10QSB

U.S. Securities and Exchange Commission

Washington, D. C. 20549

FORM 10-QSB

þ QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 2, 2005

o TRANSITION REPORT UNDER SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___to ___

Commission File Number : 0-26226

MICROFIELD GROUP, INC.

(Exact name of small business issuer as specified in its charter)

Oregon	93-0935149
(State or other jurisdiction	(I. R. S. Employer
of incorporation or organization)	Identification No.)

1631 NW Thurman St., Suite 200
Portland, Oregon 97209
(Address of principal executive offices and zip code)
(503) 419-3580
(Issuer’s telephone number including area code)

Check whether the issuer (1) filed all reports required to be filed by Section 3 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 þ       No o

The number of shares outstanding of the Registrant’s Common Stock as of July 2, 2005 was 18,776,240 shares. (This number does not include 951,455 shares registered in Issuer’s name and pledged to secure a liability).

Transitional Small Business Disclosure Format (check one): Yes o       No þ

MICROFIELD GROUP, INC.

FORM 10-QSB

INDEX

	Page
PART 1 FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets – July 2, 2005 and January 1, 2005		3
Condensed Consolidated Statements of Operations – three and six months ended July 2, 2005 and July 3, 2004		4
Condensed Consolidated Statement of Cash Flows – six months ended July 2, 2005 and July 3, 2004		5
Notes to Condensed Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3. Controls and Procedures		31
PART II            OTHER INFORMATION
Item 1. Legal Proceedings		34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3. Defaults Upon Senior Securities		34
Item 4. Submission of Matters to a Vote of Security Holders		35
Item 6. Exhibits		35
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

2

Item 1. Financial Statements

MICROFIELD GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

	July 2,			January 1,
	2005			2005
Current assets:
Cash and cash equivalents	$	138,689		$	10,992
Accounts receivable, net of allowances of $152,721 and $103,969		5,609,794			6,241,001
Accounts receivable – related parties		18,578			178,900
Inventory, net of allowances		243,802			239,328
Costs in excess of billings		658,497			822,656
Other current assets		118,839			450,602
Total current assets		6,788,199			7,943,479
Property and equipment, net		111,140			125,777
Intangible assets, net		1,338,006			1,393,281
Goodwill		2,276,243			2,276,243
Other assets		334,656			36,243
	$	10,848,244		$	11,775,023
Current liabilities:
Cash overdraft	$	307,652		$	26,125
Accounts payable		3,073,615			3,451,991
Accounts payable – related parties		426			99,932
Accrued payroll taxes and benefits		1,414,430			1,297,379
Bank line of credit		3,952,536			4,392,975
Current portion of notes payable (Note 4)		706,355			673,968
Current portion of notes payable – related parties (Note 4)		1,032,176			485,500
Billings in excess of costs		431,672			523,919
Other current liabilities		58,701			226,788
Total current liabilities		10,977,563			11,178,577
Long-term liabilities:
Long term notes payable (Note 4)		123,441			412,922
Long term notes payable – related parties (Note 4)		116,671			700,635
Derivative liability – notes (Note 4)		71,548			41,863
Total long-term liabilities		311,660			1,155,420
Commitments and contingencies		—			—
Shareholders’ equity (deficit):
Convertible Series 2 preferred stock, no par value, 10,000,000 shares authorized, 6,821,436 shares issued and outstanding (Note 2)		2,765,101			2,765,101
Convertible Series 3 preferred stock, no par value, 10,000,000 shares authorized, 3,641 shares authorized and outstanding (Note 2)		1,529,138			1,273,667
Convertible Series 4 preferred stock, no par value, 10,000,000 shares authorized, 4,550 and 4,605 shares issued and outstanding at July 2, 2005 and January 1, 2005, respectively (Note 2)		1,703,424			1,568,834
Common stock, no par value, 125,000,000 shares authorized, 18,776,240 and 18,491,618 shares issued and outstanding at July 2, and 2005 and January 1, 2005, respectively (Note 2)		20,915,391			20,707,192
Common stock warrants (Note 3)		2,389,879			2,256,112
Accumulated deficit		(29,743,912	)		(29,129,880	)
Total shareholders’ equity (deficit)		(440,979	)		(558,974	)
	$	10,848,244		$	11,775,023

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

3

MICROFIELD GROUP, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

	Three months ended						Six months ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Sales	$	9,006,523		$	9,646,100		$	17,901,207		$	18,836,620
Cost of goods sold		7,093,396			7,974,673			14,097,518			15,353,223
Gross profit		1,913,127			1,671,427			3,803,689			3,483,397
Operating expenses Sales, general and administrative		1,632,289			2,245,193			3,226,716			5,257,765
Income (loss) from operations		280,838			(573,766	)		576,973			(1,774,368	)
Other income (expense)
Interest expense		(401,005	)		(313,753	)		(783,835	)		(1,280,485	)
Derivative income (expense)		(42,296	)		235,179			(32,071	)		(29,313	)
Other income, net					—			10,898			18,101
Loss before provision for income taxes		(162,463	)		(652,340	)		(228,035	)		(3,066,065	)
Provision for income taxes		—			—			—			—
Loss from continuing operations		(162,463	)		(652,340	)		(228,035	)		(3,066,065	)
Discontinued operations:
Gain on sale of discontinued operations		—			—			25,062			38,272
Net loss	$	(162,463	)	$	(652,340	)	$	(202,973	)	$	(3,027,793	)
Deemed preferred stock dividend (See Note 8)		—			(380,061	)		(411,059	)		(380,061	)
Net loss attributable to common shareholders	$	(162,463	)	$	(1,032,401	)	$	(614,032	)	$	(3,407,854	)
Net loss per common share
Basic	$	(0.01	)	$	(0.06	)	$	(0.03	)	$	(0.20	)
Diluted	$	(0.01	)	$	(0.06	)	$	(0.03	)	$	(0.20	)
Shares used in per share calculations
Basic and diluted		18,557,300			16,772,570			18,524,459			16,772,570

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

4

MICROFIELD GROUP, INC.

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)

	Six Months Ended
	July 2, 2005			July 3, 2004
Cash Flows From Operating Activities:
Net loss	$	(202,972	)	$	(3,027,793	)
Add (deduct):
Gain on sale of discontinued operations – SoftBoard		(25,062	)		(38,272	)
Loss from continuing operations		(228,034	)		(3,066,065	)
Depreciation of equipment		14,634			330,252
Amortization of intangible assets		55,278			55,275
Amortization of debt discount		4,378			129,351
Noncash interest expense recorded on warrant issuance		320,967			546,603
Gain on disposal of fixed assets		—			(18,101	)
Remeasurement of warrant liability		—			21,615
Remeasurement of derivative associated with Steelcase note		32,071			7,698
Changes in current assets and liabilities:
Accounts receivable		631,207			(1,038,734	)
Accounts receivable-related party		160,322			(188,636	)
Inventory		(4,474	)		(7,931	)
Other assets		33,350			(187,807	)
Costs in excess of billings		164,159			369,973
Accounts payable		(378,374	)		(11,851	)
Accounts payable-related party		(99,506	)		239,532
Accrued payroll, taxes and benefits		117,051			1,099,875
Billings in excess of cost		(92,247	)		190,944
Other current liabilities		(162,426	)		(70,412	)
Net cash provided (used) by continuing operations		568,356			(1,598,419	)
Net cash provided by discontinued operations – SoftBoard		25,062			38,272
Net cash used by operating activities		593,418			(1,560,147	)
Cash flows from investing activities
Purchases of fixed assets		—			(45,024	)
Net cash used by investing activities		—			(45,024	)
Cash flows from financing activities:
Increase in cash overdraft position		281,527			501,099
Borrowings on line of credit		18,465,951			18,037,445
Repayments on line of credit		(18,906,390	)		(18,131,542	)
Proceeds from issuance of preferred stock, net of issuance costs		—			1,724,423
Repayments on note payable		(265,142	)		(69,773	)

5

	Six Months Ended
	July 2, 2005			July 3, 2004
Repayments on notes payable – related party		(41,667	)		(833,732	)
Borrowings on note payable – related party					600,000
Net cash provided by financing activities		(465,721	)		1,827,920
Net decrease in cash and cash equivalents		127,697			222,749
Cash and cash equivalents, beginning of period		10,992			130,533
Cash and cash equivalents, end of period	$	138,689		$	353,282
Supplemental schedule of non-cash financing and investing activities:
Repurchase of common stock with issuance of note payable – Steelcase	$	—		$	—
Conversion of notes payable-related party to preferred stock	$	—		$	1,188,919
Conversion of note payable-related party to common stock	$	—		$	—
Series 3 preferred stock issued for future related party operating lease obligations	$	—		$	130,000
Conversion of account payable-related party to preferred stock	$	—		$	210,219
Conversion of account payable-related party to common stock	$	—		$	—
Beneficial conversion feature of Series 3 and Series 4 preferred stock	$	411,060		$	1,581,701
Valuation of warrants issued with related party debt	$	—		$	155,221
Reduction of note receivable secured by common stock	$	—		$	13,137

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

6

MICROFIELD GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

July 2, 2005
(Unaudited)

1. Description of the Business

General

The accompanying unaudited condensed consolidated financial statements 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-QSB. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Accordingly, the results from operations for the three- and six-month periods ended July 2, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated January 1, 2005 financial statements and footnotes thereto included in the Company’s SEC Form 10-KSB.

Business and Basis of Presentation

Microfield Group, Inc. (the “Company” or “Microfield”) through its subsidiary Christenson Velagio, Inc. (“CVI”) specializes in the installation of electrical products and services. The Company’s objective is to leverage its assets and value to successfully build a viable, profitable electrical services and technology infrastructure business.

The condensed consolidated financial statements include the accounts of Microfield and its wholly owned subsidiary, Christenson Velagio, Inc. (collectively the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation.

The Company was incorporated in October 1986 as an Oregon Corporation, succeeding operations that began in October 1984. The Company’s headquarters are located in Portland, Oregon.

Reclassification

Certain reclassifications have been made to conform to prior periods’ data to the current presentation. These reclassifications had no effect on reported losses.

Fiscal Year

The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to the last day of December. The Company’s current fiscal year is the 52-week period ending December 31, 2005. The Company’s last fiscal year was the 53-week period ended January 1, 2005. The Company’s second fiscal quarters in fiscal 2005 and 2004 were the 13-week periods ended July 2, 2005 and July 3, 2004, respectively.

7

Stock Based Compensation

The Company accounts for its employee and director stock options in accordance with provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Pro forma disclosures as required under SFAS 123, “Accounting for Stock-Based Compensation” and as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” are presented below. Under this method, no stock based compensation expense has been recognized for stock options issued to employees because the exercise prices of options issued were equal to or greater than the fair value of the underlying shares at the date of grant .

Had compensation cost for the Company’s plan been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the total value of options granted would have been $413,890 during both the three and six months ended July 2, 2005, and $14,350 and $58,650 during the three and six months ended July 3, 2004, respectively. Such amounts would be amortized over the vesting period of the options. The total compensation expense that would have been recognized if the Company had determined such costs based on the fair value method would have been $131,412 and $204,609 for the three and six months ended July 2, 2005, and $11,912 and $23,126 for the three and six months ended July 3, 2004, respectively.

