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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
SCHEDULE 14A
 
Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934 (Amendment No.  )
 
Filed by the Registrant þ
 
Filed by a Party other than the Registrant o
 
Check the appropriate box:
o  Preliminary Proxy Statement
o  Confidential, For Use of the Commission Only (As Permitted by Rule 14a-6(e)(2))
þ  Definitive Proxy Statement
o  Definitive Additional Materials
o  Soliciting Material Pursuant to Rule 14a-11(c) or Rule 14a-12
 
CONVERTED ORGANICS INC.
(Name of Registrant as Specified In Its Charter)
 
(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
 
Payment of Filing Fee (Check the appropriate box):
 
o   No fee required
 
o   Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11.
 
  (1)   Title of each class of securities to which transaction applies: The outstanding membership units of TerraSphere Systems LLC
 
 
  (2)   Aggregate number of securities to which transaction applies: 100% of the outstanding membership units of TerraSphere Systems LLC
 
 
  (3)   Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined): A maximum being paid for 100% of the outstanding membership units of TerraSphere Systems LLC is $18,962,500.18. The transaction value is based on 34,166,667 shares of Converted Organics Inc. common stock being issued at the average of the high and low price of the registrant’s common stock reported on the NASDAQ Stock Market on July 6, 2010, or $0.555.
 
 
  (4)   Proposed maximum aggregate value of transaction: $18,962,500.18
 
 
  (5)   Total fee paid:
 
 
þ   Fee paid previously with preliminary materials.
 
o   Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the form or schedule and the date of its filing.
 
  (1)   Amount Previously Paid: $1,352.03
 
 
  (2)   Form, Schedule or Registration Statement No.:
 
 
  (3)   Filing Party:
 
 
  (4)   Date Filed:
 


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This proxy statement is dated July 30, 2010 and is first being mailed to stockholders on or about July 30, 2010.
 
Converted Organics Inc.
137A Lewis Wharf
Boston, MA 02110
617 624 0111
 
 
Dear Stockholder:
 
A Special Meeting of Stockholders of Converted Organics Inc. (the “Company”) will be held at Renaissance Boston Waterfront Hotel, 606 Congress Street, Boston, MA, 02210, on August 31, 2010 at 9:30 a.m. local time. The attached material includes the Notice of Special Meeting and the Proxy Statement, which describes the business to be transacted at the meeting. We ask that you give them your careful attention.
 
On July 6, 2010, a Membership Interest Purchase Agreement was entered into by and among the Company, TerraSphere, Inc., a wholly owned subsidiary of the Company, TerraSphere Systems LLC (“TerraSphere”) and the members of TerraSphere, pursuant to which the Company agreed to acquire 100% of TerraSphere. The maximum total purchase price for TerraSphere will be $25,830,000, which includes earn-out payments of up to $11,040,000, payable solely in shares of common stock valued at $0.756 per share. Pursuant to the purchase agreement, if the acquisition is approved by the Company’s stockholders, the Company will issue up to 34,166,667 shares of its common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to certain anti-dilution adjustments described in this proxy statement. Of these shares, 19,563,492 shares will be issued at the closing of the acquisition, and the remainder of the shares will be issued if TerraSphere achieves certain milestones described in this proxy statement. Upon completion of the proposed acquisition, TerraSphere would become a wholly-owned subsidiary of the Company. TerraSphere designs, builds and operates highly efficient and scalable systems, featuring a patented, proprietary technology that utilizes vertically-stacked modules to house rows of plants, which are then placed perpendicular to an interior light source to grow pesticide-free, organic fruits and vegetables. Due to a controlled, indoor environment, the system generates fresh produce year-round in any location or climate world-wide.
 
Pursuant to the rules of the NASDAQ Stock Market, the TerraSphere acquisition requires the approval of the Company’s stockholders.
 
Your vote is important. Please sign, date and return your proxy card as soon as possible to make sure that your shares are represented at the special meeting. You may also vote by telephone or the internet, as described on the proxy card. If you are a stockholder of record, you may also cast your vote in person at the special meeting. If your shares are held in an account at a brokerage firm or bank, you must instruct your broker or bank how to vote your shares, or you may cast your vote in person at the special meeting by obtaining a proxy from your brokerage firm or bank.
 
This proxy statement sets forth more information about TerraSphere, the TerraSphere members and the purchase agreement. We encourage you to carefully read this proxy statement before voting, including the section entitled “Risk Factors” beginning on page 12.
 
On behalf of the Board of Directors, I would like to thank you for your continued support and confidence.
 
Sincerely,
 
/s/  Edward J. Gildea
Edward J. Gildea
President, Chief Executive Officer and
Chairman of the Board
 
Important Notice Regarding the Availability of Proxy Materials
for the Special Stockholder Meeting to be Held on August 31, 2010:
The Proxy Statement is available at [http://ir.convertedorganics.com/annuals.cfm]


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Converted Organics Inc.
137A Lewis Wharf
Boston, MA 02110
617 624 0111
 
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD AUGUST 31, 2010
 
TO THE STOCKHOLDERS OF CONVERTED ORGANICS INC.:
 
NOTICE IS HEREBY GIVEN that a special meeting of stockholders of Converted Organics Inc., a Delaware corporation (the “Company”), relating to the proposed acquisition with TerraSphere Systems LLC, a Massachusetts limited liability company (“TerraSphere”), will be held at 9:30 a.m. Eastern time on August 31, 2010, at Renaissance Boston Waterfront Hotel, 606 Congress Street, Boston, MA, 02210, to consider and vote upon the following matter:
 
Proposal 1.  The issuance of up to 34,166,667 shares of Company common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to upward adjustment based on certain anti-dilution protections described in this proxy statement. This proposal is called the “TerraSphere Proposal.”
 
Proposal 2.  Any adjournment of the special meeting for the purpose of soliciting additional proxies. This proposal is called the “Adjournment Proposal.”
 
On July 6, 2010, a Membership Interest Purchase Agreement was entered into by and among the Company, TerraSphere, Inc., a wholly owned subsidiary of the Company, TerraSphere and the members of TerraSphere, pursuant to which the Company agreed to acquire 100% of TerraSphere. The maximum total purchase price for TerraSphere will be $25,830,000, which includes earn-out payments of up to $11,040,000, payable solely in shares of common stock valued at $0.756 per share. Pursuant to the purchase agreement, if the acquisition is approved by the Company’s stockholders, the Company will issue up to 34,166,667 shares of its common stock, subject to upward adjustment based on certain anti-dilution protections, to the members of TerraSphere in exchange for 100% of the units of TerraSphere. Of these shares, 19,563,492 shares will be issued at the closing of the acquisition, and the remainder of the shares will be issued if TerraSphere achieves certain milestones described in this proxy statement. Upon completion of the proposed acquisition, TerraSphere would become a wholly-owned subsidiary of the Company. The acquisition of TerraSphere will require the issuance of approximately 84.6% of the outstanding shares of Company before the issuance and would represent 45.7% of our voting shares following the issuance, assuming the maximum number of shares are issued in the transaction.
 
Pursuant to the rules of the NASDAQ Stock Market, the TerraSphere acquisition requires the approval by a majority of the total votes cast at a special meeting of stockholders at which a quorum is present.
 
Mr. Edward J. Gildea, the Company’s Chairman and Chief Executive Officer, has an interest in 8.75% of the units of TerraSphere, and family members of Mr. Gildea hold significant units of TerraSphere and serve as officers of TerraSphere. Our board of directors formed an Acquisition Committee of disinterested directors to evaluate and, if appropriate, negotiate the proposed TerraSphere acquisition because of Mr. Gildea’s interest in TerraSphere. The Acquisition Committee obtained valuation advice and a fairness opinion from an independent investment bank, and negotiated the terms of the TerraSphere acquisition with TerraSphere management. Mr. Gildea did not participate in the negotiations. The Acquisition Committee unanimously determined that the terms of the TerraSphere acquisition are advisable, fair to, and in the best interests of our stockholders. Upon the Acquisition Committee’s unanimous recommendation, our board of directors then unanimously (with Mr. Gildea abstaining) determined that the terms of the TerraSphere acquisition are advisable, fair to, and in the best interests of, our stockholders.
 
After careful consideration, and upon the unanimous recommendation of an Acquisition Committee of the disinterested directors, our board of directors has unanimously (with Mr. Gildea abstaining) approved the proposal referred to above and concluded that it is advisable, fair to, and in the best interests of our stockholders. The Acquisition Committee and our board of directors unanimously


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recommend that our stockholders vote “FOR” the TerraSphere Proposal referred to above, and “FOR” the Adjournment Proposal.
 
The Company’s board of directors has fixed the record date as the close of business on July 21, 2010, as the date for determining stockholders entitled to receive notice of and to vote at the special meeting and any adjournment thereof. The holders of record of the Company’s common stock on the record date are entitled to have their votes counted at the special meeting or any adjournment.
 
The proxy statement accompanying this notice sets forth more information about TerraSphere, the TerraSphere members, the purchase agreement and the interests of Mr. Gildea in the acquisition. The accompanying materials also provide instructions on how to vote your shares in person at the special meeting or by proxy.
 
Dated: July 30, 2010
 
By Order of the Board of Directors
 
/s/  Edward J. Gildea
Edward J. Gildea
President, Chief Executive Officer and
Chairman of the Board
 
Boston, Massachusetts
 
July 30, 2010
 
 
Your vote is important.
 
If you do not plan to attend the meeting, please sign, date and promptly return the enclosed proxy. A postage-paid reply envelope is enclosed for your convenience. A stockholder who submits a proxy may revoke it at any time before the vote is taken at the meeting, or by voting in person at the meeting.


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SUMMARY TERM SHEET
 
This section summarizes information related to the proposal to be voted on at the special meeting. The proposal is described in greater detail elsewhere in this proxy statement. You should carefully read this entire proxy statement and the other documents to which you are referred.
 
  •  The purpose of the special meeting is to approve our acquisition of TerraSphere Systems LLC, or TerraSphere, pursuant to the Membership Interest Purchase Agreement, or purchase agreement, between us, TerraSphere Inc., our wholly owned subsidiary, TerraSphere and TerraSphere’s members dated July 6, 2010. See the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition” on page 23 for more information about the acquisition and see the section entitled “The Purchase Agreement” on page 36 for more information about the purchase agreement.
 
  •  The maximum total purchase price for TerraSphere will be $25,830,000, which includes earn-out payments of up to $11,040,000, payable solely in shares of common stock valued at $0.756 per share. Pursuant to the purchase agreement, if the acquisition is approved by our stockholders, we will issue up to 34,166,667 shares of our common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to upward adjustment based on certain anti-dilution protections, which represents 84.6% of our voting shares prior to the issuance and would represent 45.7% of our voting shares following the issuance, assuming the maximum number of shares are issued in the transaction, based on our outstanding capital stock at July 6, 2010. Of these shares, 19,563,492 shares will be issued at the closing of the acquisition, and the remainder of the shares will be issued if TerraSphere achieves certain milestones described in this proxy statement.
 
  •  TerraSphere designs, builds and operates highly efficient and scalable systems, featuring a patented, proprietary technology that utilizes vertically-stacked modules to house rows of plants, which are then placed perpendicular to an interior light source to grow pesticide-free, organic fruits and vegetables. Due to a controlled, indoor environment, the system generates fresh produce year-round in any location or climate world-wide.
 
  •  Our Chairman and Chief Executive Officer, Mr. Edward Gildea, has an interest in 8.75% of the units of TerraSphere. In addition, relatives of Mr. Gildea hold an additional 30.75% of the units of TerraSphere. Furthermore, Mark C. Gildea, the brother of Edward Gildea, is the President and Chief Executive Officer of TerraSphere, and William A. Gildea, also the brother of Edward Gildea, is an independent contractor of TerraSphere. See section entitled “The TerraSphere Acquisition — Interests of Our Officers and Directors in the TerraSphere Acquisition” on page 35.
 
  •  Because of Mr. Gildea’s relationship with TerraSphere, our board of directors formed an Acquisition Committee to evaluate and, if appropriate, negotiate the proposed TerraSphere acquisition. The Acquisition Committee obtained valuation advice and a fairness opinion from an independent investment bank, and negotiated the terms of the TerraSphere acquisition with the TerraSphere management. Mr. Gildea did not participate in the negotiations. See section entitled “The TerraSphere Acquisition — Opinion of the Acquisition Committee’s Financial Advisor Regarding the TerraSphere Acquisition” on page 30.
 
  •  Due to the number of shares that would be issued in the acquisition and the related party nature of the acquisition, Rule 5635(a) of the NASDAQ Marketplace Rules requires us to obtain stockholder approval of the issuance of common stock to the TerraSphere members.
 
  •  With limited exceptions, the shares to be issued to the TerraSphere members are subject to lock-up restrictions on future sales for periods of between six and eighteen months. See section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — Lock-Up of Shares” on page 25 for more information.
 
  •  During the applicable lock-up period described above, we have agreed to provide certain of the TerraSphere members anti-dilution rights that require us to issue them additional shares if we sell our common stock at a price per share that is lower than the price at which we valued the shares to be issued in the TerraSphere acquisition. Messrs. Edward Gildea and William Gildea have not been provided this anti-dilution protection. See section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — Anti-Dilution Protection” on page 25 for more information.


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QUESTIONS AND ANSWERS ABOUT THE TERRASPHERE ACQUISITION
AND THE SPECIAL MEETING
 
These Questions and Answers below are only summaries of matters described in this proxy statement. They do not contain all of the information that may be important to you. You should read carefully the entire document, including the annexes to this proxy statement. The terms “Converted,” “Company,” “we,” or “our” refer to Converted Organics Inc.
 
Q. What is being voted on?
 
A. There are two proposals being presented at the special meeting. The TerraSphere Proposal is the approval of the acquisition of TerraSphere Systems LLC, or TerraSphere, by us through the issuance of up to 34,166,667 shares of our common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to certain anti-dilution adjustments described in this proxy statement. Of these shares, 19,563,492 shares will be issued at the closing of the acquisition, and the remainder of the shares will be issued if TerraSphere achieves certain milestones described in this proxy statement.
 
The Adjournment Proposal is the approval of any adjournment of the special meeting for the purpose of soliciting additional proxies.
 
Q. Why am I being asked to approve the TerraSphere acquisition?
 
A. Our stock is listed on the NASDAQ Capital Market. Rule 5635(a) of the NASDAQ Marketplace Rules requires listed companies to obtain stockholder approval of issuances of common stock in certain circumstances, including in connection with the acquisition of the stock or assets of another company, if:
 
• the securities to be issued represent 20% or more of the number of shares of common stock outstanding before the issuance;
 
• the common stock has or will have upon issuance voting power equal to or in excess of 20% of the voting power outstanding before the issuance of stock or securities convertible into or exercisable for common stock; or
 
• any director, officer or substantial shareholder of the listed company has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the listed company or assets to be acquired or in the consideration to be paid in the transaction or series of related transactions and the present or potential issuance of common stock, or securities convertible into or exercisable for common stock, could result in an increase in outstanding common shares or voting power of 5% or more.
 
You are being asked to approve the issuance of the shares to be issued to the TerraSphere members because the issuance implicates each of the circumstances listed above, and, pursuant to the purchase agreement, our stockholders’ approval of the issuance of the shares is a condition to closing the TerraSphere acquisition. We will hold a special meeting of our stockholders to obtain approval of the issuance of the shares. This proxy statement contains important information about the special meeting, us, TerraSphere, the TerraSphere members, the purchase agreement and the interests of our Chairman and Chief Executive Officer in the acquisition, and you should read it carefully.
 
Q. Why are we proposing the TerraSphere acquisition?
 
A. We believe that the acquisition will provide substantial strategic and financial benefits to our stockholders. We believe our acquisition of TerraSphere will expand our portfolio of sustainable, environmentally-friendly businesses, and will provide us with an immediate revenue stream.
 
For a description of the other factors considered by the Acquisition Committee of our board of directors in determining to recommend approval of the TerraSphere acquisition, see “The TerraSphere Acquisition — Our Reasons for the TerraSphere Acquisition” beginning on page 28.


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Q. Do our Acquisition Committee and board of directors recommend voting in favor of the TerraSphere acquisition and issuance of the shares in connection with the acquisition?
 
A. Yes. Our board of directors appointed an Acquisition Committee of disinterested directors, who have no interest in TerraSphere to evaluate and, if appropriate, negotiate the terms of the acquisition. We refer to them in this proxy statement as the Acquisition Committee. The Acquisition Committee unanimously determined that the terms of the TerraSphere acquisition are advisable, fair to, and in the best interests of our stockholders. The Acquisition Committee has unanimously recommended that you vote “FOR” approval of the issuance of the shares in connection with the TerraSphere acquisition. Based solely on the Acquisition Committee’s unanimous recommendation, our board of directors (with Mr. Gildea abstaining) has also unanimously recommended that you vote “FOR” approval of the issuance of the shares in connection with the TerraSphere acquisition.
 
The reasons the Acquisition Committee’s recommendation are discussed in detail in “The TerraSphere Acquisition — Our Reasons for the TerraSphere Acquisition” beginning on page 28.
 
Q. Why are we proposing to approve any adjournment of the special meeting?
 
A. We are proposing to approve any adjournment of the special meeting so that we may delay the meeting in the event that it appears that the other proposal to be presented at the meeting will not be approved. This will provide our management with more time to solicit stockholders to vote or change their votes.
 
Q. What vote is required by our stockholders to approve the issuance of the shares in connection with the TerraSphere acquisition?
 
A. Pursuant to applicable NASDAQ Marketplace Rules and our by-laws, the affirmative vote of a majority of the total votes cast at a special meeting at which a quorum is present is required to approve the issuance of the shares in connection with the TerraSphere acquisition. As of the record date, our directors and executive officers were entitled to vote less than 1% of our outstanding shares of common stock.
 
Q. Is the TerraSphere acquisition a related person transaction?
 
A. Yes. Mr. Edward Gildea holds 8.75% of the units of TerraSphere. In addition, relatives of Mr. Gildea hold an additional 30.75% of the units of TerraSphere. If the acquisition is completed, and assuming all milestones are achieved, Mr. Gildea would receive 3,240,741 shares of our common stock in exchange for his TerraSphere units and his relatives would receive an additional 10,775,463 of our common stock in exchange for their TerraSphere units. Furthermore, Mark C. Gildea, the brother of Edward J. Gildea, is the President and Chief Executive Officer of TerraSphere, and William A. Gildea, also the brother of Edward J. Gildea, is an independent contractor of TerraSphere.
 
Because of Mr. Gildea’s relationship with TerraSphere, our board of directors formed the Acquisition Committee to evaluate and, if appropriate, negotiate the proposed TerraSphere acquisition. The Acquisition Committee obtained valuation advice and a fairness opinion from an independent investment bank, and negotiated the terms of the TerraSphere acquisition with the TerraSphere management. Mr. Gildea did not participate in the negotiations.
 
For a further discussion of related persons, see “The TerraSphere Acquisition — Interests of Our Officers and Directors in the TerraSphere Acquisition” beginning on page 35.
 
Q. How do our officers and directors intend to vote their shares?
 
A. All of our officers and directors have indicated that they intend to vote all of their common stock in favor of the TerraSphere Proposal and the Adjournment Proposal. As of the record date, our directors and executive officers were entitled to vote less than 1% of our outstanding shares of common stock.
 
Q. When do you expect the acquisition to be completed?
 
A. It is anticipated that the acquisition will be completed promptly following the special meeting on August 31, 2010.


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Q. Do our stockholders have appraisal rights under Delaware law?
 
A. Our stockholders do not have appraisal rights under Delaware law.
 
Q. If I am not going to attend the special meeting in person, should I return my proxy card instead?
 
A. Yes. After carefully reading and considering the information in this proxy statement, please fill out and sign your proxy card. Then return it in the return envelope as soon as possible, so that your shares may be represented at the special meeting. You may also submit a proxy by telephone or on the internet, as explained on the proxy card. A properly executed proxy will be counted for the purpose of determining the existence of a quorum.
 
Q. How do I change my vote?
 
A. You must send a later-dated, signed proxy card to our corporate secretary prior to the date of the special meeting or attend the special meeting in person and vote. If you have instructed your broker to vote your shares, you must follow your broker’s directions in order to change those instructions.
 
Q. If my shares are held in “street name,” will my broker automatically vote them for me?
 
A. No. Your broker can vote your shares only if you provide instructions on how to vote. You should instruct your broker to vote your shares. Your broker can tell you how to provide these instructions.
 
Q. Who will bear the costs of the proxy solicitation?
 
A. We will bear the costs of soliciting proxies, including the printing, mailing and filing of this proxy statement and any additional information furnished to stockholders. Our directors, officers and employees may also solicit proxies by telephone, email, facsimile and in person, without additional compensation. Upon request, we will reimburse brokerage houses and other custodians, nominees and fiduciaries for their reasonable out-of-pocket expenses for distributing proxy materials. We have retained Phoenix Advisory Partners to assist it in soliciting proxies.
 
We have agreed to pay Phoenix Advisory Partners, LLC a fee of $7,500, plus expenses, for its services in connection with the special meeting.
 
Q. Who can help answer my questions?
 
A. If you have questions, you may write or call:
 
Phoenix Advisory Partners, LLC
110 Wall Street
27th Floor
New York, NY 10005
(866) 351-1539
 
Q. When and where will the special meeting be held?
 
A. The meeting will be held at 9:30 a.m. Eastern time on August 31, 2010 at Renaissance Boston Waterfront Hotel, 606 Congress Street, Boston, MA 02210.
 


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SUMMARY OF THE PROXY STATEMENT
 
This summary highlights selected information from this proxy statement and does not contain all of the information that is important to you. To better understand the TerraSphere acquisition, you should read carefully this entire document and the other documents to which this proxy statement refers you, including the purchase agreement attached as Annex A to this proxy statement. The purchase agreement is the legal document that governs the TerraSphere acquisition. The purchase agreement is also described in detail elsewhere in this proxy statement. See “Where You Can Find More Information.”
 
The Parties
 
Converted Organics Inc.
 
We operate processing facilities that use food waste and other raw materials to manufacture all-natural fertilizer and soil amendment products combining nutritional and disease suppression characteristics. In addition to our sales in the agribusiness market, we sell and distribute our products in the turf management and retail markets. We also hope to achieve additional revenue by licensing the use of our technology to others. We currently operate two facilities:
 
  •  Woodbridge facility.  A facility in Woodbridge, New Jersey that we have equipped as our first internally constructed organic waste conversion facility (the “Woodbridge facility”). Operations at the Woodbridge facility began in late June 2008 and we are processing solid waste and are producing both liquid and dry fertilizer and soil amendment products.
 
  •  Gonzales facility.  A facility in Gonzales, California that we acquired in January 2008, which is operational and produces liquid fertilizer products (the “Gonzales facility”). The Gonzales facility began to generate revenue in February 2008.
 
Our principal executive office is located at 137A Lewis Wharf, Boston, MA 02110, and our phone number is (617) 624-0111.
 
TerraSphere Inc.
 
TerraSphere Inc. is a Delaware corporation that is our wholly owned subsidiary formed for the sole purpose of holding the units of TerraSphere.
 
TerraSphere Systems LLC
 
TerraSphere is dedicated to building highly efficient systems for growing pesticide-free, organic fruits and vegetables in a controlled indoor environment. TerraSphere’s clean technology helps to promote the sustainable consumption of natural resources by accelerating plant production and maximizing crop yields, while improving environmental footprints through the reduction of carbon emissions and fuel use associated with traditional crop production and distribution.
 
TerraSphere’s principal executive office is located at 137A Lewis Wharf, Boston, MA 02110, and its phone number is (617) 557-5440 .
 
The Purchase Agreement; Purchase Price; Lock-Up of Shares Issued; Anti-Dilution Protection (see page 27)
 
We have agreed to acquire 100% of the equity interests in TerraSphere pursuant to a purchase agreement we entered into with TerraSphere and its members. Upon completion of the acquisition, TerraSphere would become a wholly-owned subsidiary of the Company.
 
Purchase Price
 
The maximum total purchase price for TerraSphere will be $25,830,000, which includes earn-out payments of up to $11,040,000, payable solely in shares of common stock valued at $0.756 per share. We will


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issue up to 34,166,667 shares of our common stock, subject to upward adjustment based on certain anti-dilution protections, in consideration for 100% of the outstanding units of TerraSphere, which represents 84.6% of our voting shares prior to the issuance and would represent 45.7% of our voting shares following the issuance, assuming the maximum number of shares are issued in the transaction, based on our outstanding capital stock at July 6, 2010.
 
Pursuant to the terms of the purchase agreement, each TerraSphere member was given the option to receive either:
 
  •  such member’s pro rata portion of $21,000,000 worth of our common stock, valued at $0.756 per share, which is the price which was the average closing price for our common stock over the fifteen day period preceding the date of the execution of the purchase agreement (we refer to this $0.756 price in this proxy statement as the “Closing Price Per Share”) (the shares to be issued pursuant to this immediate payment structure are referred to as the “Option One Shares”); or
 
  •  such member’s pro rata portion of up to $28,000,000 worth of our common stock, valued at the Closing Price Per Share, in an earn-out payment structure consisting of up to four milestone payments (the shares to be issued pursuant to this earn-out payment structure are referred to as the “Option Two Shares”).
 
The earn-out payment is structured such that the TerraSphere members electing to receive Option Two Shares will be paid their respective pro rata portion of our common stock, valued at the Closing Price Per Share, in accordance with the following schedule:
 
(1) on the date of the closing, $12,000,000 of our common stock;
 
(2) $5,000,000 of our common stock, if, and only if, between the date of the purchase agreement and the earlier of the 90th day following the closing or the 180th day following the date of the purchase agreement, for a period of five consecutive trading days, our Market Capitalization (as defined in the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition”) exceeds the sum of: (1) our Initial Market Capitalization (as defined in the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition”) on the date of the purchase agreement plus (2) the Closing Price Per Share multiplied by the number of shares of our common stock to be issued to TerraSphere members electing Option One Shares, the number of shares of our common stock to be issued pursuant to paragraph 1 above and, if such calculation is being made prior to the closing, the number of shares of our common stock to be issued pursuant to this paragraph 2. Notwithstanding the foregoing, if between the date of the purchase agreement and the earlier of the 90th day following the closing or the 180th day following the date of the purchase agreement, we complete a debt or equity financing with a third party other than project financing, unless such project financing is completed for TerraSphere (referred to as a “Financing”), the cash received from the Financing during such period shall be added to the Market Capitalization. In addition, if between the closing and December 31, 2011, we sell equity of either the TerraSphere or any of TerraSphere’s subsidiaries, any cash received from such equity sales during such period shall be added to the Market Capitalization.
 
