Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements included elsewhere in this report. This discussion contains forward-looking statements that relate to future events or our future financial performance. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These forward-looking statements are based largely on our current expectations and are subject to a number of uncertainties and risks including the Risk Factors identified in our Annual Report on Form 10-KSB/A for the year ended December 31, 2007. Actual results could differ materially from these forward-looking statements. Converted Organics Inc. is sometimes referred to herein as "we", "us", "our" and the "Company". Introduction
Our operating structure is composed of our parent company, Converted Organics Inc., and three operating subsidiaries. The first is Converted Organics of Woodbridge, LLC, which includes the start up operation of our Woodbridge, NJ facility, second, Converted Organics of California, LLC, which includes the operating activity of our Gonzales, CA facility and third, Converted Organics of Rhode Island, LLC which was formed in July 2008 for the purpose of designing, financing and building a Rhode Island facility. Converted Organics Inc. transitioned from a development stage company in the second quarter of 2008 (as operations have commenced and we recorded revenues of approximately $1,200,000 for the nine months ended September 30, 2008) to an operating company that constructs and operates processing facilities that will use food waste as raw material to manufacture all-natural soil amendment products combining nutritional and disease suppression characteristics. In addition to our current sales in the agribusiness market, we plan to sell and distribute our products in the turf management and retail markets. We have hired experienced sales personnel in these markets and have begun to introduce the product to the marketplace.
Woodbridge Facility
We obtained a long-term lease for a site in a portion of an industrial building in Woodbridge, New Jersey that was modified and equipped as our first internally constructed organic waste conversion facility. Operations began in late June of 2008 at the Woodbridge facility and currently we are processing both liquid and solid waste and we are producing a liquid fertilizer and soil enhancement product. Construction is still in process on certain aspects of the facility and as of the filing of this report we are not producing any solid product. We expect to produce solid product by the end of December 2008, and our plan is to produce and store the solid product for sale into the retail market in the spring of 2009. We feel that this strategy will produce a favorable selling price for the dry product. When fully operational, the Woodbridge facility is expected to process approximately 78,000 tons of organic food waste and produce approximately 7,500 tons of dry product and 6,700 tons of liquid product annually. During the first four to six months of operations at our Woodbridge facility, we expect to incur operating losses and we may not generate sufficient cash to pay for the anticipated operating expenses. We plan to use funds we have already received from the exercise of Class A warrants to fund the working capital requirements at that facility until it becomes cash flow positive. We feel that there will be sufficient production of liquid product that, when sold, will allow the plant to be cash flow positive even though we plan to inventory the dry product until spring 2009.

UOP Acquisition; Gonzales Facility
On January 24, 2008, we acquired the net assets of United Organic Products, LLC ("UOP"), which was under common ownership with Waste Recovery Industries, LLC ("WRI"). With this acquisition, we acquired a leading liquid fertilizer product line, as well as the Gonzales facility, which is a state-of-the-art production facility that services a strong West Coast agribusiness customer base through established distribution channels. This facility is operational and began to generate revenues for us in February 2008. The purchase price of $2,500,000 was paid in cash of $1,500,000 and notes payable of $1,000,000. The note matures on February 1, 2011, has an interest rate of 7% per annum, is payable monthly in arrears, and is convertible into our common stock six months after the acquisition date for a price equal to the average closing price of our common stock on NASDAQ for the five days preceding conversion.
The Gonzales facility generated revenue during the first nine months of 2008 of approximately $1,169,000. These sales, however, resulted in a negative operating margin of approximately $88,000. This negative margin is due primarily to low sales in the quarter ended September 30, 2008 due to the seasonality of agricultural sales in California during the summer months. Our plan to improve operating margins consists of channeling sales into the profitable turf and retail markets and by generating tip fees from receiving additional quantities of food waste. In addition, we plan to add capacity to the Gonzales plant during 2008 and 2009, whereby the plant will produce approximately three times its current production and will be capable of producing both liquid and solid products. Completion of the plant expansion is dependent on our ability to raise additional capital which is further discussed in the liquidity and capital resources section. We expect that the cash flow generated from the Gonzales facility will be sufficient to sustain its operation regardless of whether we are able to increase capacity. If capacity is increased, we expect the cash flow from the Gonzales facility to offset some of the losses we expect to incur in connection with the start-up and ramp-up of the production capacity at the Woodbridge facility and remainder of the Company's operations. However, the cash flow will not be sufficient to offset all of the anticipated losses.
WRI Acquisition
On January 24, 2008, we acquired the assets, including the intellectual property, of WRI. This acquisition makes us the exclusive owner of the proprietary technology and process known as the High Temperature Liquid Composting ("HTLC") system, which processes various biodegradable waste products into liquid and solid organic-based fertilizer and feed products. The purchase price of $500,000 was paid with a 7% short-term note that matured and was repaid on May 1, 2008. Interest on that note was paid monthly. In addition, the purchase agreement provides for a technology fee payment of $5,500 per ton of waste-processing capacity that is added to plants that were not planned at the time of this acquisition and that use this new technology. The per-ton fee is not payable on the Woodbridge facility, the facility that is being planned in Rhode Island, or the Gonzales facility acquired in the acquisition or the currently planned addition thereto, except to the extent that capacity (in excess of the currently planned addition) is added to the Gonzales facility in the future. Also, the purchase agreement provides that if we decide to exercise our right, obtained in the WRI acquisition, to enter into a joint venture with Pacific Seafood Inc. for the development of a fish waste-processing product (the "Eureka product"), we will pay 50% of our net profits earned from this Eureka product to the seller of WRI. Combined payments of both the $5,500 per ton technology fee and the profits paid from the Eureka product, if any, is capped at $7.0 million with no minimum payment required. In April 2008, we entered into an agreement with Pacific Seafoods Inc. whereby we will pay Pacific Seafoods Inc. 50% of the net profits from the Eureka product. As of the filing date of this report no profits have been earned from the Eureka product. It is our

