10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2011

Commission File Number 000-52590

Paxton Energy, Inc.
(Exact name of registrant as specified in its charter)
Nevada	20-1399613
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
295 Highway 50, Suite 2, Lake Village Professional Building, Stateline, NV 89449 Mailing Address:  P.O. Box 1148, Zephyr Cove, NV 89448-1148
(Address of principal executive offices) (zip code)
(775) 588-5390
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   x No   o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes   ¨ No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o	Smaller reporting company x
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes   o No   x

As of August 11, 2011, issuer had 59,548,682 outstanding shares of common stock, par value $0.001.

TABLE OF CONTENTS

		Page
PART I – FINANCIAL INFORMATION
	Item 1. Financial Statements
	Condensed Consolidated Balance Sheets (Unaudited)	2
	Condensed Consolidated Statements of Operations (Unaudited)	3
	Condensed Consolidated Statement of Stockholders’ Equity (Deficit)  (Unaudited)	4
	Condensed Consolidated Statements of Cash Flows (Unaudited)	5
	Notes to Condensed Consolidated Financial Statements (Unaudited)	6
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
	Item 3. Quantitative and Qualitative Disclosures about Market Risk	28
	Item 4. Controls and Procedures	29
PART II – OTHER INFORMATION
	Item 1. Legal Proceedings	31
	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	31
	Item 3. Defaults Upon Senior Securities	31
	Item 5. Other Information	32
	Item 6. Exhibits	33
	Signatures	34

PART I – FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

Paxton Energy, Inc., has included its unaudited condensed consolidated balance sheets as of June 30, 2011, and December 31, 2010 (the end of its most recently completed fiscal year) unaudited condensed consolidated statements of operations for the three and six months ended June 30, 2011 and 2010, and for the period from June 30, 2004 (date of inception) through June 30, 2011, unaudited condensed consolidated statement of stockholders’ equity (deficit) for the six months ended June 30, 2011, and unaudited condensed consolidated statements of cash flows for the six months ended June 30, 2011 and 2010, and for the period from June 30, 2004 (date of inception) through June 30, 2011, together with unaudited condensed notes thereto.  In the opinion of management of Paxton Energy, Inc., the consolidated financial statements reflect all adjustments, all of which are normal recurring adjustments, necessary to fairly present the consolidated financial condition, results of operations, and cash flows of Paxton Energy, Inc., for the interim periods presented.  The consolidated financial statements included in this report on Form 10-Q should be read in conjunction with the audited financial statements of Paxton Energy, Inc., and the notes thereto for the year ended December 31, 2010, included in its annual report on Form 10-K.

1

PAXTON ENERGY, INC.
(AN EXPLORATION-STAGE COMPANY)
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
	June 30,			December 31,
	2011			2010
ASSETS
Current Assets
Cash and cash equivalents	$	4,031		$	53,421
Receivable from attorneys' trust accounts		668			668
Prepaid expenses and other current assets		14,896			9,339
Total Current Assets		19,595			63,428
Property and Equipment, net of accumulated depreciation		2,392			341
Oil and gas properties, using full cost accounting		6,286,449			587,886
Deferred financing costs		432,112			-
Other assets		14,610			-
Total Assets	$	6,755,158		$	651,655
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities
Accounts payable	$	286,693		$	193,651
Accrued liabilities		534,632			376,903
Payable to Bayshore Exploration L.L.C.		106,153			113,544
Payable to officer		-			30,000
Notes payable		345,000			330,000
Unsecured convertible promissory notes payable, net of discount		56,613			184,335
Subordinated note payable		500,000			-
Convertible debentures, net of discount		250,530			-
Accrued registration rights penalties and interest		12,655			12,097
Total Current Liabilities		2,092,276			1,240,530
Long-Term Liabilities
Long-term asset retirement obligation		36,887			36,714
Derivative liabilities		1,739,373			243,376
Total Long-Term Liabilities		1,776,260			280,090
Stockholders' Equity (Deficit)
Preferred stock, $0.001 par value; 10,000,000 shares authorized,
none issued and outstanding		-			-
Common stock, $0.001 par value; 500,000,000 shares authorized,
58,907,556 and 20,343,263 shares issued and outstanding, respectively		58,908			20,343
Additional paid-in capital		18,751,174			11,348,416
Deficit accumulated during the exploration stage		(15,923,460	)		(12,237,724	)
Total Stockholders' Equity (Deficit)		2,886,622			(868,965	)
Total Liabilities and Stockholders' Equity (Deficit)	$	6,755,158		$	651,655

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

PAXTON ENERGY, INC.
(AN EXPLORATION-STAGE COMPANY)
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
													For the Period from
													June 30, 2004
	For the Three Months Ended						For the Six Months Ended						(Date of Inception)
	June 30,						June 30,						through
	2011			2010			2011			2010			June 30, 2011
Oil and gas revenues, net	$	175		$	2,983		$	5,654		$	6,119		$	368,214
Costs and Operating Expenses
Lease operating expenses		(80	)		2,729			3,310			4,460			146,778
Impairment loss on oil and gas properties		-			-			-			-			3,847,192
Accretion of asset retirement obligations		87			78			173			341			8,581
General and administrative expense		646,613			334,713			1,069,512			386,382			3,758,842
Share-based compensation		3,439,027			1,666,500			3,523,125			1,878,663			7,431,407
Total costs and operating expenses		4,085,647			2,004,020			4,596,120			2,269,846			15,192,800
Loss from operations		(4,085,472	)		(2,001,037	)		(4,590,466	)		(2,263,727	)		(14,824,586	)
Other income (expense)
Interest income		-			-			-			-			63,982
Change in fair value of derivative liabilities		1,349,520			(10,914	)		1,312,339			(38,348	)		1,070,766
Gain on transfer of common stock from
Bayshore Exploration, L.L.C.		-			-			-			-			24,000
Interest expense		(54,785	)		(37,122	)		(72,522	)		(64,465	)		(527,135	)
Amortization of deferred financing costs		(67,576	)		-			(67,576	)		-			(67,576	)
Amortization of discount on convertible
debentures and notes and other debt		(113,420	)		(9,692	)		(267,511	)		(9,692	)		(1,662,911	)
Total other income (expense)		1,113,739			(57,728	)		904,730			(112,505	)		(1,098,874	)
Net Loss	$	(2,971,733	)	$	(2,058,765	)	$	(3,685,736	)	$	(2,376,232	)	$	(15,923,460	)
Basic and Diluted Loss Per Common Share	$	(0.07	)	$	(0.62	)	$	(0.11	)	$	(0.72	)
Basic and Diluted Weighted-Average
Common Shares Outstanding		40,436,426			3,340,667			32,288,112			3,303,874

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

PAXTON ENERGY, INC.
(AN EXPLORATION-STAGE COMPANY)
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
For the Six Months Ended June 30, 2011
(Unaudited)
							Deficit
							Accumulated			Total
					Additional		During the			Stockholders'
	Common Stock				Paid-In		Exploration			Equity
	Shares		Amount		Capital		Stage			(Deficit)
Balance - December 31, 2010		20,343,263	$	20,343	$	11,348,416	$	(12,237,724	)	$	(868,965	)
Issuance of common stock and warrants for cash,
January 2011, $0.15 per unit		600,000		600		89,400		-			90,000
Issuance of common stock and warrants upon
conversion of notes payable and accrued interest,
January 2011 to June 2011, $0.0292 to $0.0625
per share		7,014,293		7,015		430,621		-			437,636
Issuance of common stock in connection with the
Montecito Asset Sale Agreement		15,000,000		15,000		3,660,000		-			3,675,000
Issuance of common stock for legal services		200,000		200		49,800		-			50,000
Share-based compensation from grant of common
stock options and issuance of common stock warrants
to officers, directors and consultants		-		-		196,187		-			196,187
Share-based compensation from issuance of common
stock to officers		15,750,000		15,750		2,976,750		-			2,992,500
Net loss		-		-		-		(3,685,736	)		(3,685,736	)
Balance - June 30, 2011		58,907,556	$	58,908	$	18,751,174	$	(15,923,460	)	$	2,886,622

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

PAXTON ENERGY, INC.
(AN EXPLORATION-STAGE COMPANY)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
							For the Period from
							June 30, 2004
	For the Six Months Ended						(Date of Inception)
	June 30,						through
	2011			2010			June 30, 2011
Cash Flows From Operating Activities
Net loss	$	(3,685,736	)	$	(2,376,232	)	$	(15,923,460	)
Adjustments to reconcile net loss to net cash used in
operating activities:
Impairment loss on oil and gas properties		-			-			3,847,192
Share-based compensation for services		3,573,125			1,878,663			7,481,407
Amortization of deferred financing costs and discount
on convertible debentures and notes and other debt		335,087			9,692			1,730,487
Gain on transfer of common stock from
Bayshore Exploration, L.L.C.		-			-			(24,000	)
Accretion of asset retirement obligations		173			341			8,581
Depreciation expense		305			332			5,127
Change in fair value of derivative liabilities		(1,312,339	)		38,348			(1,070,766	)
Changes in assets and liabilities:
Accounts receivable		-			-			16,818
Prepaid expenses and other current assets		(5,557	)		1,041			(14,896	)
Other assets		(14,610	)		-			(14,610	)
Accounts payable and accrued liabilities		259,523			151,778			1,178,327
Payable to officer		(30,000	)		34,250			-
Accrued registration rights penalties and interest		558			37,033			302,969
Net Cash Used In Operating Activities		(879,471	)		(224,754	)		(2,476,824	)
Cash Flows From Investing Activities
Acquisition of oil and gas properties		(1,523,563	)		-			(3,440,078	)
Purchase of property and equipment		(2,356	)		-			(7,519	)
Net Cash Used In Investing Activities		(1,525,919	)		-			(3,447,597	)
Cash Flows From Financing Activities
Proceeds from the issuance of common stock and warrants,
net of registration and offering costs		90,000			-			3,134,970
Proceeds from issuance of convertible notes and other debt,
and related beneficial conversion features and common
stock, less amounts held in attorneys' trust accounts		90,000			229,745			1,327,332
Proceeds from issuance of convertible debentures		2,550,000			-			2,550,000
Proceeds from related parties for issuance of secured
convertible notes and other debt, and related beneficial
conversion features and common stock		-			-			180,000
Payment of deferred financing costs		(374,000	)		-			(374,000	)
Payment of payable to Bayshore Exploration L.L.C.		-			-			(489,600	)
Payment of principal on notes payable to stockholder		-			-			(325,000	)
Payment of principal on note payable		-			-			(75,250	)
Net Cash Provided By Financing Activities		2,356,000			229,745			5,928,452
Net Increase (Decrease) In Cash And Cash Equivalents		(49,390	)		4,991			4,031
Cash and Cash Equivalents At Beginning Of Period		53,421			4,026			-
Cash and Cash Equivalents At End Of Period	$	4,031		$	9,017		$	4,031

Supplemental Cash Flow Information—Note M.

The accompanying notes are an integral part of these condensed consolidated financial statements.

5

PAXTON ENERGY, INC.

(An Exploration Stage Company)

Notes to Condensed Consolidated Financial Statements

(A)           Organization, Change in Control and Significant Accounting Policies

Organization – Paxton Energy, Inc. (the “Company”) was organized under the laws of the State of Nevada on June 30, 2004.  During August 2004, shareholder control of the Company was transferred, a new board of directors was elected and new officers were appointed.  These officers and directors managed the Company until March 17, 2010, at which time, the existing members of the Company’s board of directors resigned, new members were appointed to the board of directors, and managerial control of the Company was transferred to new management.  The new board of directors immediately commenced, among other things, the placement of unsecured convertible promissory notes to raise funds for working capital and held a meeting of stockholders on June 29, 2010, at which the stockholders approved 1) a 1-for-3 reverse common stock split, 2) a second reverse stock split of approximately 1 share for 2.4 shares of common stock, 3) the amendment of the Company’s certificate of incorporation to increase the Company’s authorized capital from 100 million to 500 million shares of common stock and from 5 million to 10 million shares of preferred stock, and 4) the adoption of the 2010 Stock Option Plan.

Nature of Operations – During June 2005, the Company commenced acquiring working interests in oil and gas properties principally located in the Cooke Ranch prospect in LaSalle County, Texas.  In connection with these properties in Texas, the Company is engaged primarily as a joint interest owner with Bayshore Exploration L.L.C. (Bayshore) in the acquisition, exploration, and development of oil and gas properties and the production and sale of oil and gas.  Through June 30, 2011, the Company has participated in drilling ten wells in Texas.  Additionally, the Company owns a working interest in the 8,843-acre balance of the Cooke Ranch prospect and has the right to participate in a program to acquire up to a 75% working interest in leases adjacent to the Cooke Ranch prospect, where, to date, the Company has acquired an interest in leases on approximately 2,268 gross acres.  Current management of the Company is currently evaluating the oil and gas properties in Texas.  As further described in Note B, the Company acquired a 70% leasehold working interest, with a net revenue interest of 51.975%, of certain oil and gas leases in the Gulf of Mexico.  The Company is considered to be in the exploration stage due to the lack of significant revenues.

Condensed Interim Consolidated Financial Statements– The accompanying unaudited condensed consolidated financial statements of Paxton Energy, Inc., have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q.  Accordingly, these consolidated financial statements do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements.  These consolidated financial statements should be read in conjunction with the Company’s annual financial statements and the notes thereto for the year ended December 31, 2010, and for the period from June 30, 2004 (date of inception) through December 31, 2010, included in the Company’s annual report on Form 10-K.  In the opinion of the Company’s management, the accompanying unaudited condensed financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to fairly present the Company’s financial position as of June 30, 2011 and its consolidated results of operations for the three months ended June 30, 2011 and 2010, and its consolidated results of operations and cash flows for the six months ended June 30, 2011 and 2010 and for the period from June 30, 2004 (date of inception), through June 30, 2011.  The results of operations for the three months and the six months ended June 30, 2011, may not be indicative of the results that may be expected for the year ending December 31, 2011.

Business Condition – The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  The Company has not had significant revenue and is still considered to be in the exploration stage.  The Company incurred losses of $2,971,733 and $3,685,736 for the three months and the six months ended June 30, 2011 and $4,154,493 for the year ended December 31, 2010.  The Company also used cash of $879,471 and $498,605 in its operating activities during the six months ended June 30, 2011 and the year ended December 31, 2010, respectively.  Through June 30, 2011, the Company has accumulated a deficit during the exploration stage of $15,923,460.  At June 30, 2011, the Company has a working capital deficit of $2,072,681 including current liabilities of $2,092,276.  These conditions raise substantial doubt about the Company’s ability to continue as a going concern.

6

As discussed above, the existing members of the Company’s board of directors resigned on March 17, 2010 and new members were appointed.  During the period since the change of control in March 2010, the accomplishments of the new board of directors include, among other things, the following:

· The placement of unsecured convertible promissory notes in the amount of $458,000 to provide working capital for the Company.

· The settlement of its liability for accrued registration rights penalties and interest in the amount of $698,092 by the issuance of common stock.

· The conversion of all outstanding options and warrants to purchase 683,176 shares of common stock into 683,176 shares of common stock.

· The consummation of two reverse stock splits that resulted in a total of approximately 10 million post-consolidation shares of common stock outstanding at the date of the reverse stock splits.

· The sale of $255,000 of equity securities.

· The sale of convertible debentures and warrants for gross proceeds of $2,550,000.

· The acquisition of a 70% leasehold working interest, with a net revenue interest of 51.975%, of certain oil and gas leases owned by Montecito, for $1,500,000 in cash, a subordinated promissory note in the amount of $500,000, and 15 million shares of common stock. 

