The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, the financial statements and notes thereto included in Item 1 of this Form 10-Q and the financial statements and notes thereto and our Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2008 included in our 2008 Annual Report on Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward looking statements that may be included in this report, are subject to risks and uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words "believe," "expect," "intend," "plan," "project," "will" and similar phrases as they relate to us are intended to identify such forward-looking statements. In addition, please see the "Risk Factors" in Part 1, Item 1A of our 2008 Annual Report on Form 10-K and in Part II, Item 1A of this Form 10-Q for a discussion of items that may affect our future results.

Overview

Active Power is a manufacturer and provider of critical power solutions incorporating uninterruptible power supply (UPS) systems that provide business continuity to enterprises requiring protection against electrical power disturbances. Our products are designed to deliver continuous clean power, protecting customers from voltage fluctuations, such as surges and sags and frequency fluctuations, and also to provide ride-through, or temporary, power to bridge the gap between a power outage and the restoration of utility power. Our target customers are those global enterprises requiring "power insurance" because they have zero tolerance for downtime in their mission critical operations. The UPS products we manufacture utilize green technology to create a renewable energy source. These products are highly reliable, are energy and space efficient, and significantly reduce client electricity expenses. As of March 31, 2009, we have shipped more than 2,200 flywheels in UPS system installations, delivering more than 550 megawatts of power to customers in more than 40 countries around the world. We are headquartered in Austin, Texas, with international offices in the U.K., Germany and Japan.

Our patented flywheel-based UPS systems store kinetic energy by constantly spinning a compact steel wheel ("flywheel") driven from utility power in a low friction environment. When the utility power used to spin the flywheel fluctuates or is interrupted, the flywheel's inertia causes it to continue spinning. The resulting kinetic energy of the spinning flywheel generates electricity known as "bridging power" for short periods, until utility power is restored or a backup electricity generator starts and takes over generating longer-term power in the case of an extended electrical outage. We believe our flywheel products provide many competitive advantages over conventional battery-based UPS systems, including substantial space savings; higher power densities, "green" energy storage, and higher power efficiencies of up to 98%. This high energy efficiency reduces operating costs and provides customers a lower total cost of ownership. We offer our flywheel products with load capabilities from 130 kVA to 8,400 kVA. We typically target higher power applications of 200 kVA and above, largely because a majority of customers in this market segment have backup generators. Our flywheel products are marketed under the brand name CleanSource®. Our continuous power systems are marketed under the name PowerHouse and combine our UPS system with switchgear and a generator to provide complete short- and long-term protection in the event of a power disturbance.

We believe a number of underlying macroeconomic trends place Active Power in a strong position to be one of the leading providers of critical power protection. These trends include:

• the ever-increasing demands placed on the public utility infrastructure;

• an inadequate investment in global utility infrastructure;

• rising costs of energy world wide;

• significant costs of downtime;

• a rapidly expanding need for data centers that require reliable, efficient power; and

• an increasing demand for economically green solutions.

We have evolved significantly since our founding in 1992 as an engineering business focused on research, development and invention. The technological foundation of Active Power has yielded more than 150 worldwide patents and a highly differentiated, cost-efficient product platform. Since 2005, we have changed our business focus to successfully

commercialize our technologies by building the Active Power brand, expanding our sales distribution, focusing on product cost reduction, and building technical innovations to serve clients with mission critical power applications globally.

We sell our products to a wide array of commercial and industrial customers and across a variety of vertical markets, including data centers, manufacturing, technology, broadcast and communications, financial, utilities, healthcare, government and airports. We have expanded our global sales channels and direct sales force, selling in all major geographic regions of the world, but particularly in North America, Europe and Asia.

