10KSB 1 form10-ksb_14252.txt ZAP FORM 10-KSB ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB (Mark One) [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 [_] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ________________ Commission file number 0-303000 ZAP ---------------------------------------------- (Name of small business issuer in its charter) California 94-3210624 --------------------------------- --------------------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 501 Fourth Street, Santa Rosa California 95401 ---------------------------------------- --------------------------------- (Address of principal executive offices) (Zip Code) Issuer's telephone number (707) 525-8658 Securities registered under Section 12(b) of the Exchange Act: Common Stock, no par value NYSE Arca ------------------------------ ----------------------------------------- Title of Each Class Name Exchange on Which Registered Securities registered under Section 12(g) of the Exchange Act: None Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. Yes [_] No [x] Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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. [_] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X] State issuer's revenues for its most recent fiscal year. $3,602,000 The aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant's as of March 24, 2006 was $35,353,000 computed by reference to the price at which the registrant's Common Stock was last traded on that date. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. 32,870,849 shares of Common Stock, no par value, outstanding as of March 24, 2006. (ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS) Check whether the issuer has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court. Yes [X] No [_] DOCUMENTS INCORPORATED BY REFERENCE The information required by Part III of this Form 10-KSB, other than Item 13, is incorporated by reference, to the Company's Definitive Proxy Statement for the Company's 2006 Annual Meeting of Shareholders. Transitional Small Business Disclosure Format (Check one): Yes [_] No [X] ================================================================================ TABLE OF CONTENTS ITEM NO. PAGE ================================================================================ PART I ------ ITEM 1. DESCRIPTION OF BUSINESS.............................................4 ITEM 2. DESCRIPTION OF PROPERTY............................................21 ITEM 3. LEGAL PROCEEDINGS..................................................22 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS................23 PART II ------- ITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES ....................23 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION..........30 ITEM 7. FINANCIAL STATEMENTS...............................................36 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE................................66 ITEM 8A. CONTROLS AND PROCEDURES............................................66 ITEM 8B. OTHER INFORMATION..................................................66 PART III ------- ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES ACT ...............66 ITEM 10. EXECUTIVE COMPENSATION ............................................67 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS ...................................67 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.....................67 ITEM 13. EXHIBITS...........................................................67 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.............................70 PART 1 SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This annual report of Form 10-KSB and the documents incorporated by reference herein contain forward-looking statements that are not statements of historical fact and may involve a number of risks and uncertainties. These statements relate to analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable. These statements may also relate to our future prospects, developments and business strategies. We have used the words "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "will," "plan," "predict," "project" and similar terms and phrases, including references to assumptions, in this annual report of Form 10-KSB and our incorporated documents to identify forward-looking statements. These forward-looking statements are made based on expectations and beliefs concerning future events affecting us and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control, that could cause our actual results to differ materially from those matters expressed in or implied by these forward-looking statements. The following factors are among those that may cause actual results to differ materially from our forward-looking statements: o general economic and industry conditions; o our history of losses, deficits and negative operating cash flows; o our limited operating history; o industry competition; o environmental and government regulation; o whether the alternative energy and gas-efficient vehicle market for our products continues to grow and, if it does, the pace at which it may grow; o our ability to attract and retain the personnel qualified to implement our growth strategies; o our ability to obtain approval from government authorities for our products; o our ability to protect the patents on our proprietary technology; o our ability to fund our short-term and long-term financing needs; and o other factors including those discussed in "Risk Factors" in this annual report on Form 10-KSB and incorporated documents. You should keep in mind that any forward-looking statement made by us in this annual report or elsewhere speaks only as of the date on which we make it. New risks and uncertainties arise from time to time, and it is impossible for us to predict these events or how they may affect us. We have no duty to, and do not intend to, update or revise the forward-looking statements in this annual report after the date of filing, except as may be required by law. In light of these risks and uncertainties, you should keep in mind that any forward-looking statement made in this annual report or elsewhere might not occur. In this annual report on Form 10-KSB the terms "ZAP," "Company," "we," "us" and "our" refer to ZAP and its subsidiaries. GENERAL ZAP stands for Zero Air Pollution(R). ZAP was founded on September 23, 1994, during an era when government and industry were debating how to solve the country's growing transportation problems. ZAP began to invent, design, manufacture, and market innovative products like its zero-emission ZAP(R)electric bicycle and ZAPPY(R) electric scooter that were cost-effective and practical for world markets. Today, ZAP is moving forward with a campaign to stay at the forefront of fuel-efficient transportation with new technologies, including energy efficient gas systems, hydrogen, electric and other innovative power systems. ZAP is also investing in advanced energy solutions, utilizing advanced batteries, hybrid technology and innovative fuel cell designs. In the process of building ZAP, the Company has pioneered a growing niche for alternative transportation. In 1995, ZAP began marketing electric transportation on the Internet through the website at www.zapworld.com. From 1996 through 1998, we continued to add to our product line; in 1999, ZAP added electric motorbikes; in 2001 it added electric dive scooters; in 2003, ZAP announced its first electric automobiles, including the first-ever production electric automobile imported from its manufacturing partner in China; in 2004 ZAP introduced electric all-terrain vehicles and the fuel-efficient Smart Car; and in 2005 ZAP introduced multi-fuel vehicles, capable of running on ethanol and/or gasoline. Today, ZAP is a one-stop portal for a diverse lineup of quality, affordable advanced automotive technologies. ZAP has delivered more than 90,000 vehicles to customers in more than 75 different countries. Our goal is to become the largest and most complete distribution portal in the United States for advanced technology vehicles. We are focused on creating a distribution channel for our automobile and consumer products by establishing qualified automobile-dealers and developing relationships with specialty dealers throughout the United States. We currently market and sell our automobile products through qualified automotive dealers including our subsidiary, Voltage Vehicles. We currently market and sell our consumer products directly to consumers through our Internet Web site, independent representatives, retail outlets and qualified automobile dealers. We continue to develop new products independently and through development and acquisition agreements with companies and manufacturers, and by the purchase of products manufactured to our specifications. We have grown from a single product line to a full product line of electric vehicle and advanced transportation products. Most of our domestic manufacturing has been transferred to lower-cost overseas contract manufacturers. 5 ZAP was incorporated under the laws of the State of California, on September 23, 1994, as "ZAP Power Systems." The name of the Company was changed to "ZAPWORLD.COM" on May 16, 1999 in order to increase our visibility in the world of electronic commerce. We subsequently changed our name to ZAP on June 18, 2001 in order to reflect our growth and entry into larger, more traditional markets. Our principal executive offices are located at 501 Fourth Street Santa Rosa, California, 95401. Our telephone number is (707) 525-8658. SUBSIDIARIES We have the following wholly owned subsidiaries : RAP Group, Inc., a California company ("RAP Group"), Voltage Vehicles, a Nevada company ("Voltage Vehicles"),ZAP Rental Outlet, a Nevada company ("ZAP Rentals"), ZAP Stores, Inc., a California company ("ZAP Stores"), ZAP Manufacturing, Inc., a Nevada company ("ZAP Manufacturing") and ZAP World Outlet, Inc., a California company ("ZAP World"). RAP Group is engaged primarily in the sale and liquidation of conventional automobiles; Voltage Vehicles is engaged primarily in the distribution and sale of advanced technology and conventional automobiles; ZAP Stores is engaged primarily in consumer sales of ZAP products and ZAP Manufacturing is not currently an operating subsidiary. ZAP World Outlet is not currently operating subsidiaries. RAP Group and Voltage Vehicles were acquired by the Company in July 2002. The RAP Group and Voltage Vehicles have active operations and generated approximately 82% of the Company's consolidated revenues in 2005. BUSINESS DEVELOPMENT Our business strategy has been to develop, acquire and commercialize advanced transportation vehicles and technology, including electric vehicles and electric vehicle power systems, low emission vehicles, fuel cell powered vehicles, hybrid, ethanol and fuel-efficient vehicles. Such vehicles have fundamental, practical and environmental advantages over conventional internal combustion modes of transportation and can be produced commercially on an economically competitive basis. In 2005, we continued to enhance and broaden our electric vehicle product line. ZAP entered into an exclusive manufacturing contract with a Chinese automaker to produce a unique car aimed at filling the need for gas-free, all-electric cars that are practical and affordable. Based on this relationship, we introduced the Xebra, the nation's only production all-electric vehicle with top speeds greater than 25 mph. We introduced the ZAPPY Express Scooter, a more powerful electric scooter with a comfortable seat. Further, we introduced electric all-terrain vehicles (ATVs). We also entered into an exclusive distribution agreement with Obvio !, a Brazilian manufacturer of flex-fuel vehicles capable of running on ethanol, gasoline, or any blend of the two. In an effort to become the largest distributor of advanced technology vehicles in the United States, we are actively developing a network of automobile dealers that will be qualified to sell our automobile and consumer products. We have already established dealers in California, Colorado, Pennsylvania, New York, Nevada, Florida, New Hampshire and Washington. 6 PRODUCT SUMMARY We market many forms of advanced transportation vehicles, including electric automobiles, fuel-efficient vehicles, motorcycles, bicycles, scooters, neighborhood electric vehicles and all terrain vehicles. We market products designed solely by us, as well as products we design together with other companies. Most of our products are manufactured in China. Our automobiles are assembled outside of the United States, but made to comply with United States laws. The Smart Car Americanized by ZAP is manufactured and made compliant for sale in the United States by a registered importer. We also make the Xebra compliant for the United States market. Our automobile products require registration with state vehicle registration departments and must be sold through licensed dealers, while our consumer vehicles can be sold directly to consumers without registration. Our automobile vehicles are subject to environmental and safety compliance with various Federal and State governmental regulations, including regulations promulgated by the Environmental Protection Agency, National Highway Traffic Safety Administration and Air Resource Board of the State of California (CARB). The costs of these compliance activities can be substantial. Our existing product line, which includes completed, market ready products and planned introductions, is as follows: AUTOMOTIVE LINE --------------- The Company possesses exclusive licenses, know-how, and technology that enable the Company to import various foreign made vehicles. SMART CAR AMERICANIZED BY ZAP. The Smart Car Americanized by ZAP, which is assembled by Mercedes Benz, is imported through a registered importer and made compliant for sale in the United States. Smart Cars must be modified to meet applicable U.S. laws before they can be sold in the U.S. As of this date and to our knowledge, through proprietary recalibration technology and through compliance contractor, G & K Automotive, which has clearances from the Department of Transportation and letters of conformity from the Enviromental Protection Agency, that allows models of the Smart Car, as modified, to be sold in the U.S. Additional clearances will be needed to sell this vehicle in volumes and to sell other models of the Smart Car. The California Air Resources Board must certify the car before it could be sold in California and four other states. ZAP will need to set up large contractors to handle the demand for this vehicle. The current EPA and DOT clearances gives ZAP the opportunity to be the first to market and distribute Smart Cars as Americanized for ZAP in the U.S. ZAP is not affiliated with, or authorized by, SMART GMBH, the manufacturer of SMART automobiles, or the SmartUSA division of Mercedes-Benz LLC, the exclusive authorized U.S. importer and distributor of those vehicles. The Smart Car has a gas turbo engine. The car is a two-passenger coupe eight feet in length that provides ample room for two adult passengers. Other "smart" features and options of the Smart Car Americanized by ZAP include a 61-hp, 3-cyclinder turbocharged engine, equipped with an advanced electronic stabilization program, or ESP, an anti-skid design that throttles the engine torque along with an anti-lock braking system. The unique 6-speed automatic gear transmission with kick down function allows the user to switch between "automatic" and "manual" gear shifting via a control program that changes gears in response to varying driving characteristics. These cars are and will be sold 7 through Voltage Vehicles to qualified ZAP dealers. ZAP XEBRA. This electric vehicle is the only production Electric Vehicle ("EV") offered in the U.S. with a top speed of 40 miles per hour. It will also be the first vehicle imported from China. There will initially be two models offered, a 4 passenger vehicle with its niche focused on city/commuter use, and a 1 seat industrial vehicle with a pickup bed focused on municipalities, maintenance, universities and warehouses. The Xebra passenger will have an MSRP of less than $10,000. OBVIO!. OBVIO ! Automotoveiculos S.P.E. Ltda of Rio de Janeiro, Brasil has assembled a network of suppliers to incorporate the latest advances in automotive engineering into a new generation of automobiles that meets the challenges of today's urban driving. Cars imported from OBVIO! will have trybrid technology meaning the cars can run on gasoline, electricity, and alcohol. OBVIO! is anticipated to be available in fall 2007, and will be available in two models - an economy 828 model, and a full-performance 012 model. PERSONAL TRANSPORTATION ----------------------- ZAPPY(R). This electric scooter is a stand-up, portable, lightweight scooter featuring a 12-volt battery with a built-in charger and a collapsible frame. The design includes a unique folding mechanism and proprietary circuitry, which increases the efficiency and range of the vehicle. In the fourth quarter of 2003, we introduced a new ZAPPY(R) Scooter which offered significant upgrades over the previous design with respect to performance, construction and appearance. ZAPPY 3. The ZAPPY 3 is a three-wheeled scooter that uses a wheel-motor drive technology built into the hub of the front wheel to enable increased stability while enhancing maneuverability. The riding platform has two smaller wheels on either side with the larger wheel motor in front, so a person can ride in standing position with both feet placed side-by-side, rather than skateboard-style standing sideways which was the design of the original ZAPPY(R). We exclusively own the design of this vehicle. This vehicle is not subject to state vehicle registration laws, and may be sold directly to consumers. ZAPPY EXPRESS. The ZAPPY Express scooter is a powerful two-wheeled scooter with a comfortable seat. This model is more powerful, has greater speed, and more range per charge than any other of our scooter lines. This vehicle is also not subject to state vehicle registration laws, and may be sold directly to consumers. POWERBIKE(R). The Powerbike resembles a mountain bicycle with an electric motor attached. It was designed to appeal to the low cost mass merchant. This vehicle is not subject to state vehicle registration laws and may be sold directly to consumers. OTHER ELECTRIC AND FUEL-EFFICIENT VEHICLES. Under various distribution agreements, we have the right to distribute a wide spectrum of personal and industrial electric vehicles. In 2004, we announced the introduction of our electric all-terrain vehicles, which we began selling at the end of 2004. 8 ENERGY PRODUCTS --------------- ZAP PORTABLE ENERGY(TM). This is a portable lithium energy power source and battery charger for low-voltage consumer electronic products. This device uses a "smart" microprocessor control system to power multiple hand-held electronic devices or to charge batteries. The ZAP Portable Energy can be used to power avariety of mobile consumer electronic devices, such as PDAs, digital cameras,cellular telephones, MP3 players, laptops and equivalent low-voltage devices. We manufacture the ZAP Portable Energy in China for distribution and sale in the United States under our name. We are marketing and planning to sell this product through independent representatives for resale and distribution to retail stores, as well as directly to consumers over our Internet sales portal. MICROPROCESSOR DRIVE CONTROLLERS. We are working to develop, independently and in collaboration with other companies, a series of low cost proprietary controller microprocessors for all of our products. These devices will increase efficiency and lower costs of operation by providing more efficient use of power to charge and to power our products. FUEL CELL TECHNOLOGIES. In August 2004, Voltage Vehicles entered into an exclusive distribution agreement with Apollo to acquire certain exclusive rights to purchase and market Apollo products including Alkaline Fuel Cell products, Tri-Polar Lead-Cobalt battery technology, and certain propulsion systems, together with related advanced technology products owned by Apollo. Our Chief Executive Officer, Mr. Steven Schneider is a member of the Advisory Board of Directors of Apollo. The Company demonstrated its first hybrid fuel cell vehicle in the fourth quarter of 2005. In December 2004, we entered into an exclusive purchase and distribution agreement with Anuvu for their patented fuel cell for on road applications, and completed the production of a prototype fuel cell car. DISTRIBUTION AND MARKET OUTLETS We employ the following methods to distribute our products: AUTO DEALER PROGRAM. The Company began establishing ZAP qualified auto dealers in various locations in the United States in the fourth quarter of 2003. We started to receive commitments from each qualified dealer to purchase a minimum number of vehicles annually. In 2004, we expanded this network to include the gas-efficient Smart Car Americanized by ZAP. Currently, we have qualified dealers in New York, New Hampshire, Nevada, Colorado, Pennsylvania, Florida, California and Washington. We intend to use these ZAP qualified dealers to sell all ZAPCAR (TM) . Some dealers will also sell other vehicle products, such as scooters and bikes, depending on demand. RAP GROUP, INC. The Company distributes its conventional cars through RAP, a wholly owned subsidiary, located in Fulton, California. RETAIL OUTLETS. The Company markets its consumer products to independent representatives and retail outlets, as well as undertaking direct marketing activities with these entities. ELECTRIC VEHICLE RENTAL PROGRAM. The Company established ZAP Rental Outlets in 2002 to rent neighborhood electric vehicles in tourist locations. In 9 September 2003, we acquired a fleet of electric vehicles. Some of these have been sold and others are being rented from time to time in various locations. INTERNET SALES. The Company markets and sells its consumer products directly to consumers on its Web site. ACQUISITION OF NEW BUSINESSES AND ASSETS On March 1, 2004, we entered into an Asset Purchase Agreement with Electric Transportation Company, LLC, a California limited liability company ("ETC"), to purchase certain assets including electric vehicles and intellectual property. We paid ETC for the assets by issuing 121,951 shares of our common stock valued at $250,000 as consideration for the purchase of the assets. The Company has acquired from Smart Automobile LLC the exclusive distribution, marketing, and technology rights throughout the United States to make the Smart Cars U.S. compliant, through registered importer G & K Automotive,for a period of ten years. These rights also included the proprietary computer technology and process for making vehicles DOT and EPA compliant. These rights were acquired through the payment of $1 million in cash upon execution of the agreements, $1 million in cash upon delivery of the first 1,000 Smart Cars, and $8 million in preferred stock. A more detailed conversion agreement was completed and signed on October 25, 2004. Under this agreement Smart Automobile, LLC (SA) exchanged their original Preferred Shares for new Preferred Shares with the designation of SA. These SA preferred Shares convert to ZAP common shares under the following