The Company entered into an agreement with a consulting company on September 7, 2010, under which the consultant agreed to provide the Company with one or more financial and strategic business plans.  Thereafter, on September 27, 2010, the Company entered into an agreement with an investment banking firm to provide investment banking and financial advisory services.  Services under these two agreements are being provided to the Company in connection with the evaluation and due diligence of potential oil and gas property acquisitions.

The Company is currently seeking equity, debt, and transaction financing to fund these potential acquisitions and other expenditures, although the Company does not have any definitive contracts or commitments for either at this time.  The Company will have to raise additional funds to continue operations and, while the Company has been successful in doing so in the past, there can be no assurance that it will be able to do so in the future.  The Company’s continuation as a going concern is dependent upon its ability to obtain necessary additional funds to continue operations and the attainment of profitable operations.

Basic and Diluted Loss per Common Share – Basic loss per common share amounts are computed by dividing net loss by the weighted-average number of shares of common stock outstanding during each period.  Diluted loss per share amounts are computed assuming the issuance of common stock for potentially dilutive common stock equivalents. All outstanding stock options, warrants, and convertible promissory notes are currently antidilutive and have been excluded from the diluted loss per share calculations.  None of the options and warrants to acquire 43,170,427 shares of common stock, or the promissory notes and debentures convertible into 18,847,075 shares of common stock and warrants to purchase 106,138 shares of common stock were included in the computation of diluted loss per share at June 30, 2011.  None of the options to acquire 7,000,000 shares of common stock or promissory notes convertible into approximately 520,000 shares of common stock were included in the computation of diluted loss per share at June 30, 2010

7

Fair Values of Financial Instruments – The carrying amounts reported in the consolidated balance sheets for receivable from attorneys’ trust accounts, accounts payable, payable to Bayshore Exploration L.L.C., and payable to officer approximate fair value because of the immediate or short-term maturity of these financial instruments.  The carrying amounts reported for notes payable, unsecured convertible promissory notes payable, subordinated note payable, and convertible debentures approximate fair value because the underlying instruments are at interest rates which approximate current market rates.  The fair value of derivative liabilities are estimated based on the method disclosed in Note J to these condensed consolidated financial statements.

Recently Issued Accounting Statements – In 2011, the Financial Accounting Standards Board ("FASB") issued new accounting guidance that amends some fair value measurement principles and disclosure requirements. The new guidance states that the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets and prohibits the grouping of financial instruments for purposes of determining their fair values when the unit of account is specified in other guidance. The Company will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2011, and does not anticipate that this adoption will have a significant impact on its consolidated financial position or results of operations.

In 2011, the FASB issued new disclosure guidance related to the presentation of the Statement of Comprehensive Income. This guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The Company will adopt this accounting standard upon its effective date for periods ending on or after December 15, 2011, and does not anticipate that this adoption will have any impact on its consolidated financial position or results of operations.

(B)           Oil and Gas Acquisition Agreements

Montecito Agreement

On May 6, 2011, the Company completed its acquisition of certain assets pursuant to an Asset Sale Agreement (the Montecito Agreement) with Montecito Offshore, L.L.C. (Montecito).   The assets consist of certain oil and gas leases located in the Vermillion 179 tract, which is in the shallow waters of the Gulf of Mexico offshore from Louisiana.  Pursuant to the terms of the Montecito Agreement, as amended, Montecito agreed to sell the Company a 70% leasehold working interest, with a net revenue interest of 51.975%, of certain oil and gas leases owned by Montecito, for $1,500,000 in cash, a subordinated promissory note in the amount of $500,000, and 15 million shares of common stock.  The leasehold interest has been capitalized in the amount of $5,698,563, representing $2,000,000 in cash and promissory note, $3,675,000 for the common stock based on a closing price of $0.245 per share on the closing date, and $23,563 in acquisition costs.  No drilling or production has commenced as of June 30, 2011.

Virgin Oil Agreement

On April 29, 2011, the Company entered into an Agreement of Merger (the Agreement) with PaxAcq Inc. (PaxAcq), a newly-created wholly-owned subsidiary of the Company, with Virgin Oil Company, Inc. (Virgin), and with Virgin Offshore U.S.A., Inc., a wholly-owned subsidiary of Virgin.  Pursuant to the terms of the Agreement, at closing, the shareholders of Virgin would have received an aggregate of 70 million shares of the Company’s common stock in exchange for all of the issued and outstanding shares of Virgin and PaxAcq would have merged with and into Virgin, so that Virgin would become a wholly-owned subsidiary of the Company.  However, effective June 29, 2011, the Agreement was deemed null and void as a result of the Company’s inability to raise a net of $5 million of equity within 60 days, as required under the terms of the Agreement.

8

(C)           Accrued Liabilities

Accrued liabilities consisted of the following at June 30, 2011 and December 31, 2010:

	June 30,		December 31,
	2011		2010
Accrued salaries	$	368,940	$	281,593
Accrued payroll taxes		48,706		27,262
Accrued director fees		11,533		18,000
Accrued interest		102,953		47,548
Other accrued expenses		2,500		2,500
Total accrued liabilities	$	534,632	$	376,903

     
 

(D)           Notes Payable

On September 3, 2008, the Company issued $225,000 of secured promissory notes to four individuals who were unaffiliated with the Company and $75,000 of secured promissory notes to two individuals who were related parties at the time.  All of these promissory notes bear interest at 12% per annum, with interest payable monthly.  The promissory notes were originally due September 1, 2009 and are secured by all of the assets of the Company.  With the change in management control in March 2010, accrued interest on these notes was paid through January 31, 2010 and the due dates of the promissory notes were extended to August 31, 2010.  The notes came due on August 31, 2010 and have not been paid.  Both the non-payment of interest and the Company’s failure to repay the notes when they matured constitute events of default under the notes.  Upon the occurrence of an event of default, the noteholders have the right to exercise their rights under the security agreement associated with the notes.  These rights include, among other things, the right to foreclose on the collateral if necessary.  The Company is currently negotiating with its secured lenders for an extension or other resolution.  The Company can provide no assurance that it will obtain an extension or other resolution, or that the secured creditors will not eventually foreclose if not paid in the near term.

Between July 9, 2009 and December 31, 2009, the Company’s two former officers and directors loaned the Company a total of $30,000 to provide working capital for the immediate needs of the Company.  These notes bear interest at 12%, are not collateralized, and were originally due December 30, 2009.  With the change in management control in March 2010, accrued interest on these notes was paid through January 31, 2010 and the due dates of the promissory notes were extended to August 31, 2010.  The notes came due on August 31, 2010 and have not been paid.  Both the non-payment of interest and the Company’s failure to repay the notes when they matured constitute events of default under the notes.  The Company is currently negotiating with its lenders for an extension or other resolution.  The Company can provide no assurance that it will obtain an extension or other resolution.

To provide working capital to the Company, four parties advanced the Company $115,000 between March 28, 2011 and April 6, 2011.  As consideration for their advances, the Company issued warrants to these parties to acquire 115,000 shares of the Company’s common stock.  The warrants are exercisable for a period of five year at an exercise price of $0.30 per share.  The warrants contain full ratchet anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $6,509 and recorded a corresponding discount to the liability for the advances.  The total discount to the liability has been amortized during the quarter ended June 30, 2011.  Of the amounts advanced, $100,000 was satisfied through the issuance of convertible debentures and warrants, as disclosed in Note G.  The remaining $15,000 was to be repaid out of the first closing of the convertible debenture financing.  However, the advance was not repaid out of the first closing of that financing.  The advance is accruing interest at the rate of 10% per annum and is to be promptly repaid.

9

A summary of notes payable at June 30, 2011 and December 31, 2010 is as follows:

	June 30,		December 31,
	2011		2010
2008 secured promissory notes to six individuals	$	300,000	$	300,000
2009 unsecured promissory notes to former officers		30,000		30,000
March 2011 advance		15,000		-
	$	345,000	$	330,000

(E)           Unsecured convertible promissory notes payable

$300,000 Convertible Promissory Note Offering

Commencing in March 2010, new management of the Company initiated the placement of unsecured convertible promissory notes to raise up to $300,000 for the payment of transaction expenses, payment of certain accounts payable, and to provide working capital.  These notes bear interest at 9% per annum.  The repayment of the notes, including accrued interest, was due on December 31, 2010 if not converted into common stock earlier.  Originally, the principal amount of the notes, plus accrued interest, were to be automatically converted, in whole, into shares and warrants of the Company upon the completion of a planned $3,000,000 sale of common stock and warrants as part of the change of control and the exchange of oil and gas interests by the Company’s new chief executive officer with the Company.  However, in October 2010, management of the Company decided to allow the conversion of notes payable under this offering prior to the completion of the planned $3,000,000 placement and prior to the automatic conversion process described in the notes.  

The number of shares of common stock and warrants to be issued upon such conversion is equal to a discount of 66% of the price of the common stock and warrants in the planned $3,000,000 placement of common stock and warrants.  As such, the conversion price is $0.051 per share of common stock and warrant to purchase one half share of common stock.  The holders of these convertible promissory notes will be entitled to the same registration rights, if any, given to the purchasers of the planned $3,000,000 offering.  Proceeds from the convertible note offering totaled $298,000.  In November 2010, the Company received notice of conversion of notes totaling $158,000, plus accrued interest of $8,630, which were converted into 3,267,247 shares of common stock and warrants to purchase 1,633,625 shares of common stock.  During the six months ended June 30, 2011, the Company received notice of conversion of notes totaling $130,000, plus accrued interest of $9,923, which were converted into 2,743,592 shares of common stock and warrants to purchase 1,371,802 shares of common stock.  The warrants are exercisable at $0.45 per share until August 31, 2013.  The unconverted balance of these promissory notes is $10,000 and $140,000 at June 30, 2011 and December 31, 2010, respectively.  In July 2011, the remaining $10,000 note and unpaid accrued interest was converted into 213,049 shares of common stock and warrants to purchase 106,525 shares of common stock.

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Convertible Promissory Notes to an Unaffiliated Entity

In April and December of 2010 and in February and April of 2011, the Company has issued unsecured convertible promissory notes to an unaffiliated entity.  Aggregate proceeds from the convertible promissory notes total $160,000.  The convertible promissory notes bear interest at 8% per annum.  The and unpaid accrued interest are generally due approximately nine months after the issuance date.  In general, the notes are convertible until maturity at a variable conversion price equal to 50% of the average of the lowest three closing bid prices from the ten trading days prior to the date of the conversion notice.  In December 2010, the Company received notices of conversion of notes totaling $21,000, which were converted into 377,290 shares of common stock, or a weighted-average conversion price of $0.05566 per share.  During the six months ended June 30, 2011, the Company received notices of conversion of notes totaling $41,000 and accrued interest of $2,000, which were converted into 1,186,315 shares of common stock, or a weighted-average conversion price of $0.03625 per share.

This variable conversion feature constitutes an embedded derivative under generally accepted accounting principles and is required to be valued at its fair value.  The fair value of the beneficial conversion feature has been estimated at a total of $152,308 for the four notes, which has been recorded as discounts to the carrying amount of the convertible promissory notes.  The discounts are being amortized over the period from the issuance dates to the maturity dates.  The Company recognized interest expense from the amortization of the discounts in the amount of $39,187 for the three months ended June 30, 2011 and $59,717 for the six months ended June 30, 2011.  The Company recognized interest expense from the amortization of the discount in the amount of $9,692 for the three and six months ended June 30, 2010.  The carrying amount of the convertible promissory notes is $46,613 at June 30, 2011, representing their unconverted face amount of $98,000 less the unamortized discount of $51,387.  The carrying amount of the convertible promissory notes was $27,896 at December 31, 2010, representing their unconverted face amount of $64,000 less the unamortized discount of $36,104.   

Convertible Promissory Notes Issued in Exchange for Accounts Payable

On October 12, 2010, an unrelated third party acquired the rights to certain of the Company’s past-due accounts payable totaling $193,676.  That entity and the Company then agreed to convert the past-due accounts payable into Convertible Redeemable Notes Payable with an aggregate principal amount of $193,676.  These notes were due October 12, 2012 and bore interest at 6%.  Interest was payable on or before the due date of the notes and was payable in shares of the Company’s common stock.  The holder of the notes was entitled, at its option, to convert all or any portion of the principal of the notes, along with related accrued interest, into shares of the Company’s common stock at a conversion price equal to $0.05 per share.  On October 18, 2010, the note holder converted $43,676 of principal into 873,522 shares of common stock. During the three months ended March 31, 2011, the remaining $150,000 of principal and $4,219 of accrued interest were converted into 3,084,386 shares of common stock.

The fair value of the beneficial conversion feature was originally estimated at $193,676 for these convertible promissory notes, which was recorded as discounts to the carrying amount of the convertible promissory notes.  The discounts were amortized over the period from the issuance dates of the notes to the earlier of the maturity dates or the conversion dates.  The Company recognized interest expense from the amortization of the discounts in the amount of $133,561 for the three months ended March 31, 2011.  The carrying amount of the convertible promissory notes was $16,439 at December 31, 2010, representing their unconverted face amount of $150,000 less the unamortized discount of $133,561.

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A summary of unsecured convertible promissory notes at June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011						December 31, 2010
	Unpaid Principal		Unamortized Discount		Carrying  Value		Unpaid Principal		Unamortized Discount		Carrying Value
$300,000 Convertible Note Offering	$	10,000	$	-	$	10,000	$	140,000	$	-	$	140,000
Convertible Notes to an Unaffiliated Entity		98,000		51,387		46,613		64,000		36,104		27,896
Convertible Notes Issued for Accounts Payable		-		-		-		150,000		133,561		16,439
	$	108,000	$	51,387	$	56,613	$	354,000	$	169,665	$	184,335

(F)           Subordinated Note Payable

As further described in Note B, on May 6, 2011, the Company acquired a leasehold interest in oil and gas properties from Montecito Offshore, L.L.C.   Pursuant to the terms of the agreement, as amended, the Company issued a subordinated promissory note in the amount of $500,000 as partial consideration for the purchase.  The note bears interest at 9% per annum.  The note and unpaid interest were originally due ninety days after the date of the promissory note, but have been extended to August 15, 2011. The note is secured by a second lien mortgage, subordinated to the convertible debentures issued in May 2011, as further described in Note G to these condensed consolidated financial statements. The Company is currently negotiating with Montecito to extend the maturity date of the note as it does not have the cash to repay the note at this time.  There can be no assurances that an extension will be granted on terms acceptable to the Company, if at all.

      
   

(G)           Convertible Debentures and related warrants

In May 2011 the Company sold units to certain investors for aggregate cash proceeds of $2,550,000 at a price of $30,000 per unit. Each unit consisted of a secured convertible debenture in the principal amount of $30,000 and a warrant to purchase 200,000 shares of the Company’s common stock.  The convertible debentures mature in May 2012 and bear interest at 9% per annum.  The debentures are convertible at the holder’s option at any time into common stock at a conversion price of $0.15 per share.  The debentures will automatically be redeemed with a 30% premium upon a Change of Control or Listing Event (each as defined in the convertible debenture). Interest on the debentures is payable quarterly in arrears in cash.   The Company is in default under the convertible debentures because it has not made the interest payment that was due on July 1, 2011.  To date, such default has not been either cured or waived by the holders of the convertible debentures.  Upon the occurrence of an event of default, the debenture holders have the right to exercise their rights under the Mineral Mortgage associated with the debentures.  These rights include, among other things, the right to foreclose on the collateral if necessary.  The Company is currently working to resolve the default on these debentures.  The Company can provide no assurance that it will obtain a resolution, or that the secured creditors will not eventually foreclose if not paid in the near term. 