Results of Operations



                                                                                                   Variance
($ in thousands)                                    Three months ended March 31,                 2009 vs. 2008
                                                         % of                      % of
                                                         total                     total
                                             2009       revenue        2008       revenue         $          %
Product revenue                            $  9,709          87 %    $  6,248          83 %    $  3,461       55 %
Service and other revenue                     1,434          13 %       1,290          17 %         144       11 %

Total revenue                                11,143         100 %       7,538         100 %       3,605       48 %

Cost of product revenue                       6,901          62 %       5,657          75 %       1,244       22 %
Cost of service and other revenue               980           9 %       1,098          15 %        (118 )    (11 )%

Total cost of revenue                         7,881          71 %       6,755          90 %       1,126       17 %

Gross profit                                  3,262          29 %         783          10 %       2,479      317 %
Operating expenses:
Research and development                      1,101          10 %       1,402          19 %        (301 )    (21 )%
Selling and marketing                         3,330          30 %       2,950          39 %         380       13 %
General and administrative                    1,139          10 %       1,182          16 %         (43 )     (4 )%

Total operating expenses                      5,570          50 %       5,534          73 %          36        1 %

Operating loss                               (2,308 )       (21 )%     (4,751 )       (63 )%      2,443       51 %
Interest income (expense)                       (10 )        -            163           2 %        (173 )   (106 )%
Other income (expense)                          (49 )        -            119           2 %        (168 )   (141 )%

Net loss                                   $ (2,367 )       (21 )%   $ (4,469 )       (59 )%   $  2,102       47 %

Product revenue. Product revenue consists of sales of our CleanSource power quality products, comprised of both UPS and DC product lines, and sales of Continuous Power Systems (CPS) which are comprised of our UPS systems and some combination of third-party ancillary equipment, such as engine generators and electrical and switchgear products. The CPS products may be sold in a containerized solution or as separate equipment. Product revenue also includes sales of our CoolAir DC and CoolAir UPS products.

The increase in product revenue from the same period of 2008 was due to higher sales volume of all products lines, especially the CleanSource UPS product line. Our UPS products represented approximately 85% of our total revenue in the first quarter of 2009, compared to 69% of total revenue in the first quarter of 2008. A single product, depending on its power rating, may be comprised of multiple flywheel units. The average selling price over the first three months of 2009 was $80,000 per quarter-megawatt flywheel, compared to $78,000 in the comparable period in 2008.

During the three-month period ended March 31, 2009 we sold 119 flywheel units compared to 64 flywheel units in the comparable period of 2008. The frequency and timing of our larger system sales, including megawatt class UPS products, made directly by us is more unpredictable than orders received from our OEM partners, and can result in material changes in period-to-period revenue. Such revenues may also occur in periods other than when originally anticipated, which can add to the potential variability in our quarterly financial results and affect our ability to meet forecasted targets. For example, the absence of large system sales in the first quarter of 2009 contributed to the decrease in total revenues from the prior quarter. However, we had an increase in system sales when compared to the first quarter of 2008.

North American sales were 76% of our total revenue for the three-month period ended March 31, 2009 compared to 61% for the same period of 2008, and 67% in the three-month period ended December 31, 2008. This reflects an 86% increase in sales in our North American business in the first quarter of 2009 compared to the first quarter of 2008 and a decrease in our international sales from the prior quarter and the first quarter of 2008.

Since 2005 we have been increasing the size of our direct sales organization in an effort to expand the territories in which we sell our Active Power branded products. Most of this effort initially was focused in the EMEA market where we

now have multiple sales offices. In 2007, we also opened our first Asian sales office in Tokyo. Sales of Active Power branded products through our direct and manufacturer's representative channels were 57% of our total revenues for the three-month period ended March 31, 2009, compared to 56% for the same period of 2008. As direct sales typically have higher profit margins than sales through our OEM channels, we will continue to focus on our direct sales channel to increase revenue and improve profit margins. We believe sales of our Active Power branded products to government facilities and industrial customers in regions that were not covered by our OEMs will continue to increase over time and will continue to become a larger percentage of our total revenue.

Caterpillar remains our largest OEM partner and largest overall customer and represented 43% of our revenue for the three-month period ended March 31, 2009, compared to 44% of our revenue for the three-month period ended March 31, 2008. We have had recent success with Caterpillar selling our megawatt-class UPS products along with their large engine generators, and expect total revenue from this channel to continue to increase in 2009 in absolute terms.