formula: For every 1,000 Smart vehicles delivered to ZAP in the years 2004, 2005, and 2006 that are fully EPA compliant to sell in the United States allow the holder of 500 preferred stock SA to convert to $500,000 of common and stock and allow the holder to receive 505,000 warrants with an exercise price of $2.50 per share exercisable until July 7, 2009, or when all the preferred shares have been converted. Upon EPA compliance, and the legal right to sell the first 98 vehicles currently in inventory, the holder can convert 500 preferred shares to $500,000 common stock immediately, and receive 505,000 warrants. This was issued in 2004. SA was also granted a $1 million loan. This loan is currently in default. As of March 31, 2006, Smart Automobile had delivered 96 Smart Cars Americanized by ZAP to the Company for sale in the United States. Smart Automobile is not affiliated with Mercedes Benz. ENVIRONMENTAL INITIATIVES AND LEGISLATION In 1992, Federal legislation (United States Energy Policy Act of 1992) was enacted to promote the use of alternative fuel vehicles, including electric vehicles. Acquisition of a qualified electric vehicle entitles the owner to a Federal tax credit equal to 10% of the cost of the vehicle. Several states have also adopted legislation that sets mandates for the introduction of electric vehicles. Many foreign countries have also initiated either mandates or incentives for electric vehicles or are planning such programs in the future. As we commercialize new transportation technology, we have been required to expend our resources in educating legislators of the benefits of these vehicles. In November 2002, President Bush signed into law legislation, which transfers regulation of electric bicycles from the National Highway Traffic Safety Administration to the Consumer Product Safety Commission. This effectively 10 changes the regulating standards for electric vehicles from motor vehicles standards to consumer standards such as those governing bicycles, relieving the need for regulatory compliance in connection with the sale of our bicycle products. Although many government agencies are concerned about rising global air pollution, it is expected that we will need to continue to expend considerable resources in the future in the governmental process to continue the current favorable governmental climate for the zero emission vehicles. RESEARCH AND PRODUCT DEVELOPMENT; PRODUCT DISTRIBUTION We are primarily a marketer and distributor of ZAP products and products manufactured for ZAP, such as the ZAP Xebra and the Smart Car Americanized by ZAP. Thus, we do not currently require large expenditures for internal research and development costs. In order to maintain our competitive advantage, we search globally for the latest advanced technology vehicles and then assess the feasibility of including the new item into our product lines. We look to acquire new technologies through development agreements, licenses and distribution agreements. We are primarily focused on developing ZAP qualified dealers throughout the United States that will sell our automobile and consumer products, in creating relationships with independent representatives and mass merchandisers for the distribution and sale of our products to consumers, and in direct sales to consumers through our Internet sales portal. LICENSES, PATENTS AND TRADEMARKS We have the following patents covering our electric vehicles: ---------------------------- --------------------- -------------------------- UNITED STATES PATENT DATE SUBJECT OF PATENT ---------------------------- --------------------- -------------------------- Patent No. 5,491,390 February 13,1996 Electric motor power system for bicycles, tricycles, and scooters ---------------------------- --------------------- -------------------------- Patent No. 5,671,821 September 30, 1997 Electric motor system ---------------------------- --------------------- -------------------------- Patent No. 5,848,660 December 15, 1998 ZAPPY scooter ---------------------------- --------------------- -------------------------- Design Patent No. 433,718 November 14, 2000 ZAPPY scooter ---------------------------- --------------------- -------------------------- Patent No. 6,059,062 Acquired in December Powered roller skates 1999 in the empower acquisition ---------------------------- --------------------- -------------------------- Patent No. 6,050,357 Powered skateboard ---------------------------- --------------------- -------------------------- Patent No. 5,423,278 June 13, 1995 Submersible marine vessel ---------------------------- --------------------- -------------------------- 11 ---------------------------- --------------------- -------------------------- Patent No. 5,634,423 June 3, 1997 Personal submersible marine vehicle ---------------------------- --------------------- -------------------------- Patent No. 5,303,666 April 19, 1994 Submersible marine vessel ---------------------------- --------------------- -------------------------- Design Patent No. 347,418 May 31, 1994 Scuba scooter ---------------------------- --------------------- -------------------------- Design Patent No. 359,022 June 6, 1995 Scuba scooter ---------------------------- --------------------- -------------------------- Design Patent No. 453,726S February 19, 2002 Submersible marine vehicle ---------------------------- --------------------- -------------------------- Patent No. 6,748,892 June 15, 2004 Seascooter ---------------------------- --------------------- -------------------------- Patent No. 115,434 Powered Scooter ---------------------------- --------------------- -------------------------- We also hold several other patents in the electric vehicle industry. As part of our acquisition of all of the assets of Electric Vehicles Systems Inc., we also acquired the PowerSki(R) trademark (Registration #No. 2,224,640) and two United States Patents (Patent #No. 5,735,361) and (Patent #No. 5,913,373). We currently have a patent pending for the ZAPPY3. We also have several copyright registrations for various advertisements that we use to promote our products. We hold and utilize several trademarks: we were assigned the trademark ZAP(R) on September 23, 1994 (Reg. No. 1,794,866); the ELECTRICRUIZER(R) mark was registered on April 2, 1999 (Reg. No. 2,248,753); the ZAPPY(R) mark was registered on March 21, 2000 (Reg. No. 2,330,894); the POWERBIKE(R) mark was registered on June 1, 1999; trademark ZAPWORLD.COM(R) was registered on July 25, 2000 (Reg. No. 2,371,240); the trademark ZAP Electric Vehicle Outlet (R) was registered on March 28, 2000 (Reg. No. 2,335,090); the mark Zero Air Pollution (R) was registered on February 28, 2000 (Reg. No. 2,320,346); SWIMMY was registered on July 25, 2003 (Reg. No.2,689,203). In 2004, ZAP was issued the trademark ZAP Seascooter(R) and was registered on September 21, 2004 (Reg. No.2,885,816). ZAP Car(R)was registered (Reg. No. 6,912,329) on December 21, 2004. BACKLOG As of March 30, 2006, the Company has over $1 billion in dated backlog orders from auto-dealer purchase contracts for the Smart Cars Americanized for ZAP. The Company still has these orders in hand, however, due to delays beyond ZAP's control,the Company will need additional converters, and suppliers to fulfill these orders, and continued government approvals and has no commitment or time table to complete this number of Smart-Cars Americanized for ZAP for sale in the U.S. market at this time. Through March 30, 2006, ZAP has delivered or scheduled to deliver approximately $2.4 million in Smart-Cars Americanized for ZAP. The backlog for our consumer products on the same date was $39,700. We are planning to introduce new consumer product models shortly. We also have a backlog of $220,000 for various electric vehicles that we anticipate shipping by the end of second quarter of 2006. COMPETITIVE CONDITIONS The competition to develop and market advanced technology vehicles has been intense and is expected to continue to increase. Our principal competitive advantages over our competitors are our ownership of fundamental technology, our trade name and brand recognition, our ability to be a low cost manufacturer through domestic and international contract manufacturing arrangements and our growing distribution network. We benefit from our high name recognition in the 12 advanced transportation vehicle industry coupled with a rapidly developing consumer sales business on our website. In order to reduce costs, our production activities have been transferred to lower cost contract manufacturers outside the United States, which enables us to offer our products at competitive prices. This also enables us to concentrate on our marketing and sales efforts and the growth of our distribution network. We offer one of the broadest lines of personal electric vehicles currently available, which we believe reinforces our name recognition in the market place. In the advanced technology vehicle market in the United States, we compete with large manufacturers, including Honda, Toyota, and Daimler-Chrysler, who have more significant financial resources, established market positions, longstanding relationships with customers and dealers, and who have more significant name recognition, technical, marketing, sales, manufacturing, distribution and other resources than we do. Each of these companies is currently working to develop, market and sell advanced technology vehicles in the United States market. The resources available to our competitors to develop new products and introduce them into the market place exceed the resources currently available to our Company. We also face competition from smaller companies with respect to our consumer products, such as our electric bicycle and scooter. We expect to face competition from the makers of consumer batteries and small electronics with respect to the ZAP PE. This intense competitive environment may require us to make changes in our products, pricing, licensing, services, distribution or marketing to develop, maintain and extend our current technology and market position. EMPLOYEES As of March 30, 2006, the Company had a total of 31 employees. We believe our employee relations are generally good. Our employees are not represented by a collective bargaining unit. BANKRUPTCY PLAN OF REORGANIZATION On March 1, 2002, we filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Northern District of California, Santa Rosa Division. The first impact of the Chapter 11 filing was to stay certain legal proceedings that had been instituted against us. Management also believed that the Chapter 11 filing would allow us to reorganize our business operations, debt and capital structure, and revise our general business direction, and seek debtor-in-possession financing on terms favorable to the Company. On June 20, 2002, the Bankruptcy Court entered an order confirming a second amended plan of reorganization (the "confirmed plan of reorganization"). On June 14, 2004, the Bankruptcy Court entered an order closing the Chapter 11 case and officially terminating our operations under the jurisdiction of the Bankruptcy Court. Under the confirmed plan of reorganization we were able to: (a) alter our equity and debt structures to permit us to emerge from the reorganization proceedings with a viable capital structure; (b) maximize the value of the ultimate recoveries to all creditor groups on a fair and equitable basis; and (c) settle, compromise, or otherwise dispose of certain claims and interests on 13 terms that we believed to be fair and reasonable and in the best interests of their respective estates, creditors, and stakeholders. Under the terms the confirmed plan of reorganization the Company undertook and completed the following: o A 6 -to -1 reverse stock split of our common stock; o The common shareholders received one warrant in Series B, C and D to purchase common stock for each common share issued to the claimant (post stock-split); o The cancellation of certain indebtedness in exchange for cash, common stock and/or warrants to purchase shares of common stock. The warrants were issued to each claimant during 2002; o Payment of $50,000 to a claimant of secured pre-petition debt. $50,000 is the estimated value of the collateral, plus 5% interest on a declining balance, payable monthly over three years, commencing August 20, 2002; o Conversion of 2,250 shares of our preferred stock, originally valued at $1,000 per share, into 630,000 shares of common stock (post the 6:1 reverse stock split). The preferred shareholders also received 2.5 million Series A warrants, to vest in accordance with a schedule outlined in the Plan and one warrant in Series B, C and D to purchase common stock for each common share issued to the claimant; o The assumption and assignment, or rejection of executory contracts or unexpired leases to which we were a party; o Authorization to issue 100 million shares of common stock and 50 million shares of preferred stock. o Authorization to issue 10 million common shares each for the following warrants: Series A, B, C, D and K for a total of 50 million warrants, with the expiration dates for the warrants ranging from 12 to 36 months; o The creation of an Incentive Stock Option Plan for employees within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended, with an option by the Incentive Stock Option Plan to purchase 10 million shares of ZAP common stock at an exercise price equal to the closing price on the date of issue; o Authorization to execute a $500,000 convertible debenture for the purchase of inventory from a new supplier in exchange for a note with interest at 6% per annum; or shares of common stock at $0.50 per share or 15% of the outstanding shares of the Reorganized ZAP, whichever amount is greater. The supplier was also given warrants in Series B, C and D for each common share owned (The entire debt was converted to common stock during 2002); and o Authorization to complete the acquisition of Voltage Vehicles and RAP Group, Inc. effective July 1, 2002. RISK FACTORS We have a history of losses, and we might not achieve or maintain profitability. Since we began operation in 1994, we have not generated a profit from operations during any fiscal year. Our net sales decreased in 2005 to $3,602,000 from those in 2004 ($4,772,000), and 2004 net sales were less than those for 2003 ($5,828,000). We incurred net losses of $23,501,000, $27,834,000 and $5,542,000 for the years ended December 31, 2005, 2004 and 2003, respectively. 14 As a consequence, we can give no assurance that we will be able to operate profitably in the future. In each of the 11 years since we began operations, we have not generated enough revenue to exceed our expenditures. Since our inception, we have financed our operations primarily through private and public offerings of our equity securities. Our planned expenditures are based primarily on our internal estimates of our future sales and ability to raise additional financing. If revenues or additional financing do not meet our expectations in any given period of time, we will have to cut our planned expenditures which could have an adverse impact on our business and force us to cease operations. Our cash on hand declined from $5.4 million on December 31, 2004 to $1.5 million on December 31, 2005. Failure to achieve profitable operations may require us to seek additional financing when none is available or is only available on unfavorable terms. We face intense competition which could cause us to lose market share. In the advanced technology vehicle market in the United States, we compete with large manufacturers, including Honda, Toyota, and Daimler-Chrysler, who have more significant financial resources, established market positions, long-standing relationships with customers and dealers, and who have more significant name recognition, technical, marketing, sales, manufacturing, distribution, financial and other resources than we do. Each of these companies is currently working to develop, market, and sell advanced technology vehicles in the United States market. The resources available to our competitors to develop new products and introduce them into the marketplace exceed the resources currently available to us. We also face competition from smaller companies with respect to our consumer products, such as our electric bicycle and scooter. We expect to face competition from the makers of consumer batteries and small electronics with respect to the ZAP PE. This intense competitive environment may require us to make changes in our products, pricing, licensing, services, distribution, or marketing to develop, maintain, and extend our current technology and market position. Our Smart Car is produced and sold outside of the United States by Daimler-Chrysler. If Daimler-Chrysler decides to sell the Smart Car in the United States, which it has indicated it could do as early as 2007, it could have a substantial adverse effect on the Company's Smart Car business. Changes in the market for electric vehicles could cause our products to become obsolete or lose popularity. The electric vehicle industry is in its infancy and has experienced substantial growth and change in the last few years. To-date, demand for and interest in electric vehicles has been sporadic. As a result, growth in the electric vehicle industry depends on many factors, including: continued development of product technology; the environmental consciousness of customers; the ability of electric vehicles to successfully compete with vehicles powered by internal combustion engines; widespread electricity shortages and the resultant increase in electricity prices, especially in our primary market, California, which could derail our past and present efforts to promote electric vehicles as a practical solution to vehicles which require gasoline; and future regulation and legislation requiring increased use of nonpolluting vehicles. 15 We cannot assure you that growth in the electric vehicle industry will continue. Our business may suffer if growth in the electric vehicle industry slows down or if we are unable to maintain the pace of industry demands. We may be unable to keep up with changes in electric vehicle technology and, as a result, may suffer a decline in our competitive position. Our current products are designed for use with, and are dependent upon, existing electric vehicle technology. As technologies change, we plan to upgrade or adapt our products in order to continue to provide products with the latest technology. However, our products may become obsolete or our research and development efforts may not be sufficient to adapt to changes in or create necessary technology. As a result, our potential inability to adapt and develop the necessary technology may harm our competitive position. The failure of certain key suppliers to provide us with components could have a severe and negative impact upon our business. We rely on a small group of suppliers to provide us with components for our products, some of whom are located outside of the United States. If these suppliers become unwilling or unable to provide components, there are a limited number of alternative suppliers who could provide them. Changes in business conditions, wars, governmental changes, and other factors beyond our control or which we do not presently anticipate could affect our ability to receive components from our suppliers. Further, it could be difficult to find replacement components if our current suppliers fail to provide the parts needed for these products. A failure by our major suppliers to provide these components could severely restrict our ability to manufacture our products and prevent us from fulfilling customer orders in a timely fashion. Our Smart Car products are currently acquired overseas through retail purchases from sales lots or from brokers in Europe and Asia. Daimler-Chrysler has refused to sell the Smart Car to us directly, and there is no assurance that we will continue to be able to purchase a sufficient number of Smart Cars at retail or from brokers. Our Smart Cars must be modified to meet applicable U.S. and state regulations. We have a contract with the only companies who are qualified to do these modifications, Smart Automobile LLC and its compliance contractor, G&K Automotive, which has clearances from the Department of Transportation and a letter of conformity from the Environmental Protection Agency. We are therefore dependent on these companies for the continued delivery of Americanized Smart Cars. As described elsewhere, we have entered into a contract with a Brazilian automobile manufacturer, OBVIO, for the delivery of 50,000 multi-fuel vehicles in two different models. OBVIO is a new developer and manufacturer of automobiles in Brazil and there are many risks associated with its design and manufacturing of cars for us, including, but not limited to, risks associated with the constructing its factory, hiring personnel, acquiring equipment, assembling a network of suppliers and developing the vehicle assembly process. Litigation risks. On October 28, 2005, we filed a Complaint against Daimler-Chrysler Corporation and others in Los Angeles Superior Court. The Complaint includes claims for intentional and negligent interference with prospective economic relations, trade libel, 16 defamation, breach of contract/agreement to negotiate in good faith, breach of implied covenant of good faith and fair dealing, and unfair competition. The Complaint alleges that Daimler-Chrysler has engaged in a series of anti-competitive tactics aimed at defaming us and disrupting our third-party relationships. The Complaint requests damages in excess of $500 million and other relief. Although Daimler-Chrysler has not yet filed a response to our Complaint, we anticipate that it will vigorously defend these charges and may file counterclaims against us. Daimler-Chrysler has significantly stronger financial and other resources, and could force us to expend significant time and money in a protracted legal battle. There is no assurance that we would be successful on our claims and we may be subject to liability on any counterclaims that Daimler-Chrysler may assert. The litigation could also be disruptive to our business and divert the time and effort of our key executives and other personnel. Product liability or other claims could have a material adverse effect on our business. The risk of product liability claims, product recalls, and associated adverse publicity is inherent in the manufacturing, marketing, and sale of electrical vehicles. Although we have product liability insurance for our consumer products for risks of up to an aggregate of $2,000,000, that insurance may be inadequate to cover all potential product claims. We also carry liability insurance on our automobile products. Any product recall or lawsuit seeking significant monetary damages either in excess of our coverage, or outside of our coverage, may have a material adverse effect on our business and financial condition. We may not be able to secure additional product liability insurance coverage on acceptable terms or at reasonable costs when needed. A successful product liability claim against us could require us to pay a substantial monetary award. Moreover, a product recall could generate substantial negative publicity about our products and business and inhibit or prevent commercialization of other future product candidates. Although we have experienced no product liability claims or product recalls through March 31, 2006, there is a risk that such claims and/or recalls could occur in the future. The implementation of a product distribution network presents many risks. One of our primary goals has been to increase the capacity of our product distribution network. Unfortunately, dealers are often hesitant to provide their own financing to contribute to this network. As a result, we have had to, and we anticipate that we will continue to have to, provide financing for dealers who would like to participate as our regional distribution centers. The further expansion of our product distribution network will require a significant capital investment and will require extensive amounts of time from our management. A capital investment such as this presents many risks, foremost among them being that we may not realize a significant return on our investment if the network is not profitable. Our inability to collect receivables from our dealers could cause us to suffer losses. Lastly, the amount of time that our management will need to devote to this project may divert them from performing other functions necessary to assure the success of our business. Failure to manage our growth effectively could adversely affect our business. 