The debentures contain full ratchet anti-dilution protection.  In addition, the conversion price shall be adjusted if the conversion price of securities in a subsequent offering by the Company is adjusted pursuant to a make good provision.  The shares of common stock issuable upon conversion of the debentures are entitled to piggyback registration rights.  The Company has determined that this anti-dilution reset provision caused the conversion feature to be bifurcated from the debentures, treated as a derivative liability, and accounted for at its fair value.  Upon issuance, the Company determined the fair value of the conversion feature was $1,110,308 and recorded a corresponding discount to the convertible debentures.

In connection with this placement, the Company issued warrants to acquire 17 million shares of the Company’s common stock to the debenture holders.  The warrants are exercisable for a period of five years at an exercise price of $0.30 per share.  The warrants will be exercisable on a cashless basis at any time six months after issuance if there is not an effective registration statement registering for resale the shares issuable upon exercise of the warrants. The shares of common stock issuable upon exercise of the warrants are entitled to piggyback registration rights.  The warrants contain full ratchet anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $1,256,886 and recorded a corresponding discount to the convertible debentures.

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The total discount to the debentures of $2,367,194 is being amortized over the one year term of the debentures using the effective interest method.  During the period from the issuance of the debentures in May 2011 through June 30, 2011, the Company amortized discount of $67,724.  The carrying amount of the convertible debentures was $250,530 at June 30, 2011, representing their unconverted face amount of $2,550,000 less the unamortized discount of $2,299,470.   

 In connection with this sale of convertible debentures and warrants, the Company 1) paid its placement agent a cash payment of $324,000, 2)issued five-year warrants to its placement agent to acquire 1.7 million shares of common stock, which was 10% of the aggregate number of shares of Common Stock issuable upon conversion of the debentures, and 3) paid $50,000 for legal services in connection with the issuance of these convertible debentures and warrants.  The warrants issued to the placement agent are exercisable at $0.30 per share, may be exercised on a cashless basis, and contain full ratchet anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $125,688 and recorded a corresponding charge to deferred financing costs.  Total deferred financing costs recorded for the issuance of convertible debentures was $499,688.  Deferred financing costs are being amortized over the one year term of the debentures using the effective interest method.  During the period from the issuance of the debentures in May 2011 through June 30, 2011, the Company amortized deferred financing costs of $67,576.  

Pursuant to the debentures and warrants, no holder may convert or exercise such holder’s debenture or warrant if such conversion or exercise would result in the holder beneficially owning in excess of 4.99% of our then issued and outstanding common stock. A holder may, however, increase or decrease this limitation (but in no event exceed 9.99% of the number of shares of common stock issued and outstanding) by providing the Company with 61 days’ notice that such holder wishes to increase or decrease this limitation.

Pursuant to a Mineral Mortgage between the Company and the purchasers of the debentures and warrants, the Company granted a first priority lien on all assets acquired from Montecito Offshore, L.L.C., as further discussed in Note B to these condensed consolidated financial statements.

(H)           Common Stock

Issuance of Common Stock to Officers

Effective June 3, 2011, the Board of Directors approved the issuance of 15,750,000 shares of common stock to two of the executive officers of the Company as additional bonus compensation for their accomplishments since the change of control of the Company on March 17, 2010.  For accounting purposes, this issuance has been recorded at $2,992,500, or $0.19 per share, the closing price of the common stock on the date the issuance was authorized.

13

Issuance of Common Stock for Legal Services

On May 5, 2011, the Company issued 200,000 shares of common stock to a law firm as compensation for legal services rendered to the Company.  For accounting purposes, this issuance has been recorded at $50,000, or $0.25 per share, the closing price of the common stock on the date the issuance was made.

Issuance of Common Stock and Warrants for Cash

During the six months ended June 30, 2011, the Company sold 600,000 shares of common stock and warrants to purchase 300,000 shares of common stock.  The warrants are exercisable at $0.45 per share and expire on August 31, 2013.  Proceeds to the Company from the sale were $90,000, which were allocated $60,780 to the common stock and $29,220 to the warrants based on their relative fair values.

Issuance of Common Stock in Satisfaction of Payable to Former Officers and Consultant

In connection with the change of managerial control of the Company in March 2010, the new board of directors agreed to issue 1,250,000 post-split shares of the Company’s common stock to former management and 250,000 post-split shares to a consultant as compensation for services.  The former management and consultant completed all that was required of them under this arrangement during March, 2010.  Accordingly, the Company recognized this obligation to these individuals and the associated compensation during March, 2010 by recording $212,163 of share-based compensation representing the estimated value of 1,500,000 shares of post-split shares of the Company’s common stock.  The estimated value of the shares was based on the closing price of the common stock on March 17, 2010, adjusted for the expected dilutive effects of various stock issuances that were required to occur prior to the issuance of the post-split shares.  In September, 2010, the Company issued 1,500,000 shares to the former management and consultant, and the obligation was satisfied.

(I)           Stock Options and Warrants

Stock Options and Compensation-Based Warrants

On June 29, 2010, the stockholders of the Company approved the adoption of the 2010 Stock Option Plan.  Effective June 3, 2011, the Company amended and restated the 2010 Stock Option Plan and adopted the Paxton Energy, Inc. Amended and Restated 2010 Incentive Stock Option Plan.  The Amended Plan provides for the issuance of stock grants and granting of incentive and nonqualified stock options to employees and consultants of the Company.  Generally, options granted under the plan may not have a term in excess of ten years.  The Amended Plan reserves 35 million shares of the Company’s common stock for issuance there under.

Generally accepted accounting principles for stock options and compensation-based warrants require the recognition of the cost of services received in exchange for an award of equity instruments in the financial statements, is measured based on the grant date fair value of the award, and requires the compensation expense to be recognized over the period during which an employee or other service provider is required to provide service in exchange for the award (the vesting period).  No income tax benefit has been recognized for share-based compensation arrangements and no compensation cost has been capitalized in the accompanying condensed balance sheet.

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A summary of stock option and compensation-based warrant activity for the six-month period ended June 30, 2011 is presented below:

						Weighted
	Shares			Weighted		Average
	Under			Average		Remaining	Aggregate
	Option or			Exercise		Contractual	Intrinsic
	Warrant			Price		Life	Value
Outstanding at December 31, 2010		13,750,000		$	0.30	8.9 years
Granted or issued		8,250,000			0.20
Canceled		(1,500,000	)		0.38
Outstanding at June 30, 2011		20,500,000			0.24	7.2 years	$	-
Exercisable at June 30, 2011		10,444,506		$	0.25	8.3 years	$	-

During the six months ended June 30, 2011, the Company granted options to an employee and to a new director to acquire an aggregate of 1,250,000 shares of common stock at $0.30 per share.  Of these options, 416,733 vested immediately and 833,267 vest over periods of up to two years.  Additionally, during the six months ended June 30, 2011, options to acquire 3,500,000 shares of common stock were modified to reduce the exercise price from $0.38 to $0.30 per share and options to acquire 1,500,000 shares of common stock were canceled as part of the termination of services of a consultant.  The effects of these modifications on share-based compensation were not material.  During the six months ended June 30, 2010, the Company granted options to acquire 7,000,000 shares of common stock at $0.24 per share.  These options vested immediately.  The fair value of these stock options was estimated on the date of grant using the Black-Scholes option pricing model.  The weighted-average fair value of the stock options granted during the six months ended June 30, 2011 was $0.1780 per share.  The weighted-average assumptions used for the options granted during the six months ended June 30, 2011 were risk-free interest rate of 1.58%, volatility of 234%, expected life of 5.1 years, and dividend yield of zero.  The weighted-average fair value of the stock options granted during the six months ended June 30, 2010 was $0.2131 per share.  The weighted-average assumptions used for the options granted during the six months ended June 30, 2010 were risk-free interest rate of 1.78%, volatility of 215%, expected life of 5.0 years, and dividend yield of zero.  The assumptions employed in the Black-Scholes option pricing model include the following.  The expected life of the options granted is equal to the average of the vesting period and the term of the option, as allowed for under the simplified method prescribed by Staff Accounting Bulletin 107.   The expected volatility is based on the historical price volatility of the Company’s common stock. The risk-free interest rate represents the U.S. Treasury constant maturities rate for the expected life of the related stock options. The dividend yield represents anticipated cash dividends to be paid over the expected life of the stock options.

In June 2011, the Company issued warrants to acquire 7 million shares of common stock to its placement agent under a consulting agreement, all of which have been earned upon issuance.  The warrants are exercisable at $0.18 per share and contain full ratchet anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the warrants is subject to derivative liability treatment and is required to be accounted for at its fair value.  Upon issuance, the Company determined the fair value of the warrants was $334,438 and recorded share-based compensation in that amount.  There were no compensation-based warrants issued during the six months ended June 30, 2010.

For the three-month periods ended June 30, 2011 and 2010, the Company reported compensation expense related to stock options and compensation-based warrants of $446,527 and $1,491,700.  For the six-month periods ended June 30, 2011 and 2010, the Company reported compensation expense related to stock options and compensation-based warrants of $530,625 and $1,491,700.  As of June 30, 2011, there was approximately $315,000 of unrecognized compensation cost related to stock options that will be recognized over a weighted average period of approximately 1.6 years.  The intrinsic values at June 30, 2011 are based on a closing price of $0.14.

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Other Stock Warrants

A summary of other stock warrant activity for the six-month period ended June 30, 2011 is presented below:

					Weighted
			Weighted		Average
	Shares		Average		Remaining	Aggregate
	Under		Exercise		Contractual	Intrinsic
	Warrant		Price		Life	Value
Outstanding at December 31, 2010		2,183,625	$	0.45	2.7 years	$	-
Issued		20,486,802		0.31
Outstanding at June 30, 2011		22,670,427		0.33	4.4 years	$	-

  
  

(J)           Derivative Liabilities

Convertible Debenures and Related Warrants

As described above in Notes E, G and I to these condensed consolidated financial statements, the Company issued convertible debentures and various warrants which contain full ratchet anti-dilution protection.  The Company has determined that this anti-dilution reset provision of the convertible debentures and these warrants is subject to derivative liability treatment and is required to be accounted for at fair value.  Upon issuance, the Company determined the aggregate fair value of the conversion feature and of the warrants was $2,833,829.  The Company has determined the aggregate fair value of the conversion feature and the warrants was $1,617,929 at June 30, 2011, resulting in a gain on the change in the derivative liability of $1,215,900 for the three months and the six months ended June 30, 2011.

The Company estimated the fair value of the conversion feature and the warrants using the Lattice model. Accordingly, the fair value of the conversion feature and warrants as determined using the Lattice model is affected by the Company’s stock price on the date of issuance as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the debentures and warrants, actual and projected redemptions and conversion price resets.  Expected volatility is based primarily on the historical volatility of other comparable oil and gas companies.  Volatility used in the calculation ranged from a low of 64% in year one to a high of 137% in year five. Management estimated that the probability of the debentures being redeemed at 0% initially, increasing by 1% per month thereafter to a maximum of 20%.

Beneficial Conversion Feature

As described above in Note E to these condensed consolidated financial statements, the Company issued unsecured convertible promissory notes to an unaffiliated entity which contains a beneficial conversion feature which is treated as an embedded derivative under generally accepted accounting principles and is required to be accounted for at fair value.  The Company has estimated the fair value of the beneficial conversion feature based on the intrinsic value of the conversion feature, which equals the difference between the variable conversion price of the notes and the closing price of the Company’s common stock on the date of the valuation.  The fair value of the beneficial conversion feature was estimated to be $121,444 and $243,376 as of June 30, 2011 and December 31, 2010, respectively.  The Company recognized a gain from the change in fair value of this beneficial conversion feature of $133,620 and $96,439 for the three months and six months ended June 30, 2011.  The Company recognized a loss from the change in fair value of this beneficial conversion feature of $20,192 for the three and six months ended June 30, 2010.

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Warrants

Effective January 1, 2009 the Company adopted the provisions of new accounting standards related to embedded derivatives and reclassified the fair value of certain common stock purchase warrants from equity to liability status as if these warrants were treated as a derivative liability since their date of issue in April 2006.  The warrants did not qualify for hedge accounting, and as such, all changes in the fair value of these warrants were recognized currently in results of operations until June 29, 2010 when the warrants were canceled.  The Company recognized a gain from the change in fair value of these warrants of $9,278 for the three months ended June 30, 2010 and recognized a loss from the change in fair value of these warrants of $18,156 for the six months ended June 30, 2010.

(K)           Fair Value Measurements

For asset and liabilities measured at fair value, the Company uses the following hierarchy of inputs:

• Level one — Quoted market prices in active markets for identical assets or liabilities;

• Level two — Inputs other than level one inputs that are either directly or indirectly observable; and

• Level three — Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use.

Liabilities measured at fair value on a recurring basis at June 30, 2011 are summarized as follows:

	Level 1		Level 2		Level 3		Total
Derivative liability - conversion
feature of debentures and
related warrants	$	-	$	1,617,929	$	-	$	1,617,929
Derivative liability - beneficial
conversion feature	$	-	$	121,444	$	-	$	121,444

   

Liabilities measured at fair value on a recurring basis at December 31, 2010 are summarized as follows:

	Level 1		Level 2		Level 3		Total
Derivative liability - beneficial
conversion feature	$	-	$	243,376	$	-	$	243,376

As further described in Note J, the fair value of the derivative liability for the conversion feature of the convertible debentures and related warrants is measured using the Lattice Model and as further described in Note E, the fair value of the beneficial conversion feature is measured using the intrinsic value method, equal to the excess of the market price of the stock over the conversion price, multiplied by the number of shares to be received upon conversion.

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(L)           Related-Party and Other Transactions

Payable to Officer

In connection with their employment agreements, the Company agreed to provide for one-time payments aggregating $70,000 to reimburse two of the executive officers for sums and expenditures made and services provided prior to and in connection with the change of control of the Company in March 2010.   At December 31, 2010, the Company has reimbursed part of this amount, leaving a balance payable to one of these officers of $30,000.  The balance of this obligation to the officer has been paid as of June 30, 2011.

(M)           Supplemental Cash Flow Information

During the six months ended June 30, 2011, the Company had the following noncash investing and financing activities:

· The Company issued 2,743,592 shares of common stock as a result of the conversion of $130,000 of principal of 9% convertible promissory notes and $9,923 of related accrued interest.

· The Company issued 1,186,315 shares of common stock as a result of the conversion of $41,000 of principal of 8% convertible promissory notes with an unaffiliated entity and $2,000 of related accrued interest.

· The Company issued 3,084,386 shares of common stock as a result of the conversion of $150,000 of principal of 6% convertible promissory notes with an unaffiliated entity and $4,219 of related accrued interest.

· The Company issued 15 million shares of common stock and a subordinated promissory note in the amount of $500,000 in connection with its acquisition of certain oil and gas leases from Montecito Offshore, L.L.C.

· In connection with the sale of convertible debentures and warrants, the Company issued five-year warrants to its placement agent to acquire 1.7 million shares of common stock.  These warrants had a fair value of $125,688, which was capitalized as deferred financing costs.

During the six months ended June 30, 2010, the Company had the following noncash investing and financing activity:

· The Company issued 5,801,060 shares of common stock in exchange for the settlement of $698,092 of accrued registration rights penalties and interest.

· The Company issued 683,176 shares of common stock in exchange for the cancellation of options and warrants to acquire 683,176 shares of common stock.

