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TECOGEN INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

Forward-looking statements are made throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," "seeks," "estimates" and similar expressions are intended to identify forward-looking statements. Such forward-looking statements include, among other things, statements regarding our current and future cash requirements, our expectations regarding suppliers of cogeneration units, and statements regarding potential financing activities in the future. While the Company may elect to update forward-looking statements in the future, it specifically disclaims any obligation to do so, even if the Company's estimates change, and readers should not rely on those forward-looking statements as representing the Company's views as of any date subsequent to the date of the filing of this Quarterly Report. There are a number of important factors that could cause the actual results of the Company to differ materially from those indicated by such forward-looking statements, including those detailed under the heading "Risk Factors" in this Quarterly Report. Overview Tecogen designs, manufactures and sells industrial and commercial cogeneration systems that produce combinations of electricity, hot water, and air conditioning using automotive engines that have been specially adapted to run on natural gas. In some cases, our customers may choose to have the Company engineer and install the system for them rather than simply purchase the cogeneration and/or chiller units, which we refer to as "turnkey" projects. Cogeneration systems are efficient because in addition to supplying mechanical energy to power electric generators or compressors - displacing utility supplied electricity - they provide opportunity for the facility to incorporate the engine's waste heat into onsite processes such as space and potable water heating. We produce standardized, modular, small-scale products, with a limited number of product configurations that are adaptable to multiple applications. We refer to these combined heat and power products as CHP (electricity plus heat) and MCHP (mechanical power plus heat). Results of Operations Revenues Revenues in the second quarter of 2014 were $4,539,857 compared to $2,803,460 for the same period in 2013, an increase of $1,736,397 or 61.9%. Product revenues in the second quarter of 2014 were $2,007,926 compared to $807,854 for the same period in 2013, an increase of $1,200,072 or 149%. This increase was the aggregate of an increase in cogeneration sales of $962,095 and an increase in chiller sales of $237,977. Service revenues in the second quarter of 2014 were $2,531,931 compared to $1,995,606 for the same period in 2013, an increase of $536,325 or 27%. This increase is due to an increase in installation activity of $463,125 and an increase of $73,200 by the service group. Revenues in the first six months of 2014 were $8,755,614 compared to $6,849,778 for the same period in 2013, an increase of $1,905,836 or 27.8%. Product revenues in the first six months of 2014 were $3,952,702 compared to $2,860,519 for the same period in 2013, an increase of $1,092,183 or 38.2%. This increase was the aggregate of an increase in cogeneration sales of $838,208 and an increase in chiller sales of $253,975. Service revenues in the first six months of 2014 were $4,802,912 compared to $3,989,259 for the same period in 2013, an increase of $813,653 or 20.4%. This increase is due to an increase in installation activity of $715,418 and an increase of $98,235 by the service group. Cost of Sales Cost of sales in the second quarter of 2014 was $3,191,184 compared to $1,989,587 for the same period in 2013 an increase of $1,201,597, or 60.4%. During the second quarter of 2014 our overall gross profit margin was 29.7% compared to 29.0% for the same period in 2013, an increase of 0.7%. The growth in sales volume and the increasing number of turnkey projects have continued to improve gross margins. Cost of sales in the first six months of 2014 was $5,980,715 compared to $4,923,941 for the same period in 2013 an increase of $1,056,774, or 21.5%. During the first six months of 2014 our overall gross profit margin was 31.7% compared to 28.1% for the same period in 2013, an increase of 3.6%. The growth in sales volume and the increasing number of turnkey projects have continued to improve gross margins. Contract Research and Development There was no contract research and development income for the three months ended and six months ended June 30, 2014 and three months ended June 30, 2013. For the six months ended June 30, 2013 there was $67,000, which is classified as an offset to applicable expenses. 18