(3) $2,000,000 of our common stock, if, and only if, $2,000,000 of TerraSphere’s accounts receivable as of the date of the purchase agreement are received prior to February 28, 2011;
 
(4) $5,000,000 of our common stock, or the Milestone Three Payment, if TerraSphere generates Gross Margin (as defined in the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition”) of $6,000,000 from its operations during the period from the date of the purchase agreement through December 31, 2011; provided that, if TerraSphere generates Gross Margin of at least $4,200,000, or the Milestone Three Gross Margin Threshold, from its operations during such period, the TerraSphere members will be entitled to a pro rata portion of the common stock; and
 
(5) $4,000,000 of our common stock, or the Milestone Four Payment, if, and only if, TerraSphere generates Gross Margin of $4,000,000, or the Milestone Four Gross Margin Target, from its operations during any six-month period commencing on the date of the purchase agreement and ending on


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December 31, 2012; provided that, if TerraSphere achieves the Milestone Three Gross Margin Threshold, but does not achieve the Milestone Three Gross Margin Target, 83.3% of the difference between the Milestone Three Gross Margin Target and the actual Gross Margins achieved pursuant to paragraph 4 above may be added by the TerraSphere members to the Milestone Four Payment and the Milestone Four Gross Margin Target.
 
Lock-Up of Shares
 
With limited exceptions, the shares to be issued to the TerraSphere members are subject to the following sale restrictions absent our approval:
 
  •  the Option One Shares are subject to a lock-up the term of which is six months, beginning on the closing of the acquisition; and
 
  •  the Option Two Shares are subject to a lock-up the term of which is the longer of: (a) eighteen months, beginning on the closing of the acquisition, or (b) six months, beginning on the date when shares of common stock are issued pursuant to the foregoing milestone payments.
 
Anti-Dilution Protection
 
During the applicable lock-up period described above, we have agreed to provide the TerraSphere members anti-dilution rights. The rights provide that if we issue shares of our common stock for cash consideration in connection with a financing transaction at a price less than the Closing Price Per Share, or $0.756 per share, then the TerraSphere members shall receive additional shares of our common stock based on a weighted average dilution formula. See the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — Anti-Dilution Protection” for details about the formula. Messrs. Edward Gildea and William Gildea have not been provided this anti-dilution protection.
 
The purchase agreement, which is the legal document governing the TerraSphere acquisition, is attached at Annex A to this document. You should read the agreement carefully and in its entirety.
 
Voting Power; Record Date
 
You will be entitled to vote or direct votes to be cast at the special meeting if you owned shares of our common stock at the close of business on July 21, 2010, the record date for the special meeting. You will have one vote for each share of common stock you owned at the close of business on the record date. On the record date, there were 42,359,041 shares of common stock outstanding.
 
Approval of the TerraSphere Members
 
All of the TerraSphere members have approved the transactions contemplated in the purchase agreement. Accordingly, no further action by the TerraSphere members is needed to approve the acquisition.
 
Quorum and Vote Required to Approve the Proposals by the Our Stockholders
 
  •  A quorum of our stockholders is necessary to hold a valid meeting. A quorum will be present at the special meeting if a majority of our outstanding shares entitled to vote at the meeting are represented in person or by proxy. Abstentions will count as present for the purposes of establishing a quorum for the meeting. Brokers may not vote on the proposal without stockholder action. We will not have any broker non-votes at the meeting.
 
  •  The approval of the TerraSphere Proposal and the Adjournment Proposal will require the affirmative vote of the holders of a majority of the shares of common stock present in person or represented by proxy and cast at the special meeting.


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Proxies
 
Proxies may be solicited by mail, telephone or in person. If you grant a proxy, you may revoke your proxy before it is exercised at the special meeting by sending a notice of revocation to our corporate secretary, submitting a later-dated proxy statement or voting in person at the special meeting.
 
Recommendations of the Acquisition Committee and Our Board of Directors (see pages 28 & 29)
 
After careful consideration, the Acquisition Committee of our board of directors, which was delegated the authority to evaluate and, if appropriate, negotiate the proposed acquisition of TerraSphere, has unanimously determined that the terms of the TerraSphere acquisition are advisable, fair to and in the best interests of our stockholders, has unanimously recommended that our board of directors approve the TerraSphere acquisition, has unanimously recommended that our board of directors recommend the TerraSphere acquisition, including the issuance of the shares contemplated in the purchase agreement, to our stockholders, and has unanimously recommended that you vote “FOR” the issuance of the shares contemplated in the purchase agreement, as described in this proxy.
 
Based solely upon the unanimous recommendations of the Acquisition Committee, our board of directors has also unanimously (with Mr. Gildea abstaining) determined that the terms of the TerraSphere acquisition are advisable, fair to and in the best interests of our stockholders, has unanimously approved the TerraSphere acquisition, and authorized us to enter into the purchase agreement, and has unanimously recommended that you vote “FOR” the issuance of the shares contemplated in the purchase agreement, as described in this proxy.
 
The factors that our board of directors and the Acquisition Committee relied upon to approve the TerraSphere acquisition and to recommend stockholder approval are described in more detail under the headings “The TerraSphere Acquisition Our Reasons for the TerraSphere Acquisition” beginning on page 28 and “The TerraSphere Acquisition — Recommendations of our Board of Directors” beginning on page 29.
 
Opinion of the Acquisition Committee’s Financial Advisor (beginning on page 30)
 
The Company engaged Duff & Phelps, LLC (“Duff & Phelps”) to serve as the financial advisor to the Acquisition Committee, and to provide an opinion as to the fairness, from a financial point of view, to the Company, and, accordingly, to the holders of the Company’s common stock, other than those holders who also own units of TerraSphere, of the consideration to be paid by the Company in the TerraSphere acquisition. On June 28, 2010, Duff & Phelps rendered its oral opinion to the Acquisition Committee, which opinion was subsequently confirmed in a written opinion dated July 6, 2010, to the effect that, subject to the limitations, exceptions, assumptions and qualifications set forth therein, as of July 6, 2010, the consideration to be paid by the Company in the TerraSphere acquisition was fair, from a financial point of view, to the Company and, accordingly, to the holders of the Company’s common stock, other than those holders who also own units of TerraSphere.
 
The Duff & Phelps opinion was directed to the Acquisition Committee and addresses only the fairness, from a financial point of view, to the Company and, accordingly, to the holders of the Company’s common stock, other than those holders who also own units of TerraSphere, of the consideration to be paid by the Company in the TerraSphere acquisition. The Duff & Phelps opinion:
 
  •  does not address the merits of the underlying business decision to enter into the TerraSphere acquisition versus any alternative strategy or transaction;
 
  •  is not a recommendation as to how the Acquisition Committee or the Company’s board of directors or any stockholder should vote or act with respect to any matters relating to the TerraSphere acquisition, or whether to proceed with the TerraSphere acquisition or any related transaction; and
 
  •  does not indicate that the consideration paid is the best possibly attainable under any circumstances.


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Instead, the Duff & Phelps opinion merely states whether the consideration in the TerraSphere acquisition is within a range suggested by certain financial analyses. The decision as to whether to proceed with the TerraSphere acquisition or any related transaction may depend on an assessment of factors unrelated to the financial analysis on which the Duff & Phelps opinion is based.
 
The full text of the written opinion of Duff & Phelps, which sets forth, among other things, the assumptions made, procedures followed, matters considered and qualifications and limitations of the review undertaken in rendering the opinion, is attached as Annex B to this proxy statement. The Company encourages its stockholders to read the full text of the Duff & Phelps opinion carefully and in its entirety.
 
Financial Projections
 
Neither we nor TerraSphere, as a matter of course, publish our respective business plans and strategies or make public projections as to future revenues, earnings, or other results other than our periodic revenue and earnings guidance. However, TerraSphere’s management prepared the respective prospective financial information referenced in this proxy statement to present certain projections of financial performance for the respective companies, and these projections were provided to our Acquisition Committee, Duff & Phelps and our board of directors in connection with their financial analysis of the proposed acquisition. The projections were prepared by TerraSphere management solely for the purpose of evaluating the TerraSphere acquisition.
 
This prospective financial information was not prepared with a view toward public disclosure or with a view toward complying with U.S. generally accepted accounting principles, or GAAP, the published guidelines of the Securities and Exchange Commission, or SEC, or the guidelines established by the American Institute of Certified Public Accountants for preparation and presentation of prospective financial information, but, in the view of TerraSphere’s management, was prepared on a reasonable basis, reflects the best estimates and judgments available as of the date of their preparation, and presents, to the best of TerraSphere management’s knowledge and belief, a potential course of action and potential future financial performance of the company at the time the projections were prepared. However, this information is not fact and should not be relied upon as being necessarily indicative of future results, and readers of this proxy statement are cautioned not to place undue reliance on the prospective financial information.
 
Neither our nor TerraSphere’s independent auditors, nor any other independent accountants, have compiled, examined, or performed any procedures with respect to the prospective financial information contained herein, nor have they expressed any opinion or any other form of assurance on such information or its achievability, and assume no responsibility for, and disclaim any association with, the prospective financial information.
 
The assumptions and estimates underlying the prospective financial information are inherently uncertain and, though considered reasonable by TerraSphere’s management as of the date of its preparation, are subject to a wide variety of significant business, economic, and competitive risks and uncertainties that could cause actual results to differ materially from those contained in the prospective financial information, including, among others, the risks and uncertainties described in “Risk Factors” and “Special Note Regarding Forward-Looking Statements.” Accordingly, there can be no assurance that the prospective results are indicative of our future performance or that of the combined company or that actual results will not differ materially from those presented in the prospective financial information. Inclusion of the prospective financial information in this proxy statement should not be regarded as a representation by any person that the results contained in the prospective financial information will be achieved.
 
Neither we nor TerraSphere intends to update or otherwise revise the prospective financial information to reflect circumstances existing or events occurring, including changes in general economic or industry conditions, since its preparation, even if any or all of the underlying assumptions are shown to be in error.
 
Interests of Our Officers and Directors in the TerraSphere Acquisition (see page 35)
 
When you consider the unanimous recommendation of our board of directors (with Mr. Gildea abstaining) in favor of the TerraSphere acquisition you should note that Mr. Gildea has an interest in 8.75% of the units of


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TerraSphere. In addition, relatives of Mr. Gildea hold an additional 30.75% of the units of TerraSphere. If the acquisition is completed and assuming all milestones are achieved, Mr. Gildea would receive 3,240,741 shares of our common stock in exchange for his TerraSphere units and his relatives would receive an additional 10,775,463 of our common stock in exchange for their TerraSphere units. Furthermore, Mark C. Gildea, the brother of Edward Gildea, is the President and Chief Executive Officer of TerraSphere, and William A. Gildea, also the brother of Edward Gildea, is an independent contractor of TerraSphere.
 
Because of Mr. Gildea’s relationship with TerraSphere, our board of directors formed the Acquisition Committee to evaluate and, if appropriate, negotiate the proposed TerraSphere acquisition. The Acquisition Committee obtained valuation advice and a fairness opinion from an independent investment bank, and negotiated the terms of the TerraSphere acquisition with the TerraSphere management. Mr. Gildea did not participate in the negotiations.
 
Conditions to the Closing of the Purchase Agreement (see page 39)
 
Consummation of the purchase agreement is conditioned upon certain closing conditions, including, without limitation:
 
  •  the receipt of the approval of our stockholders at the special meeting;
 
  •  that there shall not have occurred and be continuing any event or occurrence, or series of events or occurrences, that individually or in the aggregate, would reasonably be expected to have a material adverse effect on TerraSphere;
 
  •  we shall have restructured our $17,500,000 of New Jersey Economic Development Bonds in such form as is reasonably acceptable to a majority-in-interest of the TerraSphere members; and
 
  •  that no litigation, action, suit or other proceeding involving us, TerraSphere or the TerraSphere members, is threatened or commenced, which would question the validity of the purchase agreement or would be reasonably expected to have a material adverse effect on TerraSphere.
 
Termination of the Purchase Agreement (see page 40)
 
The purchase agreement may be terminated and/or abandoned at any time prior to the closing by:
 
  •  mutual written consent; or
 
  •  either party if there shall have been a material breach of any representation, warranty, covenant or agreement on the part of the other party; or
 
  •  either party if the closing has not been consummated on or before September 7, 2010; or
 
  •  either party if the closing conditions have not been met or waived.
 
In the event of termination and abandonment by either party, all further obligations of the parties shall terminate, no party shall have any right against the other party, and each party shall bear its own costs and expenses.
 
U.S. Federal Income Tax Consequences of the TerraSphere Acquisition
 
No gain or loss will be recognized by us or by holders of shares of our common stock as a result of the TerraSphere acquisition.
 
Anticipated Accounting Treatment
 
We will account for the TerraSphere acquisition as a purchase under U.S. generally accepted accounting principles. Under the acquisition method of accounting, the assets and liabilities of TerraSphere will be recorded as of the date of the closing of the TerraSphere acquisition, at their respective fair values, and


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consolidated with those of us. The results of operations of TerraSphere will be consolidated with ours beginning on the date of the closing of the TerraSphere acquisition.
 
Regulatory Approvals
 
We are not aware of any governmental or regulatory approval required for completion of the TerraSphere acquisition, other than compliance with applicable corporate laws of Delaware, compliance with securities laws and filing with the NASDAQ Stock Market, with respect to the shares of our common stock to be issued to the TerraSphere stockholders pursuant to the purchase agreement. If any other governmental approvals or actions are required, we intend to try to obtain them. We cannot assure you, however, that we will be able to obtain any such approvals or actions.
 
Risk Factors
 
In evaluating the proposals to be voted on at the special meeting, you should carefully read this proxy statement and especially consider the factors discussed in the section entitled “Risk Factors.”


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RISK FACTORS
 
You should carefully consider the following risk factors, together with all of the other information included in this proxy statement, before you decide whether to vote or direct your vote to be cast to approve the TerraSphere acquisition. In assessing these risks, you should also refer to the other information included in this proxy statement, including the consolidated financial statements and the accompanying notes of TerraSphere, as well as the pro forma financial information set forth herein.
 
Risks Relating to the TerraSphere Acquisition
 
We will issue a large number of shares of common stock in connection with the acquisition, which will result in substantial dilution to our existing stockholders. Our stockholders may not realize a benefit from the TerraSphere acquisition commensurate with the ownership dilution they will experience in connection with the shares issued to acquire TerraSphere.
 
If the TerraSphere acquisition is approved and assuming all milestones are achieved by TerraSphere, we will issue up to 34,166,667 shares of our common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to upward adjustment based on certain anti-dilution protections, in consideration for 100% of the outstanding units of TerraSphere, which represents 84.6% of our voting shares prior to the issuance and would represent 45.7% of our voting shares following the issuance, assuming the maximum number of shares are issued in the transaction, based on our outstanding capital stock at July 6, 2010. Our issuance of the shares will result in substantial percentage dilution of our existing stockholders’ ownership interests. Our issuance of the shares may also have an adverse impact on our net income per share in fiscal periods that include or follow the closing of the TerraSphere acquisition.
 
If we are unable to realize sufficient strategic and financial benefits from the TerraSphere acquisition, our stockholders will have experienced substantial dilution of their ownership interest without receiving commensurate benefit.
 
The actual value of the consideration we will pay to the TerraSphere members may exceed the value allocated to it at the time we entered into the purchase agreement.
 
Under the purchase agreement, the number of shares of common stock we will issue as consideration at closing or upon the achievement of milestones is fixed, and there will be no adjustment for changes in the market price of our common stock. The per share value of the shares issued to the TerraSphere members was based on the closing price of our common stock during the 15-day period preceding the date of the execution of the purchase agreement, or $0.756. Neither we nor the TerraSphere members are permitted to abandon or terminate the transaction solely because of changes in the market price of our common stock between the signing of the purchase agreement and the closing. Our common stock has historically experienced significant volatility. Stock price changes may result from a variety of factors that are beyond our control, including changes in our business, operations and prospects, regulatory considerations and general market and economic conditions. The value of the shares we issue to acquire TerraSphere may be significantly higher at the closing or upon the achievement of milestones than when we entered into the purchase agreement.
 
If the conditions to the closing of the purchase agreement are not met, the TerraSphere acquisition will not occur, which could adversely impact the market price of our common stock as well as our business, financial condition and results of operations.
 
The purchase agreement is subject to closing conditions that must be satisfied or waived before the TerraSphere acquisition can be completed, including, without limitation, obtaining the requisite approval of our stockholders with respect to our proposed issuance of common stock in the acquisition. These conditions are summarized in the section in this proxy statement entitled “The Purchase Agreement — Conditions to Closing” beginning on page 39 and are described in detail in the purchase agreement attached to this proxy statement at Annex A. We cannot assure you that each of the conditions will be satisfied.


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If the conditions are not satisfied or waived in a timely manner and the TerraSphere acquisition is delayed, we may lose some or all of the intended or perceived benefits of the transaction which could cause our stock price to decline and harm our business. If the acquisition is not completed for any reason, our stock price may decline to the extent that the current market price reflects a market assumption that the acquisition will be completed.
 
In addition, we will be required to pay our costs related to the acquisition even if the acquisition is not completed, such as amounts payable to legal and financial advisors and independent accountants, and such costs are significant. All of these costs will be incurred whether or not the transaction is completed.
 
We may be required to issue additional shares of common stock to certain of the TerraSphere members if we issue shares of our common stock at a price less than the price per share at which we valued the shares issued to the TerraSphere members.
 
The TerraSphere members are required to lock-up the shares they will receive in the acquisition for a period of either six or eighteen months. During the applicable lock-up period, we have agreed to provide the TerraSphere members anti-dilution rights. The rights provide that if we issue shares of our common stock for cash consideration in connection with a financing transaction at a price less than $0.756 per share, then the TerraSphere members shall receive additional shares of our common stock based on a weighted average dilution formula. See the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — Anti-Dilution Protection” for details about the formula. Messrs. Edward Gildea and William Gildea have not been provided this anti-dilution protection.
 
The market price of our common stock may decline as a result of the issuance of shares in connection with the TerraSphere acquisition.
 
The market price of our common stock may decline as a result of the TerraSphere acquisition for a number of reasons including if:
 
  •  we do not achieve the perceived benefits of the TerraSphere acquisition as rapidly or to the extent anticipated by financial or industry analysts;
 
  •  the effect of the TerraSphere acquisition on our business and prospects is not consistent with the expectations of financial or industry analysts; or
 
  •  investors react negatively to the effect on our business and prospects from the TerraSphere acquisition.
 
As shares of our common stock issued in the TerraSphere acquisition become eligible for resale, the sale of those shares could adversely impact our stock price.
 
All of the shares of our common stock issued to the TerraSphere members in the acquisition will be restricted securities and may not be sold absent registration under the Securities Act or pursuant to Rule 144 or another available exemption from registration. Additionally, TerraSphere members entitled to an aggregate of 8,611,111 shares of common stock are required to lock-up the shares they will receive in the acquisition for a period of six months and TerraSphere members entitled to an aggregate of up to 25,555,556 shares of common stock (assuming all milestones are achieved by TerraSphere) are required to lock-up the shares they will receive in the acquisition for a period of eighteen months.
 
Accordingly, a substantial number of shares of our common stock will become eligible for resale six months after the closing date, with an additional substantial number of shares of our common stock becoming eligible for resale eighteen months after the closing date. Our stock price may suffer a significant decline as a result of the sudden increase in the number of shares sold in the public market or market perception that the increased number of shares available for sale will exceed the demand for our common stock.


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We may face challenges in integrating our business with TerraSphere’s and, as a result, we may not realize the expected benefits of the proposed acquisition.
 
We will be required to integrate the operations and personnel of both our company and TerraSphere, which will require a significant investment of our management’s time and effort as well as the investment of capital. The successful integration of the two companies will require, among other things, coordination of sales and marketing operations and the integration of TerraSphere’s operations into our organization. The diversion of the attention of our senior management and any difficulties encountered in the process of combining the companies could cause the disruption of, or a loss of momentum in, the activities of the combined business.
 
The inability to successfully integrate the operations and personnel of the two companies, or any significant delay in achieving integration, could have a material adverse effect on the combined business after the completion of the acquisition, and, as a result, on our cash flows, results of operations and financial position.
 
The combined business will continue to require significant capital, and financing may not be available to us on reasonable terms, if at all.
 
Our current operations are not cash flow positive and have required us to raise significant external financing. The combined business will continue to require significant working capital for the manufacturing and marketing activities as well as the expansion and integration of TerraSphere’s operations. Our existing resources will be insufficient to satisfy our liquidity requirements, and we will need to sell additional equity or debt securities to finance these operations. Any sale of additional equity or debt securities may result in additional dilution to our stockholders, and we cannot be certain that we will be able to obtain additional public or private financing in amounts, or on terms, acceptable to us, or at all.
 
The financial projections in this proxy statement are only estimates of future results and there is no assurance that we will achieve the results shown in the financial projections.
 
The financial projections included elsewhere in this proxy statement are only estimates of possible future operating results and not guarantees of future performance. The future operating results of the combined business will be affected by numerous factors, including those discussed in this “Risk Factors” section of this proxy statement. TerraSphere prepared the financial projections in good faith based upon assumptions. Although such assumptions are believed to be reasonable, no assurance can be given regarding the attainability of the projections or the reliability of the assumptions on which they are based. The projections are subject to the uncertainties inherent in any attempt to predict the results of operations for a business, especially where new products are involved. Certain of the assumptions used will inevitably not materialize and unanticipated events will occur. Therefore, the actual results of operations are likely to vary from the projections and such variations may be material and adverse to us. We will conduct our business in a manner different from that set forth in the assumptions as changing circumstances may require.
 
Risks Relating to the Business of TerraSphere
 
TerraSphere has a limited operating history, and its prospects are difficult to evaluate.
 
TerraSphere is an early stage company and its activities have been limited primarily to developing its technology, and consequently there is limited historical financial information related to operations available upon which you may base your evaluation of TerraSphere’s business and prospects. The revenue and income potential of TerraSphere’s business is unproven. If TerraSphere is unable to develop its business, it will not achieve its goals and could suffer economic loss or collapse, which may have a material negative effect on our financial performance.


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TerraSphere’s licensees are generally early stage companies and the failure of such licensees to be successful may adversely effect TerraSphere’s future revenues.
 
TerraSphere principally generates revenue from its licensing activities. TerraSphere generates revenues from its licensee partners initially from license fees payable from such partners, followed by such partners purchasing equipment from TerraSphere and finally from royalties from product sales. Many of TerraSphere’s licensees are early stage companies that may be under capitalized. If these licensees are not successful they may not be in a position to pay TerraSphere any future license fees, or to purchase equipment or pay royalties in the future. The failure of TerraSphere’s licensees may have a material adverse effect on TerraSphere’s future revenues.
 
TerraSphere is dependent on a small number of major customers for its revenues.
 
To date, TerraSphere has relied on a few major customers for a majority of its revenues. During the three month period ended March 31, 2010, 100% of TerraSphere’s revenues were from two customers. The loss of any of TerraSphere’s major customers could adversely effect its results of operations.
 
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This proxy statement contains forward-looking statements that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this proxy statement regarding strategy, future operations, future financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words.
 
The parties may not actually achieve the plans, intentions or expectations disclosed in the forward-looking statements, and you should not place undue reliance on the forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements made by the parties. The parties to this proxy statement have included important factors in the cautionary statements included in this proxy statement, particularly in the “Risk Factors” section, that the parties believe could cause actual results or events to differ materially from the forward-looking statements made by the parties, including, among others:
 
  •  the demand for organic fertilizer and the resulting prices that customers are willing to pay;
 
  •  the availability of an adequate supply of food waste stream feedstock and the competition for such supply;
 
  •  the unpredictable cost of compliance with environmental and other government regulation;
 
  •  the time and cost of obtaining USDA, state or other organic product labeling designations, and changes to such labeling requirements that may adversely affect our ability to market our products;
 
  •  our ability to manage expenses;
 
  •  our ability to remain in compliance with standards set by the National Organic Program;
 
  •  supply of organic fertilizer products from the use of competing or newly developed technologies;
 
  •  our ability to attract and retain key personnel;
 
  •  to the extent we complete any acquisitions, our ability to finance those acquisitions, and our ability to efficiently integrate future acquisitions, if any, or any other new lines of business that we may enter in the future;
 
  •  adoption of new accounting regulations and standards;
 
  •  adverse changes in the securities markets;


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  •  our ability to sell sufficient quantities of product to cover operating expenses;
 
  •  our ability to maintain production levels sufficient to meet customer demand;
 
  •  our ability to comply with continued listing requirements of the NASDAQ Capital Market; and
 
  •  the availability of, and costs associated with, sources of liquidity (including working capital requirements), as well as our ability to obtain bond financing for future facilities.
 
Further, the forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures, collaborations, dividends or investments made by the parties.
 
You should read this proxy statement, including all annexes to this proxy statement, completely and with the understanding that actual future results may be materially different from what the parties expect. Neither we nor TerraSphere assume any obligation to update any forward-looking statements.


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SELECTED SUMMARY HISTORICAL FINANCIAL INFORMATION FOR TERRASPHERE
 
The following tables summarize TerraSphere consolidated financial and other data. The consolidated statements of operations data for the years ended December 31, 2009 and 2008 and the consolidated balance sheet data as of December 31, 2009 and 2008 have been derived from TerraSphere’s audited consolidated financial statements included elsewhere in this proxy statement. The consolidated statement of operations data for the three months ended March 31, 2010 and 2009, and the consolidated balance sheet data as of March 31, 2010, have been derived from TerraSphere’s unaudited consolidated financial statements included elsewhere in this proxy statement. The unaudited consolidated financial statements have been prepared on a basis consistent with TerraSphere’s audited financial statements and include, in the opinion of management, all adjustments that management considers necessary for the fair statement of the financial information set forth in those consolidated financial statements. The following financial data should be read in conjunction with, and is qualified by reference to, TerraSphere’s consolidated financial statements and related notes and schedules included elsewhere in this proxy statement and the information under “TerraSphere’s Management’s Discussion and Analysis of Financial Condition and Results of Operations” below. Historical results are not necessarily indicative of the results to be expected in any future period.
 