The Company paid $0 and $28,093 for interest during the six months ended June 30, 2011 and 2010, respectively.

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(N)           Subsequent Events

Conversion of Promissory Notes to an Unaffiliated Entity

In December of 2010, the Company issued an unsecured convertible promissory note in the amount of $35,000 to an unaffiliated entity.  In July 2011, the Company received notices for the conversion of the remaining principal balance of this note in the amount of $23,000 and accrued interest of $1,400, which were converted into 428,077 shares of common stock.

Conversion of Promissory Note from $300,000 Offering

Commencing in March 2010, new management of the Company initiated the placement of unsecured convertible promissory notes to raise up to $300,000.  In July 2011, the last remaining note in the principal amount of $10,000, plus unpaid accrued interest, was converted into 213,049 shares of common stock and warrants to purchase 106,525 shares of common stock.

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes to our financial statements included elsewhere in this report.  This discussion contains forward-looking statements that involve risks and uncertainties.  Actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors discussed elsewhere in this report.

Certain information included herein contains statements that may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, such as statements relating to our anticipated revenues, costs and operating expenses and results, estimates used in the preparation of our financial statements, future performance and operations, plans for future oil and gas exploration, sources of liquidity, and financing sources.  Such forward-looking information involves important risks and uncertainties that could significantly affect anticipated results in the future, and accordingly, such results may differ from those expressed in any forward-looking statements made herein.  These risks and uncertainties include those relating to the availability of funding from external sources on terms acceptable to us for planned exploration, development, or acquisitions; the ability of our management to develop and execute an effective exploration, development, and acquisition plan; the ability of third-party project operators and contractors to identify suitable prospects and conduct required operations effectively and economically and in accordance with contractual requirements; future results of drilling individual wells and other exploration and development activities; future variations in well performance as compared to initial test data; the prices at which we may be able to sell oil or gas; domestic or global economic conditions; the inherent uncertainty and costs of prolonged arbitration or litigation; and changes in federal or state tax laws or the administration of such laws.

Company Overview

Paxton Energy, Inc. is an oil and gas exploration and production company with assets in Texas and a recently acquired property in the Gulf of Mexico.  Our assets in Texas consist of a minority working interest in limited production and drilling prospects in the Cooke Ranch area of La Salle County, Texas, and Jefferson County, Texas, all operated by Bayshore Exploration L.L.C.  The Texas asset had limited revenues and substantial losses, which we expect for the foreseeable future. We have recently determined to expand our operations.  In April 2011, we acquired our assets in the Gulf of Mexico referred to as Vermilion 179 (“VM 179”) consisting of a leasehold working interest in certain oil and gas leases located offshore from Louisiana, upon which no drilling or production has commenced as of yet.

In Texas, we have working interests ranging from 4% to 31.75% (net revenue interests ranging from 3% to 23.8125%) in the various wells in which we have participated.  In the Gulf of Mexico, we have a 70% leasehold working interest, with a net revenue interest of 51.975% of certain oil and gas leases in the Vermillion 179 tract.  VM 179 is adjacent to Exxon's VM 164 #A9 well.

We are seeking to make additional acquisitions that are currently producing oil in the United States as a way to increase our cash flow.  Other than as disclosed herein, we currently do not have any contracts or agreements to acquire additional companies and/or working interests in existing wells, and no assurances can be given that we will identify or acquire such additional acquisitions on terms acceptable to us, if at all.  Additional acquisitions will likely require the issuance of equity or debt securities, either directly or indirectly to raise funds for such acquisitions.

Organization

Paxton Energy, Inc. was organized under the laws of the State of Nevada on June 30, 2004.  On March 17, 2010, the Company entered into a “Change of Control and Recapitalization Agreement” with Charles Volk of San Francisco, California (the “Change of Control Agreement”).  On that same day, all our directors and officers resigned and were replaced by Charles F. Volk, Jr., James E. Burden, and Clifford Henry as directors and Charles F, Volk, Jr. as CEO, Treasurer (Chief Financial Officer) and Chairman of the Board of Directors and James E. Burden as President and Secretary.  The Change of Control Agreement provides for the Company to issue 62,700,000 shares of the Company’s common stock to Mr. Volk and others upon the transfer to the Company of producing and non-producing oil and gas properties with minimum net tangible worth of $2,000,000, and an annual net cash flow of $1,000,000. In July 2011, the Company and Mr. Volk entered into an agreement whereby Mr. Volk agreed to reduce the total number of shares issuable pursuant to the Change of Control Agreement to 10 million.

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Recent Developments

Montecito Acquisition

On May 6, 2011, we acquired VM 179 pursuant to an Asset Sale Agreement (the “Montecito Agreement”) with Montecito Offshore, L.L.C. (“Montecito”), on March 28, 2011, as amended on April 7, 2011 and May 2, 2011.  Montecito is controlled by Robert Smith, who became our President in June 2011.  Pursuant to the terms of the Montecito Agreement, Montecito sold us a 70% leasehold working interest (Montecito retains the remaining 30% working interest), with a net revenue interest of 51.975%, of certain oil and gas leases owned by Montecito, for $1,500,000 in cash, a subordinated promissory note in the amount of $500,000 (the “Montecito Note”), and 15 million shares of common stock.   The Montecito Note is due on August 15, 2011, bears interest at a rate of 9% per annum, and its security interest is subordinated to the security interest of the Bridge Notes issued in the Financing (as defined below).  We are currently negotiating with Montecito to extend the maturity date of the Montecito Note as we do not have the cash to repay it at this time.  There can be no assurances that an extension will be granted on terms acceptable to us, if at all.  In the event that we are unable to obtain an extension, we will be in default under the Montecito Note, and Montecito can enforce its rights pursuant the security interest granted, subject to the rights of the holders of the Bridge Notes, who hold a senior security position.

 

Drilling is required on VM 179 to produce oil, and we will require approximately $2,800,000 in dry hole costs, which represents our 70% working interest costs of drilling.  In the event that Montecito does not pay their 30% of expenses in connection with drilling wells, they will forfeit their working interest in the well to us.  If that occurs, we will either need to pay all the expenses in connection with the well or sell a portion of our working interest to another partner.  We are seeking $15,000,000 to provide the necessary capital to complete the VM 179 well, establish connections to the feeder line, and provide additional operating capital.  We have received interest from at least one lender for a credit facility for $10,000,000, however, no contracts or agreements have been executed and we can provide no assurances that this, or any lender, will provide us with the additional funds we seek on terms acceptable to us, if at all.  Drilling of wells is expected to occur within 90 days after receipt of sufficient funds to commence the drilling program.

We have the right to participate in the VM 179 lease for 70% working interest and direct the operations. We intend to utilize a local operator with extensive Gulf of Mexico offshore drilling experience to drill VM 179.  We have already identified three operators that have done work in the Vermilion area and have experience with the formation.  We are soliciting bids and drilling plans for our review from these operators.   Permits to drill VM 179 for our wholly owned subsidiary, PaxAcq Inc., a Louisiana corporation (“PaxAcq”), are expected to be filed shortly and should take approximately one month to be approved.

Private Placement Offering

In May 2011, we completed a private placement offering which generated aggregate cash gross proceeds of $2,450,000 and the conversion of $100,000 in prior debt (the “Financing”).  The proceeds were raised through the sale of secured convertible debentures (the “Bridge Notes”) and warrants (the “Bridge Warrants”) to purchase shares of our common stock.  The Bridge Notes mature in May 2012 and bear interest at 9% per annum and are convertible at the holder’s option at any time into Common Stock at a conversion price of $0.15 per share.  The Bridge Warrants are exercisable for a period of five year at an exercise price of $0.30 per share.  As of August 15, 2011, we are in default under the Bridge Notes because we have not made the interest payment that was due on July 1, 2011 in the aggregate amount of $34,669.63.  To date, such default has not been either cured or waived by the holders of the Bridge Notes.

In connection with the Financing, we paid the placement agent, Buckman, Buckman & Reid, Inc. a 10% commission of the gross proceeds, a 2% non-accountable expense allowance of the gross proceeds and a $50,000 retainer, and we issued five-year warrants to acquire 1,700,000 shares of Common Stock at an exercise price of $0.30 (the “Bridge Agent Warrants”).

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The Bridge Note holders were granted piggyback registration rights with respect to the shares of common stock issuable upon conversion of the Bridge Notes and exercise of the Bridge Warrants. In addition, the Bridge Note holders were granted a security interest in the form of a Mineral Mortgage whereby the Bridge Note holders secured a first priority lien on all assets we acquired from Montecito pursuant to the Montecito Agreement.

Results of Operations

Results of Operations as a Comparison of the Three and Six Months Ended June 30, 2011 and 2010

Oil and Gas Revenues

Our oil and gas revenues were $175 and $5,654 for the three and six months ended June 30, 2011, respectively, compared to $2,983 and $6,119 for the three and six months ended June 30, 2010, respectively, representing a decrease of $2,808 for the three-month period and a decrease of $465 for the six-month period. The decrease in oil and gas revenue is principally related to the shutting in of two of our wells during most of the quarter ended June 30, 2011 pending workover to enhance production and due to an adjustment of estimated revenues for the first quarter to actual revenues received. The level of oil and gas production through June 30, 2011 continues not to be significant, and accordingly we continue to be characterized as an exploration-stage company.

Cost and Operating Expenses

Our costs and operating expenses were $4,085,647 and $4,596,120 for the three and six months ended June 30, 2011, respectively, compared to $2,004,020 and $2,269,846 for the three and six months ended June 30, 2010, respectively, representing an increase of $2,081,627 for the three-month period and an increase of $2,326,274 for the six-month period.

Lease Operating Expenses – Lease operating expenses were $(80) and $3,310 for the three and six months ended June 30, 2011, respectively, compared to $2,729 and $4,460 for the three and six months ended June 30, 2010, respectively, representing a decrease of $2,809 for the three-month period and a decrease of $1,150 for the six-month period. The level of oil and gas production through June 30, 2011 was not significant and our amount of lease operating expenses is relatively consistent in relation to our oil and gas production.

Accretion of Asset Retirement Obligations – Accretion of asset retirement obligations was $87 and $173 for the three and six months ended June 30, 2011, respectively, compared to $78 and $341 for the three and six months ended June 30, 2010, respectively, representing an increase of $9 for the three-month period and a decrease of $168 for the six-month period. The change in accretion of asset retirement obligations expenses principally reflects the fact that the original accretion period for certain wells has past.

General and Administrative Expense – General and administrative expense was $646,613 and $1,069,512 for the three and six months ended June 30, 2011, respectively, as compared to $334,713 and $386,382 for the three and six months ended June 30, 2010, respectively, representing an increase of $311,900 for the three-month period and an increase of $683,130 for the six-month period.  The increase in general and administrative expense during the three and six months ended June 30, 2011 is related primarily to: (1) increases of $152,521 and $316,948, respectively, for compensation and related payroll taxes as a result of the increase in officers and employees from two at June 30, 2010 to five at June 30, 2011 and due to the accrual of bonuses totaling $87,500 for two officers as compensation under their employment agreements for the acquisition of VM 179; and (2) increases for consulting, legal, accounting, and audit services of $177,094 and $396,367 for the three and six months ended June 30, 2011, respectively, compared to the prior period.  The increases for consulting, legal, accounting and audit services were a result of our expanded acquisition and financing activities since the Change of Control Agreement in March 2010; which increases were offset by a decrease of $70,000 for expenses recorded effective April 1, 2010 that were authorized and accrued under the employments agreements to provide for one-time payments to reimburse the two officers for sums and expenditures made and services provided prior to and in connection with the change of control of the Company in March 2010.

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Share-Based Compensation – We have entered into various transactions that have resulted in the recording of share-based compensation during the three and six months ended June 30, 2011 and 2010.  Share-based compensation for the three and six months ended June 30, 2011 was $3,439,027 and $3,523,125, respectively.  The transactions during the three and six months ended June 30, 2011 were as follows:

· Effective June 3, 2011, we issued 15,750,000 shares of common stock, pursuant to the Amended and Restated 2010 Incentive Stock Option Plan,  to two executive officers as additional bonus compensation for their accomplishments since the change of control of the Company on March 17, 2010.  For accounting purposes, this issuance has been recorded at $2,992,500, or $0.19 per share, the closing price of the common stock on the date the issuance was authorized; and

· During the period since the reorganization, we have granted options to acquire common stock to our officers and employees, as well as to certain consultants. Certain of these options vested immediately, while other options vest over periods of up to thirty months from the grant date. Additionally, we have issued compensation-based warrants to financial advisory firms.  Share-based compensation is measured on the grant date for stock options and on the issue date for compensation-based warrants, and recognized over the vesting period. For the three months and six months ended June 30, 2011, we reported share-based compensation related to these stock options and warrants of $446,527 and $530,625, respectively.

Share-based compensation for the three months and six months ended June 30, 2010 was $1,666,500 and $1,878,663, respectively.  The transactions during the three and six months ended June 30, 2010 were as follows:

· In March 2010, we agreed to issue 1,250,000 post-split shares of common stock to former management and 250,000 post-split shares to an advisor as compensation for services in connection with the change of managerial control of the Company.  The former management and advisor completed all that was required of them under this arrangement during the quarter ended March 31, 2010.  Accordingly, we recognized this obligation to these individuals and the associated compensation during the quarter ended March 31, 2010 by recording $212,163 of stock-based compensation representing the estimated value of 1,500,000 shares of post-split shares of our common stock;

· As part of the reorganization, we agreed to issue 249,296 shares of common stock following the initial stock split to two newly appointed members of the board of directors.  With the approval of the initial 1-for-3 common stock split, the required conditions for the issuance had been met and the common stock was deemed to have been issued as of June 30, 2010.  The issuance was valued at the closing price of the common stock on June 29, 2010.  We recorded share-based compensation of $54,000, or approximately $0.22 per share;

· As part of the reorganization, we agreed to issue 683,176 shares of common stock following the initial stock split in exchange for the cancelation of all common stock options and warrants previously outstanding.  The exchange was accounted for as a modification of the options and warrants pursuant to generally accepted accounting principles for share-based compensation, whereby compensation in the amount of $120,800 was recognized for the value of the common stock issued in excess of the value of the options and warrants that were canceled.  The common stock issued was valued at the closing price of approximately $0.22 per share on June 29, 2010 and the value of the warrants and options that were canceled were valued using the Black-Scholes pricing model.  With the approval of the initial 1-for-3 common stock split, the required conditions for the issuance had been met and the common stock was deemed to have been issued as of June 30, 2010; and

· On May 18, 2010, our board of directors approved the grant of options to the Company’s Chief Executive Officer, President, and outside director to acquire an aggregate of seven million shares of common stock at an exercise price of $0.24 per share, subject to the approval of the shareholders of both reverse common stock splits and the approval of the 2010 Stock Option Plan, which approvals were received on June 29, 2010.  The options have a term of ten years and were fully vested at the grant date.  For both the three and six month periods ended June 30, 2010, we reported stock-based compensation related to these stock options of $1,491,700.

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Although the net changes with respect to our revenues and our costs and operating expenses for the three and six months ended June 30, 2011 and 2010, are summarized above, the trends contained therein are limited and should not be viewed as a definitive indication of our future results.