Accordingly, under SFAS No. 123, the Company’s net loss and loss per share for the three and six months ended July 2, 2005 and July 3, 2004, would have been changed to the pro forma amounts indicated below:

	Three Months Ended						Six Months Ended
	July 2,			July 3,			July 2,			July 3,
	2005			2004			2005			2004
Net loss attributable to common shareholders, as reported	$	(162,463	)	$	(1,032,401	)	$	(614,032	)	$	(3,407,854	)
Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(131,412	)		(11,912	)		(204,609	)		(23,126	)
Pro forma net loss	$	(293,875	)	$	(1,044,313	)	$	(818,641	)	$	(3,430,980	)
Net loss per common share:
Basic and diluted, as reported	$	(0.01	)	$	(0.06	)	$	(0.03	)	$	(0.20	)
Basic and diluted, pro forma	$	(0.01	)	$	(0.06	)	$	(0.04	)	$	(0.20	)

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised 2004), “Share-Based Payment” which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. Statement 123R supersedes APB opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach in Statement 123R is similar to the approach described in Statement 123. However, Statement 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro-forma disclosure is no longer an alternative. On April 14, 2005, the SEC amended the effective date of the provisions of this statement. The

8

effect of this amendment by the SEC is that the Company will have to comply with Statement 123R and use the Fair Value based method of accounting no later than the first quarter of 2006. Management has not determined the impact that this statement will have on Company’s consolidated financial statements.

New Accounting Pronouncements

FIN 47. In March 2005, the FASB issued FASB Interpretation (FIN) No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143,” which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. The Company is required to adopt the provisions of FIN 47 no later than the first quarter of fiscal 2006. The Company does not expect the adoption of this Interpretation to have a material impact on its consolidated financial position, results of operations or cash flows.

SFAS 154. In May 2005 the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in non-discretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company does not expect the adoption of this SFAS to have a material impact on its consolidated financial position, results of operations or cash flows.

2. Capital Stock

The Company has authorized 10,000,000 shares of Preferred stock, no par value. As of July 2, 2005 and January 1, 2005, the Company had 6,821,436 shares of Series 2 preferred stock issued and outstanding. As of July 2, 2005 and January 1, 2005, the Company had 3,641 shares of Series 3 preferred stock issued and outstanding. As of July 2, 2005 and January 1, 2005, the Company had 4,550 and 4,605 shares of Series 4 preferred stock issued and outstanding, respectively. The Company has authorized 125,000,000 shares of Common Stock, no par value. As of July 2, 2005 and January 1, 2005, the Company had 18,776,240 and 18,491,618 shares of common stock issued and outstanding, respectively. This number does not include 951,455 shares registered in Issuer’s name and pledged to secure a liability.

Series 2 Preferred Stock

The terms of the Series 2 preferred stock are as follows.

Dividends. Series 2 preferred stock issued and outstanding shall be entitled to receive a cash dividend in the amount of 6.5% of the Issue Price per annum. The Series 2 preferred stock dividends shall be payable in cash, quarterly, subject to the declaration of the dividend by the board of

9

directors, if and when the board of directors deems advisable. Any declared but unpaid dividend will not bear interest and will be payable out of net profits; if net profits are not sufficient to pay this dividend, either in whole or in part, then any unpaid portion of the dividend will be paid in full out of net profits of the Corporation in subsequent quarters before any dividends are paid upon shares of Junior Stock. Thus far, no dividends have been declared. As of July 2, 2005 there were dividends of approximately $319,508 in arrears.

Liquidation Preference. In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, except in certain circumstances, the holders of each share of Series 2 preferred stock shall be entitled to be paid out of the assets of the Corporation available for distribution to its shareholders, before any declaration and payment or setting apart for payment of any amount shall be made in respect of Junior Stock, an amount equal to the Issue Price and all accrued but unpaid dividends.

Conversion. Each holder of any share(s) of Series 2 preferred stock may, at the holder’s option, convert all or any part of such share(s) from time to time held by the holder into shares of common stock at any time after the date of issuance. Each such share of Series 2 preferred stock shall be converted into one share of fully-paid and non-assessable shares of common stock. Each share of Series 2 preferred stock shall automatically be converted into shares of common stock on a one-for-one basis immediately upon the consummation of the Company’s sale of its common stock in a bona fide, firm commitment, underwritten public offering under the Securities Act of 1933, as amended, which results in aggregate cash proceeds (before underwriters’ commissions and offering expenses) to the Company of $5,000,000 or more. In any event, if not converted to common stock, each share of Series 2 preferred stock shall automatically be converted into shares of common stock on a one-for-one basis immediately upon the third anniversary of the date of issuance of the Series 2 preferred stock.

Voting Rights. Each holder of Series 2 preferred stock shall have the right to one vote for each share of Common Stock into which such Series 2 preferred stock could then be converted

Series 3 Preferred Stock

The terms of the Series 3 preferred stock are as follows.

Dividends. Series 3 preferred stock issued and outstanding shall be entitled to receive a cash dividend in the amount of 6.5% of the Issue Price per annum. The Series 3 preferred stock dividends are cumulative and shall be payable in cash, quarterly, subject to the declaration of the dividend by the board of directors, if and when the board of directors deems advisable. Any declared but unpaid dividend will not bear interest and will be payable out of net profits; if net profits are not sufficient to pay this dividend, either in whole or in part, then any unpaid portion of the dividend will be paid in full out of net profits of the Corporation in subsequent quarters before any dividends are paid upon shares of Junior Stock. If this preferred stock is converted into the Company’s common stock, and there exist undeclared dividends on the conversion date, the dividends will remain an obligation of the Company, and will be paid when declared and when there are legally available funds to make that payment. Thus far, no dividends have been declared. As of July 2, 2005 there were $124,174 of undeclared dividends in arrears.

Liquidation Preference. In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, except in certain circumstances, the holders of each share of Series 3 preferred stock shall be entitled to be paid out of the assets of the Corporation available for distribution to its shareholders, before any declaration and payment or setting apart for payment of any amount shall be made in respect of Junior Stock, an amount equal to the Issue Price and all accrued but unpaid dividends.

Conversion. Each holder of any share(s) of Series 3 preferred stock may, at the holder’s option, convert all or any part of such share(s) from time to time held by the holder into shares of common stock at any time after one year from the date of issuance. Each such share of Series 3 preferred stock shall be converted into one thousand shares of fully-paid and non-assessable shares of common stock. Each share of Series 3 preferred stock shall automatically be converted into shares of common stock on a one-for-one thousand basis immediately upon the consummation of the Company’s sale of its common stock in a bona fide, firm commitment, underwritten public offering under the Securities Act of 1933, as amended, which results in

10

aggregate cash proceeds (before underwriters’ commissions and offering expenses) to the Company of $5,000,000 or more. In any event, if not converted to common stock, each share of Series 3 preferred stock shall automatically be converted into shares of common stock on a one-for-one thousand basis immediately upon the third anniversary of the date of issuance of the Series 3 preferred stock. The Company has recorded a beneficial conversion feature of $983,017, which represents the difference between the conversion price and the fair value of the Company’s common stock on the commitment date, which was also the issuance date. This beneficial conversion feature is being amortized over the conversion period of one year. At July 2, 2005, the beneficial conversion feature associated with the Series 3 preferred stock was fully amortized.

Voting Rights. Each holder of Series 3 preferred stock shall have the right to one vote for each share of Common Stock into which such Series 3 preferred stock could then be converted.

Series 4 Preferred Stock

The terms of the Series 4 preferred stock are as follows.

Dividends. Series 4 preferred stock issued and outstanding shall be entitled to receive a cash dividend in the amount of 6.5% of the Issue Price per annum. The Series 4 preferred stock dividends are cumulative shall be payable in cash, quarterly, subject to the declaration of the dividend by the board of directors, if and when the board of directors deems advisable. Any declared but unpaid dividend will not bear interest and will be payable out of net profits; if net profits are not sufficient to pay this dividend, either in whole or in part, then any unpaid portion of the dividend will be paid in full out of net profits of the Corporation in subsequent quarters before any dividends are paid upon shares of Junior Stock. If this preferred stock is converted into the Company’s common stock, and there exist undeclared dividends on the conversion date, the dividends will remain an obligation of the Company, and will be paid when declared and when there are legally available funds to make that payment. Thus far, no dividends have been declared. As of July 2, 2005 there were $140,172 of undeclared dividends in arrears.

Liquidation Preference. In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, except in certain circumstances, the holders of each share of Series 4 preferred stock shall be entitled to be paid out of the assets of the Corporation available for distribution to its shareholders, before any declaration and payment or setting apart for payment of any amount shall be made in respect of Junior Stock, an amount equal to the Issue Price and all accrued but unpaid dividends.

Conversion. Each holder of any share(s) of Series 4 preferred stock may, at the holder’s option, convert all or any part of such share(s) from time to time held by the holder into shares of common stock at any time after one year from the date of issuance. Each such share of Series 4 preferred stock shall be converted into one thousand shares of fully-paid and non-assessable shares of common stock. Each share of Series 4 preferred stock shall automatically be converted into shares of common stock on a one-for-one thousand basis immediately upon the consummation of the Company’s sale of its common stock in a bona fide, firm commitment, underwritten public offering under the Securities Act of 1933, as amended, which results in aggregate cash proceeds (before underwriters’ commissions and offering expenses) to the Company of $5,000,000 or more. In any event, if not converted to common stock, each share of Series 4 preferred stock shall automatically be converted into shares of common stock on a one-for-one thousand basis immediately upon the third anniversary of the date of issuance of the Series 4 preferred stock. The Company has recorded a beneficial conversion feature of $598,684, which represents the difference between the conversion price and the fair value of the Company’s common stock on the commitment date, which was also the issuance date. This beneficial conversion feature is being amortized over the conversion period of one year. At July 2, 2005, the beneficial conversion feature associated with the Series 4 preferred stock was fully amortized.

Voting Rights. Each holder of Series 4 preferred stock shall have the right to one vote for each share of Common Stock into which such Series 4 preferred stock could then be converted.

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Common Stock

During the six months period ended July 2, 2005, the Company issued an aggregate of 229,358 shares of common stock in exchange for 826,400 cashless warrants exercised. These warrants were issued during fiscal year 2000 in connection with debt financing (Note 3). The Company also issued an aggregate of 55,264 shares of common stock in exchange for conversion of 55.263 shares of Series 4 Preferred Stock at $380 per preferred share.

3. Stock Options and Warrants

Stock Incentive Plan

The Company has a Stock Incentive Plan (the “Plan”). At July 2, 2005 and July 3, 2004, 3,176,825 and 618,890 shares of common stock were reserved, respectively, for issuance to employees, officers, directors and outside advisors. Under the Plan, the options may be granted to purchase shares of the Company’s common stock at fair market value, as determined by the Company’s Board of Directors, at the date of grant. The options are exercisable over a period of up to five years from the date of grant or such shorter term as provided for in the Plan. The options become exercisable over periods from zero to four years.