                 
    Years Ended December 31,
    2009   2008
 
Selected Operating Data:
               
Revenues
  $ 36,732     $ 1,458,569  
Cost of goods sold
          730,446  
Gross profit
    36,732       728,123  
Income (loss) from operations
    (1,261,850 )     14,342  
Other income, net
    45,896       78,614  
Net income (loss)
    (1,215,954 )     92,956  
 
                 
    As of December 31,
    2009   2008
 
Selected Balance Sheet Data:
               
Cash
  $ 197,046     $ 8,083  
Accounts receivable
          400,000  
Other assets
    63,036       123,096  
Leasehold improvements
    161,948        
Patent and patent costs, net
    134,932       98,347  
Total assets
    591,527       629,526  
Working capital (deficit)
    (1,336,832 )     137,072  
Total liabilities
    1,625,787       390,341  
Total members’ equity (deficit)
    (1,034,260 )     239,185  
 
                 
    Three Months Ended
    March 31,
    2010   2009
 
Selected Operating Data:
               
Revenues
  $ 1,684,183     $ 9,183  
Cost of goods sold
    703,301        
Gross profit
    980,882       9,183  
Income (loss) from operations
    533,067       (219,137 )
Other income (expenses)
    13,285       (5,782 )
Income (loss) before provision for income taxes
    546,352       (224,919 )
Net income (loss)
    158,352       (224,919 )


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    As of March 31,
    2010
 
Selected Balance Sheet Data:
       
Cash
  $ 106,830  
Accounts receivable
    950,000  
Other assets
    112,407  
Leasehold improvements, net
    158,819  
Patent and patent costs, net
    148,259  
Total assets
    1,557,332  
Working capital (deficit)
    (1,211,655 )
Total liabilities
    2,375,006  
Total members’ deficit
    (817,674 )


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SELECTED UNAUDITED PRO FORMA COMBINED CONDENSED FINANCIAL DATA
 
The following tables summarize selected unaudited pro forma consolidated condensed financial data. The unaudited pro forma consolidated balance sheet data as of March 31, 2010 gives effect to the acquisition of TerraSphere, on the balance sheet of Converted Organics Inc., as if it had occurred on March 31, 2010, and the unaudited pro forma consolidated statements of operations data for the year ended December 31, 2009 and for the three month period ended March 31, 2010 give effect to the acquisition, on the statements of operations of Converted Organics Inc., as if it had occurred on January 1, 2009. The pro forma financial statements are based upon available information and certain assumptions that we believe are reasonable. The unaudited pro forma consolidated financial statements do not purport to represent what our financial condition or results of operations would actually have been had these transactions in fact occurred as of the dates indicated above or to project our results of operations for the period indicated or for any other period. The following pro forma financial data should be read in conjunction with our Form 8-K dated July 6, 2010 and filed on July 7, 2010, the historical financial statements and the related notes of Converted Organics Inc., which are included in our Annual Report on Form 10-K for the year ended December 31, 2009, the quarterly financial statements and the related notes of Converted Organics Inc., which are included in our Form 8-K as of March 31, 2010, and the TerraSphere Systems, LLC financial statements and the unaudited pro forma consolidated financial statements included elsewhere in this proxy.
 
                 
    Three Months Ended March 31, 2010
        Historical
        Converted
    Pro Forma
  Organics Inc.
    Consolidated   and Subsidiaries
 
Selected Operating Data:
               
Revenues
  $ 2,544,009     $ 859,826  
Cost of goods sold
    2,669,402       1,966,101  
Gross loss
    (125,393 )     (1,106,275 )
Loss from operations
    (4,980,173 )     (5,346,573 )
Other expenses
    (1,019,835 )     (1,033,120 )
Loss before provision for income taxes
    (6,000,008 )     (6,379,693 )
Net loss
    (6,000,008 )     (6,379,693 )
Net loss per share, basic and diluted
    (0.10 )     (0.17 )
Weighted average common shares outstanding
    56,389,068       37,864,169  
 
                 
    Year Ended December 31, 2009
        Historical
        Converted
    Pro Forma
  Organics Inc.
    Consolidated   and Subsidiaries
 
Selected Operating Data:
               
Revenues
  $ 2,670,514     $ 2,633,782  
Cost of goods sold
    6,914,857       6,914,857  
Gross loss
    (4,244,343 )     (4,281,075 )
Loss from operations
    (17,994,628 )     (16,066,111 )
Other expenses
    (4,993,781 )     (5,039,677 )
Loss before provision for income taxes
    (22,988,409 )     (21,105,788 )
Net loss
    (22,988,409 )     (21,105,788 )
Net loss per share, basic and diluted
    (0.61 )     (1.08 )
Weighted average common shares outstanding
    38,114,781       19,569,853  
 


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    As of March 31, 2010
        Historical
        Converted
    Pro Forma
  Organics Inc.
    Consolidated   and Subsidiaries
 
Selected Balance Sheet Data:
               
Cash
  $ 4,220,189       4,113,359  
Accounts receivable, net
    1,445,450       495,450  
Other prepaid expenses
    730,840       624,319  
Property and equipment, net
    18,541,647       18,382,828  
Construction-in-progress
    409,654       328,637  
Intangibles, net
    11,923,617       1,923,617  
Goodwill
    12,370,000        
Total assets
    52,692,960       28,913,887  
Working capital
    983,247       1,804,969  
Total liabilities
    (26,957,014 )     (24,971,941 )
Total owners’ equity
    25,735,946       (3,941,946 )
 
PRICE RANGE OF SECURITIES AND DIVIDENDS
 
Converted Organics
 
Our common stock has been listed on the NASDAQ Capital Market under the symbol “COIN” since March 16, 2007. Prior to March 16, 2007, there was no public market for our common stock. The following table sets forth the range of high and low closing prices per share as reported on NASDAQ for the periods indicated.
 
                 
2010
  High   Low
 
First Quarter
  $ 1.14     $ 0.68  
Second Quarter (through July 6, 2010)
  $ 1.18     $ 0.54  
 
                 
2009
  High   Low
 
First Quarter
  $ 4.05     $   .76  
Second Quarter
  $ 2.19     $ .76  
Third Quarter
  $ 1.48     $ .95  
Fourth Quarter
  $ 1.30     $ .59  
 
                 
2008
  High   Low
 
First Quarter
  $ 14.17     $ 3.52  
Second Quarter
  $ 10.37     $ 4.50  
Third Quarter
  $ 7.83     $ 2.99  
Fourth Quarter
  $ 6.46     $ 2.00  
 
Holders
 
As of July 2, 2010, there were approximately 7,000 beneficial holders of our common stock.
 
Dividends
 
Beginning with the first quarter of 2007, at the end of each calendar quarter, holders of record of our common stock received a 5% common stock dividend until the Woodbridge facility commenced commercial

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operations on June 30, 2008. We did not issue fractional shares as a part of the dividend program nor did we issue shares with respect to the calendar quarter in which we commenced commercial operations. We also issued a special 15% common stock dividend, payable on December 1, 2008, for all holders of record of our common stock on November 17, 2008. During 2008, we issued 1,232,552 shares as stock dividends.
 
We have not declared or paid any cash dividends and do not intend to pay any cash dividends in the foreseeable future. We intend to retain any future earnings for use in the operation and expansion of our business. Any future decision to pay cash dividends on common stock will be at the discretion of our Board of Directors and will depend upon our financial condition, results of operation, capital requirements and other factors our Board of Directors may deem relevant.
 
TerraSphere
 
TerraSphere securities are not publicly traded.
 
THE SPECIAL MEETING
 
We are furnishing this proxy statement to our stockholders as part of the solicitation of proxies by our board of directors for use at the special meeting in connection with the proposed acquisition of TerraSphere. This document provides you with the information you need to know to be able to vote or instruct your vote to be cast at the special meeting.
 
Date, Time and Place.  We will hold the special meeting at 9:30 a.m., Eastern time, on August 31, 2010, at Renaissance Boston Waterfront Hotel, 606 Congress Street, Boston, MA 02210.
 
Purpose.  At the special meeting, holders of our common stock will be asked to approve the issuance of at least 34,166,667 shares of our common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to upward adjustment based on certain anti-dilution protections described in this proxy statement.
 
The Acquisition Committee of our board of directors unanimously determined that the terms of the TerraSphere acquisition are advisable, fair to, and in the best interests of our stockholders. Upon the Acquisition Committee’s unanimous recommendation, our board of directors then unanimously (with Mr. Gildea abstaining) determined that the terms of the TerraSphere acquisition are advisable, fair to, and in the best interests of, our stockholders.
 
The special meeting has been called only to consider approval of the TerraSphere Proposal and the Adjournment Proposal. Under Delaware law and our bylaws, no other business may be transacted at the special meeting.
 
Record Date; Who Is Entitled to Vote.  The “record date” for the special meeting is July 21, 2010. Record holders of our common stock at the close of business on the record date are entitled to vote or have their votes cast at the special meeting. On the record date, there were 42,359,041 outstanding shares of our common stock. Each share of common stock is entitled to one vote at the special meeting.
 
Vote Required.  Approval of TerraSphere Proposal and the Adjournment Proposal requires the affirmative vote of the holders of a majority of the shares of common stock present in person at the meeting or represented by a proxy and entitled to vote thereon.
 
Abstentions; Broker Non-Votes.  Abstaining from voting or not voting on the proposal, either in person or by proxy or voting instruction, will have the effect of voting against the TerraSphere Proposal and the Adjournment Proposal.
 
A broker non-vote occurs when a broker submits a proxy card with respect to shares held in a fiduciary capacity (typically referred to as being held in “street name”) but declines to vote on a particular matter because the broker has not received voting instructions from the beneficial owner and does not have discretionary authority to vote on the proposal. Under the rules that govern brokers who are voting with respect to shares held in street name, brokers have the discretion to vote such shares on routine matters, but


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not on non-routine matters. The matters currently planned to be considered by the stockholders are not routine matters. As a result, brokers can only vote the common stock if they have instructions to do so. Broker non-votes will not be counted in determining whether the proposal to be considered at the meeting is approved.
 
Voting Your Shares.  Each share of common stock that you own in your name entitles you to one vote per proposal.
 
There are three ways for holders of record to have their shares represented and voted at the special meeting:
 
By signing and returning the enclosed proxy card.  If you duly sign and return a proxy card, your “proxy,” whose names are listed on the proxy card, will vote your shares as you instruct on the card. If you sign and return the proxy card, but do not give instructions on how to vote your shares, your shares will be voted as recommended by our board of directors, which is “FOR” approval of the TerraSphere Proposal and the Adjournment Proposal.
 
By telephone or on the internet.  You can submit a proxy to vote your shares by following the telephone or internet voting instructions included with your proxy card. If you do, you should not return the proxy card.
 
You can attend the special meeting and vote in person.  We will give you a ballot when you arrive. However, if your shares are held in the “street name” of your broker, bank or another nominee, you must get a proxy from the broker, bank or other nominee. That is the only way we can be sure that the broker, bank or nominee has not already voted your shares.
 
Questions About Voting.  If you have any questions about how to vote or direct a vote in respect of your shares, you may call Phoenix Advisory Partners, LLC at (866) 351-1539. You may also want to consult your financial and other advisors about the vote.
 
Revoking Your Proxy and Changing Your Vote.  If you give a proxy, you may revoke it or change your voting instructions at any time before it is exercised by:
 
  •  if you have already sent in a proxy, sending another proxy card with a later date;
 
  •  if you voted by telephone or by internet, calling the same number or going to the same website and following the instructions;
 
  •  notifying us in writing before the special meeting that you have revoked your proxy; or
 
  •  attending the special meeting, revoking your proxy and voting in person.
 
If your shares are held in “street name,” consult your broker for instructions on how to revoke your proxy or change your vote.
 
Solicitation Costs.  We will pay for all costs incurred in connection with the solicitation of proxies from our stockholders on behalf of our board of directors, including assembly, printing and mailing of this document, its related attachments, and the proxy card. Our directors, officers and employees may solicit proxies by telephone, email, facsimile and in person, without additional compensation. Upon request, we will reimburse brokerage houses and other custodians, nominees and fiduciaries for their reasonable out-of-pocket expenses for distributing proxy materials. We have agreed to pay Phoenix Advisory Partners, LLC a fee of $7,500, plus expenses, for its services in connection with the special meeting.


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THE TERRASPHERE ACQUISITION PROPOSAL
 
Approval of the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
At the special meeting and any adjournment or postponement thereof, our stockholders will be asked to consider and vote upon a proposal to approve the issuance of at least 34,166,667 shares of our common stock to the members of TerraSphere in exchange for 100% of the units of TerraSphere, subject to upward adjustment based on certain anti-dilution protections described in this proxy statement.
 
Further information with respect to the issuance of the shares, the TerraSphere acquisition, TerraSphere, the purchase agreement and TerraSphere’s members is contained elsewhere in this proxy statement.
 
The Acquisition Committee unanimously recommends a vote “FOR” the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
Upon the unanimous recommendation of the Acquisition Committee, our board of directors unanimously (with Mr. Gildea abstaining) recommends a vote “FOR” the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
THE ADJOURNMENT PROPOSAL
 
This proposal allows our board of directors to submit a proposal to adjourn the special meeting to a later date or dates, if necessary, to permit further solicitation of proxies in the event there are not sufficient votes at the time of the special meeting to approve the TerraSphere Proposal. If this proposal is not approved by our stockholders, our board of directors may not be able to adjourn the special meeting to a later date in the event there are not sufficient votes at the time of the special meeting to approve the TerraSphere Proposal.
 
After careful consideration of all relevant factors, our board of directors determined that the Adjournment Proposal of the special meeting for the purpose of soliciting additional proxies is in our best interests and in the best interest of our stockholders. The board of directors has approved and declared the Adjournment Proposal advisable and recommends that you vote or give instructions to vote “FOR” the proposal.
 
THE TERRASPHERE ACQUISITION
 
The following is a description of the material aspects of the TerraSphere acquisition, including the purchase agreement. While we believe that the following description covers the material terms of the acquisition, the description may not contain all of the information that is important to you. We encourage you to carefully read this entire proxy statement, including the purchase agreement attached to this proxy statement at Annex A, for a more complete understanding of the acquisition.
 
Description of the TerraSphere Acquisition
 
General
 
On July 6, 2010, we entered into a purchase agreement with TerraSphere Inc., our wholly owned subsidiary, TerraSphere and the members of TerraSphere. Pursuant to the purchase agreement, the maximum total purchase price for TerraSphere will be $25,830,000, which includes earn-out payments of up to $11,040,000, payable solely in shares of common stock valued at $0.756 per share. We will issue up to 34,166,667 shares of our common stock, subject to upward adjustment based on certain anti-dilution protections, in consideration for 100% of the outstanding units of TerraSphere, which represents 84.6% of our voting shares prior to the issuance and would represent 45.7% of our voting shares following the issuance. Upon completion of the proposed acquisition, TerraSphere would become our wholly-owned subsidiary.


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Pursuant to the terms of the purchase agreement, each TerraSphere member was given the option to receive either:
 
  •  such member’s pro rata portion of $21,000,000 worth of our common stock, valued at $0.756 per share, which is the price which was the average closing price for our common stock over the fifteen day period preceding the date of the execution of the purchase agreement (we refer to this $0.756 price in this proxy statement as the “Closing Price Per Share”) (the shares to be issued pursuant to this immediate payment structure are referred to as the “Option One Shares”); or
 
  •  such member’s pro rata portion of up to $28,000,000 worth of our common stock, valued at the Closing Price Per Share, in an earn-out payment structure consisting of up to four milestone payments (the shares to be issued pursuant to this earn-out payment structure are referred to as the “Option Two Shares”).
 
The earn-out payment is structured such that the TerraSphere members electing to receive Option Two Shares will be paid their respective pro rata portion of our common stock, valued at the Closing Price Per Share, in accordance with the following schedule:
 
(1) on the date of the closing, $12,000,000 of our common stock;
 
(2) $5,000,000 of our common stock, if, and only if, between the date of the purchase agreement and the earlier of the 90th day following the closing or the 180th day following the date of the purchase agreement, for a period of five consecutive trading days, our Market Capitalization (as defined below) exceeds the sum of: (1) our Initial Market Capitalization (as defined below) on the date of the purchase agreement plus (2) the Closing Price Per Share multiplied by the number of shares of our common stock to be issued to TerraSphere members electing Option One Shares, the number of shares of our common stock to be issued pursuant to paragraph 1 above and, if such calculation is being made prior to the closing, the number of shares of our common stock to be issued pursuant to this paragraph 2. Notwithstanding the foregoing, if between the date of the purchase agreement and the earlier of the 90th day following the closing or the 180th day following the date of the purchase agreement, we complete a debt or equity financing with a third party other than project financing, unless such project financing is completed for TerraSphere (referred to as a “Financing”), the cash received from the Financing during such period shall be added to the Market Capitalization. In addition, if between the closing and December 31, 2011, we sell equity of either the TerraSphere or any of TerraSphere’s subsidiaries, any cash received from such equity sales during such period shall be added to the Market Capitalization.
 
(3) $2,000,000 of our common stock, if, and only if, $2,000,000 of TerraSphere’s accounts receivable as of the date of the purchase agreement are received prior to February 28, 2011;
 
(4) $5,000,000 of our common stock, or the Milestone Three Payment, if TerraSphere generates Gross Margin (as defined below) of $6,000,000 from its operations during the period from the date of the purchase agreement through December 31, 2011; provided that, if TerraSphere generates Gross Margin of at least $4,200,000, or the Milestone Three Gross Margin Threshold, from its operations during such period, the TerraSphere members will be entitled to a pro rata portion of the common stock; and
 
(5) $4,000,000 of our common stock, or the Milestone Four Payment, if, and only if, TerraSphere generates Gross Margin of $4,000,000, or the Milestone Four Gross Margin Target, from its operations during any six-month period commencing on the date of the purchase agreement and ending on December 31, 2012; provided that, if TerraSphere achieves the Milestone Three Gross Margin Threshold, but does not achieve the Milestone Three Gross Margin Target, 83.3% of the difference between the Milestone Three Gross Margin Target and the actual Gross Margins achieved pursuant to paragraph 4 above may be added by the TerraSphere members to the Milestone Four Payment and the Milestone Four Gross Margin Target.


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For the purposes of the above milestone calculations we agreed upon the following definitions for “Market Capitalization,” “Initial Market Capitalization,” and “Gross Margin”:
 
  •  The term “Market Capitalization” means on any date the number of shares of our common stock outstanding on such date, less any shares issued in a Financing, multiplied by the closing price of one share of our common stock as reported by the NASDAQ Stock Market.
 
  •  The term “Initial Market Capitalization” means the number of shares of our common stock outstanding on the date of the purchase agreement multiplied by the Closing Price Per Share, or $0.756.
 
  •  The term “Gross Margin” means:
 
  •  With respect to license revenue, the amount of such revenue without deduction.
 
  •  With respect to royalty income from licenses, the amount of such revenue without deduction.
 
  •  With respect to equipment sales, the dollars billed for the sale of equipment to licensees or others, and subtracting all external costs to manufacture, fabricate or produce, deliver and install the equipment, including all parts, fabrication costs, additional drawings and direct labor and consulting costs.
 
  •  With respect to revenues from build own operate projects, the revenues from such projects, and subtracting costs related to facility personnel, maintenance, utilities, disposal fees, fertilizer, rent, permits and licenses.
 
Lock-Up of Shares
 
With limited exceptions, the shares to be issued to the TerraSphere members are subject to the following sale restrictions absent our approval:
 
  •  the Option One Shares are subject to a lock-up the term of which is six months, beginning on the closing of the acquisition; and
 
  •  the Option Two Shares are subject to a lock-up the term of which is the longer of: (a) eighteen months, beginning on the closing of the acquisition, or (b) six months, beginning on the date when shares of common stock are issued pursuant to the foregoing milestone payments.
 
The above restrictions will not apply to the following transfers; provided the transfers do not involve a disposition for value and provided that we receive a lock-up agreement for the balance of the lock-up period discussed above from each donee, trustee, distributee, or transferee, as the case may be:
 
  •  as a bona fide gift or gifts;
 
  •  to any trust for the direct or indirect benefit of the TerraSphere members or the immediate family of the TerraSphere members;
 
  •  as a distribution to members, partners or stockholders of a TerraSphere member; or
 
  •  to any beneficiary of a TerraSphere member pursuant to a will or other testamentary document or applicable laws of descent.
 
Anti-Dilution Protection
 
During the applicable lock-up period described above, we have agreed to provide the TerraSphere members anti-dilution rights. The rights provide that if we issue shares of our common stock for cash consideration in connection with a financing transaction at a price less than the Closing Price Per Share, or $0.756 per share, then the TerraSphere members shall receive additional shares of our common stock based on the following formula:
 
New shares to be issued = [(A*B) / [B*(C/D)]] — A


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  A:  For each TerraSphere member, the number of shares of our common stock received at closing less any shares sold, assigned, or transferred by such TerraSphere member.
 
  B:  $0.756 (subject to adjustment for stock splits or dividends)
 
  C:  The sum of the number shares of our common stock issued and outstanding immediately prior to any dilutive issuance plus the number of shares of our common stock which the consideration we receive from the dilutive issuance would purchase at a price of B. above.
 
  D:  The sum of the number of shares of our common stock issued and outstanding immediately prior to the dilutive issuance plus the number of shares of our common stock so issued in connection with the dilutive issuance.
 
Messrs. Edward Gildea and William Gildea have not been provided this anti-dilution protection.
 
Background of the TerraSphere Acquisition
 
During March 2010, our Chief Financial Officer, Mr. David Allen, contacted Atlas Advisors, LLC, or Atlas, a consulting firm that was assisting us with business development to discuss potential new acquisitions and new lines of business. As part of the discussion, Mr. Allen suggested that Atlas contact Mr. William Gildea and look into whether TerraSphere would be a good acquisition candidate. Atlas met with Mr. William Gildea to discuss TerraSphere and after their meeting Atlas suggested that they believed we should conduct some preliminary analysis as to whether TerraSphere would be a good fit for us.
 
On March 12, 2010, Mr. Edward Gildea introduced the topic of holding discussions with TerraSphere with our board of directors. Due to Mr. Gildea’s relationship with TerraSphere, our board decided to create an Acquisition Committee comprised of the three independent and disinterested directors, Messrs. Robert Cell, John DeVillars and Edward Stoltenberg, to review and evaluate a possible transaction with TerraSphere. Mr. Cell was made chairman of the committee. Mr. Allen was instructed by the Acquisition Committee to prepare an initial presentation for the committee regarding TerraSphere and to begin discussions with Atlas regarding a possible acquisition of TerraSphere.
 
On March 16, 2010, Mr. Allen and Atlas received correspondence from Mr. William Gildea containing TerraSphere’s valuation model with an enterprise value of $83 million.
 
Between March 22-29, 2010, we and TerraSphere discussed possible deal structures, and we continued performing due diligence on TerraSphere.
 
On March 30, 2010, the Acquisition Committee met with Mr. Allen and Atlas to discuss the TerraSphere opportunity. At the meeting, Atlas indicated that based on its review of TerraSphere, it believed a $40 million valuation was fair from a financial point of view for TerraSphere. Between March 30-31, 2010, we continued to receive additional due diligence items from TerraSphere.
 
On April 2, 2010, the Acquisition Committee met again to discuss the transaction. The Acquisition Committee determined that although it believed a TerraSphere acquisition had merit, it do not feel it could proceed at the proposed valuation. The Acquisition Committee instructed Mr. Cell (the chairman of the committee) to continue to review the transaction.
 
Between April 2-9, 2010, we and the Acquisition Committee continued to review a possible TerraSphere acquisition. During this period, we authorized our outside legal counsel, Cozen O’Connor, to begin preparation of the purchase agreement.
 
On April 9, 2010, our board of directors held a previously schedule meeting, at which the board continued to discuss a possible transaction with TerraSphere.
 
On April 13-14, 2010, Mr. Cell met Messrs. William Gildea and Mr. Edward Gildea in Chicago to discuss the TerraSphere transaction and TerraSphere’s valuation assumptions.
 
On April 23, 2010, the Acquisition Committee met to discuss Mr. Cell’s meeting with TerraSphere. After discussion at the meeting, the Acquisition Committee instructed Mr. Allen to contact Mr. William Gildea and


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to continue negotiations at an enterprise valuation of $20 million and to attempt to purchase 100% of TerraSphere.
 
On April 23, 2010, Mr. Allen and Mr. William Gildea discussed the revised proposed valuation and deal structure.
 
On April 24, 2010, Mr. William Gildea delivered a counterproposal to Mr. Allen that provided that we acquire 51% of TerraSphere with options to acquire the remaining interest over a one year period. In addition, the proposal required us to commit to certain funding requirements during such period, if needed by TerraSphere. Further, the proposal asked for price protection on the shares of our common stock being issued such that if we issued shares in the future for financings, the TerraSphere members would receive additional shares of common stock.
 
On April 25, 2010, Mr. Allen contacted Mr. William Gildea and proposed that the option for us to acquire the remaining 49% of TerraSphere be exercisable by us on a more expedited basis and that we were not willing to provide price protection for Messrs. William Gildea or Edward Gildea. On April 26, 2010, Mr. Allen met with Mr. William Gildea at our offices to further discuss the parameters of the price protection.
 
On April 27, 2010, Mr. Allen provided TerraSphere with an initial draft of the purchase agreement prepared by Cozen O’Connor. On May 3, 2010, Clark, Balboni & Gildea, or CBG, legal counsel to TerraSphere provided its initial comments to the purchase agreement.
 
On May 4, 2010, TerraSphere notified us that based on certain tax advice received it wished to structure the acquisition as a 100% acquisition of the members interest. After notifying the chairman of the Acquisition Committee, Mr. Allen informed TerraSphere that he believed a 100% acquisition would be in our best interest as well.
 
On May 5, 2010, Cozen O’Connor sent a revised draft of the purchase agreement to CBG with the revisions agreed to on May 4, 2010. On May 7, 2010, CBG provided its comments to the revised purchase agreement.
 
On May 11, 2010, the Acquisition Committee engaged Duff & Phelps, LLC, or Duff & Phelps, to provide the Acquisition Committee with an opinion as to the fairness, from a financial point of view, to us and our stockholders (other than our stockholders who are also TerraSphere members) of the proposed consideration to be paid by us in the TerraSphere transaction.
 
On May 12, 2010, the Acquisition Committee met to discuss the status of the TerraSphere transaction.
 
On May 17, 2010, Cozen O’Connor sent a revised draft of the purchase agreement. On May 18, 2010, CBG provided its comments to the revised purchase agreement. On May 18, 2010, Cozen O’Connor responded to CBG comments on the purchase agreement.
 
On May 20, 2010, Mr. Allen distributed draft TerraSphere financial statements to the Acquisition Committee. On May 21, 2010, the Acquisition Committee met to discuss the transaction with Mr. Allen, Duff & Phelps and Cozen O’Connor. At the meeting, Duff & Phelps informed the Acquisition Committee that it would not be able to arrive at a favorable opinion as to the fairness of the consideration to be paid by the Company in the TerraSphere acquisition. However, Duff & Phelps suggested that the parties consider restructuring the TerraSphere acquisition to include an earn-out feature that would permit the Company to pay a portion of the total consideration contingent upon TerraSphere’s achievement of specified milestones and, as a result, less up-front consideration. Based on Duff & Phelps’ suggestion, the Acquisition Committee instructed Mr. Allen, Mr. Cell and Mr. Allen to prepare alternative transaction structures that required less consideration to be paid at closing with additional consideration to be paid on the achievement of milestones by TerraSphere.
 
On May 30, 2010, Mr. Allen sent a revised transaction structure to Mr. William Gildea, which structure provided for less consideration to be paid at closing with additional consideration to be paid on the achievement of milestones by TerraSphere. On May 31, 2010, Mr. William Gildea informed Mr. Allen that the proposal sent by Mr. Allen on May 30 would not be acceptable to the TerraSphere members.


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On June 2, 2010, the Acquisition Committee met to discuss the status of the transaction. Mr. William Gildea attended a portion of the meeting. At the meeting, the Acquisition Committee informed Mr. William Gildea that it believed a structured transaction with less consideration to be paid at closing with additional consideration to be paid on the achievement of milestones by TerraSphere was required due to the early stage nature of TerraSphere’s operations. At the meeting, Mr. William Gildea informed the Acquisition Committee that TerraSphere was willing to continue a dialogue of a structured transaction.
 
