Edgar Filing: SPACEDEV INC

FORM 10-QSB/A
(AMENDMENT NO. 1)
U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20429

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the quarterly period ended September 30, 2005

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

For the transition period from _____________________ to ________________________
Commission File Number 000-28947.

SPACEDEV, INC.
(Exact name of registrant as specified in its charter)

Colorado 84-1374613

(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

13855 Stowe Drive, Poway, California 92064

(Address of principal executive offices)

(Issuer's telephone number) (858) 375-2030.

________________________________________________________________________________
(Former name, former address and former fiscal year,
if changed since last report)

Checkmark whether the issuer (1) has filed all reports required to be filed by
Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes __X__ No ____

Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act) Yes _____ No __X__

State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 24,359,156 shares of Issuer's voting
common stock were outstanding on November 1, 2005.

PAGE

EXPLANATORY NOTE: This Amendment No. 1 corrects a typographical error in the
Form 8-K filed on October 26, 2005. The merger agreement provides that the
number of shares issuable upon the earnout potentially payable for the fiscal
year ending December 31, 2005 is based on a dollar amount of $3,000,000, which
is the numerator in the stated quotient formula for the number of shares
issuable. This dollar amount was erroneously reported as $3,500,000 in the
original filing. Except for such correction, this Amendment No. 1 does not
otherwise modify or update the original Form 8-K filing. For convenience of the
reader, this Amendment No. 1 repeats the complete text of the Form 8-K,
including the items which have not been amended.

SPACEDEV, INC.
AMENDMENT NO. 1 TO FORM 10-QSB
FOR THE QUARTER ENDED SEPTEMBER 30, 2005

INDEX PAGE

PART I -- FINANCIAL INFORMATION 1

ITEM 1. FINANCIAL STATEMENTS 1

Consolidated Balance Sheets 1
Consolidated Statements of Operations 3
Consolidated Statements of Cash Flows 4
Notes to Consolidated Financial Statements 6

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 14

Overview 14
Recent Developments 15
Critical Accounting Standards 17
Results of Operations 17
Liquidity and Capital Resources 23
Cash Flows 24
Recent Accounting Pronouncements 25

ITEM 3. CONTROLS AND PROCEDURES 34

PART II -- OTHER INFORMATION 35

ITEM 1. LEGAL PROCEEDINGS 35

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES 35

ITEM 3. DEFAULTS UPON SENIOR SECURITIES 35

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 35

ITEM 5. OTHER INFORMATION 35

ITEM 6. EXHIBITS 36

SIGNATURES 37

PAGE

PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SPACEDEV, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

At September 30, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2004
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ASSETS

CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . $4,022,243 $4,078,593
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . 1,096,645 427,358
Work in progress . . . . . . . . . . . . . . . . . . . . . . . . . . 10,412 5,754
Note receivable (Note 5) . . . . . . . . . . . . . . . . . . . . . . 1,326,453 -
-------------------------------------------------------------------------- ------------- -------------
Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 6,455,753 4,511,705

FIXED ASSETS - NET. . . . . . . . . . . . . . . . . . . . . . . . . . . . 822,980 248,066

OTHER ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,469 43,042
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$7,343,202 $4,802,813
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The accompanying notes are an integral part of these
consolidated financial statements.

PAGE 1

SPACEDEV, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

At September 30, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2004
-------------------------------------------------------------------------- ------------- -------------

LIABILITIES AND STOCKHOLDERSEQUITY

CURRENT LIABILITIES
Current portion of notes payable (Note 3(a)). . . . . . . . . . . . $ 18,797 $ 36,239
Current portion of capitalized lease obligations . . . . . . . . . . 2,479 3,943
Accounts payable and accrued expenses. . . . . . . . . . . . . . . . 398,443 161,980
Accrued payroll, vacation and related taxes. . . . . . . . . . . . . 350,145 207,028
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 126,453 49,779
Employee stock purchase plan . . . . . . . . . . . . . . . . . . . . 9,974 3,406
Other accrued liabilities. . . . . . . . . . . . . . . . . . . . . . 168,470 265,547
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TOTAL CURRENT LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . $ 1,074,761 727,922