Our products perform well in harsh environments where power quality or reliability is particularly poor, which makes them a good fit for countries with a poor power infrastructure or in harsh manufacturing or process environments, or situations where reliability is paramount, such as mission-critical business applications. Therefore we have traditionally focused our direct sales efforts on these type of customer situations. Due to the large size of some of our customer orders relative to our current total revenue levels, our quarterly total revenue trend and the proportion of sales made directly by us can be expected to fluctuate.

Service and other revenue.Service and other revenue primarily relates to revenue generated from both traditional (after-market) service work and from customer-specific system engineering. This includes revenue from design, installation, startup, repairs or reconfigurations of our products, and the sale of spare or replacement parts to our OEM and end-user customers. It also includes revenue associated with the costs of travel of our service personnel and revenues or fees received upon contract deferment or cancellation.

Service and other revenue increased by 11% for the three-month period ended March 31, 2009, compared to the same prior year period. This increase is primarily due to higher levels of service and contract work from direct product sales made in prior quarters. For some of these customers we provide a full power solution, including site preparation, installation of an entire power solution and provision of all products required to provide a turnkey product to the end user. Where we make sales through our OEM channel, it is typical for the OEM to provide these types of services to their end-user customers. We anticipate that service and other revenue will continue to grow with product revenue and as our installed base of product expands, because as more units are sold to customers, more installation, startup and maintenance services will be required. We anticipate that service and other revenue will continue to grow as our installed base of products expands because as more units are sold to customers, more installation, startup and maintenance services will be required.

Cost of product revenue. Cost of product revenue includes the cost of component parts of our products or ancillary equipment that are sourced from external suppliers, personnel, equipment and other costs associated with our assembly and test operations, including costs from having underutilized facilities, shipping costs, warranty costs, and the costs of manufacturing support functions such as logistics and quality assurance. The cost of product revenue as a percentage of total product revenue decreased from 75% in the first quarter of 2008 to 62% in the three-month period ended March 31, 2009 due to the effect of increased flywheel units sold, improved efficiency in our manufacturing operations due to the higher sales volume that utilizes more of our manufacturing capacity, and material and overhead costs reductions. We have instituted programs to reduce product and component costs where feasible, and this has resulted in a decrease in materials costs as a percentage of product revenue and helped us to mitigate the impact of increased raw commodity pricing on our total product costs. We continue to operate a manufacturing facility that has a capacity level significantly greater than our current product revenue levels. In addition, a large portion of the costs involved in operating our manufacturing facility are fixed in nature and we incur approximately $750,000 to $1.0 million in unabsorbed overhead each quarter. We continue to work on reducing our product costs through design enhancements and modifications, and vendor management programs. The accomplishment of material gross-margin levels is heavily dependent upon our sales channel mix and the effectiveness of our product pricing to our customers. Our ability to maintain and grow positive product gross margin will depend on multiple factors, including our ability to continue to reduce material costs, improve our sales channel mix in favor of direct sales versus OEM, increase product prices, and increase our total revenues to a level that will allow us to improve the utilization of our manufacturing operations.

Items that could impact our ability to further improve our gross margin include sales product volume and mix, pricing discounts and customer incentives, currency fluctuations, and variations in our product cost and productivity.

Cost of service and other revenue. Cost of service and other revenue includes the cost of component parts that we use in service or sell as spare parts, as well as labor and overhead costs of our service organization, including travel and related

costs incurred in fulfilling our service obligations to our customers. The cost of service and other revenue decreased to 68% of service and other revenue in the three-month period ended of March 31, 2009, compared to 85% in the same period of 2008. This decrease reflects better utilization of our service personnel, improved pricing for service, and higher margins on contract work compared to the prior period and the benefits of higher service volume to help meet the fixed costs of our service infrastructure. Many of the costs of the service organization are fixed in nature, and higher volume of installation, startup and service work is resulting in improved efficiency and operating results for this group. We expect this trend to continue during the remainder of 2009.