Between June 3-8, 2010, Mr. Allen and Mr. William Gildea negotiated a structured payout transaction with less consideration to be paid at closing with additional consideration to be paid on the achievement of milestones by TerraSphere. On June 8, 2010, Mr. William Gildea reported that he had come to an impasse with TerraSphere members and they would not accept a structured transaction.
 
Between June 9-21, 2010, the parties continued to negotiate. During this negotiation, the parties acknowledged that certain of the TerraSphere members, particularly the smaller equity holders, did not want to enter into a structured transaction, but wanted to receive their consideration in full at closing. In order to accommodate these members, the parties agreed to provide the TerraSphere members with two options: (1) an option to receive the $21 million valuation as previously discussed with all consideration being paid at closing; and (2) an option to receive an increased valuation of $28 million with a portion of such consideration being paid only upon the achievement of certain milestones. In negotiating such two-tiered offer, Mr. Allen informed Mr. William Gildea that such offer was contingent on a majority of TerraSphere members accepting the second option in order to keep the up-front consideration as low as possible. On June 21, 2010, the final transaction was agreed to by the parties.
 
On June 28, 2010, the Acquisition Committee met to discuss the transaction. At the meeting, Duff & Phelps made a presentation regarding the fairness to us, from a financial point of view, of the consideration to be paid by us pursuant to the purchase agreement. Duff & Phelps detailed for the Acquisition Committee the analysis performed and made a presentation concerning how it arrived at its opinion. Duff & Phelps discussed at length with the Acquisition Committee the different analyses used to determine whether the consideration to be paid by us was fair from a financial point of view to our stockholders (excluding the TerraSphere members that are our stockholders). After considerable review and discussion, the purchase agreement was unanimously approved and the board of directors (with Mr. Gildea abstaining) unanimously approved the purchase agreement. For a more detailed description of the Duff & Phelps fairness opinion, see the section entitled “The TerraSphere Acquisition — Opinion of the Acquisition Committee’s Financial Advisor Regarding the TerraSphere Acquisition.”
 
On July 6, 2010, the purchase agreement was executed by us, TerraSphere Inc., our wholly owned subsidiary, TerraSphere and the TerraSphere members.
 
On July 19, 2010, we issued Atlas 1,623,333 shares of common stock and a five-year warrant to acquire 1,623,333 shares of common stock with an exercise price of $0.54 per share. The issuance to Atlas was made pursuant to a Business Development Agreement dated January 29, 2010 between us and Atlas. Under the Business Development Agreement, we had agreed to compensate Atlas in the event of any mergers and/or acquisitions that were a result of the services provided by Atlas, such payment to have included both cash payments and equity payments. Pursuant to the agreement reached between us, in exchange for the equity consideration described above, Atlas agreed that no further consideration be paid to it in connection with our proposed acquisition of TerraSphere. The all stock payment was made to Atlas at a share price of $0.54, which was the closing price of our common stock on the date of execution of the TerraSphere purchase agreement.
 
Our Reasons for the TerraSphere Acquisition
 
In the course of reaching its unanimous decision to recommend that our board of directors approve the TerraSphere acquisition and the purchase agreement and to recommend that our stockholders vote to approve the acquisition pursuant to the purchase agreement, the Acquisition Committee consulted with our senior


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management and with its own independent financial advisors, and considered a number of potentially positive factors in its deliberations, including, but not limited to, the following:
 
  •  that the TerraSphere acquisition would allow us to expand our environmentally sustainable business into the area of urban agriculture, positioning us into what we believe is an area of significant growth;
 
  •  that the TerraSphere acquisition would give us access to proprietary technology, which is already tested, although not on a commercial scale;
 
  •  that the TerraSphere acquisition would give us access to a company which is producing revenue and expects to be cash flow positive in 2010;
 
  •  that the TerraSphere acquisition compliments our existing “green tech” businesses including food waste to fertilizer and treatment of industrial waste water; and
 
  •  that the TerraSphere acquisition provides access to key operating personnel including the inventor of the technology and an existing client base.
 
The Acquisition Committee also considered potential negative factors relating to the TerraSphere acquisition, including:
 
  •  that TerraSphere was a related party to us due to Mr. Edward Gildea’s relationship with TerraSphere;
 
  •  that TerraSphere is a start up company, that has only produced consistent revenues in the last six months other than one contract in 2008;
 
  •  that TerraSphere’s licensees are themselves start up companies, which increased the credit risk to TerraSphere if such licensees were not successful or sufficiently capitalized; and
 
  •  that TerraSphere had not had produced product on a commercial scale.
 
Recommendation of Our Board of Directors
 
After careful consideration of a variety of factors, including the positive and negative factors described under the heading “The TerraSphere Acquisition — Our Reasons for the TerraSphere Acquisition,” on June 28, 2010, the Acquisition Committee unanimously recommended that our board of directors and stockholders approve the acquisition, including the issuance of the shares in connection with the acquisition. In particular, the Acquisition Committee unanimously:
 
  •  determined that the terms of the TerraSphere acquisition are advisable, fair to and in the best interests of our stockholders;
 
  •  recommended that our board of directors approve the TerraSphere acquisition and the related transactions, and approve the purchase agreement;
 
  •  recommended that our board of directors recommend the TerraSphere acquisition and the related transactions, including the issuance of the shares in connection with the acquisition contemplated in the purchase agreement, to our stockholders; and
 
  •  recommends that our stockholders approve the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
The Acquisition Committee unanimously recommends that you vote “FOR” the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
Having received the recommendation of the Acquisition Committee, for reasons including those described above under the heading “The TerraSphere Acquisition — Our Reasons for the TerraSphere Acquisition,” on June 28, 2010, based solely on the recommendation of the Acquisition Committee, our board of directors unanimously (with Mr. Gildea abstaining) approved the TerraSphere acquisition and related transactions and


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the issuance of the shares in connection with the acquisition, and recommends such matters to our stockholders. In particular, the board of directors unanimously (with Mr. Gildea abstaining):
 
  •  determined that the terms of the TerraSphere acquisition are advisable, fair to and in the best interests of our stockholders;
 
  •  approved the TerraSphere acquisition and related transactions, and authorized us to enter into the purchase agreement; and
 
  •  recommends that our stockholders approve the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
Based solely on the recommendation of the Acquisition Committee, our board of directors unanimously (with Mr. Gildea abstaining) recommends that you vote “FOR” the TerraSphere acquisition and the issuance of the shares in connection with the acquisition.
 
Opinion of the Acquisition Committee’s Financial Advisor
 
The Company engaged Duff & Phelps to serve as the financial advisor to the Acquisition Committee and to provide an opinion as to the fairness, from a financial point of view, to the Company, and, accordingly, to the holders of the Company’s common stock, other than those holders who also own units of TerraSphere, of the consideration to be paid by the Company in the TerraSphere acquisition. Duff & Phelps is a leading independent financial advisory firm, offering a broad range of valuation, investment banking services and consulting services, including fairness and solvency opinions, mergers and acquisitions advisory, mergers and acquisitions due diligence services, financial reporting and tax valuation, fixed asset and real estate consulting, ESOP and ERISA advisory services, legal business solutions, and dispute consulting. Duff & Phelps is regularly engaged in the valuation of businesses and securities and the preparation of fairness opinions in connection with mergers, acquisitions and other strategic transactions.
 
On June 28, 2010, Duff & Phelps rendered its oral opinion to the Acquisition Committee, which opinion was subsequently confirmed in a written opinion dated July 6, 2010, to the effect that, subject to the limitations, exceptions, assumptions and qualifications set forth therein, as of July 6, 2010, the consideration to be paid by the Company in the TerraSphere acquisition was fair, from a financial point of view, to the Company and, accordingly, to the holders of the Company’s common stock, other than those holders who also own units of TerraSphere.
 
The full text of the written opinion of Duff & Phelps, which sets forth, among other things, the assumptions made, procedures followed, matters considered and qualifications and limitations of the review undertaken in rendering the opinion, is attached as Annex B to this proxy statement. This summary of the Duff & Phelps opinion set forth below is qualified in its entirety by reference to the full text of the Duff & Phelps opinion. The Company encourages its stockholders to read the full text of the Duff & Phelps opinion carefully and in its entirety.
 
In connection with its opinion, Duff & Phelps made such reviews, analyses and inquiries as Duff & Phelps deemed necessary and appropriate under the circumstances. Duff & Phelps also took into account its assessment of general economic, market and financial conditions, as well as its experience in securities and business valuation, in general, and with respect to similar transactions, in particular. Duff & Phelps’ procedures, investigations, and financial analysis with respect to the preparation of its opinion included, but were not limited to, the items summarized below:
 
  •  Discussed the TerraSphere acquisition, the operations, financial condition, future prospects and projected operations and performance of the Company and TerraSphere with the managements of the Company and TerraSphere;
 
  •  Reviewed the Company’s audited financial statements as filed with the SEC for the years ending December 31, 2008 and 2009 as well as the March 31, 2010 10-Q;


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  •  Reviewed TerraSphere’s audited financial statements as of December 31, 2009 and unaudited financial statements as of March 31, 2010;
 
  •  Reviewed year-to-date unaudited trial balance of TerraSphere as of June 22, 2010;
 
  •  Reviewed the three-year financial forecasts prepared by the management of the Company and the five-year financial forecasts prepared by the management of TerraSphere;
 
  •  Met with licensees of TerraSphere and discussed strategic plans and business models;
 
  •  Reviewed a draft of the purchase agreement received on June 28, 2010;
 
  •  Reviewed the due diligence packet pertaining to the sale of the PharmaSphere division (“PharmaSphere”) of TerraSphere;
 
  •  Reviewed investor presentations of TerraSphere dated March 2010 and October 2009;
 
  •  Reviewed the historical trading price and trading volume of the Company’s common stock and the publicly traded securities of certain other companies that Duff & Phelps deemed relevant;
 
  •  Compared the financial performance of the Company and TerraSphere and the prices and trading activity of the Company’s common stock with those of certain other publicly traded companies that Duff & Phelps deemed relevant; and
 
  •  Conducted such other analyses and considered such other factors as Duff & Phelps deemed appropriate.
 
In performing its analyses and rendering its opinion with respect to the TerraSphere acquisition, Duff & Phelps, with the Company’s consent:
 
  •  Relied upon the accuracy, completeness, and fair presentation of all information, data, advice, opinions and representations obtained from public sources or provided to it from private sources, including Company management, and did not independently verify such information;
 
  •  Assumed that any estimates, evaluations, forecasts and projections furnished to Duff & Phelps were reasonably prepared and based upon the best currently available information and good faith judgment of the person furnishing the same;
 
  •  Assumed that the final versions of all documents reviewed by Duff & Phelps in draft form conform in all material respects to the drafts reviewed;
 
  •  Assumed that information supplied to Duff & Phelps and representations and warranties made in the purchase agreement are accurate in all material respects;
 
  •  Assumed that all of the conditions required to implement the TerraSphere acquisition will be satisfied and that the TerraSphere acquisition will be completed in accordance with the purchase agreement without any amendments thereto or any waivers of any terms or conditions thereof;
 
  •  Relied upon the fact that the Acquisition Committee and the Company have been advised by counsel as to all legal matters with respect to the TerraSphere acquisition, including whether all procedures required by law to be taken in connection with the TerraSphere acquisition have been duly, validly and timely taken;
 
  •  Assumed that all governmental, regulatory or other consents and approvals necessary for the consummation of the TerraSphere acquisition will be obtained without any adverse effect on the Company or TerraSphere or the contemplated benefits expected to be derived in the TerraSphere acquisition; and
 
  •  Assumed the offer from a private equity group to purchase newly issued units of PharmaSphere for $6.7 million for an approximate ownership of 52.9% of PharmaSphere was still outstanding and available to be accepted by TerraSphere.
 
The Duff & Phelps opinion noted that the management of the Company directed Duff & Phelps to assume that TerraSphere members owning 69% of the units of TerraSphere will elect to receive Option Two


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Shares. The Duff & Phelps opinion further noted that the number of shares of the Company’s common stock to be issued in connection with the TerraSphere acquisition is subject to certain potential anti-dilution adjustments after the closing as to which Duff & Phelps expressed no opinion.
 
Duff & Phelps did not make any independent evaluation, appraisal or physical inspection of the Company’s solvency or of any specific assets or liabilities (contingent or otherwise). The Duff & Phelps opinion should not be construed as a valuation opinion, credit rating, solvency opinion, an analysis of the Company’s credit worthiness, as tax advice, or as accounting advice. Duff & Phelps was not requested to, and did not, (a) initiate any discussions with, or solicit any indications of interest from, third parties with respect to the TerraSphere acquisition, the assets, businesses or operations of the Company, or any alternatives to the TerraSphere acquisition, (b) negotiate the terms of the TerraSphere acquisition, and therefore, Duff & Phelps assumed that such terms are the most beneficial terms, from the Company’s perspective, that could, under the circumstances, be negotiated among the parties to the purchase agreement and the TerraSphere acquisition, or (c) advise the Acquisition Committee, the Company’s board of directors or any other party with respect to alternatives to the TerraSphere acquisition. In addition, Duff & Phelps did not express any opinion as to the market price or value of the Company’s common stock after announcement of the TerraSphere acquisition. Duff & Phelps did not make, and assumed no responsibility to make, any representation, or render any opinion, as to any legal matter.
 
In rendering its opinion, Duff & Phelps did not express any opinion with respect to the amount or nature of any compensation to any of the Company’s officers, directors, or employees, or any class of such persons, relative to the consideration to be received by any other party, or with respect to the fairness of any such compensation. Duff & Phelps also expressed no opinion with respect to the impact of the TerraSphere acquisition on any particular holder of the Company’s common stock other than in its capacity as such.
 
The basis and methodology for the Duff & Phelps opinion were designed specifically for the express purposes of the Acquisition Committee and may not translate to any other purposes. The Duff & Phelps opinion:
 
  •  does not address the merits of the underlying business decision to enter into the TerraSphere acquisition versus any alternative strategy or transaction;
 
  •  is not a recommendation as to how the Acquisition Committee or the Company’s board of directors or any stockholder should vote or act with respect to any matters relating to the TerraSphere acquisition, or whether to proceed with the TerraSphere acquisition or any related transaction; and
 
  •  does not indicate that the consideration paid is the best possibly attainable under any circumstances.
 
Instead, the Duff & Phelps opinion merely states whether the consideration in the TerraSphere acquisition is within a range suggested by certain financial analyses. The decision as to whether to proceed with the TerraSphere acquisition or any related transaction may depend on an assessment of factors unrelated to the financial analysis on which the Duff & Phelps opinion is based. The Duff & Phelps opinion should not be construed as creating any fiduciary duty on the part of Duff & Phelps to any party.
 
Duff & Phelps prepared the opinion effective as of July 6, 2010. The Duff & Phelps opinion is necessarily based upon market, economic, financial and other conditions as they exist and can be evaluated as of July 6, 2010, and Duff & Phelps disclaims any undertaking or obligation to advise any person of any change in any fact or matter affecting the opinion which may come or be brought to the attention of Duff & Phelps after July 6, 2010.
 
The following is a summary of the material analyses performed by Duff & Phelps in connection with rendering its opinion. Duff & Phelps noted that the basis and methodology for its opinion have been designed specifically for this purpose and may not translate to any other purposes. While this summary describes the material information in Duff & Phelps’ opinion, the material analyses performed and the material factors considered by Duff & Phelps, it does not purport to be a comprehensive description of all analyses and factors considered by Duff & Phelps. The Duff & Phelps opinion is based on the comprehensive consideration of the various analyses performed.


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In performing its analyses, Duff & Phelps considered general business, economic, industry and market conditions, financial and otherwise, and other matters as they existed on, and could be evaluated as of, the date of its written opinion. No company, transaction or business used in Duff & Phelps’s analyses for comparative purposes is identical to the Company, TerraSphere or the TerraSphere acquisition. Duff & Phelps made judgments and assumptions with regard to industry performance, general business, economic, regulatory, market and financial conditions and other matters, many of which are beyond the control of the Company, such as the impact of competition on the business of the Company, TerraSphere and on the industry generally, industry growth and the absence of any adverse material change in the financial condition and prospects of the Company, TerraSphere or the industry or in the markets generally. Duff & Phelps believes that mathematical analyses (such as determining average and median) are not by themselves meaningful methods of using selected company data and must be considered together with qualities, judgments and informed assumptions to arrive at sound conclusions. While the results of each analysis were taken into account in reaching its overall conclusion with respect to fairness, Duff & Phelps did not make separate or quantifiable judgments regarding individual analyses. The implied reference range values indicated by Duff & Phelps’s analyses are illustrative and not necessarily indicative of actual values or predictive of future results or values, which may be significantly more or less favorable than those suggested by the analyses. In addition, any analyses relating to the value of assets, businesses or securities do not purport to be appraisals or to reflect the prices at which businesses or securities actually may be sold, which may depend on a variety of factors, many of which are beyond the control of the Company and Duff & Phelps. Much of the information used in, and accordingly the results of, Duff & Phelps’s analyses are inherently subject to substantial uncertainty.
 
In arriving at its opinion, Duff & Phelps did not attribute any particular weight to any particular analysis or factor considered by it, but rather made qualitative judgments as to the significance and relevance of each analysis and factor. Several analytical methodologies were employed by Duff & Phelps in its analyses, and no one single method of analysis should be regarded as critical to the overall conclusion reached by Duff & Phelps. Each analytical technique has inherent strengths and weaknesses, and the nature of the available information may further affect the value of particular techniques. Accordingly, Duff & Phelps believes that its analyses must be considered as a whole and that selecting portions of its analyses and of the factors considered by it, without considering all analyses and factors in their entirety, could create a misleading or incomplete view of the evaluation process underlying its opinion. The conclusion reached by Duff & Phelps, therefore, is based on the application of Duff & Phelps’ own experience and judgment to all analyses and factors considered by Duff & Phelps, taken as a whole.
 
The Duff & Phelps opinion was provided to the Acquisition Committee in connection with its consideration of the TerraSphere acquisition and was only one of many factors considered by the Acquisition Committee in evaluating the TerraSphere acquisition. Neither the Duff & Phelps opinion nor its analyses were determinative of the consideration to be paid by the Company in the TerraSphere acquisition or of the views of the Acquisition Committee or the management of the Company with respect to the TerraSphere acquisition.
 
The following is a summary of the material financial analyses prepared in connection with the Duff & Phelps opinion to the Acquisition Committee. The order of the analyses does not represent relative importance or weight given to those analyses by Duff & Phelps. The fact that any specific analysis has been referred to in the summary below is not meant to indicate that such analysis was given greater weight than any other analysis. The financial analyses summarized below include information presented in tabular format. In order to fully understand the financial analyses used by Duff & Phelps, the tables must be read together with the text of each summary. The tables alone do not constitute a complete description of the financial analyses. Rather, the analyses listed in the tables and described below must be considered as a whole; considering any portion of such analyses and of the factors considered, without considering all analyses and factors, could create a misleading or incomplete view of the process underlying Duff & Phelps’ opinion.
 
Transaction Overview
 
The Company directed Duff & Phelps to assume that holders of 69% of TerraSphere’s outstanding units would elect to receive Option Two Shares, resulting in 57.3% of the aggregate consideration to be paid by the Company in connection with the TerraSphere acquisition being paid at the closing of the TerraSphere


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acquisition and the balance being contingent and paid upon TerraSphere’s achievement of the four milestones contemplated by the purchase agreement. Based on the average closing price per share of the Company’s common stock during the 15-day period ending July 2, 2010, the aggregate implied value of the shares to be delivered upon closing of the TerraSphere acquisition was approximately $14.8 million. To estimate the range of potential values of the aggregate consideration to be paid in connection with the TerraSphere acquisition, including the shares paid at closing and pursuant to the milestone payments, Duff & Phelps applied probability percentages of 70%, 85% and 100% to the achievement of such milestones and the value of the resulting milestone payments, which, when added to the implied value of the shares to be paid at closing of $14.8 million, resulted in implied aggregate consideration values of approximately $22.5 million, $24.2 million and $25.8 million, respectively, or a range of implied aggregate consideration values of approximately $22.5 million to $25.8 million.
 
Company Analysis
 
Duff & Phelps reviewed the share price trading history for the Company’s common stock for the period commencing March 16, 2007 and ending July 2, 2010. Duff & Phelps also reviewed the volume weighted average price of the Company’s common stock for the 30-day, 60-day, 90-day, 6-month and 1-year periods ending July 2, 2010. This analysis showed the following:
 
         
    Volume Weighted
Time Period Ending July 2, 2010
  Average Price
 
30-day
  $ 0.83  
60-day
  $ 1.04  
90-day
  $ 1.04  
6-month
  $ 1.02  
1-year
  $ 1.04  
 
In addition, based on approximately 40.5 million shares of the Company’s common stock outstanding as of July 2, 2010, the closing price of the Company’s common stock on July 2, 2010 and the 15-day average of the closing prices of the Company’s common stock, Duff & Phelps derived a range of equity values for the Company of approximately $24.3 million to $30.6 million. Duff & Phelps then added approximately $18.5 million, the book value of the net debt of the Company as of March 31, 2010, to derive a range of enterprise values for the Company of approximately $43 million to $49 million.
 
TerraSphere Analysis
 
PharmaSphere Analysis
 
Based on information provided by TerraSphere management, Duff & Phelps noted that in February 2010, a private equity group offered to purchase 52.9% of newly issued units of PharmaSphere for an aggregate purchase price of $6.7 million, and that such offer remained outstanding as of July 6, 2010. After applying an assumed 20% illiquidity discount, this aggregate offer price implied an equity value for PharmaSphere of approximately $4.8 million.
 
Discounted Cash Flow Analyses
 
TerraSphere Discounted Cash Flow Analysis
 
Duff & Phelps performed a discounted cash flow analysis to estimate the present value of the free cash flows of TerraSphere (excluding cash flows from PharmaSphere) through the calendar year ending December 31, 2029 (which takes into consideration the life of the existing patents) based on TerraSphere management’s financial projections and estimates as to the minimum milestones needed to achieve full earnout payments under the purchase agreement, and discount rates ranging from 30.0% to 50.0%. This analysis indicated a range of enterprise values for TerraSphere of approximately $15.6 million to $30.7 million, compared to a range of implied aggregate transaction consideration values of approximately $22.5 million to $25.8 million.


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TerraSphere Existing Licensees Discounted Cash Flow Analysis
 
Duff & Phelps also performed a discounted cash flow analysis to estimate the present value of the free cash flows of existing licensees of TerraSphere through the calendar year ending December 31, 2029 based on TerraSphere management’s financial projections and discount rates ranging from 25.0% to 35.0%. To estimate the value of the existing licensees of TerraSphere products, Duff & Phelps projected the revenues from the existing licensees through 2029 (which takes into consideration the life of the existing patents) and assumed TerraSphere would not obtain any new licensees. This analysis indicated a range of enterprise values for TerraSphere of approximately $9.2 million to $12.8 million.
 
Using the ranges of enterprise values for TerraSphere of approximately $15.6 million to $30.7 million calculated using the discounted cash flow analysis summarized above, Duff & Phelps then adjusted for cash and debt and added the implied equity value of $4.8 million for PharmaSphere and derived a range of implied equity values for TerraSphere of approximately $20.3 million to $35.4 million, compared to a range of implied aggregate transaction consideration values of approximately $22.5 million to $25.8 million.
 
Contribution Analysis
 
Duff & Phelps analyzed the expected contribution percentages of each of the Company and TerraSphere to the post-transaction combined equity value as implied by the estimated equity value ranges for TerraSphere calculated as summarized above, as compared to the Company’s market capitalization, excluding any possible synergies that the combined company may realize following the consummation of the TerraSphere acquisition. Duff & Phelps noted that the TerraSphere acquisition could result in holders of the Company’s common stock owning approximately 67.4% of the combined company if no milestones payments are paid by the Company and approximately 54.2% if all the milestone payments are paid by the Company, compared to the relative contribution by the Company to the combined company of earnings before interest, taxes, depreciation and amortization, or “EBITDA”, excluding EBITDA from PharmaSphere, based upon forecasts prepared by Company management and TerraSphere management, of 25.6% in 2011, 36.7% in 2012 and 45.7% in 2013.
 
Other Items
 
The Duff & Phelps engagement letter and amendment with the Company, dated May 11, 2010, and June 23, 2010, respectively, provided that, for its services, Duff & Phelps is entitled to receive from the Company a fee of $250,000, which was due and payable as follows: $100,000 non-refundable retainer payable upon execution of the engagement letter, and $150,000 payable upon Duff & Phelps informing the Acquisition Committee that Duff & Phelps is prepared to deliver its opinion. The engagement letter also provided that Duff & Phelps would be paid additional fees at its standard hourly rates for any time incurred should Duff & Phelps be called upon to support its findings subsequent to the delivery of the opinion. In addition, the Company agreed to reimburse Duff & Phelps for its reasonable out-of-pocket expenses and to indemnify Duff & Phelps and certain related persons against liabilities arising out of Duff & Phelps’ service as a financial advisor to the Acquisition Committee. Other than this engagement, during the two years preceding the date of its opinion, Duff & Phelps performed financial advisory services to a subsidiary of TerraSphere for which Duff & Phelps received customary fees and indemnification. Other than such services, during the two years preceding the date of Duff & Phelps’ opinion, Duff & Phelps did not have any material relationship with any party to the TerraSphere acquisition for which compensation was received or is intended to be received, nor is any such material relationship or related compensation mutually understood to be contemplated.
 
Interests of Our Officers and Directors in the TerraSphere Acquisition
 
When you consider the unanimous (with Mr. Gildea abstaining) recommendation of our board of directors in favor of the TerraSphere acquisition you should note that our Chairman and Chief Executive Officer, Mr. Edward Gildea, has an interest in 8.75% of the units of TerraSphere. In addition, relatives of Mr. Gildea hold an additional 30.75% of the units of TerraSphere. If the acquisition is completed, and assuming all milestones are achieved, Mr. Gildea would receive 3,240,741 shares of our common stock in exchange for his


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TerraSphere units and his relatives would receive an additional 10,775,463 of our common stock in exchange for their TerraSphere units.
 
Furthermore, Mark C. Gildea, the brother of Edward J. Gildea, is the President and Chief Executive Officer of TerraSphere, and William A. Gildea, also the brother of Edward J. Gildea, is an independent contractor of TerraSphere.
 
Effective April 2, 2010, Mark C. Gildea entered into an employment agreement with TerraSphere, pursuant to which TerraSphere employed Mr. Gildea as its President and Chief Executive Officer for a term of five years. Mr. Gildea’s annual salary is $180,000, subject to discretionary annual increases at the discretion of the board of directors, and Mr. Gildea is entitled to an annual bonus of at least $20,000. In the event Mr. Gildea is terminated without cause and in connection with a change of control of TerraSphere, he shall be entitled to severance, payable in a single lump sum, equal to thirty-six months base salary and all options or equity interests previously granted shall immediately vest. Our acquisition of TerraSphere constitutes a change of control as such term is defined in Mr. Gildea’s employment agreement, such that if Mr. Gildea is terminated in connection with the change of control transaction, he shall be entitled to the foregoing severance benefits.
 
