Note C - Long-Term Debt and Other Financing Arrangements

2011 Activity (Values for warrants are determined using the Black Scholes Option Pricing Model)

As of January 1, 2011, we had $3,624,172 of outstanding Class 2 Notes and 5,898,780 unissued warrants valued at $29,615. These Class 2 Notes are working capital notes secured by accounts receivable, inventory, and intellectual property and have been issued primarily to certain shareholders that are directors or beneficially own more than five percent of the outstanding shares of common stock of the Company (see Note D – Related Party Transactions). The Notes bear interest at 10%, payable at maturity of the note and earn warrants at the rate of five warrants per year per dollar invested. The warrants have an exercise price ranging from $0.10 to $0.25 per share of our common stock. The holder can elect to forgo warrants and earn an additional 2% interest.

During the quarter ended March 31, 2011, we issued $420,000 of Class 2 Notes. We also issued 49,315 warrants valued at $533. During the quarter ended June 30, 2011, we issued $344,000 of Class 2 Notes. $160,000 of these Class 2 Notes and their associated interest have the right, through December 5, 2011 and subject to certain restrictions, to be converted into Class 3 Notes. See the transactions detailed in Note D – Related Party Transactions for a description of the restrictions. These Class 3 Notes would mature on July 1, 2013, earn 8% interest, and would be convertible at $0.10 per share. We also issued 280,274 warrants valued at $1,088. We had 10,656,498 accrued warrants that were earned but not issued as of June 30, 2011, valued at $30,510. The value of these unissued warrants is reflected in the balance sheet as a liability as “Accrued Warrants for Interest”.

As of June 30, 2011, $331,500 of the Class 2 Notes were earning 10% interest and accruing warrants, $318,366 of the Class 2 Notes were earning default interest of 14% and accruing warrants, $3,738,306 of the Class 2 Notes were earning interest at 12% and do not earn warrants.

As of June 30, 2011, $318,366 of the Class 2 Notes were past due and in default. $3,775,806 of Class 2 Notes are due July 1, 2013 (see the next paragraph for details of this transaction). $80,000 of Class 2 Notes were due June 30, 2011. $10,000 of Class 2 Notes were due August 3, 2011. $204,000 of Class 2 Notes are due December 23, 2011. See Note J – Subsequent Events for recent activity associated with the maturity of Class 2 Notes.

On May 4, 2011, $1,781,112 of Class 2 Notes ceased accruing warrants and began accruing an additional 2% interest; on May 12, 2011, $1,794,694 of Class 2 Notes ceased accruing warrants and began accruing an additional 2% interest; on May 17, 2011, all of these notes had their due dates extended to July 1, 2013, and waived any default interest payments due retroactively from September 30, 2010 through May 17, 2011. This was accounted for in accordance with ASC 470-60 as a troubled debt restructuring and resulted in a gain of $72,000. For more information on the circumstances surrounding these transactions, please see Note D – Related Party Transactions.

As of January 1, 2011, we had $4,953,633 of outstanding Class 3 Notes. Of these, $3,671,642 bear interest at 8% and $1,281,989 bear interest at 12%, payable January 1st and July 1st of each year. The Notes are secured by our intellectual property and have been issued primarily to certain shareholders that are directors or beneficially own more than five percent of the outstanding shares of common stock of the Company (see Note D – Related Party Transactions). Also, $3,671,642 of the Notes are convertible into the Company’s common stock at $0.25 per share, and $1,281,989 of the Notes are convertible into the Company’s stock at $0.15 per share. No new Class 3 Notes were issued during the six-month period ended June 30, 2011. As of June 30, 2011, all but $85,000 of the Class 3 Notes are in default. See Note J – Subsequent Events for recent activity associated with the maturity of Class 3 Notes.

The Company is in default under the terms of the Fifth Amended and Restated Note and Warrant Purchase Agreement (the “Agreement”), because as of June 30, 2011 it failed to make full payment of principal and interest on $318,366 of Class 2 Notes and $4,868,633 of Class 3 Notes that were past their maturity dates. As of June 30, 2011, the outstanding unpaid interest on the defaulted Class 2 Notes and Class 3 Notes was $90,102 and $862,882 respectively.

