================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------- FORM 10-KSB -------------- [X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended: December 31, 2007 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from: _____________ to _____________ -------------- PURADYN FILTER TECHNOLOGIES INCORPORATED ---------------------------------------------- (Name of small business issuer in its charter) -------------- Delaware 0-29192 14-1708544 ---------------------------- ------------ ------------------- (State or Other Jurisdiction (Commission (I.R.S. Employer of Incorporation) File Number) Identification No.) 2017 High Ridge Road, Boynton Beach, Florida 33426 -------------------------------------------------- (Address of Principal Executive Office) (Zip Code) (561) 547-9499 ---------------------------------------------------- (Registrant's telephone number, including area code) N/A ------------------------------------------------------------- (Former name or former address, if changed since last report) -------------- SECURITIES REGISTERED PURSUANT TO SECTION 12(B)OF THE ACT: TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------------- NONE NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common stock, par value $.001 per share -------------------------------------------------------------------------------- (Title of Class) -------------- Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] State issuer's revenue for its most recent fiscal year. $3,082,873. State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, or the average bid and asked price of such common equity, as of a specified date within the past 60 days. The aggregate market value of the voting stock held by non-affiliates computed at the closing price of $.31 Puradyn Filter's common stock on March 25, 2008 is approximately $3,540,991. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of March 27, 2008, there were 31,786,352 shares of registrant's common stock outstanding, par value $.001. ================================================================================ INDEX PART I ITEM 1. DESCRIPTION OF BUSINESS........................................... 3 Forward Looking Statements The Company Products Warranties Marketing Distribution Sales Manufacturing and Production Competition Intellectual Property Governmental Approval Engineering and Development Employees ITEM 2. DESCRIPTION OF PROPERTY........................................... 9 ITEM 3. LEGAL PROCEEDINGS................................................. 9 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 9 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES.............. 10 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS........ 11 General Critical Accounting Policies and Estimates Results of Operations Liquidity and Capital Resources Impact of Inflation Quarterly Fluctuations Risk Factors Affecting Future Results of Operations ITEM 7. FINANCIAL STATEMENTS.............................................. 18 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES............................................. 18 ITEM 8A(T)CONTROLS AND PROCEDURES.......................................... 18 ITEM 8B. OTHER INFORMATION................................................. 19 PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT................. 20 ITEM 10. EXECUTIVE COMPENSATION............................................ 24 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER TRANSACTIONS............... 27 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE......................................... 28 ITEM 13. EXHIBITS.......................................................... 29 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES............................ 30 2 PART I The term "the Company", "Puradyn", "we", "us" or "our" refers to Puradyn Filter Technologies Incorporated, unless the context otherwise implies. The term "Ltd." and "Puradyn, Ltd" refers to the Company's subsidiary, Puradyn Filter Technologies, Ltd., unless the context otherwise implies. ITEM 1. DESCRIPTION OF BUSINESS FORWARD LOOKING STATEMENTS This Annual Report on Form 10-KSB contains forward-looking statements that involve substantial risks and uncertainties. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They use words such as "may", "will", "expect", "intend", "anticipate", "believe", "estimate", "continue" and other similar words. You should read statements that contain these words carefully because they discuss our future expectations, making projections of our future results of operations or our financial condition or state other "forward-looking" information. Forward-looking statements involve known and unknown risks and uncertainties which may cause the actual results, performance or achievements of our Company to be materially different from those which may be expressed or implied by such statements. The factors listed in the section entitled "Risk Factors Affecting Future Results of Operations" in the section "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as any other cautionary language in this report, provide examples of risks, uncertainties and events which may cause our actual results to differ materially from the expectations we described in our forward-looking statements. Except as required by law or regulation, we do not undertake any obligation to publicly update forward-looking statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. OTHER PERTINENT INFORMATION You can learn more about the Company by visiting our website at www.puradyn.com. Information on the website is neither incorporated into, nor a part of, this report. We encourage you to read this and other reports filed by the Company with the Securities and Exchange Commission. Puradyn will provide you with a copy of any or all of these reports at no charge. Certain of our SEC filings are available over the Internet at the SEC's web site at http://www.sec.gov. You may also read and copy any materials the Company files with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549, or call the SEC Public Reference Room to obtain information at 1-800-SEC-0330. THE COMPANY Puradyn Filter Technologies Incorporated designs, manufactures, markets and distributes worldwide the PURADYN(R) bypass oil filtration system (the "Puradyn") for use with substantially all internal combustion engines and hydraulic equipment that use lubricating oil. Working in conjunction with an engine's full-flow oil filter, the Puradyn system cleans oil by continually removing solid, liquid and gaseous contaminants from the oil through a sophisticated and unique filtration and evaporation process. For engine lubricating oil, our filters incorporate an additive package. Because lubricating oil is kept in a continually clean state, the Puradyn has been used effectively to extend oil-drain intervals and to extend the time between engine overhauls. We are the exclusive manufacturer of the disposable replacement filter elements ("Element") for the Puradyn. We operate through: o Puradyn Filter Technologies Incorporated - parent company o Puradyn Filter Technologies, Ltd. ("Ltd.", "Puradyn, Ltd") Ltd. is a wholly owned subsidiary established in 2000 which primarily distributes and markets the Puradyn system in countries outside North America, including Europe, the Middle East, the former Soviet Union, Scandinavia and South Africa through a network of independent distributors. PRODUCTS The core product, the patented Puradyn bypass oil filtration system, is offered in two models, TF and PFT, and can be attached to almost any engine and hydraulic systems. The concept of bypass filtration is similar to a dialysis machine that filters blood to rid it of impurities, keeping the oil continually clean. Whenever the engine or machinery is 3 operating, the Puradyn is extracting from the oil solid particles down to less than one micron (1/39 millionth of an inch), as well as gaseous and liquid contaminants, while protecting the engine or hydraulic equipment from harmful wear caused by contaminants in the oil. Additive packages in which chemicals are added to the filtering media replenish spent additives in the oil, helping to maintain the oil's proper chemical balance and viscosity. The condition of the oil is monitored through use of a simple oil analysis sample taken in lieu of a regularly scheduled maintenance oil change. If the sample results, typically received in 5 to 7 days, show that the condition of the oil is considered good for continued use, only the Puradyn replacement element is to be changed - there is no need to change the oil if it is clean. Consequently, the Puradyn significantly reduces maintenance costs by decreasing oil consumption, engine wear and certain other types of general maintenance as well as reducing environmental concerns and costs associated with the storage and disposal of waste oil. These potential savings are achieved from utilizing the Puradyn, which generally has a relatively short payback period of, on average, nine to fourteen months. The Puradyn system is currently manufactured in six different sizes suitable for placement on engines or equipment with oil sump capacities ranging from 8 to 300 quarts. The later generation PFT model offers the same benefits and features of the original TF model, with the added enhancements of easier serviceability and the main component of the system being more corrosion-resistant. All Puradyn systems are compatible with virtually all standard and synthetic oils on the market and they work with engines using gasoline, diesel, propane or natural gas. The Puradyn system cannot be used on engines that do not have a pressurized lubricating system, and none of the products can be used on any engines that mix oil with fuel. We also manufacture and distribute Elements for the Puradyn system. Depending upon the application, we generally recommend that the Element be replaced at the engine manufacturer's recommended/approved periodic oil change interval or as oil analysis dictates. The type of Element used also depends upon the specific type of engine or hydraulic application. A customer can change the Element and take the required oil sample in approximately five to ten minutes. By continually removing contaminants and replacing vital additives through a patented time-release additive package to keep oil constantly clean, the Puradyn Element substantially extends intervals between oil changes. Elements are interchangeable between similar-sized models. The Company has implemented patented and/or proprietary technology in the filter Elements that provides several advantages including: o An additive package in which pelletized chemicals are added to the filtering media to replenish additives in the oil. This additive package helps to maintain the oil's chemical balance and viscosity. In 2006, the Company re-engineered the additive package to be compatible with new oils designed to meet EPA 2007 on-highway exhaust emission standards, and be simultaneously backwards-compatible with all older API diesel lubrication oil service categories. o CGP(R) Extended Life Filter Element containing a patent-pending process for chemical grafting. This new technology improves the attraction and retention of soot and other solid contaminants to the packed cotton filter material. CGP technology was developed over a three-year period inclusive of laboratory and field-testing. Consolidated results from across the country show that test vehicles averaged more than 160,000 miles without the need for a traditional oil change. o Ease of maintenance: The filter Element can be replaced in a matter of seconds. When the Element is changed, an insignificant amount of make-up oil is added to replace any oil retained in the used Element or consumed during the normal engine combustion process. The Company's performance warranties require the user to change the Puradyn filter element and take a small sample of the oil for submission to an oil-testing laboratory at the same intervals that the original equipment manufacturer ("OEM") recommends for an oil change, or as oil analysis dictates (See "Warranties"). The oil analysis allows end users to monitor oil quality and, to some degree, engine condition and provides a trend and timeline for both the Company and end user should a problem arise. The Puradyn has no moving parts and consequently requires no significant ongoing maintenance. As long as Elements are changed at the recommended intervals and other standard preventive maintenance procedures such as 4 changing factory full flow and air filters and oil analysis are completed, the Company believes the Puradyn will perform as designed........ We are also distributor for the following companies: o Honeywell Consumer Products Group, manufacturer of FRAM(R) filters. We able to offer the full line of FRAM filters to our distributors. o MotorCheck(TM) On-Site Oil Analysis. The analyzer combines optical emission and infrared oil analysis with optional viscometer within a desktop-sized enclosure for fast, accurate fluid analysis. WARRANTIES The Puradyn carries a six-month 'money-back' performance guarantee, and is currently warranted to the original user to be free of defects in material and workmanship for five years with unlimited miles/hours, with a one-year limited warranty on the heating element. For the Company's performance guarantee and warranties to remain in effect, users must, among other things, maintain a record of the laboratory oil analysis results. To date, there have been no material warranty claims, although there can be no assurances that such a trend will continue. The Company has received letters from several OEMs including Deere & Company, Detroit Diesel Corporation, Caterpillar, Inc., Ford Motor Company, Mack Trucks, Inc., Cummins Engine Company, Inc., Daimler Corporation, which have all stated that the installation and use of the Puradyn does not void their manufacturer warranties unless an engine failure is attributed to the Puradyn. Oil analysis is a standard industry practice endorsed by OEMs and various fleet maintenance organizations and most engine manufacturers will accept oil analyses as alternatives to their recommended oil change intervals. MARKETING The Company's products are marketed to numerous industries including marine, trucking, agricultural, bus, generator, construction, mining, industrial and a multitude of hydraulic applications, and other users of engines or equipment that utilize up to 50 weight oil for lubrication. Currently, the Company's primary focus is on the industrial/construction, generator set, marine, and OEM segments. Instead of traditional media advertising campaigns, the Company is concentrating instead on direct sales contacts, trade shows, white papers and other methods of demonstration, such as Internet-based marketing, to promote its products, generate awareness and stimulate sales. Our products have achieved recognition from well-known sources, including certification (in 1994) and re-certifications (in 1998 and 2003) by the California Environmental Protection Agency's Department of Toxic Substances as a `Pollution Prevention' technology. We believe that such recognition, as well as our presence at national industry trade shows, have and will continue to enable the Company to increase industry recognition of the Puradyn name and products. We rely on management's ability to determine the existence and extent of available markets for our product. Company management and consultants have considerable sales and marketing backgrounds and devote a significant portion of their time to sales-related activities. One of our marketing strategies is based on creating customer `pull-through', a sustained level of request for our product on the OEM level from end-users. To date, customer pull-through has resulted in a limited number of our systems being factory-installed at individual Volvo Trucks, N.A., Mack, Kenworth and Freightliner truck facilities. Taking a long-terms approach, management believes that federal government entities and the U.S. military are markets that can be successfully cultivated, based on the following: o 2007 National Stocking Number (NSN) assigned to a specific Puradyn system kit to be installed on the U.S. Army's Mine Protection Vehicle family. 5 o 2006 final test results from the US Department of Energy, which shows that the systems used in evaluation of the benefits and cost analysis of bypass oil filtration, have produced an estimated savings of 89% in oil usage and purchases when used on heavy-duty diesel engines. o 2006 initial and subsequent 2007 and 2008 orders placed by the U.S. Military to have them installed on new trucks supplied by Freightliner LLC for foreign military sales. o New five-year contract awarded in December 2004 from the General Services Administration (GSA) for its Vehicular Multiple Award Schedule, New Technologies, which simplifies the procurement process for governmental agencies. The Company has established in-house investor relations and marketing departments. DISTRIBUTION We have formal distribution agreements with domestic and international distributors wherein they are required to maintain minimum product inventory levels, maintain a storefront and services bay(s), and retain access to qualified technicians trained by our technical personnel in product installation and service. All distributors must pay in a timely fashion, and with respect to international distributors, the agreements typically establish the minimum dollar amount of inventory to be purchased as well as shipping terms. The Company has warehouse distributors located throughout North America. The remaining distributors are located primarily in South America, England, Europe and Asia. These distributors purchase product directly from the Company and sell to their existing or new customers. The Company will accept returns of products that are defective at the time of sale to the distributor or prove to be defective during the warranty period. Returns are subject to specific conditions. As a significant portion of our products are sold to distributors and end users for use on transportation vehicles, this could unfavorably affect our overall exposure to credit risk as these customers could be affected by potential economic or other conditions. Puradyn, Ltd. operates from the U.K. to generate distribution and sales in Europe, the Middle East, the former Soviet Union, South Africa and Scandinavia. There can be no assurance that such distributors will be successful in introducing the Puradyn in their territories as they will face obstacles similar to those the Company and its other distributors have encountered in introducing an innovative technology in their territories. Ltd. has successfully commenced or completed various evaluation programs, including those of two large international generator manufacturers, four truck OEMs, one construction equipment OEM and one diesel engine OEM. One of the world's largest OEMs of medium-size power generators approved and began purchasing the Puradyn from Ltd. in 2002. SALES DIRECT SALES The Company directly and/or with the assistance of its manufacturer's representatives, distributors or other agents, markets its products directly to OEMs, other distributors and national accounts. Typically larger customers, and some smaller customers, require an evaluation period to operate the system on their equipment. While set for a specific period of time, usually ranging from three to twelve months, evaluations are often influenced by a number of variables including equipment downtime or servicing which may extend the evaluation period. Consequently, the sales period can be relatively long. We believe this evaluation period will continue to be shortened as the Company's products gain wider acceptance and support from well-known end users and OEMs. Currently, our products are being evaluated (in various stages of progress) by numerous potential end users and existing customers including, among others: o A major engine OEM o A major transmission OEM o A road materials handling Company o Two leading food companies o The U.S. Military o Two major long-haul carriers 6 In December 2004 we were awarded a new five-year contract on the Vehicular Multiple Award Schedule, New Technologies, which replaced the schedule on which we had currently been. This enables us to offer our Puradyn system to all federal government agencies. The new schedule allows easy access