A total of 1,200,000 options to purchase shares of the Company’s common stock were granted to employees and directors of the Company during the three and six months ended July 2, 2005, respectively. The 1,200,000 options issued during the three months ended July 2, 2005 are forfeited if not exercised within five years, and 1,000,000 of these options vest ratably over forty-eight months starting with the month of grant. The remaining 200,000 options were fully vested upon grant. The weighted average per share value of the options granted in the second quarter of 2005 was $0.34.

The following table summarizes the changes in stock options outstanding and the related prices for the shares of the Company’s common stock issued to employees, officers and directors of the Company under the Plan.

	Options Outstanding						Options Exercisable
			Weighted Average		Weighted				Weighted
			Remaining		Average				Average
Exercise	Number		Contractual Life		Exercise		Number		Exercise
Prices	Outstanding		(Years)		Price		Exercisable		Price
$0.04 — $0.05		16,000		1.58	$	0.04		16,000	$	0.04
$0.31 — $0.60		3,134,436		4.19	$	0.41		1,426,225	$	0.43
$1.76 — $2.70		26,388		4.85	$	2.27		26,388	$	2.27
		3,176,824		4.13	$	0.42		1,468,613	$	0.46

Transactions involving stock options issued are summarized as follows:

				Weighted Average
	Number of Shares			Price Per Share
Outstanding at January 3, 2004		688,936		$	0.84
Granted		1,919,188			0.43
Exercised		—			—
Cancelled or expired		(445,075	)		0.96
Outstanding at January 1, 2005		2,163,049		$	0.46
Granted		1,200,000			0.34
Exercised		—			—
Cancelled or expired		(186,225	)		0.39
Outstanding at July 2, 2005		3,176,824		$	0.42

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The Company has computed for pro forma disclosure purposes the value of all options granted during fiscal quarters in 2005 and 2004 using the Black-Scholes pricing model as prescribed by SFAS No. 123. The following assumptions were used to calculate the value of options granted during the second quarter of 2005:

Risk-free interest rate		3.61	%
Expected dividend yield		—
Expected life	5 years
Expected volatility		121	%

Common Stock Warrants

In connection with debt financing entered into during fiscal year 2000, the Company issued two stock warrants each to purchase individually 1,033,000 common shares at a price of $0.50 per share and $0.38722 per share, respectively. The warrants had an initial term of 3 years and were to expire in June 30, 2005. Proceeds from the debt were allocated between the debt and warrants based on the fair value of the warrants issued using the Black-Scholes model. The combined value assigned to the warrants when they were issued was approximately $357,000 and was initially recorded as debt discount and recognized as interest expense over the life of the debt. On September 15, 2003, the Company extended the life of a portion of these warrants until June 30, 2007 as partial consideration to satisfy a $150,000 promissory note between CTS and Aequitas Capital Management (“Aequitas,” formerly known as JMW Capital Partners, Inc). In accordance with FIN 44, the fair value of the warrants on the date of the settlement of the $150,000 promissory note between CTS and Aequitas was determined to be $468,000. The difference of $110,000 between the initial fair value and the fair value at the date of the extension was recorded as equity and a loss on debt extinguishment. During the period ended July 2, 2005, the warrant holder exercised 826,400 warrants in exchange for 229,358 shares of the Company’s common stock (Note 2).

In connection with an April 2003 common stock private placement, the Company issued 111,308 warrants to purchase common stock. Each warrant is exercisable into one share of common stock at $0.40 per share and will expire in 2008. Subsequent to this private placement, the Company exercised an option to convert $1,400,000 of outstanding debt into preferred stock that is convertible into shares of common stock. This exercise, when aggregated with all other outstanding equity arrangements, resulted in the total number of common shares that could be required to be delivered to exceed the number of authorized common shares. In accordance with EITF 00-19, the fair value of the warrants issued in the private placement must be recorded as a liability in the financial statements using the Black-Scholes model, and any subsequent changes in the Company’s stock price to be recorded in earnings. Accordingly, the fair value of these warrants at the date of issuance was determined to be $19,832. At the end of each quarter the increase or decrease in derivative value was recorded in earnings in the consolidated statement of operations. At September 1, 2004, the Company’s shareholder’s voted to increase the authorized shares available for issuance or conversion, which cured the situation described above. Accordingly, the fair value of the warrants on September 1, 2004 was determined to be $48,976. The warrant liability was reclassified to shareholders’ equity and the increase from the prior quarter end warrant value was recorded in earnings.

In September 2003, in connection with a preferred stock private placement, the Company issued 333,334 warrants to purchase common stock. Each warrant is exercisable into one share of common stock at $0.42 per share and will expire in 2008. Subsequent to this private placement, the Company exercised an option to convert $1,400,000 of outstanding debt into preferred stock that is convertible into shares of common stock. This exercise, when aggregated with all other outstanding equity arrangements, resulted in the total number of common shares that could be required to be delivered to exceed the number of authorized common shares. In accordance with EITF 00-19, the fair value of the warrants issued in the private placement must be recorded as a liability in the financial statements using the Black-Scholes model, and any subsequent changes in the Company’s stock price to be recorded in earnings. Accordingly, the fair value of these warrants at the date of issuance was determined to be $64,902. At the end of each quarter the increase or decrease in derivative value was recorded in earnings in the consolidated statement of operations. At

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September 1, 2004, the Company’s shareholder’s voted to increase the authorized shares available for issuance or conversion, which cured the situation described above. Accordingly, the fair value of the warrants on September 1, 2004 was determined to be $139,000. The warrant liability was reclassified to shareholders’ equity and the increase from the prior quarter end warrant value was recorded in earnings.

In connection with the January 22, 2004 debt issuance by Destination Capital, LLC (see Note 5), the Company is obligated to issue warrants to purchase the Company’s common stock. According to the terms of the debt issuance, warrants in the amount of one percent of the Company’s fully diluted common stock will be issued to the debt holders on the first day of each calendar month that the debt is outstanding. The Company repaid this debt in April 2004, and accordingly is obligated to issue 1,403,548 warrants, which is equivalent to 4% of the fully diluted common stock outstanding under the terms outlined in that agreement. Each warrant is exercisable into one share of common stock at $0.31 per share, subject to changes specified in the debt agreement, and will expire in 2008. Prior to this debt issuance, the Company exercised an option to convert $1,400,000 of outstanding debt into preferred stock that is convertible into shares of common stock. This exercise, when aggregated with all other outstanding equity arrangements, resulted in the total number of common shares that could be required to be delivered to exceed the number of authorized common shares. In accordance with EITF 00-19, the fair value of the warrants issued in connection with the debt issuance must be recorded as a liability for warrant settlement in the financial statements using the Black-Scholes model, and any subsequent changes in the Company’s stock price to be recorded in earnings. Accordingly, the aggregate fair value of these warrants, on the date each of the obligations to issue warrants arose, was determined to be $701,824. At the end of each quarter the increase or decrease in derivative value was recorded in earnings in the consolidated statement of operations. At September 1, 2004, the Company’s shareholder’s voted to increase the authorized shares available for issuance or conversion, which cured the situation described above. Accordingly, the fair value of the warrants on September 1, 2004 was determined to be $780,373. The warrant liability was reclassified to shareholders’ equity and the increase from the prior quarter end warrant value was recorded in earnings.

In connection with the August 24, 2004 debt issuance by Destination Capital, LLC (see Note 5), the Company is obligated to issue warrants to purchase the Company’s common stock. According to the terms of the debt issuance, warrants in the amount of 12.5% percent of the loan balance, outstanding on the first day of each month, will be issued to the debt holders for each calendar month that the debt is outstanding. Each warrant is exercisable into one share of common stock at the lesser of $0.38 per share or the price applicable to any shares, warrants or options issued (other than options issued to employees or directors) while the loan is outstanding, and will expire in 2009. Prior to this debt issuance, the Company exercised an option to convert $1,400,000 of outstanding debt into preferred stock that is convertible into shares of common stock. This exercise, when aggregated with all other outstanding equity arrangements, resulted in the total number of common shares that could be required to be delivered to exceed the number of authorized common shares. In accordance with EITF 00-19, the fair value of the 37,500 warrants initially issued in connection with the debt issuance must be recorded as a liability for warrant settlement in the financial statements using the Black-Scholes model, and any subsequent changes in the Company’s stock price to be recorded in earnings. Accordingly, the aggregate fair value of these warrants, issued prior to September 1, 2004, was determined to be $17,513. At the end of each quarter the increase or decrease in derivative value was recorded in earnings in the consolidated statement of operations. At September 1, 2004, the Company’s shareholder’s voted to increase the authorized shares available for issuance or conversion, which cured the situation described above. Accordingly, the fair value of the warrants on September 1, 2004 was determined to be $20,775. The warrant liability was reclassified to shareholders’ equity and the increase from the prior quarter end warrant value was recorded in earnings.

For the months from September 1, 2004 to July 2, 2005, according to the terms of the warrant provision of the August 24, 2004 debt agreement, the Company is obligated to issue 1,588,542 additional warrants. The value of these warrants of $604,955 was added to shareholders’ equity on the consolidated balance sheet, with a corresponding expense charged to interest expense in the consolidated statement of operations. This included charges against earnings of $178,917 and $320,967 associated with an aggregate of 444,792 and 894,792 warrants, respectively, that the Company was obligated to issue for the three and six months ended July 2, 2005.

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On September 10, 2004, the Company entered into a Master Vehicle Lease Termination Agreement with CLLLC (see Note 18), under which the Company terminated its previous master vehicle lease agreement with CLLLC. Under the terms of this termination agreement, the Company was released from its obligation under the previous master vehicle lease agreement. In consideration for this release the Company issued 1,000,000 warrants to purchase the Company’s common shares, which were valued at $515,000 using the Black Scholes model. This warrant value was recorded in the Company’s consolidated balance sheet as common stock warrants, with a corresponding expense recorded in the Company’s consolidated statement of operations in the third quarter of 2004.

4. Debt

Operating Line of Credit

As of July 1, 2005, the Company has a $5,000,000 credit facility. This credit facility expires in January 2006. In most prior years, this facility has been renewed annually. There can be no assurance that this facility will be renewed. Borrowings under the line of credit are due on demand, bear interest payable weekly at prime plus 6 1/2% and are collateralized by accounts receivable. The borrowing base is limited by certain factors such as length of collection cycle, subordination of collateral position on bonded work and other credit related factors. Subject to these limitations, the Company had no available borrowing capacity at July 2, 2005. As of July 2, 2005 and January 1, 2005, borrowings of $3,952,536 and $4,392,975, respectively, were outstanding under the facility. The Company was in compliance with the terms of the borrowing facility at quarter end.

Long Term Debt

The Company had notes payable outstanding at July 2, 2005 and January 1, 2005. The total amount of these debts and their terms are summarized below.