Effective April 2, 2010, William A. Gildea entered into an engagement agreement with TerraSphere, pursuant to which TerraSphere engaged Mr. Gildea as an independent contractor for a term of three years. Mr. Gildea’s compensation for such independent contracting services is a flat monthly fee of $16,667 per month, and Mr. Gildea will be entitled to an annual bonus equal to that which is paid to senior management employees if TerraSphere develops a companywide bonus plan. In the event Mr. Gildea’s engagement is terminated without cause during the first two years of the engagement, he will be entitled to receive one-half of such annual compensation (or $100,000) subject to his execution of a non-competition agreement and release.
 
Because of Mr. Edward Gildea’s relationship with TerraSphere, our board of directors formed the Acquisition Committee to evaluate and, if appropriate, negotiate the proposed TerraSphere acquisition. The Acquisition Committee obtained valuation advice and a fairness opinion from an independent investment bank, and negotiated the terms of the TerraSphere acquisition with the TerraSphere management. Mr. Gildea did not participate in the negotiations.
 
U.S. Federal Income Tax Consequences
 
No gain or loss will be recognized by us or by holders of shares of our common stock as a result of the TerraSphere acquisition.
 
Regulatory Approvals
 
We are not aware of any governmental or regulatory approval required for completion of the TerraSphere acquisition, other than compliance with applicable corporate laws of Delaware, compliance with securities laws and filing with the NASDAQ Stock Market, with respect to the shares of our common stock to be issued to the TerraSphere stockholders pursuant to the purchase agreement. If any other governmental approvals or actions are required, we intend to try to obtain them. We cannot assure you, however, that we will be able to obtain any such approvals or actions.
 
THE PURCHASE AGREEMENT
 
The discussion in this proxy statement of the TerraSphere acquisition and the principal terms of the purchase agreement described below are qualified in their entirety by reference to the copy of the purchase agreement attached as Annex A hereto, and incorporated herein by reference. The following description summarizes the material provisions of the purchase agreement, which agreement we urge you to read carefully because it is the principal legal document that governs the TerraSphere acquisition.
 
The representations and warranties described below and included in the purchase agreement were made by us and TerraSphere as of specific dates. The assertions embodied in these representations and warranties


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may be subject to important qualifications and limitations agreed to by us and TerraSphere in connection with negotiating the purchase agreement. The representations and warranties may also be subject to a contractual standard of materiality that may be different from what may be viewed as material to stockholders, or may have been used for the purpose of allocating risk among us and TerraSphere, rather than establishing matters as facts. The purchase agreement is described in this proxy statement and included as Annex A only to provide you with information regarding its terms and conditions at the time it was entered into by the parties. Accordingly, you should read the representations and warranties in the purchase agreement not in isolation but rather in conjunction with the other information contained in this document.
 
General; Unit Purchase Consideration
 
Pursuant to the purchase agreement, we agreed to acquire 100% of the units of TerraSphere. We will make the acquisition by issuing up to 34,166,667 shares of our common stock to the TerraSphere members, subject to upward adjustment based on certain anti-dilution protections, in exchange for 100% of the units of TerraSphere. Upon completion of the proposed acquisition, TerraSphere would become our wholly-owned subsidiary. For a more detailed description of the share issuance to be made pursuant to the purchase agreement, please see the section “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — General.”
 
With limited exceptions, the shares to be issued to the TerraSphere members are subject to the following sale restrictions absent our approval:
 
  •  the Option One Shares are subject to a lock-up the term of which is six months, beginning on the closing of the acquisition; and
 
  •  the Option Two Shares are subject to a lock-up the term of which is the longer of: (a) eighteen months, beginning on the closing of the acquisition, or (b) six months, beginning on the date when shares of common stock are issued pursuant to the foregoing milestone payments.
 
During the applicable lock-up period described above, we have agreed to provide the TerraSphere members anti-dilution rights. The rights provide that if we issue shares of our common stock for cash consideration in connection with a financing transaction at a price less than $0.756 per share, then the TerraSphere members shall receive additional shares of our common stock based on a weighted average dilution formula. See the section entitled “The TerraSphere Acquisition — Description of the TerraSphere Acquisition — Anti-Dilution Protection” for details about the formula. Messrs. Edward Gildea and William Gildea have not been provided this anti-dilution protection.
 
Representations and Warranties
 
In the purchase agreement, TerraSphere’s controlling members, consisting of Messrs. William Gildea, Edward Gildea and Nick Brusatore make certain representations and warranties (subject to certain exceptions) relating to, among other things:
 
  •  organization and standing;
 
  •  capitalization;
 
  •  authority and enforceability to enter into purchase agreement;
 
  •  no violation of organizational documents, contracts or laws;
 
  •  required consents and approvals;
 
  •  financial statements, accounts receivables and undisclosed liabilities;
 
  •  real estate and personal property;
 
  •  intellectual property;
 
  •  material agreements;


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  •  environmental matters;
 
  •  taxes;
 
  •  employee matters;
 
  •  permits;
 
  •  insurance matters;
 
  •  conflicts of interest; and
 
  •  information about customers.
 
In the purchase agreement, we make certain representations and warranties (subject to certain exceptions) relating to, among other things:
 
  •  organization and standing;
 
  •  authority and enforceability to enter into purchase agreement;
 
  •  no violation of organizational documents, contracts or laws;
 
  •  required consents and approvals;
 
  •  legal matters; and
 
  •  due diligence.
 
Conduct of Business Pending Closing
 
Until the closing of the acquisition, TerraSphere agreed, among other items:
 
  •  to use commercially reasonable efforts to carry on its respective businesses in the ordinary course in substantially the same manner as previously conducted;
 
  •  to preserve its business organization and goodwill;
 
  •  to maintain its material rights and franchises;
 
  •  to retain the services of its officers and key employees;
 
  •  to preserve its relationships with its customers, suppliers and others; and
 
  •  to protect all confidential and proprietary information and intellectual property from dissipation, destruction, theft or other loss or disclosure.
 
In addition, until the closing of the acquisition, TerraSphere agreed not to, without our prior written consent, among other things:
 
  •  declare or pay any dividends;
 
  •  issue any interests in TerraSphere;
 
  •  amend or propose to amend its organizational documents;
 
  •  merge or consolidate with or acquire any equity interest in any person;
 
  •  assume or incur any indebtedness for borrowed money;
 
  •  enter into or modify any material contract;
 
  •  incur any large capital expenditures;
 
  •  record or effectuate the transfer of record ownership of, or beneficial interest in, any units;
 
  •  make any change in its lines of business; or


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  •  take any other action that would cause any of the representations and warranties made not to remain true and correct.
 
Restrictive Covenants; Non-Competition; Non-Solicitation
 
The purchase agreement also contains restrictive covenants of the parties, including covenants providing for:
 
  •  the TerraSphere members’ protection of confidential information of TerraSphere subject to certain exceptions as required by law, regulation or legal or administrative process;
 
  •  each of the controlling members of TerraSphere, which consist of Messrs. William Gildea, Edward Gildea and Nick Brusatore, not to compete with TerraSphere for a period of five years; and
 
  •  each of the controlling members of TerraSphere not to solicit business from TerraSphere’s customers for a period of five years.
 
Conditions to Closing
 
Converted Organics Closing Conditions
 
Our obligation to consummate the purchase agreement is conditioned upon certain closing conditions, including:
 
  •  the approval of our shareholders authorizing us to consummate the TerraSphere acquisition and to issue the common stock pursuant to the purchase agreement;
 
  •  each of the representations and warranties of TerraSphere and its members being true and correct in all material respects (if not qualified by materiality) and in all respects (if qualified by materiality) as of the date of the closing;
 
  •  since the date of the purchase agreement, that there shall not have occurred and be continuing any event or occurrence, or series of events or occurrences, that individually or in the aggregate, would reasonably be expected to have a material adverse effect on TerraSphere;
 
  •  no litigation, action, suit or other proceeding involving or potentially involving a liability, obligation or loss on the part of TerraSphere, which would question the validity of the purchase agreement or be reasonably expected to have a material adverse effect on TerraSphere, shall have been threatened or commenced;
 
  •  all consents and all authorizations, permits, and approvals required to consummate the transactions provided for in the purchase agreement shall have been obtained; and
 
  •  we shall have received from the NASDAQ Stock Market all approvals that are required to compete the TerraSphere acquisition.
 
TerraSphere Closing Conditions
 
The obligation of TerraSphere and its members to consummate the purchase agreement is conditioned upon certain closing conditions, including:
 
  •  each of our representations and warranties being true and correct in all material respects (if not qualified by materiality) and in all respects (if qualified by materiality) as of the date of the closing;
 
  •  no litigation, action, suit or other proceeding involving or potentially involving a liability, obligation or loss on the part of TerraSphere, which would question the validity of the purchase agreement or be reasonably expected to have a material adverse effect on TerraSphere, shall have been threatened or commenced; and
 
  •  we shall have restructured our $17,500,000 of New Jersey Economic Development Bonds in such form as is reasonably acceptable to a majority-in-interest of the TerraSphere members.


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The parties may waive any inaccuracies in the representations and warranties made to such party contained in the purchase agreement and waive compliance with any agreements or conditions for the benefit of itself or such party contained in the purchase agreement. We cannot assure you that all of the conditions will be satisfied or waived.
 
Indemnification
 
Indemnification by the Controlling Members of TerraSphere
 
The controlling members of TerraSphere, which consist of Messrs. William Gildea, Edward Gildea and Nick Brusatore, have agreed, on a joint and several basis, to indemnify us from any damages arising from: (a) any misrepresentation, breach of representation or warranty or any non-fulfillment of any covenant or agreement made by or to be performed by TerraSphere or any controlling members; or (b) any and all actions, suits, proceedings, demands, assessments, judgments, reasonable attorneys’ fees, costs and expenses incident to any of the foregoing.
 
With certain exceptions, the controlling members will have no obligation to indemnify us with respect to misrepresentations or breaches of warranties until the aggregate amount of all damages incurred or suffered exceeds $100,000 in the aggregate, in which event we will be entitled to indemnification for the amount of damages arising under such indemnification in excess of such amount.
 
With certain exceptions, the maximum aggregate amount of damages subject to indemnification claims by us is the total purchase price received by the controlling members (and any assignees of such members’ interest), or $13,580,000 worth of our common stock valued at $0.756 per share, assuming all milestones are achieved. As all the controlling members selected the Option Two Shares, if the milestones are not achieved by TerraSphere, such members will receive fewer shares, which will reduce their indemnification obligations.
 
Any claims for damages with respect to breaches of representations and warranties by the controlling member shall be satisfied by either cash, or to the extent the members hold sufficient shares of our common stock, such member may return of the appropriate number of shares of our common stock to us, with the shares to be valued at the average closing price of the our common stock for the five days prior to the date when the subject claim accrued.
 
Indemnification by Converted Organics
 
We have agreed to indemnify the TerraSphere members from any damages arising from: (a) any misrepresentation, breach of representation or warranty or any non-fulfillment of any covenant or agreement made by or to be performed by the buyer of TerraSphere; or (b) any and all actions, suits, proceedings, demands, assessments, judgments, reasonable attorneys’ fees, costs and expenses incident to any of the foregoing.
 
With certain exceptions, we will have no obligation to indemnify the TerraSphere members with respect to misrepresentations or breaches of warranties until the aggregate amount of all damages incurred or suffered exceeds $100,000 in the aggregate, in which event the TerraSphere members will be entitled to indemnification for the amount of damages arising under such indemnification in excess of such amount.
 
With certain exceptions, the maximum aggregate amount of damages subject to indemnification claims by the TerraSphere members is the total purchase price received by the controlling members as set forth above.
 
Termination
 
The purchase agreement may be terminated and/or abandoned at any time prior to the closing by:
 
  •  by mutual written consent;
 
  •  by either party if there shall have been a material breach of any representation, warranty, covenant or agreement on the part of the other party;
 
  •  by either party if the closing has not been consummated on or before August 31, 2010 (provided such date will be extended to September 30, 2010 if we receive comments from the SEC on this proxy statement); or


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  •  by either party if the closing conditions have not been met or waived.
 
In the event of termination and abandonment by either party, all further obligations of the parties shall terminate, no party shall have any right against the other party, and each party shall bear its own costs and expenses.
 
Amendment, Extension and Waiver
 
The purchase agreement may be amended by the parties thereto at any time by execution of an instrument in writing signed by us and the controlling members. At any time prior to the closing, the parties, to the extent allowed by applicable law, may extend the time for the performance of the obligations under the purchase agreement, waive any inaccuracies in representations and warranties made to the other party and waive compliance with any of the agreements or conditions for the benefit of the other party.
 
To the extent a waiver by any party renders the statements in this proxy statement materially misleading, we intend to supplement this proxy statement and resolicit proxies from our stockholders to the extent required by law.
 
INFORMATION ABOUT TERRASPHERE
 
General
 
TerraSphere Systems, LLC, or TerraSphere, designs and builds highly efficient systems that grow an abundance of crops in compact, safe, pollutant-free facilities. TerraSphere’s technology is fully contained, which means crops can be grown year-round in any location using precise combinations of light, water, and nutrients to maximize production. TerraSphere’s technology is patented in the United States, with several international patents pending. TerraSphere’s wholly owned subsidiary, PharmaSphere, LLC, or PharmaSphere, is a pre-revenue company that will use the TerraSphere technology to grow plants and herbs that express high value compounds that are used as pharmaceutical ingredients.
 
TerraSphere’s units consist of vertically stacked modules housing rows of plants that are placed perpendicular to an interior light source (the “TerraSphere System” or “Technology”). The modules produce an abundance of crops with strong, compact, multi-directional growth. TerraSphere believes the Technology’s greatest advantage over traditional growth methods is its ability to generate higher yields per square foot of land than traditional growing methods. The contained nature of the TerraSphere System also provides many benefits related to year-round production, cost control, food safety and environmental concerns.
 
In 2008, TerraSphere completed its system design and testing, built a demonstration plant in Michigan under a joint venture agreement, and sold its first license for the rights to utilize the technology in the Province of British Columbia. In 2009, TerraSphere began construction of the foregoing plant in Vancouver.
 
TerraSphere has eight full-time employees. TerraSphere operates out of its research and manufacturing facility in Vancouver and its corporate office in Boston, Massachusetts. TerraSphere began generating revenue in 2007.
 
TerraSphere believes its Technology has several key benefits over competing growth methods. These include:
 
  •  higher productivity rates;
 
  •  full control of the growth environment;
 
  •  the ability to grow high quality, flavor rich produce year-round in almost any location;
 
  •  food safety;
 
  •  reduced water use;
 
  •  minimal waste generation; and


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  •  produce that is pathogen-free, chemical-free and has a significantly longer shelf life (due to the controlled growth environment and reduced transportation to end markets).
 
TerraSphere uses its Technology to generate revenue in two ways:
 
  •  Licensing the Technology:  TerraSphere licenses its patented Technology along with facility plans, engineering expertise, construction advice, and consulting and development expertise. This model gives qualified partners the opportunity to develop and operate a TerraSphere facility to meet their own requirements. Licenses can be granted for a specific size facility or specific menu of crops. TerraSphere will offer consulting services to plant licensees for a limited period of time to ensure the efficient and effective startup of operations.
 
  •  Entering into Partnerships to Own and Operate TerraSphere Facilities:  TerraSphere will seek qualified local partners to build and operate TerraSphere facilities. Under the joint-venture model, both parties contribute to the capital costs of the project and split the associated risks by selling TerraSphere Systems and equipment to licensees and project partners.
 
Overview of the Technology
 
TerraSphere believes its Technology has a competitive advantage over traditional growth methods, the most important of which is its ability to generate significantly larger yields per square foot of floor space. The Technology consists of collapsible trays that contain rows of plants placed perpendicular to a light source. The TerraSphere Technology has adjustable lighting. As the plants mature, the lights can be adjusted for maximum growth. The high pressure watering tanks and lines will ensure even distribution of water and nutrition to vegetation. The result is an abundance of plants with strong, compact, even growth. The Technology can be used to grow numerous different types of crops, from lettuce to tree seedlings to rare medicinal herbs. The following is a brief overview of how the Technology works and its advantages over other growth technologies.
 
Flat Trays
 
The trays that make up the TerraSphere System allow for efficient loading and unloading of the crops. The plastic trays rest on an aluminum frame which then clamp on four galvanized chains. These trays can be adjusted in height to accommodate any type of plant. The fertilizer is fed at one end and drained at the other by gravity, ensuring that each plant receives the proper nutrition for maximum growth. A UV Protected food grade ABS material is used for its light weight and cost savings.
 
The flat trays in which the crops are grown are a reusable plastic injection molded unit which allows the addition of water directly into each growing unit. The mechanical medium can be reused for several years and does not require the use of non-biodegradable rock wool, which is used by most traditional hydroponic facilities and is known to pose environmental challenges.
 
Collapsible Flat Tray
 
Each steel frame structure can hold many different configurations depending on the crop and the ceiling height of the building.
 
The taller the ceiling the more tiers that can be added. The trays extend and collapse by using a winch pulley system. When the plants are being loaded the trays are completely collapsed. When the top tray is filled with plants the winch moves up. The next tray is filled and the cycle continues until all the trays are filled. Unloading is the opposite. The collapsible trays are made of stainless steel, anodized aluminum, and various other common materials.
 
Facilities
 
Depending on the ceiling height of the building and the square footage of the space, the TerraSphere System has the ability to be scaled accordingly. A typical facility is 75% growing space and 25% office and


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storage space. TerraSphere can design any size facility, depending on what a customer wants to grow and in what volumes.
 
PharmaSphere
 
Overview
 
PharmaSphere is a pre-revenue wholly owned subsidiary of TerraSphere. PharmaSphere’s business plan is to utilize the TerraSphere System for the production of high value biocompounds sourced from plants and used as active pharmaceutical ingredients, and for the production of transgenic plants (genetically engineered plants) for the biotechnology market.
 
PharmaSphere will install TerraSphere Systems in retrofitted warehouses, and extract and purify the compounds using environmentally friendly technologies. Additional environmental benefits include less water and fertilizer use by metered dispensing, less waste water or fertilizer discharge due to plant uptake, no chemical pesticides, no fuel and oil use by agricultural machinery, and no transportation of bulk plant materials to distant processing facilities.
 
PharmaSphere will cultivate “native” or “wild” plants that naturally express biocompounds, called “natural products or extracts.” Depending on obtaining partners and financing, PharmaSphere would cultivate “transgenic” plants, namely plants that have been genetically altered by the insertion of foreign DNA encoding the expression of a specific compound.
 
The model for PharmaSphere’s natural product business is to cultivate plants expressing biocompounds with well-established pharmaceutical, nutraceutical and cosmeceutical uses, and extract and purify the compounds for sale to customers for use in their products as “active ingredients” or chemical synthesis “starting material.” Unless there are a number of potential buyers for the compound in question, PharmaSphere will not grow the plant source without a partner or a long-term purchase agreement.
 
A major concern of sellers of natural product drugs, nutraceuticals and cosmeceuticals is the unreliable supply of top quality active ingredients because the cultivation of source plants in the field is erratic and the quality of extracts is uneven. With the TerraSphere system and state-of-the art extraction, purification and quality control technologies, PharmaSphere believes it can provide its customers a reliable supply of consistently high quality plant compounds.
 
By isolating the plants from the environment, the TerraSphere system allows each plant species’ growth parameters to be optimized for maximum compound expression by the precise control of light, temperature, water, carbon dioxide and fertilizer. The benefits are:
 
  •  increased compound expression levels through (a) optimization of growth parameters, and (b) removal of the adverse impact of weather, soil conditions, disease and pests;
 
  •  reduced costs of compound purification as the plants will not be taking up field-growth contaminants such as pesticide residues, fuel and oil leakage from machinery and impurities from the soil and rain, all of which must be removed to purify compounds from field-grown plants; and
 
  •  shortened plant growth cycles, or “turns.”
 
PharmaSphere’s transgenic plant business model is to form development partnerships with pharmaceutical and biotechnology companies having product pipelines that include recombinant biopharmaceutical compounds (antibodies and other therapeutic proteins and vaccines). A typical partnership would first determine the feasibility of efficient expression of the compound of interest in the TerraSphere system, and then scale up production to the desired quantities. PharmaSphere would receive upfront and milestone payments and royalties. PharmaSphere does not intend to cultivate transgenic plants without partners, and there is no assurance that PharmaSphere will be able to find such partners.


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PharmaSphere Plant Growth System
 
PharmaSphere believes the TerraSphere system is ideal for growing both native plants and transgenic plants as it permits full environmental containment and controlled growth conditions. The expression of natural compounds from native plants grown in the system is greatly enhanced by the absence of field-growth hazards such as weather, soil conditions, pests and disease.
 
A typical PharmaSphere commercial-scale biopharmaceutical production facility will contain hundreds of structures and extraction and purification areas in one single-story industrial building, and will comply with U.S. Food and Drug Administration (“FDA”) current Good Manufacturing Practices (cGMPs). The planting, harvest and storage areas of the building will provide containment at the BL-2 level for transgenic plant cultivation. USDA licensure for cultivating transgenic plants is not necessary, as transgenic plants growing in the trays will not be considered to be growing in the field, or in a greenhouse with inadequate containment. USDA licensure is not required in any event to grow native plants expressing natural compounds. A facility for cultivating native plants to produce natural products will comply with BL-2 to provide a flexible facility that could also be used to grow transgenic plants.
 
Other Applications
 
TerraSphere believes another potential application is the growth of plants that naturally express various biocompounds and substances that are used as nutrition supplements, cosmetic ingredients or herbal remedies. They are not regulated as “drugs” if health claims do not accompany their marketing. PharmaSphere believes it can economically grow large amounts of these plants using the TerraSphere System and can increase the expressed quantities of the biocompounds by optimizing and controlling growth conditions.
 
Market Demand
 
TerraSphere
 
The U.S. organic produce market has grown significantly in recent years. TerraSphere believes that a decrease in farmland near urban areas coupled with the increase in demand for organic foods creates a compelling opportunity to grow whole, organic foods locally for urban consumers (businesses, food markets, restaurants). Organic and natural foods are traditionally grown on smaller farms across the country and in hydroponic facilities on large farms in the western United States. The long distance between western suppliers and east coast markets increases both the economic cost and the environmental impacts of the produce. Seasonal constraints make it impossible to stock locally-grown, organic produce in northern cities year round. TerraSphere offers the ability to deliver fresh, local produce to whole foods markets, restaurants and other buyers, without seasonal interruption. This is true not only in the United States, but in cities throughout the world.
 
Food security is also a growing concern, which TerraSphere believes creates demand for the Technology since it grows produce in contained, secure facilities that are not dependent on environmental conditions.
 
PharmaSphere
 
Natural Biocompounds (therapeutic biocompounds native to a plant species): PharmaSphere intends to cultivate plants expressing natural biocompounds, and to extract, purify and market these compounds. As determined by customer requirements, either crude extracts or purified compounds will be sold as “active pharmaceutical ingredients” or as “starting material” for chemical synthesis. Potential customers are pharmaceutical companies with generic products, as well as patented products, and those biotechnology companies that add value to generic compounds with proprietary formulations for safer and more effective delivery. Unless the biocompound in question has a number of potential buyers, PharmaSphere will not grow the plant source without a partner or a long-term supply agreement. PharmaSphere expects revenues from this market will not be achieved until approximately 12 months after completion of its first facility.
 
Transgenic or Recombinant Biopharmaceuticals (therapeutic biocompounds from foreign DNA inserted in a plant host): In this category, working with partners, PharmaSphere would produce high value recombinant


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antibodies and other therapeutic proteins and subunit vaccines. PharmaSphere believes plants offer the prospect of inexpensive biopharmaceutical production without sacrificing product quality or safety. PharmaSphere believes the use of transgenic plants for pharmaceutical production has important safety and economic advantages, including the absence of animal contaminants such as viruses which are toxic to humans, less complex purification requirements, quicker conduct of feasibility studies and more rapid production implementation and scale-up due to shorter periods of time required for plant transformation and cultivation of the needed quantities of transformed plants. Transforming animals and building up transgenic herds require substantially more time.
 
Competitive Advantages
 
TerraSphere competes with both traditional field agriculture and greenhouses. TerraSphere believes its Technology has several advantages over both types of competitors, which include:
 
  •  Higher Productivity:  The difference in productivity between growing in cubic feet versus square feet is considerable and gives TerraSphere’s Technology a competitive advantage. Furthermore, yields are higher than in plants grown in the field since variable weather and soil conditions, and the presence of pests and diseases, which adversely impact yields, are not a factor. Finally, the ability to grow crops year round increases productivity.
 
  •  Lower Energy Costs:  A TerraSphere facility uses less energy than traditional agricultural methods. With unpredictable and often rising energy costs coupled with finite energy resources, this is a competitive advantage.
 
  •  Controlled Environment:  A fully automated, mechanized system that grows plants in peat provides many advantages, such as no cross contamination of the product (as is the case with certain organic produce), no exposure for contamination in water, and complete control of fertilizer type and quality.
 
  •  Ease of Facility Siting:  TerraSphere’s automated Technology allows people to grow crops in their community that are not indigenous to the geography or region. The TerraSphere System and harvesting stations can be installed in almost any location, including any retrofitted industrial/warehouse building with a minimum clearance of 25 feet.
 
  •  Extended Produce Shelf Life:  The ability to locate facilities near end markets, regardless of geography or climate, means produce is fresher when it arrives and has a longer shelf life.
 
  •  Lower Cleaning and Product Preparation Costs:  Cleaning and product preparation costs are substantially lower because impurities, including pesticide residues, fuel and oil leakage from machinery, and impurities from the soil and rain that are taken up by plants in the field are not a factor.
 
  •  Minimal Fertilizer and No Pesticides:  Precisely controlled growth conditions mean that plants grown in the TerraSphere System require less fertilizer than plants grown in the field or a greenhouse. The controlled environment also means that no chemical pesticides are required.
 
  •  Water Conservation:  The TerraSphere System’s watering injection system recycles water; therefore, the TerraSphere System requires less water and generates little to no wastewater. Water is a significant cost for farms and greenhouses and wastewater is a major environmental concern associated with traditional methods.
 
Government Regulation
 
In order to assure pharmaceutical product safety, quality and consistency, PharmaSphere is required to produce “active pharmaceutical ingredients” and chemical synthesis “starting material” in compliance with “current Good Manufacturing Practices” (or cGMPs) promulgated by the FDA. If PharmaSphere were to produce finished, end-use drugs, it would also be required to comply with cGMPs. In general, cGMPs entail process and equipment validation, maintenance of rigorous quality control procedures and extensive documentation. PharmaSphere facilities will be inspected by the FDA, including those located abroad that manufacture product to be sold in the United States. Similar regulation exists in Canada and other countries.