Other Income (Expense)

Change in fair value of derivative liabilities – As more fully discussed in Notes E, G and J to the accompanying condensed consolidated financial statements, we issued unsecured convertible promissory notes commencing in April 2010 which contain a variable conversion price (beneficial conversion feature).  In addition, during the quarter ended June 30, 2011, we issued convertible debentures and warrants that contain full ratchet anti-dilution protection.  These features are treated as embedded derivatives under generally accepted accounting principles and are required to be accounted for at fair value. We have estimated the fair value of the beneficial conversion feature of the unsecured convertible promissory notes based on the intrinsic value of the conversion feature, which equals the difference between the variable conversion price of the notes and the closing price of our common stock on the date of the valuation.  We have estimated the fair value of the conversion feature of the debentures and related warrants using the Lattice model.  The fair value of these derivative liabilities was estimated to be $1,739,373 and $243,376 as of June 30, 2011 and December 31, 2010, respectively. We recognized a gain from the change in fair value of these derivative liabilities of $1,349,520 and $1,312,339 for the three and six months ended June 30, 2011, respectively.  We recognized a loss from the change in fair value of the beneficial conversion feature of $20,192 for both the three and six months ended June 30, 2010.

Effective January 1, 2009 with the adoption of the provisions of new accounting standards for embedded derivatives, warrants to acquire our common stock that were previously treated as equity must be treated as a derivative liability and measured at fair value. These warrants were canceled in June 2010 with the issuance of common stock. We recognized a gain from the change in fair value of these warrants of $9,278 for the three months ended June 30, 2010 and we recognized a loss from the change in fair value of these warrants of $18,156 for the six months ended June 30, 2010.

Interest Expense – We incurred interest expense of $54,785 and $72,522 for the three and six months ended June 30, 2011, respectively, compared to $37,122 and $64,465 for the three and six months ended June 30, 2010, respectively, representing increases of $17,663 and $8,057 for the three and six months ended June 30, 2011, respectively. The increase in interest expense is due to the issuance of new debt commencing in April 2010, offset by the elimination of virtually all interest on the registration rights penalties in June 2010 with the issuance of common stock in settlement of substantially all of the registration rights penalties.

Amortization of deferred financing costs –  In connection with this sale of convertible debentures and warrants, we 1) paid our placement agent a cash payment of $324,000, 2)issued five-year warrants to our placement agent to acquire 1.7 million shares of common stock, and 3) paid $50,000 for legal services.  We determined the fair value of the warrants was $125,688.  Total deferred financing costs recorded for the issuance of convertible debentures was $499,688.  Deferred financing costs are being amortized over the one year term of the debentures using the effective interest method.  During the period from the issuance of the debentures in May 2011 through June 30, 2011, we amortized deferred financing costs of $67,576.

Amortization of discount on convertible debentures and notes and other debt –As more fully discussed in Notes E and G to the accompanying condensed consolidated financial statements, we have issued convertible promissory notes and debentures to several individuals or entities, commencing in April 2010. In each case, the notes have a favorable conversion price in comparison to the market price of our common stock on the date of the issuance of the notes. The fair value of this beneficial conversion feature is measured on the issue date of the notes. Generally, a discount is recorded for this beneficial conversion feature and amortized over the life of the note as a non-cash charge to the statement of operations. We have amortized $113,420 and $267,511 of discount on convertible notes and debentures for the three and six months ended June 30, 2011, respectively, compared to $9,692 for both the three and six months ended June 30, 2010. As of June 30, 2011, there is $51,387 of recorded, but unamortized, discount on the unsecured convertible promissory notes to an unaffiliated entity and $2,299,470 of discount on convertible debentures that will be amortized over the remaining terms of the respective notes or debentures.

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Liquidity and Capital Resources

During the fiscal year ended December 31, 2010 and the six months ended June 30, 2011, our principal sources of liquidity consisted of proceeds from recently issued unsecured convertible promissory notes, convertible debentures, common stock and warrants. During the fiscal year ended December 31, 2010 and the six months ended June 30, 2011, our sources of capital resources were 1) a private placement of convertible debentures in the aggregate amount of $2,550,000, 2) a private placement of convertible promissory notes in the aggregate amount of $298,000, 3) the issuance of four separate unsecured convertible promissory notes totaling $160,000, 4) a private placement of common stock and warrants in the aggregate amount of $255,000, and 5) an issuance of an unsecured note for $15,000.  At June 30, 2011, we had $4,031 in cash. At June 30, 2011, we had a working capital deficit of $2,072,681, as compared to a deficit of $1,177,102 as of December 31, 2010. In addition, we have total stockholders’ equity of $2,886,622 at June 30, 2011, compared to total stockholders’ deficit of $868,965 at December 31, 2010, an increase in the stockholders’ equity of $3,755,587.

Our operations used net cash of $879,471 during the six months ended June 30, 2011 compared to using $224,754 of net cash during the six months ended June 30, 2010.  Net cash used in operating activities during the six months ended June 30, 2011 consisted of our net loss of $3,685,736 less the loss in fair value of derivative liabilities of $1,312,339, the total of which was offset by non-cash expenses of stock-based compensation of $3,573,125, amortization of deferred financing costs and discount on convertible notes of $335,087, depreciation expense of $305, and accretion of asset retirement obligations of $173, and further offset by non-cash changes in working capital and other assets of $209,914.

Investing activities during the six months ended June 30, 2011 included cash paid totaling $1,523,563 toward the acquisition of oil and gas leases under the Montecito Agreement.  We also acquired office equipment with a cost of $2,356.  We had no investing activities during the six months ended June 30, 2010.

Financing activities provided $2,356,000 of net cash during the six months ended June 30, 2011 compared to $229,745 during the six months ended June 30, 2010. Cash flows from financing activities during the six months ended June 30, 2011 relate to 1) proceeds from a private placement of convertible debentures in the aggregate amount of $2,550,000, less issuance costs of $374,000, 2) the receipt of proceeds from the placement of unsecured convertible promissory notes in the amount of $75,000, 3) proceeds of $90,000 from the issuance of common stock and warrants, and 4) proceeds from an unsecured note payable of $15,000.

On October 12, 2010, an unrelated third party acquired the rights of certain of our past-due accounts payable totaling $193,676. We issued promissory notes to this third party in the amount of $193,676 to convert the outstanding accounts payable into promissory notes and then converted the promissory notes into convertible redeemable notes. These notes are due October 12, 2012 and bear interest at 6% per annum commencing October 31, 2010. Interest was payable on or before the due date of the notes and was payable in shares of our common stock, at our option. The holder of the notes is entitled, at its option, to convert all or any portion of the principal of the notes, along with related accrued interest, into shares of our common stock at a conversion price equal to $0.05 per share. On October 18, 2010, the note holder converted $43,676 of principal into 873,522 shares of common stock. During the six months ended June 30, 2011, the remaining $150,000 of principal and $4,219 of accrued interest was converted into 3,084,386 shares of common stock.

On September 7, 2010 we entered into a consulting agreement with Undiscovered Equities. Under the terms of the agreement, the consultant agreed to provide us with one or more financial and strategic business plans. Thereafter, on September 27, 2010, we entered into an agreement with National Securities Corp. to provide investment banking and financial advisory services. Services under these two agreements are being provided to us in connection with the evaluation and due diligence of potential oil and gas property acquisitions.

We are currently seeking debt and equity financing to fund potential acquisitions and other expenditures, although we do not have any contracts or commitments for either at this time. We will have to raise additional funds to continue operations and, while we have been successful in doing so in the past, there can be no assurance that we will be able to do so in the future. Our continuation as a going concern is dependent upon our ability to obtain necessary additional funds to continue operations and the attainment of profitable operations.

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May 2011 Financing

In May 2011, we completed the Financing which generated aggregate cash gross proceeds of $2,450,000 and the conversion of $100,000 in prior debt. The proceeds were raised through the sale of the Bridge Notes and Bridge Warrants.

The Bridge Notes mature in May 2012 and bear interest at 9% per annum and are convertible at the holder’s option at any time into Common Stock at a conversion price of $0.15 per share. The Bridge Notes will automatically be redeemed with a 30% premium upon a Change of Control or Listing Event (each as defined in the Note). Interest on the Bridge Notes is payable quarterly in arrears in cash. The Bridge Notes contain full ratchet anti-dilution protection. In addition the conversion price shall be adjusted if the conversion price of securities in a subsequent offering by us is adjusted pursuant to a make good provision. The shares of Common Stock issuable upon conversion of the Note are entitled to piggyback registration rights.  As of August 15, 2011, we are in default under the Bridge Notes because we have not made the interest payment that was due on July 1, 2011 in the aggregate amount of $34,669.63.

The Bridge Warrants are exercisable for a period of five years at an exercise price of $0.30 per share. The Bridge Warrants will be exercisable on a cashless basis at any time six months after issuance if there is not an effective registration statement registering for resale the shares issuable upon exercise of the Bridge Warrants. The shares of Common Stock issuable upon exercise of the Bridge Warrants are entitled to piggyback registration rights.

Pursuant to the Bridge Notes and Bridge Warrants, no holder may convert or exercise such holder’s Note or Bridge Warrant if such conversion or exercise would result in the holder beneficially owning in excess of 4.99% of our then issued and outstanding common stock. A holder may, however, increase or decrease this limitation (but in no event exceed 9.99% of the number of shares of Common Stock issued and outstanding) by providing the Company with 61 days’ notice that such holder wishes to increase or decrease this limitation.

Pursuant to the Security Agreement, between ourselves and the investors, we granted the investors a first priority lien on all assets acquired from Montecito pursuant to the Montecito Agreement.

Critical Accounting Policies

We have identified the policies outlined below as critical to our business operations and an understanding of our results of operations.  The list is not intended to be a comprehensive list of all of our accounting policies.  In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management's judgment in their application.  The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis or Plan of Operations where such policies affect our reported and expected financial results.  For a detailed discussion on the application of these and other accounting policies, see the Notes to the December 31, 2010 Financial Statements filed in our Annual Report on Form 10-K with the U.S. Securities and Exchange Commission on April 1, 2011.  Note that our preparation of the financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period.  There can be no assurance that actual results will not differ from those estimates.

Stock-based Compensation

We calculate the fair value of all share-based payments to employees and non-employee directors, including grants of stock options and stock awards and amortize these fair values to share-based compensation in the statement of operations over the respective vesting periods of the underlying awards.  Share-based compensation related to stock options is computed using the Black-Scholes option pricing model.  We estimate the fair value of stock option awards using assumptions about volatility, expected life of the awards, risk-free interest rate, and dividend yield rate. The expected volatility in this model is based on the historical volatility of our common stock. The risk-free interest rate is based on the U.S. Treasury constant maturities rate for the expected life of the related options. The expected life of the options granted is equal to the average of the vesting period and the term of the option, as allowed for under the simplified method prescribed by Staff Accounting Bulletin 107.  The expected dividend rate takes into account the absence of any historical payments and management’s intention to retain all earnings for future operations and expansion.  We estimate the fair value of restricted stock awards based upon the closing market price of our common stock at the date of grant. We charge the fair value of non-restricted awards to share-based compensation upon grant.

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We account for equity instruments issued in exchange for the receipt of goods or services from other than employees and non-employee directors in accordance with ASC 505-50, Equity-Based Payments to Non-Employees.  Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable.  The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services.  The fair value of the equity instrument is charged directly to share-based compensation expense and credited to paid-in capital.

Convertible Debt and Derivative Accounting

For convertible debt that is issued with a beneficial conversion feature, we perform an allocation of the proceeds of the convertible note between the principal amount of the note and the fair value of the beneficial conversion feature.  The fair value of the beneficial conversion feature is recorded as a discount to the principal amount of the note, but not in excess of the principal amount of the note.  The discount is amortized over the period from the issuance date to the maturity date or the date of conversion, whichever occurs earlier, as a non-cash charge to the statement of operations.  Upon the issuance of the note, an assessment is made of the beneficial conversion feature to determine whether the beneficial conversion feature should be accounted for as equity or liability.  In the case of a variable conversion price, the feature is accounted for as a derivative liability and carried at fair value on the balance sheet.  The fair value of the derivative liability is remeasured each reporting period and the change in fair value to recorded in the statement of operations.

For convertible debentures and various warrants which contain full ratchet anti-dilution protection, we have determined that the convertible debentures and warrants are subject to derivative liability treatment and are required to be accounted for at their fair value.  We estimated the fair value of the conversion feature and the warrants using the Lattice model. Accordingly, the fair value of the conversion feature and warrants as determined using the Lattice model is affected by our stock price on the date of issuance as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the debentures and warrants, actual and projected redemptions and conversion price resets.  Expected volatility is based primarily on the historical volatility of other comparable oil and gas companies.

Revenue Recognition

All revenues are derived from the sale of produced crude oil and natural gas.  Revenue and related production taxes and lease operating expenses are recorded in the month the product is delivered to the purchaser.  Payment for the revenue, net of related taxes and lease operating expenses, is received from the operator of the well approximately 45 days after the month of delivery.  Accounts receivable are stated at the amount management expects to collect.  Management provides for probable uncollectible amounts through a charge to earnings and a credit to an allowance based on its assessment of the collectability of the receivable.  At June 30, 2011 and 2010, no allowance for doubtful accounts was deemed necessary.

Income Taxes

Provisions for income taxes are based on taxes payable or refundable and deferred taxes.  Deferred taxes are provided on differences between the tax bases of assets and liabilities and their reported amounts in the financial statements and tax operating loss carryforwards.  Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

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Impairment of Long-Lived Assets

Long-lived assets, including oil and gas properties, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.  Recoverability is measured by a comparison of the carrying amount of an asset or asset group to estimated future undiscounted net cash flows of the related asset or group of assets over their remaining lives.  If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized for the amount by which the carrying amount exceeds the estimated fair value of the asset.  Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent of other groups of assets.  The impairment of long-lived assets requires judgments and estimates.  If circumstances change, such estimates could also change.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

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ITEM 4.  CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of June 30, 2011. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as a result of the material weaknesses described below, our disclosure controls and procedures are not designed at a reasonable assurance level and are ineffective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is not accumulated nor communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. The material weaknesses, which relate to internal control over financial reporting, that were identified are: 

a) We did not have sufficient personnel in our accounting and financial reporting functions.  As a result, we were not able to achieve adequate segregation of duties and were not able to provide for adequate review of the financial statements. This control deficiency, which is pervasive in nature, results in a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis;

b)  We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of U.S. generally accepted accounting principles (“U.S. GAAP”) commensurate with our complexity and our financial accounting and reporting requirements. This control deficiency is pervasive in nature. Further, there is a reasonable possibility that material misstatements of the financial statements including disclosures will not be prevented or detected on a timely basis as a result; and

c) We lack a system to administratively review, audit or verify the reporting by Bayshore of revenues and expenditures in connection with the oil and gas properties on which we conduct activities.  Similarly, we have not obtained units of production or similar third-party purchaser confirmation of the details of our oil and gas production.  There is a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis without the ability to independently review and verify the results of our revenue and expenses related to our operations.

The material weaknesses identified did not result in the restatement of any previously reported financial statements or any other related financial disclosure, and management does not believe that the material weaknesses had any effect on the accuracy of our financial statements for the current reporting period.

We are committed to improving our financial organization. As part of this commitment, we will create a segregation of duties consistent with control objectives and will look to increase our personnel resources and technical accounting expertise within the accounting function by the end of fiscal 2011 to resolve non-routine or complex accounting matters. In addition, when funds are available to us, which we expect to occur by the end of fiscal 2011, we will take the following action to enhance our internal controls: Hiring additional knowledgeable personnel with technical accounting expertise to further support our current accounting personnel, which management estimates will cost approximately $75,000 per annum. We have in the past, and will continue to engage outside consultants in the future as necessary in order to ensure proper treatment of non-routine or complex accounting matters.  In addition, management is working to establish a system to administratively review, audit or verify the reporting by Bayshore of revenues and expenditures in connection with the oil and gas properties on which we conduct activities.