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TECOGEN INC. Operating Expenses General and administrative expenses consist of executive staff, accounting and legal expenses, office space, general insurance and other administrative expenses. General and administrative expenses in the second quarter ending June 30, 2014 were $1,911,071 compared to $1,419,020 for the same period in 2013, an increase of $492,051 or 34.7%. This increase was due to an overall increase in costs attributable to expenses related to the transition to becoming a public company. These items include larger administrative staff, listing fees, higher insurance expense and technology. General and administrative expenses in the first six months of 2014 were $3,673,063 compared to $2,965,580 for the same period in 2013, an increase of $707,483 or 23.9%. This increase was due to an overall increase in costs attributable to expenses related to the transition to becoming a public company. These items include larger administrative staff, listing fees, higher insurance expense and technology. Selling expenses consist of sales staff, commissions, marketing, travel and other selling related expenses. Selling expenses for the second quarter of 2014 were $405,108 compared to $286,101 for the same period in 2013, an increase of $119,007 or 41.6%. A large portion of this increase is due to higher commissions in this period due to the higher sales. Selling expenses for the first six months of 2014 were $826,728 compared to $565,471 for the same period in 2013, an increase of $261,257 or 46.2%. The largest portion of this increase is due to higher commissions in this period due to higher sales. Research and development expenses consist of engineering and technical staff, materials, outside consulting and other related expenses. Research and development expenses in the second quarter ending June 30, 2014 were $251,582 compared to $260,262 for the same period in 2013, a decrease of $8,680 or 3.3%. This decrease was due to completion of the heat pump development project as the program migrated to production. Current projects include the emissions control retrofits utilizing the Company's patents and an InVerde product improvement programs. Research and development expenses for the first six months of 2014 were $559,716 compared to $505,405 for the same period in 2013, an increase of $54,311 or 3.3%. This increase was due to the timing of the beginning and completion of projects. Current projects include development projects in emissions controls and the InVerde product line. Loss from Operations Loss from operations for the second quarter of 2014 was $1,219,088 compared to $1,151,510 for the same period in 2013, an increase of $67,578. The increase in the loss was due to the growth in operating expenses offset by the increase in revenue and gross profit discussed above. Loss from operations for the first six months of 2014 was $2,284,608 compared to $2,110,619 for the same period in 2013, an increase of $173,989. The increase in the loss was due to the growth in operating expenses offset by the increase in revenue and gross profit discussed above. Other Income (Expense), net Other expense, net for the three months ended June 30, 2014 was $42,303 compared to $33,796 for the same period in 2013. Other income (expense) includes interest income and other income of $15,079, net of interest expense on notes payable of $57,382 for the second quarter of 2014. For the same period in 2013, interest and other income was $2,591 and interest expense was $36,387. The increase in interest income of $12,488 is the result of short-term investments held during the second quarter of 2014 that were not held during the second quarter of 2013. The increase in interest expense of $20,995 was mainly due to the increase in note payable balances carried during the three months ended June 30, 2014 as compared to the same period in 2013. Other expense, net for the six months ended June 30, 2014 was $73,988 compared to $53,227 for the same period in 2013. Other income (expense) includes interest income and other income of $18,164, net of interest expense on notes payable of $92,152 for the first six months of 2014. For the same period in 2013, interest and other income was $6,537 and interest expense was $59,764. The increase in interest income of $11,627 is the result of short-term investments held during the first six months of 2014 that were not held during the first six months of 2014. The increase in interest expense of $32,388 was mainly due to the increase in note payable balances carried during the first six months of 2014 as compared to the first six months of 2013. Provision for Income Taxes The Company did not record any benefit or provision for income taxes for the three or six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and 2013, the income tax benefits generated from the Company's net losses have been fully reserved. Noncontrolling Interest The noncontrolling interest share in the losses of Ilios was $31,684 for the three months ended June 30, 2014 compared to $94,826 for the same period in 2013, a decrease of $63,142 or 66.6%. The decrease was due to a decrease in the Ilios loss in the second quarter of 2014 as compared to the same period in 2013. Noncontrolling interest ownership percentage as of June 30, 2014 and 2013 was unchanged at 35.0% for both periods. 19



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TECOGEN INC. The noncontrolling interest share in the losses of Ilios was $90,844 for the six months ended June 30, 2014 compared to $212,973 for the same period in 2013, a decrease of $122,129 or 57.3%. The decrease was due to a decrease in the Ilios loss in the first six months of 2014 as compared to the same period in 2013. Noncontrolling interest ownership percentage as of June 30, 2014 and 2013 was unchanged at 35.0% for both periods. Net loss Net loss attributable to Tecogen for the three months ended June 30, 2014 was $1,229,707 compared to $1,090,480 for the same period in 2013, an increase of $139,227. The increase in net loss was the result of the increase in gross profit not offsetting the increase in operating expenses as described above. Net loss attributable to Tecogen for the six months ended June 30, 2014 was $2,267,752 compared to $1,950,873 for the same period in 2013, an increase of $316,879. The increase in net loss was the result of the increase in gross profit not offsetting the increase in operating expenses as described above. Liquidity and Capital Resources Consolidated working capital at June 30, 2014 was $8,509,763 compared to $5,565,789 at December 31, 2013, an increase of $2,943,974. Included in working capital were cash and cash equivalents of $3,377,897 and $584,375 in short-term investments at June 30, 2014, compared to $7,713,899 in cash and cash equivalents at December 31, 2013, a decrease of $3,751,627. The decrease in working capital is due to the lower cash resulting from operating losses, increases in inventory and unbilled revenue from turnkey projects. Cash used in operating activities for the six months ended June 30, 2014 was $2,917,046 compared to $675,653 for the same period in 2013. Our accounts receivable balance increased to $4,418,165 at June 30, 2014 compared to $3,740,885 at December 31, 2013, using $677,280 of cash due to timing of billing, shipments, collections and changes in allowance. In addition, amounts due from related parties increased by $148,830 using cash due to timing of billing, shipments and collections. Our inventory increased to $3,887,277 as of June 30, 2014 compared to $3,343,793 as of December 31, 2013, using $543,484 of cash to purchase inventory to build modules in backlog and to support ongoing turnkey projects. As of June 30, 2014, the Company's backlog of product and installation projects (and excluding service contracts) was $11.7 million, consisting of $6 million of purchase orders actually received by us and $5.7 million of projects in which the customer's internal approval process is complete, financial resources have been allocated and the customer has made a firm verbal commitment that the order is in the process of execution. Backlog at the beginning of any period is not necessarily indicative of future performance. Our presentation of backlog may differ from other companies in our industry. Our inventory balances have increased to support production demands, tightening available working capital. Accounts payable increased to $2,453,029 as of June 30, 2014 from $2,338,046 at December 31, 2013, providing $114,983 in cash flow for operations. Accrued expenses increased to $1,255,978 as of June 30, 2014 from $1,139,554 as of December 31, 2013, providing $116,424 of cash for operations. The Company expects accounts payable and accrued expenses to increase into the foreseeable future as operations continue to expand. During the first six months of 2014 our investing activities used $818,847 of cash and included purchases of short-term investments of $584,375 to support performance bonds, purchases of property and equipment of $120,773 and expenditures related to intangible assets of $113,699. During the first six months of 2014 our financing activities included the payment of principal balances on demand notes payable to our Chief Executive Officer aggregating $2,950,000. In addition we received proceeds from sales of our common stock of $2,351,335 and proceeds from the exercise of stock options of $6,000. The proceeds were used for general corporate purposes, including research and development. At June 30, 2014 our commitments included various leases for office and warehouse facilities of $4,753,648 to be paid over several years through 2024. The source of funds to fulfill these commitments will be provided from cash balances, operations or through debt or equity financing. On March 14, 2013 the Company received a prepayment for purchases of modules, parts and service to be made by American DG Energy in the amount of $827,747. The Company provides a discount on these prepaid purchases equal to 6% per annum on deposit balances. The 6% discount is recorded as interest expense in the accompanying statements of operations. As of June 30, 2014 the outstanding balance on this prepayment was $0 and is included in due from related party, net of amounts receivable but not yet due from American DG Energy, in the accompanying condensed consolidated balance sheet. During 2013, the Company entered into multiple demand notes, with John N. Hatsopoulos, our Chief Executive Officer. These agreements totaled a principal balance of $2,950,000 and had interest rates as quoted from time to time in the Wall Street Journal plus 1.5% per year and 6%. On January 6, 2014, the Company repaid all demand note owed to its Chief Executive Officer, including accrued interest of $200,658. 20