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PharmaSphere’s plant cultivation system, in addition to its extraction and purification operations, must comply with cGMPs. If PharmaSphere intends to cultivate, extract and purify controlled substances, it will be required to register with the U.S. Drug Enforcement Administration (“DEA”) as a controlled substance bulk manufacturer. Registration entails the DEA’s inspecting and testing PharmaSphere’s physical security systems, verifying its compliance with state and local laws, and reviewing its background and history.
 
The field cultivation, interstate movement and importation of transgenic plants in the United States is regulated by the U.S. Department of Agriculture (“USDA”) under the Plant Protection Act. A separate permit is required for each activity, the most important and complex of which is the field-growing permit. Biopharmaceuticals, which are regulated by the FDA, are also subject to the USDA regulatory framework if produced by transgenic plants.
 
If PharmaSphere cultivates transgenic plants within the TerraSphere System, a field-growing permit from the USDA under the Plant Protection Act would not be necessary. If PharmaSphere were to transport transgenic plant materials such as seeds, seedlings or leaves across state lines or import them from abroad, it would be required to obtain a movement or importation permit from the USDA. PharmaSphere anticipates engaging in such transportation and importation from time to time. A development partner might require harvested transgenic plants or plant materials to be transported across state lines to its own facilities for processing. If so, PharmaSphere will be required to obtain a USDA movement permit.
 
PharmaSphere will submit to the FDA and maintain a “Drug Master File” for each native plant compound it sells to customers in the United States as an “active pharmaceutical ingredient” or chemical synthesis “starting material.” If other countries where it solicits customers have similar systems, it will make filings as required.
 
Should PharmaSphere sell products as finished, end-use drugs in the United States, it will be required to obtain premarket approval for each such drug product and its intended use from the FDA under the Federal Food, Drug, and Cosmetic Act. In general, if a drug is novel, it cannot be sold unless covered by an approved New Drug Application (“NDA”) after the completion of lengthy and expensive three-phase clinical trials. Similar regulation exists in foreign countries. PharmaSphere does not intend to sell finished drugs requiring NDA approval without a partner to fund the clinical trials and regulatory submissions.
 
A nutraceutical, cosmeceutical, or herbal product if marketed without specific health claims and labeling is not a “drug,” but may be a “dietary supplement,” a “food,” or a “cosmetic” as defined and regulated under the FDA laws. PharmaSphere could produce such products on its own or with partners.
 
PharmaSphere’s facilities in the United States will be subject to federal, state and local laws and regulations regarding the use, storage, handling and disposal of hazardous materials, including materials routinely used in life science research laboratories and for bioprocessing activities such as compound extraction and purification. Foreign countries generally have comparable laws and regulations.


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TERRASPHERE’S MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion should be read in conjunction with the consolidated year-end and unaudited interim financial statements and related notes to the consolidated year-end and interim unaudited financial statements included elsewhere in this report. This discussion contains forward-looking statements that relate to future events or TerraSphere’s future financial performance. These statements involve known and unknown risks, uncertainties and other factors that may cause TerraSphere’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievement expressed or implied by these forward-looking statements. These forward-looking statements are based largely on TerraSphere’s current expectations and are subject to a number of uncertainties and risks. Actual results could differ materially from these forward-looking statements.
 
TerraSphere Overview
 
TerraSphere Systems LLC, located in Boston, Massachusetts designs and builds highly efficient systems for growing organic fruits and vegetables in a controlled, indoor environment. TerraSphere partners with private businesses and public institutions to create solutions for food production challenges. TerraSphere derives its revenues from licensing fees and royalties, the sale of equipment and expects future revenue from operating facilities using the TerraSphere System. The TerraSphere System uses technology to operate automated, software driven plant growth systems that can be used to grow a variety of crops, from lettuce to tree seedlings to rare medicinal herbs.
 
PharmaSphere, LLC, located in Boston, Massachusetts, is a wholly-owned subsidiary of TerraSphere. PharmaSphere’s business plan is to utilize the TerraSphere System for the production of high value biocompounds sourced from plants and used as active pharmaceutical ingredients and for the production of transgenic plants (genetically engineered plants) for the biotechnology market. PharmaSphere has a wholly-owned subsidiary PharmaSphere Worcester, LLC, which was formed to build a facility in Worcester, Massachusetts utilizing PharmaSphere’s business plan. The building of the facility has not commenced. PharmaSphere has no revenue to date.
 
TerraSphere Systems Canada, Inc., or TerraSphere Canada, located in Vancouver, British Columbia, operates the research and manufacturing facility for TerraSphere and is 85% owned by TerraSphere.
 
Future Development
 
TerraSphere plans on entering into partnerships to own and operate TerraSphere facilities. TerraSphere will seek qualified local partners to build and operate TerraSphere facilities. Under the joint-venture model, both parties contribute to the capital costs of the project and split the associated risks by selling TerraSphere systems and equipment to licensees and project partners. TerraSphere will also continue to market its exclusive licensing agreements to interested third parties throughout North America, Asia and Europe.
 
Trends and Uncertainties Affecting Operations
 
TerraSphere is subject to a number of factors that may affect its operations and financial performance. These factors include, but are not limited to, the ability of entering into partnerships to own and operate TerraSphere facilities, the ability to market its exclusive licensing agreements to interested third parties and market acceptance of TerraSphere patented technology. Furthermore, TerraSphere’s plans call for raising debt and/or equity financing to expand its operations. Currently there has been a slowdown in lending in both the equity and bond markets which may hinder its ability to raise the required funds.
 
Results of Operations for the Three Months Ended March 31, 2010 and 2009
 
For the three month period ended March 31, 2010, TerraSphere had revenue of approximately $1,684,000 compared to $9,000 for the same period in 2009. The $1,675,000 increase is comprised of equipment sales of $675,000 and granting a licensing fee for approximately $1,000,000.


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For the three month period ended March 31, 2010, TerraSphere had cost of goods sold of approximately $703,000 compared to no cost of goods sold for the same period in 2009. The increase in cost of goods sold is related to the equipment sales of $675,000 as well as additional work on previous equipment sold in prior years.
 
TerraSphere had general and administrative expenses of approximately $437,000 and $227,000 for the three month periods ended March 31, 2010 and 2009, respectively. The approximately $210,000 increase in general and administrative expenses from 2010 to 2009 is composed of increases in legal and professional fees related to the future construction of the Worcester PharmaSphere facility.
 
Provision for income taxes totaling $388,000 was recorded for the three month period ended March 31, 2010 as TerraSphere elected to be treated as a taxable association effective February 22, 2010 for United States federal and state tax purposes.
 
Net income after tax for the three month period ended March 31, 2010 was $158,000 compared to a loss of $225,000 for the three month period ended March 31, 2009. The increase in net income of $383,000 is made up of equipment sales of $675,000 and granting a licensing fee for approximately $1,000,000.
 
Results of Operations for the Years Ended December 31, 2009 and 2008
 
For the year ended December 31, 2009, TerraSphere had revenues of approximately $37,000 compared to $1,459,000 for the same period in 2008. The decrease was due to no new licensing fees or equipment sales being consummated in 2009.
 
For the year ended December 31, 2009, TerraSphere had no cost of goods sold. Cost of goods sold for the year ended December 31, 2008 totaling $730,000 were related to equipment sales of $622,000 and licensing fees of $800,000.
 
TerraSphere had general and administrative expenses of approximately $1,292,000 and $674,000 for the years ended December 31, 2009 and 2008, respectively. The approximately $618,000 increase in general and administrative expenses from 2009 to 2008 is composed of increases in legal and professional fees related to the future construction of the Worcester PharmaSphere facility.
 
Net loss for the year ended December 31, 2009 was $1,216,000 compared to a net income of $93,000 for the year ended December 31, 2008. The decrease in net income is the result of no new licensing fees or equipment sales being consummated in 2009 to offset the increase in general and administrative expenses.
 
Results of Operations for the Years Ended December 31, 2008 and 2007
 
For the year ended December 31, 2008, TerraSphere had revenues of approximately $1,459,000 compared to $21,000 for the same period in 2007. The increase is due to equipment sales of $622,000 and licensing fees of $800,000 in 2008. There were no equipment sales or licensing fees consummated in 2007.
 
For the year ended December 31, 2008, TerraSphere had cost of goods sold of approximately $730,000 compared to $405,000 for the same period in 2007. Cost of goods sold increase in 2008 is related to equipment sales of $622,000 and licensing fees of $800,000.
 
TerraSphere had general and administrative expenses of approximately $674,000 and $346,000 for the years ended December 31, 2008 and 2007, respectively. The approximately $327,000 increase in general and administrative expenses from 2008 to 2007 is composed of increases in legal and professional fees related to the future construction of the Worcester PharmaSphere facility.
 
Net income for the year ended December 31, 2008 was $93,000 compared to a net loss of $625,000 for the year ended December 31, 2007. The increase in net income is the result of equipment sales of $622,000 and licensing fees of $800,000 in 2008.


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Changes in Balance Sheet
 
As of March 31, 2010, TerraSphere had current assets of approximately $1.2 million compared to $289,000 as of December 31, 2009. TerraSphere’s total assets were approximately $1.6 million as of March 31, 2010 compared to approximately $592,000 as of December 31, 2009. The majority of the increase in assets from December 31, 2009 to March 31, 2010 is due to an increase in accounts receivable arising from the granting of an exclusive licensing agreement.
 
As of March 31, 2010, TerraSphere had current liabilities of approximately $2.4 million compared to $1.6 million at December 31, 2009. This increase is due largely to legal and professional fees incurred and the recording of a deferred tax liability.
 
As of December 31, 2009, TerraSphere had current assets of approximately $289,000 compared to $527,000 as of December 31, 2008. TerraSphere’s total assets were approximately $592,000 as of December 31, 2009 compared to approximately $630,000 as of December 31, 2008, a decrease in total assets of $38,000.
 
As of December 31, 2009, TerraSphere had current liabilities of approximately $1.6 million compared to $390,000 at December 31, 2008. This increase is due largely to legal and professional fees incurred.
 
Liquidity and Capital Resources
 
As of March 31, 2010 and December 31, 2009, TerraSphere had $106,000 and $197,000, respectively, in cash on hand. The major uses of cash during the three months ended March 31, 2010 were approximately $119,000 for operating activities and $97,000 for investing activities offset by an increase in cash of approximately $162,000 from financing activities.
 
Subsequent to March 31, 2010, TerraSphere entered into exclusive licensing agreements totaling $3.8 million. Based on the terms of these agreements, TerraSphere will receive installment payments throughout the year with the final installment payment being received in March 2011.
 
Off-Balance Sheet Transactions
 
TerraSphere does not engage in material off-balance sheet transactions.
 
Critical Accounting Policies
 
Use of Estimates
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and disclosures in the consolidated financial statements. Actual results could differ from those estimates.
 
Foreign Operations
 
The accounting records of TerraSphere Canada are maintained in Canadian dollars, its functional currency. Revenue and expense transactions are translated to U.S. dollars using the average exchange rate of the month in which the transaction took place. Assets and liabilities are translated to U.S. dollars using the exchange rate in effect as of the balance sheet date. Equity transactions are translated to U.S. dollars using the exchange rate in effect as of the date of the equity transaction. Translation gains and losses are reported as a component of accumulated other comprehensive income or loss. Gains and losses resulting from transactions which are denominated in other than the functional currencies are reported as foreign currency exchanges gain (loss) in the statements of operations and comprehensive income (loss) in the period the gain or loss occurred.


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Patent and Patent Costs, Net
 
TerraSphere accounts for its patent and patent related costs in accordance with ASC 250, which requires that intangible assets with finite lives, such as TerraSphere’s, specifically identifiable costs for patent and patent applications, be capitalized and amortized over their respective estimated lives and reviewed for impairment whenever events or other changes in circumstances indicate that the carrying amount may not be recoverable.
 
Pre-Construction Costs
 
Pre-construction costs include architectural and engineering services related to the building of the PharmaSphere facility.
 
Revenue Recognition
 
Revenue is recognized when all of the following criteria are met: persuasive evidence of a sales arrangement exists; delivery of the product has occurred; the sales price is fixed or determinable; and, collectability is reasonably assured.
 
In those cases where all four criteria are not met, TerraSphere defers recognition of revenue until the period these criteria are satisfied. Revenue is generally recognized upon shipment or upon completed performance on exclusive technology licenses where the term is equal to the life of the associated intellectual property.
 
TerraSphere recognizes deferred revenue when payment has been received for product sales but the revenue recognition criteria has not been met. In addition, TerraSphere defers revenue when payment has been received for future services to be provided.
 
Income Taxes
 
TerraSphere elected to be treated as a taxable association effective February 22, 2010 for United States federal and state tax purposes. TerraSphere accounts for income taxes following the asset and liability method in accordance with ASC 740. Under such method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years that the asset is expected to be recovered or the liability settled.
 
Management performs an evaluation of TerraSphere’s tax positions, ensuring that these tax return positions meet the “more likely than not” recognition threshold and can be measured with sufficient precision. These evaluations provide management with a comprehensive model for how TerraSphere should recognize, measure, present and disclose in its financial statements certain tax positions that TerraSphere has taken or expects to take on income tax returns.


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BENEFICIAL OWNERSHIP OF SECURITIES
 
Security Ownership of Converted Organics
 
Set forth below is information regarding the beneficial ownership of our common stock, as of July 7, 2010, by:
 
  •  each person whom we know owned, beneficially, more than 5% of the outstanding shares of our common stock;
 
  •  each of our directors;
 
  •  each of our executive officers that were included in our annual meeting proxy statement; and
 
  •  all of our current directors and executive officers as a group.
 
We believe that, except as otherwise noted below, each named beneficial owner has sole voting and investment power with respect to the shares listed. Unless otherwise indicated herein, beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission, and includes voting or investment power with respect to shares beneficially owned. Shares of common stock to be received upon conversion of preferred stock, or subject to options or warrants currently exercisable or exercisable on or within 60 days of the date of this report, are deemed outstanding for computing the percentage ownership of the person holding such options or warrants, but are not deemed outstanding for computing the percentage ownership of any other person.
 
                                 
    Number of Shares of Common
  Percentage of Outstanding
Name of Beneficial Owner(1)
  Stock Beneficially Owned   Shares of Common Stock(2)
    Before the
  After the
  Before the
  After the
    TerraSphere
  TerraSphere
  TerraSphere
  TerraSphere
    Acquisition   Acquisition   Acquisition   Acquisition
 
Edward J. Gildea
    898,970 (3)     3,413,311 (3)     2.2 %     4.5 %
David R. Allen
    390,141 (4)     390,141 (4)     1.0 %     *  
Robert E. Cell
    204,000 (5)     204,000 (5)     *       *  
John P. DeVillars
    204,000 (5)     204,000 (5)     *       *  
Edward A. Stoltenberg
    213,269 (6)(7)     213,269 (6)(7)     *       *  
All directors and officers as a group (five persons)
    1,910,380       5,151,121       4.5 %     6.7 %
5% Shareholders
                               
Oppenheimer Funds, Inc.(8)
    2,284,409               5.3 %     3.0 %
 
 
* Less than 1%
 
(1) The address of all persons named in this table, with the exception of Oppenheimer Funds, Inc. is: c/o Converted Organics Inc., 137A Lewis Wharf, Boston, MA 02110.
 
(2) Percentage of common stock outstanding before the TerraSphere acquisition is based on 40,520,708 shares of our common stock outstanding as of July 7, 2010, and percentage of common stock outstanding after the TerraSphere acquisition assumes the issuance of 34,166,667 shares of common stock in connection with the TerraSphere acquisition, which assumes that all milestones are achieved by TerraSphere.
 
(3) Includes 1,400 Class B Warrants and options to purchase 725,000 shares. The “After the TerraSphere Acquisition” amount includes 3,240,741 shares that Mr. Gildea would receive if all milestones are achieved by TerraSphere.
 
(4) Includes options to purchase 381,195 shares.
 
(5) Includes options to purchase 204,000 shares.
 
(6) Includes options to purchase 194,000 shares.
 
(7) Includes 2,966 shares beneficially owned and held in trust.


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(8) The following information is based on the Schedule 13G filed February 2, 2010. Oppenheimer Funds, Inc. is an investment adviser in accordance with Rule 13d-1(b)(1)(ii)(E) of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All beneficial ownership is disclaimed pursuant to Rule 13d-4 of the Exchange Act. All positions reported reflect the exercise of warrants for shares of common stock. The principal address of Oppenheimer Funds, Inc. is Two World Financial Center, 225 Liberty Street, New York, NY 10289.
 
STOCKHOLDER PROPOSALS FOR THE 2011 ANNUAL MEETING
 
Should a stockholder desire to include in next year’s annual meeting proxy statement a proposal other than those made by the Board, such proposal must be sent to the Corporate Secretary of the Company at 137A Lewis Wharf, Boston, MA 02110. Stockholder proposals must be received at our principal executive offices no later than 120 days prior to the first anniversary of the date our fiscal 2010 annual meeting proxy statement was mailed to stockholders, which was May 19, 2010. All stockholder proposals received after this date will be considered untimely and will not be included in the proxy statement for the fiscal 2011 annual meeting. The deadline for submission of shareholder proposals that are not intended to be included in our proxy statement is 45 days prior to the first anniversary of the date our fiscal 2010 annual meeting proxy statement was mailed to stockholders, which was May 19, 2010.
 
DELIVERY OF DOCUMENTS TO STOCKHOLDERS
 
Pursuant to the rules of the SEC, we and our agents that deliver communications to our stockholders are permitted to deliver to two or more stockholders sharing the same address a single copy of our proxy statement. Upon written or oral request, we will deliver a separate copy of the proxy statement to any stockholder at a shared address who wishes to receive separate copies of such documents in the future. Stockholders receiving multiple copies of such documents may likewise request that we deliver single copies of such documents in the future. Stockholders may notify us of their requests by calling or writing us at our principal executive offices at 137A Lewis Wharf, Boston, MA 02110, and our phone number is (617) 624-0111.
 
WHERE YOU CAN FIND MORE INFORMATION
 
We file reports, proxy statements and other information with the SEC. You may read and copy reports, proxy statements and other information filed by us with the SEC at its public reference room located at 100 F Street, N.E., Washington, D.C. 20549-1004. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You may also obtain copies of the materials described above at prescribed rates by writing to the SEC, Public Reference Section, 100 F Street, N.E., Washington, D.C. 20549-1004. We files our reports, proxy statements and other information electronically with the SEC. You may access information on us at the SEC web site containing reports, proxy statements and other information at http://www.sec.gov.


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INDEX TO FINANCIAL STATEMENTS
 
         
TERRASPHERE SYSTEMS LLC.
       
    F-3  
CONSOLIDATED FINANCIAL STATEMENTS
       
    F-4  
    F-5  
    F-6  
    F-7  
    F-8  
 
TERRASPHERE SYSTEMS LLC.
       
CONSOLIDATED FINANCIAL STATEMENTS
       
    F-16  
    F-17  
    F-18  
    F-19  
    F-20  
 
CONVERTED ORGANICS INC.
       
UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS
       
    F-28  
    F-31  
    F-32  
    F-33  
    F-34  


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TERRASPHERE SYSTEMS LLC

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2009 AND 2008
AND FOR THE YEARS ENDED
DECEMBER 31, 2009, 2008 AND 2007

WITH REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
 


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Members of
  TerraSphere Systems LLC
 
We have audited the accompanying consolidated balance sheets of TerraSphere Systems LLC (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations and comprehensive income (loss), changes in members’ equity (deficit) and cash flows for the years ended December 31, 2009, 2008 and 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of TerraSphere Systems LLC as of December 31, 2009 and 2008, and the results of their operations and their cash flows for the years ended December 31, 2009, 2008 and 2007 in conformity with accounting principles generally accepted in the United States of America.
 
/s/ CCR LLP
 
Glastonbury, Connecticut
June 3, 2010


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TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2009 AND 2008
 
                 
    2009     2008  
 
ASSETS
Current assets:
               
Cash
  $ 197,046     $ 8,083  
Accounts receivable
          400,000  
Other receivables
    15,244       109,080  
Inventories — work in process
    34,565        
Prepaid expenses
    42,100       10,250  
                 
Total current assets
    288,955       527,413  
Leasehold improvements
    161,948        
Patent and patent costs, net
    134,932       98,347  
Other assets
    5,692       3,766  
                 
Total assets
  $ 591,527     $ 629,526  
                 
 
LIABILITIES AND MEMBERS’ EQUITY (DEFICIT)
Current liabilities:
               
Note payable — member
  $ 20,000     $  
Due to member
    102,292        
Accounts payable
    732,866       258,454  
Accrued expenses
    6,862       6,388  
Deferred revenue
    763,767       125,499  
                 
Total current liabilities
    1,625,787       390,341  
                 
Members’ equity (deficit)
               
TerraSphere Systems LLC members’ equity (deficit)
               
Members’ equity (deficit)
    (1,043,475 )     247,412  
Accumulated other comprehensive income (loss)
    (42,254 )     6,614  
                 
Total TerraSphere Systems LLC members’ equity (deficit)
    (1,085,729 )     254,026  
Noncontrolling interest
    51,469       (14,841 )
                 
Total members’ equity (deficit)
    (1,034,260 )     239,185  
                 
Total liabilities and members’ equity (deficit)
  $ 591,527     $ 629,526  
                 
 
The accompanying notes are an integral part of these consolidated financial statements.


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TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
 
                         
    2009     2008     2007  
 
Revenue
                       
Sales
  $     $ 621,877     $  
Licensing and marketing fees
    36,732       836,692       21,427  
                         
      36,732       1,458,569       21,427  
Cost of goods sold
          730,446       404,760  
                         
Gross profit (loss)
    36,732       728,123       (383,333 )
Operating expenses
                       
General and administrative expense
    1,291,586       673,805       346,372  
Research, development and testing expense
    613       26,941       16,159  
Amortization expense
    6,383       13,035       1,884  
                         
Income (loss) from operations
    (1,261,850 )     14,342       (747,748 )
                         
Other income (expense)
                       
Other income
    19,356       123,566       114,113  
Foreign currency gain (loss)
    35,758       (44,952 )     8,778  
Interest expense
    (9,218 )            
                         
Total other expense
    45,896       78,614       122,891  
                         
Net income (loss)
    (1,215,954 )     92,956       (624,857 )
Net income (loss) attributable to noncontrolling interest
    74,934       16,647       (26,887 )
                         
Net income (loss) attributable to TerraSphere Systems LLC before other comprehensive income (loss)
    (1,290,888 )     76,309       (597,970 )
Other comprehensive income (loss):
                       
Foreign currency translation adjustment
    (57,491 )     31,678       (21,900 )
                         
Comprehensive income (loss)
    (1,348,379 )     107,987       (619,870 )
Comprehensive income (loss) attributable to noncontrolling interest
    (8,623 )     4,752       (3,285 )
                         
Comprehensive income (loss) attributable to TerraSphere Systems LLC
  $ (1,339,756 )   $ 103,235     $ (616,585 )
                         
 
The accompanying notes are an integral part of these consolidated financial statements.


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TERRASPHERE SYSTEMS LLC

CONSOLIDATED STATEMENTS OF CHANGES IN MEMBERS’ EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
 
                                         
    TerraSphere Systems LLC              
          Accumulated
                   
          Other
                Members’ Equity
 
    Members’ Equity
    Comprehensive
          Noncontrolling
    (Deficit)
 
    (Deficit)     Income (Loss)     Total     Interest     Total  
 
Balance, December 31, 2006
    244,093       (1,697 )     242,396       (6,068 )     236,328  
Contributions
    215,000             215,000             215,000  
Foreign currency translation adjustment
          (18,615 )     (18,615 )     (3,285 )     (21,900 )
Net loss
    (597,970 )           (597,970 )     (26,887 )     (624,857 )
                                         
Balance, December 31, 2007
  $ (138,877 )   $ (20,312 )   $ (159,189 )   $ (36,240 )   $ (195,429 )
Contributions
    309,980             309,980             309,980  
Foreign currency translation adjustment
          26,926       26,926       4,752       31,678  
Net income
    76,309             76,309       16,647       92,956  
                                         
Balance, December 31, 2008
    247,412       6,614       254,026       (14,841 )     239,185  
Foreign currency translation adjustment
          (48,868 )     (48,868 )     (8,623 )     (57,491 )
Net income (loss)
    (1,290,888 )           (1,290,888 )     74,934       (1,215,954 )
                                         
Balance, December 31, 2009
  $ (1,043,475 )   $ (42,254 )   $ (1,085,729 )   $ 51,469     $ (1,034,260 )
                                         
 
The accompanying notes are an integral part of these consolidated financial statements.


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TERRASPHERE SYSTEMS LLC

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
 
                         
    2009     2008     2007  
 
Cash flows from operating activities
                       
Net income (loss)
  $ (1,215,954 )   $ 92,956     $ (624,857 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
                       
Amortization of patents and patent costs
    6,383       13,035       1,884  
Changes in operating assets and liabilities:
                       
(Increase) decrease in:
                       
Accounts receivable
    400,000       (400,000 )      
Other receivables
    103,392       (3,503 )     59,763  
Inventories
    (34,565 )     23,043       (23,043 )
Prepaid expenses
    (31,850 )     36,006       (46,256 )
Other assets
    (1,493 )           1,163  
Increase (decrease) in:
                       
Accounts payable
    452,871       127,980       73,234  
Accrued expenses
    474       6,389        
Deferred revenue
    638,268       (418,609 )     544,108  
                         
Net cash provided by (used in) operating activities
    317,526       (522,703 )     (14,004 )
                         
Cash flows from investing activities
                       
Patent costs
    (42,968 )     (34,966 )     (60,098 )
Expenditures for leasehold improvements
    (149,636 )            
                         
Net cash used in investing activities
    (192,604 )     (34,966 )     (60,098 )
                         
Cash flows from financing activities
                       
Member contributions
          309,980       215,000  
Advances from member
    102,292              
Proceeds from notes payable — member
    20,000              
                         
Net cash provided by financing activities
    122,292       309,980       215,000  
                         
Effect of exchange rate changes on cash
    (58,251 )     28,357       (36,453 )
                         
Increase (decrease) in cash
    188,963       (219,332 )     104,445  
Cash, beginning of year
    8,083       227,415       122,970  
                         
Cash, ending of year
  $ 197,046     $ 8,083     $ 227,415  
                         
 
The accompanying notes are an integral part of these financial statements.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2009 AND 2008
 
NOTE 1 — NATURE OF OPERATIONS
 
TerraSphere Systems LLC (“TerraSphere”), located in Boston, Massachusetts designs and builds highly efficient systems for growing organic fruits and vegetables in a controlled, indoor environment. The Company partners with private businesses and public institutions to create solutions for food production challenges. The Company derives its revenues from licensing fees and royalties, the sale of equipment and expects future revenue from operating facilities using the TerraSphere System. The TerraSphere System uses technology to operate automated, software driven plant growth systems that can be used to grow a variety of crops, from lettuce to tree seedlings to rare medicinal herbs.
 