17 We plan to increase sales and expand our operations substantially during the next several years through internally-generated growth and the acquisition of businesses and products. To manage our growth, we believe we must continue to implement and improve our operational, manufacturing, and research and development departments. We may not have adequately evaluated the costs and risks associated with this expansion, and our systems, procedures, and controls may not be adequate to support our operations. In addition, our management may not be able to achieve the rapid execution necessary to successfully offer our products and services and implement our business plan on a profitable basis. The success of our future operating activities will also depend upon our ability to expand our support system to meet the demands of our growing business. Any failure by our management to effectively anticipate, implement, and manage changes required to sustain our growth would have a material adverse effect on our business, financial condition, and results of operations. We cannot assure you that we will be able to successfully operate acquired businesses, become profitable in the future, or effectively manage any other change. An inability to successfully operate recently acquired businesses and manage existing business would harm our operations. The loss of certain key personnel could significantly harm our business. The Company's performance is substantially dependent upon the services of its executive officers and other key employees, as well as on its ability to recruit, retain, and motivate other officers and key employees. Competition for qualified personnel is intense and there are a limited number of people with knowledge of and experience in the advanced technology vehicle industry. The loss of services of any of our officers or key employees, or our inability to hire and retain a sufficient number of qualified employees, will harm our business. Specifically, the loss of Mr. Schneider, our Chief Executive Officer, Mr. Starr, our Chairman of the Board, or Mr. Scheder-Bieschin, our President, whose specialized knowledge of the electric vehicle industry is essential to our business, would be detrimental. Regulatory requirements may have a negative impact upon our business. While our products are subject to substantial regulation under federal, state, and local laws, we believe that the products we have sold are materially in compliance with all applicable laws. However, to the extent the laws change, or if we introduce new products in the future, some or all of our products may not comply with applicable federal, state, or local laws. Further, certain federal, state, and local laws and industrial standards currently regulate electrical and electronics equipment. Although standards for electric vehicles are not yet generally available or accepted as industry standards, our products may become subject to federal, state, and local regulation in the future. Compliance with this regulation could be burdensome, time consuming, and expensive. Our automobile products are subject to environmental and safety compliance with various federal and state regulations, including regulations promulgated by the EPA, NHTSA, and Air Resource Board of the State of California, and compliance 18 certification is required for each new model year. The cost of these compliance activities and the delays and risks associated with obtaining approval can be substantial. Although the Company has been marketing its Smart Car product in the United States, the car must be certified by the California Air Resources Board before it can be sold in California, New York, and three other states. In addition, the two models of our OBVIO products will need to satisfy all regulatory requirements before they can be sold in the United States. The risks, delays, and expenses incurred in connection with such compliance could be substantial. International expansion may cause problems for us. We have been shifting our manufacturing overseas, including contracting with OBVIO, a Brazilian company, for the manufacture of 50,000 vehicles over three years. There are many risks associated with international business. These risks include, but are not limited to, language barriers, fluctuations in currency exchange rates, political and economic instability, regulatory compliance difficulties, problems enforcing agreements, and greater exposure of our intellectual property to markets where a high probability of unlawful appropriation may occur. A failure to successfully mitigate any of these potential risks could damage our business. We may not be able to protect our internet address. We currently hold the internet address, http://www.zapworld.com, a portal through which we sell our products. We may not be able to prevent third parties from acquiring internet addresses that are confusingly similar to our address, which could adversely affect our business. Governmental agencies and their designees generally regulate the acquisition and maintenance of internet addresses. However, the regulation of internet addresses in the United States and in foreign countries is subject to change. As a result, we may not be able to acquire or maintain relevant internet addresses in all countries where we conduct business. Our success is heavily dependent on protecting our intellectual property rights. We rely on a combination of patent, copyright, trademark, and trade secret protections to protect our proprietary technology. Our success will, in part, depend on our ability to obtain trademarks and patents. We hold several patents registered with the United States Patent and Trademark Office. These registrations include both design patents and utility patents. In addition, we have recently submitted provisional patents which may or may not be afforded the limited protection associated with provisional patents. We have also registered numerous trademarks with the United States Patent and Trademark Office, and have several pending at this time. We cannot assure you that the trademarks and patents issued to us will not be challenged, invalidated, or circumvented, or that the rights granted under those registrations will provide competitive advantages to us. We also rely on trade secrets and new technologies to maintain our competitive position. Although we have entered into confidentiality agreements with our employees and consultants, we cannot be certain that others will not gain access to these trade secrets. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. 19 We may be exposed to liability for infringing intellectual property rights of other companies. Our success will, in part, depend on our ability to operate without infringing on the proprietary rights of others. Although we have conducted searches and are not aware of any patents and trademarks which our products or their use might infringe, we cannot be certain that infringement has not or will not occur. We could incur substantial costs, in addition to the great amount of time lost, in defending any patent or trademark infringement suits or in asserting any patent or trademark rights, in a suit with another party. Risk of Unregistered Securities Offering. In the past, we have had numerous sales of our securities which were not registered under federal or state securities laws. We have strived to comply with all applicable Federal and state securities laws in connection with our issuances of unregistered securities. However to the extent we have not complied, there may be liability for the purchase price of the securities sold together with interest and the potential of regulatory sanctions Risk of Delisting. On December 19, 2005, we received a notice from the staff of PCX Equities, Inc. ("PCXE"), a subsidiary of the Pacific Exchange that we had not met their listing maintenance requirements for share bid price set forth in PCXE Rule 5.5(h)(4). In response to that notice, we developed a plan addressing the listing deficiency and provided it to the PCXE Staff. On January 19, 2006, we were notified by the PCXE Equity Qualification Panel that the Panel had considered our plan for the listing deficiency and will permit us to maintain our listing on the Archipelago Exchange, subject to regaining compliance in accordance with the terms of the Panel's notice. Under the Panel's notice, we must regain the one dollar minimum price per share requirement by our next annual shareholders meeting, tentatively scheduled for June 2006 or, in the alternative, receive shareholder approval at such meeting for a reverse stock split in a ratio designed to regain compliance with the share bid price requirement. On March 7, 2006, we were notified that the Archipelago Exchange and Pacific Exchange were renamed as "NYSE Arca," In connection with their acquisition by an affiliate of the New York Stock Exchange. On March 24,2006 the closing sales price of our common stock was $1.35. Our stock price and trading volume may be volatile, which could result in substantial losses for our stockholders. The equity trading markets may experience periods of volatility, which could result in highly variable and unpredictable pricing of equity securities. The market price of our common stock could change in ways that may or may not be related to our business, our industry or our operating performance and financial condition. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. We have experienced significant volatility in the price of our stock over the past few years. See Item 5. Market For Common Equity and Related Shareholder Matters. For example, on December 31, 2004, our stock had a high of $5.15 and on December 31, 2005, it had a low of $.26. If the market price of our common stock declines significantly, you may be unable to resell your common stock at or about its purchase price. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. In addition, the 20 stock markets in general can experience considerable price and volume fluctuations. A substantial number of shares we have issued in exempt transactions are, or are being made, available for sale on the open market, and the resale of these securities might adversely affect our stock price. We have on file with the SEC effective registration statements for a substantial number of shares for resale. The selling stockholders under our effective registration statements will be permitted to sell their registered shares in the open market from time to time without advance notice to us or to the market and without limitations on volume. The sale of a substantial number of shares of our commons stock under our registration statements, or the anticipation of such sales, could make it more difficult for us to sell equity or equity-related securities in the future at a time and at a price that we might otherwise wish to effect sales. We have not paid cash dividends on our common stock and do not anticipate paying any dividends on our common stock in the foreseeable future. We have not achieved profitable operations and if we do realize a profit in the future, we anticipate that we will retain all future earnings and other cash resources for the future operation and development of our business. Accordingly, we do not intend to declare or pay any cash dividends on our common stock in the foreseeable future. Payment of any future dividends will be at the direction of our board of directors after taking into account many factors, including our operating results, financial conditions, current and anticipated cash needs and plans for expansion. ITEM 2. DESCRIPTION OF PROPERTY. The chart below contains a summary of our principal facilities: Location Use Square Feet Rent --------------------------- ------------------- ----------- ----------- 501 Fourth Street, SR Corporate Headquarters 20,000 $ - (1) 44720 Main Street,Mendocino Retail Outlet 5,507 $ - (2) 6784 Sebastopol Avenue, Seb Distribution Center 10,000 $ 6,607 6786 Sebastopol Avenue, Seb Warehouse 6,000 $ 4,162 6793 Mc Kinley Street, Seb Warehouse 4,000 $ 2,774 3362 Fulton Road, SR Office, Automobile Lot 10,000 $ 5,000 3405 Fulton Road, SR Automobile Lot 11,000 $ 5,500 (1) Under the terms of the Mortgage, dated March 7, 2003, between the Company and Atocha Land LLC concerning the Fourth Street location, monthly payments of principal and interest amortizing the underlying $2 million debt have 21 commenced on April 7, 2005, with the interest at the prime rate plus 2%. The underlying debt may be converted to ZAP's common shares at Atocha's option. See also below. (2) In the second quarter of 2005, ZAP issued 455,442 common shares in exchange for the purchase of real estate. ZAP recorded the common shares at the appraised value of the real estate. Under the terms of the purchase, ZAP is obligated to issue additional common shares for no additional consideration if after 1 year the market price of ZAP's common shares is less than the market price at their date of issuance. The Company purchased the Fourth Street building in March 2003 to use as our principal executive offices. The building was built originally in 1906 and is in downtown Santa Rosa. Over the years it was updated and remodeled by previous owners and the Company. The Company has renovated the building during its ownership with new carpets, paint and remodeled to include a new showroom and conference room. The building and contents are adequately insured in the opinion of management. The Company occupies more than 90 percent of the building. The property tax rate is set at 1 percent per year of the assessed value (currently set at the 2004 appraised value of $2.9 million). The building is being depreciated over a 30 year useful life. The Company has a $2 million convertible note due in March 2025, with annual interest at 7.5%. The Company began making payments in April 2005 of $15,166 per month. The note is payable with equal principal and interest payments over the next 240 months. The noteholder has the option to convert some or all of the unpaid principal and accrued interest to shares of ZAP's common stock at $2.15 per share or an agreed upon conversion price (as defined). The seller also received common stock and warrants in connection with the transaction. The Company purchased the Mendocino California property in May 2005 which is currently being used as a retail outlet. The net book value of our real estate holdings at December 31, 2005 was approximately $4 million. The rest of our facilities are leased. The property located at 3405 and 3362 Fulton Road is rented on a month-by-month basis from ZAP's Chief Executive Officer. The lease for the property at 6784 Sebastopol Avenue expired in February 2006 and is now monthly. The company is in the process of locating new warehouse space. The Company plans to renew the month to month leases based on the Company's needs. The Company believes these properties are adequate for the Company's foreseeable needs. It is management's opinion that our insurance policies cover all insurance requirements of the landlords. We own the basic tools, machinery and equipment necessary for the conduct of our repairs, our minimal research and development, and vehicle prototyping activities. We believe that the above facilities are generally adequate for present operations. ITEM 3. LEGAL PROCEEDINGS. In the normal course of business, we may become involved with various litigation proceedings. Except as stated below, we know of no pending or threatened legal proceeding to which we are or will be a party which, if successful, might result in a material adverse change in our business, properties or financial condition. However, as with most businesses, we are occasionally parties to lawsuits incidental to our business, none of which are anticipated to have a material adverse impact on our financial position, results of operations, liquidity or cash flows. 22 A dormant complaint filed in 2002 against the RAP Group and Steve Schneider the CEO of ZAP, individually was reactivated by the plaintiff (Jim Arnold Trucking). The Compliant alleges breach of contract, promissory estoppel and fraud and seeks contract damages in the amount $71,000 plus monthly storage fees and punitive damages of $750,000. The Company has cross-claimed against Plaintiffs seeking compensatory damages, attorneys' fees and equitable relief for breach of oral contract, common count for goods sold and delivered, conversion, liability of surety, violation of statue, and violation of the Unfair Practices Act. On February 17, 2005, the court referred the matter to non-binding arbitration. The non binding arbitration hearing was held on July 27, 2005 where the arbritrator awarded the plaintiff damages in the amount of $68,290 plus prejudgement interest of 7%. ZAP intends to assert its defenses vigorously and to litigate its cross-complaint aggressively. A settlement conference is set for April 19, 2006. The Company has also requested a trial in this matter on May 2, 2006. Management believes that the ultimate resolution of this claim will not have a material adverse effect on our financial position or on results of operations. On October 28, 2005, we filed a complaint against DaimlerChrysler Corporation and others in the Los Angeles Superior Court, under the title ZAP V. DAIMLERCHRYSLER AG, ET AL. The complaint includes claims for intentional and negligent interference with prospective economic relations; trade libel; defamation; breach of contract - agreement to negotiate in good faith; breach of implied covenant of good faith and fair dealing; and unfair competition. The complaint alleges that DaimlerChrysler has engaged in a series of anti-competitive tactics aimed at defaming ZAP and disrupting its third-party business relationships. As a result of the allegations, the complaint requests damages in excess of $500 million and such other relief as the court deems just and proper. DaimlerChrysler has not yet filed a response to our complaint. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of our security holders during the fourth quarter of the year-ended December 31, 2005. PART II ITEM 5. MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND SMALL BUSINESS PURCHASES OF EQUITY SECURITIES. MARKET INFORMATION Our common stock has been listed on the NYSE Arca Exchange (previously the Pacific Exchange and the Arca Exchange) under the symbol "ZP" since June, 2005. Prior to that date, it was quoted for trading on the National Association of Securities Dealers' OTC Bulletin Board. For the periods since our listing on the NYSE Arca Exchange, following table sets forth the high and low sales prices for the periods indicated. For the periods prior to our listing on the NYSE Arca Exchange the table sets forth the high and low bid prices for our common stock for the periods indicated and Quotations reflect 23 inter-dealer prices, without retail markup, markdown or commission and may not be reflective of actual transactions BID PRICE ----------------------- PERIOD HIGH LOW -------------------------------------------- ------ ------ FISCAL YEAR 2005: DECEMBER 31, 2005 $ 1.07 $ 0.26 SEPTEMBER 30, 2005 1.40 0.96 JUNE 30, 2005 3.03 0.93 MARCH 31, 2005 3.56 2.35 FISCAL YEAR 2004: DECEMBER 31, 2004 $ 5.15 $ 1.06 SEPTEMBER 30, 2004 2.60 0.81 JUNE 30, 2004 4.20 0.55 MARCH 31, 2004 0.95 0.53 HOLDERS We have approximately 3,735 record holders of our common stock as of March 24, 2006, according to a shareholders' list provided by our transfer agent as of that date. The number of registered shareholders does not include any estimate by us of the number of beneficial owners of common shares held in street name. The transfer agent and registrar for our common stock is Continental Trust & Transfer Company. DIVIDEND POLICY We have never declared nor paid any cash dividends on our common stock, and we do not anticipate that we will pay any dividends on our common stock in the foreseeable future. Any future determination to declare and pay of cash dividends will be at the discretion of our board of directors, and will be dependent upon our financial condition, results of operations, capital requirements and other factors as our board of directors may deem relevant at that time. RECENT SALES OF UNREGISTERED SECURITIES We have sold or issued the following securities not registered under the Securities Act by reason of the exemption afforded under Section 4(2) of the Securities Act of 1933, during the year covered by this report. Except as stated 24 below, no underwriting discounts or commissions were payable with respect to any of the following transactions. COMMON STOCK ISSUED On January 1, 2005, we issued 116,099 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On January 1, 2005, we issued 288 shares of common stock to C Warrant Holders, in connection with its exercise of warrants. On January 5, 2005, we purchased assets with value of $15,989 from Suppliers with 5,420 shares of common stock. On January 13, 2005, we issued 30,000 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $83,100. On January 14, 2005, we issued 51,376 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On January 14, 2005, we issued 42 shares of common stock to C Warrant Holders, in connection with its exercise of warrants. On January 14, 2005, we purchased inventory with value of $247,500 from Suppliers with 90,000 shares of common stock. On January 20, 2005, we issued 10,000 shares of common stock to Consultant in payment for professional services valued at $23,500. On January 20, 2005, we settled an obligation with a professional organization, for $13,600, which was paid with 5,787 shares of common stock. On January 24, 2005, we issued 14,193 shares of common stock to B and B2 Warrant Holders, in connection with its exercise of warrants. On January 28, 2005, we issued 382 shares of common stock to Professional Organization in payment for professional services valued at $1000. On January 28, 2005, we issued 11,699 shares of common stock to Employees for employment bonuses valued at $30,651. On January 28, 2005, we purchased assets with value of $3,500 from Suppliers with 1,336 shares of common stock. On January 28, 2005, we issued 3,817 shares of common stock to Professional Contractors in payment for professional services valued at $10,000. On January 28, 2005, we issued 83,166 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On February 2, 2005, we issued 70,000 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On February 2, 2005, we purchased assets with value of $72.75 from Suppliers with 25 shares of common stock. On February 8, 2005, we issued 2,631 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On February 8, 2005, we issued 1,678 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $5,000. On February 15, 2005 the Company issued 600,000 shares of common stock to accredited investors for $1,250,125. 