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Management believes that hiring additional knowledgeable personnel with technical accounting expertise will remedy the following material weaknesses: (A) lack of sufficient personnel in our accounting and financial reporting functions to achieve adequate segregation of duties; and (B) insufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of US GAAP commensurate with our complexity and our financial accounting and reporting requirements. 

Management believes that the hiring of additional personnel who have the technical expertise and knowledge with the non-routine or technical issues we have encountered in the past will result in both proper recording of these transactions and a much more knowledgeable finance department as a whole. Due to the fact that our accounting staff consists of a Chief Financial Officer working with other members of management, additional personnel will also ensure the proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide the cross training needed to support us if personnel turnover issues within the department occur. We believe this will greatly decrease any control and procedure issues we may encounter in the future.

We will continue to monitor and evaluate the effectiveness of our disclosure controls and procedures and our internal controls over financial reporting on an ongoing basis and are committed to taking further action and implementing additional enhancements or improvements, as necessary and as funds allow.

Changes in internal control over financial reporting.

We regularly review our system of internal control over financial reporting and make changes to our processes and systems to improve controls and increase efficiency, while ensuring that we maintain an effective internal control environment. Changes may include such activities as implementing new, more efficient systems, consolidating activities, and migrating processes.

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition or operating results.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On May 5, 2011, we issued 200,000 shares of common stock to our law firm for services rendered.  The securities were issued in a transaction pursuant to Section 4(2) under the Securities Act of 1933, as amended.

On May 6, 2011, we issued 15,000,000 shares of common stock to an entity controlled by Robert Smith, our President, in connection with the acquisition of VM 179.  The securities were issued in a transaction pursuant to Section 4(2) and/or Regulation D under the Securities Act of 1933, as amended.

On May 18, 2011, we issued 5,077 shares of common stock to an accredited investor upon the conversion of accrued interest of $259.  The securities were issued in a transaction pursuant to Regulation D under the Securities Act of 1933, as amended.

On May 25, 2011, we issued 685,603 shares of common stock to two accredited investors upon the conversion of $32,500 in outstanding convertible promissory notes and accrued interest of $2,466. The securities were issued in a transaction pursuant to Regulation D under the Securities Act of 1933, as amended.

On May 26, 2011, we issued 6,430 shares of common stock to an accredited investor upon the conversion of accrued interest of $328.  The securities were issued in a transaction pursuant to Regulation D under the Securities Act of 1933, as amended.

On June 6, 2011, we issued 15 million shares of common stock to Charles Volk, our Chief Executive Officer and 750,000 shares of common stock to James Burden, our President, as a bonus for services rendered to our company. The securities were issued in a transaction pursuant to Section 4(2) under the Securities Act of 1933, as amended.

On June 7, 2011, we issued 1,067,825 shares of common stock to four accredited investors upon the conversion of $50,000 in outstanding convertible promissory notes and accrued interest of $4,459. The securities were issued in a transaction pursuant to Regulation D under the Securities Act of 1933, as amended.

On June 24, 2011, we issued 192,000 shares of common stock to an accredited investor upon the conversion of $12,000 in outstanding convertible promissory notes.  The securities were issued in a transaction pursuant to Regulation D under the Securities Act of 1933, as amended.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

On September 3, 2008, we issued $300,000 of secured promissory notes to six individuals, two of whom are related parties.  All of these promissory notes bear interest at 12% per annum, with interest payable monthly.  The promissory notes were originally due on September 1, 2009 and are secured by all of our assets.  With the change in management control in March 2010, accrued interest on these notes was paid through January 31, 2010 and the due dates of the promissory notes were extended to August 31, 2010.  The notes came due on August 31, 2010 and have not been paid.  Both the non-payment of interest and our failure to repay the notes when they matured constitute events of default under the notes.  As a result of the event of default, the noteholders have the right to exercise their rights under the security agreement associated with the notes.  These rights include, among other things, the right to foreclose on the collateral.  We are currently negotiating with our secured lenders for an extension or other resolution.  We can provide no assurance that we will obtain an extension or other resolution, or that the secured creditors will not eventually foreclose if not paid in the near term.

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In May 2011, we completed the Financing which generated aggregate cash gross proceeds of $2,450,000 and the conversion of $100,000 in prior debt. The proceeds were raised through the sale of the Bridge Notes and Bridge Warrants.  The Bridge Notes mature in May 2012, and bear interest at 9% per annum and are convertible at the holder’s option at any time into Common Stock at a conversion price of $0.15 per share. The Bridge Notes will automatically be redeemed with a 30% premium upon a Change of Control or Listing Event (each as defined in the Note). Interest on the Bridge Notes is payable quarterly in arrears in cash. The Bridge Notes contain full ratchet anti-dilution protection. In addition the conversion price shall be adjusted if the conversion price of securities in a subsequent offering by us is adjusted pursuant to a make good provision. The shares of Common Stock issuable upon conversion of the Note are entitled to piggyback registration rights.  As of August 15, 2011, we are in default under the Bridge Notes because we have not made the interest payment that was due on July 1, 2011 in the aggregate amount of $34,669.63.

ITEM 5.  OTHER INFORMATION

(a) Form 8-K Information

Asher Financing I

On February 7, 2011, the Company entered into a Securities Purchase Agreement with Asher Enterprises, Inc., an accredited investor (“Asher”), providing for the sale by the Company to Asher of an 8% convertible debenture in the principal amount of $35,000 (the “Asher I Debenture”).

The Asher I Debenture matures on November 9, 2011 (the “Asher I Maturity Date”) and bears interest at the annual rate of 8%.  The Company is not required to make any payments until the Asher I Maturity Date.

Asher is permitted to convert, at any time, the outstanding principal and accrued interest on the Asher I Debenture into shares of the Company’s common stock (“Common Stock”) at a conversion price per share equal to fifty percent (50%) of the average of the three (3) lowest closing bid prices of the Common Stock during the 10 trading days immediately preceding the conversion date.

Asher agreed to restrict its ability to convert the Asher I Debenture and receive shares of the Company’s Common Stock such that the number of shares of Common Stock held by Asher in the aggregate and its affiliates after such conversion or exercise does not exceed 4.99% of the then issued and outstanding shares of the Company’s Common Stock.

Asher Financing II

On April 5, 2011, the Company entered into a Securities Purchase Agreement with Asher, providing for the sale by the Company to Asher of an 8% convertible debenture in the principal amount of $40,000 (the “Asher II Debenture”).

The Asher II Debenture matures on January 9, 2012 (the “Asher II Maturity Date”) and bears interest at the annual rate of 8%.  The Company is not required to make any payments until the Asher II Maturity Date.

Asher may convert, at any time, the outstanding principal and accrued interest on the Asher II Debenture into shares of Common Stock at a conversion price per share equal to fifty percent (50%) of the average of the three (3) lowest closing bid prices of the Common Stock during the 10 trading days immediately preceding the conversion date.

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Asher agreed to restrict its ability to convert the Asher II Debenture and receive shares of the Company’s Common Stock such that the number of shares of Common Stock held by Asher in the aggregate and its affiliates after such conversion or exercise does not exceed 4.99% of the then issued and outstanding shares of the Company’s Common Stock.

Default on Bridge Notes

In May 2011, the Company completed a private placement of the issuance of $2,550,000 principal amount of secured convertible debentures (the “Bridge Notes”).  The Bridge Notes mature on May 5, 2012 and bear interest at 9% per annum and are convertible at the holder’s option at any time into Common Stock at a conversion price of $0.15 per share.  Interest on the Bridge Notes is payable quarterly in arrears in cash, with the first payment required on July 1, 2011.  In addition, the Bridge Note holders were granted a security interest in the form of a Mineral Mortgage whereby the Bridge Note holders secured a first priority lien on all assets the Company acquired from Montecito Offshore, L.L.C. (“Montecito”) pursuant to the Asset Sale Agreement with Montecito.

The Company is in default under the Bridge Notes because it has not made the interest payment in the aggregate amount of $34,669.63 that was due on July 1, 2011.  As a result of the default, the Bridge Note holders may force us into a foreclosure proceeding pursuant to which the assets could be sold in order to satisfy the amounts due. We are currently negotiating with the holders of the Bridge Notes to either extend the maturity date of the Bridge Notes or provide a waiver.  There can be no assurances that an agreement will be reach on terms acceptable to us, if at all.

Resignation of Stephen Spalding

Effective July 18, 2011, Stephen Spalding resigned as the Chief Financial Officer of the Company. Mr. Spalding’s decision to resign did not arise or result from any disagreement with the Company on any matters relating to the Company’s operations, policies or practices.

(b) Director Nomination Procedures

We do not have a standing nominating committee nor are we required to have one. We do not have any established procedures by which security holders may recommend nominees to our Board of Directors, however, any suggestions on directors, and discussions of board nominees in general, is handled by the entire Board of Directors.

ITEM 6.  EXHIBITS

10.01	Securities Purchase Agreement, dated as of February 7, 2011, by and between Paxton Energy, Inc. and Asher Enterprises, Inc.
10.02	Form of Convertible Promissory Note, issued February 7, 2011
10.03	Securities Purchase Agreement, dated as of April 5, 2011, by and between Paxton Energy, Inc. and Asher Enterprises, Inc.
10.04	Form of Convertible Promissory Note, issued April 5, 2011
10.05	Amended and Restated 2010 Incentive Stock Option Plan
31.01	Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.02	Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.01	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	PAXTON ENERGY, INC.
Date:  August 15, 2011	By:	/s/ CHARLES F. VOLK, JR.
		Charles F. Volk, Jr. Chief Executive Officer (Principal Executive Officer, Principal Financial Officer and Principal Accounting Officer)

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EX-10.01

Exhibit 10.01

Exhibit 10.01 is filed by pdf reference.

EX-10.02

Exhibit 10.02

EX-10.03

    ex10-03.htm
    
    
    

EX-10.04

    ex10-04.htm
    
    
    

EX-10.05

Exhibit 10.05

a Nevada corporation

PAXTON ENERGY, INC.

AMENDED AND RESTATED

2010 INCENTIVE STOCK OPTION PLAN

The Paxton Energy, Inc. 2010 Incentive Stock Option Plan (the “Plan”) was adopted by the Board of Directors on May 18, 2010 and was approved by the Stockholders of the Company on June 29, 2010, and in order to provide greater flexibility to retain and to attract directors, executives and selected employees and consultants and reward them for making major contributions to the success of the Company, the Board of Directors, by action effective June 3, 2011, amended and restated in its entirety the provisions of the Plan, as set forth hereafter.  The objectives set forth above are accomplished by making long-term incentive awards under the Plan thereby providing Participants with a proprietary interest in the growth and performance of the Company.  The Paxton Energy, Inc. 2010 Incentive Stock Option Plan is hereby amended and restated as follows:

1. Definitions.

(a) "Board" - The Board of Directors of the Company.

(b) "Code" - The Internal Revenue Code of 1986, as amended from time to time.

(c) "Committee" - The Compensation Committee of the Company's Board, or such other committee of the Board that is designated by the Board to administer the Plan, composed of not less than two members of the Board all of whom are disinterested persons, as contemplated by Rule 16b-3 ("Rule 16b-3") promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act").

(d) "Company" – Paxton Energy, Inc. and its subsidiaries including subsidiaries of subsidiaries.

(e) "ExchangeAct" - The Securities Exchange Act of 1934, as amended from time to time.

(f) "Fair Market Value" - The fair market value of the Company's issued and outstanding Stock as determined in good faith by the Board or Committee.

(g) "Grant" - The grant of any form of stock option, stock award, or stock purchase offer, whether granted singly, in combination or in tandem, to a Participant pursuant to such terms, conditions and limitations as the Committee may establish in order to fulfill the objectives of the Plan.

(h) "Grant Agreement" - An agreement between the Company and a Participant that sets forth the terms, conditions and limitations applicable to a Grant.

(i)  "Option" - Either an Incentive Stock Option, in accordance with Section 422 of Code, or a Nonstatutory Option, to purchase the Company's Stock that may be awarded to a Participant under the Plan. A Participant who receives an award of an Option shall be referred to as an "Optionee."

(j) "Participant" - A director, officer, employee or consultant of the Company to whom an Award has been made under the Plan.

(k) "Restricted Stock Purchase Offer" - A Grant of the right to purchase a specified number of shares of Stock pursuant to a written agreement issued under the Plan.

(l) "Securities Act" - The Securities Act of 1933, as amended from time to time.

(m) "Stock" - Authorized and issued or unissued shares of common stock of the Company.

(n) "Stock Award" - A Grant made under the Plan in stock or denominated in units of stock for which the Participant is not obligated to pay additional consideration.

2. Administration. The Plan shall be administered by the Board, provided however, that the Board may delegate such administration to the Committee. Subject to the provisions of the Plan, the Board and/or the Committee shall have authority to (a) grant, in its discretion, Incentive Stock Options in accordance with Section 422 of the Code, or Nonstatutory Options, Stock Awards or Restricted Stock Purchase Offers; (b) determine in good faith the fair market value of the Stock covered by any Grant; (c) determine which eligible persons shall receive Grants and the number of shares, restrictions, terms and conditions to be included in such Grants; (d) construe and interpret the Plan; (e) promulgate, amend and rescind rules and regulations relating to its administration, and correct defects, omissions and inconsistencies in the Plan or any Grant; (f) consistent with the Plan and with the consent of the Participant, as appropriate, amend any outstanding Grant or amend the exercise date or dates thereof; (g) determine the duration and purpose of leaves of absence which may be granted to Participants without constituting termination of their employment for the purpose of the Plan or any Grant; and (h) make all other determinations necessary or advisable for the Plan's administration. The interpretation and construction by the Board of any provisions of the Plan or selection of Participants shall be conclusive and final. No member of the Board or the Committee shall be liable for any action or determination made in good faith with respect to the Plan or any Grant made thereunder.

3. Eligibility.

(a) General:  The persons who shall be eligible to receive Grants shall be directors, officers, employees or consultants to the Company. The term consultant shall mean any person, other than an employee, who is engaged by the Company to render services and is compensated for such services. An Optionee may hold more than one Option. Any issuance of a Grant to an officer or director of the Company subsequent to the first registration of any of the securities of the Company under the Exchange Act shall comply with the requirements of Rule 16b-3.

(b) Incentive Stock Options:  Incentive Stock Options may only be issued to employees of the Company. Incentive Stock Options may be granted to officers or directors, provided they are also employees of the Company. Payment of a director's fee shall not be sufficient to constitute employment by the Company.

The Company shall not grant an Incentive Stock Option under the Plan to any employee if such Grant would result in such employee holding the right to exercise for the first time in any one calendar year, under all Incentive Stock Options granted under the Plan or any other plan maintained by the Company, with respect to shares of Stock having an aggregate fair market value, determined as of the date of the Option is granted, in excess of $100,000. Should it be determined that an Incentive Stock Option granted under the Plan exceeds such maximum for any reason other than a failure in good faith to value the Stock subject to such option, the excess portion of such option shall be considered a Nonstatutory Option. To the extent the employee holds two (2) or more such Options which become exercisable for the first time in the same calendar year, the foregoing limitation on the exercisability of such Option as Incentive Stock Options under the Federal tax laws shall be applied on the basis of the order in which such Options are granted. If, for any reason, an entire Option does not qualify as an Incentive Stock Option by reason of exceeding such maximum, such Option shall be considered a Nonstatutory Option.