intention to expense the payments, if any, that are paid on either the profits from the Eureka product or the $5,500 per ton technology fee, as they are paid or become due.
Rhode Island Facility
As of the filing of this report, the Rhode Island Industrial Facilities Corporation has provided initial approval to the Company's Revenue Bond Financing Application for up to $15 million for the construction of the new facility. In addition, the Rhode Island Resource Recovery Corporation ("RIRRC") gave us final approval to lease nine acres of land in the newly created Lakeside Commerce Industrial Park in Johnston, RI. We previously filed an application with the Rhode Island Department of Environmental Management for the operation of a Putrescible Waste Recycling Center at that site. On September 1, 2008, we entered into a twenty year ground lease with the RIRRC under which we are obligated to pay $9,167 per month, plus $8 per ton of fertilizer (liquid or solid) sold from the facility.
January 2008 Financing
Also, on January 24, 2008, we entered into a private financing with three investors (the "Investors") for a total amount of $4,500,000 (the "Financing"). The Financing was offered at an original issue discount of 10%. We used the proceeds to fund the acquisitions described above, to fund further development activities and to provide working capital. As consideration for the Financing, the Investors received a note issued by the Company in the amount of $4,500,000, with interest accruing at 10% per annum to be paid monthly and with the principal balance to be paid by January 24, 2009 (the "Note"). In addition, we issued to the Investors 750,000 Class A Warrants and 750,000 Class B Warrants, which may be exercised at $8.25 and $11.00 per warrant share, respectively (the "Warrants"). A placement fee of $225,000 was paid from the proceeds of this loan.
In connection with the Financing, we agreed to have a shareholder vote to seek approval to issue a convertible debenture in exchange for the Note with an interest rate of 10% per annum, which would be convertible into common stock (the "Convertible Debenture"). In April 2008, we received shareholder approval and the Note was replaced by the Convertible Debenture and one half of each of the Class A Warrants and of the Class B Warrants issued to the Investors were returned to the Company.
The Convertible Debenture provides the Investors the option, at any time on or before the maturity date of January 24, 2009, to convert the outstanding principal of this Convertible Debenture into our common stock at the conversion price equal to the lowest of (i) the fixed conversion price of $6.00 per share,
(ii) the lowest price, conversion price or exercise price set by the Company in any equity financing transaction, convertible security, or derivative instrument issued after January 24, 2008, or (iii) the default conversion price, which is, if and so long as there exists an event of default, then 70% of the average of the three lowest closing prices of common stock during the twenty day trading period immediately prior to the notice of conversion. In connection with the financing, we entered into a registration rights agreement with the Investors, which called for the Company to register the securities within certain time periods. We have filed the required registration statements and such registration statements have been declared effective. However, the registration statement filed for the convertible debt and the date the warrant registration statement was declared effective by the SEC did not occur within the timelines agreed to in the registration rights agreement. The registration rights agreement called for $90,000 per month in liquidated damages, payable in cash, if we did not file the registration statement for the Convertible Debenture and liquidated