25 On February 15, 2005, we settled an obligation with Lessors, for $81,600, which was paid with 29,781 shares of common stock. On February 15, 2005, we issued 32,920 shares of common stock to various Consultants in payment for professional services valued at $90,200. On February 23, 2005, we issued 727 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On February 23, 2005, we settled an obligation with a Dealer, for $34,200, which was paid with 12,000 shares of common stock. On March 1, 2005, we issued 955 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On March 2, 2005, we purchased inventory with value of $7,250 from Suppliers with 3,593 shares of common stock. On March 8, 2005, we settled an obligation with Professional Organization, for $10,000, which was paid with 2,932 shares of common stock. On March 8, 2005, we issued 150,000 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On March 11, 2005, we issued 100,000 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On March 14, 2005, we issued 5,000 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On March 14, 2005, we issued 3,571 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $10,000. On March 14, 2005, we purchased assets with value of $25,850 from Suppliers with 13,376 shares of common stock. On March 14, 2005, we issued 929 shares of common stock to Employees for employment bonuses valued at $2,600. On March 17, 2005 the Company cancelled 200,000 shares of common stock to institutional investors in connection with cancellation of a financing deal. Money was returned to the institutional investor. On March 23, 2005, we issued 700 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On March 23, 2005, we issued 19,940 shares of common stock to Professional Contractors in payment for professional services valued at $55,035. On March 28, 2005, we issued 30,000 shares of common stock to B2 Warrant Holders, in connection with its exercise of warrants. On March 28, 2005, we issued 1,544 shares of common stock to Employees for employment bonuses valued at $4,600. On March 28, 2005, we issued 5,369 shares of common stock to Consultant in payment for professional services valued at $16,000. On April 6, 2005, we issued 100,000 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. On April 6, 2005, we issued 29,754 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $85,691. On April 7, 2005, we issued 41,095 shares of common stock to Contractors in payment for professional services valued at $120,000. On April 14, 2005, we issued 16,716 shares of common stock to Employees for commission bonuses valued at $47,141. On April 14, 2005, we issued 3,546 shares of common stock to Contractors in payment for professional services valued at $10,000. On April 27, 2005, we issued 4,000 shares of common stock to Employees for commission bonuses valued at $11,802. On April 29, 2005, we issued 177 shares of common stock to Contractors in payment for professional services valued at $500. On April 29, 2005, we issued 333 shares of common stock to B Warrant Holders, in connection with its exercise of warrants. 26 On May 3, 2005, we purchased real estate with value of $1,045,000 from Property Owners with 355,442 shares of common stock. On May 9, 2005, we purchased assets with value of $3,000 from Suppliers with 1140 shares of common stock. On May 9, 2005, we issued 1826 shares of common stock to Employees for commission bonuses valued at $4,800. On May 18, 2005, we purchased assets with value of $1,000 from Suppliers with 377 shares of common stock. On May 19, 2005, we issued 150,000 shares of common stock to K Warrant Holders, in connection with its exercise of warrants. On May 25, 2005, we issued 3,093 shares of common stock to Employees for commission bonuses valued at $6,000. On May 25, 2005, we issued 258 shares of common stock to Consultants in payment for professional services valued at $500. On June 1, 2005, we issued 19,108 shares of common stock to Contractors in payment for professional services valued at $30,000. On June 7, 2005, we issued 3,571 shares of common stock to Contractors in payment for professional services valued at $3,321. On June 7, 2005, we issued 1,000 shares of common stock to Employees for bonuses valued at $930. On June 7, 2005, we established a deposit reserve for real estate with value of $93,000 from Property Owners with 100,000 shares of common stock. On June 7, 2005, we purchased inventory with value of $785 from Suppliers with 844 shares of common stock. On June 14, 2005, we purchased inventory with value of $3,000 from Suppliers with 2,128 shares of common stock. On June 17, 2005, we settled an obligation with Lessors, for $63,000, which was paid with 42,000 shares of common stock. On June 17, 2005, we issued 13,333 shares of common stock to Contractors in payment for professional services valued at $20,000. On June 27, 2005, we settled an obligation with Contractors, for $1,784, which was paid with 1,166 shares of common stock. On June 30, 2005, we issued 27,105 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $36,592. On June 30, 2005, we issued 940 shares of common stock to Contractors in payment for professional services valued at $1,270. On June 30, 2005, we issued 1,481 shares of common stock to Contractors in payment for professional services valued at $2,000. On July 8, 2005, we issued 43,361 shares of common stock to Professional Contractors in payment for professional services valued at $52,900. On July 19, 2005, we issued 28,720 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $31,592. On August 5, 2005, we issued 9,259 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $10,000. On August 5, 2005, we issued 1,389 shares of common stock to Employees for employment compensation valued at $1,500. On August 17, 2005, we issued 6,637 shares of common stock to Professional Contractors in payment for professional services valued at $7,500. On August 19, 2005, we issued 18,018 shares of common stock to Consultants in payment for professional services valued at $20,000. On August 19, 2005, we issued 4,505 shares of common stock to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company valued at $5,000. 27 On August 23, 2005, we settled an obligation with Lessors, for $12,000, which was paid with 11,429 shares of common stock. On August 30, 2005, we issued 4,464 shares of common stock to Professional Contractors in payment for professional services valued at $5,000. On September 9, 2005, we issued 10,000 shares of common stock to Employees, in connection with its exercise of 10,000 employee stock options. On September 14, 2005, we issued 15,000 shares of common stock to Employees for employment compensation valued at $15,600. On September 15, 2005, we issued 20,214 shares of common stock to Consultant in payment for professional services valued at $21,225. On September 15, 2005, we issued 35,000 shares of common stock to Consultant in payment for professional services valued at $36,750. On September 27, 2005, we issued 8,772 shares of common stock to Professional Contractors in payment for professional services valued at $10,000. On October 13, 2005, we issued 27,956 shares of common stock to Professional Contractors in payment for professional services valued at $26,000. On October 21, 2005, we issued 31,875 shares of common stock to Professional Contractors in payment for professional services valued at $25,500. On October 27, 2005, we settled an obligation with Lessors for $25,296, which was paid with 31,230 shares of common stock. On October 27, 2005, we issued 61,728 shares of common stock to Professional Contractors in payment for professional services valued at $50,000. On October 28, 2005, we issued 61,728 shares of common stock to Consultants in payment for professional services valued at $50,000. On November 3, 2005, we purchased assets with value of $11,600 from Contractors with 14,321 shares of common stock. On November 3, 2005, we issued 4,938 shares of common stock to Professional Contractors in payment for professional services valued at $4,000. On November 9, 2005, we purchased inventory with value of $4,500 from Suppliers with 5,625 shares of common stock. On November 14, 2005, we issued 6,667 shares of common stock to Consultants in payment for professional services valued at $5,000. On November 14, 2005, we issued 3,333 shares of common stock to Professional Contractors in payment for professional services valued at $2,500. On November 15, 2005, we purchased inventory with value of $177,204 from Suppliers with 192,613 shares of common stock. On November 28, 2005, we issued 100,000 shares of common stock to Professional Contractors in payment for professional services valued at $100,000. On November 28, 2005, we issued 66,579 shares of common stock to Consultants in payment for professional services valued at $25,300. ZAP ESOP OPTIONS ISSUED On March 14, 2005, we issued 120,000 ESOP options with $2.80 exercise price to ZAP Employees for employment compensation. On June 7, 2005, we issued 1,248,194 ESOP options with $0.93 exercise price to ZAP Employees for employment compensation. On September 14, 2005, we issued 250,000 ESOP options with $1.04 exercise price to ZAP Employees for employment compensation. On December 1, 2005, we issued 50,000 ESOP options with $0.65 exercise price to ZAP Employee for employment compensation. $1.50 WARRANTS ISSUED On September 20, 2005, we issued 750,000 shares of $1.50 warrants to Lawyers in connection with legal fees. 28 On October 21, 2005, we issued 75,000 shares of $1.50 warrants to Consultants in payment for professional services. $2.50 WARRANTS ISSUED On February 15, 2005 the Company issued 300,000 shares of $2.50 warrants to accredited investors in connection with an investment. On February 15, 2005, we issued 30,000 shares of $2.50 warrants to Consultant in payment for professional services. $3.05 WARRANTS ISSUED On February 15, 2005, we issued 1,125,000 shares of $3.05 warrants to Consultants in connection to a consulting agreement. $3.25 WARRANTS ISSUED On January 20, 2005, we issued 200,000 shares of $3.25 warrants to Consultants in connection to a consulting agreement. On February 7, 2005, we issued 1,000,000 shares of $3.25 warrants to Consultants in connection to a consulting agreement. On February 15, 2005 the Company issued 300,000 shares of $3.25 warrants to accredited investors in connection with an investment. On February 15, 2005, we issued 30,000 shares of $3.25 warrants to Consultant in payment for professional services. On March 3, 2005, we issued 1,000,000 shares of $3.25 warrants to Lawyers in settlement of indebtedness arising from the provision of legal services rendered to the Company. On March 8, 2005, we issued 600,000 shares of $3.25 warrants to Consultants in payment for professional services. On April 1, 2005 the Company issued 300,000 shares of $3.25 warrants to Consultants for serving on the Advisory Board. On April 14, 2005, we issued 100,000 shares of $3.25 warrants to Consultant in connection with professional services. On April 19, 2005, we issued 500,000 shares of $3.25 warrants to Consultant in connection with professional services. $4.00 WARRANTS ISSUED On February 15, 2005 the Company issued 300,000 shares of $4.00 warrants to accredited investors in connection with an investment. On February 15, 2005, we issued 30,000 shares of $4.00 warrants to Consultant in payment for professional services. $4.05 WARRANTS ISSUED On February 15, 2005, we issued 562,500 shares of $4.05 warrants to Consultants in connection to a consulting agreement. $4.75 WARRANTS ISSUED On February 15, 2005, we issued 562,500 shares of $4.75 warrants to Consultants in connection to a consulting agreement. K2 WARRANTS ISSUED 29 On June 7, 2005, we issued 1,450,694 shares of $3.25 warrants to Employees for employment contracts and bonuses. B2 WARRANTS ISSUED On September 14, 2005, we issued 500,000 shares of B2 warrants to Consultant in connection with professional services. On September 14, 2005, we issued 250,000 shares of B2 warrants to Employees for employment contracts and bonuses. On September 15, 2005, we issued 250,000 shares of B2 warrants to Consultant in connection with professional services. On November 7, 2005, we issued 50,000 shares of B2 warrants to Consultant in connection with professional services. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion and analysis of our financial condition and results of operations should be read in conjunction with, and are qualified by reference to, our Financial Statements and related notes thereto in Item 7 of this report. Certain statements set forth below under this caption constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform of 1995. Refer to Item 1 of this report. Also, for a discussion of certain risk factors applicable to our business and operations see "Risk Factors" in Item 1 of this report. 30 SUMMARY OF KEY ACCOMPLISHMENTS DURING 2005 The Company delivered the first U. S. Compliant Smart Cars Americanized by ZAP to qualified dealers in seven states. The future delivery schedule has not yet been determined. ZAP will need the support of a major manufacturer and additional governmental approvals to be able to deliver existing customer orders for Smart Cars. ZAP entered into an agreement in September 2005, for a $425 million revolving financing facility with Surge Capital II, LLC. This new facility gives ZAP the ability to start fulfilling purchase orders it has already received for SMART cars that will be modified to meet United States environmental and safety standards. The facility may also be used for importation of other brands of fuel-efficient vehicles from global manufacturers that would be distributed through ZAP's dealer network. The financing facility has a term of one year, but may be extended upon agreement by both parties. The financing is based on orders ZAP receives from dealers who must be approved in advance by Surge Capital and is secured by a first lien on substantially all of ZAP's assets. ZAP signed an exclusive North American distribution agreement with a Brazilian auto manufacturer OBVIO ! Automotoveiculos S.P.E. Ltda., of Rio de Janeiro. ZAP and OBVIO ! have agreed to collaborate in the design and manufacture of high efficiency, high performance urban cars. Prototypes of both models were introduced in late 2005 at the San Francisco Auto Show. Under the terms of the agreement, ZAP is ordering 50,000 vehicles from OBVIO ! during the three year period following initial delivery. On October 28, 2005, the Company announced that it will be proceeding with legal action against Daimler Chrysler and others serving a complaint that seeks in excess of $500 million in redress for more than a year-long campaign of misconduct against ZAP by Daimler and Ulrich Walker, the then -CEO of its subsidiary Smart gmbh. The complaint filed in Los Angeles Superior Court, details a series of anti-competitive tactics, aimed at defaming ZAP and disrupting its third-party business relationships. ZAP anticipates proceeding to trial in this matter before the close of the year 2006. ZAP established a primary listing in 2005 on the Archipelago Exchange ("ArcaEx"), a facility of the Pacific Exchange. The ticker symbol changed from ZAPZ to ZP. Subsequently, ArcaEx completed a merger with the New York Stock Exchange to form the New York Stock Exchange Group on March 7, 2006. The all-electronic stock exchange Archipelago is now a wholly owned subsidiary of the NYSE Group, Inc. The company's listing is now on NYSE Arca, and continues to trade under the ticker symbol ZP. 31 YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004 NET SALES for the year ended December 31, 2005 were $3.6 million compared to $4.8 million in 2004. RAP's net sales for 2005 were $2.5 million versus $3.6 million in 2004. Net sales for ZAP in 2005 were $1.1 million versus $1.2 million in 2004. The decrease in sales was primarily due to less demand by consumers for conventional gasoline automobiles sold by RAP together with competitive rebates throughout the year by major automobile manufacturers. GROSS PROFIT was $341,000 for the year ended December 31, 2005 compared to $1.1 million for the year ended December 31, 2004. The RAP Group accounted for $303,000 of the gross profit for the year ended December 31, 2005 versus $782,000 in 2004. ZAP's gross profit, excluding the RAP Group, decreased from $258,000 in 2004 to $38,000 in 2005. The change in gross profit was due to a lower volume of sales together with smaller profits on conventional automobile sales. SALES AND MARKETING EXPENSES for the year ended 2005 were $909,000 as compared to $803,000 in 2004. RAP's expenses were $138,000 versus $143,000 in 2004. For ZAP, the expenses were $771,000 versus $660,000 in 2004. As a percentage of sales, total selling expenses increased from 17% in 2004 to 25% in 2005. The increase of $106,000 was due to an increase in marketing and promotion expenses for the Smart-Car Americanized by ZAP. GENERAL AND ADMINISTRATIVE EXPENSES for the year ended December 31, 2005 were $18.3 million as compared to $18.2 million in 2004. RAP's portion of the expenses was $735,000 versus $682,000 in 2004. For ZAP, the expenses increased from $17.5 million to $17.6 million. As a percentage of sales, general and administration expenses increased from 381% to 509%. RAP's increase of $53,000 was primarily due to slightly higher inflationary increases in expenses. The major components of ZAP's General and Administration expenses for the year ended 2005 were: salaries and benefits $1.2 million, allowance for Smart-Car note receivable of $1 million,the variable accounting adjustments to modified warrants that total $5.2 million in credits, mostly non-cash expenses resulted in consulting fees of $13.7 million, professional fees of $3.3 million and amortization of $1.1 million. Although the total expenses for both 2005 and 2004 were comparable the Company did experience higher consulting and professional fees for the year ended 2005. The increase was due to costs associated with identifying future funding sources for the company. Also legal fees were higher in connection with the filing of the Daimler Chrysler lawsuit. The increase in 2005 expenses were offset by favorable adjustments to non-cash employee compensation. RESEARCH AND DEVELOPMENT expense of $156,000 in 2005 represents expenses to develop a hybrid fuel cell vehicle which is powered by hydrogen and electricity. IMPAIRMENT LOSS resulted from an independent valuation of the Smart Automobile license as of December 31, 2005 which estimated the fair value to be $3.1 million with a remaining life of two years. The fair value was less than the $8.8 million recorded net book value of the license at year-end. Accordingly, the Company recorded an impairment charge of $5.7 million for the year ended December 31, 2005. Also included in the impairment loss was a provision for estimated investment losses on a joint venture of $372,000 and goodwill adjustments on RAP and Voltage Vehicles for $301,000. 32 LOSS ON DISPOSAL OF FIXED ASSETS in 2004 was due to the write-off of certain leasehold improvements where the Company has never utilized certain rental office space that was renovated by the Company. Also, adjustments were made to various cars in the Las Vegas Rental Fleet that are not operational and are in disrepair. Furthermore, the Company disposed of certain machinery, equipment,computers, and furniture that were no longer being used. INTEREST EXPENSE decreased from $1.1 million to $17,000 in 2005. The decrease in interest expense reflects a non recurring non-cash interest expense of $1 million in 2004 for note discounts from a beneficial conversion feature, and for warrants issued with the notes. The $1 million was charged to expense in 2004, when the notes were converted to common stock. GAIN (LOSS)ON REVALUATION OF WARRANT LIABILITY In 2004 a loss of $3,045,800 was recorded due to a revaluation of a warrant liability. In 2005, a gain of $2,215,000 was recorded due to the revaluation and settlement of one warrant liability and the revaluation of another warrant liability. OTHER INCOME decreased from $522,000 in 2004 to $189,000 of expense for the year ended December 31, 2005. The other income in 2004 is primarily due to a 2004 non-recurring entry for a lawsuit settlement where the Company recognized the accrued liability as other income. In 2005, the other income is primarily due to a mark-to-market adjustment related to a put option liability recorded as part of an acquisition of real property. NET LOSS was $23.5 million for the year ended December 31, 2005 as compared to a loss of $29.4 million for December 31, 2004. LIQUIDITY AND CAPITAL RESOURCES The Company used cash from operations of $4,624,000 and $3,783,000 during the years ended December 31, 2005 and 2004, respectively. Cash used in operations in 2005 was the result of the net loss incurred for the year of $23.5 million, offset by non-cash expenses of $16.3 million. Included in the non-cash expenses were the following: the impairment write-down of the Smart Auto license of $5.7 million, charges of $15.9 million for stock based compensation for consulting and other services, a reversal of $5.4 million of compensation expenses related to warrants subject to variable accounting, a gain on revaluation of warrant liability of $2.2 million and a $1 million allowance established for the past due Smart Automotive LLC note receivable. The net change in operating assets and liabilities resulted in a cash increase of $2.6 million. The change was primarily due to decreases in trade receivables and inventories to generate cash and an increase in accrued liabilities. Investing activities used cash of $798,000 and $1.2 million during the year ended December 31, 2005 and 2004, respectively. In 2005, the Company's investing activities used cash for the acquisition of property and equipment. In 2004, the Company's investing activities used cash for the acquisition of the Smart Automobile license and acquisition of property and equipment. Financing activities provided cash of $1,615,000 and $9.8 million during the year ended December 31, 2005 and 2004, respectively. At December 31, 2005 the Company had cash of $1.5 million as compared to 33 $5.4 million at December 31, 2004. The Company's working capital at December 31, 2005 was $543,000. The Company pledged 2,941,176 shares of restricted ZAP common stock as collateral for a loan. These shares were previously issued to Mercatus Partners LLP in January 2003 as collateral for a loan that never funded. The shares were reported to the Company as lost in December 2003. In December 2004,the shares were reissued to Mercatus Partners who then assigned the shares and their interests to Phi-Nest Fund, L.P. as collateral for a loan that has not funded. The Company amended the Loan Agreement allowing them to purchase ans sell 500,000 shares for $1.16 per share. On March 30, 2006, the Company received $500,000 as partial payment from the sale. The collateral was reduced to 2,441,176 shares and the loan is still pending. In January 2005, the Company paid $1,000,000 to Smart Automobile LLC and Thomas Heidemann (President of Smart Auto LLC) in exchange for a note receivable. The note bears interest at 5% per annum, payable in 24 equal monthly installments beginning January 7, 2006. The note is in default as of January 7, 2006 since the Company has not received the required payments and is uncertain if any payments will be received in the future and has therefore established a reserve of $1 million in the event efforts to collect the note are unsuccessful. In March of 2003, the Company purchased a three-story 20,000 square foot office building in downtown Santa Rosa for $2.9 million in convertible debt, stock and warrants. The building is the corporate headquarters of the Company. Terms of the transaction included a convertible promissory note for $2 million payable over 22 years with interest only for the first two years. At that time, the payee has the option to convert some or all of the unpaid principal and accrued interest to shares of ZAP's common stock at an agreed upon conversion price. The seller also received a certain amount of common stock and warrants in connection with the transaction. Although we currently have a financing facility with Surge Capital II to purchase vehicles, we still need additional sources of funding. In order to finance all our working capital requirements, we are currently seeking both debt and equity investments with several investors, but there can be no assurances that we will obtain this capital or that it will be obtained on terms favorable to us. There can be no assurance that any required or desired financing will be available through bank borrowings, debt, or equity offerings, or otherwise, on acceptable terms. If future financing requirements are satisfied through the issuance of equity securities, investors may experience significant dilution in the net book value per share of common stock and there is no guarantee that a market will exist for the sale of the Company's shares. In addition to the above working capital needs, our other capital needs are to fund our growth strategy, which includes increasing our shopping mall presence, improving and increasing distribution channels, establishing Company owned and franchised ZAP stores, expanding our electric vehicle dealerships, introducing new products, improving existing product lines, and developing a strong corporate infrastructure. SEASONALITY AND QUARTERLY RESULTS The Company's business is subject to seasonal influences. Sales volumes of our consumer products in this industry typically slow down during the winter months, November to March in the U.S. The Company intends to develop a wide auto distribution network to counter any seasonality effects. 