NOTES PAYABLE, LESS CURRENT MATURITIES (NOTE 3(A)). . . . . . . . . . . . - 18,797

CAPITALIZED LEASE OBLIGATIONS, LESS CURRENT MATURITIES. . . . . . . . . . - 2,479

DEFERRED GAIN - ASSETS HELD FOR SALE (NOTE 3(A)). . . . . . . . . . . . . 859,996 977,267
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TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,934,757 1,726,465

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERSEQUITY
Convertible preferred stock, $.001 par value, 10,000,000 shares
authorized, 248,460 and 250,000 shares issued and outstanding,
respectively (Note 4) . . . . . . . . . . . . . . . . . . . . . 248 250
Common stock, $.0001 par value; 50,000,000 shares authorized, and
22,319,156 and 20,026,263 shares issued and outstanding,
respectively (Note 4) . . . . . . . . . . . . . . . . . . . . . 2,231 2,002
Additional paid-in capital (Note 4). . . . . . . . . . . . . . . . . 20,091,408 16,724,176
Additional paid-in capital - stock options . . . . . . . . . . . . . - 750,000
Deferred compensation. . . . . . . . . . . . . . . . . . . . . . . . - (250,000)
Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . . . . (14,685,442) (14,150,080)
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TOTAL STOCKHOLDERSEQUITY. . . . . . . . . . . . . . . . . . . . . . . . . 5,408,445 3,076,348
-------------------------------------------------------------------------- ------------- -------------

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY . . . . . . . . . . . . . . . . $ 7,343,202 $ 4,802,813
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The accompanying notes are an integral part of these consolidated financial statements.

PAGE 2

SPACEDEV, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

-----------------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------------------
Three and Nine Months Ending Three-Months Ending Nine-Months Ending
------------------------------------------- ------------------------------------------
September 30, 2005 % 2004 % 2005 % 2004 %
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

NET SALES. . . . . . . . . . . . . . $ 2,234,010 100.0% $ 1,230,126 100.0% $ 5,942,558 100.0% $ 3,445,569 100.0%

TOTAL COST OF SALES. . . . . . . . . 1,709,077 76.5% 952,944 77.5% 4,571,505 76.9% 2,702,583 78.4%

GROSS MARGIN . . . . . . . . . . . . 524,933 23.5% 277,182 22.5% 1,371,053 23.1% 742,986 21.6%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

OPERATING EXPENSES
Marketing and sales expense . . . 188,655 8.4% 120,367 9.8% 493,344 8.3% 335,652 9.7%
General and administrative. . . 253,341 11.3% 108,049 8.8% 654,524 11.0% 313,784 9.1%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

TOTAL OPERATING EXPENSES . . . . . . 441,996 19.8% 288,416 18.6% 1,147,868 19.3% 649,436 18.8%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

INCOME FROM OPERATIONS . . . . . . . 82,937 3.7% 48,766 4.0% 223,185 3.8% 93,550 2.7%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

NON-OPERATING (INCOME) EXPENSE
Interest income . . . . . . . . . (24,848) -1.1% (69,632) -0.5% (69,632) -1.2% (5,619) -0.2%
Interest expense. . . . . . . . . 452 0.0% 23,110 1.9% 2.283 0.0% 62,633 1.8%
Gain on building sale (Note 3(a)) (29,318) -1.3% (29,318) -2.4% (87,953 -1.5% (87,954) -2.6%
Non-Cash loan fee - equity conversions
(Note 3(c)). - 0.0% 663,481 53.9% 28,875 0.5% 2,456,794 71.3%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

TOTAL NON-OPERATING (INCOME) EXPENSE (53,714) -2.4% 651,654 53.0% (126,427) -2.1% 2,425,854 70.4%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

INCOME (LOSS) BEFORE TAXES . . . . . 136,651 6.1% (602,888) -49.0% 349,612 5.9% (2,332,304) -67.7%

INCOME TAX PROVISION . . . . . . . . 400 0.0% - 0.0% 1,200 0.0% - 0.0%

NET INCOME (LOSS). . . . . . . . . . $ 136,251 6.1% (602,888) -49.0% $ 348,412 5.90% $(2,332,304) -67.7%
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