	July 2,			January 1,
	2005			2005
Steelcase, Inc. promissory note, quarterly interest only payments at 12% per annum beginning June 1, 2003. Annual principal payments of $69,773, second payment due February 28, 2005, third payment due and payable February 28, 2006, collateralized by 951,445 shares of the Company’s common stock (reduced by derivative allocation of $3,176) The Company is currently in default under the terms of the Note Agreement.	$	136,369		$	133,984
Oregon-SW Washington Electrical Trust Funds (comprised of several union benefits funds and pension trusts) promissory note in the amount of $952,907 payable monthly in payment amounts ranging from $25,000 per month to $75,000 per month including interest at 7% per annum, due and payable in full by September 1, 2006.		693,427			952,907
Destination Capital, LLC business loan agreement, net of debt discount of $9,487, nine monthly payments of interest only, starting September 24, 2004, with fifteen monthly payments of principal and interest of $83,333, thereafter. Interest accrued at prime plus 10%. (See Note 5)		1,148,847			1,186,135
Total debt		1,978,643			2,273,026
Less current portion		(1,738,531	)		(1,159,469	)
Long term debt	$	240,112		$	1,113,557

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All long-term portion of debt matures before the end of September 2006.

5. Related Party Transactions

The Company has a number of promissory notes, lines of credit and lease obligations owing to related parties. The following table lists the notes and obligations outstanding at July 2, 2005 by related party.

			Amount
			of		Monthly
Related Party	Type of Obligation	Maturity Date	Obligation		Payment
Destination Capital LLC(a)	Note Payable	August 24, 2006	$	1,158,335	$	83,333	(c)
Mark Walter	Bond guarantee fees	open		—		900	(b)
CEI(a)	Equipment lease	December 1, 2007		—		40,000
Destination Microfield, LLC(d)	Vehicle lease	August 1, 2006		—		29,000	(e)
John B. Conroy	Note receivable	September 16, 2005		66,250		—

(a)	Robert J. Jesenik, a director and significant shareholder of the Company, also owns a significant interest in these entities.
(b)	This bond guarantee fee is an approximation, and fluctuates based on the total open bond liability.
(c)	This payment amount is for principal only. An additional amount is due monthly which includes interest at prime plus 10%.
(d)	William C. McCormick, a director and former interim CEO, holds a minority ownership interest in this entity.
(e)	These payments vary over the term of the loan. This amount represents the monthly payment in effect on July 2, 2005.

Terms and conditions of each of the notes and agreements are listed below.

Notes Payable to Destination Capital, LLC

On January 22, 2004, the Company entered into a Contract of Sale and Security Agreement with Destination Capital LLC (Destination) under which the Company agreed to sell up to 15% of its acceptable, eligible accounts receivable to Destination, in exchange for borrowing up to $600,000 from that entity under the terms of a Promissory Note. Destination is an entity in which Robert J. Jesenik, a shareholder and director of the Company, holds a significant interest. Under the terms of the agreement between the Company and Destination, the Company paid interest at the rate of 18% per annum on the amount of the note outstanding, and also issued warrants in the amount of 1% of the fully diluted common shares, per month, for each calendar month in which the Note was outstanding. The warrants have a five-year life and will be issued at the lower of $0.42 or the price of any other common or preferred equity issued in the six months following the date of the agreement. During the 6 month agreement period, the Company issued incentive stock options at $0.31 per share, therefore the price per share used for these warrants was reduced to $0.31. The Company initially was obligated to issue warrants to purchase 350,387 common shares at the time this note was issued. The fair value of these warrants was determined to be $155,221 using the Black Scholes

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pricing model. The assumptions used included a risk free rate of 3.1%, volatility of 152%, fair market value of the Company’s stock of $.48 per share and a remaining life of 5 years. The calculated fair value amount was recorded as a debt discount and is being amortized over the six-month term of the debt. This debt was outstanding on February 1, 2004, March 1, 2004 and April 1, 2004 and in accordance with the terms of the note agreement, the Company is further obligated to issue additional warrants to purchase 1,053,159 shares of the Company’s common stock. These warrants were valued using the Black Scholes pricing model. The assumptions used included risk free rates ranging from of 3.1% to 3.3%, volatility of 152%, remaining lives of 5 years for each warrant issuance, and fair market values of the Company’s stock on those three dates of $0.46, $0.60 and $0.62 per share, respectively. The fair value of these warrants in the amount of $780,373 was recorded as interest expense in the consolidated statement of operations for the year ended January 1, 2005. At the date of each of those warrant issuances, the Company did not have sufficient authorized common shares to effect the exercise of these warrants, accordingly, the fair value of all of these warrants was classified as liability for warrant settlement on the consolidated balance sheet. On September 1, 2004, the Company’s shareholders voted to increase the Company’s authorized common shares from 25,000,000 to 125,000,000. The fair market values of these warrants were re-measured on that date and reclassified as common stock warrants in the shareholders’ equity section on the balance sheet, with the increase or decrease in their values recorded as an increase or reduction of interest expense in the consolidated statement of operations. The Note was repaid in full during April 2004.

On August 24, 2004 the Company entered into a Business Loan Agreement with Destination under which the Company can borrow up to $2,000,000 based on Destination’s discretion and funds availability. Under the terms of the agreement, the Company pays interest at prime plus 10% (prime plus 12% in the event of a default), with nine monthly interest only payments starting September 24, 2004, and 15 monthly principal payments of $83,333 and accrued interest until maturity. At loan maturity on August 24, 2006, any remaining principal and accrued interest owed is then due and payable. This loan is immediately due if there occurs a default, there is a sale or disposal of all or substantially all of the assets or stock of the Company, or if there is a transfer of ownership or beneficial interest, by merger or otherwise, of the stock of the Company or its subsidiary. Additionally, the Company will issue to Destination the number of warrants equal to 12.5% of the value of the loan balance, on the first day of each month the loan is outstanding. These warrants have a five year life and will be issued at the lower of $0.38 or the price applicable to any shares, warrants or options (excluding options granted to employees or directors) issued by the Company while the loan is outstanding. Beginning August 1, 2004, the Company was obligated to issue the following warrant amounts based on the outstanding loan balances on the first day of each month.

			Warrants to be
Date	Loan Balance		Issued
August 1, 2004	$	300,000		37,500
September 1, 2004	$	750,000		93,750
October 1, 2004	$	1,200,000		150,000
November 1, 2004	$	1,200,000		150,000
December 1, 2004	$	1,200,000		150,000
January 1, 2005	$	1,200,000		150,000
February 1, 2005	$	1,200,000		150,000
March 1, 2005	$	1,200,000		150,000
April 1, 2005	$	1,200,000		150,000
May 1, 2005	$	1,200,000		150,000
June 1, 2005	$	1,200,000		150,000
July 1, 2005	$	1,158,334		144,792
Total warrants to be issued as of July 2, 2005				1,626,042

The Company initially was obligated to issue warrants to purchase 37,500 common shares at the time this note was issued. The fair value of these warrants was determined to be $17,513 using the Black Scholes pricing model. The assumptions used included a risk free rate of 3.8%, volatility of 155%, fair market value of the Company’s stock of $.50 per share and a remaining life of 5 years. The calculated fair value amount was recorded as a debt discount and is being amortized over the twenty-four month term of the debt. The warrants issued from September 1, 2004 through July 1, 2005 were also valued using the Black Scholes pricing model. The assumptions used include risk free rates ranging from 3.39% to 4.17%, volatility percentages ranging from 121% to 155%, remaining lives of 5 years for each warrant issuance, and fair market values of the Company’s stock ranging from $0.30, to $0.60 per share. At the time these warrant obligations arose, the Company had sufficient authorized common shares to effect the exercise of these

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warrants. Accordingly, the fair values of the warrants issued from September 1, 2004 through July 2, 2005, $604,955, were classified as common stock warrants in the shareholders’ equity (deficit) section on the consolidated balance sheet, and expensed as interest expense in the consolidated statement of operations, as they were issued.

Bond Guarantee Fees

A certain number of CVI construction projects require the Company to maintain a surety bond. The bond surety company requires an additional guarantee for issuance of the bond. The Company has an agreement with Mark Walter, the Company’s President under which at quarter end pays Walter between $600 and $1,200 per month for his guarantee of this bond liability. The guarantee fee is computed as 15% (annualized) of the open liability under bonds issued for CVI.

Equipment Lease Agreement

On September 1, 2003, CTS entered into an agreement with CEI for use of certain equipment leased by CEI from an outside party. Robert J. Jesenik, a Director and significant Shareholder, owns a substantial ownership interest in CEI. The equipment consists of various construction vehicles, trailers, miscellaneous construction equipment, office furniture, computer hardware and software. Under the terms of the lease CTS pays CEI $40,000 monthly beginning on September 1, 2003, with the final payment due on December 1, 2007. The lease is accounted for as an operating lease and contains a 10% purchase option at the end of the lease term, December 31, 2007. The Company reached agreement on a payment plan to the lessor, under which $10,000 of the monthly lease obligation will be paid to the lessor in an equivalent amount of the Company’s Series 3 preferred stock. This arrangement to tender a portion of the payment with preferred stock in lieu of cash, was for the thirteen monthly payments beginning with the December 2003 lease payment, through the payment due in December 2004. Beginning with the payment due in January 2005, the total monthly amount due was paid entirely in cash.

Master Vehicle Lease Agreement

The Company entered into a new Master Vehicle Lease Agreement, effective September 9, 2004, with Destination Microfield, LLC. Destination Microfield, LLC is partially owned by William C. McCormick, interim CEO for the Company. In accordance with the terms of the agreement, the Company will make twelve monthly payments of $29,000 starting October 5, 2004, twelve monthly payments of $35,000, starting October 5, 2005, and three monthly payments of $45,000 ending on December 9, 2006. This lease is accounted for as an operating lease with equal monthly amounts charged to expense in the consolidated statement of operations over the life of the lease.

Real Property Sub Leases

On September 1, 2003, CTS entered into seven real property subleases with CEI for use of buildings, offices and storage yards to house the operations and property of CTS. Robert J. Jesenik, a Director and significant Shareholder, owns a substantial ownership interest in CEI. CTS has operating activities in Portland and Eugene, Oregon. The monthly sublease payments totaled $58,625 through November 30, 2004. On November 30, 2004, the Company terminated its lease with CEI for space in the Thurman Building and entered into a lease directly with the building owner for a smaller space in the building. As of January 1, 2005 the Company’s total real property lease payments totaled $48,842, of which $675 was on a month-to-month basis. The remaining $48,167 is due on leases with maturity dates between September 2005 and October 2008. The rent per month on the Thurman Building is $31,025. The annual rent obligations from January 1, 2005, for each property are listed in the table below.