to our products without the usual lengthy bid process to all federal agencies that purchase vehicles, including construction equipment, medium and heavy trucks, waste disposal vehicles, aerial lift vehicles and fire trucks. The contract period is for five years from the date of the award (to December 2009) with three five-year options. During 2007 and 2006 two customers together accounted for approximately 44% and 39%, respectively, of the Company's consolidated net sales. These two customers individually accounted for greater than 10% each of net sales, or approximately $769,000 and $417,000 and approximately $570,000 and $791,000, respectively in 2006 and 2007. At December 31, 2007 there were five customers whose trade receivable balances equaled or exceeded 5% of total receivables, representing approximately 24%, 10%, 8%, 8%, and 7% of total accounts receivable. The loss of business from one or a combination of the Company's significant customers could adversely affect its operations. The Company's sales are made on credit terms, which vary depending on the nature of the sale. The Company believes it has established sufficient reserves to accurately reflect the amount or likelihood of product returns or credits and uncollectible receivables. However, there can be no assurance that actual returns and uncollectible receivables will not exceed the Company's recorded reserves. In 2007, sales to a customer with one of the nation's largest privately held fleet of trucks and equipment, represented 18% of our consolidated net sales. In 2002, after extensive testing, one of the world's largest manufacturers of medium-size power generators purchased over $350,000 of product. This customer accounted for 14% of our 2006 consolidated net sales and 26% of our 2007 consolidated net sales. INTERNATIONAL SALES The Company, directly and/or with the assistance of commission-based manufacturer's representatives, has established primarily non-exclusive distributors in various countries, including Denmark, South Africa, Nigeria, United Kingdom, Kuwait, United Arab Emirates, Thailand, Colombia, and others. The ultimate success of these and other distributors depends upon, among other things, their abilities to successfully introduce and sell the product in their territories including obtaining local evaluations, establishing distribution and other factors similar to those faced by the Company in the United States. Total international sales amounted to approximately 51% and 53% of consolidated net sales in 2007 and 2006, respectively. MANUFACTURING AND PRODUCTION The Company purchases component parts for its Puradyn systems and manufactures its entire line of filter Elements. The component parts are assembled, packed and shipped from our facility in Boynton Beach, Florida. We currently source (i.e., purchase each raw material and component part from a specific vendor) substantially all of our raw materials and component parts from various vendors in the United States. Substantially all the tools and dies used by certain of our vendors are owned by the Company. We have researched alternative sources of supply and do not anticipate that the loss of any single supplier would have a material long-term adverse effect on our business, operations or financial condition. In January 2004, we received ISO 9001:2000 certification from the International Organization for Standardization. ISO 9001:2000 is a series of internationally accepted, multi-part quality management systems for industry-wide standardization applied to manufacturing and service organizations. Management believes this certification will reinforce recognition of its tangible commitment to quality control from OEMs and other potential large customers. The Company successfully completed subsequent surveillance audits and in December 2007, completed its recertification audit to retain 9001:2000 certification. COMPETITION Competitive bypass oil filters produced by other companies in varying degrees address the issues of solid or liquid contaminant filtration through centrifugal design, media filtration or evaporation. However, Puradyn believes that it designs and manufactures the only bypass oil filtration system that incorporates all of the following features: 7 o Filtering solid contaminants to below one micron, including enhanced soot retention through the use of a patent-pending process for chemical grafting; o Effectively removing harmful gaseous and liquid contaminants through a heated evaporation chamber; o Replenishing the base additives; o Maintaining oil viscosity In addition, the Puradyn system was the only bypass oil filtration system designated by the California EPA as a `Pollution Prevention' technology during the tenure of its program which has since been discontinued. The certificate states in part, "The PURADYN(R) system has been shown to be an effective means of extending engine oil change intervals without adversely affecting engine wear or performance." Tests performed by a leading independent testing facility demonstrated that the Puradyn system surpassed the capacity, efficiency and overall performance of its leading competitors. Using our standard filter with additives, the Puradyn system tested 92.05% efficient under the SAE HS806-95 (modified) standards for filter capacity and contaminant removal. Efficiency reflects the ability to remove particles and other chemicals from the oil. While efficiency is not necessarily a standard of comparison to other products, it does demonstrate the filtering capability of the Puradyn unit. The use of our products reduces the need for maintenance services, replacement parts, original oil sales and waste oil disposal. INTELLECTUAL PROPERTY The Company owns patents for the Puradyn system; filter Elements, oil flow meter, and two patents for technology which include a manifold type full-flow filter/bypass filtration unit (side-by-side) in the U.S. and certain other countries. The expiration dates of these patents range from May 2014 to October 2016. In addition, we received patents from the United States Patent Office and certain other countries for a filter Element containing an additive package in which pelletized chemicals are added to the filtering media to replenish additives in used oil. This is especially important on engines built since the enactment of the Clean Air Act of 1992, which requires tighter specifications for diesel engines. We applied for a provisional patent application for improved filtration efficiency using CGP(R), a process for chemical grafting that can significantly increase the life of the filter Element and further safely extend oil drain intervals. There can be no assurance that such patents will withstand competitive threats to their patentability or, in the case of the redesigned Puradyn, be developed into commercially viable products. We have registered the product trademark "Puradyn" in the United States and other countries where the "Purifiner" trademark was registered, and have registered the product trademarks "CGP" and "Keep It Clean!" in the United States. GOVERNMENTAL INFLUENCE Our products typically do not require any governmental approvals. As part of the certification process under the California Environmental Protection Agency's Department of Toxic Substances in July 1994 and subsequent re-certifications in July 1998 and August 2003, the Company obtained an Executive Order issued by the State of California Air Resources Board stating that the Puradyn does not reduce the effectiveness of applicable vehicle pollution control systems, and may be installed on all 2002 and older model vehicles with pressure oil systems. 2007 emissions standards represented landmark regulations. Today, catalytic converters and particulate traps in addition to using exhaust gas recirculation (EGR) are required to meet these new emission standards. Due to the after-treatment devices and their sensitivity to ash content, the oil industry developed entirely new additive formulations removing any additives that produced ash as a byproduct. In order to be compatible with the new oil formulation, we developed an entirely new additive package for 2007. In addition, this new additive package is backwards-compatible in that it is also compatible with the pre-2007 oils. Both lab and field tests of the new additive package have demonstrated excellent results. As more engine manufacturers move to these new methods, including EGR, the oil is being subjected to more extreme conditions increasing the need for finer filtration of contaminants such as soot; reduction of water and gaseous contaminants, and constant replenishment of oil additives to combat oxidation and acid. 8 We believe that engine and truck manufacturers can capitalize on our enhanced technology to remove soot from their oil to maintain their extended drain intervals by operating on constantly clean oil. EMPLOYEES At December 31, the Company had 25 employees, including 2 from Puradyn Ltd., in the following areas: o 11 in manufacturing, assembly, quality control, warehousing and shipping o 1 in purchasing o 2 in customer service o 2 in marketing and sales o 1 in technical support and installation assistance o 2 in engineering and development o 3 in finance o 2 in administrative positions o 1 in administration and sales None of the employees are represented by a labor union. ITEM 2. DESCRIPTION OF PROPERTY. In December 2002, the Company moved into new leased corporate facilities within two miles of its former location, where substantially all of the Company's operations are conducted, expanding from approximately 14,000 sq. ft. to approximately 25,500 sq. ft. (5,000 sq. ft. for administration, 20,500 sq. ft. (versus former 10,000 sq. ft.) for manufacturing.) The lease term at the new facility is for 68 months with a total lease obligation of approximately $774,000. The Company is currently negotiating the renewal of this lease. In order to support its operations in Europe, Ltd. had a lease for 3,150 square feet in Devon, England, which extended through March 31, 2002, whereupon it converted to a month-to-month basis for approximately $2,000 per month. Due to anticipated increased sales activity, Ltd. moved to a 4,260 square foot facility in Devon in September 2003. They assumed the existing lease, which expired in August 2004. In September 2005, this lease was renewed with a term that expires in September 2010. ITEM 3. LEGAL PROCEEDINGS. None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None 9 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES. The Company common stock is included for quotation on the OTC Bulletin Board under the symbol PFTI. As of December 31, 2007, there were approximately 297 stockholders of record of the Company's stock. The closing bid price quoted on the OTC for the Company's Common Stock at March 25, 2008 was $.31. The transfer agent for the Company's common stock is Florida Atlantic Stock Transfer, Inc., 7130 Nob Hill Road, Tamarac, Florida 33321. The Company has never declared or paid cash dividends on its common stock. The Company presently intends to retain future earnings, if any, to finance the expansion of its business and does not anticipate any cash dividends will be paid in the foreseeable future. The future dividend policy will depend on our earnings, capital requirements, expansion plans, financial condition and other relevant factors. The following table indicates the high and low sales prices for the quarterly periods in 2007 and 2006: QUARTER ENDED 2007 SALES PRICE 2006 SALES PRICE -------------------------- ------------------------- HIGH LOW HIGH LOW ------------- ------------ ------------ ------------ March 31 $0.96 $0.56 $1.90 $0.67 June 30 $0.80 $0.40 $1.75 $1.00 September 30 $0.50 $0.30 $1.33 $0.90 December 31 $0.60 $0.32 $1.20 $0.55 10 RECENT SALES OF UNREGISTERED SECURITIES In December 2007, the Company received loans from two shareholders, who were also members of the Board of Directors, in the amount of $100,000. During the quarter ending March 31, 2008, the Company received additional loans from the same shareholders, in the amount of $420,000. On March 24, 2008, $420,000 of these loans were converted into 1,200,000 shares of common stock, 600,000 shares issued to the Chief Executive Officer and a member of the Board of Directors, respectively, at $.35 per share, the closing price as of the date of approval. On March 26, 2008 a $100,000 loan from the Chief Executive Officer was converted into 285,714 shares of common stock, at $.35 per share, the closing price as of the date of approval. Inasmuch each of the investors had a preexisting relationship with the issuer, are stockholders and/or are members of management, are accredited and sophisticated investors, the issuance of the securities was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS General Sales of the Company's products will depend principally upon end user demand for such products and acceptance of the Company's products by OEMs. The oil filtration industry has historically been competitive and, as is typically the case with innovative products, the ultimate level of demand for the Company's products is subject to a high degree of uncertainty. Developing market acceptance for the Company's existing and proposed products will require substantial marketing and sales efforts and the expenditure of a significant amount of funds to inform customers of the perceived benefits and cost advantages of its products. Through industry data research, we have been able to identify the potential applications where management believes market penetration is most accessible. Currently no bypass oil filtration system has captured a substantial share of the estimated recurring $15 billion potential market. We believe we are in a unique position to capitalize on the growing acceptance of bypass oil filtration given that our product and our Company are positioned as, including, but not limited to: o A competitively priced, value-added unique product based on an advanced, patented technology o An alternative solution to the rising costs and increasing dependence on foreign oil o Providing an operational maintenance solution to end users in conjunction with existing and reasonably foreseeable federal environmental applications We continue to incorporate the focus of our sales strategy on individual sales and distribution efforts as well as on the development of a strong nationwide distribution network that will not only sell but also install and support our product. We also continue to focus our sales and marketing efforts to target areas and issues specific to the bypass oil filtration industry, cultivating an innovative outlook on oil maintenance, specifically, that oil does not need to be changed on a regular basis if kept in a clean state 11 This strategy includes focus on: o The expansion of existing strategic relationships o Development and expansion of our distribution network with qualified distributors in order to establish a sales- and service-oriented nationwide infrastructure o Continuing to target existing and new industrial/construction equipment fleets, marine applications, and major diesel engine and generator set OEMs o Creating customer 'pull-through', a sustained level of request for our product on the OEM level o Converting customer evaluations into sales, both immediate and long term While this is a long-term and ongoing commitment, we believe we have achieved a limited amount of industry acceptance based on recent accomplishments: o 2007 announcement that a fleet of 100 trucks have exceeded 100 million miles without an oil-related oil change during the coarse of an 8-year period using the Puradyn system. o 2007 announcement that initial orders have been placed for the Puradyn oil filtration system by one of the largest global providers of innovative mechanical solutions, technology, and services for the oil and gas industry. o 2007 announcement that the Puradyn has been approved by Cascade Sierra Solutions as a recommended product for inclusion in its outreach centers, which proved information, technology and products for transportation specialists geared to conservation of oil and energy. o 2007 announcement that Wastequip, Inc., the leading manufacturer of waste handling, recycling, and material handling equipment has been named exclusive distributor of the Puradyn in the waste industry. o 2006 announcement that the Puradyn has been approved for use by one of the largest international diversified energy resource companies for retrofit of equipment used at one of its key coal mine facilities in the Southwestern U.S. o 2006 final results released by the U.S. Department of Energy of a three-year evaluation (2002-2005) of the cost analysis and benefits of bypass filtration technology show 89% oil savings on heavy-duty diesel engines. o 2006 announcement that the U.S. Military has ordered the Puradyn system installed on new trucks supplied by Freightliner LLC for foreign military sales. o 2006 continued testing by the U.S. Military for use of the PURADYN system on several other applications. We believe that industry acceptance resulting in sales will continue to grow in 2008; however, there can be no assurance that any of our sales efforts or strategic relationships will meet management's expectations or result in actual revenues. Even with the above announcements, business revenue in 2007 was below management expectation with only a $343,000 increase in Puradyn product sales over 2006. Sales for Rentar units we distribute decreased $205,000 from 2006, which were the major factorsresulting in our total net sales showing only a $10,000 net increase over 2006. The Company continues to make progress with major OEM's to substantiate Puradyn's installation. We believe this will help build strong sales growth with a concurrent reduction of the need for potential customers to test our systems on their own equipment before a purchase decision is made. In addition, one of our major customer's sales decreased because of the desire to first improve their maintenance tracking system before resuming normal purchasing patterns of the Puradyn. The Company's sales effort not only involves educating the potential customer on the benefits of our product, but also allowing the customer to test and evaluate the PURADYN system on its fleet vehicles. While set for a specific period of time, typically ranging from three to twelve months, evaluations are often influenced by a number of variables including equipment downtime or servicing, which may extend the evaluation period. Consequently, the sales cycle can be relatively long. Management believes that this evaluation period has shortened as our products gain wider acceptance, support and usage from well-known customers and OEMs. The Company utilizes its wholly owned subsidiary, Puradyn Filter Technologies, Ltd. ("Ltd."), in the United Kingdom to sell the Company's products in Europe, the Middle East and Africa. International sales are especially well suited to our product given that environmental controls are not as regulated in countries outside North America. Certain applications representing a higher return on investment are more prevalent in use outside of North America and end-users consequently are more receptive to the total maintenance package, including the use of oil analysis, which the Puradyn system represents. In 2007, total international sales accounted for 51% of the Company's consolidated net sales. The Company recognizes revenue from product sales to customers, distributors and resellers when products that do not require further services or installation by the Company are shipped, when there are no uncertainties surrounding customer acceptance and for which collectibility is reasonably assured in accordance with Staff Accounting 12 Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements. Cash received by the Company prior to shipment is recorded as deferred revenue. Sales are made to certain customers under terms allowing certain limited rights of return and other limited product and performance warranties for which provision has been made in the accompanying financial statements. Management believes based on past experience and future expectations that such limited return rights and warranties will not have a material adverse effect on the Company's financial statements. Going Concern The Company's financial statements have been prepared on the basis that it will operate as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has