34 INFLATION Our raw materials and finished products are sourced from stable, cost-competitive industries. As such, we do not foresee any material inflationary trends for our raw materials and finished goods sources. GOODWILL Goodwill consists of the excess consideration paid over net assets acquired. Impairment of goodwill is evaluated whenever a triggering event is encountered. The impaired value is determined by reference to cash flows anticipated from estimated proceeds from selling the related technology and/or sales of products directly linked to the technology and assets that gave rise to the goodwill. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management of the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting period. The amounts estimated could differ materially from actual results. 35 ITEM 7. FINANCIAL STATEMENTS. Index to Financial Statements ----------------------------- Description Page No. ----------- -------- Report of Independent Registered Public Accounting Firm.....................37 Consolidated Balance Sheet at December 31, 2005 ............................38 Consolidated Statement of Operations for the years ended December 31, 2005 and 2004......................................39 Consolidated Statement of Shareholders' Equity for the years ended December 31, 2005 and 2004......................................40 Consolidated Statement of Cash Flows for the years ended December 31, 2005 and 2004......................................41 Notes to Consolidated Financial Statements...............................42-65 36 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of ZAP We have audited the accompanying consolidated balance sheet of ZAP as of December 31, 2005, and the related consolidated statements of operations, shareholders' equity, and cash flows for the years in the two-year period ended December 31, 2005. These consolidated 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 standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements audited by us present fairly, in all material respects, the consolidated financial position of ZAP at December 31, 2005, and the consolidated results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principals. /s/ ODENBERG, ULLAKKO, MURANISHI & CO. LLP ------------------------------------------- San Francisco, California March 24, 2006, except Note 18 which is as of March 30, 2006 37 ZAP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET DECEMBER 31, 2005 (In thousands, except per share data) ASSETS ------ Current assets: Cash and cash equivalents $ 1,547 Accounts receivable, net of allowance of $333 185 Smart Car inventory 1,378 Inventories 1,872 Prepaid non-cash professional fees 546 Other prepaid expenses and other current assets 182 -------- Total current assets 5,710 Property and equipment, net 5,006 Other assets: Patents and trademarks, net 124 Goodwill 175 Smart Automobile license, net 3,100 Prepaid non-cash professional fees, less current portion 284 Deposits and other 278 -------- $ 14,677 ======== LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ Current liabilities: Current portion of long-term debt $ 104 Accounts payable 189 Accrued liabilities 1,949 Put option liability 969 License fee payable 906 Deferred revenue 1,050 -------- Total current liabilities 5,167 Long-term debt, less current portion 1,898 -------- Total Liabilities 7,065 -------- Commitments and contingencies Shareholders' equity: Preferred stock; 50 million shares authorized; no par value; 7,500 shares issued and outstanding 7,500 Common stock; 100 million shares authorized; no par value; 32,585,000 shares issued and outstanding 78,451 Common Stock issued as loan collateral (3,529) Notes receivable from shareholders, net (56) Accumulated deficit (74,754) -------- Total shareholders' equity 7,612 -------- $ 14,677 ======== See accompanying notes to consolidated financial statements. 38 ZAP AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In thousands; except per share data) Year ended December 31 -------------------- 2005 2004 -------- -------- Net sales $ 3,602 $ 4,772 Cost of goods sold (exclusive of amortization of smart license) 3,261 3,679 -------- -------- Gross profit 341 1,093 -------- -------- Operating expenses: Sales and marketing (non-cash of $0 and $420 in 2005 and 2004, respectively) 909 803 General and administrative (non-cash of $10,505 and $13,121 in 2005 and 2004, respectively) 18,352 18,180 Research and development 156 -- Loss on disposal of equipment 36 366 Loss on joint venture investment 372 -- Impairment loss on Smart Automobile license and goodwill 6,022 -- -------- -------- Total operating expenses 25,847 19,349 -------- -------- Loss from operations (25,506) (18,256) -------- -------- Other income (expense): Interest expense, net (non-cash of $0 and $1,000 in 2005 and 2004, respectively) (17) (1,129) Other income (expense), net (189) 522 Loss on Fusion Capital stock purchase transaction -- (5,797) Gain (Loss) on revaluation of warrant liabilities 2,215 (3,045) Write-off of notes receivable from shareholders -- (111) -------- -------- 2,009 (9,560) -------- -------- Loss before reorganization fees and income taxes (23,497) (27,816) Reorganization fees -- (13) -------- -------- Loss before income taxes (23,497) (27,829) Provision for income taxes (4) (5) -------- -------- Net loss $(23,501) $(27,834) Preferred stock deemed dividend resulting from beneficial conversion feature -- (1,570) -------- -------- Net loss attributable to common shareholders $(23,501) $(29,404) ======== ======== Net loss per share attributable to common shareholders: Basic and diluted $ (0.75) $ (1.67) Weighted average number of common shares outstanding: Basic and diluted 31,534 17,587 See accompanying notes to consolidated financial statements. 39 ZAP AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (In thousands)
Common Notes Convertible stock Receivable preferred stock Common stock issued from -------------------- -------------------- Accumulated as loan Share- Shares Amount Shares Amount Deficit collateral holders Total -------- -------- -------- -------- -------- -------- -------- -------- Balance at December 31, 2003 0.31 $ 165 13,228 $ 26,455 $(23,419) $ -- $ (167) $ 3,034 Issuance of common stock for: Building improvements 173 231 231 Automobile inventory 474 712 712 Other inventory and equipment 254 373 373 Consulting and other services 1,192 1,866 1,866 Employee compensation 256 252 252 Cash 1,145 2,300 2,300 Commitment and signing shares issued to Fusion Capital 300 612 612 Exercise of warrants and options 3,617 5,316 (14) 5,302 Debt converted to common stock 2,000 1,000 1,000 Preferred stock converted to common stock (2.74) (2,596) 3,944 2,596 -- Loan collateral 2,941 3,529 (3,529) -- Fair value of warrants issued for: Consulting and other services 10,097 10,097 Smart Automobile license 586 586 Intrinsic value of options issued to employees 6,691 6,691 Notes receivable write-off 111 111 -- Beneficial conversion feature on convertible debt 1,000 1,000 Issuance of preferred stock for: Cash 1.12 1,123 1,123 Inventory and equipment 0.51 510 510 Consulting and other services 0.30 298 298 Smart Automobile license 8.00 8,000 8,000 Net loss -- -- -- - (27,834) -- -- (27,834) -------- -------- -------- -------- -------- -------- -------- -------- Balance at December 31, 2004 7.50 7,500 29,524 63,616 (51,253) (3,529) (70) 16,264 -------- -------- -------- -------- -------- -------- -------- -------- Issuance of common stock for: Real property and other assets 514 1,211 1,211 Inventory 224 235 235 Consulting and other services 879 1,405 1,405 Employee compensation 38 83 83 Cash 630 1,250 1,250 Repurchased shares from Fusion Capital (200) (500) (500) Exercise of warrants and options 886 978 978 Investment in joint venture 90 248 248 Fair value of warrants issued for consulting and other services 9,290 9,290 Reclassification of warrant liability 6,711 6,711 Put option liability (638) (638) Employee warrants - variable accounting adjustment (5,438) (5,438) Proceeds from notes receivable 14 14 -- Net loss -- -- -- -- (23,501) -- -- (23,501) -------- -------- -------- -------- -------- -------- -------- -------- Balance at December 31, 2005 7.50 $ 7,500 32,585 $ 78,451 $(74,754) $ (3,529) $ (56) $ 7,612 ======== ======== ======== ======== ======== ======== ======== ========
See accompanying notes to consolidated financial statements. 40 ZAP AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) Year ended December 31 -------------------- 2005 2004 -------- -------- Operating activities: Net loss $(23,501) $(27,834) Items not requiring the current use of cash: Depreciation and amortization 1,426 1,030 Loss on disposal of fixed assets 36 366 Impairment write down of Smart Auto license 5,721 -- Impairment of goodwill 301 -- Loss on investment in joint venture 372 -- Beneficial conversion feature and warrant discount on convertible debt -- 1,000 Loss on Fusion Capital stock purchase transaction -- 5,797 Gain on revaluation of warrant liabilities (2,215) -- Loss on revaluation of anti-dilution liability 331 -- Loss on revaluation of warrant liability -- 3,045 Allowance for doubtful accounts (215) (150) Write-off of notes receivable from shareholders -- 111 Stock-based compensation for consulting and other services 15,860 6,598 Stock-based employee compensation (5,355) 6,943 Amortization of note discount 10 51 Changes in other items affecting operations: Accounts receivable 224 271 Inventories 573 483 Advance on Smart car inventory 188 (1,566) Prepaid expenses 42 (98) Other assets -- 40 Accounts payable 39 (387) Accrued liabilities 1,464 (168) Deferred revenue 75 685 -------- -------- Cash used for operating activities (4,624) (3,783) -------- -------- Investing activities: Acquisition of Smart Automobile license -- (1,000) Acquisition of property and equipment (406) (169) Acquisition of distribution license (268) -- Investment in joint venture (124) -- -------- -------- Cash used for investing activities (798) (1,169) -------- -------- Financing activities: Issuance of common stock 1,250 3,423 Exercise of warrants and options 978 5,302 Proceeds from debt -- 1,030 Payments on long-term debt (127) -- Payments on note receivable from shareholder 14 -- Repurchase of common stock (500) -- -------- -------- Cash provided by financing activities 1,615 9,755 -------- -------- Increase (decrease) in cash and cash equivalents (3,807) 4,803 Cash and cash equivalents at beginning of year 5,354 551 -------- -------- Cash and cash equivalents at end of year $ 1,547 $ 5,354 ======== ======== See accompanying notes to consolidated financial statements. 41 ZAP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND OPERATIONS: ZAP ("The Company" or "ZAP"), was incorporated in California in September 1994. ZAP markets many forms of advanced transportation, including alternative energy and fuel efficient automobiles, motorcycles, bicycles, scooters, personal watercraft, hovercraft, neighborhood electric vehicles, commercial vehicles and more. Additionally, the Company produces an electric scooter, known as the ZAPPY(R), using parts manufactured by various contractors. The Company has also established a rental program to rent neighborhood electric cars, primarily through agencies. The Company's business strategy has been to develop, acquire and commercialize electric vehicles and electric vehicle power systems, which have fundamental practical and environmental advantages over available internal combustion modes of transportation that can be produced commercially on an economically competitive basis. The Company intends to further expand its technological expertise through an aggressive plan of acquisitions of companies with exciting new products in the advanced transportation industry and strategic alliances with certain manufacturers, distributors and sales organizations. The Company's business goal is to become the largest and most complete distribution portal for advanced transportation (fuel efficient) and electric vehicles. In 2005, the Company continued to accelerate its market positioning in the electric vehicle industry. The Company is now focused on creating a distribution channel for its vehicles, with special emphasis on entrepreneurs in the power-sport and independent auto industry. A summary of significant accounting policies is as follows: Basis of presentation --------------------- Going Concern - The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern. The Company incurred net losses attributable to common shareholders of $23.5 million and $29.4 million in 2005 and 2004, respectively. The accumulated deficit at December 31, 2005 was $75 million. As described more completely in Note 18, Subsequent Events (Unaudited), during March 2006, the Company has raised $1.1 million from the exercise of warrants and the sale of common stock and $1.2 million through the sale of Smart cars that were paid for during 2004. Management believes this will provide adequate funds to sustain operations at expected levels, at least through 2006. The Company may need to arrange additional financing in the future. There can be no assurance that additional financing would be available, or if it is available, that it would be on acceptable terms. The Company's future liquidity and capital requirements will depend on numerous factors, including successful development, marketing and sale of advanced technology vehicles, protection of intellectual property rights, costs of developing its new products, including the necessary intellectual property rights, obtaining regulatory approvals for its new products, market acceptance of all its products, existence of competing products in its current and anticipated markets, and its ability to raise additional capital in a timely manner. Management expects to be able to raise additional capital; however, the Company may not be able to obtain additional financing on acceptable terms, or at all. Principles of consolidation --------------------------- The accompanying consolidated financial statements include the accounts of ZAP, RAP Group ("RAP"), Voltage Vehicles ("VV"), ZAP Rentals and ZAP Stores for the years ended December 31, 2005 and 2004. All subsidiaries are 100% owned by ZAP. All significant intercompany transactions and balances have been eliminated. Revenue recognition ------------------- The Company records revenues only upon the occurrence of all of the following conditions: o The Company has received a binding purchase order or similar commitment from the customer or distributor authorized by a representative empowered to commit the purchaser (evidence of a sale). o The purchase price has been fixed, based on the terms of the purchase order. o The Company has delivered the product from its distribution center to a common carrier acceptable to the purchaser. The Company's customary shipping terms are FOB shipping point. o The Company deems the collection of the amount invoiced probable. The Company provides no price protection. Product sales are net of promotional discounts, rebates and return allowances. The Smart Cars have a three year warranty. However, sales of Smart Cars through December 31, 2005 have not been material. 42 Deferred revenue ----------------- During 2005 and 2004, one of the Company's subsidiaries, VV, sold licenses to auto dealerships under the ZAP name. The license agreements generally run for a period of five years and call for the licensee to purchase a minimum number of electric vehicles from ZAP each year. The Company collected $1,050,000 related to these agreements, which is classified as deferred revenue until such time as the Company begins delivering normal anticipated volume of electric vehicles to these dealerships. Allowance for doubtful accounts ------------------------------- The Company performs ongoing credit evaluations of its customers' financial condition and, generally, requires no collateral from its customers. The Company records an allowance for doubtful accounts receivable for credit losses at the end of each period based on an analysis of individual aged accounts receivable balances. As a result of this analysis, the Company believes that its allowance for doubtful accounts is adequate at December 31, 2005 and 2004. If the financial condition of the Company's customers should deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Cash and cash equivalents ------------------------- The Company considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. The Company maintains the majority of its cash balances with one major financial institution. At times the balances may exceed federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents. Inventories ----------- Inventories consist primarily of automobiles, parts and supplies, and finished goods and are carried at the lower of cost (first-in, first-out method) or market. Property and equipment ---------------------- Property and equipment consists of building and improvements, machinery and equipment, office furniture and equipment, vehicles, and leasehold improvements. Property and equipment is stated at cost and is depreciated or amortized using straight-line and accelerated methods over the asset's estimated useful life. Costs of maintenance and repairs are charged to expense as incurred; significant renewals and betterments are capitalized. Estimated useful lives are as follows: Machinery and equipment 3-10 years Computer equipment and software 3-5 years Office furniture and equipment 3-7 years Vehicles 5 years Leasehold improvements 10 years or life of lease, whichever is shorter Building and improvements 30 years 43 Patents and trademarks ---------------------- Patents and trademarks consist of costs expended to perfect certain patents and trademarks acquired and are amortized over ten years. For each of the years ended December 31, 2005 and 2004, amortization expense was approximately $19,000 and $43,000, respectively. Smart Automobile LLC license ---------------------------- The Smart Car license has been adjusted to fair value at December 31, 2005, and is being amortized using the straight-line method over a two year term remaining estimated life. (See Note 2). Long-lived assets ----------------- Long-lived assets are comprised of property and equipment and intangible assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. An estimate of undiscounted future cash flows produced by the asset, or by the appropriate grouping of assets, is compared to the carrying value to determine whether impairment exists. If an asset is determined to be impaired, the loss is measured based on quoted market prices in active markets, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including a discounted value of estimated future cash flow and fundamental analysis. The Company reports an asset to be disposed of at the lower of its carrying value or its estimated net realizable value. Goodwill -------- Goodwill results from the Company's acquisition of the RAP Group Inc. and Voltage Vehicles in 2002. The Company tests for goodwill impairment annually in December, absent earlier indicators of impairment. The valuation of goodwill is based on the Company's discounted projected cash flows of RAP and VV. The valuation of goodwill related to RAP and VV indicated that the fair value of goodwill at December 31, 2005 was less than its carrying value. Accordingly, the Company recorded a goodwill impairment charge of $301,000 in 2005 ($200,000 relating to RAP and $101,000 relating to Voltage Vehicles). Goodwill consists of the following (in thousands): December 31, 2005 -------- RAP $ -- Voltage Vehicles 175 -------- $ 175 ======== 44 Investment in Chinese Joint Venture ----------------------------------- During 2005, the Company invested approximately $372,000 in a Chinese Joint Venture for the purpose of manufacturing products. The investment consisted of issuing 90,000 shares of common stock valued at $248,000 and $124,000 in cash. In the fourth quarter, the Company adjusted its investment to zero and expensed $372,000. The Company's interest in the joint venture is 80%. However, the joint venture has not begun any manufacturing activity and the Company does not have a date that any profits will be generated by the joint and has accordingly established a reserve for the full amount of the investment. Advertising ----------- The cost of advertising is expensed as incurred. Advertising and marketing expenses amounted to $356,000 and $377,000 in the years ended December 31, 2005 and 2004, respectively. Warranty -------- The Company provides 30 to 90 day warranties on its products and records the estimated cost of the product warranties at the date of sale. The estimated cost of warranties has not been significant to date. Shipping and handling costs --------------------------- Shipping and handling costs have been included in cost of goods sold. Research and development ------------------------ Research and product development costs are expensed as incurred. Income taxes ------------ The Company accounts for income taxes using an asset and liability method for financial accounting and reporting purposes. Deferred income tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities, operating loss and tax credit carryforwards and are measured using the currently enacted tax rates and laws. The Company has made no provision for income taxes except for the minimum state tax due in any period presented in the accompanying consolidated financial statements because it incurred operating losses in each of these periods. Use of estimates ---------------- The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting period. The amounts estimated could differ from actual results. Risks and uncertainties ----------------------- The Company relies on Smart Automobile LLC and other registered importers to supply pre-Americanized Smart (R) cars; to convert or Americanize Smart (R) cars for sale in certain states in the United States; and to provide services under warranties and all other maintenance and repair services. If Smart Automobile LLC is unable to supply Americanize or service Smart (R) cars, and the Company is unable to obtain alternative sources of supply for these products and services, the Company might not be able to fill existing backorders and/or to sell more Smart (R) cars. 45 Fair value of financial instruments ----------------------------------- The Company measures its financial assets and liabilities in accordance with U.S. generally accepted accounting principles. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties. For certain of the Company's financial instruments, including cash equivalents, accounts receivable, accounts payable and accrued liabilities, the carrying amount approximates fair value because of the short maturities. The fair value of debt is not determinable due to the terms of the debt and the lack of a comparable market for such debt. Comprehensive Loss ------------------ The Company has no components of other comprehensive loss other than its net loss, and, accordingly, its comprehensive loss is equivalent to its net loss for the periods presented. Stock-based compensation ------------------------- Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, establishes a fair-value method of accounting for stock options and similar equity instruments. The fair-value method requires that compensation cost be measured on the value of the award at the grant date, and recognized over the service period. SFAS No. 123 as amended allows companies to either account for stock-based compensation to employees under the provisions of SFAS No. 123 as amended or under the provisions of Accounting Principles Board (APB) Opinion No. 25 and its related interpretations. The Company accounts for its stock-based compensation to employees in accordance with the provisions of APB Opinion No. 25. The Company has recorded deferred compensation for the difference, if any, between the exercise price and the deemed fair market value of the common stock for financial reporting purposes of stock options granted to employees. The compensation expense related to such grants is amortized over the vesting period of the related stock options on a straight-line basis. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123, as amended, and Emerging Issues Task Force (EITF) Issue No. 96-18 Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Had the Company determined compensation cost based on the fair value at the grant date for its employee stock options under SFAS No. 123, the Company's net loss would have increased to the proforma amounts indicated below for the years ended December 31: 46 2005 2004 -------- -------- Net loss attributable to common shareholders, as reported $(23,501) $(29,404) Add: Stock-based employee compensation expense and variable accounting adjustments to modified warrants included in reported net loss, net of related tax effects (5,438) 7,080 Less: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects, and variable accounting adjustment related to modified warrants (1,609) (16,790) -------- -------- Pro forma net loss attributable to common shareholders $(30,548) $(39,114) ======== ======== Net loss per share attributable to common shareholders: As reported $ (0.75) $ (1.67) ======== ======== Pro forma $ (0.97) $ (2.22) ======== ======== The vesting of all unvested employee stock options will be accelerated upon the occurrence of a change of control of the company. Net loss per share attributable to common shareholders ------------------------------------------------------- Basic net loss per share is computed by dividing net loss attributable to common shareholders by the weighted average number of shares of common stock outstanding during the year. The computation of diluted earnings per common share is similar to the computation of basic net loss per share attributable to common shareholders, except that the denominator is increased for the assumed conversion of convertible securities and the exercise of options and warrants to the extent they are dilutive using the treasury stock method. The weighted average shares used in computing basic and diluted net loss per share attributable to common shareholders were the same for the two years ended December 31, 2005 and 2004. Options, warrants and convertible debt for 59,432,000 shares and 51,875,000 shares were excluded from the computation of loss per share at December 31, 2005 and 2004, respectively, as their effect is anti-dilutive. Also excluded are convertible preferred shares. The number of common shares issuable related to the convertible preferred shares are not determinable at December 31, 2005 and 2004. Common shares issued as collateral for a loan that has not been finalized totaling 2.941 million shares have been excluded from the weighted average number of shares outstanding for 2004 and 2005. Recent accounting pronouncements -------------------------------- In November 2004, the FASB issued SFAS No. 151, Inventory Costs, An Amendment of ARB No. 43, Chapter 4 ("SFAS 151"). SFAS 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recognized as current period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not believe that the adoption of SFAS 151 will have a material impact on its results of operations or financial position. 47 In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-based Payment, ("SFAS 123R"). SFAS 123R addresses the accounting for share-based payments to employees, including grants of employee stock options. Under the new standard, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. Instead, companies will be required to account for such transactions using a fair-value method and recognize the expense in the consolidated statement of operations. SFAS 123R became effective for the Company commencing January 1, 2006. The Company has not yet determined which fair-value method and transitional provision it will follow, however, it expects that the adoption of SFAS 123R will have a significant impact on its results of operations. The Company does not expect the adoption of SFAS 123R to materially impact its overall financial position. See Stock-based Compensation earlier in this Note 1 for the pro forma impact on net loss and net loss per share from calculating stock-based compensation costs under the fair value alternative of SFAS 123. The determination of compensation cost for share-based payment transactions after the effective date of SFAS 123R may be different from the determination of compensation cost under SFAS 123; however the Company has not yet quantified such differences. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an Amendment of APB Opinion NO. 29 ("SFAS 153"). The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in APB Opinion No. 29, however, included certain exceptions to that principle. SFAS 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005. The adoption of SFAS 153 has not had a material impact on our results of operations or financial position. In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations." Interpretation No. 47 clarifies that an entity must record a liability for a "conditional" asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. We adopted Interpretation No. 47 in the fourth quarter of 2005. Its implementation did not have a material impact on our results of operations or financial position. In June 2005, the FASB issued Statement No. 154, "Accounting Changes and Error Corrections" ("FAS 154"), a replacement of APB No. 20, Accounting Changes and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. FAS 154 applies to all voluntary changes in accounting principle and changes the requirements for accounting for and reporting of a change in accounting principle. This statement establishes that unless impracticable, retrospective application is the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. It also requires the reporting of an error correction which involves adjustments to previously-issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect that the adoption of FAS 154 will have a material impact on our results of operations or financial position. 48 In February 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 155 "Accounting for Certain Hybrid Financial Instruments ("FAS 155). This Statement amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities," and No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." FAS 155: (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (v) amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This statement is effective for years beginning after September 15, 2006. The Company does not believe this statement will have a material impact on its results of operations or financial position. NOTE 2 - SMART AUTOMOBILE LICENSE On April 19, 2004, ZAP entered into an Exclusive Purchase, License and Supply Agreement with Smart-Automobile LLC ("SA"), a California limited liability company, to distribute and manufacture Smart(R) cars. Smart is the brand name for a 3-cyclinder gas turbo engine car manufactured by Daimler Chrysler AG, which can achieve estimated fuel economy of 40 miles per gallon. SA is not affiliated with Daimler Chrysler, but is a direct importer. Under the agreement ZAP will be the exclusive distributor and licensee of the right to manufacture and distribute Smart(R) cars in the United States and the non-exclusive distributor and licensee outside of the United States for a period of ten years from SA. Subject to the terms of the agreement, ZAP will pay SA a license and distribution fee of $10,000,000: a $1 million payment in cash was made upon execution of the agreement, $1 million will be payable in cash ratably commencing with the delivery of the first 1,000 smart cars, and $8 million was paid in ZAP preferred stock. A more detailed agreement was signed and completed on October 25, 2004. Under this agreement SA exchanged their original Preferred Shares for new Preferred Shares with the designation of SA. These SA preferred shares convert to ZAP common shares under the following formula: For every 1,000 Smart(R) vehicles delivered to ZAP in the years 2004, 2005 and 2006 which are fully EPA compliant to sell in the United States as new cars, the holder shall convert 500 shares of preferred stock SA to $500,000 of common stock, and allow the holder to receive 505,000 warrants with an exercise price of $2.50 per share exercisable through July 7, 2009, or when all the preferred have been converted. During 2004, ZAP allowed SA to convert 500 preferred shares to $500,000 of common stock prior to delivering any EPA compliant Smart Cars. 49 The Company recorded the cost of the Smart Automobile license at $10.6 million, based on: 1) the $10 million the Company paid to Smart Automobile LLC as consideration for a Purchase, License and Supply Agreement dated April 19, 2004; and 2) the fair value of five-year warrants issued under the Agreement for the purchase of 505,000 common shares at $2.50 per share and expiring in July 1, 2009. The warrants were valued at $1.16 per share using the Black-Scholes option pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 3.08%; contractual life of 4.5 years; and volatility of 229.43%. During the fourth quarter of 2005, the Company filed a lawsuit against Daimler Chrysler Corporation ("Daimler Chrysler") and others alleging that Daimler Chrysler has engaged in a series of anti-competitive tactics aimed at defaming ZAP and disrupting its third party relationships including this arrangement (see Note 15). Shortly thereafter, the Company commenced its annual impairment assessment. An independent valuation of the Smart Automobile license as of December 31, 2005 estimated the fair value to be $3.1 million with a remaining life of two years which was less than the $10.6 million recorded cost of the license. The carrying cost of the license was $8.8 million prior to the impairment calculation and accordingly, the Company recorded an impairment charge of $5.721 million for the year ended December 31, 2005. The valuation of the license was based on the Company's discounted projected cash flows from projected sales of Smart Cars over the estimated life of the license agreement. The remaining value of the license is being amortized using the straight-line method over the next two years, which is the revised estimated life of the license. License amortization for the years ended December 31, 2005 and 2004 was $1,058,586 and $706,000 respectively. NOTE 3 - INVENTORIES Inventories at December 31, 2005 are summarized as follows (thousands): Vehicles $ 605 Parts and supplies 284 Finished goods 1,163 -------- 2,052 Less - inventory reserve 180 -------- $ 1,872 ======== Inventory reserve policy ------------------------ The Company records inventory at the lower of cost or market and establishes reserves for slow moving or excess inventory, product obsolescence and valuation impairment. In determining the adequacy of its reserves, at each reporting period the Company analyzes the following, among other things: o Current inventory quantities on hand; o Product acceptance in the marketplace; o Customer demand; o Historical sales; o Forecasted sales; o Product obsolescence; and o Technological innovations. Any modifications to the Company's estimates of its reserves are reflected in cost of goods sold within the statement of operations during the period in which such modifications are determined by management. Changes in the Company's inventory reserve during the year ended December 31, 2005 are as follows (in thousands): Balance as of January 1, 2005 $ 176 Provision for slow moving inventory 76 Write-off of slow moving inventory (72) -------- Balance as of December 31, 2005 $ 180 ======== 50 Note 4 - NOTES RECEIVABLE SMART AUTOMOBILE LLC In January 2005, the Company advanced $1,000,000 to Smart Automobile, LLC and Thomas Heidemann (President of Smart Automobile, LLC) in exchange for a note receivable. The note is secured by an interest in certain equipment owned by Smart Automobile, LLC, and bears interest at 5% per annum and is payable in 24 equal monthly installments beginning January 7, 2006. The Company had also earlier prepaid $1.6 million to Smart Automobile, LLC as deposits on Smart cars. The note is in default as of March 31, 2006 and to date the Company has not received any of the required payments. At this time it is uncertain if any of the scheduled payments will be received in the future, or if Smart Automobile has cash resources to repay the loan. Accordingly, the Company has established a reserve of $1 million. The Company has also named Smart Automobile LLC as a party in its lawsuit against Daimler Chrysler AG (See Note 15). NOTE 5 - PROPERTY AND EQUIPMENT Property and equipment at December 31, 2005 are summarized as follows (thousands): Land $ 1,078 Buildings and improvements 3,319 Machinery and equipment 500 Computer equipment and software 154 Office furniture and equipment 129 Leasehold improvements 9 Vehicles 657 -------- 5,846 Less - accumulated depreciation and amortization 840 -------- $ 5,006 ======== The land and building and certain equipment, with a net book value of $2,897,000 at December 31, 2005, are pledged as security for certain indebtedness (see Note 7). Depreciation and amortization expense for the years ended December 31, 2005 and 2004 was approximately $256,000 and $230,000, respectively. NOTE 6 - OTHER ACCRUED LIABILITIES Accrued liabilities at December 31, 2005 consisted of the following (in thousands): Accrued professional fees $ 551 Accrued payables 133 Customer deposits 443 Warrant liabilities 194 Other accrued expenses 628 -------- $ 1,949 ======== 51 NOTE 7 - DEBT The Company has a $2 million convertible note due in March 2025, with annual interest at 2% through March of 2005, and thereafter at the prime rate (as defined) plus 2%. Payments started on April 2005, at which time, the note is payable with equal principal and interest payments over the next 240 months. The noteholder has the option to convert some or all of the unpaid principal and accrued interest to shares of ZAP's common stock at $2.15 per share or an agreed upon conversion price (as defined). The note was issued in exchange for the purchase of the Company's new corporate headquarters and is secured by this property. The note has a balance of $2,002,000 at December 31, 2005. Scheduled annual maturities for long-term debt for years ending after December 31, 2005 are as follows: $104,000 - 2006 ; $104,000 - 2007; $104,000 - 2008; $104,000 - 2009; $104,000 - 2010 and $1,482,000 - thereafter. NOTE 8 - Revolving Financing Facility On September 12, 2005,the Company signed a $425 million revolving financing facility with Surge Capital II, LLC that, subject to certain conditions, can be used by ZAP to import Smart Cars Americanized by ZAP and other advanced transportation vehicles for ZAP's dealers. The financing agreement has a term of one year, but may be extended upon agreement by both parties. The financing is based on orders ZAP receives from dealers who must be approved in advance by Surge Capital II, LLC and is secured by a first lien on substantially all of ZAP's assets. No funds have been drawn on the financing facility as of December 31, 2005. Each financing incurs an interest charge equal to 2% of the principal amount for the first 30 days and thereafter at a Per Diem Rate of .067%. NOTE 9 - INCOME TAXES The provision for income taxes for all periods presented in the consolidated statements of operations represents minimum California franchise taxes. Income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 34% to pretax losses as a result of the following: 2005 2004 -------- -------- Computed expected tax expense $ (7,991) $ (9,462) Losses and credits for which no benefits have been recognized 8,505 2,398 Stock grants and warrants not deductible for income tax purposes (516) 6,934 Meals and entertainment expenses, and officers life insurance not deductible for income tax purposes 3 133 State tax expense, net of federal income tax benefit 3 2 -------- -------- $ 4 $ 5 ======== ======== 52 The tax effect of temporary differences that give rise to significant portions of the deferred tax assets at December 31, 2005 is presented below: 2005 -------- Deferred tax assets: Net operating loss carryovers $ 19,702 Fixed assets, due to differences in depreciation 193 Inventory 86 Bad debt reserve 142 Notes receivable reserve 428 General business credits 132 Intangible assets, due to impairment and amortization 2,568 Investment in Joint venture, due to impairment 159 Other 13 -------- Total gross deferred tax assets 23,423 Valuation allowance (23,423) -------- Net deferred tax assets $ -- ======== The net change in the valuation allowance for the year ended December 2005 was an increase of $14.9 million. Because there is uncertainty regarding the Company's ability to realize its deferred tax assets, a 100% valuation allowance has been established. As of December 31, 2005, the Company had federal tax net operating loss carryforwards of approximately $47.7 million, which will expire in the years 2005 through 2026. The Company also has federal research and development credit carryforwards as of December 31, 2005 of approximately $132,000, which will expire in the years 2005 through 2024. State tax net operating loss carryforwards were approximately $39.5 million as of December 31, 2005. The state net operating loss carryforwards will expire in the years 2006 through 2015. The Company's ability to utilize its net operating loss and research and development tax credit carryforwards may be limited in the future if it is determined that the Company experienced an ownership change, as defined in Section 382 of the Internal Revenue Code. NOTE 10 - STOCK OPTIONS During 2002 as part of the confirmed plan of reorganization, ZAP created a new Incentive Stock Option Plan ("2002 Plan"). Options to purchase common stock are granted by the Board of Directors under two Stock Option Plans, referred to as the 2002 and 1999 plans. Options granted may be incentive stock options (as defined under Section 422 of the Internal Revenue Code) or nonstatutory stock options. The numbers of shares available for grant under the 2002 and 1999 Plans are 10,000,000 and 1,500,000 respectively. Options are granted at no less than fair market value on the date of grant. Options granted in 2005 and 2004 generally become exercisable as they vest over a three year period, and expire ten years after the date of grant. 53 Option activity under the 2002 and 1999 plans is as follows (thousands): 2002 Plan 1999 Plan --------------------- --------------------- Weighted Weighted Average Average Number of Exercise Number of Exercise Shares Price Shares Price -------------------- --------------------- Outstanding at January 1, 2004 1,490 $ 0.38 161 $ 1.20 Granted 3,604 1.33 -- -- Exercised (35) 0.25 -- -- Canceled (175) 0.53 (2) 1.20 -------------------- --------------------- Outstanding at December 31, 2004 4,884 $ 1.02 159 1.20 Granted 1,668 1.07 -- -- Exercised (10) 0.25 -- -- Canceled (280) 0.92 (4) 1.20 ------- ------- Outstanding at December 31, 2005 6,262 $ 1.04 155 $ 1.20 ======= ======= The weighted average fair value of options granted during the years ended December 31, 2005 and 2004 was $1.06 and $1.27, respectively. The following information applies to options outstanding at December 31, 2005: 2002 Plan 1999 Plan ------------- ------------- Range of exercise prices $0.25 - $2.80 $1.20 Weighted average remaining life (years) 5.01 2.97 Options exercisable 2,888,161 155,000 Weighted average exercise price $1.04 $1.20 The fair value of each option and warrant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2005 2004 ---------------- ---------------- Dividends None None Expected volatility 151.10 - 221.37% 227.90 - 243.29% Risk free interest rate 3.71 - 4.65% 3.25 - 4.78% Expected life 1.25 - 9.9 years 10 years At December 31, 2005, the Company has outstanding stock options for employees to purchase 1,993,333 shares and for directors to purchase 4,423,017 shares, at exercise prices ranging from $0.25 to $2.80. NOTE 11 - MAJOR CUSTOMERS During 2005 and 2004, no single customer accounted for more than 10% of the Company's net sales, or receivables. 