Research and development. Research and development expense primarily consists of compensation and related costs of employees engaged in research, development and engineering activities, third party consulting and product development activities, as well as an allocated portion of our occupancy costs. Overall our research and development expenses were $301,000, or 21%, lower than the first quarter of 2008, and were $112,000, or 9%, lower than the preceding quarter. The decrease from the same period in 2008 was due to headcount reductions compared to 2008 and lower project related development costs this year. The prior year expenses included higher prototype and development costs for paralleling our megawatt-class UPS products. We believe research and development expenses in the second quarter will remain at similar levels to those recorded in the first quarter.

Selling and marketing. Selling and marketing expense primarily consists of compensation, including variable sales compensation, and related costs, for sales and marketing personnel, and related travel, selling and marketing expenses, as well as an allocated portion of our occupancy costs and the cost of our foreign sales operations. Selling and marketing costs were $380,000, or 13%, higher than the amount recorded in the first quarter of 2008, and were $291,000, or 10%, higher than the immediately preceding quarter. The increase from the same period in 2008 is due to increased variable sales compensation associated with the increase in revenue compared to 2008. The increase in our sales and marketing costs from the three-month period ended December 31, 2008 reflects increased spending on marketing activities in 2009, including tradeshows, as well as increased third party manufacturing representative commissions, and a higher allowance for doubtful accounts. Our total headcount in sales and marketing in the first quarter of 2009 remained at similar levels to the prior quarter, although we have changed the composition of our sales team over the last year as we expand our direct sales force. We believe that sales and marketing expenses will remain at similar levels in the second quarter of 2009 to those recorded in the first quarter of 2009.

General and administrative. General and administrative expense is primarily comprised of compensation and related costs for executive and administrative personnel, professional fees, and taxes, including sales, property and franchise taxes. General and administrative expenses decreased by $43,000, or 4%, from the levels of the same period in 2008 and decreased by $295,000, or 21%, from the three-month period ended December 31, 2008. This decrease from the three-month period ended December 31, 2008 predominantly reflects lower professional fees. During the last quarter of 2007, we incurred legal fees in connection with a tender offer with respect to certain of the Company's employees as a result of the stock option review to correct errors in option pricing. We are currently in the process of negotiating to settle the outstanding tax matters resulting from the option investigation with the Internal Revenue Service, and may still record additional expense to cover tax obligations for innocent employees who were affected by the option review. We would record any further expenses at the time we legally finalize those obligations for our employees. Absent the impact of such expenses from the option review, we anticipate that the level of general and administrative expenses should stay at similar levels in the second quarter of 2009.

Interest income (expense). Interest income (expense) has decreased from $163,000 in the three-month period ended March 31, 2008 to ($10,000) in the three-month period ended March 31, 2009. This reflects the decrease in our average cash and investments balance compared to the prior year as we have used our investments to fund operations, decreasing interest rates available in credit markets and interest expense paid on balances outstanding under our Loan Agreement. Our average cash and investments balance over the three month period ending March 31, 2009 has decreased by approximately $9.1 million, or 46%, compared to the average balance over the comparable period ending March 31, 2008.

Other income (expense). Other income in the first quarter of 2009 increased over the preceding quarter due to our sale of previously expensed equipment and foreign exchange gains on a bank account held in foreign currency.

Liquidity and Capital Resources

Our primary sources of liquidity at March 31, 2009 are our cash and investments on hand, our bank credit facilities and projected cash flows from operating activities. If we meet our cash flow projections in our current business plan, we expect that we will not require additional financing in order to continue operating and growing our business during 2009. Our business plan and our assumptions around the adequacy of our liquidity are based on estimates regarding expected revenues and future costs. However, there are scenarios in which our revenues may not meet our projections or our costs may exceed our estimates. Further, our estimates may change and future events or developments may also affect our estimates. Any of these factors may change our expectation of cash usage in 2009 or significantly affect our level of liquidity, which may require us to seek additional financing or take other measures to reduce our operating costs in order to continue operating. Our cash and investments at March 31, 2009 totaled $10.5 million.