damages equal to the average closing price of 375,000 Class A warrants and 375,000 Class B warrants for each 30 day period, commencing May 13, 2008, and multiplying that average by 2% for every month that the registration statement was not declared effective.
Therefore, on April 24, 2008, we began to incur liquidated damages in connection with the Convertible Debenture of $90,000 per month and as of May 13, 2008, we began to incur liquidated damage obligations in connection with the Warrants according to the formula described above. We paid a total of approximately $102,000 in liquidated damages related to the Convertible Debentures. On June 7, 2008 the warrant registration statement was declared effective and we paid an additional $56,000 in liquidated damages as a result of the effective date going past the date agreed to in the registration rights agreement. At this time, we are not subject to further liquidated damages.
Also in connection with this financing, we entered into a Security Agreement with the Investors, whereby we granted the Investors a security interest in Converted Organics of California, LLC and any and all assets that are acquired by the use of funds from the Financing. In addition, we granted the Investors a security interest in Converted Organics of Woodbridge, LLC and all assets subordinate only to the current lien held by the holder of the bonds issued in connection with the Woodbridge facility of approximately $17,500,000. Pro Forma Financial Information
The unaudited supplemental pro forma information discloses the results of operations for the current fiscal year up to the date of the most recent interim period presented (and for the corresponding period in the preceding year) as though the business combination had been completed as of the beginning of the period reported on.
The pro forma condensed consolidated financial information is based upon available information and certain assumptions that the Company believes are reasonable. The unaudited supplemental pro forma information does not purport to represent what the Company's financial condition or results of operations would actually have been had these transactions in fact occurred as of the dates indicated above or to project the Company's results of operations for the period indicated or for any other period.

                                                   Nine months ending September 30,
                                                         2008                  2007
   Revenues (in thousands)                  $           1,181       $         1,067
   Net loss (in thousands)                            (11,621 )              (3,647 )
   Net loss per share - basic and diluted               (2.21 )               (1.11 )

Construction and Start-up Period
We have commenced plant operations at our Woodbridge facility. Our process engineer, Weston Solutions, Inc., has completed the design, mass balance, energy balance, and process flow drawings for the Woodbridge facility. This work formed the basis for soliciting bids for a guaranteed maximum price contract for the construction of the Woodbridge facility. In addition, our management team has been focused primarily on constructing the Woodbridge facility, conducting start-up trials and bringing operations to full-scale production as quickly as practicable. Operations began in late June of 2008 at the Woodbridge facility and currently we are processing liquid and solid waste and we are producing a liquid

fertilizer and soil enhancement product. Construction is still in process on certain aspects of the facility and as of the filing of this report we are not producing any solid product. We expect to produce solid product by the end of December, 2008. We have budgeted approximately $14.6 million for the design, building, and testing of our facility, including related non-recurring engineering costs. The capital outlay of $14.6 million has and will come from the $25.4 million raised by our initial public offering of stock and the issuance of New Jersey Economic Development Bonds, both of which closed on February 16, 2007 and does not include $4.6 million of lease financing provided by the New Jersey landlord.
As of September 30, 2008, we have incurred approximately $10.6 million of the $14.6 million in planned construction costs. The total cost is expected to exceed the estimate of $14.6 million by approximately $1 million (which does not include $4.6 million of lease financing) also, we currently plan to purchase additional equipment, which would allow us to produce additional product, which is in high demand by the retail market. The estimated cost of this additional equipment would be approximately $1.5 million. Also, we have decided to incorporate the HTLC technology acquired from WRI into the Woodbridge facility. We estimate that these costs could be approximately $3.0 million dollars, bringing the total plant cost to $20.1 million, not including lease financing. Installation of the HTLC technology and additional equipment is dependent on our ability to raise additional capital which is further discussed in the liquidity and capital resources section. The purpose of adding the HTLC technology to the Woodbridge facility is two fold: first it will significantly lower operating costs, most notably utility costs as the need to evaporate significant amounts of liquid byproduct would no longer be necessary, and two, the non evaporated liquid by product can be used in the production process and sold as additional product.
Full-scale Operations
Operations at the Woodbridge facility are expected to achieve the initial design capacity of approximately 250 tons per day within four to six months following commencement of operations. Upon commencement of operations, there will be two revenue streams: (i) tip fees that in our potential markets range from $50 to $100 per ton, and (ii) product sales. Tip fees are paid to us to receive the organic waste stream from the waste hauler; the hauler pays us, instead of a landfill, to take the waste. If the haulers source separate and pay in advance, they will be charged tip fees that are up to 20% below market. Operations are expected to be stabilized at design capacity within four to six months of commencement.
Operations at the Gonzales facility began in February 2008, with the production of approximately 25 tons per day of liquid fertilizer. This output is presently being sold into the California agricultural market. Future Development
Subject to the availability of development capital for which we have no current commitments, we intend to commence development and construction of other facilities while completing construction of our Woodbridge facility. Assuming needed capital is available, the timing of our next facility is dependent on many factors, including locating property suited for our use, negotiating favorable terms for lease or purchase, obtaining regulatory approvals, and procuring raw material at favorable prices.
We anticipate that our next facility will be located in Rhode Island. We have signed a ground lease with the Rhode Island Resource Recovery Corporation for a proposed facility in Johnston, Rhode Island. Other locations in Massachusetts and New York, as well as other states, will be considered as determined by management.