incurred net losses each year since inception and has relied on the sale of its stock from time to time and loans from third parties and from related parties to fund its operations. These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led the Company's independent registered public accounting firm Webb & Company P.A. to include a statement in its audit report relating to the Company's audited consolidated financial statements for the years ended December 31, 2007 and December 31, 2006 expressing substantial doubt about the Company's ability to continue as a going concern. The Company has been addressing the liquidity and working capital issues and continues to attempt to raise additional capital with institutional and private investors and current stockholders. Cost reductions continue to be implemented by the Company, including acquiring alternative suppliers for raw materials. The company expects to see results from these reductions, as well as other cost reduction plans through 2008. Additionally, the Company is reviewing cost of material increases, some of which were passed through to its customers as product price increases, beginning January, 2008. Critical Accounting Policies and Estimates The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to product returns, bad debts, inventories, financing operations, warranty obligations and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. Allowance for Doubtful Accounts The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial conditions of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company provides for potential uncollectible accounts receivable based on customer specific identification and historical collection experience. If market conditions decline, actual collection experience may not meet expectations and may result in decreased cash flows and increased bad debt expense. The policy for determining past due status is based on the contractual payment terms of each customer, which is generally net 30 or net 60 days. Once collection efforts by the Company and its collection agency are exhausted, the determination for charging off uncollectible receivables is made. Estimation of Product Warranty Cost The Company provides for the estimated cost of product warranties at the time revenue is recognized. While the Company engages in product quality programs and processes, including actively monitoring and evaluating the quality of its component suppliers, the Company's warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material 13 usage or service delivery costs differ from the Company's estimates, revisions to the estimated warranty liability would be required. Estimation of Inventory Obsolescence The Company provides for estimated inventory obsolescence or unmarketable inventory in amounts equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Impairment of Long-Lived Assets The Company periodically evaluates the recoverability of the carrying amount of its long-lived assets under the guidelines of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Factors that the Company considers in making this evaluation include estimating the undiscounted net cash flows estimated to result from the assets over their remaining useful life. Should the Company's estimates of these factors change, the Company's results of operations and financial condition could be adversely impacted. Revenue Recognition Revenue is recognized when earned. The Company's revenue recognition policies are in compliance with the provisions issued in SAB No. 104, Revenue Recognition in Financial Statements. Revenue from product sales to customers, distributors and resellers is recorded when products that do not require further services or installation by the Company are shipped, when there are no uncertainties surrounding customer acceptance and for which collectibility is reasonably assured. The Company provides for sales returns based on an historical analysis of returns. The estimate is updated for current return activity and the provision is adjusted accordingly. Should actual returns exceed management's estimates, the provision may require further adjustment and accordingly, net sales may decrease. Recent Accounting Pronouncements In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes," which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with FIN 48, the Company must adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. The effective date of FIN 48 for the Company is January 1, 2007. The adoption of FIN 48 has not had a material impact on the Company's condensed consolidated financial statements In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements". SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. SFAS No. 157 applies whenever other standards require assets or liabilities to be measured at fair value and does not expand the use of fair value in any new circumstances. SFAS No. 157 establishes a hierarchy that prioritizes the information used in developing fair value estimates. The hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data such as the reporting entity's own data. SFAS No. 157 requires fair value measurements to be disclosed by level within the fair value hierarchy. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 157 is not expected to have a material effect on the Company's financial statements. In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115". This statement permits entities to choose to measure many financial instruments and certain other items at fair value. Most of the provisions of SFAS No. 159 apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" applies to all entities with available-for-sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provision of SFAS No. 157, "Fair Value Measurements". The adoption of this statement is not expected to have a material effect on the Company's financial statements. In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51". This statement improves the 14 relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards that require; the ownership interests in subsidiaries held by parties other than the parent and the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, changes in a parent's ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently, when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value, entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 affects those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The adoption of this statement is not expected to have a material effect on the Company's financial statements. Results of Operations The following table sets forth (amounts in thousands) the Company's operating information for the years ended December 31, 2007 and 2006: (IN THOUSANDS) INCREASE 2007 2006 (DECREASE) ------- ------- -------- Net sales $ 3,083 $ 3,073 $ 10 Operating costs and expenses: Cost of products sold 2,832 2,567 265 Salaries and wages 1,075 1,348 (273) Selling and administrative 1,061 1,343 (282) ------- ------- ------- 4,968 5,258 (290) Loss from operations (1,885) (2,185) (300) Other income (expense): Interest income 33 50 (17) Interest expense (589) (518) (71) ------- ------- ------- Total other expense (556) (468) (88) Net loss $(2,441) $(2,653) $ (212) ======= ======= ======= Year Ended December 31, 2007 Compared to Year Ended December 31, 2006 INCREASE 2007 2006 (DECREASE) ------- ------- -------- Gross sales $ 3,126 $ 3,046 $ 80 Sales returns & allowances (43) 27 (70) Net Sales $ 3,083 $ 3,073 $ 10 INCREASE 2007 2006 (DECREASE) ------- ------- -------- US domestic sales $ 1,563 $ 1,425 $ 138 US international sales 353 815 (462) UK sales 1,210 806 404 Rentar sales (included above) 38 243 (205) NET SALES Although net sales increased marginally by approximately $10,000 from approximately $3,073,000 in 2006 to approximately $3,083,000 in 2007, sales of Puradyn products actually increased $343,000. Sales of Rentar units accounted for a decrease of approximately $205,000 in gross sales for 2007 as compared to 2006. Domestic sales generated from the U.S. operations increased approximately $138,000 in 2007 as compared to 2006. The mix of product sold continues to change as unit sales revenues have decreased slightly while filter sales have increased more significantly. Initial indications show a strengthening order backlog for the beginning of 2008. The increase in Sales Returns and Allowances for the year ending December 31, 2007 was a result of a decrease during the year ending December 31, 2006 which was due to a reduction in the cumulative historical rate of returns. COST OF SALES Cost of sales increased by approximately $265,000 from approximately $2,567,000 in 2006 to approximately $2,832,000 in 2007. The increase is primarily due to expensing of scrap inventory and increases in raw material costs. Cost of products sold, as a percentage of sales, increased from 84% in 2006 to 92% in 2007. The Company is offsetting these cost increases with product price increases beginning January, 2008. SALARIES AND WAGES Salaries and wages decreased approximately $273,000 due to a net reduction of three employees, representing a decrease of approximately $462,000, which was partially offset by cost of living salary increases. 15 SELLING AND ADMINISTRATIVE EXPENSES Selling and administrative expenses decreased by approximately $281,000 from approximately $1,343,000 in 2006 to approximately $1,062,000 in 2007. During 2007 the Company's expenses related to stock compensation decreased approximately $329,000. These decreases were primarily the result of extension of employee stock options, warrants issued to employees/directors and amortization of warrants issued to investors, of approximately $173,000, $101,000, and $66,000, respectively, all of which occurred in 2006. During 2007 the Company incurred cost increases in Selling and Marketing, Shareholder loans, Rent, and Patent expenses of approximately $31,000, $21,000, $14,000 and $13,000 respectively. INTEREST INCOME Interest income decreased by approximately $17,000 primarily due to reserves established beginning October 1, 2007, against shareholder loan interest that was previously accruing at approximately $12,000 per quarter. INTEREST EXPENSE Interest expense increased by approximately $71,000 from $518,000 in 2006 to $589,000 in 2007. The Company pays interest monthly on the note payable to stockholder at the prime rate, which was 6.75% as of December 31, 2007. Approximately $16,000 of this increase was attributable to this credit line interest with a higher average principal balance offset by a lower interest rate of 6.75% at December 31, 2007 as compared to a lower average principal balance and a higher interest rate of 8.25% at December 31, 2006. Approximately $87,000 of this increase is attributable to a reserve established during the period ending June 30, 2007 against a shareholder loan receivable. This increase was partially offset by a decrease of approximately $38,000 relating to a reduction of amortization of deferred finance costs. Liquidity and Capital Resources The Company's consolidated financial statements have been prepared on the basis that it will operate as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. As such, the consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. The Company has incurred net losses each year since inception and has relied on the sale of its stock from time to time and loans from third parties and from related parties to fund its operations. These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led the Company's independent auditors Webb & Company, P.A., to include a statement in its audit report relating to the Company's audited consolidated financial statements for the years ended December 31, 2007 and December 31, 2006 expressing substantial doubt about the Company's ability to continue as a going concern. The Company is currently addressing the liquidity and working capital issues and is in the process of attempting to raise additional capital with institutional and private investors and current stockholders. During 2007, the Company raised a total of $1.475 million in capital from an institutional investor and current stockholders. As of December 31, 2007, the Company had cash and cash equivalents of approximately $112,000. For the year ended December 31, 2007, net cash used in operating activities was approximately $1,809,000, which primarily resulted from the net loss of approximately $2,441,000, combined with changes in working capital amounts. Net cash used in investing activities was approximately $55,000 for purchases of property and equipment. Net cash provided by financing activities was approximately $1,909,000 for the year, primarily due to proceeds of $1,473,000 of funds from the sale of common stock to a private placement investor, as well as an increase in shareholder loans of $411,000. Beginning on March 28, 2002, the Company had a binding agreement with one of its stockholders, who is also a Board Member, to fund up to $6.1 million. Amounts drawn bear interest at the prime rate per annum (6.75% at December 31, 2007) payable monthly and were to become due and payable on December 31, 2005, or upon a change in control of the Company or consummation of any other financing over $7 million. In April 2005, the repayment date was extended to December 31, 2006. In March 2006, 2007 and 2008, respectively, the repayment dates were further extended to December 31, 2007, December 31, 2008, and December 31, 2009, respectively. In consideration for the stockholder entering into this loan agreement, the Company has granted the stockholder a total of 475,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company's stock on the dates of grant. As of December 31, 2007, the Company had drawn all of the $6.150 million of the available funds. At December 31, 2007, the Company had working capital of approximately $366,000 and its current ratio (current assets to current liabilities) was 1.20 to 1, as compared with working capital of approximately $692,000 and a current ratio of 1.53 to 1 at December 31, 2006. The Company anticipates increased cash flows from 2008 sales activity; however, additional cash will still be needed to support operations and meet working capital needs. If 16 additional capital is not raised, budgeted sales levels are not achieved or significant unanticipated expenditures occur, the Company will have to modify its business plan, reduce or discontinue some of its operations or seek a buyer for part of its assets to continue as a going concern through 2008. There can be no assurance that the Company will be able to raise the additional capital or that it will continue to operate as a going concern in which event investors could lose their entire investment in the Company. While the Company believes it can attain profitable operations in the future, there is no assurance that sales will increase to the level required to generate profitable operations to provide positive cash flow from operations. Impact of Inflation Inflation has not had a significant impact on the Company's operations. However, any significant decrease in the price for oil or labor, environmental compliance costs, and engine replacement costs could adversely impact the Company's end users cost/benefit analysis as to the use of the Company's products. Quarterly Fluctuations The Company's operating results may fluctuate significantly from period to period as a result of a variety of factors, including product returns, purchasing patterns of consumers, the length of the Company's sales cycle to key customers and distributors, the timing of the introduction of new products and product enhancements by the Company and its competitors, technological factors, variations in sales by product and distribution channel, and competitive pricing and general economic conditions throughout the industrialized world. Consequently, the Company's product revenues may vary significantly by quarter and the Company's operating results may experience significant fluctuations. Risk Factors Affecting Future Results of Operations The Company's future results of operations involve a number of risks and uncertainties - many beyond our control - that could cause actual events or results to be significantly different from those described in this document. The following outlines a number of risks that could impact the Company's financial condition and results of operations. o Our ability to operate as a going concern. o Our ability to raise capital to fund operations is limited. o Potential for continuing losses and accumulated deficit affects our outlook. o Our products may not satisfy our customers' needs. o Our product may not obtain market acceptance. o We are dependent on distributors and a few significant customers and their loss could have a significant adverse impact on us. o Competition may adversely affect our operations, specifically alternative products designed by OEMs or in conjunction with a third party. o We market a limited number of related products, which makes us vulnerable if our products do not gain market acceptance. o There are risks associated with our international operations and international distribution. Our foreign operations are subject to a number of risks, including longer payment cycles, unexpected changes in regulatory requirements, import and export restrictions and tariffs, difficulties in staffing and managing foreign operations, the burden of complying with a variety of foreign laws, greater difficulty in accounts receivable collection, potentially adverse tax consequences, currency fluctuations, enforcing patent protection and political and economic instability. o Our intellectual property rights may not provide meaningful protection for us. o We will likely experience possible fluctuations in operating results, which will expose us to greater uncertainties. 17 o Our product acceptance represents an educational and behavioral change resulting in a relatively long sales cycle. ITEM 7. FINANCIAL STATEMENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE ---- Reports of Independent Registered Public Accounting Firm ................... 33 Consolidated Financial Statements: Consolidated Balance Sheet - December 31, 2007......................... 34 Consolidated Statements of Operations - Years ended December 31, 2007 and 2006............................. 35 Consolidated Statements of Changes in Stockholders' Deficit - Years ended December 31, 2007 and 2006............................. 36 Consolidated Statements of Cash Flows - Years ended December 31, 2007 and 2006............................. 37 Notes to Consolidated Financial Statements............................. 38 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE. ITEM 8AT. CONTROLS AND PROCEDURES Our management, including our chief financial officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making its assessment of internal control over financial reporting, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control--Integrated Framework. Based on this evaluation, our management concluded that, as of December 31, 2007, our internal control over financial reporting was effective based on those criteria. 