(c) Nonstatutory Option:  The provisions of the foregoing Section 3(b) shall not apply to any Option designated as a "Nonstatutory Option" or which sets forth the intention of the parties that the Option be a Nonstatutory Option.

(d) Stock Awards and Restricted Stock Purchase Offers:  The provisions of this Section 3 shall not apply to any Stock Award or Restricted Stock Purchase Offer under the Plan.

4. Stock.

(a) Authorized Stock: Stock subject to Grants may be either unissued or reacquired Stock.

(b) Number of Shares:  Subject to adjustment as provided in Section 5(i) of the Plan, the total number of shares of Stock which may be purchased or granted directly by Options, Stock Awards or Restricted Stock Purchase Offers, or purchased indirectly through exercise of Options granted under the Plan shall not exceed Thirty-Five Million (35,000,000).  If any Grant shall for any reason terminate or expire, any shares allocated thereto but remaining unpurchased upon such expiration or termination shall again be available for Grants with respect thereto under the Plan as though no Grant had previously occurred with respect to such shares. Any shares of Stock issued pursuant to a Grant and repurchased pursuant to the terms thereof shall be available for future Grants as though not previously covered by a Grant.

(c) Reservation of Shares:  The Company shall reserve and keep available at all times during the term of the Plan such number of shares as shall be sufficient to satisfy the requirements of the Plan. If, after reasonable efforts, which efforts shall not include the registration of the Plan or Grants under the Securities Act, the Company is unable to obtain authority from any applicable regulatory body, which authorization is deemed necessary by legal counsel for the Company for the lawful issuance of shares hereunder, the Company shall be relieved of any liability with respect to its failure to issue and sell the shares for which such requisite authority was so deemed necessary unless and until such authority is obtained.

(d) The proceeds received by the Company from the sale of Stock pursuant to the exercise of Options or rights under Stock Purchase Agreements will be used for general corporate purposes.

5. Terms and Conditions of Options. Options granted hereunder shall be evidenced by agreements between the Company and the respective Optionees, in such form and substance as the Board or Committee shall from time to time approve. The form of Incentive Stock Option Agreement attached hereto as Exhibit A and the three forms of a Nonstatutory Stock Option Agreement for employees, for directors and for consultants, attached hereto as Exhibit B-1, Exhibit B-2 and Exhibit B-3, respectively, shall be deemed to be approved by the Board. Option agreements need not be identical, and in each case may include such provisions as the Board or Committee may determine, but all such agreements shall be subject to and limited by the following terms and conditions:

(a) Number of Shares: Each Option shall state the number of shares to which it pertains.

(b) Exercise Price: Each Option shall state the exercise price, which shall be determined as follows:

(i) Any Incentive Stock Option granted to a person who at the time the Option is granted owns (or is deemed to own pursuant to Section 424(d) of the Code) stock possessing more than ten percent (10%) of the total combined voting power or value of all classes of stock of the Company ("Ten Percent Holder") shall have an exercise price of no less than 110% of the Fair Market Value of the Stock as of the date of grant; and

(ii) Incentive Stock Options granted to a person who at the time the Option is granted is not a Ten Percent Holder shall have an exercise price of no less than 100% of the Fair Market Value of the Stock as of the date of grant.

For the purposes of this Section 5(b), the Fair Market Value shall be as determined by the Board in good faith, which determination shall be conclusive and binding; provided however, that if there is a public market for such Stock, the Fair Market Value per share shall be the average of the bid and asked prices (or the closing price if such stock is listed on the NASDAQ National Market System or Small Cap Issue Market) on the date of grant of the Option, or if listed on a stock exchange, the closing price on such exchange on such date of grant.

(c)  Medium and Time of Payment:  The exercise price shall become immediately due upon exercise of the Option and shall be paid in cash or check made payable to the Company. Should the Company's outstanding Stock be registered under Section 12(g) of the Exchange Act at the time the Option is exercised, then the exercise price may also be paid as follows:

(i) in shares of Stock held by the Optionee for the requisite period necessary to avoid a charge to the Company's earnings for financial reporting purposes and valued at Fair Market Value on the exercise date, or

(ii) through a special sale and remittance procedure pursuant to which the Optionee shall concurrently provide irrevocable written instructions (a) to a Company designated brokerage firm to effect the immediate sale of the purchased shares and remit to the Company, out of the sale proceeds available on the settlement date, sufficient funds to cover the aggregate exercise price payable for the purchased shares plus all applicable Federal, state and local income and employment taxes required to be withheld by the Company by reason of such purchase and (b) to the Company to deliver the certificates for the purchased shares directly to such brokerage firm in order to complete the sale transaction.

At the discretion of the Board, exercisable either at the time of Option grant or of Option exercise, the exercise price may also be paid (i) by Optionee's delivery of a promissory note in form and substance satisfactory to the Company and permissible under applicable law and bearing interest at a rate determined by the Board in its sole discretion, but in no event less than the minimum rate of interest required to avoid the imputation of compensation income to the Optionee under the Federal tax laws, or (ii) in such other form of consideration permitted by Nevada law as may be acceptable to the Board.

(d) Term and Exercise of Options:  Any Option granted to an employee of the Company shall become immediately exercisable unless the Board shall specifically determine otherwise, as provided herein. In no event shall any Option be exercisable after the expiration of ten (10) years from the date it is granted, and no Incentive Stock Option granted to a Ten Percent Holder shall, by its terms, be exercisable after the expiration of five (5) years from the date of the Option. Unless otherwise specified by the Board or the Committee in the resolution authorizing such Option, the date of grant of an Option shall be deemed to be the date upon which the Board or the Committee authorizes the granting of such Option.

Each Option shall be exercisable to the nearest whole share, in installments or otherwise, as the respective Option agreements may provide. During the lifetime of an Optionee, the Option shall be exercisable only by the Optionee and shall not be assignable or transferable by the Optionee, and no other person shall acquire any rights therein. To the extent not exercised, installments (if more than one) shall accumulate, but shall be exercisable, in whole or in part, only during the period for exercise as stated in the Option agreement, whether or not other installments are then exercisable.

(e) Termination of Status as Employee, Consultant or Director:  If Optionee's status as an employee shall terminate for any reason other than Optionee's disability or death, then Optionee (or if the Optionee shall die after such termination, but prior to exercise, Optionee's personal representative or the person entitled to succeed to the Option) shall have the right to exercise the portions of any of Optionee's Incentive Stock Options which were exercisable as of the date of such termination, in whole or in part, not less than 30 days nor more than three (3) months after such termination (or, in the event of "termination for good cause" as that term is defined in Nevada case law related thereto, or by the terms of the Plan or the Option Agreement or an employment agreement, the Option shall automatically terminate as of the termination of employment as to all shares covered by the Option).

With respect to Nonstatutory Options granted to employees, directors or consultants, the Board may specify such period for exercise, not less than 30 days (except that in the case of "termination for cause" or removal of a director, the Option shall automatically terminate as of the termination of employment or services as to shares covered by the Option, following termination of employment or services as the Board deems reasonable and appropriate. The Option may be exercised only with respect to installments that the Optionee could have exercised at the date of termination of employment or services. Nothing contained herein or in any Option granted pursuant hereto shall be construed to affect or restrict in any way the right of the Company to terminate the employment or services of an Optionee with or without cause.

(f) Disability of Optionee:  If an Optionee is disabled (within the meaning of Section 22(e)(3) of the Code) at the time of termination, the three (3) month period set forth in Section 5(e) shall be a period, as determined by the Board and set forth in the Option, of not less than six months nor more than one year after such termination.

(g) Death of Optionee:  If an Optionee dies while employed by, engaged as a consultant to, or serving as a Director of the Company, the portion of such Optionee's Option which was exercisable at the date of death may be exercised, in whole or in part, by the estate of the decedent or by a person succeeding to the right to exercise such Option at any time within (i) a period, as determined by the Board and set forth in the Option, of not less than six (6) months nor more than one (1) year after Optionee's death, which period shall not be more, in the case of a Nonstatutory Option, than the period for exercise following termination of employment or services, or (ii) during the remaining term of the Option, whichever is the lesser. The Option may be so exercised only with respect to installments exercisable at the time of Optionee's death and not previously exercised by the Optionee.

(h) Nontransferability of Option:  No Option shall be transferable by the Optionee, except by will or by the laws of descent and distribution.

(i) Recapitalization:  Subject to any required action of shareholders, the number of shares of Stock covered by each outstanding Option, and the exercise price per share thereof set forth in each such Option, shall be proportionately adjusted for any increase or decrease in the number of issued shares of Stock of the Company resulting from a stock split, stock dividend, combination, subdivision or reclassification of shares, or the payment of a stock dividend, or any other increase or decrease in the number of such shares affected without receipt of consideration by the Company; provided, however, the conversion of any convertible securities of the Company shall not be deemed to have been "effected without receipt of consideration" by the Company.

In the event of a proposed dissolution or liquidation of the Company, a merger or consolidation in which the Company is not the surviving entity, or a sale of all or substantially all of the assets or capital stock of the Company (collectively, a "Reorganization"), unless otherwise provided by the Board, this Option shall terminate immediately prior to such date as is determined by the Board, which date shall be no later than the consummation of such Reorganization.  In such event, if the entity which shall be the surviving entity does not tender to Optionee an offer, for which it has no obligation to do so, to substitute for any unexercised Option a stock option or capital stock of such surviving of such surviving entity, as applicable, which on an equitable basis shall provide the Optionee with substantially the same economic benefit as such unexercised Option, then the Board may grant to such Optionee, in its sole and absolute discretion and without obligation, the right for a period commencing thirty (30) days prior to and ending immediately prior to the date determined by the Board pursuant hereto for termination of the Option or during the remaining term of the Option, whichever is the lesser, to exercise any unexpired Option or Options without regard to the installment provisions of Paragraph 6(d) of the Plan; provided, that any such right granted shall be granted to all Optionees not receiving an offer to receive substitute options on a consistent basis, and provided further, that any such exercise shall be subject to the consummation of such Reorganization.

Subject to any required action of shareholders, if the Company shall be the surviving entity in any merger or consolidation, each outstanding Option thereafter shall pertain to and apply to the securities to which a holder of shares of Stock equal to the shares subject to the Option would have been entitled by reason of such merger or consolidation.

In the event of a change in the Stock of the Company as presently constituted, which is limited to a change of all of its authorized shares without par value into the same number of shares with a par value, the shares resulting from any such change shall be deemed to be the Stock within the meaning of the Plan.

To the extent that the foregoing adjustments relate to stock or securities of the Company, such adjustments shall be made by the Board, whose determination in that respect shall be final, binding and conclusive. Except as expressly provided in this Section 5(i), the Optionee shall have no rights by reason of any subdivision or consolidation of shares of stock of any class or the payment of any stock dividend or any other increase or decrease in the number of shares of stock of any class, and the number or price of shares of Stock subject to any Option shall not be affected by, and no adjustment shall be made by reason of, any dissolution, liquidation, merger, consolidation or sale of assets or capital stock, or any issue by the Company of shares of stock of any class or securities convertible into shares of stock of any class.

The Grant of an Option pursuant to the Plan shall not affect in any way the right or power of the Company to make any adjustments, reclassifications, reorganizations or changes in its capital or business structure or to merge, consolidate, dissolve, or liquidate or to sell or transfer all or any part of its business or assets.

(j) Rights as a Shareholder:  An Optionee shall have no rights as a shareholder with respect to any shares covered by an Option until the effective date of the issuance of the shares following exercise of such Option by Optionee. No adjustment shall be made for dividends (ordinary or extraordinary, whether in cash, securities or other property) or distributions or other rights for which the record date is prior to the date such stock certificate is issued, except as expressly provided in Section 5(i) hereof.

(k) Modification, Acceleration, Extension, and Renewal of Options:  Subject to the terms and conditions and within the limitations of the Plan, the Board may modify an Option, or, once an Option is exercisable, accelerate the rate at which it may be exercised, and may extend or renew outstanding Options granted under the Plan or accept the surrender of outstanding Options (to the extent not theretofore exercised) and authorize the granting of new Options in substitution for such Options, provided such action is permissible under Section 422 of the Code and applicable securities laws.  Notwithstanding the provisions of this Section 5(k), however, no modification of an Option shall, without the consent of the Optionee, alter to the Optionee's detriment or impair any rights or obligations under any Option theretofore granted under the Plan.

(l) Exercise Before Exercise Date:  At the discretion of the Board, the Option may, but need not, include a provision whereby the Optionee may elect to exercise all or any portion of the Option prior to the stated exercise date of the Option or any installment thereof. Any shares so purchased prior to the stated exercise date shall be subject to repurchase by the Company upon termination of Optionee's employment as contemplated by Section 5(n) hereof prior to the exercise date stated in the Option and such other restrictions and conditions as the Board or Committee may deem advisable.

(m) Other Provisions:  The Option agreements authorized under the Plan shall contain such other provisions, including, without limitation, restrictions upon the exercise of the Options, as the Board or the Committee shall deem advisable. Shares shall not be issued pursuant to the exercise of an Option, if the exercise of such Option or the issuance of shares thereunder would violate, in the opinion of legal counsel for the Company, the provisions of any applicable law or the rules or regulations of any applicable governmental or administrative agency or body, such as the Code, the Securities Act, the Exchange Act, Nevada law, and the rules promulgated under the foregoing or the rules and regulations of any exchange upon which the shares of the Company are listed. Without limiting the generality of the foregoing, the exercise of each Option shall be subject to the condition that if at any time the Company shall determine that (i) the satisfaction of withholding tax or other similar liabilities, or (ii) the listing, registration or qualification of any shares covered by such exercise upon any securities exchange or under any state or federal law, or (iii) the consent or approval of any regulatory body, or (iv) the perfection of any exemption from any such withholding, listing, registration, qualification, consent or approval is necessary or desirable in connection with such exercise or the issuance of shares thereunder, then in any such event, such exercise shall not be effective unless such withholding, listing registration, qualification, consent, approval or exemption shall have been effected, obtained or perfected free of any conditions not acceptable to the Company.

(n) Repurchase Agreement:  The Board may, in its discretion, require as a condition to the Grant of an Option hereunder, that an Optionee execute an agreement with the Company, in form and substance satisfactory to the Board in its discretion ("Repurchase Agreement"), (i) restricting the Optionee's right to transfer shares purchased under such Option without first offering such shares to the Company or another shareholder of the Company upon the same terms and conditions as provided therein; and (ii) providing that upon termination of Optionee's employment with the Company, for any reason, the Company (or another shareholder of the Company, as provided in the Repurchase Agreement) shall have the right at its discretion (or the discretion of such other shareholders) to purchase and/or redeem all such shares owned by the Optionee on the date of termination of his or her employment at a price equal to: (A) the fair value of such shares as of such date of termination; or (B) if such repurchase right lapses at 20% of the number of shares per year, the original purchase price of such shares, and upon terms of payment permissible under applicable law; provided that in the case of Options or Stock Awards granted to officers, directors, consultants or affiliates of the Company, such repurchase provisions may be subject to additional or greater restrictions as determined by the Board or Committee.

6. Stock Awards and Restricted Stock Purchase Offers.

(a) Types of Grants.

(i) Stock Award.  All or part of any Stock Award under the Plan may be subject to conditions established by the Board or the Committee, and set forth in the Stock Award Agreement, which may include, but are not limited to, continuous service with the Company, achievement of specific business objectives, increases in specified indices, attaining growth rates and other comparable measurements of Company performance. Such Awards may be based on Fair Market Value or other specified valuation. All Stock Awards will be made pursuant to the execution of a Stock Award Agreement substantially in the form attached hereto as Exhibit C.