PharmaSphere, LLC (“PharmaSphere”), located in Boston, Massachusetts, is a wholly owned subsidiary of TerraSphere. PharmaSphere’s business plan is to utilize the TerraSphere System for the production of high value biocompounds sourced from plants and used as active pharmaceutical ingredients, and for the production of transgenic plants (genetically engineered plants) for the biotechnology market. PharmaSphere has a wholly-owned subsidiary PharmaSphere Worcester, LLC which was formed to build a facility in Worcester, Massachusetts utilizing PharmaSphere’s business plan. The building of the facility has not commenced. PharmaSphere has no revenue to date.
 
TerraSphere Systems Canada, Inc., (“TerraSphere Canada”) located in Vancouver, British Columbia, operates the research and manufacturing facility for TerraSphere and is eighty-five percent owned by TerraSphere.
 
NOTE 2 — MANAGEMENT’S PLAN OF OPERATIONS
 
The Company has sustained a net loss in 2009 and has a members’ deficit totaling approximately $1,034,000 and has negative working capital totaling approximately $1,337,000 at December 31, 2009. Subsequent to December 31, 2009, the Company has entered into four exclusive licensing agreements totaling $3,800,000 and has received installment payments on those agreements totaling $760,000 with the remaining installments to be made on a quarterly basis through April 2011 (See Note 11). Management believes the above licensing agreements will provide the necessary working capital through 2010. The Company is currently pursuing additional exclusive licensing agreements. The Company is also pursuing a possible acquisition by another entity to further its mission of creating solutions to food production challenges.
 
NOTE 3 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
CONSOLIDATION
 
The accompanying consolidated financial statements include the transactions and balances of TerraSphere Systems LLC and its wholly-owned subsidiary, PharmaSphere, LLC. The assets, liabilities and results of operations of TerraSphere Systems Canada, Inc. are included in the consolidated financial statements with appropriate recognition of noncontrolling interest. All intercompany transactions and balances have been eliminated in consolidation.
 
CODIFICATION
 
Effective July 1, 2009, the Financial Accounting Standard Board’s (“FASB”) Accounting Standards Codification (“ASC”) became the single official source of authoritative, non-governmental U.S. generally accepted accounting principles (“GAAP”). The historical GAAP hierarchy was eliminated and the ASC became the only level of authoritative GAAP. The Company’s accounting policies were not affected by the conversion to ASC.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
FOREIGN OPERATIONS
 
The accounting records of TerraSphere Canada are maintained in Canadian dollars, its functional currency. Revenue and expense transactions are translated to U.S. dollars using the average exchange rate of the month in which the transaction took place. Assets and liabilities are translated to U.S. dollars using the exchange rate in effect as of the balance sheet date. Equity transactions are translated to U.S. dollars using the exchange rate in effect as of the date of the equity transaction. Translation gains and losses are reported as a component of accumulated other comprehensive income or loss. Gains and losses resulting from transactions which are denominated in other than the functional currencies are reported as foreign currency exchanges gain (loss) in the statements of operations and comprehensive income (loss) in the period the gain or loss occurred.
 
USE OF ESTIMATES
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and disclosures in the consolidated financial statements. Actual results could differ from those estimates.
 
ACCOUNTS RECEIVABLE
 
Accounts receivable represents balances due from customers, net of applicable reserves for doubtful accounts. In determining the need for an allowance, objective evidence that a single receivable is uncollectible, as well as historical collection patterns for accounts receivable are considered at each balance sheet date. At December 31, 2009 and 2008, an allowance for doubtful accounts was not required.
 
INVENTORIES
 
Inventories are valued at the lower of cost or market, with cost determined by the first in, first out method. Inventories consist of the work-in-process related to twelve TerraSphere System units at December 31, 2009. There were no inventory reserves at December 31, 2009 or 2008.
 
LEASEHOLD IMPROVEMENTS
 
Leasehold improvements are carried at cost and are amortized over their estimated service life or the remaining term of the related lease, whichever is shorter. There was no amortization expense incurred in the years ended December 31, 2009, 2008 or 2007 as the assets had not been placed in service.
 
PATENT AND PATENT COSTS
 
The Company accounts for its patent and patent costs in accordance with ASC 250, which requires that intangible assets with finite lives, such as the Company’s specifically identifiable costs for patent and patent applications, be capitalized and amortized over their respective estimated lives and reviewed for impairment whenever events or other changes in circumstances indicate that the carrying amount may not be recoverable.
 
REVENUE RECOGNITION
 
Revenue is recognized when all of the following criteria are met:
 
  •  Persuasive evidence of a sales arrangement exists;
 
  •  Delivery of the product has occurred;
 
  •  The sales price is fixed or determinable, and;
 
  •  Collectability is reasonably assured.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
In those cases where all four criteria are not met, the Company defers recognition of revenue until the period these criteria are satisfied. Revenue is generally recognized upon shipment or upon completed performance on exclusive technology licenses where the term is equal to the life of the associated intellectual property.
 
The Company recognizes deferred revenue when payment has been received for product sales when the revenue recognition criteria have not been met. In addition, the Company defers revenue when payment has been received for future services to be provided.
 
INCOME TAXES
 
No provision for income taxes is recognized because the Company is a limited liability company. In lieu of federal and state income taxes, all income, losses, deductions and credits pass through to the members for them to report on their personal returns. Management has performed an evaluation of the Company’s tax positions, ensuring that these tax return positions meet the “more likely than not” recognition threshold and can be measured with sufficient precision. These evaluations provide management with a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements certain tax positions that the Company has taken or expects to take on income tax returns. Based upon these evaluations, management has concluded that the Company has no uncertain tax positions that qualify for either recognition or disclosure in the financial statements as of December 31, 2009.
 
RESEARCH AND DEVELOPMENT
 
Research and development costs are charged to operations as incurred. For the years ended December 31, 2009, 2008 and 2007, the Company recorded $613, $26,941 and $16,159 in research and development costs, respectively.
 
FAIR VALUE MEASUREMENTS
 
The Company applies FASB ASC 820, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. FASB ASC 820 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.
 
FASB ASC 820 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB ASC 820 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
 
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls


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Table of Contents

TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
 
NOTE 4 — CONCENTRATION OF CREDIT RISK
 
The Company’s financial instrument that is exposed to a concentration of credit risk is cash. The Company places its cash deposits with credit worthy banking institutions in the United States and Canada which are continually reviewed by management. From time to time, the bank balances of the Company’s cash may exceed current United States and Canadian insured limits. However, the Company has not experienced any losses in this area and management believes its cash deposits are not subject to significant credit risk. At December 31, 2009 and 2008, the Company’s did not have cash balances on deposit that exceeded United States and Canadian federal depository insurance limits.
 
NOTE 5 — PATENT AND PATENT COSTS
 
The following reflects the Company’s patent and patent costs at December 31:
 
                 
    2009     2008  
 
Carousel with spheres patent
  $ 32,407     $ 32,407  
Carousel with arcuate ribs patent
    9,666       5,795  
Rotatable carousel with arcuate ribs patent
    13,582       8,192  
Carousel with spheres application (Canadian)
    7,199       5,321  
Carousel with spheres application (Canadian)
    5,836       3,976  
Carousel with spheres application (European)
    19,001       17,382  
Carousel with spheres application (Chinese)
    10,391       10,391  
Carousel with spheres application (Hong Kong)
    1,461       1,461  
Carousel with spheres application (Japanese)
    14,901       10,396  
Rotatable carousel with arcuate ribs application
    8,514       8,514  
Rotatable carousel with drum-like members (Canadian)
    4,760        
Rotatable carousel with drum-like members application
    5,267        
Carousel with spheres application
    10,040       10,040  
Tray apparatus costs
    5,780       440  
Collapsible stack costs
    6,140        
Marchildon costs
    2,338        
                 
Total
    157,283       114,315  
Accumulated amortization
    22,351       15,968  
                 
Total, net amortization
  $ 134,932     $ 98,347  
                 
 
Amortization expense for the years ended December 31, 2009, 2008 and 2007 was $6,383, $13,035 and $1,884, respectively.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Aggregate expected amortization expense in future years is expected to be as follows:
 
         
2010
  $ 6,724  
2011
    6,724  
2012
    6,724  
2013
    6,724  
2014
    6,724  
Thereafter
    101,312  
         
Total
  $ 134,932  
         
 
NOTE 6 — NOTES PAYABLE
 
On May 29, 2009, the Company issued an unsecured note payable to a member in the amount of $20,000 with a fixed rate of 10% maturing July 29, 2009. The Company is in default of the note and the member has not called the note as of December 31, 2009. The principal due in 2010 is $20,000. The Company has accrued and incurred $1,189 in interest as of December 31, 2009.
 
NOTE 7 — DUE TO MEMBER
 
During the year ended December 31, 2009, a member provided an advance to the Company for working capital with an interest rate of 10%. The amount due to member at December 31, 2009 is $102,292. The Company has accrued and incurred $5,673 in interest as of and in the year ended December 31, 2009.
 
NOTE 8 — DEFERRED REVENUE
 
The Company has recorded deferred revenue of $763,767 and $125,499 at December 31, 2009 and 2008, respectively. On May 18, 2007, TerraSphere Canada entered into a marketing agreement with the Squamish Nation (“Squamish”) to promote the TerraSphere System to other First Nations bands in Canada for $200,000 Canadian dollars ($183,772 U.S.). The Company is recognizing the marketing fee over the term of the agreement (See Note 10). At December 31, 2009 and 2008, deferred revenue associated with this agreement is approximately $89,000 and $125,000, respectively. The Company also has deferred a $675,000 payment from the Squamish received in December 2009 for the sale of twelve TerraSphere System units to be delivered in the first quarter of 2010.
 
NOTE 9 — COMMITMENTS AND CONTINGENCIES
 
LEASE
 
On September 30, 2009, the Company entered into an operating lease agreement to begin November 1, 2009 for warehouse space in Vancouver, British Columbia for TerraSphere Canada. The term is five years and the Company has a right to extend for an additional five years. Future minimum payments under this lease are as follows:
 
         
2010
  $ 89,990  
2011
    89,990  
2012
    89,990  
2013
    89,990  
2014
    74,990  
         
Total
  $ 434,950  
         


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Rent expense incurred in connection with this lease was $14,998 for the year ended December 31, 2009.
 
MARKETING AGREEMENT
 
On May 18, 2007, TerraSphere Canada entered into a marketing agreement with the Squamish Nation to promote the TerraSphere System to other First Nations bands in Canada. The Squamish paid TerraSphere $200,000 Canadian dollars ($183,772 U.S.) to secure the rights to work with the First Nations bands across Canada through May 2012. This fee is being recognized as revenue over the term of the agreement (Note 9). Revenue recognized in connection with this agreement was $36,732, $36,732 and $21,427 for the years ended December 31, 2009, 2008 and 2007, respectively.
 
In addition, the agreement stipulates that Squamish will receive a fee of 10% of any license fee agreement executed between TerraSphere and a First Nations band. Squamish also has the right of first refusal to participate in an ownership interest of any venture formed pursuant to First Nation band license agreement. These rights must be executed no later than May, 2012.
 
NOTE 10 — SUBSEQUENT EVENTS
 
In connection with the preparation of the consolidated financial statements, management evaluated subsequent events after the balance sheet date of December 31, 2009 through June 3, 2010.
 
Subsequent to December 31, 2009, the Company entered into four exclusive licensing agreements totaling $3,800,000. As of the date the consolidated financial statements were issued, the Company has received installment payments of $760,000 with the remaining installments to be made on a quarterly basis through April 2011. In addition to the licensing fees, the agreements provide the Company royalty income of 3% — 6% of net sales.


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Table of Contents

 
TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED FINANCIAL STATEMENTS
 
AS OF MARCH 31, 2010 (UNAUDITED)
AND DECEMBER 31, 2009 (AUDITED)
AND FOR THE THREE MONTH PERIODS ENDED
MARCH 31, 2010 (UNAUDITED) AND MARCH 31, 2009 (UNAUDITED)
 


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TERRASPHERE SYSTEMS LLC
 
TABLE OF CONTENTS
 
         
    Page
 
CONSOLIDATED FINANCIAL STATEMENTS
       
    F-16  
    F-17  
    F-18  
    F-19  
    F-20  


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Table of Contents

TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED BALANCE SHEETS
 
                 
    March 31, 2010     December 31, 2009  
    (Unaudited)     (Audited)  
 
ASSETS
Current assets:
               
Cash
  $ 106,830     $ 197,046  
Accounts receivable
    950,000        
Other receivables
    52,796       15,244  
Inventories — work in process
          34,565  
Prepaid expenses
    53,725       42,100  
                 
Total current assets
    1,163,351       288,955  
Leasehold improvements, net
    158,819       161,948  
Patent and patent related costs, net
    148,259       134,932  
Pre-construction costs
    81,017        
Other assets
    5,886       5,692  
                 
Total assets
  $ 1,557,332     $ 591,527  
                 
 
LIABILITIES AND MEMBERS’ EQUITY (DEFICIT)
Current liabilities:
               
Note payable — member
  $ 20,000     $ 20,000  
Due to member
    164,351       102,292  
Accounts payable
    1,357,304       732,866  
Accrued expenses
    10,767       6,862  
Deferred tax liability
    388,000        
Deferred revenue
    434,584       763,767  
                 
Total current liabilities
    2,375,006       1,625,787  
                 
Members’ equity (deficit)
               
TerraSphere Systems LLC members’ equity (deficit)
               
Members’ equity (deficit)
    (667,616 )     (1,043,475 )
Accumulated other comprehensive loss
    (77,756 )     (42,254 )
                 
Total TerraSphere Systems LLC members’ equity (deficit)
    (745,372 )     (1,085,729 )
Noncontrolling interest
    (72,302 )     51,469  
                 
Total members’ equity (deficit)
    (817,674 )     (1,034,260 )
                 
Total liabilities and members’ equity (deficit)
  $ 1,557,332     $ 591,527  
                 
 
The accompanying notes are an integral part of these consolidated interim financial statements.


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Table of Contents

TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
 
                 
    Three Month Periods Ended  
    March 31, 2010     March 31, 2009  
    (Unaudited)  
 
Revenue
               
Sales
  $ 675,000     $  
Licensing and marketing fees
    1,009,183       9,183  
                 
      1,684,183       9,183  
Cost of goods sold
    703,301        
                 
Gross profit
    980,882       9,183  
Operating expenses
               
General and administrative expense
    436,998       226,684  
Amortization expense
    10,817       1,636  
                 
Income (loss) from operations
    533,067       (219,137 )
                 
Other income (expense)
               
Other income
          3,246  
Foreign currency gain (loss)
    17,190       (8,554 )
Interest expense
    (3,905 )     (474 )
                 
Total other income (expense)
    13,285       (5,782 )
                 
Net income (loss) before tax provision
    546,352       (224,919 )
Provision for income taxes
    388,000        
                 
Net income (loss)
    158,352       (224,919 )
Net loss attributable to noncontrolling interest
    (117,507 )     (16,932 )
                 
Net income (loss) attributable to TerraSphere Systems LLC before other comprehensive income (loss)
    275,859       (207,987 )
Other comprehensive income (loss):
               
Foreign currency translation adjustment
    (41,766 )     3,146  
                 
Comprehensive income (loss)
    234,093       (204,841 )
Comprehensive income (loss) attributable to noncontrolling interest
    (6,264 )     472  
                 
Comprehensive income (loss) attributable to TerraSphere Systems LLC
  $ 240,357     $ (205,313 )
                 
 
The accompanying notes are an integral part of these consolidated interim financial statements.


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TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED STATEMENT OF CHANGES IN MEMBERS’ EQUITY (DEFICIT)
FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2010
 
                                         
    TerraSphere Systems LLC              
          Accumulated
                   
          Other
                Members’ Equity
 
    Members’ Equity
    Comprehensive
          Noncontrolling
    (Deficit)
 
    (Deficit)     Loss     Total     Interest     Total  
    (Unaudited)  
 
Balance, December 31, 2009
  $ (1,043,475 )   $ (42,254 )   $ (1,085,729 )   $ 51,469     $ (1,034,260 )
Contributions
    100,000             100,000             100,000  
Foreign currency translation adjustment
          (35,502 )     (35,502 )     (6,264 )     (41,766 )
Net income (loss)
    275,859             275,859       (117,507 )     158,352  
                                         
Balance, March 31, 2010
  $ (667,616 )   $ (77,756 )   $ (745,372 )   $ (72,302 )   $ (817,674 )
                                         
 
The accompanying notes are an integral part of these consolidated interim financial statements.


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TERRASPHERE SYSTEMS LLC
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                 
    Three Month Periods Ended  
    March 31, 2010     March 31, 2009  
    (Unaudited)  
 
Cash flows from operating activities:
               
Net income (loss)
  $ 158,352     $ (224,919 )
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
               
Amortization of patents and patent related costs
    2,364       1,636  
Amortization of leasehold improvements
    8,453        
Deferred income taxes
    388,000        
Changes in operating assets and liabilities:
               
(Increase) decrease in:
               
Accounts receivable
    (950,000 )     400,000  
Other receivables
    (36,140 )     290  
Inventories
    34,565        
Prepaid expenses
    (11,625 )      
Other assets
          3,766  
Increase (decrease) in:
               
Accounts payable
    612,026       (60,921 )
Accrued expenses
    3,905       (5,681 )
Deferred revenue
    (329,183 )     (9,183 )
                 
Net cash (used in) provided by operating activities
    (119,283 )     104,988  
                 
Cash flows from investing activities:
               
Patent and patent related costs
    (15,691 )     (33,250 )
Pre-construction costs
    (81,017 )      
                 
Net cash used in investing activities
    (96,708 )     (33,250 )
                 
Cash flows from financing activities:
               
Member contributions
    100,000        
Advances from member
    62,059       9,100  
                 
Net cash provided by financing activities
    162,059       9,100  
                 
Effect of exchange rate changes on cash
    (36,284 )     2,885  
                 
(Decrease) increase in cash
    (90,216 )     83,723  
Cash, beginning of period
    197,046       8,083  
                 
Cash, end of period
  $ 106,830     $ 91,806  
                 
 
The accompanying notes are an integral part of these consolidated interim financial statements.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS
(UNAUDITED)
 
NOTE 1 — NATURE OF OPERATIONS
 
TerraSphere Systems LLC (“TerraSphere”), located in Boston, Massachusetts designs and builds highly efficient systems for growing organic fruits and vegetables in a controlled, indoor environment. The Company partners with private businesses and public institutions to create solutions for food production challenges. The Company derives its revenues from licensing fees and royalties, the sale of equipment and expects future revenue from operating facilities using the TerraSphere System. The TerraSphere System uses technology to operate automated, software driven plant growth systems that can be used to grow a variety of crops, from lettuce to tree seedlings to rare medicinal herbs. The Company is also pursuing a possible acquisition by another entity to further its mission of creating solutions to food production challenges.
 
PharmaSphere, LLC (“PharmaSphere”), located in Boston, Massachusetts, is a wholly-owned subsidiary of TerraSphere. PharmaSphere’s business plan is to utilize the TerraSphere System for the production of high value biocompounds sourced from plants and used as active pharmaceutical ingredients and for the production of transgenic plants (genetically engineered plants) for the biotechnology market. PharmaSphere has a wholly-owned subsidiary PharmaSphere Worcester, LLC, which was formed to build a facility in Worcester, Massachusetts utilizing PharmaSphere’s business plan. The building of the facility has not commenced. PharmaSphere has no revenue to date.
 
TerraSphere Systems Canada, Inc. (“TerraSphere Canada”), located in Vancouver, British Columbia, operates the research and manufacturing facility for TerraSphere and is eighty-five percent owned by TerraSphere.
 
NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
CONSOLIDATION
 
The accompanying consolidated financial statements include the transactions and balances of TerraSphere System LLC and its wholly-owned subsidiary, PharmaSphere, LLC. The assets, liabilities and results of operations of TerraSphere Systems Canada, Inc. are included in the consolidated financial statements with appropriate recognition of noncontrolling interest. All intercompany transactions and balances have been eliminated in consolidation.
 
CODIFICATION
 
Effective July 1, 2009, the Financial Accounting Standard Board’s (“FASB”) Accounting Standards Codification (“ASC”) became the single official source of authoritative, non-governmental U.S. generally accepted accounting principles (“GAAP”). The historical GAAP hierarchy was eliminated and the ASC became the only level of authoritative GAAP. The Company’s accounting policies were not affected by the conversion to ASC.
 
FOREIGN OPERATIONS
 
The accounting records of TerraSphere Canada are maintained in Canadian dollars, its functional currency. Revenue and expense transactions are translated to U.S. dollars using the average exchange rate of the month in which the transaction took place. Assets and liabilities are translated to U.S. dollars using the exchange rate in effect as of the balance sheet date. Equity transactions are translated to U.S. dollars using the exchange rate in effect as of the date of the equity transaction. Translation gains and losses are reported as a component of accumulated other comprehensive income or loss. Gains and losses resulting from transactions which are denominated in other than the functional currencies are reported as foreign currency exchanges gain (loss) in the statements of operations and comprehensive income (loss) in the period the gain or loss occurred.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
USE OF ESTIMATES
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and disclosures in the consolidated financial statements. Actual results could differ from those estimates.
 
ACCOUNTS RECEIVABLE
 
Accounts receivable represent balances due from customers, net of applicable reserves for doubtful accounts. In determining the need for an allowance, objective evidence that a single receivable is uncollectible, as well as historical collection patterns for accounts receivable are considered at each balance sheet date. At March 31, 2010 and December 31, 2009, the Company has determined that an allowance for doubtful accounts is not deemed necessary.
 
INVENTORIES
 
Inventories are valued at the lower of cost or market, with cost determined by the first in, first out method. Inventories consisted of the work-in-process related to twelve TerraSphere System units at December 31, 2009. There were no inventory reserves at March 31, 2010 or December 31, 2009.
 
LEASEHOLD IMPROVEMENTS
 
Leasehold improvements are carried at cost and are amortized over their estimated service life or the remaining term of the related lease, whichever is shorter. Amortization expense incurred for the three month periods ended March 31, 2010 and 2009 was $8,453 and $-0-, respectively.
 
PATENT AND PATENT RELATED COSTS
 
The Company accounts for its patent and patent related costs in accordance with ASC 250, which requires that intangible assets with finite lives, such as the Company’s specifically identifiable costs for patent and patent applications, be capitalized and amortized over their respective estimated lives and reviewed for impairment whenever events or other changes in circumstances indicate that the carrying amount may not be recoverable.
 
PRE-CONSTRUCTION COSTS
 
Pre-construction costs include architectural and engineering services related to the building of the PharmaSphere facility.
 
REVENUE RECOGNITION
 
Revenue is recognized when all of the following criteria are met:
 
  •  Persuasive evidence of a sales arrangement exists;
 
  •  Delivery of the product has occurred;
 
  •  The sales price is fixed or determinable, and;
 
  •  Collectability is reasonably assured.
 
In those cases where all four criteria are not met, the Company defers recognition of revenue until the period these criteria are satisfied. Revenue is generally recognized upon shipment or upon completed


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
performance on exclusive technology licenses where the term is equal to the life of the associated intellectual property.
 
The Company recognizes deferred revenue when payment has been received for product sales but the revenue recognition criteria have not been met. In addition, the Company defers revenue when payment has been received for future services to be provided.
 
INCOME TAXES
 
No provision for income taxes is recognized for the period from January 1, 2010 through February 21, 2010 because the Company is a limited liability company. In lieu of federal and state income taxes, all income, losses, deductions and credits pass through to the members for them to report on their personal returns.
 
The Company elected to be treated as a taxable association effective February 22, 2010 for United States federal and state tax purposes (Note 11). The Company accounts for income taxes following the asset and liability method in accordance with ASC 740. Under such method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years that the asset is expected to be recovered or the liability settled.
 
Management has performed an evaluation of the Company’s tax positions, ensuring that these tax return positions meet the “more likely than not” recognition threshold and can be measured with sufficient precision. These evaluations provide management with a comprehensive model for how the Company should recognize, measure, present and disclose in its financial statements certain tax positions that the Company has taken or expects to take on income tax returns. Based upon these evaluations, management has concluded that the Company has no uncertain tax positions that qualify for either recognition or disclosure in the financial statements as of March 31, 2010. See Note 9 for additional information.
 
RESEARCH AND DEVELOPMENT
 
Research and development costs are charged to operations as incurred. There were no research and development costs incurred for the three month periods ended March 31, 2010 and 2009.
 
FAIR VALUE MEASUREMENTS
 
The Company applies FASB ASC 820, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. FASB ASC 820 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.
 
FASB ASC 820 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB ASC 820 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
 
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
 
NOTE 3 — CONCENTRATION OF CREDIT RISK
 
The Company’s financial instruments that are exposed to a concentration of credit risk are cash and accounts receivable.
 
Cash — The Company places its cash deposits with credit worthy banking institutions in the United States and Canada which are continually reviewed by management. From time to time, the bank balances of the Company’s cash may exceed current United States and Canadian insured limits. The Company, however, has not experienced any losses in this area and management believes its cash deposits are not subject to significant credit risk. At March 31, 2010 and December 31, 2009, the Company’s did not have cash balances on deposit that exceeded United States and Canadian federal depository insurance limits.
 
Accounts receivable — One customer accounted for one hundred percent of the Company’s accounts receivable at March 31, 2010. Two customers accounted for one-hundred percent of sales for the three month period ended March 31, 2010.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
NOTE 4 — PATENT AND PATENT RELATED COSTS
 
The following reflects the Company’s patent and patent related costs at:
 
                 
    March 31, 2010     December 31, 2009  
 
Carousel with spheres patent
  $ 32,407     $ 32,407  
Carousel with arcuate ribs patent
    9,666       9,666  
Rotatable carousel with arcuate ribs patent
    13,582       13,582  
Carousel with spheres application (Canadian)
    10,259       7,199  
Carousel with spheres application (Canadian)
    6,711       5,836  
Carousel with spheres application (European)
    21,024       19,001  
Carousel with spheres application (Chinese)
    10,391       10,391  
Carousel with spheres application (Hong Kong)
    1,461       1,461  
Carousel with spheres application (Japanese)
    14,901       14,901  
Rotatable carousel with arcuate ribs application
    8,514       8,514  
Rotatable carousel with drum-like members (Canadian)
    4,760       4,760  
Rotatable carousel with drum-like members application
    5,267       5,267  
Carousel with spheres application
    10,040       10,040  
Tray apparatus costs
    5,780       5,780  
Collapsible stack costs
    6,140       6,140  
Marchildon costs
    2,338       2,338  
Apparatus for growing plants costs
    9,733        
                 
Total
    172,974       157,283  
Accumulated amortization
    24,715       22,351  
                 
Total, net amortization
  $ 148,259     $ 134,932  
                 
 
Amortization expense for the three month periods ended March 31, 2010 and 2009 was $2,364, and $1,636, respectively.
 