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Location	Maturity		2005		2006		2007		2008		2009
Thurman Building		10/31/08	$	186,150	$	372,297	$	372,297	$	310,247		—
Swan Island		11/30/05		32,563		—		—		—		—
Eugene		09/30/05		25,359		—		—		—		—
Crown Plaza Office		7/31/07		9,397		18,795		12,530		—		—
Pope Storage		*
Montgomery Park		*
Storage
Total			$	253,469	$	391,092	$	384,827	$	310,247		—

* Month-to-Month

Administrative Services Agreement

On September 15, 2003, CTS entered into an administrative services agreement with CEI for the extension of certain administrative and related services by the Company to CEI. Robert J. Jesenik, a Director and Significant shareholder, owns a substantial ownership interest in CEI. Under the terms of the agreement, certain employees provided administrative and related services to CEI upon reasonable request. The agreement is subject to a 60-day notice period before termination by either party. The monthly payment for these services was determined at the effective date of the agreement to be approximately $35,000, with a provision to be adjusted as needed based on the level of usage of these services by CEI. During the first quarter of 2005, the payment by CEI for these services was renegotiated to approximately $12,500 per month as the cost of services to CEI has been reduced.

Note receivable

In 1998, John B. Conroy, then the Company’s Chairman, CEO and President, entered into a transaction whereby he purchased 45,000 shares of the Company’s common stock at $1.75 per share. Mr. Conroy issued a promissory note to the Company for $78,750 in payment for the shares. On May 17, 2004 the Note was replaced with a new non-recourse note for $66,250 under which the original amount of the note was offset against a $12,500 amount owed by the Company to Mr. Conroy. The note also acknowledges the outstanding accrued interest due by Mr. Conroy in the amount of $21,937. Additionally, the interest rate of the new promissory note was established at 3.4% per annum, and the due date was extended to August 29, 2006. Mr. Conroy resigned as Chairman, CEO and President on September 16, 2002, and resigned as a director in October 2003. At July 2, 2005, accrued interest receivable under this note totaled $27,369. The Company has accounted for the $78,750 due from Mr. Conroy as a reduction in common stock equity in prior years. In May 2004, the Company accounted for the $12,500 amount due to Mr. Conroy and additional $637 of interest adjustment as an increase in common stock equity.

6. Legal Proceedings

Shareholder lawsuit and settlement

In March, 2004, Kurt Underwood (former President/CEO of Microfield Group, Inc.) filed a lawsuit in Multnomah County Circuit Court, Portland, Oregon under case number 0403-02370 against Robert J. Jesenik, Aequitas Capital Management (formerly known as JMW Capital Partners), Destination Capital, LLC, Microfield Group, Inc., Christenson Electric, Inc., Steven M. Wright, Andrew S. Craig, Thomas A. Sidley, R. Patrick Hanlin, Michael Stansell, Brian A. Oliver, Brian N. Christopher, Kevin D. Robertson, Christenson Group, LLC, and Christenson Velagio, Inc. The lawsuit alleged that the Defendants violated Oregon securities law and Oregon common law in connection with the following transactions (which closed simultaneously in September 2003): (1) the merger of CTS Acquisition Co. (a wholly-owned subsidiary of the Company) with and into Christenson Technology Services, Inc.; and (2) the merger of VSI Acquisition Co. (A wholly-owned subsidiary of the Company) with and into Velagio, Inc. In addition, the lawsuit

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alleged that Mr. Underwood was terminated as an employee entitling him to severance pay. The lawsuit sought damages of approximately $1.4 million.

On May 27, 2004, the Company, certain executives, board members and related companies filed two separate answers, affirmative defenses, and counterclaims against Mr. Underwood in Multnomah County Circuit Court alleging violations of Oregon Securities law and Oregon common law in connection with the above named transactions. In addition, the countersuit alleged that Mr. Underwood was terminated by the Company for good cause. The lawsuit sought damages of not less than $2.5 million and return of the 3.4 million shares of Microfield stock held by Mr. Underwood in exchange for the return of the shares of Velagio stock held by the Company.

On May 11, 2005 the Company and Mr. Underwood entered into a Settlement Agreement under which both parties agreed to drop their respective lawsuits. The Settlement Agreement provides that the Company and certain defendants will jointly and severally purchase Mr. Underwood’s Microfield Stock for the aggregate purchase price of $362,500. The purchase price will be allocated as follows: $50,000 to the purchase of Mr. Underwood’s 119,050 Series 2 preferred shares and the balance to the purchase of Mr. Underwood’s 3,404,958 common shares. Additionally, the Settlement Agreement terminates Mr. Underwood’s Microfield Warrant. Microfield assigned its right to purchase Underwood’s shares under the Settlement Agreement to Energy Fund II, LLC, a related party. Payment under the Settlement Agreement occurred as scheduled on August 1, 2005.

7. Subsequent Events

On July 20, 2005, the Company entered into an agreement to purchase all the outstanding shares of Christenson Electric, Inc. (CE) in exchange for 2 million shares of the Company’s common stock at $.64 per common share, and the assumption of interest-bearing debt within CE of approximately $4.6 million. The transaction was valued at approximately $5.9 million. CE is in the business of wind farm construction and electrical maintenance, and construction of substation distribution and transmission facilities across the United States. CE also provides services to Bonneville Power Administration and other major utilities under long-standing contractual relationships. The assets of CE were principally equipment and intangibles. As a result of the transaction, CE is a wholly-owned subsidiary of Microfield Group, Inc.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of the financial condition and results of operations of Microfield Group, Inc. should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements and the Notes thereto included in the Company’s Annual Report on Form 10-KSB for the year ended January 1, 2005.

Forward-Looking Statements

Certain statements contained in this Form 10-QSB concerning expectations, beliefs, plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements which are other than statements of historical facts are “forward-looking statements” within the meaning of the federal securities laws. Although the Company believes that the expectations and assumptions reflected in these statements are reasonable, there can be no assurance that these expectations will prove to be correct. These forward-looking statements involve a number of risks and uncertainties, and actual results may differ materially from the results discussed in the forward-looking statements. Any such forward-looking statements should be considered in light of such important factors and in conjunction with other documents of the Company on file with the SEC.

New factors that could cause actual results to differ materially from those described in forward-looking statements emerge from time to time, and it is not possible for the Company to predict all of such factors, or the extent to which any such factor or combination of factors may cause actual results to differ from those contained in any forward-looking statement. Any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligations to update the information contained in such statement to reflect subsequent developments or information.

Overview

Microfield Group, Inc. (the “Company”) specializes in the installation of electrical products and services. The Company’s objective is to leverage its assets and value to successfully build a viable, profitable electrical services and technology infrastructure business.

In September 2003, the Company acquired privately held Velagio, Inc. (Velagio) and Christenson Technology Services, Inc. (CTS). In December, 2003 the service and technology teams of Velagio and CTS were consolidated into one subsidiary under the name Christenson Velagio, Inc. (CVI) in order to take full advantage of inherent synergies within the subsidiaries, as well as capture competitive advantage. The newly formed organization conducts business in the electrical services and technology infrastructure sectors. CVI has the ability to deliver the following products and services:

• Computer Telephony Integration

• Digital Video CCTV Systems and Infrastructure

• Telecommunications Systems and Infrastructure

• Enterprise Security Systems

• Wireless Networking Solutions

• Life Safety Systems Design and Installation

• Information Technology Network Design & Engineering

• Voice/Data Systems and Infrastructure

• Electrical Design & Engineering

• Electrical Construction Services

• Lighting Services

• Electrical System Audits

These services and capabilities are expected to provide the substantial majority of the Company’s sales in the foreseeable future. The Company’s results will therefore depend on continued and increased market

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acceptance of these products and the Company’s ability to install and service them to meet the needs of its customers. Any reduction in demand for, or increase in competition with respect to these products could have a material adverse effect on the Company’s financial condition and results of operations.

During 2003, the Company made the decision to discontinue the operations of Velagio and previously acquired Innovative Safety Technologies, Inc. (IST). This decision was made based on the declining sales in these two entities, and the fact that many of the employees whose focus was in sales of these products and services were no longer with the Company. The remaining assets and liabilities were merged into CVI in December in conjunction with the combination of Velagio, IST and CTS. As of July 2, 2005, Microfield Group, Inc. has one wholly-owned subsidiary, Christenson Velagio, Inc.

The Company’s current acquisition strategy is to evaluate potential merger opportunities as they develop.

Management’s Focus in Evaluating Financial Condition and Operating Performance

Management meets regularly to review the Operations, Finance and Administration functions of the business. Operations consists of customer solicitation and project work performance, and Finance and Administration, consists of the administration and support of the Company. Based on the information reviewed, meetings are held daily, weekly and monthly. Following is a list of the most critical information which management examines when evaluating the performance and condition of the Company.

     Revenue. Sales personnel and project managers are responsible for obtaining work to be performed by the Company. Revenue is booked daily based on the Company’s revenue recognition policy. These bookings are reviewed the following day by the President, the Chief Financial Officer (CFO) and several of their direct reports. Decisions about various aspects of the business are made, and actions are taken based on the prior day’s revenue, and whether or not it met daily and weekly revenue goals and expectations. Monthly customer revenue is also examined, in detail, as a part of a review of the Company’s financial statements for the prior month by the Company’s executive team and its board of directors.

     Expense Control. The Company has various controls in place to monitor spending. These range from authorization and approvals by the President and CFO as well as review of the periodic check runs by the CFO and reviews of labor efficiency and utilization by the President and his project managers. An organizational team, which is comprised of the President, CFO, several department heads and key employees, meets weekly to review reports that monitor expenses and cost efficiency, among other factors. Additionally, the executive team, comprised of the Company’s President, CFO and Controller, meets weekly to review operations, and monthly with the board of directors to review monthly spending patterns and expenses as a part of the review of the prior month’s financial statements.

      Cash Requirements. The Company focuses on cash daily, through a series of meetings that highlight cash received from borrowings on the prior day’s billings, cash required to fund daily operating needs, cash received from customers and several other factors that impact cash. Management reviews accounts receivable reports, ineligible receivables and accounts payable reports in conjunction with preparing a daily cash flow schedule that projects and tracks all cash sources and uses. Management and the board of directors use this information in determining cash requirements.

      Customer service. Management considers the Company’s reputation as one of its most valuable assets. Much of the Company’s revenue is based either on repeat business or referrals from its loyal customer base. The Company reviews service issues and any customer feedback continually to ensure continued customer satisfaction through timely and high quality work.

      Safety. Safety is of utmost importance to the Company and its employees. The Company’s engineers, electricians and technicians are required to undergo regular educational seminars, which include safety training. The Company has well defined procedures designed to prevent accidents. Management

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reviews reports on the Company’s safety record, and examines the facts and circumstances surrounding specific accidents to ensure that all procedures were followed, or to modify procedures if needed.

Business Characteristics

      Revenue. The Company generates revenue by performing electrical service work and technology infrastructure design and installation. These projects are obtained by the Company’s sales force and project managers. These projects come from direct solicitation of work, the bidding process, referrals, regular maintenance relationships and repeat customer projects.

      Cash. The Company generates cash mainly through operations. Cash is borrowed daily from an asset based lender under a revolving credit facility. These borrowings are repaid through collections from customers’ accounts. Each day, the Company submits to its lender, a summary of customer billings, cash collections, ineligible accounts and the amount of the borrowing requested. The lender approves the submission and deposits funds directly into the Company’s bank account.