NET INCOME (LOSS) PER SHARE:
Net income (loss) . . . . . . . $ 0.01 $ (0.03) $ 0.02 $ (0.13)
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

Weighted-Average Shares
Outstanding 21,241,448 19,228,019 21,777,211 18,019,886

FULLY DILUTED NET INCOME (LOSS) PER SHARE:
Net income (loss) . . . . . . . $ 0.00 ($0.03) $ 0.01 $ (0.13)
------------------------------------- ------------ ------ ----------- ------- ------------ ------ ----------- -------

Fully Diluted Weighted-Average
Shares Outstanding 29,362,131 19,228,019 21,719,369 18,019,886

PAGE 3

SPACEDEV, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

------------------------------------------------------------- ------------ ------------
------------------------------------------------------------- ------------ ------------

Nine-Months Ended September 30,. . . . . . . . . . . . . . . 2005 2004
------------------------------------------------------------- ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) . . . . . . . . . . . . . . . . . . . $ 348,412 $(2,332,304)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization. . . . . . . . . . . 108,265 55,236
Gain on disposal of building sale. . . . . . . . . (87,953) (87,954)
Non-cash loan fees . . . . . . . . . . . . . . . . 28,875 2,456,794
Change in operating assets and liabilities . . . . (84,760) (25,552)

NET CASH PROVIDED BY OPERATING ACTIVITIES. . . . . . . . . . 312,839 66,220

CASH FLOWS FROM INVESTING ACTIVITIES
Notes Receivable. . . . . . . . . . . . . . . . . . . . (1,326,453) -
Purchases of fixed assets . . . . . . . . . . . . . . . (651,864) (165,770)
------------------------------------------------------------- ------------ ------------

NET CASH USED IN INVESTING ACTIVITIES . . . . . . . . . . . . (1,978,317) (165,770)

CASH FLOWS FROM FINANCING ACTIVITIES
Principal payments on notes payable . . . . . . . . . . (27,330) (32,555)
Principal payments on capitalized lease obligations . . (2,774) (9,163)
Employee Stock Purchase Plan. . . . . . . . . . . . . . 48,343 -
Payments on notes payable - related party . . . . . . . - (614,778)
Proceeds from issuance of common and preferred stock. . 600,881 3,783,725
Proceeds from revolving credit facility . . . . . . . . - 458,908
------------------------------------------------------------- ------------ ------------

NET CASH PROVIDED BY FINANCING ACTIVITIES. . . . . . . . . . 619,120 3,586,137

Net (decrease) increase in cash and cash equivalents . . . . (1,046,358) 3,486,587

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD . . . . . . 5,068,601 592,006
------------------------------------------------------------- ------------ ------------

CASH AND CASH EQUIVALENTS AT END OF PERIOD . . . . . . . . . $ 4,022,243 $ 4,078,593
------------------------------------------------------------- ------------ ------------
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The accompanying notes are an integral part of these consolidated financial
statements.

PAGE 4

SPACEDEV, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONT'D.
(UNAUDITED)

-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
Nine-Months Ended September 30, . . . . . . . . . . . . . . . . . . . .. . . . 2005 2004
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SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,283 $305,038

NONCASH INVESTING AND FINANCING ACTIVITIES:

During the nine-months ending September 30, 2005 and 2004, the Company converted
$47,702 and $12,628 of employee stock purchase plan contributions into
34,040 and 14,070 shares of common stock, respectively.

During the nine-months ending September 30, 2005, the Company declared dividends
payable of $128,057 to the holders of its preferred stock.

During the nine-months ending September 30, 2005, the Company converted
dividends payable of $174,976 into 113,621 shares of common stock to the
holders of its preferred stock.

During the nine-months ending September 30, 2005, the Company did not maintain a
balance under its revolving credit facility, therefore the Company recorded
no non-cash loan fees.

During the nine-months ending September 30, 2004, the Company issued 1,954,661
shares of its common stock to the Laurus Master Fund from conversions under
its revolving credit facility, thereby realizing a corresponding reduction
in current liabilities of approximately $1,240,500 The Company recorded
additional non-cash loan fees of approximately $1,718,000 and charged these
fees to expense.

