, in common with most enterprises that require capital to develop and implement their strategy, are challenged by the impact the crisis in the global capital markets is having on its ability to finance its plans. To a significant degree, our business success will depend on the state of the capital markets, and investors in our securities should take into account the macro-economic impact of the availability of credit and capital funding when assessing the business development plans of the Company. Should the Company not be able to raise enough capital it may be forced to sell all or a portion of its existing biodiesel facility or other assets at a discount to market value and incur impairment related to these assets to generate cash to continue the Company’s business plan or possibly discontinue our operations. Subsequent to June 30, 2009, we drew down short term borrowings from our line of credit with Laird Cagan totaling $171,000 to meet some of our 2009 operating costs, however, to continue operations the Company needs to secure additional near term equity or debt financing. Until such additional capital is raised, the Company is dependent on financing from this related party and the arrangement of extended term with our trade creditors. There can be no assurance that additional financing will be available on terms satisfactory to the Company. The accompanying financial statements do not include any adjustments that may result should the Company be unable to continue as a going concern.

Historical Sources and Uses of Cash

Operating Activities

Net cash used in operating activities for the six months ended June 30, 2009 was $1,979,087 primarily from selling, general and administrative expenses and research and development expense offset by gross profits from operations of $82,243 and positive changes in working capital of $1,502,714. The generation of cash from working capital arose principally from the aging of our accounts payable and aging of interest and accruing fees on our debt facilities. Net cash used in operating activities for the same six months of fiscal 2008 was $4,019,310 primarily to develop our business, including general and administrative and research and development costs. Net cash used in operating activities was lower in the current year as compared to the prior year period due to reduced spending in all areas including professional services, salaries, supplies and services and travel. The increase in accounts payable in 2009 offsets the decreased use in cash due to the fact that we delayed payments to vendors during the six months ended June 30, 2009.

Investing Activities

Net cash used in investing activities during the six months ended June 30, 2009 was $83,034, which consisted primarily of purchases of property, plant and equipment relating to our biodiesel facility in India. For the six months ended June 30, 2008, net cash used by investing activities of $1,087,648 consisted primarily of purchases of property, plant and equipment relating to the construction of our biodiesel facility in India and the construction of

34

our cellulosic demonstration plant in Butte, Montana. Offsetting this amount was the $2,568,216 provided by the redemption of time deposits and $500,000 from the release of a restricted letter of credit.

Financing Activities

Net cash provided by financing activities during the six months ended June 30, 2009 and 2008 was $1,624,359, and $5,044,742, respectively, which consisted primarily of the proceeds from our working capital line with Secunderabad and the proceeds from a credit facility provided by a related party (a former director and significant shareholder) for the six months ended June 30, 2009 and from proceeds of the $5 million senior secured note from Third Eye Capital for the six months ended June 30, 2008.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments 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 amount of net sales and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Impairment of Long-Lived Assets

Our long-lived assets are primarily associated with our plant in Kakinada, India. In fiscal 2008, we began operation of our biodiesel plant and we continued the construction of our glycerin refinery and pre-treatment plant. The refinery and pre-treatment plant are expected to be fully operational by the third quarter of 2009. Costs for building them remained in construction-in-progress at June 30, 2009, and will be reclassified once the refinery and pre-treatment plant are fully operational and placed in service.

Additional long-lived assets consist of our two sites in Illinois and Nebraska. The land and improvements are held for development of production facilities.

We evaluate impairment of long-lived assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We assess the impairment of long-lived assets, including property and equipment and purchased intangibles subject to amortization, when events or changes in circumstances indicate that these assets have been impaired and we accordingly write them down to their new fair value. Forecasts of future cash flows are critical judgments in this process and are based on our experience and knowledge of our operations and the industries in which we operate and are critical to our impairment assessments. These forecasts could be significantly affected by future changes in market conditions, the economic environment, and capital spending decisions of our customers, inflation and our ability to secure additional working capital to allow us to achieve the forecasted results.

With respect to our idle landholdings in Illinois and Nebraska we considered whether these assets were impaired by looking at the undiscounted cash flows compared to our carrying values in accordance with SFAS 144 and concluded that these assets were not impaired. The determination of estimated future undiscounted cash flows is highly uncertain in the current economic environment. Our estimated undiscounted cash flows considered principally the current value of the underlying land assuming a near-term sale in an orderly market, as well as anticipated cash flows from executing our planned development activities (development of cellulosic ethanol plants). These cash flow estimates, while they represents our best estimate of future undiscounted cash flows, are highly uncertain and could be negatively affected by the continued erosion of the capital markets, availability of capital negating the company’s ability to generate cash flows as planned from the development and operation of ethanol facilities at these locations or forcing the Company to liquidate these assets to generate working capital in a manner that is not consistent with an orderly sale. As of June 30, 2009, the Company has determined that no indicators of impairment exist since our December 31, 2008 and 2007 analysis and, accordingly, no long-term asset impairment losses have been recorded in the three months ended June 30, 2009 or 2008. We will continue to assess the factors above and their impact on the cash flow estimates. Upon continued degredation of the economic factors effecting cash flow estimates, knowledge of other prevalent indicators, or actions that we believe would force a liquidation, we will reassess the value of these assets in accordance with SFAS 144.

35

Inventories

Inventories are stated at the lower of cost, using the first-in and first-out (FIFO) method, or market. In assessing the ultimate realization of inventories, we perform a periodic analysis of market prices and compare that to our weighted-average FIFO cost to ensure that our inventories are properly stated at the lower of cost or market

Stock-Based Compensation

Stock-Based Compensation Expense. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”), requiring us to recognize expense related to the fair value of our stock-based compensation awards adjusted to reflect only those shares that are expected to vest. Our implementation of SFAS 123(R) used the modified-prospective-transition method.

We made the following estimates and assumptions in determining fair value of stock options as prescribed by SFAS 123(R):

·

Valuation and Amortization Method — We estimate the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

·

Expected Term — The expected term represents the weighted-average period that our stock-based awards are expected to be outstanding. We applied the “Simplified Method” as defined in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 and 110.

·

Expected Volatility — The Company’s expected volatilities are based on the historical volatility of comparable public companies’ stock for a period consistent with our expected term.

·

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

·

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used in measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measurements, however, the application of this statement may change current practice. On January 1, 2008, the Company adopted SFAS 157 and the adoption of this statement had no material effect on the Company’s financial statements. On February 12, 2008, the FASB issued FASB Staff Position (FSP) No. 157-2, “Effective Date of FASB Statement No. 157.” FSP 157-2 delays the effective date of adoption for non-financial assets and liabilities to fiscal years beginning after November 15, 2008. As such, the Company adopted the provisions of SFAS 157 with respect to non-recurring fair value measurements for non-financial assets and liabilities as of January 1, 2009. Adoption of this statement did not have a material effect on the Company’s financial statements.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141R”). This statement changes the accounting for acquisition transaction costs by requiring them to be expensed in the period incurred, and also changes the accounting for contingent consideration, acquired contingencies and restructuring costs related to an acquisition. Also in December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements-an amendment of ARB No. 51” (“SFAS 160”). This statement will change the accounting and reporting for minority interests, which will be re-characterized as non controlling interests, classified as a component of equity and accounted for at fair value. SFAS 141(R) and SFAS 160 are effective for the Company’s 2009 financial statements. Early adoption is prohibited. The effect the adoption of SFAS 141(R) will have on the Company’s financial statements will depend on the nature and size of acquisitions we complete after we adopt SFAS 141(R). We adopted SFAS 160 as of January 1, 2009. As a result, we reclassified the 49% non-controlling interest in