54 NOTE 12 - COMMITMENT The Company presently rents its warehouse under an operating lease that expires in 2006. The monthly rent is adjusted annually to reflect the average percentage increase in the Consumer Price Index. The Company leases the location of its car outlet and another warehouse from the Company's CEO (see Note 14). Rent expenses under all leases were approximately $484,000 and $460,000 in 2005 and 2004, respectively. NOTE 13 - SHAREHOLDERS' EQUITY While the Company was in the process of amending and restating its articles of incorporation, the Secretary of State of California noted that the confirmed plan of reorganization of June 20, 2002, did not authorize the Board to designate its preferred shares, so the Board amended the articles through shareholder vote to grant the Board this authority. The record date for this vote was September 30, 2004. The Amended and Restated Articles of Incorporation provide, among other things, for the authorization of the Company to issue 100,000,000 shares of Common Stock and 50,000,000 shares of Preferred Stock, as well as for the elimination of all prior classes and series of preferred stock. The Board of Directors was further authorized, subject to limitations prescribed by law, to fix the designations, determinations, powers, preference and rights, and the qualifications, limitations or restrictions thereof, of any wholly unissued series of Preferred Stock. Common stock ------------ 2005 ISSUANCES STOCK ISSUED FOR ASSETS. In 2005, the Company issued stock for inventory and assets and recorded the cost at the intrinsic value of the stock or the fair value of the assets, whichever is more reliably measurable. During 2005, 455,442 shares with value of $1.1 million were issued for purchase of real estate. ZAP recorded the common shares at the appraised value of the real estate. Under the terms of the purchase, ZAP is obligated to issue additional common shares for no additional consideration if at the end of 1 year the market price of ZAP's common shares is less than the market price at their date of issuance. In the third quarter of 2005, ZAP calculated the fair value of the anti-dilution obligation to issue additional shares ("put option liability") using a binomial pricing model to estimate future stock prices, using the following assumptions: historical stock price volatility of 139.6%, a risk free interest rate of 4.01%, and an expected dividend rate of 0.00%. ZAP calculated the fair value of the put option liability at the date of the common stock issuance at $600,593, and reclassified the obligation from common stock to a liability in the third quarter. Zap also entered into other equity transactions that contained the potential obligation to issue additional shares. The put option liability related to those transactions was originally valued at $37,066. The liabilities were revalued and recorded at $969,000 at December 31, 2005, with the change of $331,000 recorded as an expense in other income. These liabilities were calculated using a binomial pricing model to estimate future stock prices, using the following assumptions: historical stock price volatility of 109.2%, a risk free interest rate of 4.38%, and an expected dividend rate of 0.00%. ZAP also issued 59,000 shares to acquire other assets valued at $111,000 and 223,833 shares for automobile and other inventory. STOCK ISSUED FOR SERVICES. In 2005, the Company issued shares of its common stock for consulting and other services and employee compensation. The stock grants were recorded at the intrinsic value of the stock on the date of grant. During 2005, the Company issued grants for 321,351 shares as consideration under agreements for consulting and related services, 134,592 shares were issued for legal fees, 114,440 shares were issued for rent expense, 308,795 shares were issued for other outside services and 38,795 shares were issued for employee compensation. 55 STOCK ISSUED FOR CASH. During 2005, the Company raised $1.25 million in cash through the issuance of 630,000 shares of common stock and three warrants to an investor. Each of the three warrants is exercisable for five years and is exercisable for 300,000 shares of common stock at initial exercise prices of $2.50, $3.25 and $4.00 per share. In addition, the Company issued 885,510 shares for $973,000 upon exercises of options and warrants. STOCK ISSUED FOR INVESTMENT. During 2005, the company issued 90,000 shares for an investment stake in a Chinese joint venture. 2004 ISSUANCES STOCK ISSUED FOR ASSET PURCHASES AND SERVICES. During 2004, the Company issued grants for 2.349 million shares of its common stock. The stock grants were issued as consideration under agreements for consulting and other services; for building improvements, automobile and other inventory and equipment; and for employee services. For stock issued for inventory and other assets, the Company recorded cost as the intrinsic value of the stock or as the fair value of the assets, whichever was more reliably measurable. For stock issued for consulting and other services and for stock issued as employee compensation, the Company recorded cost as the intrinsic value of the stock at the date of grant. The stock grants resulted in noncash selling and marketing expense and general and administrative expense totaling $1,958,000. STOCK ISSUED FOR CASH. During 2004, the Company raised $2.3 million in cash through the issuance of 1,145,000 shares of common stock at prices of $.53 to $3.56 per share. In 2004 the Company also issued 3.617 million shares of common stock for $5.316 million, upon exercises of warrants and options. STOCK ISSUED FOR CONVERSIONS. In 2004 the Company also borrowed $1 million under a 1.45% convertible note. The note was converted at $.50 per share into 2 million shares of common stock. The conversion price was below the common stock market price of $.56 per share at the date the note was issued. The Company also issued the noteholder warrants to purchase 2 million shares of common stock at $1.20 per share. The warrants expire on July 1, 2007. The warrants were valued at $1.29 per share using the Black-Scholes option-pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 3.14%; contractual life of 2.75 years; and volatility of 268.10%. The fair value of the warrants and beneficial conversion feature exceeded the $1 million face value of the note, and accordingly the value of the warrants and beneficial conversion feature was credited to common stock, and the offsetting note discount was limited to the face value of the note. The note discount of $1 million was amortized to interest expense over the term of the note, until the note was converted to common stock. Upon conversion of the note, the balance of the note discount was recorded as interest expense. During 2004, the Company also issued 3.944 million common shares upon the conversion of convertible preferred stock issued in 2003 and 2004 as consideration for cash, inventory, equipment, consulting and other services, and the Smart Automobile license. The preferred stock was convertible into common shares at various conversion prices. STOCK ISSUED AS COLLATERAL. In December 2004, the Company issued 2.9 million common shares as collateral for a $1 million loan. The $3.529 million market value of these shares at the date of issuance was recorded in common stock with an offsetting contra equity account. These shares were previously issued to Mercatus Partners LLP in January 2003 as collateral for a loan that never funded. The shares were reported as lost to the Company in December 2003. In December 2004, the shares were reissued to Mercatus Partners who then assigned the shares and their interests to Phi-Nest Fund, L.P. as 56 collateral for the $1 million loan commitment. The company has since amended the Loan Agreement allowing Phi-Nest to purchase and sell 500,000 shares for $1.16 per shares. On March 30, 2006, the Company received $500,000 as partial payment from the sale. The collateral was reduced to 2,441,176 shares and the loan is still pending. FUSION CAPITAL STOCK PURCHASE AGREEMENT On July 22, 2004, the Company entered into a $24.5 million stock purchase agreement with Fusion Capital Fund II, LLC ("Fusion Capital"). The stock purchase agreement provided for the issuance of up to $24.5 million in common stock over a 40 month period. The purchase prices would be based on market price on the date of sale without any fixed discount. The agreement also provided for the immediate issuance of 300,000 common shares as commitment and signing shares at no cost, and the immediate issuance of five-year warrants for the purchase of 2.5 million shares of common stock at $2.50 to $5.50 per share. The stock purchase agreement required the Company to file a registration statement by August 20, 2004 for the resale of shares issued or issuable under the stock purchase agreement, and to have the registration agreement declared effective within 120 days. The stock purchase agreement provided for cash liquidated damages if the Company failed to meet the registration deadlines. The warrant agreement provided that Fusion Capital could use a cashless exercise feature if an effective registration was not available. In July 2004, the Company made an initial issuance under the agreement of 200,000 common shares at $2.50 per share. The Company also issued 300,000 common shares as commitment and signing shares at no cost. The Company did not file the required registration statement by August 20, 2004, Fusion Capital refused to purchase any additional shares, and due to its dispute with Fusion Capital the Company did not issue warrants until February 2005. The Company and Fusion Capital terminated the stock purchase agreement on February 22, 2005. Under the termination agreement, the Company repurchased the 200,000 common shares from Fusion Capital for the original issuance price of $500,000; and Fusion Capital retained the 300,000 commitment and signing common shares and the five year warrants for the purchase of 2.5 million shares at $2.50 to $5.50 per share. The termination agreement amended the original registration statement filing requirement to provide that the Company would use its best efforts to obtain an effective registration statement by September 1, 2005, and that the warrant holders could use a cashless exercise feature if an effective registration was not available. The warrants under the stock purchase agreement and the termination agreement are summarized as follows: two warrants for 500,000 shares each, with an exercise price of $2.50 per share; one warrant for 500,000 shares with an exercise price of $3.50 per share; one warrant for 500,000 shares with an exercise price of $4.50 per share; and one warrant for 500,000 shares with an exercise price of $5.50 per share. The $2.50 warrants expire on July 7, 2009. All other warrants expire on July 20, 2009. The warrants were valued at inception at prices ranging from $2.07 to $2.08 using the Black-Scholes option-pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 3.68%; the contractual life of 5.0 years; and volatility of 229.40%. The $5.185 million fair value of the warrants at inception and the $612,000 market value of the commitment and signing shares, based upon market prices of $1.70 to $2.10 per share at issuance, were recorded as deferred offering costs and such costs would have been charged against proceeds from stock issuances under the stock purchase agreement. The Company wrote off the deferred offering costs in 2004 when Fusion 57 Capital refused to purchase any additional stock, and recorded a $5.8 million charge to other expense. The Company revalued the warrant liability in February 2005 and recorded the market to market adjustment of $1.5 million in other income. The remaining warrant liability was transferred to equity since the Company was no longer required to file a registration statement for the warrant shares. The warrants were revalued at December 31, 2004 at prices ranging from $3.28 to $3.30 per share, with the marked-to-market adjustment of $3.045 million recorded in other expense. The fair value of the warrants at December 31, 2004 was calculated using the Black-Scholes option pricing model with the following assumptions: expected dividend of 0.0%; risk free interest rate of 3.47%; the remaining contractual life of 4.5 years; and volatility of 223.26%. Preferred stock --------------- Prior to amending and restating its articles of incorporation on September 30, 2004, the Company was authorized to issue 50 million shares of preferred stock. In December 2003, the Board of Directors established four classes of preferred stock with 4 separate timelines. The four classes of preferred shares convert to common shares as follows: Class B converts to 2000 shares, Class C converts to 1,500 shares, Class D converts to 1,000 shares and Class F converts to 500 shares. Four time-line definitions were also established. Each time line gives the bearer the right to convert the preferred shares to common a certain number of days after issuance as follows II after 30 days, III after 90 days, IV after 180 days and V after 1 year. Dividends are cumulative and accrue at 6% per year and payable on June 30th of each year or on conversion date. Dividends are payable in cash or in common stock at the Company's option. The Preferred Stock holders have no voting rights. The liquidation value is its stated value plus accrued and unpaid dividends thereon. Series SA Preferred stock ------------------------- The Company has designated 8,000 shares of preferred stock as Series SA Preferred Stock ("SA" preferred stock). On October 25, 2004, the SA preferred stock was issued to Smart Automobile, LLC in exchange for Class D convertible preferred stock. These preferred shares had previously been issued to Smart-Automobile, LLC in April 2004 in connection with an Exclusive Purchase, License and Supply Agreement entered into between the Company and Smart-Automobile, LLC. The SA preferred stock may be converted at the option of the holder into common shares upon deliveries of Smart (R) automobiles to the Company in 2004, 2005 and 2006. For every delivery of 1,000 vehicles that are fully EPA compliant and salable as new cars in the United States, the preferred shareholder may convert 500 SA preferred shares into $500,000 of common stock, based on the market value (as defined) of stock at the conversion date. Not withstanding the foregoing conversion requirements, the preferred shareholder may immediately convert 500 preferred shares into $500,000 of common shares. In October 2004, 500 SA preferred shares were converted into 423,729 common shares. The preferred shares may not be converted after December 31, 2006. The Company has the right to redeem all or a portion of the outstanding shares of SA preferred stock after March 1, 2008 at a price of $.10 per share. The preferred stock participates with the common shareholders as to any dividends payable on common stock, based on the number of shares into which the SA preferred stock is then convertible. The preferred stock also has liquidation preference, upon 58 liquidation, dissolution or winding up of the Company or disposition of substantially all of the assets of the Company ("liquidation event"). The liquidation preference is calculated as if each 100 shares of SA preferred stock had been converted into 1 share of common stock immediately prior to the liquidation event. The preferred shareholders are not entitled to vote on any matters, unless otherwise required by law. Other Convertible Preferred Stock During 2003 and 2004, the Company issued convertible preferred shares with conversion dates ranging from 30 days to 1 year. The preferred shares were converted into common shares in 2004. The convertible preferred issuances were primarily in consideration for cash, automobiles, legal fees, and consulting services. For stock issued for inventory and equipment, the Company recorded cost as the intrinsic value of the common stock into which the preferred stock was convertible or as the fair value of the assets, whichever was more reliably measurable. For preferred stock issued for consulting and other services, the Company recorded cost as the intrinsic value of the common stock into which the preferred was convertible. The preferred stock issuances resulted in non-cash general and administrative expenses totaling $298,000 in 2004 and $109,000 in 2003. The preferred shares issued for cash generally included warrants to purchase common shares. The proceeds from the issuance of the preferred shares with warrants were allocated between the preferred stock and warrants, based on their relative fair values. This resulted in a beneficial conversion feature for certain of the preferred shares. The intrinsic value of the beneficial conversion feature was calculated at the date of issuance as the difference between the conversion price of the preferred stock and the fair value of the Company's common stock into which the preferred was convertible, multiplied by the number of common shares into which the preferred was convertible. The beneficial feature totaling $1.57 million was reported in 2004 as a preferred stock deemed dividend in the statement of operations. Warrants -------- The Company is authorized to issue 10 million shares each of Series B, C, D and K Unrestricted Warrants. On November 8, 2004, the Board of Directors of ZAP extended the expiration dates and exercise prices of the following Company warrants: 1) Series B and B-2 Warrants expire on July 1, 2007 and have an exercise price of $1.20. 2) Series C and C-2 Warrants expire on July 1, 2007 and have an exercise price of $5.00. 3) Series D and D-2 Warrants expire on July 1, 2007 and have an exercise price of $8.00. 4) Series K and K-2 Warrants expire on July 1, 2007 and have an exercise price of $1.00. The Board of Directors has also established the following restricted classes of warrants: Series $1.50, Series $2.50, Series $3.05, Series $3.50, Series $4.00, Series $4.05, Series $4.50, Series $4.75, Series $5.00, and Series $5.50, with various expiration periods. 59 The Board of Directors of ZAP has the right to (i) decrease the exercise price of the warrants, (ii) increase the life of the warrants in which event the exercise price may be increased, or (iii) make such other changes as the Board of Directors of ZAP deems necessary and appropriate under the circumstances provided the changes contemplated do not violate any statutory or common law. Shares acquired through exercises of warrants for all Series other than Series B, C, D and K are restricted as to sale. However, the warrants may be assigned, sold, or transferred by the holder without restriction. Series B, C, and D warrants not exercised may be redeemed by ZAP for a price of $0.01 per warrant upon thirty (30) days' written notice to the holders thereof; provided, however, that if not all unexercised warrants in a particular series are redeemed, then the redemption shall be pro-rated equally among the holders of unexercised warrants in the series. Total warrants outstanding at December 31, 2005 are summarized as follows (in thousands): Number of Exercise Expiration Warrants Price Dates -------- ----- ----- Series B-Unrestricted 4,370 1.20 7-1-07 Series B-2-Restricted 12,998 1.20 7-1-07 Series C-Unrestricted 6,897 5.00 7-1-07 Series C-2-Restricted 1,551 5.00 7-1-07 Series D-Unrestricted 7,438 8.00 7-1-07 Series D-2-Restricted 1,351 8.00 7-1-07 Series K-Unrestricted 4,040 1.00 7-1-07 Series K-2-Restricted 5,045 1.00 7-1-07 $1.50 Warrants Restricted 825 1.50 various $2.50 Warrants Restricted 2,440 2.50 7-7-09 $3.05 Warrants Restricted 1,125 3.05 2-15-08 $3.25 Warrants Restricted 300 3.25 various $3.50 Warrants Restricted 500 3.50 7-20-09 $4.00 Warrants Restricted 330 4.00 2-15-08 $4.05 Warrants Restricted 563 4.05 2-15-08 $4.50 Warrants Restricted 500 4.50 7-20-09 $4.75 Warrants Restricted 563 4.75 2-15-08 $5.00 Warrants Restricted 749 5.00 12-10-07 $5.50 Warrants Restricted 500 5.50 7-20-09 -------- 52,085 ======== Replacement warrants --------------------- On July 1, 2004, the B and B-2 warrants and C and C-2 warrants expired, and replacement warrants were issued. The Company issued replacement B and B-2 warrants to purchase 15,199,373 common shares at $1.26 per share, and 60 replacement C and C-2 warrants to purchase 8,988,743 common shares at $5.00 per share. These replacement warrants are nonforfeitable and vested immediately, and expire on January 1, 2005. The Company recorded compensation expense totaling $2.5 million for replacement warrants held by current employees based on the intrinsic value of the warrants. The Company also recorded prepaid professional fees of $5.1 million for replacement warrants held by consultants currently providing consulting services to the Company. The prepaid fees are being charged to expense over the terms of the related consulting agreements. The consulting expense was calculated using the Black-Scholes option-pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 1.64%; contractual life of 6 months; and volatility of 163.4%. For warrants issued to investors and to consultants no longer providing consulting services to the Company, there was no accounting consequence resulting from the replacements. The Company amended the Loan Agreement allowing them to purchase and sell 500,000 shares for $1.16 per share. On March 30, 2006, the Company received $500,000 as a partial payment from the sale. The collateral was reduced to 2,441,176 shares and the loan is still pending. Modified warrants ------------------ On November 8, 2004, the Company repriced the B and B-2 warrants; and extended the terms of the B and B-2 and the C and C-2 warrants. The exercise price of the B and B-2 warrants was reduced from $1.26 per share to $1.20 per share, and the expiration dates of the B and B-2 and the C and C-2 warrants were extended from January 1, 2005 to July 1, 2007. On December 2, 2004, the C and C-2 warrants were temporarily repriced from $5.00 per share to $3.25 per share for 30 days. As result of the repricing of the B and B-2 and C and C-2 warrants, the warrants held by current employees are accounted for using the variable method of accounting under APB No. 25 and FIN 44. Accordingly, the intrinsic value of the employee warrants at December 31, 2004 was used to calculate compensation expense for the year, and resulted in an additional compensation charge of $2.9 million. The fair value of warrants held by consultants currently providing services to the Company was calculated at November 8, 2004, and resulted in an adjustment of $2.2 million to prepaid professional fees. The prepaid professional fees are being charged to expense over the terms of the related consulting agreements. The fair value of the consultant warrants at November 8, 2004 was determined using the Black-Scholes option pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 3.08%; contractual life of 2.7 years; and volatility of 228.9%. For warrants held by investors and by consultants no longer providing services, there was no accounting consequence resulting from the repricing and term modifications. On November 8, 2004, the Company also extended terms of certain D and D-2 warrants and K and K-2 warrants, from July 1, 2005 to July 1, 2007. The Company recorded compensation expense of $749,000 for warrants held by current employees based on the intrinsic value of the warrants. The Company also recorded prepaid professional fees of $470,000 for warrants held by consultants currently providing consulting services to the Company. The prepaid professional fees are being charged to expense over the terms of the related consulting agreements. The consulting expense was calculated using the Black-Scholes option-pricing model with the following assumptions: expected dividend yield of 0.0%; risk free interest rate of 3.08%; contractual life of 2.7 years; and volatility of 228.9%. For warrants issued to investors and to consultants no longer providing consulting services, there was no accounting consequence resulting from the term modifications. In November 2004, the Company repriced B and B2 and C and C2 warrants, including warrants held by employees. As a result, the warrants held by current employees are being accounted for using the variable method of accounting under APB No. 25 and FIN 44. Accordingly, the intrinsic value of the employee warrants at December 31, 2005 was used to calculate compensation expense for the year, and resulted in a reduction in compensation expense of $5,438,000. This adjustment reverses the previously recorded intrinsic value related to these warrants that was recorded in 2004 as compensation expense. 