During the nine-months ending September 30, 2004, the Company issued 589,212
shares of its common stock to the participants in our convertible debt
program in 2003 from conversions of warrants thereby receiving cash in the
amount of $227,500. The Company recorded additional non-cash loan fees of
approximately $738,700 and charged these fees to expense.

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

PAGE 5

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying consolidated financial statements of SpaceDev, Inc. (the
"Company") include the accounts of the Company and its inactive subsidiary,
SpaceDev, Inc., an Oklahoma corporation. In the opinion of management, the
consolidated financial statements reflect all normal and recurring adjustments,
which are necessary for a fair presentation of the Company's financial position,
results of operations and cash flows as of the dates and for the periods
presented. The consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information. Consequently, these statements do not include all disclosures
normally required by generally accepted accounting principles of the United
States of America for annual financial statements nor those normally made in an
Annual Report on Form 10-KSB. Accordingly, reference should be made to the
Company's Form 10-KSB filed on March 28, 2005 and other reports the Company
filed with the U.S. Securities and Exchange Commission for additional
disclosures, including a summary of the Company's accounting policies, which
have not materially changed. The consolidated results of operations for the
three- and nine month periods ending September 30, 2005 are not necessarily
indicative of results that may be expected for the fiscal year ending December
31, 2005 or any future period, and the Company makes no representations related
thereto.

The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
certain estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosures of contingent assets and liabilities and the results of
operations during the reporting period. Actual results could differ materially
from those estimates.

2. REVENUE RECOGNITION

The Company's revenues for the nine months ended September 30, 2005 and 2004
were derived primarily from United States government cost plus fixed fee
(CPFF). Revenues from the CPFF contracts during the nine months ended September
30, 2005 and 2004 were recognized as expenses as incurred. Estimated contract
profits are taken into earnings in proportion to revenues recorded. Time and
material revenues are recognized as services are performed and costs incurred.
Actual results of contracts may differ from management's estimates and such
differences could be material to the consolidated financial statements.
Professional fees are billed to customers on a time and materials basis. Time
and material revenues are recognized as services are performed and costs
incurred.

3. NOTES PAYABLE

a) Building and Settlement Notes

In December 2002, the Company entered an agreement to sell its interest in its
facility. The transaction closed in January 2003. The escrow transaction
included the sale of the land and building. Net fixed assets were reduced by
approximately $1.9 million and notes payable were reduced by approximately $2.4
million while a deferred gain was recorded. In conjunction with the sale, the
Company entered into a lease agreement with the buyer to leaseback its
facilities. The Company's Chief Executive Officer provided a guarantee for the
leaseback. The gain on the sale of the facility was deferred and amortized in
proportion to the gross rental charged to expense over the lease term. Deferred
gain of $1,172,720 is being amortized at the rate of $117,272 per year for ten
(10) years ending in January 2013. As of September 30, 2005, the deferred gain
was $859,996. This amortization is included in the Company's occupancy and
facility expense, included in the Company's non-operating expenses, and totaled
$87,953 and $87,954 for the nine months ended September 30, 2005 and 2004,
respectively.

Deferred gain consisted of the following:

PAGE 6

Nine Months Ended September 30, 2005

Original Deferred Gain $1,172,720
Less Amortization 2003 (107,499)
Less Amortization 2004 (117,272)
Less Amortization 2005 (87,953)
---------------------- -----------
$ 859,996
---------------------- -----------

In 2001, the Company entered into three settlement loan agreements with various
vendors. The total of $171,402 for all three loans called for payments between
24 and 50 months with interest that ranges from 0% to 8%. At September 30, 2005
and 2004, the outstanding balances on these notes were $18,797 and $55,036,
respectively, with interest expense for the nine months ended September 30, 2005
and 2004 of $1,277 and $3,691, respectively. As of September 30, 2005, only one
note remained outstanding.

Future -minimum principal payments on settlement notes are as follows:

For the twelve months ended September 30,

2006 $ 18,797
2007 -
2008 -
---------------------- -----------
Total Settlement Notes $ 18,797

b) Related Parties

The Company had a note payable to its CEO. As part of the Company's preferred
stock offering (see Note 5), the note was paid in full during the third quarter
of 2004 and no amounts were outstanding at September 30, 2005 or 2004.