Should additional funding be required, we may need to raise the required funds through borrowings or public or private sales of debt or equity securities. If we raise additional funds through the issuance of debt or equity securities, the percentage ownership of our stockholders could be significantly diluted. If we obtain additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, and the terms of the debt securities issued could impose significant restrictions on our operations. We do not know whether we will be able to secure additional funding, or funding on terms acceptable to us, to continue our operations as planned. If financing is not available, we may be required to reduce, delay or eliminate certain activities or to license or sell to others some of our proprietary technology.

In October 2007, we entered into a Loan and Security Agreement (the "Loan Agreement") with Silicon Valley Bank ("SVB"). The Loan Agreement provides for a secured revolving line of credit in an amount of up to $5.0 million, subject to a borrowing base formula. In 2008, we modified the Loan Agreement to provide for a U.S. export-import credit facility that would add a U.S. government guarantee to the payments for these foreign shipments and make more of our foreign shipments eligible as security for the credit facility. Prior to this modification, export revenues were not eligible to be included as part of the borrowing base, which may have limited our ability to utilize the revolving credit facility. All amounts borrowed under this facility are subject to a borrowing base formula based on eligible receivables and inventory. During the year ended December 31, 2008, we borrowed $2.0 million under the Loan Agreement and this balance remained outstanding at March 31, 2009. Based on the borrowing base formula, we had an additional $0.7 million available for use at March 31, 2009 under the Loan Agreement.

The Loan Agreement requires us to maintain a minimum liquidity ratio of unrestricted cash to the outstanding amounts under the Loan Agreement of at least 1.35 to 1. In addition, the Loan Agreement contains customary affirmative covenants, including covenants that require, among other things, the delivery of financial statements, compliance with laws, the maintenance of insurance and the protection and registration of intellectual property rights. Further, the Loan Agreement contains customary negative covenants, including covenants that limit or restrict our ability to, among other things, dispose of assets, change our business, change our CEO or CFO, make acquisitions, be acquired, incur indebtedness, grant liens, make investments, make distributions, repurchase stock, and enter into certain transactions with our affiliates, in each case subject to customary exceptions for a credit facility of this size and type.

Revolving loans under this credit facility may be borrowed, repaid and re-borrowed until October 5, 2010, at which time all amounts borrowed must be repaid and all outstanding letters of credit must be cash collateralized. Revolving loans bear interest at a floating per annum rate equal to the greater of (i) SVB's prime rate plus 0.25% or (ii) 5.25%. A default interest rate shall apply during an event of default at a rate per annum equal to 5.0% above the otherwise applicable interest rate. The revolving loans are secured by a first priority lien on substantially all of our assets, provided that such security interest is limited to no more than 65% of the outstanding capital stock of each of our subsidiaries held by us.

The Loan Agreement includes customary events of default that include among other things, non-payment of principal, interest or fees, violation of covenants, the occurrence of a material adverse change, bankruptcy and insolvency events, defaults under material agreements, material judgments against us and inaccuracy of representations and warranties. The occurrence of an event of default could result in the acceleration of any outstanding obligations under the Loan Agreement.

The following table summarizes the quarterly changes in cash used in operating activities:

Three months ended Variance ($ in thousands) March 31, 2009 vs. 2008 2009 2008 $ % Cash used in operating activities $ (521 ) $ (5,006 ) $ (4,485 ) (90 )%

Cash used in operating activities decreased by 90% in the first quarter of 2009 compared to the same period of 2008. Approximately $2.4 million of this decrease was due to lower operating losses in our business in 2009 compared to 2008. The rest of the decrease in cash used in operating activities was due to changes in our working capital. In 2008, we had increased investment in receivables and inventory during the first quarter, as well as decreased amounts of deferred revenue. In the first quarter of 2009, we were able to generate funds from operation by decreasing our receivables and inventory from the prior quarter by approximately $2.2 million. Some of this was attributable to lower business . . .