61 Warrants issued in 2005 ------------------------ During 2005, the Company issued warrants in connection raising capital and license fees. In addition, during 2005, the Company issued warrants to purchase an aggregate 9,365,694 shares of its common stock under agreements with vendors, employees, and consultants to perform legal, financial, business advisory and other services. The warrant grants to vendors and consultants were non-forfeitable and fully vested at the date of issuance and were valued using the Black-Scholes option pricing model with the following range of assumptions: Low High ------ ------ Exercise price per share $ 1.00 $ 4.75 Market price .80 3.41 Assumptions: Expected dividend yield 0% 0% Risk free rate of return 2.87% 4.3% Contractual life .5 year 6.92 years Volatility 137% 211% Fair market value 0.29 2.13 Pursuant to the requirements of FASB Statement No. 123 and EITF 96-18 and 00-18 related to accounting for stock-based compensation, the Company recognized non-cash general and administrative expense in the amount of $13.6 million attributable to the warrants issued to consultants at the date of grant during 2005. On September 20, 2005, ZAP issued non-forfeitable, fully vested 6.92 year warrants to purchase 750,000 common shares at $1.50 per share. ZAP is required to deliver registered shares upon the exercise of the warrants. The fair value of the warrants of $890,000 was recorded as a warrant liability at September 30, 2005 pursuant to EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock." The fair value of $890,000, or $1.19 per share, was calculated at the date of issuance using the Black-Scholes option pricing model using the following assumptions: risk free interest rate of 3.90%; expected dividend rate of 0.00%; volatility of 211.5%; and expected term of 5.75 years. The warrants were revalued on December 31, 2005. The fair value of $194,000, or $0.26 per share, was calculated using the Black-Scholes option pricing model using the following assumptions: risk free interest rate of 4.26%; expected dividend rate of 0.00%; volatility of 230.3%; and expected term of 5.5 years. The difference of $696,000 was recorded in other income. Warrants issued in 2004 ------------------------ During 2004, the Company issued warrants for common stock in connection with issuances of common and preferred stock for cash and for automobiles and other assets. The Company also issued warrants in connection with convertible debt issuances, the acquisition of the Smart Automobile license, and the Fusion Capital stock purchase. The Company also issued warrants to employees for 2,244,164 shares of common stock as compensation; and warrants to vendors and consultants for 5,420,500 shares of common stock for legal, financial, business advisory, and promotional and other services. The warrants to vendors and consultants were nonforfeitable and fully vested at the date of issuance and were valued using the Black-Scholes option pricing model with the following assumptions: 62 Low High ------ ------ Exercise price per share $1.07 $5.50 Market price $0.56 $4.00 Assumptions: Expected dividend yield 0.0% 0.0% Risk free rate of return 1.64% 3.08% Volatility 163.4% 228.9% Fair market value $0.15 $2.08 Pursuant to APB No. 25, FAS 123, and EITF Nos. 96-18 and 00-18 relating to accounting for stock-based compensation, the Company recognized noncash general and administrative expenses in the amount of $1.8 million attributable to warrants issued to employees and consultants at the date of grant during 2004. Stock-based non-cash expenses are summarized as follows: Year ended December 31, ----------------------------- 2005 2004 ------------ ------------ Consulting and other services: Stock grants $ 2,254,000 $ 2,004,000 Warrants 13,606,000 1,295,000 Replacement warrants -- 3,123,000 Modified warrants -- 176,000 ------------ ------------ 15,860,000 6,598,000 ------------ ------------ Employees: Stock grants 83,000 252,000 Warrants (2,505,000) 503,000 Replacement warrants (2,933,000) 2,505,000 Modified warrants -- 3,683,000 ------------ ------------ (5,355,000) 6,943,000 ------------ ------------ $ 10,505,000 $ 13,541,000 ============ ============ NOTE 14 - RELATED PARTY Rental agreements ----------------- The Company leases office space, land and warehouse space from its CEO and major shareholder (see note 12). These properties are used to operate the car outlet and to store inventory. Rental expense under these leases was approximately $196,000 and $126,000 for the year ended December 31, 2005 and 2004, respectively. 63 Consulting services and other services -------------------------------------- In November and December 2003, the Company entered into certain agreements with two cousins of Steven M. Schneider, the CEO. One cousin received 25,000 B-2 Restricted warrants and 25 shares of preferred stock, which was later converted into 50,000 shares of restricted common stock. The stock and warrants were issued for website design services. The other cousin received 200,000 shares of unrestricted common stock in January 2004. The shares were issued for consulting services to be provided through March 11, 2007. In April 2004, the Company issued 2 million B-2 restricted warrants and 1 million K-2 restricted warrants to Sunshine 511 Holdings for consulting services to be provided through March 11, 2007. The managing partner of Sunshine 511 Holdings is the cousin of the CEO of ZAP. The fair value of the warrants issued was determined using the Black-Scholes option pricing model (See Note 13). The resulting fair value of $5.6 million (which includes amounts related to warrant repricings) was recorded as prepaid consulting services and was being amortized using the straight-line method over the term of this agreement. In the fourth quarter of 2005, the Company expensed approximately $2.2 million, the carrying value of the prepaid services, since only limited services have been received to date nor are there any assurances that future services will be received. Also in 2004, certain leasehold improvements in the amount of $65,000 made by the Company on rental properties were abandoned in favor of the landlord, who is the CEO of ZAP. Inventory Purchase ------------------ In December 2005, the Company purchased inventory from a related entity where three of ZAP's officers and or Directors are also members of its Board of Directors. The transaction resulted in a payable due to the related Company of $204,000 at December 31, 2005. NOTE 15 - LITIGATION From time to time, the Company may become in the future subject to legal proceedings and claims in the ordinary course of business, including employment-related and trade related claims. A dormant complaint filed in 2002 against the RAP Group and Steve Schneider the CEO of ZAP, individually was reactivated by the plaintiff (Jim Arnold Trucking). The Complaint alleges Breach of Contract, Promissory Estoppel and Fraud and seeks contract damages in the amount $71,000 plus monthly storage fees and punitive damages of $750,000. The Company has cross-claimed against Plaintiffs seeking compensatory damages, attorneys' fees and equitable relief for breach of oral contract, common count for goods sold and delivered, conversion, liability of surety, violation of statue, and violation of the Unfair Practices Act. On February 17, 2005, the court referred the matter to non-binding arbitration. The non binding arbitration hearing was held on July 27, 2005 where the arbritrator awarded the plaintiff damages in the amount of $68,290 plus prejudgement interest of 7%. ZAP intends to assert its defenses vigorously and to litigate its cross-complaint aggressively. A settlement conference is set for April 19, 2006. The Company has also requested a trial in this matter on May 2, 2006. Management believes that the ultimate resolution of this claim will not have a material adverse effect on our financial position or on results of operations. On October 28, 2005, we filed a complaint against DaimlerChrysler Corporation in the Los Angeles Superior Court, under the title ZAP v. DaimlerChrysler AG, ET AL. The complaint includes claims for intentional and negligent interference with prospective economic relations; trade libel; defamation; breach of contract - agreement to negotiate in good faith; breach of implied covenant of good faith and fair dealing; and unfair competition. The complaint alleges that DaimlerChrysler has engaged in a series of anti-competitive tactics aimed at defaming ZAP and disrupting its third-party business relationships. As a result 64 of the allegations, the complaint requests damages in excess of $500 million and such other relief as the court deems just and proper. DaimlerChrysler has not yet filed a response to our complaint. NOTE 16 - SEGMENT REPORTING In accordance with the provisions of SFAS No. 131, the Company has identified four reportable segments consisting of sales and marketing of electric products, operation of a retail car outlet, sales to and marketing of electric car dealerships and electric car rental outlets. These segments are strategic business units that offer different services. They are managed separately because each business requires different resources and strategies. The Company's chief operating decision making group, which is comprised of the Chief Executive Officer and the senior executives of each of the Company's segments, regularly evaluates financial information about these segments in deciding how to allocate resources and in assessing performance. The performance of each segment is measured based on its profit or loss from operations before income taxes. Segment results are summarized as follows (in thousands): Electric Car Car Rental products outlet dealerships outlets Total -------- -------- -------- -------- -------- Year ended December 31, 2005: Net sales $ 624 $ 2,524 $ 432 $ 22 $ 3,602 Gross profit 18 303 9 11 341 Depreciation, amortization and impairment 7,392 44 175 49 7,660 Net loss (22,106) (744) (459) (192) (23,501) Total assets 11,769 771 2,137 -- 14,677 Year ended December 31, 2004: Net sales $ 894 $ 3,555 $ 101 $ 222 $ 4,772 Gross profit (loss) 258 783 (108) 160 1,093 Depreciation, amortization and impairment 399 50 6 33 488 Net income (loss) (27,357) 397 (439) (435) (27,834) Total assets 25,901 1,271 2,408 245 29,825 NOTE 17 - SUPPLEMENTAL CASH FLOW INFORMATION A summary of non-cash investing and financing information is as follows (in thousands): Year ended December 31 ---------------------- 2005 2004 --------- -------- Cash paid during the year for: Income taxes $ 4 $ 2 Interest 59 -- Non-cash investing and financing activities: Common and preferred stock and warrants and debt issuances for: Smart Automobile license -- 9,586 Inventory 235 1,265 Investment in joint venture 248 -- Settlement of warrant liability 6,711 -- Prepaid professional fees 830 5,995 Property and equipment 1,211 561 Debt converted to common stock -- 1,000 Notes receivable from shareholders -- 14 License fee payable -- (1,000) Common stock as loan collateral -- 3,529 Conversion of preferred to common stock -- 2,596 Common stock and warrants -- (15,036) Preferred stock -- (8,510) NOTE 18 - SUBSEQUENT EVENTS (UNAUDITED) During March 2006, the Company has raised approximately $0.5 million through warrant exercises, $0.5 million through the sale of common stock (see following paragraph), and $1.2 million through the sale of Smart cars that were paid for during 2004. Also during March 2006, the Company agreed to allow Phi-Nest to purchase and sell 500,000 shares of common stock that was being held as collateral for a loan for $1.16 per share. On March 30, 2006, the Company received $500,000 as partial payment from the sale. The loan collateral was reduced to 2,441,176 shares and the loan is still pending. 65 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None ITEM 8A. CONTROLS AND PROCEDURES. (a) Evaluation of Disclosure Controls and Procedures. Securities and Exchange Commission, or SEC, rules define the term "disclosure controls and procedures" to mean a company's controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in its reports filed under the Securities Exchange Act of 1934 is accumulated and communicated to the company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. (b) Changes in Internal Control Over Financial Reporting. ----------------------------------------------------- There were no changes our internal control over financial reporting that occurred during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. ITEM 8B. OTHER INFORMATION. None. PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTORS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT. The required information for this item is incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Shareholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. Our board of directors has adopted a Code of Ethics that applies to our directors, executives, officers and employees. Our Code of Ethics can be found on our web site, which is located at www.zapworld.com. We intend to make all required disclosures concerning any amendments to, or waivers from, our Code of Ethics on our web site. Any person may request a copy of the Code of Ethics, at 66 no cost, by writing to us at the following address: ZAP, 501 Fourth Street, Santa Rosa, California 95401, Attention: Investor Relations. ITEM 10. EXECUTIVE COMPENSATION. The required information for this item is incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Shareholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. The required information for this item is incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Shareholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The required information for this item is incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Shareholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. ITEM 13. EXHIBITS. EXHIBITS. 2.1 Approved Second Amended Plan of Reorganization, dated as June 20, 2002. (5) 3.1 Amended and Restated Articles of Incorporation. (4) 3.2 Certificate of Determination of Series SA Convertible Preferred Stock. (14) 4.1 Form of common share purchase warrant of the Company held by Fusion Capital Fund II, L.P. (6) 4.2 Form of Series B common stock purchase warrant of the Company. (14) 4.3 Form of Series K common stock purchase warrant of the Company. (14) 10.1 Settlement Agreement Between ZAPWORLD.COM, Ridgewood ZAP, LLC, and the Shareholders dated June 27, 2001. (3) 10.3 2004 Consultant Stock Plan. (7) 10.4 Convertible Promissory Note, dated April 26, 2004, issued to Banks Living Trust. (1) 67 10.5 Purchase and Sale Agreement dated March 7, 2003 between ATOCHA Land LLC and ZAP. (3) 10.6 Promissory Note $2,000,000 - Atocha Land LLC and ZAP. (3) 10.7 Warrant Agreement dated April 26, 2004, issued to Banks Living Trust. (1) 10.8 Common Stock Purchase Agreement between ZAP and Fusion Capital Fund II, LLC. (6) 10.9 Registration Rights Agreement between ZAP and Fusion Capital Fund II, LLC. (6) 10.10 Form of Common Stock Purchase Warrant between ZAP and Fusion Capital Fund II, LLC (6) 10.11 Agreement for Consulting Services with Evan Rapoport dated January 8, 2004. (1) 10.12 Asset Purchase Agreement dated April 12, 2004 with Jeffrey Banks for purchase of various autos (1) 10.13 Agreement for Private Placement Investment received dated April 14, 2004 with Phi-Nest Fund LLP (1) 10.14 Consulting Agreement dated April 21, 2004 with Elexis International(1) 10.15 Consulting Agreement dated April 21, 2004 with Sunshine 511 Holdings (1) 10.16 Definitive Stock Agreement dated October 25, 2004 with Smart-Automobile, LLC (2) 10.17 Master Distribution Agreement between Apollo Energy Systems, Inc. and Voltage Vehicles Corporation, a subsidiary of ZAP. (8) 10.18 ZAP Floor Line and Dealer Development Agreement with Clean Air Motors, LLC for a $45 Million Floor Plan Line of Credit for Qualified ZAP Dealers (9) 10.19 Exclusive Purchase, License and Supply Agreement between Smart Automobile, LLC and ZAP. (10) 10.20 Amendment dated November 15, 2004 to previous consulting agreement with Sunshine Holdings 511 (14) 10.21 Secured Promissory Note Payable dated December 30, 2004 with Phi-Nest Fund, LLP. (14) 10.22 ZAP assignment of 2.9 million shares of Restricted Common Stock to Phi-Nest Fund, LLP as collateral on note payable (14) 10.23 Promissory note receivable dated January 6, 2005 for $1 million loan due from Smart Automobile, LLC and Thomas Heidemann (President Smart Automobile, LLC) (14) 68 10.24 Security Agreement dated January 6, 2005 from Smart Automobile, LLC and Thomas Heidemann (President Smart Automobile ,LLC) to secure loan above. (14) 10.25 Common Stock Purchase Agreement between ZAP and Platinum Partners Value Arbitrage Fund LP (14) 10.26 Form of Common Stock Purchase Warrant between ZAP and Platinum Partners Value Arbitrage Fund LP (14) 10.27 Common Stock Purchase Agreement between ZAP and Lazarus Investment Partners LLP (14) 10.28 Form of Common Stock Purchase Warrant between ZAP and Lazarus Investment Partners LLP (14) 10.29 Termination of Common Stock Purchase Agreement between ZAP and Fusion Capital Fund II, LLC (11) 10.30 Financing Agreement between ZAP and Surge Capital II, LLC (12) 10.31 Exclusive Purchase, License, and Supply Agreement between ZAP and Obvio! Automotoveiculos S.P.E. Ltda (13) 21.1 List of subsidiaries. (3) 23.1 Consent of Independent Registered Public Accounting Firm (Odenberg, Ullakko, Muranishi & Co. LLP). (14) 31.1 Certification of Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (14) 31.2 Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (14) 32.1 Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (14) 32.2 Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (14) (1) Previously Filed as an exhibit to the Registrants's Form 8-K for the quarter ended March 31, 2004 and incorporated by reference. (2) Previously filed as an exhibit to the Registrant's Form 8-K of November 6, 2004 and incorporated by reference. (3) Previously filed as an exhibit to the Registrant's Annual Report on Form 10-KSB for the year ended December 31, 2003 and incorporated by reference. (4) Previously filed with Pre-effective Amendment Number 3 to Form SB-2 registration statement filed with the Securities and Exchange Commission on October 3, 2001. (5) Previously filed as an exhibit to the Registrant's Form 8-K of October 20, 2002 and incorporated by reference. 69 (6) Previously filed as an exhibit to the Registrant's Current Report on Form 8-K dated July 22, 2004 and incorporated by reference. (7) Previously filed as an exhibit to the Registrant's Registration Statement on Form S-8 (File No. 333-117560) on July 22, 2004. (8) Previously filed as an exhibit to the Registrant's Current Report on Form 8K filed with the Securities and Exchange Commission on October 6, 2004 and incorporated herein by reference. (9) Previously filed as an exhibit to the Registrant's Quarterly Report on Form 10QSB for the period ended June 30, 2004 and incorporated herein by reference. (10) Previously filed as an exhibit to the Registrant's Current Report on Form 8K filed with the Securities and Exchange Commission on April 21, 2004 and incorporated herein by reference. (11) Previously filed as an exhibit to the Registrant's Current Report on Form 8K filed with the Securities and Exchange Commission on February 25, 2005 and incorporated herein by reference. (12) Previously filed as an exhibit to the Registrant's Current Report on Form 8K filed with the Securities and Exchange Commission on September 16, 2005 and incorporated herein by reference. (13) Previously filed as an exhibit to the Registrant's Current Report on Form 8K filed with the Securities and Exchange Commission on September 21, 2005 and incorporated herein by reference. (14) Previously filed as an exhibit to the Registrant's Yearly Report on Form 10KSB for the period ended December 31, 2004 and incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. The required information for this item is incorporated by reference to our Proxy Statement for the 2006 Annual Meeting of Shareholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A. 70 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. ZAP By: /s/ Steven M. Schneider ----------------------------- Steven M. Schneider Chief Executive Officer (principal executive officer) Date: March 31, 2006 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 dates indicated.
Name Position Date ---- -------- ---- By: /S/ STEVEN M. SCHNEIDER Director and Chief Executive Officer March 31,2006 ---------------------------------- (principal executive officer) Steven M. Schneider By: /S/ GARY STARR Chairman of the Board of Directors March 31,2006 ---------------------------------- Gary Starr By: /S/ WILLIAM HARTMAN Chief Financial Officer March 31,2006 ---------------------------------- (principal financial and William Hartman accounting officer) By: /S/ Maximilian F. Scheder-Bieschin President March 31, 2006 ---------------------------------- Maximilian F. Scheder-Bieschin By: /S/ RENAY CUDE Director and Secretary March 31,2006 ---------------------------------- Renay Cude By: /S/ LOUIS AULETTA Director March 31, 2006 ---------------------------------- Louis Auletta By: /S/ GUY FIERI Director March 31, 2006 ---------------------------------- Guy Fieri By: /S/ MARK HAYWOOD Director March 31, 2006 ---------------------------------- Mark Haywood By: /S/ MATTHIAS HEINZE Director March 31, 2006 ---------------------------------- Matthias Heinze
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