The Class 2 and Class 3 Notes are secured by the Company’s intellectual property pursuant to a Collateral Assignment of Proprietary Rights and Security Agreement (the “Collateral Assignment”), and the Class 2 Notes are also secured by the Company’s accounts receivable and inventory pursuant to a Security Agreement (the “Security Agreement”).

The Class 2 and Class 3 Notes in default accrue interest at their default interest rates, which are equal to their respective interest rates plus an additional 4%. As such, $318,366 of Class 2 Notes are currently accruing interest at the default rate of 14%. Also, $3,671,643 of Class 3 Notes are currently accruing interest at the default rate of 12% and $1,196,989 of Class 3 Notes are currently accruing interest at the default rate of 16%.

Pursuant to the Collateral Assignment and the Security Agreement, the Class 2 and Class 3 Note holders (or the collateral agent acting on their behalf) have the right to foreclose on the collateral covered by such agreements, and exercise any of several remedies provided in such agreements, including taking possession of such collateral and selling such collateral. See Note J– Subsequent Events for recent activity associated with the Class 2 and Class 3 Notes.

The Company is in discussions with certain note holders about curing or waiving the remaining defaults. Certain note holders have continued to purchase new notes to provide additional funding to the Company after the default. See Note J – Subsequent Events for information on note activity since June 30, 2011.

The following table summarizes Class 2 Note activity for the three-month and six-month periods ended June 30, 2011:

	Notes Issued for Cash		Class 3 Notes Issued for Class 2 Note Payment		Cash Redemption		Notes Issued for Interest Payment		Class 2 Note Balance		Warrants Issued for Interest
Balance December 31, 2010	$	-	$	-	$	-	$	-	$	3,624,172	$	-
Quarter Ended March 31, 2011		420,000		-		-		-		420,000		533
Quarter Ended June 30, 2011		344,000		-				-		344,000		1,146
Balance June 30, 2011, 2011	$	764,000	$	-	$	-	$	-	$	4,388,172	$	1,679

The following table summarizes Class 3 Note activity for the three-month and six-month periods ended June 30, 2011:

	Notes Issued For Cash		Exchange of Class 2 Note and Related Interest		Cash Redemption		Notes Issued For Interest		Class 3 Note Balance
Balance December 31, 2010	$	-	$	-	$	-	$	-	$	4,953,633
Quarter Ended March 31, 2011		-		-		-		-		-
Quarter Ended June 30, 2010		-		-		-		-		-
Balance June 30, 2011	$	-	$	-	$	-	$	-	$	4,953,633

During the quarter ended March 31, 2011, we received unsecured, non-interest bearing loans of $10,000 from certain officers of the Company. The loans do not have repayment terms but are intended to be short term. During the quarter ended June 30, 2011, these loans were repaid.

During the quarter ended March 31, 2011, we received an unsecured, non-interest bearing loan of $10,000 from a current Note Holder. The loan does not have repayment terms but is considered to be short term. There was no activity on this loan during the quarter ended June 30, 2011.

2010 Activity (Values for warrants are determined using the Black Scholes Option Pricing Model)

As of January 1, 2010, we had $2,855,112 of outstanding Class 2 Notes. The Class 2 Notes are working capital notes secured by accounts receivable, inventory, and intellectual property and have been issued primarily to certain shareholders that are directors or beneficially own more than five percent of the outstanding shares of common stock of the Company (see Note D – Related Party Transactions). The Notes bear interest at 10%, payable at maturity of the note and earn warrants at the rate of five warrants per year per dollar invested. The warrants have an exercise price of $0.15 per share of our common stock. The holder can elect to forgo warrants and earn an additional 2% interest. All notes are presently earning 10% interest and receiving warrants, except for $475,000 which are earning interest at 12%. During the quarter ended March 31, 2010, we issued $370,000 of Class 2 Notes and we paid $170,000 of Class 2 Notes by issuing Class 3 Notes. We also issued 3,700,363 warrants valued at $32,843. During the quarter ended September 30, 2010, we issued $435,600 of new Class 2 Notes and we paid $50,950 to retire a Class 2 Note. We also issued 8,509,560 warrants valued at $104,936. During the quarter ended December 31, 2010, we issued $391,784 of new Class 2 Notes and we paid $207,374 to retire Class 2 Notes. We had 5,898,780 accrued warrants that were earned but not issued as of December 31, 2010, valued at $29,615. See Note J – Subsequent Events for recent activity associated with the maturity of Class 2 Notes.