The Company has also generated cash through debt issuances and private placements of common and preferred stock. The board of directors reviews both short and long range business plans and projections, and implements funding strategies based on the cash needs produced in the projections.

      Opportunities and Risks. Some of the significant business risks CVI faces, among others, include interruption in the flow of materials and supplies, interruption of its work force through disagreements with its union, business contraction and expansion caused by the economy, and its general lack of liquidity.

As a part of its regular business planning, the Company anticipates the effect that these risks may potentially have on its financial condition. Some of the risks are planned for contractually to minimize the Company’s liability in cases where it is subject to contract performance. Others are anticipated by forging plans for staff reductions or increases should the economy move drastically in one direction. The Company also continually looks for additional funding sources and cash availability, both by improving operating performance internally and from external debt and equity sources, should its cash be strained by certain factors.

Business Goal Attainment.

When entering into the acquisitions of CTS and Velagio, the Company’s goal was to realize certain synergies within the resulting organization, save costs from eliminating duplicate processes, and come out of the combination as a breakeven or slightly profitable company. The Company achieved operating profitability in both the first and second quarters of 2005. These two consecutive quarters of profits from operations mark a turnaround from the unprofitable operations the Company sustained in the business from the acquisition date of CVI through the end of 2004.
Quarterly losses from operations during that period averaged over $1.1 million per quarter, compared to an average operating profit of just under $300,000 per quarter in 2005.

The Company’s goals for the third and fourth quarters of 2005 include working toward pre tax net profitability, further reducing its negative cash flow, and increasing top line revenue and margins. It’s anticipated that this will be done through a combination of process efficiencies, lease restructurings and general expense cutbacks. The Company anticipates that this combination of improvements, if accomplished to its targets, is intended to result in net pre-tax income during the second half of 2005.

Trends.

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CVI’s business is closely tied to the economy. In a down economy, the Company’s work becomes more dependent on repeat business from ongoing customer relationships. When the service, manufacturing and retail industries aren’t expanding, CVI’s service projects are more focused toward changes, adds, moves, and fixes within this customer base. The Company continues to see improvement in the economy at the current time, and is anticipating a modest increase in sequential quarterly revenues due to seasonal general economic trends.

In the last three years the Company has seen a dramatic downturn in spending for technology infrastructure. This affected the technology side of CTS’s business prior to its acquisition by the Company. It is anticipated that as the economy continues to improve, CVI will see increasing revenue from the sales of technology products and services.

Results of Operations

The financial information presented for the three and six months ended July 2, 2005 and July 3, 2004, represents activity in Microfield Group, Inc. and its wholly-owned subsidiary, CVI.

Sales. Revenue for the three months ended July 2, 2005 was $9,007,000 compared to $9,646,000 for the three months ended July 3, 2004. This also compares to revenue of $8,894,000 in the first quarter of 2005. This decrease in revenue between the second quarters of 2004 and 2005, is a direct result of the Company’s efforts to concentrate on more profitable business. Despite a revenue decrease of over $600,000 between year over year quarters, gross profits increased over those same two periods by over $240,000. The Company also experienced an increase in sequential quarterly revenue due to a continued improvement in the construction industry, and from seasonal work as the Company moved toward summer.

There were no sales to any customers that exceeded 10% of total revenue in the three months ended July 2, 2005. Sales to two customers comprised 10% and 11% of the Company’s total sales for the three months ended July 3, 2004.

Revenue for the six months ended July 2, 2005 was $17,901,000 compared to $18,837,000 for the six months ended July 3, 2004. There were no sales to any customers that exceeded 10% of total revenue in the six months ended July 2, 2005. There were sales one customer during the six months ended July 3, 2004 that comprised 12% of the Company’s total sales for that period.

Cost of Sales. Cost of sales totaled $7,093,000 (or 78.8% of sales) for the fiscal quarter ended July 2, 2005, compared to $7,975,000 (or 82.4% of sales) for the same period in the prior year. This reduction in costs coincides with the lower levels of sales in the current year quarter. This reduction also reflects the

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achievement of a reduction in the percentage of cost of sales to total sales of 3.6 percentage points, which is in line with the Company’s goal to focus on more profitable projects. Cost of sales for the six months ended July 2, 2005 was $14,098,000 compared to 15,353,000 for the six months ended July 3, 2004. Cost of sales includes the cost of labor, products, supplies and overhead used in providing electrical and technology services.

Gross Profit. Gross profit for the three months ended July 2, 2005 was $1,913,000 (or 21.2%) compared to $1,671,000 (or 17.3%) for the same period in 2004. This increase in gross margin of 3.9% of total sales produced an increase in gross profit of $242,000 in the second quarter of 2005 over the second quarter of 2004 on revenue that was $639,000 lower in the current year’s second quarter compared to the revenue in the prior year’s second quarter. This improvement is a direct result of the Company’s efforts to reach profitability, in part by being more selective of projects on which they bid, or work they accept. Gross profit for the six months ended July 2, 2005 was $3,804,000 (or 21.2%) compared to $3,483,000 (or 18.5%) for the same period in 2004.

Future gross profit margins will depend on the volume and mix of sales of products and services to the Company’s customers, as well as the Company’s ability to control costs. It is the Company’s goal to sustain higher levels of gross margins through continuing cost reduction efforts and an emphasis on obtaining higher gross margin work projects.

Sales, General and Administrative Expenses(S, G & A). S, G & A expenses were $1,632,000 (or 18.0% of sales) for the three months ended July 2, 2005, compared to $2,245,000 for the three months ended July 3, 2004, a reduction of $624,000. Sequential quarterly S G & A expenses decreased significantly from the fourth quarter 2004 expenses of $2,007,000 and were essentially in line with the first quarter 2005 expenses of $1,594,000. S, G & A expenses are comprised mainly of payroll costs, facilities and equipment rent, outside services, insurance, utilities and depreciation. Payroll costs, which include salary, payroll taxes and fringe benefits, totaled $1,259,000 for the three months ended July 2, 2005 compared to $1,377,000 in the three months ended July 3, 2004. This reduction is due primarily to the Company’s cost cutting efforts and not hiring new employees upon the attrition of certain employees.

Total rents for the three months ended July 2, 2005 were $153,000, which was primarily comprised of facilities rent. This is compared to $187,000 of rent incurred in the three months ended July 3, 2004. Outside services, professional fees, insurance, utilities and depreciation for the three months ended July 3, 2004 totaled $139,000, compared to $478,000 for the three months ended July 3, 2004. The current quarter included a reduction of $120,000 in legal fees from the reversal of expenses accrued in prior periods in connection with a lawsuit.

S, G & A expenses were $3,226,000 (or 18.0%) for the six months ended July 2, 2005, compared to $5,258,000 (or 27.9%) for the six months ended July 3, 2004. The reduction of over $2 million between the first six month period of 2004 to the same period in 2005 was due to reductions in payroll and payroll related costs of approximately $500,000, lower insurance and bonding costs of approximately $325,000, and lower professional fees of approximately $780,000. Included in the reduction of professional fees was the accrual of $395,000 in the six months ended July 3, 2004 for legal defense costs, and the reversal of $120,000 of that accrual in the six months ended July 2, 2005.

The level of S, G & A expense for the 2005 is anticipated to continue to be significantly lower compared to the level incurred in the 2004 due to lower payroll costs and the Company’s continued diligence in reducing costs. The Company anticipates these expenses will approximate between 16% and 22% of sales for 2005.

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Interest Expense. Interest expense was $401,000 for the three months ended July 2, 2005, compared to $314,000 for the three months ended July 3, 2004. Included in interest for 2005 is $179,000 of interest recorded as a result of the accounting treatment of the issuance of warrants associated with the debt owed to Destination Capital LLC. This expense is a non-cash expense amount. There was no interest charged in the second quarter 2004 from warrant obligations. It is anticipated that the interest expense may begin decreasing as principal payments reduce the warrant obligation incurred each month. The amount of interest charged each month is also subject to fluctuations in the Company’s stock price. As the price increases, the value of the warrants issued also increases, which may result in an increase in interest expense.

Interest expense was $784,000 for the six months ended July 2, 2005 compared to $1,280,000 for the six months ended July 3, 2004. This decrease is due in part to the lower costs for the issuance of warrants in connection with the Destination Capital note. The Company recorded $321,000 and $676,000 in non-cash interest expense under the terms of the note in the six months ended July 2, 2005 and July 3, 2004, respectively. Excluding the effect of these non-cash interest charges, interest expense was $464,000 and $605,000 for the six months ended July 2, 2005 and July 3, 2004, respectively. Interest expense is also lower due to the fact that the Company’s overall interest bearing debt totals were lower in 2005 than they were in 2004, over the same six month periods.

Derivative income/expense. The Company incurred $32,000 in non-cash derivative expense for the six months ended July 2, 2005 compared with $29,000 for the six months ended July 3, 2004. This expense is recorded based on the fluctuations of the Black Scholes value of the derivative liabilities listed on the Company’s consolidated balance sheet. The expense is computed using the fair value of the Company’s common stock, among other factors, and will produce non-cash derivative expense or derivative income as the Company’s stock price increases or decreases, respectively.

Gain / Loss From Discontinued Operations

After the acquisitions of Velagio and CTS, management discontinued the operations of both Velagio and IST due to a decline in sales and a decision to focus on the CTS business. Accordingly, the revenue, expenses and other income or losses for IST are condensed and reported as discontinued operations in the consolidated statement of operations. Certain information from those businesses is reported below.

Discontinued operations is comprised of a royalty from the sale of the SoftBoard business. The SoftBoard business was sold in 2000. As part of the sale price, the Company receives royalties from the purchaser of that business, based on sales of SoftBoard products. These royalties are listed in the income statement under “Gain on sale of discontinued operations.”

Income Taxes. There was no provision for income taxes for the three and six months ended July 2, 2005 and July 3, 2004 due to losses incurred by the Company in those periods. No tax benefit from loss carryback was recorded in either year as there was no income tax paid in the open loss carryback periods. The Company has provided a full valuation allowance on its net deferred tax asset.

Liquidity and Capital Resources

Since inception, the Company has financed its operations and capital expenditures through public and private sales of equity securities, cash from operations, and borrowings under bank lines of credit. At July

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2, 2005, the Company had negative working capital of approximately $4,189,000 and its primary source of liquidity consisted of cash and its operating line of credit.

Accounts receivable decreased to $5,610,000 at July 2, 2005 from $6,241,000 at January 1, 2005. The decrease is due to a better collection record of receivables at the end of the second quarter, and a reduction in the amount of past due receivables. Receivables are net of an allowance for doubtful accounts of $153,000 and $104,000 at July 2, 2005 and January 1, 2005, respectively. Management expects these receivables to remain fairly constant as a percentage of sales, decreasing slightly as efficiencies in the billing and collection processes are achieved. At July 2, 2005, no single customer account balance exceeded 10% of total outstanding accounts receivable.