18 This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Our management's report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management's report in this annual report. There have been no changes in our internal control over financial reporting during our fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. ITEM 8B. OTHER INFORMATION None. 19 PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT The following table sets forth the names, positions with the Company and ages of the executive officers, significant employees and directors of the Company and Ltd. Directors will be elected at the Company's Annual Meeting of Stockholders and serve for one year or until their successors are elected and duly qualified. In the absence of an Annual Meeting, the Board elects directors based upon qualifications. Additionally, the Board elects officers and their terms of office are, except to the extent governed by employment contract, at the discretion of the Board. Board of Directors and Executive Management NAME AGE POSITION ------------------------- --- -------------------------------------------------------------------- Joseph V. Vittoria 72 Chairman of the Board of Directors and Chief Executive Officer Kevin G. Kroger 56 President, Chief Operating Officer and Director John S. Caldwell (2) 63 Director Forrest D. Hayes (1), (2) 75 Director Dominick Telesco 78 Director Charles W. Walton (1) 75 Director Alan J. Sandler 69 Vice President, Chief Administrative Officer and Corporate Secretary Cindy Lea Gimler 41 Chief Financial Officer ---------- (1) Audit Committee members (2) Compensation Committee members JOSEPH V. VITTORIA was appointed to the Board of Directors and appointed as Chairman on February 8, 2000. Mr. Vittoria was Chairman and Chief Executive Officer of Travel Services International, Inc. where he served from 1998 to 2000. From 1987 to 1997, Mr. Vittoria served as Chairman and Chief Executive Officer of Avis, Inc. and was President and Chief Operating Officer of Avis, Inc. from 1982 to 1987. Mr. Vittoria also serves as Chairman of the Board of Great Wolf Resorts and is a member of the Board of City Car Services, Inc. KEVIN G. KROGER joined the Company July 3, 2000 as President and Chief Operating Officer, and was appointed to the Board of Directors in November 2000, and was also appointed to the Board of Puradyn, Ltd. in December 2000. Mr. Kroger was with Detroit Diesel Corporation from 1989 to the time he joined the Company, serving in various executive positions prior to his appointment in 1998 to the position of Vice President and General Manager of Series 30/40 Product. From 1987 to 1989 he was Vice President of R.E.S. Leasing and of VE Corporation. Prior to this, from 1971 to 1987, he held several management positions with Caterpillar Corporation. LIEUTENANT GENERAL (RETIRED) JOHN S. CALDWELL, Jr. was appointed to the Puradyn Board of Directors on August 25, 2005 and serves as Chairman of the Compensation Committee. General Caldwell served as the Army's top ranking officer for Acquisition, Logistics and Technology when he retired in January 2004. In that capacity, he was responsible to the Assistant Secretary for the direction and oversight of the Army's Research, Development and Acquisition (RDA) programs valued at approximately $20 billion per year. He was also Director of the 50,000-person Army Acquisition Workforce, responsible for personnel development and training policy and key assignment recommendations. General Caldwell currently works as Senior Vice-President of QSS Group, an IT services company supporting Federal agencies. General Caldwell holds the degrees of Bachelor of Science from the US Military Academy, West Point in New York, Master in Mechanical Engineering from Georgia Institute of Technology in Atlanta, GA, and the Industrial College of the Armed Forces. 20 FORREST D. HAYES was appointed to the Puradyn Board of Directors on November 10, 2005. Mr. Hayes is Chairman of the Audit Committee and a member of Compensation Committee. Mr. Hayes served as Vice President and CFO of Wastequip, Inc., a privately owned manufacturer of waste equipment in 1990 and 1991, and from 1992 to 2000, as a member of the Wastequip Board of Directors. Mr. Hayes was President and CEO of Brittany Corporation, a privately owned manufacturer of auto/truck parts from 1992 to 2000, and Vice-Chairman from 2000 through 2003. Prior to this, Mr. Hayes served as a CPA with Arthur Andersen from 1954 to 1990 in various capacities including Managing Partner, of the Cleveland and Cincinnati, Ohio offices. Currently serves on the boards of Polychem Corporation and Brittany Stamping LLC. DOMINICK TELESCO was appointed to the Puradyn Board of Directors on December 19, 2006. In addition to Puradyn, Mr. Telesco also serves on the Boards of Lydian Private Bank, the Palm Beach United Way, and the Palm Beach County Cultural Council. Mr. Telesco is Chairman of the Board of 3 Logistics Corporation and Datelco, Inc. Mr. Telesco is also a member of the Board of Boxwood Association, Inc. CHARLES W. WALTON, PhD. was appointed to the Puradyn Board of Directors on August 25, 2005 and is a member of the Audit Committee. Dr. Walton is Founder and Chairman Emeritus of Wastequip, Inc., which he founded in 1989 with the goal of consolidating the equipment segment of the waste management industry. As a result of over twenty-five successful acquisitions and internal growth, Wastequip is now the largest supplier of equipment in the industry with approximately $500 million in sales and 34 manufacturing plants in North America. It was recently purchased by Odyssey Investor Partners, a private equity firm headquartered in New York. Prior to founding Wastequip, Dr. Walton was President and Chief Executive Officer of Sudbury, Inc., a Fortune 500 diversified manufacturing company, which he co-founded in 1983. In 1987, he was awarded the Dively Entrepreneurship Award by Case Western Reserve Weather head School of Management and the Harvard Business School Club of Cleveland. Dr. Walton holds the degrees of Bachelor of Science in Foreign Service and PhD. in economics from Georgetown University, Washington, D.C. ALAN J. SANDLER joined the Company in June 1998 as President, Chief Operating Officer, Secretary, Chief Financial Officer, and Director. In January 2000, he became Vice President and resigned from the positions of President and Chief Operating Officer. In March 2001, he resigned as Chief Financial Officer. In August 2001, Mr. Sandler resumed the position of Chief Financial Officer and then resigned from the position in March 2002. From 1995 until 1997 Mr. Sandler served as President and Chief Executive Officer to Hood Depot, Inc., a national restaurant supply manufacturer/distributor. From 1979 to 1995 he was President and Chief Executive Officer of Sandler & Sons Dental Supply Company, a regional dental supply and equipment distributor. Previous to this position he was a Vice President of Gardner Advertising Company, a national advertising agency. Mr. Sandler was appointed as a Director of TF Purifiner Ltd. in 1999 through 2000. Effective December 16, 2004 Mr. Sandler did not seek reelection to the Board of Directors at the 2004 Annual Meeting of Stockholders in order to maintain a balanced Board with regard to independence. He currently holds the positions of Vice President, Chief Administrative Officer and Secretary to the Board. CINDY LEA GIMLER previously held the position of Accounting Manager with the Company from October 2003 through October 2004. In February, 2005 she was appointed as Chief Financial Officer. In January, 2008, she was appointed Secretary of Puradyn, Ltd. Prior to her employment with the Company, she served as Controller of Bio-Engineered Supplements & Nutrition, Inc., a nutrition products company, from October 2004 through February 2005. Ms Gimler also served as CFO of Universal Jet Aviation, a private jet charter company, from August 2000 through July 2003 and as Accounting Manager for Singer Asset Finance Co., LLC from July 1999 through August 2000. From November 1989 through August 2000 she was employed as an Accountant and Financial Analyst for Oxbow Corporation, an energy finance company. Ms. Gimler received a Masters of Business Administration and a Bachelor of Business Administration from Florida Atlantic University and is a CPA in the state of Florida. DIRECTOR COMPENSATION Each member of the Board of Directors is automatically granted 5,000 options upon election or appointment as a new member of the Board of Directors. Each director receives an additional 5,000 options at the close of each annual meeting of stockholders or on the anniversary of their appointment to the Board. Additionally, each director automatically received 2,500 options for each committee of the Board on which the director serves. Options are granted at a price equal to the fair market value of the stock on the date of grant, are exercisable commencing two years following grant, and will expire five years from the date of grant. In the event a person ceases to serve on the Board of 21 Directors, the outstanding options expire one year from the date of cessation of service. The Board of Directors will administer the Directors' Plan. The following table provides information concerning the compensation of our Board members for their services as members of our Board of Directors for the fiscal year ended December 31, 2007. The value of the warrant and options described below were calculated in accordance with FAS 123 (R) ------------------------------------------------------------------------------------------------------------------------------------ DIRECTOR COMPENSATION ------------------------------------------------------------------------------------------------------------------------------------ FEES NON-EQUITY NON-QUALIFIED ALL OTHER EARNED OR STOCK OPTION INCENTIVE PLAN DEFERRED COMPENSATION TOTAL ($) NAME PAID IN AWARDS AWARDS COMPENSATION COMPENSATION ($) (H) (A) CASH ($) ($) ($) ($) EARNINGS ($) (G) (B) (C) (D) (E) (F) ------------------------------------------------------------------------------------------------------------------------------------ Joseph V. Vittoria $ -- $ -- $ -- $ -- $ -- $ -- $ -- ------------------------------------------------------------------------------------------------------------------------------------ Richard C. Ford (1) -- -- -- -- -- -- -- ------------------------------------------------------------------------------------------------------------------------------------ Kevin G. Kroger -- -- -- -- -- -- -- ------------------------------------------------------------------------------------------------------------------------------------ John S. Caldwell (2) -- -- 3,750 -- -- -- 3,750 ------------------------------------------------------------------------------------------------------------------------------------ Forrest D. Hayes (3) -- -- 5,000 -- -- -- 5,000 ------------------------------------------------------------------------------------------------------------------------------------ Dominick Telesco(4) -- -- 1,650 -- -- -- 1,650 ------------------------------------------------------------------------------------------------------------------------------------ Charles W. Walton(5) -- -- 3,750 -- -- -- 3,750 ------------------------------------------------------------------------------------------------------------------------------------ ---------- 1 On September 7, 2007, Mr. Ford submitted his resignation as Vice-Chairman and member of the Board. 2 On October 10, 2007, Mr. Caldwell was granted options to purchase 7,500 shares of our common stock at an exercise price of $0.37 per share, vesting on August 25, 2008 and expiring on August 25, 2011; and options to purchase 7,500 shares of our common stock at an exercise price of $0.37 per share, vesting on August 25, 2009 and expiring on August 25, 2012. 3 On October 10, 2007, Mr. Hayes was granted options to purchase 10,000 shares of our common stock at an exercise price of $0.37 per share, vesting on November 10, 2008 and expiring on November 10, 2011; and options to purchase 10,000 shares of our common stock at an exercise price of $0.37 per share, vesting November 10, 2009 and expiring on November 10, 2012. 4 On December 19, 2007 Mr. Telesco was granted options to purchase 5,000 shares of our common stock at an exercise price of $0.47 per share, vesting on December 19, 2009 and expiring on December 16, 2012. 5 On October 10, 2007, Mr. Walton was granted options to purchase 7,500 shares of our common stock at an exercise price of $0.37 per share, vesting on August 25, 2008 and expiring on August 25, 2011; and options to purchase 7,500 shares of our common stock at an exercise price of $0.37 per share, vesting on August 25, 2009 and expiring on August 25, 2012. COMMITTEES OF THE BOARD OF DIRECTORS We do not have a policy regarding the consideration of any director candidates which may be recommended by our stockholders, including the minimum qualifications for director candidates, nor has our Board of Directors established a process for identifying and evaluating director nominees. We have not adopted a policy regarding the handling of any potential recommendation of director candidates by our stockholders, including the procedures to be followed. Our Board has not considered or adopted any of these policies as we have never received a recommendation from any stockholder for any candidate to serve on our Board of Directors. We do not anticipate that any of our stockholders will make such a recommendation in the near future. While there have been no nominations of additional directors proposed, in the event such a proposal is made, all members of our Board will participate in the consideration of director nominees. Our Board of Directors has created both an Audit Committee and a Compensation Committee. 22 Audit Committee During 2007, the audit committee of the board of directors was composed of two independent directors. It operates under a written charter adopted by the board of directors. The committee members are Forrest D. Hayes (Chairperson) and Charles W. Walton. The Board has determined that Mr. Hayes satisfies the criteria as an audit committee financial expert as established by the SEC under 407(d)(5) of Regulation S-B. The audit committee met four times in 2007. The audit committee reviews our financial reporting process on behalf of the board of directors. Management has the primary responsibility for the financial statements and the reporting process including the system of internal controls. In this context, the chairperson has met and held discussions with management and the independent auditors. Management represented to the committee that Puradyn's consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States, and the committee has reviewed and discussed the consolidated financial statements with management and the independent auditors. The committee discussed with the independent auditors matters required to be discussed by Statement on Auditing Standards No. 61, Communication with Audit Committees, as amended. In addition, the committee has discussed with the independent auditors the auditor's independence from the Company and its management, including the matters in the written disclosures required by the Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees. The committee discussed with our independent auditors the overall scope and plans for their respective audit. The committee meets with the independent auditors with and without management present, to discuss the results of their examinations, the evaluations of Puradyn's internal controls, and the overall quality of our financial reporting. In reliance on the reviews and discussions referred to above, the committee recommended to the board of directors, and the board has approved, that the audited consolidated financial statements be included in Puradyn's Form 10-KSB for the year ended December 31, 2007, for filing with the Securities and Exchange Commission. Submitted by the audit committee of the Board of Directors: Forrest D. Hayes Charles W. Walton Compensation Committee The compensation committee provides overall guidance for officer compensation programs, including salaries and other forms of compensation including all employee stock option grants and warrant grants to non-employees. The compensation committee is comprised of board members John S. Caldwell as chairperson, and Forrest D. Hayes. The compensation committee meets on an as-needed basis and reports to the Board of Directors. Beneficial Ownership Reporting Compliance Section 16 (a) of the Exchange Act requires the Company's directors and executive officers, and persons who own more than ten percent (10%) of a registered class of the Company's equity securities, to file with the Commission initial reports of ownership and reports of changes in ownership of common stock and other equity securities of the Company. Officers, directors and greater than ten percent (10%) stockholders are required by Commission regulation to furnish the Company with copies of all Section 16 (a) forms they file. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the year ended December 31, 2007, the following failed to meet the Section 16 (a) filing requirements applicable to its officers, directors and greater than ten percent (10%) beneficial owners for filing on a timely basis: Charles W. Walton - 2 late filings, 2 late transactions Code of Ethics We have adopted a code of ethics outlining business ethics and conflicts of interest for all officers, directors and employees of the Company, including procedures for prompt internal reporting of violations of the code to the appropriate persons. 23 You will find a copy of our code of ethics posted on our website at http://www.puradyn.com under Investor Relations, or you may write to us at Puradyn Investor Relations, 2017 High Ridge Road, Boynton Beach, FL 33426. Our Code of Ethics applies to all directors, officers and employees. We will provide a copy to you upon request at no charge. ITEM 10. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The following table summarizes all compensation recorded by us in each of the last two completed fiscal years for: o our principal executive officer or other individual serving in a similar capacity, o our two most highly compensated executive officers as that term is defined under Rule 3b-7 of the Securities Exchange Act of 1934 other than our principal executive officer who were serving as executive officers at December 31, 2007, and o up to two additional individuals for whom disclosure would have been required but for the fact that the individual was not serving as an executive officer at December 31, 2007. For definitional purposes in this annual report these individuals are sometimes refered to as the "names executive officers." The value of the warrant and options described below were calculated in accordance with FAS 123(R). During each of fiscal 2006 and fiscal 2007, each named executive officer listed below have deferred 50% of their base wages and/or annual increases. The amounts included above reflect wages actually earned during the respective periods. ----------------------------------------------------------------------------------------------------------------------------- SUMMARY COMPENSATION TABLE ----------------------------------------------------------------------------------------------------------------------------- NAME AND STOCK OPTION NON-EQUITY NONQUALIFIED ALL OTHER PRINCIPAL YEAR SALARY BONUS AWARDS AWARDS INCENTIVE PLAN DEFERRED COMPENSATION TOTAL ($) POSITION (B) ($) ($) ($) ($) COMPENSATION COMPENSATION ($) (J) (A) (C) (D) (E) (F) ($) EARNINGS (I) (G) ($) (H) ----------------------------------------------------------------------------------------------------------------------------- Joseph V. Vittoria (1) 2007 $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ -- ----------------------------------------------------------------------------------------------------------------------------- 2006 -- -- -- -- -- -- -- -- ----------------------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------------------- Richard Ford (2) 2006 196,575 -- 6,300 85,750 -- -- 9,743 298,368 ----------------------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------------------- Kevin Kroger (3) 2007 186,315 -- -- -- -- -- 21,089 207,404 ----------------------------------------------------------------------------------------------------------------------------- 2006 195,270 -- 5,565 -- -- -- 24,714 225,549 ----------------------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------------------- Alan Sandler (4) 2007 112,238 -- -- -- -- -- -- 112,238 ----------------------------------------------------------------------------------------------------------------------------- 2006 108,308 -- 2,520 -- -- -- -- 110,828 ----------------------------------------------------------------------------------------------------------------------------- ---------- (1) On October 24, 2006, Mr. Vittoria, who is also the Chairman of our Board of Directors, was appointed by the Board of Directors to the position of Chief Executive Officer. Mr. Vittoria serves in that position on a non-salaried basis. (2) Mr. Ford served as our CEO through October, 2006. Mr. Ford's compensation for fiscal 2006 includes 6,000 shares of our common stock, with a value of $1.05 per share at the time of issuance, which were granted as additional compensation. In addition, on October 24, 2006, we extended the expiration of options previously awarded to Mr. Ford purchase an aggregate of 375,000 shares of our common stock with exercise prices ranging from $0.21 per share to $0.94 per share from November 30, 2006 to November 30, 2008. Pursuant to FAS 123(R) there was an expense of $85,750 to the Company as a result of this modification. All Other Compensation in the foregoing table represents the aggregate dollar amount of a car allowance received by Mr. Ford during fiscal 2006. (3) Mr. Kroger serves as our Chief Operating Officer. Mr. Kroger's compensation for fiscal 2006 includes 5,300 shares of our common stock with a value of $1.05 per share at the time of issuance. All Other Compensation in the foregoing table represents the aggregate dollar amount of a car allowance received by Mr. Kroger during each fiscal year as well as the amount of disability and life insurance premiums we pay on his behalf. (4) Mr. Sandler serves as our Chief Administrative Officer. Mr. Sandler's fiscal 2006 compensation includes 2,400 shares of our common stock with a value of $1.05 per share at the time of issuance. 