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TECOGEN INC. On March 26, 2014, the Company secured a working capital line of credit with John Hatsopoulos, the Company's Chief Executive Officer, in the amount of $3,500,000 which may be used in the occurrence of certain events. On July 2, 2014, the date of effectiveness of the registration statement, along with the May 20, 2014 sale of common stock with gross proceeds in excess of $2,000,000, the line of credit triggers were fulfilled, and the working capital line of credit will not be drawn upon before its expiration without a separate event of default as described in the Michaelson Note. On May 20, 2014, the Company sold 647,706 shares at $4.75 in a public offering while simultaneously listing on the NASDAQ under the ticker symbol TGEN. Total gross proceeds from the offering were approximately $3.0 million, before the placement agent's fees $207,670 and certain offering expenses of $523,898. The net proceeds of the offering will be used for working capital and general corporate purposes, including expanding Tecogen's turnkey business, constructing a dedicated manufacturing facility for Tecogen's majority owned subsidiary, Ilios Inc., expanding Tecogen's low emissions technology to other markets and continuing product development. Based on our current operating plan, we believe existing resources, including our line of credit and cash and cash flows from operations, will be sufficient to meet our working capital requirements in the short term. As we continue to grow our business, our cash requirements are expected increase. As a result, we will need to raise additional capital through an equity offering to meet our operating and capital needs for future growth. Our ability to continue to access capital could be impacted by various factors, including general market conditions and the continuing slowdown in the economy, interest rates, the perception of our potential future earnings and cash distributions, any unwillingness on the part of lenders to make loans to us and any deterioration in the financial position of lenders that might make them unable to meet their obligations to us. If these conditions continue and we cannot raise funds through a public or private debt financing, or an equity offering, our ability to grow our business may be negatively affected and we may need to suspend and significantly reduce our operating costs until market conditions improve. Significant Accounting Policies and Critical Estimates The Company's significant accounting policies are discussed in the Notes to the Condensed Consolidated Financial Statements above and in our 2013 Annual Report. The accounting policies and estimates that can have a significant impact upon the operating results, financial position and footnote disclosures of the Company are described in the above notes and in our Annual Report. Seasonality We expect that the majority of our heating systems sales will be in the winter and the majority of our chilling systems sales will be in the summer. Our cogeneration and chiller system sales are not generally affected by the seasons, although customer goals will be to have chillers installed and running in the spring. Our service team does experience higher demand in the warmer months when cooling is required. These units are generally shut down in the winter and started up again in the spring. This "busy season" for the service team generally runs from May through the end of September. Off-Balance Sheet Arrangements On July 22, 2013, the Company's Chief Executive Officer personally pledged to support a bank credit facility of $1,055,000 to support bank guarantees issued on certain construction contracts. We do not have any other off-balance sheet arrangements, including any outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions or foreign currency contracts. We do not engage in trading activities involving non-exchange traded contracts. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Not applicable. 21



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TECOGEN INC.


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