Inventory increased to $244,000 at July 3, 2004 from $239,000 at January 1, 2005. The increase is due to normal fluctuations in inventory based on sales levels at any point in time. This balance mainly includes inventory used in the electrical services business. The Company maintains a fleet of trucks and vans which each maintain a certain level of inventory needed to provide timely products and services to the Company’s customers. The inventory levels should remain relatively constant, and increase slightly as the Company’s revenue increases. These balances are a significant reduction from inventory balances at July 3, 2004 of $437,000 due to write-offs of obsolete inventory and to more closely managed inventory levels.

Property and equipment, net of depreciation decreased to $111,000 at July 2, 2005 compared to $126,000 at January 1, 2005. This decrease was due to normal monthly depreciation. The Company is party to an equipment lease agreement with a related party, under which it leases furniture and fixtures, equipment, computer equipment, and job site tools and equipment (See Related Party Transactions). This lease is classified as an operating lease with a monthly payment due of $40,000. The Company anticipates spending nominal amounts to acquire fixed assets in the foreseeable future.

Accounts payable decreased to $3,073,000 at July 2, 2005 from $3,452,000 at January 1, 2005. This change is due to the timing of the purchase of materials needed to support the level of sales at the end of the first quarter 2005 compared to the level of sales at the end of 2004. Payables consist primarily of the costs of inventory, materials and supplies used in the electrical construction services and technology infrastructure services provided by the Company. The company also made efforts to shorten the days payables are outstanding.

Accrued payroll, payroll taxes and benefits were $1,414,000 at July 2, 2005 compared to $1,297,000 at January 1, 2005. This increase is due to a higher accrued payroll from an increased number of hours worked at the end of the second quarter compared to the end of the year 2004. This liability consists primarily of union and non-union payroll, and payroll withholdings, health and welfare benefits owed to the unions representing the Company’s electricians and technicians, and other payroll related obligations. This liability will vary between reporting periods based on the fact that payroll taxes decrease as the tax obligation thresholds for some of the taxes are exceeded. The combined payroll, payroll tax and benefit amounts should fluctuate with the revenues of the Company and as such, represents a main cash use of the Company’s funds. As revenues increase, the amounts due for these types of expenses will increase as well. These liabilities are normally short-term in nature with most of them being paid within one to six weeks of the expense being incurred.

The bank line of credit was approximately $3,953,000 at July 2, 2005. This is a decrease of $440,000 from $4,393,000 outstanding at January 1, 2005, and is due to a lower base of accounts receivable on which the Company can borrow. This lending facility is a primary source of funds for the Company. Amounts are drawn against it each day based on the amount of eligible revenues that are billed by the Company. As receivables are collected daily, those funds are used to pay down the facility. The facility has a limit of $5,000,000 and borrowings are based on 85% of eligible accounts receivable. As of July 2, 2005, based on eligible receivables, the Company had no available borrowing capacity.

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On January 22, 2004, the Company entered into a Contract of Sale and Security Agreement with Destination Capital LLC (Destination) under which the Company agreed to sell up to 15% of its acceptable, eligible accounts receivable to Destination, in exchange for borrowing up to $600,000 from that entity under the terms of a Promissory Note. The Company borrowed $600,000 under this facility. In April 2004, the Company raised an additional $1,750,000 through the issuance of Series 4 preferred shares, a portion of which was used to pay off the $600,000 borrowed in January 2004, with the remainder to be used for operating capital by the Company. In August 2004, the Company entered into a second borrowing agreement with Destination Capital, LLC. Under this loan agreement, the Company borrowed $1,200,000 to be used for operating capital. As of July 2, 2005, there was $1,158,000 outstanding under that loan.

The Company and its subsidiary have suffered recurring losses from ongoing operations and have experienced negative cash flows from continuing operating activities during 2004 and 2003. As of July 2, 2005 the Company had negative working capital of $4,189,000, total liabilities of $11,289,000 and an accumulated deficit of $29,744,000. While it is anticipated that the losses from continuing operations will decline as a result of cost reduction efforts, debt conversions and fundraising events, recurring losses and liquidity issues raise doubt about the Company’s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. While, the Company may not have sufficient resources to satisfy cash requirements for the next twelve months, by adjusting its operations to the level of capitalization, the Company believes it has sufficient capital resources to meet projected cash flow deficits. However, if during that period or thereafter, the Company is not successful in generating sufficient liquidity from operations or in raising sufficient capital resources, on terms acceptable to it, this could have a material adverse effect on the Company’s business, results of operations liquidity and financial condition.

The Company may have to seek additional investment capital or debt facilities. Investment capital or debt facilities may be difficult to obtain due to, among other issues, the Company’s prior financial performance. There can be no assurance that additional capital will be available or, if available, will be at terms acceptable to the Company. The Company is continuing to focus on opportunities to increase revenues and grow margins while reducing monthly expenses in an attempt to turn cash flow positive and achieve pre-tax profitability.

The Company had no commitments for capital expenditures in material amounts at July 2, 2005.

The independent auditor’s report on the Company’s January 1, 2005 financial statements included in this Annual Report states that the Company’s recurring losses raise substantial doubts about the Company’s ability to continue as a going concern.

Inflation

In the opinion of management, inflation will not have an impact on the Company’s financial condition and results of its operations.

Off-Balance Sheet Arrangements

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The Company does not maintain off-balance sheet arrangements nor does it participate in any non-exchange traded contracts requiring fair value accounting treatment.

TRENDS, RISKS AND UNCERTAINTIES

The Company has sought to identify what it believes to be the most significant risks to its business, but cannot predict whether, or to what extent, any of such risks may be realized nor can it guarantee that it has identified all possible risks that might arise. Investors should carefully consider all of such risk factors before making an investment decision with respect to the Company’s Common Stock.

CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS

The Company provides the following cautionary discussion of risks, uncertainties and possible inaccurate assumptions relevant to its business, products and services. These are factors that could cause actual results to differ materially from expected results. Other factors besides those listed here could adversely affect the Company.

Potential Fluctuations in Annual Operating Results

Annual operating results may fluctuate significantly in the future as a result of a variety of factors, most of which are outside the Company’s control, including: the demand for the Company’s products and services; seasonal trends in purchasing, the amount and timing of capital expenditures and other costs relating to the real estate construction and development; price competition or pricing changes in the market; technical difficulties or system downtime; general economic conditions and economic conditions specific to the construction industry.

Annual results may also be significantly impacted by the impact of the accounting treatment of acquisitions, financing transactions or other matters. Particularly at the Company’s early stage of development, such accounting treatment can have a material impact on the results for any quarter. Due to the foregoing factors, among others, it is likely that operating results may fall below expectations or those of investors in some future quarter.

Dependence Upon Management

Future performance and success is dependant upon the efforts and abilities of the Company’s management. To a very significant degree, the Company is dependent upon the continued services of A. Mark Walter, the President and member of the Board of Directors. If the services of either Mr. Walter, or other key employees were lost before the Company could get qualified replacements, the loss could materially adversely affect the Company’s business. The Company does not maintain key man life insurance on any of our Management.

Limitation of Liability and Indemnification of Officers and Directors

The Company’s officers and directors are required to exercise good faith and high integrity in Management affairs. The Articles of Incorporation provide, however, that officers and directors shall have no liability to shareholders for losses sustained or liabilities incurred which arise from any transaction in their respective managerial capacities unless they violated their duty of loyalty, did not act in good faith, engaged in intentional misconduct or knowingly violated the law, approved an improper dividend or stock repurchase, or derived an improper benefit from the transaction. The Articles and By-Laws also provide for the indemnification by the Company of the officers and directors against any losses or liabilities they may incur as a result of the manner in which they operate the business or conduct the internal affairs, provided that in connection with these activities they act in good faith and in a manner that they reasonably believe to be in, or not opposed to, the best interests of the Company, and their conduct does not constitute gross negligence, misconduct or breach of fiduciary obligations.

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Continued Control of Current Officers and Directors

The present officers and directors own or control approximately 51% of the Company’s outstanding voting shares of Common Stock and common stock equivalents, and therefore are in a position to elect all of our Directors and otherwise control the Company, including, without limitation, authorizing the sale of equity or debt securities of Microfield, the appointment of officers, and the determination of officers’ salaries. Shareholders have no cumulative voting rights. (See Security Ownership of Certain Beneficial Owners and Management in the Company’s Annual report on Form 10-KSB)

Management of Growth

The Company may experience growth, which will place a strain on its managerial, operational and financial systems resources. To accommodate its current size and manage growth if it occurs, the Company must devote management attention and resources to improve its financial strength and operational systems. There is no guarantee that the Company will be able to effectively manage its existing operations or the growth of its operations, or that its facilities, systems, procedures or controls will be adequate to support any future growth. The Company’s ability to manage operations and any future growth will have a material effect on its stockholders.

If the Company fails to remain current on reporting requirements, it could be removed from the OTC Bulletin Board which would limit the ability of broker-dealers to sell the Company’s securities and the ability of stockholders to sell their securities in the secondary market.

      Companies trading on the OTC Bulletin Board, must be reporting issuers under Section 12 of the Securities Exchange Act of 1934, as amended, and must be current in their reports under Section 13, in order to maintain price quotation privileges on the OTC Bulletin Board. If the Company fails to remain current on its reporting requirements, it could be removed from the OTC Bulletin Board. As a result, the market liquidity for the Company’s securities could be severely adversely affected by limiting the ability of broker-dealers to sell the Company’s securities and the ability of stockholders to sell their securities in the secondary market.

The Company’s common stock is subject to the “Penny Stock” rules of the SEC and the trading market in its securities is limited, which makes transactions in its stock cumbersome and may reduce the value of an investment in the Company’s stock.

      The Securities and Exchange Commission has adopted Rule 15g-9 which establishes the definition of a “penny stock,” for the purposes relevant to the Company, as any equity security that has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share, subject to certain exceptions. For any transaction involving a penny stock, unless exempt, the rules require:

• that a broker or dealer approve a person’s account for transactions in penny stocks; and

• the broker or dealer receive from the investor a written agreement to the transaction, setting forth the identity and quantity of the penny stock to be purchased.

 In order to approve a person’s account for transactions in penny stocks, the broker or dealer must:

• obtain financial information and investment experience objectives of the person; and

• make a reasonable determination that the transactions in penny stocks are suitable for that person and the person has sufficient knowledge and experience in financial matters to be capable of evaluating the risks of transactions in penny stocks.

The broker or dealer must also deliver, prior to any transaction in a penny stock, a disclosure schedule prescribed by the Commission relating to the penny stock market, which, in highlight form:

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• sets forth the basis on which the broker or dealer made the suitability determination; and

• that the broker or dealer received a signed, written agreement from the investor prior to the transaction.

               Generally, brokers may be less willing to execute transactions in securities subject to the “penny stock” rules. This may make it more difficult for investors to dispose of the Company’s common stock and cause a decline in the market value of its stock.

               Disclosure also has to be made about the risks of investing in penny stocks in both public offerings and in secondary trading and about the commissions payable to both the broker-dealer and the registered representative, current quotations for the securities and the rights and remedies available to an investor in cases of fraud in penny stock transactions. Finally, monthly statements have to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks.