In each contemplated market, we have started development activity to secure a facility location. We have also held preliminary discussions with state and local regulatory officials and raw material suppliers. We believe that this preliminary development work will allow us to develop and operate a third facility by the end of 2009, subject to the availability of debt financing for which we have no current commitments. We believe we will be able to use much of the engineering and design work done for our Woodbridge facility for subsequent facilities, thus reducing both the time and costs associated with these activities. We expect to form a separate wholly owned subsidiary for each facility to facilitate necessary bond financing and manage risk. Trends and Uncertainties Affecting our Operations We will be subject to a number of factors that may affect our operations and financial performance. These factors include, but are not limited to, the available supply and price of organic food waste, the market for liquid concentrate and solid organic fertilizer, increasing energy costs, the unpredictable cost of compliance with environmental and other government regulation, and the time and cost of obtaining USDA, state or other product labeling designations. Demand for organic fertilizer and the resulting prices customers are willing to pay also may not be as high as our market studies suggest. In addition, supply of organic fertilizer products from the use of other technologies or other competitors may adversely affect our selling prices and consequently our overall profitability. Liquidity and Capital Resources
At September 30, 2008, we had total current assets of approximately $4.2 million consisting primarily of cash, restricted cash, and prepaid assets, and had current liabilities of approximately $8.8 million, consisting primarily of accounts payable, accrued expenses and notes payable leaving us with negative working capital of approximately $4.6 million. Non-current assets totaled $26.9 million and consisted primarily of restricted cash, construction in process and property and equipment. Non-current liabilities consist primarily of notes payable of $667,000 and bonds payable of $17,500,000 at September 30, 2008. We have an accumulated deficit at September 30, 2008 of approximately $22 million. Owners' equity at September 30, 2008 was approximately $4.2 million. For the first nine months of 2008, we generated revenues from operations of approximately $1.2 million. Prior to 2008, the Company had no revenues.
We issued 1,800,000 Class A warrants as part of our initial public offering. We also issued an additional 293,629 Class A warrants and 375,000 Class A warrants as part of the February 16, 2007 and January 24, 2008 financings, respectively. The exercise price of each Class A warrant was $8.25 per share. In the first nine months of 2008, 756,000 of the Class A warrants were voluntarily exercised, providing us with approximately $6.1 million in cash. The remaining Class A warrants (1,029,609 from the initial public offering, 293,629 from the February 2007 financing, and 375,000 from the January 2008 financing) were redeemable at the Company's option, at a redemption price of $0.25 per warrant. We were required to provide 30 days' prior written notice to the Class A warrant holders of our intention to redeem the warrants. On September 16, 2008, we notified warrant holders that we were calling the Class A warrants for redemption, and unless the warrants were exercised prior to the redemption date, we would redeem them for $0.25 per warrant. We subsequently extended the redemption date to November 14, 2008.

In connection with the redemption, we received proceeds of approximately $5.5 million upon the exercise of approximately 673,000 Class A warrants. The remaining Class A Warrants (approximately 1.0 million) will be redeemed by us for $0.25 each and will no longer be exercisable into shares of common stock. We also issued 1,800,000 Class B warrants as part of our initial public offering, and 293,629 Class B warrants and 375,000 Class B warrants as part of the February 16, 2007 and January 24, 2008 financings, respectively, all of which have the same expiration date as the Class A warrants, which is February 16, 2012. The Class B warrants are not redeemable by the Company and, as such, we . . .