As of January 1, 2010, we had $4,522,000 of outstanding Class 3 Notes. Of these, $3,671,642 bear interest at 8% and $850,861 bear interest at 12%, payable January 1st and July 1st of each year. The Notes are secured by our intellectual property and have been issued primarily to certain shareholders that are directors or beneficially own more than five percent of the outstanding shares of common stock of the Company (see Note C – Long-Term Debt and Other Financing). Also, $3,671,642 of the Notes are convertible into the Company’s common stock at $0.25 per share, and $850,681 of the Notes are convertible into the Company’s stock at $0.15 per share. During the quarter ended March 31, 2010, we issued $176,308 of Class 3 Notes bearing 12% interest and convertible at $0.15 per share for the payment of interest, and $170,000 of Class 3 Notes bearing 12% interest and convertible at $0.15 per share for the payment of Class 2 Notes. During the quarter ended June 30, 2010, we issued $85,000 of Class 3 Notes bearing 12% interest and convertible at $0.15 per share for cash which mature on July 1, 2011. All other Class 3 Notes matured on October 1, 2010, and are currently in default. No new Class 3 Notes were issued during the quarter ended December 31, 2010. See Note J – Subsequent Events for recent activity associated with the maturity of Class 3 Notes.

The Company is in default under the terms of the Fifth Amended and Restated Note and Warrant Purchase Agreement (the “Agreement”), because it failed to make full payment of principal and interest on certain Class 2 and Class 3 Notes on their respective maturity dates.

During 2010, the Class 2 and Class 3 Notes started accruing interest at their default interest rates, which is equal to their respective interest rates plus an additional 4%.

Pursuant to the Collateral Assignment and the Security Agreement, the Class 2 and Class 3 Note holders (or the collateral agent acting on their behalf) have the right to foreclose on the collateral covered by such agreements, and exercise any of several remedies provided in such agreements, including taking possession of such collateral and selling such collateral. See Note J – Subsequent Events for recent activity associated with the Class 2 and Class 3 Notes.

The following table summarizes Class 2 Note activity for the year ended December 31, 2010:

	Notes Issued for Cash		Class 3 Notes Issued for Class 2 Note Payment			Cash Redemption			Notes Issued for Interest Payment		Class 2 Note Balance		Warrants Issued for Interest
Balance January 1, 2010	$	-	$	-		$	-		$	-	$	2,855,112	$	-
Quarter Ended March 31, 2010		370,000		(170,000	)		-			-		200,000		32,843
Quarter Ended June 30, 2010		-		-						-		-		-
Quarter Ended September 30, 2010		435,600		-			(50,950	)		-		384,650		104,936
Quarter Ended December 31, 2010		391,784		-			(207,374	)		-		184,410		-
Balance December 31, 2010	$	1,197,384	$	(170,000	)	$	(258,324	)	$	-	$	3,624,172	$	137,779

The following table summarizes Class 3 Note activity for the year ended December 31, 2010:

	Notes Issued For Cash		Exchange of Class 2 Note and Related Interest		Cash Redemption		Notes Issued For Interest		Class 3 Note Balance
Balance January 1, 2010	$	-	$	-	$	-	$	-	$	4,522,325
Quarter Ended March 31, 2010		-		170,000		-		176,308		346,308
Quarter Ended June 30, 2010		85,000		-		-		-		85,000
Quarter Ended September 30, 2010		-		-		-		-		-
Quarter Ended December 31, 2010		-		-		-		-		-
Balance December 31, 2010	$	85,000	$	170,000	$	-	$	176,308	$	4,953,633

A summary of the Company’s debt obligations is as follows as of June 30, 2011 and December 31, 2010:

	2011		2010
	(in thousands)
Short Term Notes Payable:
Class 2 Notes	$	612	$	3,624
Class 3 Notes		4,954		4,954
Net Short Term Notes Payable	$	5,566	$	8,578

Long Term Notes Payable:
Class 2 Notes	$	3,776	$	-
Class 3 Notes		-		-
Net Long Term Notes Payable	$	3,776	$	-

Total	$	9,342	$	8,578

There are no long-term maturities of debt due in 2011 or 2012. $3,775,806 of long-term debt matures July 1, 2013.

See Note J– Subsequent Events for recent activity associated with Class 2 and Class 3 Notes.