Item 3. Controls and Procedures

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report, the Company conducted an evaluation, under the supervision and with the participation of its President and acting Chief Financial Officer, of its disclosure controls and procedures (as defined in Rules 13a-15(e) of the Exchange). Based on his evaluation, the President concluded that the Company’s disclosure controls and procedures need improvement and were not adequately effective as of July 2, 2005 to ensure timely reporting with the Securities and Exchange Commission. Management is in the process of identifying deficiencies with respect to the Company’s disclosure controls and procedures and implementing corrective measures, which includes the establishment of new internal policies related to financial reporting.

Changes in Internal Control over Financial Reporting

As required by Rule 13a-15(d), Microfield management, including the President, also conducted an evaluation of Microfield’s internal controls over financial reporting to determine whether any changes occurred during the fiscal quarter that have materially affected, or are reasonably likely to materially affect, Microfield’s internal control over financial reporting. During the preparation of the Company’s financial statements as of and for the quarter ended July 2, 2005, the Company has concluded that the current system of disclosure controls and procedures was not effective because of the internal control weaknesses identified below. As a result of this conclusion, the Company has initiated the changes in internal control also described below. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events.

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Deficiencies and Corrective Actions Relating to the Company’s Internal Controls over Financial Reporting

During the course of the audit of the Company’s January 1, 2005 financial statements, the Company’s registered independent public accounting firm identified certain material weaknesses relating to the Company’s internal controls and procedures within the areas of revenue recognition, accounts payable, cash disbursements, inventory accounting and document retention. Certain of these internal control deficiencies may also constitute deficiencies in the Company’s disclosure controls.

In order to review the financial condition and prepare the financial disclosures in this document, the Company’s officers have been responding to recommendations from the Company’s registered independent public accounting firm to properly and accurately account for the financial information contained in this Form 10-QSB. Detailed validation work was done by internal personnel with respect to all material consolidated balance sheet account balances to substantiate the financial information that is contained in this Form 10-QSB. Additional analysis was performed on consolidated income statement amounts for reasonableness. Management is in the process of implementing a more effective system of controls, procedures and other changes in the areas of revenue recognition, accounts payable, cash disbursements, inventory accounting and document retention to insure that information required to be disclosed in this quarterly report on Form 10-QSB has been recorded, processed, summarized and reported accurately. Among the changes implemented are:

Revenue recognition

• Criteria and procedures established defining approved customer contracts

• Control function established to review and monitor compliance to new procedures

• Improved document control and file check out procedures

• Procedure established defining consistent percentage completion Gross Margin estimation process

Cash Disbursements and liability recognition

• Document control system established and monitored for compliance

• Cut off procedures formalized and consistently applied

• Centralized departmental budgets and accountability established

• Purchasing procedures have been formalized and implementation has begun

Account Reconciliations

• Procedures established and personnel assigned to reconcile key accounts on a timely basis

• Control function added to review reconciliations

In addition to the above, the Company made the following changes during the fiscal quarter ended July 2, 2005 in our internal control over financing reporting:

Lack of Adequate Accounting Staff

      The Company was aware of its staffing needs and took steps to address its understaffed Finance and Accounting team to correct this material weakness. During the quarter ended July 2, 2005, the Company engaged an independent contractor with extensive CFO-level management and SEC reporting experience in public companies. The Company feels this addition to the Finance and Accounting team will improve the quality of future periodic financial reporting.

Timely Closing of the Books

      Management identified a material weakness based on the Company’s delay in closing its books. To correct this material weakness, checklists have been developed delineating tasks, preparation responsibilities, and review responsibilities targeting specific completion dates. The checklists provide evidentiary support of work performed and reviewed. In the future, specific checklist will be developed for non-quarter end months, quarter end months, and the annual close. These checklists have been developed

32

and were implemented in the 2nd quarter 2005 close process and utilized in the preparation of the 2nd quarter 2005 Form 10-QSB and subsequent period ends.

The Company’s officers have been working with the Board of Directors to address recommendations from the Company’s registered independent public accounting firm regarding deficiencies in the disclosure controls and procedures. The Company is currently engaged in the implementation of a new internal software system and associated new internal control procedures. Management expects that this system along with new associated procedures, once implemented, will correct the deficiencies and will result in disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act that will timely alert the President to material information relating to the Company required to be included in the Company’s Exchange Act filings.

33

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In March, 2004, Kurt Underwood (former President/CEO of Microfield Group, Inc.) filed a lawsuit in Multnomah County Circuit Court, Portland, Oregon under case number 0403-02370 against Robert J. Jesenik, Aequitas Capital Management (formerly known as JMW Capital Partners), Destination Capital, LLC, Microfield Group, Inc., Christenson Electric, Inc., Steven M. Wright, Andrew S. Craig, Thomas A. Sidley, R. Patrick Hanlin, Michael Stansell, Brian A. Oliver, Brian N. Christopher, Kevin D. Robertson, Christenson Group, LLC, and Christenson Velagio, Inc. The lawsuit alleges that the Defendants violated Oregon securities law and Oregon common law in connection with the following transactions (which closed simultaneously in September 2003): (1) the merger of CTS Acquisition Co. (a wholly-owned subsidiary of the Company) with and into Christenson Technology Services, Inc.; and (2) the merger of VSI Acquisition Co. (A wholly-owned subsidiary of the Company) with and into Velagio, Inc. In addition, the lawsuit alleges that Mr. Underwood was terminated as an employee entitling him to severance pay. The lawsuit seeks damages of approximately $1.4 million. The Company intends to vigorously defend the lawsuit, however at the date of this filing, the outcome of this matter is uncertain. The financial statements do not reflect any adjustments relative to this uncertainty, but since the legal expenses to vigorously defend this suit are probable, a legal reserve in the amount of $395,000 was estimated with counsel, accrued as a liability and charged to earnings in the period ended April 3, 2004.

On May 27, 2004, the Company, certain executives, board members and related companies filed two separate answers, affirmative defenses, and counterclaims against Mr. Underwood in Multnomah County Circuit Court alleging violations of Oregon Securities law and Oregon common law in connection with the above named transactions. In addition, the countersuit claims that Mr. Underwood was terminated by the Company for good cause. The lawsuit seeks damages of not less than $2.5 million and return of the 3.4 million shares of Microfield stock held by Mr. Underwood in exchange for the return of the shares of Velagio stock held by the Company.

On May 11, 2005 the Company and Mr. Underwood entered into a Settlement Agreement under which both parties agreed to drop their respective lawsuits. The Settlement Agreement provides that the Company and certain defendants will jointly and severally purchase Mr. Underwood’s Microfield Stock for the aggregate purchase price of $362,500. The purchase price will be allocated as follows: $50,000 to the purchase of Mr. Underwood’s 119,050 Series 2 preferred shares and the balance to the purchase of Mr. Underwood’s 3,404,958 common shares. Additionally, the Settlement Agreement terminates Mr. Underwood’s Microfield Warrant. Microfield assigned its right to purchase Underwood’s shares under the Settlement Agreement to Energy Fund II, LLC, a related party. Payment under the Settlement Agreement occurred as scheduled on August 1, 2005.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

(a)	None
(b)	None
(c)	There have been no purchases of common stock by the Company or its affiliates during the quarter ended July 2, 2005

Item 3. Defaults Upon Senior Securities

At the date of this report, the Company was in arrearage on the payment of dividends on Series 2 preferred stock, Series 3 preferred stock and Series 4 preferred stock in the amount of $583,855. Under the terms of the issuances of these series of preferred stock, dividends are declared at the discretion of the Company’s board of directors, and will be paid when funds for payment are legally available.

34

Item 4. Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of security holders during the quarter ended July 2, 2005.

Item 6. Exhibits

      (a) The exhibits filed as part of this report are listed below:

Exhibit No.

          31.1 Certification of President pursuant to Section 302, of the Sarbanes-Oxley Act of 2002.

          31.2 Certification of Acting Chief Financial Officer pursuant to Section 302, of the Sarbanes-Oxley Act of 2002.

          32.1 Certification of President pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

          32.2 Certification of Acting Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

35

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: August 10, 2005

MICROFIELD GROUP, INC.

By: /s/ A. Mark Walter

A. Mark Walter

President

(Principal Executive Officer)

36

EX-31.1

                                                                    EXHIBIT 31.1

CERTIFICATIONS

I, A. Mark Walter, certify that:

1. I have reviewed this quarterly report on Form 10-QSB of Microfield Group,
Inc.;

2. Based on my knowledge, this quarterly 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 quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures 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 quarterly report is being prepared;

b) 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 period covered by this
report based on such evaluation; and

c) 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;

5. I have disclosed, based on my most recent evaluation, to the registrant's
auditors and the audit committee of registrant's board of directors (or persons
performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and

6. I have indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of my most recent
evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: August 10, 2005

    /s/ A. MARK WALTER
        --------------------
    A. Mark Walter
    President

                                       37

EX-31.2

                                                                    EXHIBIT 31.2

CERTIFICATIONS

I, Randall R. Reed, certify that:

1. I have reviewed this quarterly report on Form 10-QSB of Microfield Group,
Inc.;

2. Based on my knowledge, this quarterly 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 quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures 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 quarterly report is being prepared;

b) 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 period covered by this
report based on such evaluation; and

c) 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;

5. I have disclosed, based on my most recent evaluation, to the registrant's
auditors and the audit committee of registrant's board of directors (or persons
performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and

6. I have indicated in this quarterly report whether or not there were
significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of my most recent
evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date:  August 10, 2005

    /s/ RANDALL R. REED
        -------------------
    Randall R. Reed
    Acting Chief Financial Officer

                                       38

EX-32.1

                                                                    EXHIBIT 32.1

                      CERTIFICATION PURSUANT TO SECTION 906
                                       OF
                         THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report on Form 10-QSB of Microfield Group, Inc.
(the "Company") for the three and six months ended July 2, 2005, as filed with
the Securities and Exchange Commission on the date hereof (the "Covered
Report"), I, A. Mark Walter, the principal executive officer of the Company,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, hereby certify that:

The Covered Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended; and

The information contained in the Covered Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.

IN WITNESS WHEREOF, I have executed this certificate as of this 10th day of
August 2005.

/s/ A. MARK WALTER
    -----------------
    A. Mark Walter
    President

                                       39

EX-32.2

                                                                    EXHIBIT 32.2

                      CERTIFICATION PURSUANT TO SECTION 906
                                       OF
                         THE SARBANES-OXLEY ACT OF 2002

In connection with the quarterly report on Form 10-QSB of Microfield Group, Inc.
(the "Company") for the three and six months ended July 2, 2005, as filed with
the Securities and Exchange Commission on the date hereof (the "Covered
Report"), I, Randall R. Reed, the principal acting financial officer of the
Company, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002, hereby certify that:

The Covered Report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended; and

The information contained in the Covered Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.

IN WITNESS WHEREOF, I have executed this certificate as of this 10th day of
August 2005.

/s/ RANDALL R. REED
    ---------------
    Randall R. Reed
    Acting Chief Financial Officer

                                       40