24 EMPLOYMENT AGREEMENTS On July 3, 2000, the Company entered into an employment agreement, with an initial term of three years, with Mr. Kroger, who serves as our President and Chief Operating Officer. Thereafter, the contract was amended on December 23, 2002 and July 3, 2003. The contract provided for an annual salary of $166,000, minimum bonuses of $50,000, $80,000 and $80,000, respectively, for the years 2000 through 2002, 300,000 qualified stock options, a one-year salary severance clause and certain insurance and auto allowance compensations. On December 23, 2002, it was agreed that the President receive 100,000 shares of common stock in lieu of the $80,000 bonus due to be paid. The addendum dated July 3, 2003 was a one-year renewal of the original agreement. Mr. Vittoria, who has served as our Chief Executive Officer since October 2006, is not a party to an employment agreement with the Company. He receives no compensation and does not participate in any of the company's insurance plans. Mr. Ford, who formerly served as our Chief Executive Officer, was not a party to an employment agreement with the Company. His compensation was determined by the Compensation Committee of our Board of Directors. The Compensation Committee considered a number of factors in determining Mr. Ford's compensation including the scope of his duties and responsibilities to our company and the time he devotes to our business. The Compensation Committee did not consult with any experts or other third parties in determining the amount of Mr. Ford's compensation. During the fiscal year 2006 Mr. Ford's compensation package included a base annual salary of $232,960, with approximately $128,960 deferred annually, and company provided car allowance, and insurance benefits. Mr. Ford continues to be retained, on a consultant basis, with payments earned on a draw against commission basis, earning a minimum draw of $31,200 plus expenses. Mr. Sandler, who has served as our Chief Administrative Officer since January 2000, was not a party to an employment agreement with the Company. His compensation was determined by the Compensation Committee of our Board of Directors. The Compensation Committee considered a number of factors in determining Mr. Sandler's compensation including the scope of his duties and responsibilities to our company and the time he devotes to our business. The Compensation Committee did not consult with any experts or other third parties in determining the amount of Mr. Sandler's compensation. During the fiscal year 2007 Mr. Sandler's compensation package included a base annual salary of $112,000, with approximately $62,000 deferred annually, and company provided insurance benefits. The amount of payable to Mr. Sandler can be increased at any time upon the determination of the Compensation Committee of our Board of Directors. Incentive and Non-qualified Stock Option Plans The Board of Directors adopted the 2000 Non-Employee Directors' Plan (the "Directors' Plan") on November 8, 2000 under which options to purchase 400,000 shares have been authorized for issuance. The Directors' Plan will provide a means to attract and retain highly qualified persons to serve as non-employee directors and advisory directors of the Company. Each member of the Board of Directors was automatically granted 5,000 options at the date of commencement of the Directors' Plan and on their initial election as new members to the Board of Directors. Each director receives an additional 5,000 options at the close of each annual meeting of stockholders. Additionally, each director automatically receives 2,500 options for each committee of the Board on which the director serves. Options are granted at a price equal to the fair market value of the stock on the date of grant, are exercisable commencing two years following grant, and will expire five years from the date of grant. In the event a person ceases to serve on the Board of Directors, the outstanding options expire one year from the date of cessation of service. The Board of Directors will administer the Directors' Plan. The Company's 1999 Stock Option Plan (the "1999 Plan") and the 1996 Stock Option Plan (the "1996 Plan"), adopted on September 15, 1999 and amended in June 2000, and July 31, 1996, respectively, will work to increase proprietary interest in the Company of the employees, Board of Advisors, consultants, and non-employee Directors and to align more closely their interests with the interests of the Company's stockholders. The Plans will also maintain the Company's ability to attract and retain the services of experienced and highly qualified employees and non-employee directors. Under the 1999 Plan and 1996 Plan, the Company had reserved an aggregate of 3,000,000 and 2,200,000 shares, respectively, of common stock for issuance pursuant to options granted under the Plans ("Plan Options"). The Board of Directors or a Committee of the Board of Directors (the "Committee") of the Company will administer the Plans including, without limitation, the selection of the persons who will be granted Plan Options under the Plans, the type of Plan Options to be granted, the number of shares subject to each Plan Option and the Plan Option price. Options granted under the 1996 and 1999 Plans may either be options qualifying as incentive stock options ("Incentive options") under Section 422 of the Internal Revenue Code of 1986, as amended, or options that do not so qualify ("Non-Qualified Options"). In addition, the Plans also allow for the inclusion of a reload option provision ("Reload Option"), which permits an eligible person to pay the exercise price of the Plan Option with shares of Common Stock owned by the eligible person and receive a new Plan Option to purchase shares of Common Stock equal in number to the tendered shares. Any Incentive Option granted under the Plans must provide for an exercise price of not less than 100% of the fair market value of the underlying shares on the date of such grant, but the exercise price of any Incentive Option granted to an eligible employee owning more than 10% of the Company's Common Stock must be at least 110% of such fair market value as determined on the date of the grant. The term of each Plan Option and the manner in which it may be exercised is determined by the Board of the Directors or the Committee, provided that no Plan Option may be exercisable more than 10 years after the date of its grant and, in the case of an Incentive Option granted to an eligible employee owning more than 10% of the Company's common stock, no more than five years after the date of the grant. The exercise price of Non-Qualified Options shall be determined by the Board of Directors or the Committee and cannot be less than the par value of the Company's Common Stock. 25 The per share purchase price of shares subject to Plan Options granted under the Plans may be adjusted in the event of certain changes in the Company's capitalization, but any such adjustment shall not change the total purchase price payable upon the exercise in full of Plan Options granted under the Plan. Officers, directors, key employees and consultants of the Company and its subsidiaries (if applicable in the future) will be eligible to receive Non-Qualified Options under the Plans. Only officers, directors and employees of the Company who are employed by the Company or by any subsidiary thereof are eligible to receive Incentive Options. All Plan Options are generally nonassignable and nontransferable, except by will or by the laws of descent and distribution, and during the lifetime of the optionee, may be exercised only by such optionee. If an optionee's employment is terminated for any reason, other than his death or disability or termination for cause, or if an optionee is not an employee of the Company but is a member of the Company's Board of Directors and his service as a Director is terminated for any reason, other than death or disability, the Plan Option granted to him generally shall lapse to the extent unexercised on the earlier of the expiration date or one year following the date of termination. If the optionee dies during the term of his employment, the Plan Option granted to him generally shall lapse to the extent unexercised on the earlier of the expiration date of the Plan Option or the date one year following the date of the optionee's death. If the optionee is permanently and totally disabled within the meaning of Section 22 (c) (3) of the Internal Revenue Code of 1986, the Plan Option granted to him generally lapses to the extent unexercised on the earlier of the expiration date of the option or one year following the date of such disability. The Board of Directors or the Committee may amend, suspend or terminate the Plans at any time, except that no amendment shall be made which (i) increases the total number of shares subject to the Plans or changes the minimum purchase price therefore (except in either case in the event of adjustments due to changes in the Company's capitalization), (ii) extends the term of any Plan Option beyond ten years, or (iii) extends the termination date of the Plan. Unless the Plans shall theretofore have been suspended or terminated by the Board of Directors, the 1996 Plan shall terminate on July 31, 2006 and the 1999 Plan shall terminate on September 15, 2009. Any such termination of the Plans shall not affect the validity of any Plan Options previously granted thereunder. As of December 31, 2007, under the Directors' Plan, options to purchase 85,000 shares of common stock were outstanding. As of December 31, 2007, under the 1996 Plan, incentive stock options to purchase 108,232 shares of common stock were outstanding and non-qualified options to purchase 394,418 shares of common stock were outstanding and, under the 1999 Plan, incentive stock options to purchase 1,099,250 shares of common stock were outstanding and non-qualified options to purchase 80,000 shares of common stock were outstanding. ------------------------------------------------------------------------------------------------------------------------------- OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END ----------------------------------------------------------------------------------- ------------------------------------------- OPTION AWARDS STOCK AWARDS ----------------------------------------------------------------------------------- ------------------------------------------- EQUITY EQUITY INCENTIVE INCENTIVE MARKET PLAN PLAN NUMBER VALUE AWARDS: EQUITY OF OF AWARDS: MARKET OR INCENTIVE SHARES SHARES NUMBER OF PAYOUT PLAN OR OR UNEARNED VALUE OF AWARDS: UNITS UNITS SHARES, UNEARNED NUMBER OF NUMBER OF NUMBER OF OF OF UNITS OR SHARES, SECURITIES SECURITIES SECURITIES STOCK STOCK OTHER UNITS OR UNDERLYING UNDERLYING UNDERLYING THAT THAT RIGHTS OTHER UNEXERCISED UNEXERCISED UNEXERCISED OPTION HAVE HAVE THAT HAVE RIGHTS THAT OPTIONS OPTIONS UNEARNED EXERCISE OPTION NOT NOT NOT HAVE NOT NAME (#) (#) OPTIONS PRICE EXPIRATION VESTED VESTED VESTED VESTED EXERCISABLE UNEXERCISABLE (#) ($) DATE (#) ($) (#) (#) (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) ------------------------------------------------------------------------------------------------------------------------------- Joseph V. Vittoria 125,000 $ 2.25 3/28/08 ------------------------------------------------------------------------------------------------------------------------------- 150.000 2.00 2/2/09 ------------------------------------------------------------------------------------------------------------------------------- 100,000 .95 4/13/10 ------------------------------------------------------------------------------------------------------------------------------- 80,000 1.25 11/15/11 ------------------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------------------- Richard Ford 100,000 0.21 11/30/08 ------------------------------------------------------------------------------------------------------------------------------- 100,000 0.56 11/30/08 ------------------------------------------------------------------------------------------------------------------------------- 175,000 0.94 11/30/08 ------------------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------------------- Kevin Kroger 100,000 1.70 01/10/13 ------------------------------------------------------------------------------------------------------------------------------- 300,000 9.25 07/03/10 ------------------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------------------- Alan Sandler -- -- -- ------------------------------------------------------------------------------------------------------------------------------- 26 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. The following table sets forth certain information regarding the Company's common stock beneficially owned on March 28, 2008 for (i) each stockholder known by the Company to be the beneficial owner of five (5%) percent or more of the Company's outstanding Common Stock, (ii) each of the Company's named executive officers compensation, (iii) each of the Company's directors, and (iv) all names executive officers and directors as a group. In general, a person is deemed to be a "beneficial owner" of a security if that person has or shares the power to vote or direct the voting of such security, or the power to dispose or to direct the disposition of such security. A person is also deemed to be a beneficial owner of any securities of which the person has the right to acquire ownership within sixty (60) days. At March 28, 2007, there were 31,786,353 shares of Common Stock outstanding. The address of each of the persons set forth below is 2017 High Ridge Road, Boynton Beach, Florida 33426, except as otherwise noted. PERCENT OF COMMON STOCK BENEFICIAL BENEFICIALLY NAME AND ADDRESS OR IDENTITY OF GROUP OWNERSHIP OWNED ------------------------------------------ ---------- ------------ Quantum Industrial Partners LDC ("QIP") (1) 4,570,000 13.2 Glenhill Capital Management, LP (2) 4,364,661 12.6 Richard C. Ford (3) 3,606,651 10.4 Joseph V. Vittoria (4) 4,297,822 12.4 Dominick Telesco (5) 2,807,143 9.1 Kevin G. Kroger (6) 1,092,633 3.1 Alan J. Sandler (7) 318,392 -* John S. Caldwell (8) 57,500 -* Forrest D. Hayes (9) 10,000 -* Charles W. Walton (10) 407,857 1.2 Cindy Lea Gimler (11) 54,000 -* ---------- ------------ All Named Executive Officers and Directors as a group (8 persons) (4)(5)(6)(7)(8)(9)(10)(11) 9,402,490 27.1% ---------- * Less than 1% (1) Address is c/o Curacao Corporation Company, N.V., Kaya Flamboyan, Willenstad Curacao, Netherlands, Antilles. (2) Address is 598 Madison Avenue, 12th Floor, New York, NY 10022. Includes warrants to purchase 89,286 shares of common stock at $1.25 per share through October 1, 2011. (3) Includes options to purchase 100,000 shares of common stock at $.56 per share through November 30, 2008, options to purchase 100,000 shares at $.21 per share through November 30, 2008, and options to purchase 175,000 shares at $.94 per share through November 30, 2008 and purchase of 1,666,667 shares of common stock at $0.30 on June 30, 2005. (4) Mr. Vittoria serves as Chairman of the Board of Directors and Chief Executive Officer of the Company. Includes five warrants to purchase 125,000 shares of common stock at $2.25 through March 28, 2008, 150,000 shares of common stock at $2.00 through February 2, 2009, 100,000 shares of common stock at $.95 through April 14, 2010, 80,000 shares of common stock at $1.25 through November 15, 2011, and 150,000 shares of common stock at $1.25 through March 24, 2013, respectively. Includes purchase of 833,333 shares of common stock at $0.30 on June 30, 2005, 833,333 shares of common stock at $0.30 on February 28, 2006 and 214,286 shares of common stock at $.70 on August 23, 2007. Also includes the purchase of 600,000 shares of common stock at $.35 on March 24, 2008. The warrants to purchase 125,000 shares of common stock at $2.25 through March 28, 2008, are expected to expire. (5) Mr. Telesco serves as a Director. Includes purchase of 400,000 shares of common stock at $.70 on October 17, 2006, purchase of 600,000 shares of common stock at $.35 on March 24, 2008, 100,000 warrants to purchase common stock at $1.25 through October 1, 2011 and 150,000 warrants to purchase common stock at $1.25 through March 24, 2013. Does not include unvested options to purchase 5,000 shares of common stock at $.66 per share 27 vesting December 19, 2008 and unvested options to purchase 5,000 shares of common stock at $.47 per share vesting December 19 2009. (6) Mr. Kroger is President, Chief Operating Officer, and a Director. Includes options to purchase 300,000 shares of common stock at $9.25 through July 3, 2010; options to purchase 100,000 shares at $1.70 through January 10, 2013; purchase of 20,000 shares of common stock at $7.50 on September 26, 2000; purchase of 333,333 shares of common stock at $0.30 on June 30, 2005 and purchase of 334,000 shares of common stock at $0.30 on February 28, 2006 and grant of 5,300 shares at $1.05 on October 23, 2006. (7) Mr. Sandler serves as Vice President, Chief Administrative Officer and Secretary. Includes a grant of 2,400 shares at $1.05 on October 23, 2006. (8) General Caldwell serves as a Director. Includes options to purchase 5,000 shares of common stock each at $0.42 and 2,500 shares of common stock each at $0.66, through August 25, 2010 and November 30, 2010, respectively; Does not include unvested options to purchase 7,500 shares at $0.37 through August 25, 2011; and unvested options to purchase 7,500 shares at $0.37 through August 25, 2012. (9) Mr. Hayes serves as a Director. Includes options to purchase 7,500 shares of common stock at $1.00 through November 10, 2010 and options to purchase 2,500 shares of common stock at $0.68 through November 30, 2010; does not include unvested options to purchase 10,000 shares at $0.37 through November 10, 2011; and unvested options to purchase 10,000 shares at $0.37 through November 10, 2012. (10) Dr. Walton serves as a Director. Includes options to purchase 5,000 shares of common stock each at $0.42 and 2,500 shares of common stock each at $0.68, through August 25, 2010 and November 30, 2010, respectively; does not include unvested options to purchase 7,500 shares at $0.37 through August 25, 2011; and unvested options to purchase 7,500 shares at $0.37 through August 25, 2012. Also includes 21,429 warrants issued October 13, 2006 to purchase common stock at $1.25 through October 1, 2011. (11) Ms. Gimler is Chief Financial Officer and Secretary of Puradyn, Ltd. Includes options to purchase 50,000 shares of common stock, issued February 25, 2005, at $.93 through February 28, 2015. Includes purchase of 2,000 shares at $.45 on August 23, 2007 and the purchase of 2,000 shares at $.50 on November 21, 2007. Does not include unvested options to purchase 25,000 shares of common stock at $.40, which vesting begins September 26, 2008. SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS The following table sets forth securities authorized for issuance under equity compensation plans, including individual compensation arrangements, by us under our Filter Technologies, Inc. Stock Option Plan and any compensation plans not previously approved by our stockholders as of December 31, 2007. --------------------------------------------------------------------------------------------------------------------- NUMBER OF SECURITIES WEIGHTED AVERAGE NUMBER OF SECURITIES TO BE ISSUED UPON EXERCISE PRICE OF REMAINING AVAILABLE FOR EXERCISE OF OUTSTANDING OPTIONS, FUTURE ISSUANCE UNDER OUTSTANDING OPTIONS, WARRANTS AND RIGHTS EQUITY COMPENSATION PLANS WARRANTS