(ii) Restricted Stock Purchase Offer.  A Grant of a Restricted Stock Purchase Offer under the Plan shall be subject to such (i) vesting contingencies related to the Participant's continued association with the Company for a specified time and (ii) other specified conditions as the Board or Committee shall determine, in their sole discretion, consistent with the provisions of the Plan. All Restricted Stock Purchase Offers shall be made pursuant to a Restricted Stock Purchase Offer substantially in the form attached hereto as Exhibit D.

(b) Conditions and Restrictions.  Shares of Stock which Participants may receive as a Stock Award under a Stock Award Agreement or Restricted Stock Purchase Offer under a Restricted Stock Purchase Offer may include such restrictions as the Board or Committee, as applicable, shall determine, including restrictions on transfer, repurchase rights, right of first refusal, and forfeiture provisions. When transfer of Stock is so restricted or subject to forfeiture provisions it is referred to as "Restricted Stock". Further, with Board or Committee approval, Stock Awards or Restricted Stock Purchase Offers may be deferred, either in the form of installments or a future lump sum distribution. The Board or Committee may permit selected Participants to elect to defer distributions of Stock Awards or Restricted Stock Purchase Offers in accordance with procedures established by the Board or Committee to assure that such deferrals comply with applicable requirements of the Code including, at the choice of Participants, the capability to make further deferrals for distribution after retirement. Any deferred distribution, whether elected by the Participant or specified by the Stock Award Agreement, Restricted Stock Purchase Offers or by the Board or Committee, may require the payment be forfeited in accordance with the provisions of Section 6(c). Dividends or dividend equivalent rights may be extended to and made part of any Stock Award or Restricted Stock Purchase Offers denominated in Stock or units of Stock, subject to such terms, conditions and restrictions as the Board or Committee may establish.

(c) Cancellation and Rescission of Grants.  Unless the Stock Award Agreement or Restricted Stock Purchase Offer specifies otherwise, the Board or Committee, as applicable, may cancel any unexpired, unpaid, or deferred Grants at any time if the Participant is not in compliance with all other applicable provisions of the Stock Award Agreement or Restricted Stock Purchase Offer, the Plan and with the following conditions:

(i) A Participant shall not render services for any organization or engage directly or indirectly in any business which, in the judgment of the chief executive officer of the Company or other senior officer designated by the Board or Committee, is or becomes competitive with the Company, or which organization or business, or the rendering of services to such organization or business, is or becomes otherwise prejudicial to or in conflict with the interests of the Company. For Participants whose employment has terminated, the judgment of the chief executive officer shall be based on the Participant's position and responsibilities while employed by the Company, the Participant's post-employment responsibilities and position with the other organization or business, the extent of past, current and potential competition or conflict between the Company and the other organization or business, the effect on the Company's customers, suppliers and competitors and such other considerations as are deemed relevant given the applicable facts and circumstances.  A Participant who has retired shall be free, however, to purchase as an investment or otherwise, stock or other securities of such organization or business so long as they are listed upon a recognized securities exchange or traded over-the-counter, and such investment does not represent a substantial investment to the Participant or a greater than ten percent (10%) equity interest in the organization or business.

(ii) A Participant shall not, without prior written authorization from the Company, disclose to anyone outside the Company, or use in other than the Company's business, any confidential information or material, as defined in the Company's Proprietary Information and Invention Agreement or similar agreement regarding confidential information and intellectual property, relating to the business of the Company, acquired by the Participant either during or after employment with the Company.

(iii) A Participant, pursuant to the Company's Proprietary Information and Invention Agreement, shall disclose promptly and assign to the Company all right, title and interest in any invention or idea, patentable or not, made or conceived by the Participant during employment by the Company, relating in any manner to the actual or anticipated business, research or development work of the Company and shall do anything reasonably necessary to enable the Company to secure a patent where appropriate in the United States and in foreign countries.

(iv) Upon exercise, payment or delivery pursuant to a Grant, the Participant shall certify on a form acceptable to the Committee that he or she is in compliance with the terms and conditions of the Plan. Failure to comply with all of the provisions of this Section 6(c) prior to, or during the six months after, any exercise, payment or delivery pursuant to a Grant shall cause such exercise, payment or delivery to be rescinded. The Company shall notify the Participant in writing of any such rescission within two years after such exercise, payment or delivery. Within ten days after receiving such a notice from the Company, the Participant shall pay to the Company the amount of any gain realized or payment received as a result of the rescinded exercise, payment or delivery pursuant to a Grant. Such payment shall be made either in cash or by returning to the Company the number of shares of Stock that the Participant received in connection with the rescinded exercise, payment or delivery.

(d) Nonassignability.

(i) Except pursuant to Section 6(e)(iii) and except as set forth in Section 6(d)(ii), no Grant or any other benefit under the Plan shall be assignable or transferable, or payable to or exercisable by, anyone other than the Participant to whom it was granted.

(ii) Where a Participant terminates employment and retains a Grant pursuant to Section 6(e)(ii) in order to assume a position with a governmental, charitable or educational institution, the Board or Committee, in its discretion and to the extent permitted by law, may authorize a third party (including but not limited to the trustee of a "blind" trust), acceptable to the applicable governmental or institutional authorities, the Participant and the Board or Committee, to act on behalf of the Participant with regard to such Awards.

(e) Termination of Employment.  If the employment or service to the Company of a Participant terminates, other than pursuant to any of the following provisions under this Section 6(e), all unexercised, deferred and unpaid Stock Awards or Restricted Stock Purchase Offers shall be cancelled immediately, unless the Stock Award Agreement or Restricted Stock Purchase Offer provides otherwise:

(i) Retirement Under a Company Retirement Plan.  When a Participant's employment terminates as a result of retirement in accordance with the terms of a Company retirement plan, the Board or Committee may permit Stock Awards or Restricted Stock Purchase Offers to continue in effect beyond the date of retirement in accordance with the applicable Grant Agreement and the exercisability and vesting of any such Grants may be accelerated.

(ii) Rights in the Best Interests of the Company.  When a Participant resigns from the Company and, in the judgment of the Board or Committee, the acceleration and/or continuation of outstanding Stock Awards or Restricted Stock Purchase Offers would be in the best interests of the Company, the Board or Committee may (i) authorize, where appropriate, the acceleration and/or continuation of all or any part of Grants issued prior to such termination and (ii) permit the exercise, vesting and payment of such Grants for such period as may be set forth in the applicable Grant Agreement, subject to earlier cancellation pursuant to Section 9 or at such time as the Board or Committee shall deem the continuation of all or any part of the Participant's Grants are not in the Company's best interest.

(iii) Death or Disability of a Participant.

(1) In the event of a Participant's death, the Participant's estate or beneficiaries shall have a period up to the expiration date specified in the Grant Agreement within which to receive or exercise any outstanding Grant held by the Participant under such terms as may be specified in the applicable Grant Agreement. Rights to any such outstanding Grants shall pass by will or the laws of descent and distribution in the following order: (a) to beneficiaries so designated by the Participant; if none, then (b) to a legal representative of the Participant; if none, then (c) to the persons entitled thereto as determined by a court of competent jurisdiction. Grants so passing shall be made at such times and in such manner as if the Participant were living.

(2) In the event a Participant is deemed by the Board or Committee to be unable to perform his or her usual duties by reason of mental disorder or medical condition which does not result from facts which would be grounds for termination for cause, Grants and rights to any such Grants may be paid to or exercised by the Participant, if legally competent, or a committee or other legally designated guardian or representative if the Participant is legally incompetent by virtue of such disability.

(3) After the death or disability of a Participant, the Board or Committee may in its sole discretion at any time (1) terminate restrictions in Grant Agreements; (2) accelerate any or all installments and rights; and (3) instruct the Company to pay the total of any accelerated payments in a lump sum to the Participant, the Participant's estate, beneficiaries or representative; notwithstanding that, in the absence of such termination of restrictions or acceleration of payments, any or all of the payments due under the Grant might ultimately have become payable to other beneficiaries.

(4) In the event of uncertainty as to interpretation of or controversies concerning this Section 6, the determinations of the Board or Committee, as applicable, shall be binding and conclusive.

7. Investment Intent.  All Grants under the Plan are intended to be exempt from registration under the Securities Act provided by Section 4(2) thereunder. Unless and until the granting of Options or sale and issuance of Stock subject to the Plan are registered under the Securities Act or shall be exempt pursuant to the rules promulgated thereunder, each Grant under the Plan shall provide that the purchases or other acquisitions of Stock thereunder shall be for investment purposes and not with a view to, or for resale in connection with, any distribution thereof. Further, unless the issuance and sale of the Stock have been registered under the Securities Act, each Grant shall provide that no shares shall be purchased upon the exercise of the rights under such Grant unless and until (i) all then applicable requirements of state and federal laws and regulatory agencies shall have been fully complied with to the satisfaction of the Company and its counsel, and (ii) if requested to do so by the Company, the person exercising the rights under the Grant shall (i) give written assurances as to knowledge and experience of such person (or a representative employed by such person) in financial and business matters and the ability of such person (or representative) to evaluate the merits and risks of exercising the Option, and (ii) execute and deliver to the Company a letter of investment intent and/or such other form related to applicable exemptions from registration, all in such form and substance as the Company may require. If shares are issued upon exercise of any rights under a Grant without registration under the Securities Act, subsequent registration of such shares shall relieve the purchaser thereof of any investment restrictions or representations made upon the exercise of such rights.

8. Amendment, Modification, Suspension or Discontinuance of the Plan.  The Board may, insofar as permitted by law, from time to time, with respect to any shares at the time not subject to outstanding Grants, suspend or terminate the Plan or revise or amend it in any respect whatsoever, except that without the approval of the shareholders of the Company, no such revision or amendment shall (i) increase the number of shares subject to the Plan, (ii) decrease the price at which Grants may be granted, (iii) materially increase the benefits to Participants, or (iv) change the class of persons eligible to receive Grants under the Plan; provided, however, no such action shall alter or impair the rights and obligations under any Option, or Stock Award, or Restricted Stock Purchase Offer outstanding as of the date thereof without the written consent of the Participant thereunder. No Grant may be issued while the Plan is suspended or after it is terminated, but the rights and obligations under any Grant issued while the Plan is in effect shall not be impaired by suspension or termination of the Plan.

In the event of any change in the outstanding Stock by reason of a stock split, stock dividend, combination or reclassification of shares, recapitalization, merger, or similar event, the Board or the Committee may adjust proportionally (a) the number of shares of Stock (i) reserved under the Plan, (ii) available for Incentive Stock Options and Nonstatutory Options and (iii) covered by outstanding Stock Awards or Restricted Stock Purchase Offers; (b) the Stock prices related to outstanding Grants; and (c) the appropriate Fair Market Value and other price determinations for such Grants. In the event of any other change affecting the Stock or any distribution (other than normal cash dividends) to holders of Stock, such adjustments as may be deemed equitable by the Board or the Committee, including adjustments to avoid fractional shares, shall be made to give proper effect to such event. In the event of a corporate merger, consolidation, acquisition of property or stock, separation, reorganization or liquidation, the Board or the Committee shall be authorized to issue or assume stock options, whether or not in a transaction to which Section 424(a) of the Code applies, and other Grants by means of substitution of new Grant Agreements for previously issued Grants or an assumption of previously issued Grants.

9. Tax Withholding. The Company shall have the right to deduct applicable taxes from any Grant payment and withhold, at the time of delivery or exercise of Options, Stock Awards or Restricted Stock Purchase Offers or vesting of shares under such Grants, an appropriate number of shares for payment of taxes required by law or to take such other action as may be necessary in the opinion of the Company to satisfy all obligations for withholding of such taxes. If Stock is used to satisfy tax withholding, such stock shall be valued based on the Fair Market Value when the tax withholding is required to be made.

10. Availability of Information. During the term of the Plan and any additional period during which a Grant granted pursuant to the Plan shall be exercisable, the Company shall make available, not later than one hundred and twenty (120) days following the close of each of its fiscal years, such financial and other information regarding the Company as is required by the bylaws of the Company and applicable law to be furnished in an annual report to the shareholders of the Company.

11. Notice. Any written notice to the Company required by any of the provisions of the Plan shall be addressed to the chief personnel officer or to the chief executive officer of the Company, and shall become effective when it is received by the office of the chief personnel officer or the chief executive officer.

12. Indemnification of Board. In addition to such other rights or indemnifications as they may have as directors or otherwise, and to the extent allowed by applicable law, the members of the Board and the Committee shall be indemnified by the Company against the reasonable expenses, including attorneys' fees, actually and necessarily incurred in connection with the defense of any claim, action, suit or proceeding, or in connection with any appeal thereof, to which they or any of them may be a party by reason of any action taken, or failure to act, under or in connection with the Plan or any Grant granted thereunder, and against all amounts paid by them in settlement thereof (provided such settlement is approved by independent legal counsel selected by the Company) or paid by them in satisfaction of a judgment in any such claim, action, suit or proceeding, except in any case in relation to matters as to which it shall be adjudged in such claim, action, suit or proceeding that such Board or Committee member is liable for negligence or misconduct in the performance of his or her duties; provided that within sixty (60) days after institution of any such action, suit or Board proceeding the member involved shall offer the Company, in writing, the opportunity, at its own expense, to handle and defend the same.

13. Governing Law. The Plan and all determinations made and actions taken pursuant hereto, to the extent not otherwise governed by the Code or the securities laws of the United States, shall be governed by the law of the State of Nevada and construed accordingly.

14. Effective and Termination Dates. The Plan shall become effective on date it is approved by the holders of a majority of the shares of Stock then outstanding.  The Plan shall terminate ten years later, subject to earlier termination by the Board pursuant to Section 8.

The foregoing Paxton Energy, Inc. Amended and Restated 2010 Incentive Stock Option Plan (consisting of 15 pages, including this page) was duly adopted and approved by the Board of Directors on May 18, 2010, was approved by stockholders of the Corporation on June 29, 2010, was amended and restated in its entirety by the Board of Directors on June 3, 2011.

Paxton Energy, INC.

a Nevada corporation

By:           /s/ CHARLES F. VOLK, JR.

Its:           Chief Executive Officer

EX-31.01

EXHIBIT 31.01

Certification

I, Charles F. Volk, Jr., certify that:

1.           I have reviewed this report on Form 10-Q of Paxton Energy, Inc.;

2.           Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.           Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.           The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)           Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)           Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)           Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)           Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.           The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

(a)           All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)           Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:  August 15, 2011
	/s/ CHARLES F. VOLK, JR.
	Charles F. Volk, Jr.,
	Chief Executive Officer

EX-31.02

EXHIBIT 31.02

Certification

I, Charles F. Volk, Jr., certify that:

1.           I have reviewed this report on Form 10-Q of Paxton Energy, Inc.;

2.           Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.           Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.           The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)           Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)           Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)           Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)           Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.           The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

(a)           All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)           Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:  August 15, 2011

/s/ CHARLES F. VOLK, JR.

Charles F. Volk, Jr.,

Principal Financial Officer

EX-32.01

EXHIBIT 32.01

CERTIFICATIONS OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER

PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Charles F. Volk, Jr., certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Paxton Energy, Inc. on Form 10-Q for the fiscal quarter ended June 30, 2011 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in this Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of Paxton Energy, Inc.

	By:	/s/ CHARLES F. VOLK, JR.
Date: August 15, 2011	Name:	Charles F. Volk, Jr.
	Title:	Chief Executive Officer, Principal Financial Officer and Principal Accounting Officer