Aggregate expected amortization expense is expected to be as follows in the years ending December 31:
 
         
2010
  $ 5,576  
2011
    7,940  
2012
    7,940  
2013
    7,940  
2014
    7,940  
Thereafter
    110,923  
         
Total
  $ 148,259  
         
 
NOTE 5 — NOTES PAYABLE
 
On May 29, 2009, the Company issued an unsecured note payable to a member in the amount of $20,000, with a fixed interest rate of 10% per annum, maturing July 29, 2009. The Company is in default of the note and the member has not called the note as of March 31, 2010. The principal due as of March 31, 2010 is $20,000. The Company has accrued interest totaling $1,682 and $1,189 as of March 31, 2010 and December 31, 2010, respectively and incurred $493 in interest expense for the three months ended March 31, 2010.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
NOTE 6 — DUE TO MEMBER
 
During the year ended December 31, 2009, a member provided an advance to the Company for working capital with an interest rate of 10% per annum. The amount due to the member at March 31, 2010 and December 31, 2009 is $164,351 and $102,292, respectively. The Company has accrued interest totaling $9,085 and $5,673 as of March 31, 2010 and December 31, 2009, respectively and incurred $3,412 and $474 in interest for the three month periods ended March 31, 2010 and 2009, respectively.
 
NOTE 7 — DEFERRED REVENUE
 
The Company has recorded deferred revenue of $434,584 and $763,767 at March 31, 2010 and December 31, 2009, respectively.
 
On May 18, 2007, TerraSphere Canada entered into a marketing agreement with the Squamish Nation (“Squamish”) to promote the TerraSphere System to other First Nations bands in Canada for $200,000 Canadian dollars ($183,772 U.S.). The Company is recognizing the marketing fee over the term of the agreement (See Note 10). At March 31, 2010 and December 31, 2009, deferred revenue associated with this agreement is approximately $80,000 and $89,000, respectively.
 
The Company has also deferred the recognition of licensing fee deposits totaling $355,000 at March 31, 2010 as a result of the revenue recognition criteria not being met.
 
The Company had deferred a $675,000 payment from the Squamish received in December 2009 relating to twelve TerraSphere System units which were delivered during the three month period ended March 31, 2010. Accordingly, the associated revenue was recognized during the same period.
 
NOTE 8 — LICENSING FEES
 
The Company has developed a system of modules and processes for growing plants in a controlled environment. The system uses and controls precise combinations of light, water, nutrition, gravity, centrifugal forces, and gasses to produce growing conditions that can be controlled and manipulated to result in desired plant growth and maximum crop production (the “Growth System”). The Company has granted exclusive licenses to use the Growth System for the remaining term of the associated patents in accordance to the license agreement. Revenue recognized in connection with these license agreements was $1,000,000 for the three months ended March 31, 2010 as the Company has determined the revenue recognition criteria have been met.
 
NOTE 9 — INCOME TAXES
 
The Company elected to be treated as a taxable association effective February 22, 2010 (Note 2 and Note 11).
 
Income taxes for United States federal and state tax purposes for the three month period ended March 31, 2010 consisted of the following:
 
         
Current
  $  
Deferred
    388,000  
         
    $ 388,000  
         
 
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts used for income tax purposes on the cash basis of accounting and amounts of assets and liabilities for financial reporting purposes. The principal sources of these differences include the carrying value of accounts


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
receivable, accounts payable and deferred revenue for financial statement purposes which are not recognized for income tax purposes.
 
Principal components of the Company’s net deferred tax liability at March 31, 2010 are as follows:
 
         
Accounts receivable
  $ 361,000  
Accounts payable
    (78,000 )
Deferred revenue
    121,000  
Amortization expense
    (16,000 )
         
    $ 388,000  
         
 
The effective tax rate based on the federal and state statutory rates is reconciled to the actual tax rate for the three month period ended March 31, 2010 as follows:
 
         
Federal and state statutory income tax rates
    34 %
Increase (decrease) resulting from:
       
Exclusion of net loss incurred in period prior to corporate tax election
    (13 )%
Exclusion of net loss in foreign subsidiary
    (21 )%
Effect of conversion from accrual to cash basis of accounting for income tax
    71 %
         
Effective tax rate
    71 %
         
 
NOTE 10 — COMMITMENTS AND CONTINGENCIES
 
LEASE
 
On September 30, 2009, the Company entered into an operating lease agreement to begin November 1, 2009 for warehouse space in Vancouver, British Columbia for TerraSphere Canada. The term is five years and the Company has a right to extend for an additional five years. Future minimum payments under this lease are as follows:
 
         
2010 (April 1, 2010 through December 31, 2010)
  $ 67,500  
2011
    89,990  
2012
    89,990  
2013
    89,990  
2014
    74,990  
         
Total
  $ 412,460  
         
 
Rent expense incurred in connection with this lease was $22,500 for the three months ended March 31, 2010.
 
MARKETING AGREEMENT
 
On May 18, 2007, TerraSphere Canada entered into a marketing agreement with the Squamish Nation to promote the TerraSphere System to other First Nations bands in Canada. The Squamish paid TerraSphere $200,000 Canadian dollars ($183,772 U.S.) to secure the rights to work with the First Nations bands across Canada through May 2012. This fee is being recognized as revenue over the term of the agreement (Note 7). Revenue recognized in connection with this agreement was $9,183 for the three months ended March 31, 2010 and 2009.


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TERRASPHERE SYSTEMS LLC
 
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)
 
In addition, the agreement stipulates that Squamish will receive a fee of 10% of any license fee agreement executed between TerraSphere and a First Nations band. Squamish also has the right of first refusal to participate in an ownership interest of any venture formed pursuant to the First Nation band license agreement. These rights must be executed no later than May 2012.
 
NOTE 11 — SUBSEQUENT EVENTS
 
In connection with the preparation of the consolidated financial statements, management evaluated subsequent events after the balance sheet date of March 31, 2010 through June 15, 2010.
 
Subsequent to March 31, 2010, the Company entered into exclusive licensing agreements totaling $2,800,000. The Company deferred the receipt of licensing fee deposits totaling $355,000 related to these agreements at March 31, 2010. In addition to the licensing fees, the agreements provide the Company royalty income of 3% — 5% of net sales.
 
On May 5, 2010, the Company elected to be treated as a taxable association effective February 22, 2010 utilizing the seventy five day retroactive option.


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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS
 
Introduction
 
On July 6, 2010, Converted Organics Inc. (the “Company”) and its wholly-owned subsidiary TerraSphere Inc. entered into a membership interest purchase agreement (“Agreement”) with TerraSphere Systems LLC to acquire 100% of the membership interests in TerraSphere Systems LLC (“TerraSphere”) subject to, among other items, the Company’s shareholder approval. This acquisition enables the Company to license TerraSphere’s patented Growth System, which is a system of modules and processes for growing plants in a controlled environment. The system uses and controls precise combinations of light, water, nutrition, gravity, centrifugal forces, and gasses to produce growing conditions that can be controlled and manipulated to result in desired plant growth and maximum crop production.
 
Terms
 
The Agreement allows for an election by TerraSphere members to accept 1) a purchase price of $21,000,000 of Company common stock upon closing of the transaction (with a 6 month holding period) (“Option One”) or 2) a purchase price of $12,000,000 of Company common stock upon closing of the transaction with an option to earn an additional $16,000,000 in contingent consideration based upon TerraSphere achieving certain milestones and agreeing to an 18 month holding period on stock distributed to them (“Option Two”). Based on 31% of TerraSphere members’ electing Option One and 69% electing Option Two, the maximum total purchase price is $25,830,000 payable in the Company’s common stock valued at $0.756 per share. Per the Agreement, TerraSphere members who elected Option One will receive $6,510,000 upon closing and members electing Option Two will receive $8,280,000 upon closing and up to an additional $11,040,000 based on achieving the defined milestones (contingent consideration).
 
Milestone One Payment:  $3,450,000 of Company common stock, if, and only if, between the date of the Agreement and the 90th day following the closing date or the 180th day following the date of the Agreement, the following occurs (such shares to be payable within ten (10) business days of achievement of the following or the closing date, whichever is later): For a period of five (5) consecutive trading days, the Company’s market capitalization exceeds the sum of: (1) the Company’s initial market capitalization on the date of execution of the Agreement, plus (2) the closing price per share, or $0.756, multiplied by the number of shares of Company common stock to be issued at closing pursuant to the Agreement, and, if such calculation is being made prior to the closing date, including this Milestone One. If between the date of the Agreement and the 90th day following the closing date or the 180th day following the date of the Agreement, the Company completes an equity financing, the cash received from the equity financing during such period shall be added to the market capitalization. If between the closing date and December 31, 2011, the Buyer sells equity of either the Company or any of the Company’s subsidiaries, any cash received from such equity sales during such period shall be added to the market capitalization;
 
Milestone Two Payment:  $1,380,000 of Company common stock, if, and only if, $2,000,000 of TerraSphere’s accounts receivable as of the date of the Agreement are received prior to February 28, 2011;
 
Milestone Three Payment:  $3,450,000 of Company common stock, if, and only if, the Company generates gross margin of $6,000,000 (gross margin target) from its operations during the period commencing as of the date of the Agreement and ending on December 31, 2011; provided that, if the Company generates gross margin of at least $4,200,000 (gross margin threshold) from its operations during such period, the Sellers shall be entitled to a pro rata portion of the Company common stock; and
 
Milestone Four Payment:  $2,760,000 of Company common stock, if, and only if, the Company generates gross margin of $4,000,000 from its operations during any six-month period commencing on the Agreement date and ending on December 31, 2012; provided that, if the Company achieves the Milestone Three gross margin threshold, but does not achieve the Milestone Three gross margin target, 83.3% of the difference between the Milestone Three gross margin target and the actual gross margins achieved pursuant to the Agreement (the “Milestone Three Deficiency”) may be added by the Sellers to the Milestone Four Payment and the Milestone Four gross margin target. Notwithstanding anything to the contrary herein, the total


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amounts payable pursuant to the Milestone Three Payment and Milestone Four Payment shall be no more than $6,210,000 of Company common stock.
 
The Company used the following assumptions to calculate fair value of the contingent consideration:
 
Milestone One:  The acquisition of TerraSphere will diversify the Company’s base while still sustaining business practices that protect and value the environment, current customers, colleagues, and shareholders. The likelihood of meeting this milestone is largely dependent on the state of the U.S. economy and future market conditions, both of which are uncertain and unpredictable. If the U.S. economy becomes stagnant or the market conditions are not favorable for investors, the Company may not achieve this milestone. Based on the uncertainty of the U.S. economy and the unpredictability of the market over the next 6-12 months, the Company has estimated that the likelihood of achieving this milestone is 75% and, as such, has determined that the fair value of this contingent payment is $2,588,000.
 
Milestone Two:  The Company has reviewed the customers’ credit worthiness and ability to make the required installment payments. Based on this information, the Company has estimated that the likelihood of achieving this milestone is 95% and, as such, has determined that the fair value of this contingent payment is $1,311,000.
 
Milestones Three and Four:  The Company has evaluated milestones three and four together as they can be achieved over the same milestone period. The Company has reviewed TerraSphere’s operating estimates and historical data and believes these milestones are achievable. TerraSphere’s plans are based on the U.S. economy continuing to grow at a steady rate, investors investing in new technology and market acceptance of the Growth System technology. If the U.S. economy becomes stagnant or the market conditions are not favorable or the technology is not well received during the milestone periods, the Company may not achieve the milestones. Based on the uncertainty of the U.S. economy and the unpredictability of the market over the next 36 months, the Company has estimated that the likelihood of achieving milestones three and four is 50% and as such, has determined that the fair value of these contingent payments is $3,105,000.
 
The estimated purchase price at fair value is as follows:
 
         
Election of Option One
  $ 6,510,000  
Election of Option Two
    8,280,000  
Milestone one payment
    2,588,000  
Milestone two payment
    1,311,000  
Milestones three and four payments
    3,105,000  
         
    $ 21,794,000  
         
 
The following unaudited pro forma consolidated financial information gives effect to the Company acquiring 100% of the membership interests in TerraSphere Systems, LLC and should be read in conjunction with the Company’s Form 8-K dated July 6, 2010 and filed on July 7, 2010, the historical financial statements and the related notes of Converted Organics Inc., which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, the quarterly financial statements and the related notes of Converted Organics, Inc., which are included in the Company’s Form 8-K as of March 31, 2010, the TerraSphere Systems, LLC financial statements which are included in this proxy statement.
 
The unaudited pro forma consolidated balance sheet as of March 31, 2010 gives effect to the acquisition of TerraSphere Systems, LLC transaction as if it had occurred on March 31, 2010, and the unaudited pro forma consolidated statements of operations and comprehensive income (loss) for the year ended December 31, 2009 and for the three month period ended March 31, 2010 give effect to the acquisition as if it had occurred on January 1, 2009.


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The unaudited pro forma consolidated financial statements include all material pro forma adjustments necessary for their preparation, as required by Article 11 of Regulation S-X and, accordingly, do not assume any benefits from cost savings or synergies of operations.
 
The pro forma adjustments are based upon available information and certain assumptions that the Company believes are reasonable. The unaudited pro forma consolidated financial statements do not purport to represent what the Company’s financial condition or results of operations would actually have been had these transactions in fact occurred as of the dates indicated above or to project the Company’s results of operations for the period indicated or for any other period.
 
Changes in the fair value of contingent consideration that the Company recognizes after the acquisition date may be the result of additional information about facts and circumstances that existed at the acquisition date that the Company obtained after that date. Such changes are considered to be measurement period adjustments and would adjust the purchase price for changes within one year from the acquisition date. Contingent consideration classified as an asset or a liability that exceed a year from the acquisition date is remeasured at fair value and recognized in earnings.


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CONVERTED ORGANICS INC.
 
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET
AS OF MARCH 31, 2010
 
                                 
    Historical     Pro
          Pro
 
    Converted Organics
    Forma
          Forma
 
    Inc. and Subsidiaries     Adjustments     Reference     Consolidated  
 
ASSETS
CURRENT ASSETS
                               
Cash and cash equivalents
  $ 4,113,359     $ 106,830       (1 )   $ 4,220,189  
Restricted cash
    233,316                     233,316  
Accounts receivable, net
    495,450       950,000       (1 )     1,445,450  
Inventories
    371,301                     371,301  
Prepaid rent
    641,781                     641,781  
Other prepaid expenses
    624,319       106,521       (1 )     730,840  
                                 
Total current assets
    6,479,526       1,163,351               7,642,877  
                                 
Deposits
    800,419       5,886       (1 )     806,305  
Restricted cash
    29,769                     29,769  
Other assets
    166,667                     166,667  
Property and equipment, net
    18,382,828       158,819       (1 )     18,541,647  
Construction-in-progress
    328,637       81,017       (1 )     409,654  
Capitalized bond costs, net
    802,424                     802,424  
Intangible assets, net
    1,923,617       10,000,000       (1 )     11,923,617  
Goodwill
          12,370,000       (1 )     12,370,000  
                                 
Total assets
  $ 28,913,887     $ 23,779,073             $ 52,692,960  
                                 
 
LIABILITIES AND OWNERS’ EQUITY (DEFICIT)
CURRENT LIABILITIES
                               
Term notes payable — current
  $ 1,812,764     $ 184,351       (1 )   $ 1,997,115  
Accounts payable
    1,150,770       1,353,304       (1 )     2,504,074  
Accrued compensation, officers, directors and consultants
    455,218                     455,218  
Accrued legal and other expenses
    708,095       12,834       (1 )     720,929  
Accrued interest
    249,191                     249,191  
Deferred revenue
          434,584       (1 )     434,584  
Convertible notes payable, net of unamortized discount
    286,450                     286,450  
Capital lease obligations — current
    12,069                     12,069  
                                 
Total current liabilities
    4,674,557       1,985,073               6,659,630  
                                 
Capital lease obligation, net of current portion
    25,654                     25,654  
Term notes payable, net of current portion
    509,833                     509,833  
Derivative liabilities
    2,261,897                     2,261,897  
Bonds payable
    17,500,000                     17,500,000  
                                 
Total liabilities
    24,971,941       1,985,073               26,957,014  
                                 
COMMITMENTS AND CONTINGENCIES
                         
OWNERS’ EQUITY (DEFICIT)
                               
Preferred stock, $.0001 par value, authorized
                               
10,000,000 shares; no shares issued and outstanding
                         
Common stock, $.0001 par value, authorized 75,000,000 shares
    3,802       1,852       (1 )     5,654  
Additional paid-in capital
    60,209,902       21,792,148       (1 )     82,002,050  
Accumulated deficit
    (56,271,758 )                   (56,271,758 )
                                 
Total owners’ equity
    3,941,946       21,794,000               25,735,946  
                                 
Total liabilities and owners’ equity
  $ 28,913,887     $ 23,779,073             $ 52,692,960  
                                 
 
The accompanying notes are an integral part of these unaudited pro forma consolidated financial statements.


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CONVERTED ORGANICS INC.

UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
FOR THE THREE MONTH PERIOD ENDED MARCH 31, 2010
 
                                 
    Historical                  
    Converted Organics
    Pro Forma
        Pro Forma
 
    Inc. and Subsidiaries     Adjustments     Reference   Consolidated  
 
Revenues
  $ 859,826     $ 1,684,183       (2)     $ 2,544,009  
Cost of good sold
    1,966,101       703,301       (2)       2,669,402  
                             
Gross loss
    (1,106,275 )     980,882               (125,393 )
Operating expenses
                               
General and administrative expenses
    4,089,501       436,998       (2)       4,526,499  
Research and development
    64,059             (2)       64,059  
Depreciation expense
    2,819                     2,819  
Amortization of capitalized costs
    75,371       177,484       (2),(3)       252,855  
Amortization of license
    8,548                     8,548  
                             
Loss from operations
    (5,346,573 )     366,400               (4,980,173 )
                             
Other income/(expenses)
                               
Interest income
    281                     281  
Derivative gain/(loss)
    (635,155 )                   (635,155 )
Other income
          17,190       (2)       17,190  
Interest expense
    (398,246 )     (3,905 )     (2)       (402,151 )
                             
      (1,033,120 )     13,285               (1,019,835 )
                             
Loss before provision for income taxes
    (6,379,693 )     379,685               (6,000,008 )
Provision for income taxes
                         
                             
Net loss
    (6,379,693 )     379,685               (6,000,008 )
Net income (loss) attributable to noncontrolling interest
          (117,507 )     (2)       (117,507 )
                             
Net income (loss) attributable to Converted Organics Inc. before other comprehensive income (loss)
    (6,379,693 )     497,192               (5,882,501 )
Other comprehensive income (loss):
                               
Foreign currency translation adjustment
          (41,766 )     (2)       (41,766 )
                             
Comprehensive income (loss)
    (6,379,693 )     455,426               (5,924,267 )
Comprehensive income (loss) attributable to noncontrolling interest
          (6,264 )     (2)       (6,264 )
                             
Comprehensive income (loss) attributable to Converted Organics Inc. 
  $ (6,379,693 )   $ 461,690             $ (5,918,003 )
                             
Net loss per share, basic and diluted
  $ (0.17 )             (4)     $ (0.10 )
                             
Weighted average common shares outstanding
    37,864,169               (4)       56,389,068  
                             
 
The accompanying notes are an integral part of these unaudited pro forma consolidated financial statements.


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CONVERTED ORGANICS INC.

UNAUDITED PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS)
FOR THE YEAR ENDED DECEMBER 31, 2009
 
                                 
    Historical                  
    Converted Organics
    Pro Forma
        Pro Forma
 
    Inc. and Subsidiaries     Adjustments     Reference   Consolidated  
 
Revenues
  $ 2,633,782     $ 36,732       (2)     $ 2,670,514  
Cost of good sold
    6,914,857                     6,914,857  
                             
Gross loss
    (4,281,075 )     36,732               (4,244,343 )
Operating expenses
                               
General and administrative expenses
    10,049,830       1,291,586       (2)       11,341,416  
Research and development
    637,142       613       (2)       637,755  
Depreciation expense
    723,846                     723,846  
Amortization of capitalized costs
    357,718       673,050       (2),(3)       1,030,768  
Amortization of license
    16,500                     16,500  
                             
Loss from operations
    (16,066,111 )     (1,928,517 )             (17,994,628 )
                             
Other income/(expenses)
                               
Interest income
    24,097                     24,097  
Loss on impairment of long-term assets
    (3,928,129 )                   (3,928,129 )
Derivative gain/(loss)
    5,766,035                     5,766,035  
Other income
    68,995       55,114       (2)       124,109  
Interest expense
    (6,970,675 )     (9,218 )     (2)       (6,979,893 )
                             
      (5,039,677 )     45,896               (4,993,781 )
                             
Loss before provision for income taxes
    (21,105,788 )     (1,882,621 )             (22,988,409 )
Provision for income taxes
                         
                             
Net loss
    (21,105,788 )     (1,882,621 )             (22,988,409 )
Net income (loss) attributable to noncontrolling interest
          74,934       (2)       74,934  
                             
Net income (loss) attributable to Converted Organics Inc. before other comprehensive income (loss)
    (21,105,788 )     (1,957,555 )             (23,063,343 )
Other comprehensive income (loss):
                               
Foreign currency translation adjustment
          (57,491 )     (2)       (57,491 )
                             
Comprehensive income (loss)
    (21,105,788 )     (2,015,046 )             (23,120,834 )
Comprehensive income (loss) attributable to noncontrolling interest
          (8,623 )     (2)       (8,623 )
                             
Comprehensive income (loss) attributable to Converted Organics Inc. 
  $ (21,105,788 )   $ (2,006,423 )           $ (23,112,211 )
                             
Net loss per share, basic and diluted
  $ (1.08 )             (4)     $ (0.61 )
                             
Weighted average common shares outstanding
    19,569,853               (4)       38,114,781  
                             
 
The accompanying notes are an integral part of these unaudited pro forma consolidated financial statements.


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CONVERTED ORGANICS INC.
 
NOTES TO UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS
 
The following numbered notes are referenced on the Unaudited Pro Forma Consolidated Balance Sheet and Statements of Operations and Comprehensive Income (Loss).
 
(1)  The Company purchased 100% of the membership interests in TerraSphere Systems, LLC, for consideration and contingent consideration with an estimated fair value of $21,794,000 all consideration is to be paid in the Company’s common stock.
 
The estimated purchase price has been allocated to the assets and liabilities on a preliminary basis using estimated fair value information currently available. The allocation of the purchase price to the assets and liabilities will be finalized within a year as the Company obtains more information regarding asset valuations, liabilities assumed, contingent consideration and revisions of preliminary estimates of fair value made as the date of purchase. The preliminary purchase price allocation is as follows:
 
         
Cash and cash equivalents
  $ 106,830  
Accounts receivable
    950,000  
Other assets
    112,407  
Leasehold improvements
    158,819  
Construction-in-process
    81,017  
Goodwill
    12,370,000  
Patents and patent related costs
    10,000,000  
Assumption of liabilities
    (1,985,073 )
         
Total allocation of purchase price(*)
  $ 21,794,000  
         
 
The Company plans to amortize the leasehold improvements over their estimated service lives or the remaining terms of the related leases, whichever are shorter. Patents and patent related costs will be amortized over the 15 year remaining life of the patents.
 
(*) The purchase price of $21,794,000 is an estimate based on the assumptions listed in the “Unaudited Pro Forma Condensed Combined Financial Statements” section of this document. Actual results could vary significantly from this estimate. Any adjustments within one year would adjust the purchase price. Adjustments after one year of the acquisition date are remeasured to fair value at each reporting date until the contingency is resolved and the changes in fair value are recognized in earnings in accordance with ASC 805 “Business Combinations”.
 
(2) The operations of TerraSphere Systems, LLC are consolidated with the operations of Converted Organics Inc. assuming that the transaction was completed on January 1, 2009.
 
(3) Amortization expense related to the fair value assigned to the patent and patent related costs.
 
(4) Earnings per share has been recalculated to reflect the number of common stock shares issued in acquiring TerraSphere.


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Annex A
 
MEMBERSHIP INTEREST PURCHASE AGREEMENT
 
by and among
 
CONVERTED ORGANICS INC.
a Delaware corporation,
 
TERRASPHERE INC.
a Delaware corporation,
 
TERRASPHERE SYSTEMS LLC
a Massachusetts limited liability company
 
and
 
The individuals set forth on Exhibit A
 
Dated: July 6, 2010
 


Table of Contents

MEMBERSHIP INTEREST PURCHASE AGREEMENT
 
THIS MEMBERSHIP INTEREST PURCHASE AGREEMENT (this “Agreement”) is entered into on this 6th day of July, 2010, by and among CONVERTED ORGANICS INC., a Delaware corporation (“Parent”), TERRASPHERE INC., a Delaware corporation (“Buyer”), TERRASPHERE SYSTEMS LLC, a Massachusetts limited liability company (the “Company”) and the individuals owners of the Company set forth on Exhibit A hereto (each a “Seller” and collectively, the “Sellers”). For purposes of Articles II and XII, the Sellers listed on Schedule A are referred to as “Controlling Sellers.”
 
W I T N E S S E T H:
 
WHEREAS, Sellers collectively own one hundred percent (100%) of the outstanding membership interests of the Company (the “Units”);
 
WHEREAS, Buyer is a newly formed entity which is wholly-owned by Parent;
 
WHEREAS, Buyer desires to purchase all of the Units from Sellers, and Sellers and the Company desire to sell all of the Units, all on the terms and subject to the conditions set forth in this Agreement (the “Purchase Transaction”);
 
WHEREAS, Parent, Buyer and Company desire to adopt a plan of reorganization within the meaning of Section 368(a) of the Code, as set forth hereinafter, and intend that the Purchase Transaction described hereinafter constitutes a B Reorganization within the meaning of Section 368 (a)(1)(b) of the Code.
 
NOW, THEREFORE, in consideration of the foregoing and the mutual promises and covenants hereinafter set forth, the parties hereto, intending to be legally bound, hereby agree as follows:
 
Article I
 
THE TRANSACTION
 
Section 1.1  The Closing.  Subject to the terms and conditions of this Agreement, at the Closing (as hereinafter defined):
 
(a) The Sellers shall collectively convey, assign, transfer and deliver to Buyer one hundred percent (100%) of the Units, and Buyer shall purchase from Sellers, all of Sellers’ right, title and interest in and to the Units, free and clear of all Liens.
 
(b) The Units shall be made up of all of the Units owned by each Seller.
 
(c) The purchase price for the Units (the “Purchase Price”) shall be, at the option of each Seller, in the form of either:
 
(i) on the Closing Date, such Seller’s pro rata portion of $21,000,000 worth of the common stock of Parent (“Parent Common Stock”), valued at the price which is the average closing price for Parent Common Stock over the fifteen (15) Trading Day period preceding the date of the execution of this Agreement (the “Closing Price Per Share”) (the Parent Common Stock to be issued pursuant to this Section 1.1(c)(i) are referred to as the “Option One Shares”); or
 
(ii) such Seller’s pro rata portion of Parent Common Stock, valued at the Closing Price Per Share, in accordance with the following schedule (the Parent Common Stock to be issued pursuant to this Section 1.1(c)(ii), including the Milestone Payments, are referred to as the “Option Two Shares”):
 
(1) on the Closing Date, $12,000,000 of Parent Common Stock;
 
(2) $5,000,000 of Parent Common Stock (“Milestone One Payment”), if, and only if, between the date hereof and the earlier of the 90th day following the Closing Date or the