AND RIGHTS (B) (EXCLUDING SECURITIES (A) REFLECTED IN COLUMN (A)) (C) --------------------------------------------------------------------------------------------------------------------- Plan category --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- Plans approved by our stockholders: --------------------------------------------------------------------------------------------------------------------- 1996 Stock Option Plan 502,650 $1.61 1,697,350 --------------------------------------------------------------------------------------------------------------------- 1999 Stock Option Plan 1,179,250 3.26 1,820,750 --------------------------------------------------------------------------------------------------------------------- 2000 Non-Employee Directors Plan 85,000 .48 315,000 --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- Plans not approved by our stockholders 0 N/A N/A ---------------------------------------- ----------------------- ----------------------- ---------------------------- ITEM 12. CERTAIN RELATIONSHIPS, RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE. In July 2001, the Company received promissory notes from two of its officers for the exercise of their vested stock options in the amount of $875,256 and bearing interest of 5.63%. The principal and accrued interest are due upon the earlier of the expiration of the original option periods, which range from July 2008 to December 2009, or upon the 28 sale of the common stock acquired by the execution of the options. During 2007, the Company recorded approximately $99,000 of interest reserves relating to these shareholder notes. Beginning on March 28, 2002, the Company executed a binding agreement with one of its stockholders, who is also a Board Member, to fund up to $6.1 million. Amounts drawn bear interest at the prime rate per annum (6.75% at December 31, 2007) payable monthly and were to become due and payable on December 31, 2005, or upon a change in control of the Company or consummation of any other financing over $7 million. In April 2005, the maturity date was extended to December 31, 2006 and then in March 2006, 2007 and 2008, the maturity date was extended to December 31, 2007, December 31, 2008 and December 31, 2009, respectively. In consideration for the stockholder entering into this loan agreement, the Company granted the stockholder a total of 475,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company's stock on the dates of grant. As of December 31, 2007, the Company had drawn the entire $6.10 million of the available funds and paid approximately $454,000 in related interest. DIRECTOR INDEPENDENCE John S. Caldwell, Forrest D. Hayes, Dominick Telesco and Charles W. Walton qualify as "independent" directors as the term is used in Item 7(d)(3)(iv) of Schedule 14A of the Securities Exchange Act of 1934, as amended. ITEM 13. EXHIBITS Exhibits Description of Documents 3.1 Amended and Restated Certificate of Incorporation of T/F Purifier, Inc. dated December 30, 1996 (2) 3.1(a) Certificate of Amendment to Certificate of Incorporation dated February 3, 1998 (3) 3.2 Bylaws of T/F Purifier, Inc. (1) 3.3 Memorandum and Articles of Association of TV Purifier Ltd. (1) 4.1 Amendment No. 1 to Registration Rights Agreement (3) 10.1 1996 Stock Option Plan (1) 10.2 1999 Stock Option Plan (4) 10.3 2000 Non-Employee Directors' Plan (5) 10.4 2002 Audit Committee Charter (7) 10.9 Change in compensatory plan (8) 14.1 Code of Ethics (7) 23.1 Consent of Independent Registered Public Accounting Firm (6) 23.2 Consent of Independent Registered Public Accounting Firm (6) 31.1 Sarbanes-Oxley Act Section 302 Certification (6) 31.2 Sarbanes-Oxley Act Section 302 Certification (6) 32.1 Sarbanes-Oxley Act Section 906 Certification (6) 32.2 Sarbanes-Oxley Act Section 906 Certification (6) 29 (1) Incorporated by reference from the Exhibits to the company's Form 10-SB 12B Registration Statement, as amended, as filed with the Securities and Exchange Commission. (2) Incorporated by reference from the Exhibit to the company's Form 8-K, January 9, 1997, as filed with the Securities and Exchange Commission. (3) Incorporated by reference from the Exhibit to the company's Form 8-KA, February 11, 1998, as filed with the Securities and Exchange Commission. (4) Incorporated by reference from Form S-8, September 15, 1999, as filed with the Securities and Exchange Commission (5) Incorporated by reference from Form 10-KSB, August 9, 2001, as filed with the Securities and Exchange Commission. (6) Filed herewith. (7) Incorporated by reference from the Exhibit to the company's Form 8-K, November 18, 2004, as filed with the Securities and Exchange Commission. (8) Incorporated by reference from the Exhibit to the company's Form 8-K, August 22, 2005, as filed with the Securities and Exchange Commission. ITEM 14. PRINCIPAL ACCOUNTANTS FEES AND SERVICES The following table sets forth the aggregate fees billed to the Company for the years ended December 31, 2007 by Webb and Company, and December 31, 2006 by Webb & Company and DaszkalBolton, the Company's principal accountants: 2007 2006 ------- ------- Audit Fees $29,638 $28,000 Audit-Related Fees 9,718 22,500 Tax Fees -- -- All Other Fees -- 4,989 Audit Fees -- This category includes the audit of our annual financial statements, review of financial statements included in our Form 10-QSB Quarterly Reports and services that are normally provided by the independent auditors in connection with engagements for those fiscal years. This category also includes advice on audit and accounting matters that arose during, or as a result of, the audit or the review of interim financial statements. Audit-Related Fees -- This category consists of assurance and related services by the independent auditors that are reasonably related to the performance of the audit or review of our financial statements and are not reported above under "Audit Fees." The services for the fees disclosed under this category include consultation regarding our correspondence with the SEC and other accounting consulting. Tax Fees -- This category consists of professional services rendered by our independent auditors for tax compliance and tax advice. The services for the fees disclosed under this category include tax return preparation and technical tax advice. All Other Fees -- This category consists of fees for other miscellaneous items. The Audit Committee of our Board of Directors has adopted a procedure for pre-approval of all fees charged by our independent auditors. Under the procedure, the Audit Committee approves the engagement letter with respect to audit, tax and review services. Other fees are subject to pre-approval by the Audit Committee, or, in the period between meetings, by a designated member of Audit Committee. Any such approval by the designated member is disclosed to the entire Audit Committee at the next meeting. The audit and tax fees paid to the auditors with respect to fiscal year 2007 were pre-approved by the entire Audit Committee. 30 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Puradyn Filter Technologies Incorporated (Registrant) Date: March 28, 2008 By: /s/ Joseph V. Vittoria ---------------------- Joseph V. Vittoria Chairman and Chief Executive Officer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Date: March 28, 2008 By: /s/ Joseph V. Vittoria ---------------------------------------------------------- Joseph V. Vittoria Principal Executive Officer and Chairman of the Board By: /s/ Alan J. Sandler ---------------------------------------------------------- Alan J. Sandler Vice President, Chief Administrative Officer and Secretary By: /s/ Cindy Lea Gimler ---------------------------------------------------------- Cindy Lea Gimler, Chief Financial Officer Principal Financial and Accounting Officer By: /s/ Kevin G. Kroger ---------------------------------------------------------- Kevin G. Kroger, President and Chief Operating Officer and Director By: /s/ John S. Caldwell ---------------------------------------------------------- John S. Caldwell, Director By: /s/ Forrest D. Hayes ---------------------------------------------------------- Forrest D. Hayes, Director By: /s/ Charles W. Walton ---------------------------------------------------------- Charles W. Walton, Director By: /s/ Dominick Telesco ---------------------------------------------------------- Dominick Telesco, Director 31 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE ---- Reports of Independent Registered Public Accounting Firm.................. 33 Consolidated Financial Statements: Consolidated Balance Sheet - December 31, 2007....................... 34 Consolidated Statements of Operations - Years ended December 31, 2007 and 2006........................... 35 Consolidated Statements of Changes in Stockholders' Deficit - Years ended December 31, 2007 and 2006........................... 36 Consolidated Statements of Cash Flows - Years ended December 31, 2007 and 2006........................... 37 Notes to Consolidated Financial Statements........................... 38 32 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Puradyn Filter Technologies Incorporated We have audited the accompanying consolidated balance sheet of Puradyn Filter Technologies Incorporated (the Company) as of December 31, 2007, and the related consolidated statements of operations, changes in stockholders' equity (deficit) and cash flows for the two years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these 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 financial statements are free of material misstatement. The Company has determined that it is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Puradyn Filter Technologies Incorporated at December 31, 2007, and the results of their operations and their cash flows for the two years then ended in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2, the Company has suffered recurring losses from operations, its total liabilities exceed its total assets, and it has relied on cash inflows from an institutional investor and current stockholder. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regards to these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Webb and Company, P.A. -------------------------- Boynton Beach, Florida March 10, 2008 33 PURADYN FILTER TECHNOLOGIES INCORPORATED CONSOLIDATED BALANCE SHEET DECEMBER 31, 2007 Assets Current assets: Cash and cash equivalents $ 112,270 Accounts receivable, net of allowance for uncollectible accounts of $46,870 382,279 Inventories, net 1,475,380 Prepaid expenses and other current assets 181,648 ------------ Total current assets 2,151,577 Property and equipment, net 162,838 Other noncurrent assets 40,930 Deferred financing costs, net 18,522 ============ Total assets $ 2,373,867 ============ Liabilities and stockholders' deficit Current liabilities: Accounts payable 594,372 Accrued liabilities 1,054,071 Current portion of capital lease obligation 1,048 Deferred revenues 136,169 ------------ Total current liabilities 1,785,660 Capital lease obligation, less current portion 7,139 Notes Payable - stockholder 6,250,000 ------------ Total Long Term Liabilities 6,257,139 ------------ Total Liabilities 8,042,799 Commitments and contingencies -- Stockholders' deficit: Preferred stock, $.001 par value: -- Authorized shares - 500,000; None issued and outstanding Common stock, $.001 par value, 29,401 Authorized shares - 40,000,000; Issued and outstanding - 29,400,638 Additional paid-in capital 41,329,330 Notes receivable from stockholders (1,064,031) Accumulated deficit (45,825,210) Accumulated other comprehensive income (138,422) ------------ Total stockholders' deficit (5,668,932) ------------ Total liabilities and stockholders' deficit $ 2,373,867 ============ See accompanying notes to consolidated financial statements. 34 PURADYN FILTER TECHNOLOGIES INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31 2007 2006 ------------ ------------ Net sales $ 3,082,873 $ 3,072,947 Costs and expenses: Cost of products sold 2,831,560 2,566,572 Salaries and wages 1,074,519 1,348,335 Selling and administrative 1,061,828 1,343,651 ------------ ------------ Total operating costs 4,967,907 5,258,558 ------------ ------------ Loss from operations (1,885,034) (2,185,611) Other (expense) income: Interest income 32,516 50,413 Interest expense (588,583) (518,265) ------------ ------------ Total other expense (556,067) (467,852) ------------ ------------ Income taxes -- -- ============ ============ Net loss $ (2,441,101) $ (2,653,463) ============ ============ Basic and diluted loss per common share $ (.09) $ (.10) ============ ============ Basic and diluted weighted average common shares Outstanding 28,322,903 25,385,294 ============ ============ See accompanying notes to consolidated financial statements. 35 PURADYN FILTER TECHNOLOGIES INCORPORATED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' DEFICIT NOTES ACCUMULATED ADDITIONAL ACCUMULATED OTHER TOTAL COMMON STOCK PAID-IN RECEIVABLE FROM COMPREHENSIVE STOCKHOLDERS' SHARES AMOUNT CAPITAL STOCKHOLDERS DEFICIT INCOME (LOSS) DEFICIT ------------ --------- ------------ ------------- -------------- ------------- ------------ Balance at December 31, 2005 22,276,099 $ 22,276 $ 37,078,716 $ (1,088,590) $ (40,730,646) $ 13,398 $ (4,704,846) Foreign currency translation adjustment -- -- -- -- -- (166,107) (166,107) Net loss -- -- -- -- (2,653,463) -- (2,653,463) ------------ Total comprehensive loss -- -- -- -- -- -- (2,819,570) Exercise of stock options 5,000 5 2,595 -- -- -- 2,600 Issuance of common stock in private Placement, net of issuance costs 4,971,903 4,972 2,262,028 -- -- -- 2,267,000 Issuance of warrants to nonemployee directors -- -- 2,250 -- -- -- 2,250 Issuance of warrants to employee/director -- -- 100,500 -- -- -- 100,500 Issuance of warrants to investors -- -- 66,492 -- -- -- 66,492 Interest receivable related to notes receivable from stockholders -- -- -- (48,066) -- -- (48,066) Compensation expense associated with option modification -- -- 173,350 -- -- -- 173,350 Stock options issued to employees -- -- 29,250 -- -- -- 29,250 Stock options issued in lieu of compensation 57,350 57 48,160 -- -- -- 48,217 Compensation expense associated with unvested option awards -- -- 11,190 -- -- -- 11,190 ---------- --------- ------------ ------------ ------------- ------------ ----------- Balance at December 31, 2006 27,310,352 27,310 39,774,531 (1,136,656) (43,384,109) (152,709) (4,871,633) Foreign currency translation adjustment -- -- -- -- -- 14,287 14,287 Net loss -- -- -- -- (2,441,101) -- (2,441,101) ----------- Total comprehensive loss -- -- -- -- -- -- (2,426,814) Exercise of stock options 76,000 76 28,424 -- -- -- 28,500 Issuance of common stock in private Placement, net of issuance costs 2,014,286 2,015 1,472,985 -- -- -- 1,475,000 1Issuance of warrants to investors -- -- 34,200 -- -- -- 34,200 Foregiveness of stockholder loans -- -- -- 21,506 -- -- 21,506 Interest receivable related to notes receivable from stockholders -- -- -- 51,119 -- -- 51,119 Compensation expense associated with option modification -- -- 1,202 -- -- -- 1,202 Compensation expense associated with unvested option awards -- -- 17,988 -- -- -- 17,988 ---------- --------- ------------ ------------ ------------- ------------ ----------- Balance at December 31, 2007 29,400,638 $ 29,401 $ 41,329,330 $ (1,064,031) $ (45,825,210) $ (138,422) $(5,668,932) ========== ========= ============ ============ ============= ============ =========== See accompanying notes to consolidated financial statements. 36 PURADYN FILTER TECHNOLOGIES INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, ---------------------------- 2007 2006 ----------- ----------- OPERATING ACTIVITIES Net loss $(2,441,101) $(2,653,463) ----------- ----------- Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 96,001 183,728 Gain on sale of assets 578 -- Provision for bad debts (3,079) 8,398 Provision for obsolete and slow moving inventory (62,564) (24,819) Amortization of deferred financing costs included in interest expense 22,227 48,899 Interest receivable from stockholders' notes 72,626 (48,066) Compensation expense on stock-based arrangements with employees and vendors 19,190 213,790 Compensation expense on stock-based arrangements with investors and directors 34,200 169,242 Changes in operating assets and liabilities: Accounts receivable 118,687 (83,245) Inventories (140,360) (65,856) Prepaid expenses and other current assets (7,633) 71,156 Other noncurrent assets -- -- Accounts payable 277,656 46,326 Accrued liabilities 168,617 167,644 Deferred revenues 36,254 24,105 ----------- ----------- Net cash used in operating activities (1,808,701) (1,942,161) INVESTING ACTIVITIES Proceeds from sale of property and equipment 5,458 -- Purchases of property and equipment (60,878) (39,455) ----------- ----------- Net cash used in investing activities (55,420) (39,455) FINANCING ACTIVITIES Proceeds from sale of common stock 1,475,000 2,267,000 Proceeds from exercise of stock options 28,500 2,600 Proceeds from notes payable to stockholder 1,191,000 515,000 Payment of notes payable to stockholder (780,000) (747,000) Payment of capital lease obligations (5,931) (4,987) ----------- ----------- Net cash provided by financing activities 1,908,569 2,032,613 Effect of exchange rate changes on cash and cash equivalents 12,647 (151,379) ----------- ----------- Net increase (decrease) in cash and cash equivalents 57,095 (100,382) Cash and cash equivalents at beginning of period 55,175 155,557 ----------- ----------- Cash and cash equivalents at end of period $ 112,270 $ 55,175 =========== =========== SUPPLEMENTAL CASH FLOW INFORMATION Cash paid for interest $ 453,916 $ 462,784 NONCASH INVESTING AND FINANCING ACTIVITIES Common stock issued in settlement of accrued bonus $ -- $ 30,000 =========== =========== See accompanying notes to consolidated financial statements. 37 PURADYN FILTER TECHNOLOGIES INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2007 1. SIGNIFICANT ACCOUNTING POLICIES Organization Puradyn Filter Technologies Incorporated (the "Company"), a Delaware corporation, is engaged in the manufacturing, distribution and sale of bypass oil filtration systems under the trademark Puradyn(R) primarily to companies with large fleets of vehicles and secondarily to original vehicle equipment manufacturer aftermarket programs. The Company holds the exclusive worldwide manufacturing and marketing rights for the Puradyn products pursuant to licenses for two patents and through direct ownership of various other patents. Puradyn Filter Technologies, Ltd. (Ltd.), a wholly owned subsidiary in the United Kingdom, sells and distributes the Company's products in Europe, the Middle East and certain African countries. The results of the operations of Ltd. have been included in the Company's statements of operations since Ltd.'s formation on June 1, 2000. New Accounting Pronouncements In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes," which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with FIN 48, the Company must adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. The effective date of FIN 48 for the Company is January 1, 2007. The adoption of FIN 48 has not had a material impact on the Company's condensed consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 on its financial position, cash flow, and results of operations, and its adoption is not expected to have a material effect on the Company's financial statements. In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115". This statement permits entities to choose to measure many financial instruments and certain other items at fair value. Most of the provisions of SFAS No. 159 apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" applies to all entities with available-for-sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provision of SFAS No. 157, "Fair Value Measurements". The adoption of this statement is not expected to have a material effect on the Company's financial statements. In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51". This statement improves the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards that require; the ownership interests in subsidiaries held by parties other than the parent and the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, changes in a parent's ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently, when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value, entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 affects those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS 38 No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The adoption of this statement is not expected to have a material effect on the Company's financial statements Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Puradyn Filter Technologies, Ltd. All significant intercompany transactions and balances have been eliminated. Revenue Recognition The Company recognizes revenue from product sales to customers, distributors and resellers when products that do not require further services or installation at the customer's site are shipped, there are no uncertainties surrounding customer acceptance and for which collectibility is reasonably assured in accordance with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial Statements as amended and interpreted. Cash received by the Company prior to revenue recognition is recorded as deferred revenues. Sales are made to customers under terms allowing certain limited rights of return and other limited product and performance warranties for which provision has been made in the accompanying consolidated financial statements. Amounts billed to customers in sales transactions related to shipping and handling, represent revenues earned for the goods provided and are included in net sales. Costs of shipping and handling are included in cost of products sold. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from those estimates. Cash and Cash Equivalents Cash and cash equivalents include all highly liquid investments with original maturities of three months or less at the time of purchase. At December 31, 2007 and December 31, 2006, the Company did not have any cash equivalents. Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, accounts receivable, prepaid expenses and other assets, accounts payable, accrued liabilities and notes payable to stockholder approximate their fair values as of December 31, 2007 because of their short-term natures. Accounts Receivable Accounts receivable are recorded at fair value on the date revenue is recognized. The Company provides allowances for doubtful accounts for estimated losses resulting from the inability of its customers to repay their obligation. If the financial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to repay, additional allowances may be required. The Company provides for potential uncollectible accounts receivable based on specific customer identification and historical collection experience adjusted for existing market conditions. If market conditions decline, actual collection experience may not meet expectations and may result in decreased cash flows and increased bad debt expense. The policy for determining past due status is based on the contractual payment terms of each customer, which are generally net 30 or net 60 days. Once collection efforts by the Company and its collection agency are exhausted, the determination for charging off uncollectible receivables is made. Inventories Inventories are stated at the lower of cost or market using the first in, first out (FIFO) method. Production costs, consisting of labor and overhead, are applied to ending finished goods inventories at a rate based on estimated production capacity. Excess production costs are charged to cost of products sold. Provisions have been made to reduce excess or obsolete inventories to their net realizable value. 39 Deferred Financing Costs The Company capitalizes financing costs and amortizes them using the effective interest method over the term of the related debt. Amortization of deferred financing costs is included in interest expense and totaled $22,227 and $48,899 for the years ended December 31, 2007 and 2006, respectively. Accumulated amortization of deferred financing costs as of December 31, 2007 was $662,628. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets, except for assets held under capital leases, for which the Company records depreciation and amortization based on the shorter of the asset's useful life or the term of the lease. The estimated useful lives of property and equipment range from 3 to 5 years. Upon sale or retirement, the cost and related accumulated depreciation and amortization are eliminated from their respective accounts, and the resulting gain or loss is included in results of operations. Repairs and maintenance charges, which do not increase the useful lives of the assets, are charged to operations as incurred. Impairment of Long-Lived Assets Management assesses the recoverability of its long-lived assets when indicators of impairment are present. If such indicators are present, recoverability of these assets is determined by comparing the undiscounted net cash flows estimated to result from those assets over the remaining life to the assets' net carrying amounts. If the estimated undiscounted net cash flows are less than the net carrying amount, the assets would be adjusted to their fair value, based on appraisal or the present value of the undiscounted net cash flows. Product Warranty Costs In connection with the adoption of FIN 45, the Company is including the following disclosure applicable to its product warranties. The Company accrues for warranty costs based on the expected material and labor costs to provide warranty replacement products. The methodology used in determining the liability for warranty cost is based upon historical information and experience. The Company's warranty reserve is calculated as the gross sales multiplied by the historical warranty expense return rate. The following table shows the changes in the aggregate product warranty liability for the year ended December 31, 2007: Balance as of December 31, 2006 $ 71,759 Less: Payments made (10,895) Change in prior period estimate 1,397 Add: Provision for current period warranties 27,548 -------- Balance as of December 31, 2007 $ 89,809 ======== Guarantees In August 2003 the Company made a guarantee to its wholly owned subsidiary, Puradyn Filter Technologies, Ltd., that it would provide cash for working capital on an as needed basis for a minimum period of twelve months. The guarantee 40 was provided as assurance that they will continue as a going concern for 2003. This guarantee is excluded from the recognition and measurement provisions of FIN 45, as it relates to a wholly owned consolidated subsidiary. Comprehensive Income SFAS No. 130, Reporting Comprehensive Income (SFAS 130) establishes rules for reporting and displaying of comprehensive income and its components. Comprehensive income is the sum of net loss as reported in the consolidated statements of operations and other comprehensive income transactions as reported in the consolidated statement of changes in stockholders' equity (deficit). Other comprehensive income transactions that currently apply to the Company result from changes in exchange rates used in translating the financial statements of its wholly owned subsidiary, Ltd. Comprehensive income as of December 31, 2007 and 2006 is not shown net of taxes because the Company's deferred tax asset has been fully offset by a 100% valuation allowance. Advertising Costs Advertising costs are expensed as incurred. During the years ended December 31, 2007 and 2006, advertising costs incurred by the Company totaled approximately $17,000 and $37,000, respectively, and are included in selling and administrative expenses in the accompanying consolidated statements of operations. Engineering and Development Engineering and development costs are expensed as incurred. During the years ended December 31, 2007 and 2006, engineering and development costs incurred by the Company totaled approximately $31,000 and $52,000, respectively, and are included in selling and administrative expenses in the accompanying consolidated statements of operations. Foreign Currency Translation The financial statements of the Company's foreign subsidiary have been translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation (SFAS 52). All balance sheet accounts have been translated using the exchange rate in effect at the balance sheet date. Income statement amounts have been translated using an appropriately weighted average exchange rate for the year. The translation gains and losses resulting from the changes in exchange rates during 2007 and 2006 have been reported in accumulated other comprehensive income, except for gains and losses resulting from the translation of intercompany receivables and payables, which are included in earnings for the period. During the years ended December 31, 2007 and 2006, the Company recorded a foreign currency exchange rate gain of approximately $87,000 and a loss of approximately $198,000, respectively, which is included in selling and administrative expenses in the accompanying consolidated statements of operations. Income Taxes The Company accounts for income taxes under SFAS No. 109, Accounting for Income Taxes (SFAS 109). Deferred income tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Stock Option Plans We adopted SFAS 123R effective January 1, 2006 using the modified prospective application method of adoption which requires us to record compensation cost related to unvested stock awards as of December 31, 2005 recognizing the amortized grant date fair value in accordance with provisions of SFAS 123R on straight line basis over the service periods of each award. We have estimated forfeiture rates based on our historical experience. Stock option compensation expense for the year ended December 31, 2007 has been recognized as a component of cost of goods sold and general and administrative expenses in the accompanying Consolidated Financial Statements. In 2007 and 2006, respectively, 200,000 and 85,000 options were granted at fair market value on the date of grant pursuant to the Stock Option Plan. The Company leases its employees from a payroll leasing company. The Company's leased employees meet the definition of employees as specified by FIN 44 for purposes of applying SFAS 123R. 41 Stock options and warrants issued to consultants and other non-employees as compensation for services provided to the Company are accounted for based on the fair value of the services provided or the estimated fair market value of the option or warrant, whichever is more reliably measurable in accordance with SFAS 123 and EITF 96-18, Accounting for Equity Investments That are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services, including related amendments and interpretations. The related expense is recognized over the period the services are provided. Credit Risk The Company minimizes the concentration of credit risk associated with its cash and cash equivalents by maintaining its cash and cash equivalents with high quality federally insured financial institutions. However, cash balances in excess of the FDIC insured limit of $100,000 are at risk. At December 31, 2007, the Company did not have cash balance above the FDIC insured limit. The Company performs ongoing evaluations of its significant trade accounts receivable customers and generally does not require collateral. An allowance for doubtful accounts is maintained against trade accounts receivable at levels which management believes is sufficient to cover probable credit losses. There are concentrations of credit risk with respect to trade receivables due to the amounts owed by five customers at December 31, 2007 whose trade receivable balances each represented approximately 24%, 10%, 8%, 8% and 7% for a total of 57% of total accounts receivable. The loss of business from one or a combination of the Company's significant customers, or an unexpected deterioration in their financial condition, could adversely affect the Company's operations. Basic and Diluted Loss Per Share The Company follows SFAS No. 128, Earnings Per Share (SFAS 128), which requires a dual presentation of basic and diluted earnings per share. However, because of the Company's net losses, the effects of stock options and warrants would be anti-dilutive and, accordingly, are excluded from the computation of earnings per share. The number of such shares excluded from the computations of diluted loss per share totaled 3,636,543 in 2007 and 3,470,043 in 2006. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. 2. ISSUES AFFECTING LIQUIDITY AND MANAGEMENT'S PLANS The Company's financial statements have been prepared on the basis that it will operate as a going concern, which comtemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has incurred net losses each year since inception and has relied on the sale of its stock from time to time and loans from third parties and from related parties to fund its operations. These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led the Company's independent registered public accounting firm Webb & Company to include a statement in its audit report relating to the Company's audited consolidated financial statements for the year ended December 31, 2007 expressing substantial doubt about the Company's ability to continue as a going concern. The Company has been addressing the liquidity and working capital issues and continues to attempt to raise additional capital with institutional and private investors and current stockholders. Cost reductions were and continue to be implemented by the Company, including acquiring alternative suppliers for raw materials, and the company expects to see results from these reductions, as well as other cost reduction plans through 2008. Additionally, the Company is reviewing cost of material increases, which are expected to be passed through to its customers as product price increases beginning January, 2008. Additionally, we continue to address liquidity concerns because of inadequate revenue growth. As a result, cash flow from operations is insufficient to cover our liquidity needs for the immediate future. The Company is in the process of aggressively seeking to raise capital and is exploring financing availability and options with investment bankers, funds, private sources, members of management and existing shareholders. The Company has implemented further measures to preserve its ability to operate, including organizational changes, deferral of salaries, reduction in personnel and renegotiating creditor and collection arrangement. There can be no assurance that the Company will be able to raise the additional capital needed or reduce the level of expenditures in order to sustain operations. The Company has sustained losses since inception in 1987 and used net cash in operations of approximately $1,809,000 and $1,942,000 during the years ended December 31, 2007 and 2006, respectively. As a result, the Company has had to 42 rely principally on private equity funding, including the conversion of debt into stock, as well as stockholder loans to fund its activities to date. On February 2, 2004, the stockholder amended the original loan agreements to extend the maturity dates to December 31, 2005 and to waive the funding requirement mandating maturity terms until such time as the Company has raised an additional $7.0 million over the $3.5 million raised in the Company's recent private placement offering; or until such time as the Company is operating within sufficient cash flow parameters, as defined, to sustain its operations; or until a disposition of the Company occurs. In April 2005, the maturity date of the loan agreement was extended to December 31, 2006. As consideration of this extension, this stockholder was granted an additional 100,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company's stock on the date of grant. In March 2006, 2007 and 2008, the stockholder extended the maturity date of the loan agreement to December 31, 2007, December 31, 2008 and December 31, 2009, respectively. The Company experienced a modest reduction in cash used in operations in 2007 and anticipates additional reductions in cash used in operations in 2008; however, additional cash will still be needed to support operations. Management believes that the commitments received from its stockholder, the funds received from its recent current private placement offering, as well as cash from sales and current working capital will be sufficient to sustain its operations at its current level through May 2008. However, if budgeted sales levels are not achieved and/or significant unanticipated expenditures occur, the Company may have to modify its business plan, reduce or discontinue some of its operations or seek a buyer for all or part of its assets to continue as a going concern through 2008. There can be no assurance that the Company will be able to raise the additional capital needed to continue as a going concern. 3. INVENTORIES At December 31, 2007, inventories consisted of the following: Raw materials $ 780,979 Finished goods 779,005 Valuation allowance (84,604) ------------ $ 1,475,380 ============ 4. PREPAID EXPENSES AND OTHER CURRENT ASSETS At December 31, 2007, prepaid expenses and other current assets consisted of the following: Prepaid expenses $ 101,857 Deferred costs related to deferred revenue 79,791 ------------ $ 181,648 ============ 5. PROPERTY AND EQUIPMENT At December 31, 2007, property and equipment consisted of the following: Machinery and equipment $ 1,077,501 Furniture and fixtures 101,555 Leasehold improvements 122,622 Website development 72,960 Computer hardware and software 119,262 ------------ 1,493,900 Less accumulated depreciation and amortization (1,331,062) ------------ $ 162,838 ============ Depreciation and amortization expense of property and equipment for the years ended December 31, 2007 and 2006 is $96,001 and $183,728, respectively, of which approximately $18,000 and $126,000 is included in cost of products sold 43 and approximately $78,000 and $58,000 is included in selling and administrative costs, respectively, in the accompanying consolidated statements of operations. 6. LEASES The Company leases its office and warehouse facilities in Boynton Beach, Florida under a long-term noncancellable lease agreement, which contains renewal options and rent escalation clauses. A $235,000 security deposit was paid in 2002, which will be refunded ratably on an annual basis over the first three years of the lease term beginning on the last day of the first lease year, provided there has been no Event of Default, as defined, by the Company. Of this amount, $66,667 was paid to the Company in November 2003, January 2005 and January 2006, respectively. As of December 31, 2007, $34,970 is included in noncurrent assets in the accompanying consolidated balance sheet. The total minimum lease payments over the term of the lease aggregate approximately $774,000. The terms of the lease include a period of free rent and scheduled annual rate increases. As such, rent expense is recognized on a straight-line basis over the 68-month term of the lease. The Company leases a condominium in Ocean Ridge, Florida to provide accommodations for Company use. The lease is renewable annually and is paid in three installments. The Company's wholly owned subsidiary, Ltd., rented office space in Devon, England under a lease that extended through March 31, 2002 and was subsequently extended on a month-to-month basis. In September 2003, Ltd. moved to new office space by assuming the existing lease, which expired in August 2004 and was renegotiated in September 2005 and expires in September 2010. Rent expense under all operating leases for the years ended December 31, 2007 and 2006 totaled approximately $314,000 and $274,000, respectively, of which approximately $242,000 and $217,000 is included in cost of products sold and approximately $72,000 and $57,000 is included in selling and administrative costs, respectively, in the accompanying consolidated statements of operations. In May 2007, the Company entered into a capital lease obligation for the purchase of approximately $8,525 of office equipment, which is included in property and equipment, net of approximately $995 of accumulated amortization, in the accompanying consolidated balance sheet. Future minimum lease commitments due for facilities and equipment leases under noncancellable capital and operating leases at December 31, 2007 are as follows: CAPITAL OPERATING LEASES LEASES -------- --------- 2008 $ 5,479 $149,524 2009 5,479 53,103 2010 5,479 39,282 2011 2,283 2012 and thereafter -- -------- -------- Total minimum lease payments $ 18,720 $241,909 ======== ======== Less amount representing interest (10,533) -------- Present value of minimum lease payments $ 8,187 ======== 7. ACCRUED LIABILITIES At December 31, 2007, accrued liabilities consisted of the following: Accrued wages and benefits $ 680,342 Accrued expenses relating to vendors and others 73,610 Deferral of straight-line rent expense 16,790 Reclassified accounts receivable credit balances 138,016 Accrued warranty costs 89,809 Accrued interest payable relating to stockholder notes 55,504 ---------- $1,054,071 ========== 44 8. LONG-TERM DEBT NOTES PAYABLE TO STOCKHOLDER Beginning on March 28, 2002 the Company executed a binding agreement with one of its stockholders, who is also a Board Member, to fund up to $6.1 million. Under the terms of the agreements, the Company can draw amounts as needed to fund operations. Amounts drawn bear interest at the prime rate per annum (6.75% at December 31, 2007), payable monthly and were to become due and payable on December 31, 2005 or upon a change in control of the Company or consummation of any other financing over $7.0 million. In March 2006, March, 2007 and March 2008, the maturity date for the agreement was extended to December 31, 2007, December 31, 2008 and December 31, 2009, respectively. At December 31, 2007, the Company had drawn $6.1 million of the available funds. During December 2007, the Company received $100,000 in shareholder loans, which in March 2008 were converted to equity. In April 2005, the maturity date of the agreement was extended from December 31, 2005 to December 31, 2006. As consideration of this extension, this stockholder was granted an additional 100,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company's stock on the date of grant, for a period of five years. During the years ended December 31, 2007 and 2006, the Company incurred interest expense of approximately $481,000 and $465,000, respectively, on its draws, which is included in interest expense in the accompanying consolidated statements of operations. MATURITIES OF LONG-TERM OBLIGATIONS FOR FIVE YEARS AND BEYOND Long-term obligations consisted of the following at December 31, 2007: Notes payable to stockholder $ 6,250,000 Capital lease obligation 8,187 ----------- 6,258,187 Less: current maturities (1,048) ----------- $ 6,257,139 =========== The minimum annual principal payments of notes payable and capital lease obligations at December 31, 2007 were: 2008 $ 1,048 2009 6,251,859 2010 3,270 2011 2,010 ---------- $6,258,187 ========== 9. INCOME TAXES The United States and foreign components of loss from continuing operations before income taxes are as follows for the years ended December 31: 2007 2006 ----------- ----------- United States $(2,455,387) $(2,704,731) Foreign 14,286 51,268 Intercompany elimination -- -- ----------- ----------- Loss from continuing operations before income taxes $(2,441,101) $(2,653,463) The significant components of the Company's net deferred tax assets are as follows for the years ended December 31: 2007 2006 ------------ ------------ Deferred tax assets: Net operating loss carryforwards $ 14,163,096 $ 13,214,958 Depreciation and amortization 78,177 73,200 Accrued expenses and reserves 58,801 77,795 Impairment loss 78,304 78,304 Compensatory stock options and warrants 57,354 57,354 Capital Loss Carryover 40,630 40,632 Other 16,917 18,829 ------------ ------------ Total deferred tax assets 14,493,279 13,561,072 Valuation allowance (14,493,279) (13,561,072) ------------ ------------ Net deferred tax assets $ -- $ -- ============ ============ 45 SFAS 109 requires a valuation allowance to reduce the deferred tax assets reported if, based on the weight of the evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. After consideration of all the evidence, both positive and negative, management has determined that a full valuation allowance of $14,493,279 against its net deferred taxes is necessary as of December 31, 2007. The change in valuation allowance for the years ended December 31, 2007 and 2006 is $932,207 and $1,024,603 respectively. At December 31, 2007, the Company had approximately $38,990,150 of U.S. net operating loss carryforwards remaining, which expire beginning in 2022. The Company will record the benefit of approximately $1,355,000 of the net operating loss carryforwards through additional paid-in capital if and when the net operating loss carryforwards are utilized, as such amounts relate to the unrecognized tax benefit from stock option exercises. As a result of certain ownership changes, the Company may be subject to an annual limitation on the utilization of its U.S. net operating loss carryforwards pursuant to Section 382 of the Internal Revenue Code. A study to determine the effect, if any, of this change, has not been undertaken. A reconciliation of the Company's income taxes to amounts calculated at the federal statutory rate is as follows for the years ended December 31: 2007 2006 ------ ----- Federal statutory taxes (34.00)% (34.00)% State income taxes, net of federal tax benefit (3.63) (3.63) Nondeductible items 0.16 0.16 Change in valuation allowance 38.39 38.21 Other (.92) .74 ------ ----- --% --% ====== ===== 10. COMMITMENTS AND CONTINGENCIES INVESTMENT BANKING AGREEMENTS On April 24, 2006, the Company entered into a one-year non-exclusive agreement with CapitalLink, L.C., an investment banking firm, to assist in additional financing. The company agreed to pay a fee of 7% of gross proceeds received by the Company as a result of services performed under the contract, as well as reimbursement of pre-approved out of pocket expenses. There were no fees incurred and the company exercised its option not to renew the agreement. On July 10, 2006, the Company entered into a maximum 90-day agreement with TN Capital Equities, Ltd., a subsidiary of TerraNova Capital Partners, Inc., and investment banking firm, to assist the Company in obtaining additional financing. The company agreed to pay a fee of 10% of the gross proceeds received by the Company as a result of services performed under the contract, as well as reimbursement of pre-approved out of pocket expenses. There were no fees incurred and the company exercised its option not to renew the agreement. 11. STOCK OPTIONS The Company has three stock option plans, one adopted in 1996 and amended in July 1997 (the "1996 Option Plan"), one adopted in September 1999 and amended in June 2000 (the "1999 Option Plan"), and one adopted on November 8, 2000 (the "Directors' Plan"). The 1996 Option Plan provides for the granting of up to 2,200,000 options, the 1999 Option Plan provides for the granting of up to 3,000,000 options and the Directors' Plan provides for the granting of up to 400,000 options. 46 Both the 1996 and 1999 Plan provide for the granting of both incentive and non-qualified stock options to key personnel, including officers, directors, consultants and advisors to the Company, at the discretion of the Board of Directors. Each plan limits the exercise price of the options at no less than the quoted market price of the common stock on the date of grant. The option term is determined by the Board of the Directors or the Compensation Committee, provided that no option may be exercisable more than 10 years after the date of its grant and, in the case of an Incentive Option granted to an eligible employee owning more than 10% of the Company's common stock, no more than five years after the date of the grant. Generally, under the 1996 and 1999 plans, options to employees vest over four years at 25% per annum, except for certain grants to employees that vest 50% upon grant with remaining amounts over two years at 25% per annum. The Directors' Plan provides for the granting of non-qualified options to members of the Board of Directors at exercise prices not less than the quoted market price of the common stock on the date of grant and options expire five years from the date of grant. In the event a person ceases to serve on the Board of Directors, the outstanding options expire one year from the date of cessation of service. Such options may be exercised commencing two years from the date of grant. On May 11, 2006, the Company extended the expiration date of 270,000 fully vested stock options for an employee who left the Company and previously had options extended through September 30, 2006. The Company's Stock Option Plan permits an employee to exercise their stock options for up to one month after their termination date, at which time they expire. The exercise price of the options ranges from $1.72 to $1.75. In accordance with FIN 44, the Company compared the options' intrinsic value on the modification date to the original intrinsic value on the date of grant. The Company recorded approximately $88,000 of compensation expense related to this modification, which was included in the consolidated statement of operations for the year ending December 31, 2006. On October 20, 2006, the Company extended the expiration date of 375,000 fully vested stock options for an employee who left the Company in October 2006. The Company's Stock Option Plan permits an employee to exercise their stock options for up to one month after their termination date, at which time they expire. The exercise price of the options ranges from $.21 to $.94. In accordance with FIN 44, the Company compared the options' intrinsic value on the modification date to the original intrinsic value on the date of grant. The Company recorded approximately $86,000 of compensation expense related to this modification, which was included in the consolidated statement of operations for the year ending December 31, 2006. On May 23, 2007 the Company extended the expiration date of 11,650 vested stock options for a terminated employee who left the company in May, 2005. The exercise price of the options ranges from $.38 to $2.15. In accordance with SFAS 123, incremental compensation cost was recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. The Company recorded approximately $1,202 of compensation expense related to this modification, which was included in the consolidated statement of operations for the year ended December 31, 2007. During each of 2007 and 2006, 55,000 and 5,000 respectively, of options were issued to non-employee Directors. Additional information concerning the activity in the three option plans is as follows: 2007 2006 -------------------------- ------------------------- WEIGHTED AVERAGE EXERCISE OPTIONS PRICE ---------- --------- --------- --------- Outstanding, beginning of year 1,880,400 $ 3.10 2,152,070 $ 3.18 Granted 200,000 .40 135,000 .96 Exercised (76,000) .38 (5,000) .52 Cancelled (130,000) 4.28 (159,000) 2.83 Expired (107,500) 5.86 (242,670) 3.73 ---------- --------- --------- --------- Outstanding, end of year 1,766,900 2.65 1,880,400 3.10 ========== ========= Exercisable, end of year 1,505,650 $ 3.03 1,708,650 $ 3.30 ========== ========= Options available for future grant, end of year 2,135,750 2,168,250 ========== ========= 47 Summarized information with respect to options outstanding under the three option plans at December 31, 2007 is as follows: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------ --------------------------- REMAINING AVERAGE CONTRACTUAL WEIGHTED WEIGHTED RANGE OF NUMBER LIFE (IN AVERAGE NUMBER AVERAGE EXERCISE PRICE OUTSTANDING YEARS) EXERCISE PRICE EXERCISABLE EXERCISE PRICE -------------- ----------- ----------- -------------- ----------- -------------- $ .21 - $1.70 1,218,400 5.56 $ .84 957,150 $ .92 1.86 - 4.50 198,500 4.03 2.39 198,500 2.39 8.50 - 9.25 350,000 1.59 9.14 350,000 9.14 ---------- ----- ----- --------- ----- Totals 1,766,900 4.97 $2.65 1,505,650 $3.03 ========= ==== ===== ========= ===== Summarized information with respect to options outstanding under the three option plans at December 31, 2006 is as follows: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------ --------------------------- REMAINING AVERAGE CONTRACTUAL WEIGHTED WEIGHTED RANGE OF NUMBER LIFE (IN AVERAGE NUMBER AVERAGE EXERCISE PRICE OUTSTANDING YEARS) EXERCISE PRICE EXERCISABLE EXERCISE PRICE -------------- ----------- ----------- -------------- ----------- -------------- $ .21 - $1.70 1,171,900 6.2 $ .89 1,020,525 $ .88 1.86 - 4.50 246,000 4.0 2.42 225,625 2.42 8.50 - 9.25 462,500 2.1 9.07 462,500 9.07 --------- ---- ----- --------- ----- Totals 1,880,400 4.43 $3.10 1,708,650 $3.30 ========= ==== ===== ========= ===== 12. COMMON STOCK On January 30, 2006, the Company issued 40,000 shares of common stock, at $.75 per share, to an employee in lieu of a cash bonus that was previously accrued and deferred. On February 26, 2006, the Company received cash proceeds of $910,000 from five accredited investors for the purchase of 3,033,333 shares of common stock at $0.30 per share. The purchase price of $0.30, previously agreed upon and approved by the Board of Directors, was discounted approximately 20% as part of the June 2005 Equity Placement Offering, wherein these five investors funded 50% of their total predetermined contribution at that time. The 2005 funds were contributed with the understanding that the 50% balance of investment would be priced at the same purchase price as the initial On September 14, 2006, the Company issued a confidential private placement offering, with a purchase price of $0.70 per share of common stock. Each four shares purchased will entitle the purchaser to receive common stock purchase warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to October 1, 2011. As of December 31, 2006, the Company had received gross proceeds of approximately $1.357 million for an aggregate of 1,938,570 shares of common stock. In June 2007, the Company received cash proceeds of $975,000 from an accredited investor for the purchase of 1,300,000 shares of common stock at $0.75 per share as part of a private offering. In August 2007, the Company converted $500,000 previously received in the form of advances into purchases of 714,286 shares of common stock at $0.70 per share. 48 13. WARRANTS At December 31, 2007 and 2006, 1,869,643 and 1,594,643 shares, respectively, of common stock have been reserved for issuance under outstanding warrants. All of the warrants are fully vested and have expiration dates ranging from March 28, 2007 to December 19, 2016. Information concerning the Company's warrant activity is as follows: 2007 2006 ------------------- ------------------ WEIGHTED AVERAGE WEIGHTED AVERAGE EXERCISE EXERCISE ------------------- ------------------ OPTIONS PRICE OPTIONS PRICE --------- ----- --------- ----- Outstanding, at the beginning of year 1,589,643 $ .99 955,000 $1.53 Granted 380,000 $1.25 634,643 1.25 Exercised -- -- -- -- Expired 100,000 4.05 -- -- --------- ----- --------- ----- Outstanding, at the end of year 1,869,643 $1.25 1,589,643 $ .99 ========= ===== ========= ===== In consideration of the stockholder loan agreement (Item 12), the Company has granted the stockholder a total of 475,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company's stock on the dates of grant. On March 28, 2002, the Company recorded a deferred charge of $318,000. The deferred charge was initially amortized over the commitment period and subsequently revised to include the repayment period, as amended. During the years ended December 31, 2007 and 2006, the Company had amortized approximately $6,000 and $29,000 of such costs, respectively, which are included in interest expense in the accompanying consolidated statements of operations. On March 14, 2003, the Company recorded a deferred charge of $212,500. The deferred charge is being amortized over the repayment period of 21.5 months. During the years ended December 31, 2007 and 2006, the Company had amortized approximately $4,000 and $79,000 respectively, which is included in interest expense in the accompanying 2005 consolidated statement of operations. On December 15, 2004, the Company extended the life of a director's warrants by one year. The expiration date of the warrant was extended from December 2004 to December 2005. The fair value of the modified warrant was estimated at the date of grant using a Black-Scholes option pricing model and the difference in the fair value of the old award and the new award was estimated to be $20,000. During June and July 2005, the Company received cash proceeds of 1.48 million from the sale of 4,820,664 shares of common stock from a private placement offering. The funds were used for corporate purposes and to reduce the outstanding principle balance of the notes payable to stockholder. Additionally, warrants in the amount of 400,000 and 80,000 were offered to two separate participants in the private placement at a price of $0.80 per each share of common stock with an exercise date of June 17, 2006, and an expiration date of June 17, 2008. During 2006 and 2005, respectively, the Company recorded an expense of $66,492 and $79,908. As part of the September 14, 2006 private placement offering, the Company granted to investors 643,643 warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to October 1, 2011. In June 2007, the Company received cash proceeds of $975,000 from an accredited investor for the purchase of 1,300,000 shares of common stock at $0.75 per share as part of a private offering. As part of the offering, the Company awarded 380,000 warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to August 23, 2017. 14. MAJOR CUSTOMERS During 2007 and 2006, two customers together accounted for approximately 44% and 39%, respectively, of the Company's net sales. In 2007, there were two customers that individually accounted for greater than 10% of net sales, or approximately $791,000 and $570,000, while in 2006 there were two customers that individually accounted for greater than 10% of net sales, or approximately $769,000 and $417,000. There were five customers at December 31, 2007, whose trade receivable balances equaled or exceeded 5% of total receivables, representing approximately 24%, 10%, 8%, 8% and 7% respectively, of total accounts receivable. The loss of business from one or a combination of the Company's significant customers could adversely affect its operations. 49 15. GEOGRAPHIC INFORMATION The Company has two lines of product, which it manufactures and distributes from its locations in the United States and the United Kingdom. Information with respect to sales activity and long-lived assets (consisting entirely of property and equipment) in the United States and United Kingdom is as follows: YEAR ENDED DECEMBER 31 ------------------------ 2007 2006 ---------- ---------- Net sales: United States $1,873,017 $2,266,816 United Kingdom 1,209,856 806,131 ---------- ---------- $3,082,873 $3,072,947 ========== ========== Long-lived assets by area: United States $ 153,139 United Kingdom 9,699 ---------- $ 162,838 ========== 16. SUBSEQUENT EVENTS In February 2008, the Company received cash proceeds of $324,000 from an accredited investor for the purchase of 900,000 shares of common stock at $0.36 per share. As part of the offering, the Company awarded 225,000 warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to February 5, 2018. This same investor had previously purchased 1.3 million shares of common stock in a June 2007 private offering priced at $0.75 per share, bringing the total shares of Puradyn common stock purchased by this investor to 2,200,000. On February 18, 2008, the Company entered into a Master Distributor Agreement with Filter Solutions Ltd (FSL), whereby FSL assumes distributorship for the United Kingdom, Mainland Europe and Ireland. The contract contains minimum purchase requirements and shall have an initial term of five years. The Company expects that under this agreement FSL will absorb the majority of expenses attributable to the Puradyn, Ltd United Kingdom office. On March 7, 2008, the repayment date of the stockholder loan was extended from December 31, 2008 to December 31, 2009. During the quarter ending March 31, 2008, the Company received shareholder loans totaling $420,000. On March 24, 2008, the Company converted $420,000 previously received in the form of advances into purchases of 1,200,000 shares of common stock at $0.35 per share. The purchases resulted in the issuance of 300,000 warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to March 19, 2013. On March 26, 2008, the Company converted $100,000 received in the form of advance into the purchase of 285,714 shares of common stock at $.35 per share and the issuance of 71,429 warrants to purchase one share of common stock at an exercise price of $1.25 on or prior to March 20, 2013. 50