Interest expense on this note was $0 and $29,256 for the nine months ended
September 30, 2005 and 2004, respectively.

c) Revolving Credit Facility.

In June 2003, the Company entered into a Security Agreement, Secured Convertible
Note, Registration Rights Agreement and Common Stock Purchase Warrant with
Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the agreements, the Company
received a $1 million revolving credit facility in the form of a three-year
Convertible Note secured by the Company's assets subject to the amount of
eligible accounts receivables. The net proceeds from the Convertible Note were
used for general working capital purposes. Advances on the Convertible Note may
be repaid at the Company's option, in cash or through the issuance of shares of
the Company's common stock provided the market price of the common stock was
118% of the fixed conversion price or greater. The Convertible Note carries an
interest rate of Wall Street Journal Prime plus 0.75% on any outstanding
balance. In addition, the Company is required to pay a collateral management
payment of 0.55% of the average aggregate outstanding balance during each month
plus an unused line payment of 0.20% per annum. Approximately $29,600 in
interest and approximately $4,000 in fees were recorded under the revolving
credit facility in the first nine months of 2004. There was no outstanding
balance on the revolving credit facility at any time during the nine months
ended September 30, 2005.

The Convertible Note includes a right of conversion in favor of Laurus. Laurus
exercised its conversion rights from time to time in 2004 on outstanding
balances. There have been no outstanding balances in 2005. When Laurus chooses

PAGE 7

to exercise its conversion rights, the Convertible Note is converted into shares
of the Company's common stock at a fixed conversion price, subject to
adjustments for stock splits, combinations and dividends and for shares of
common stock issued for less than the fixed conversion price (unless exempted
pursuant to the agreements). The Agreement was modified on March 31, 2004 to
provide for a six-month waiver of the accounts receivable restrictions and a
fixed conversion price to Laurus of $0.85 per share on the first $500,000 after
the first $1 million. The agreement was further modified on August 25, 2004 to
provide for a fixed conversion price to Laurus of $1.00 per share on the next $1
million. Thereafter, the fixed conversion price will be adjusted to 103% of the
then fair market value of the Company's common stock ("Adjusted Fixed Conversion
Price").

Laurus converted $1,240,507 under the Convertible Note into 1,954,661 shares
during the nine months ended September 30, 2004. Laurus has converted a total of
$2,500,000 into 3,406,417 shares under the Convertible Note since the inception
of the revolving credit facility. For the nine month period ending September 30,
2004, the Company recorded $1,718,120 in expense for the non-cash loan fee based
on the fair market value of the stock when Laurus converted and $2,607,099 in
expense for the non-cash loan fee since the inception of the revolving credit
facility. There have been no conversions during the first nine months of 2005.
The fair market value of the common stock used in 2004 was established using the
closing price on the date of conversion.

Availability of funds under the revolving credit facility is based on the
Company's accounts receivable, except as waivers are provided by Laurus. In
2003, an initial three-month waiver was offered by Laurus, under which Laurus
permitted a credit advance up to $300,000, which amount would have otherwise
exceeded eligible accounts receivable. Laurus subsequently extended the waiver
for two additional six-month periods into 2004, under which Laurus permitted a
credit advance up to $1 million, which amount would have otherwise exceeded
eligible accounts receivable. The revolving credit facility is secured by all of
the assets of the Company.

In conjunction with the 2004 waiver, Laurus was paid a fee of $10,000, which was
recorded as additional interest expense in 2004. The Company is required to pay
a continuation fee of $10,000 for 2005. In addition, Laurus received a warrant
to purchase 200,000 shares of the Company's common stock for the initial $1
million revolving credit facility. The warrant exercise price was computed as
follows: $0.63 per share for the purchase of up to 125,000 shares; $0.69 per
share for the purchase of an additional 50,000 shares; and $0.80 per share for
the purchase of an additional 25,000 shares. The warrant exercise price may be
paid in cash, in shares of the Company's common stock, or by a combination of
both. Laurus exercised the warrant in part for 25,000 shares in April 2005. The
warrant may be exercised for the balance of the shares any time or from time to
time until June 3, 2008. The warrant exercise price and the number of shares
underlying the warrant are subject to adjustments for stock splits, combinations
and dividends.

In addition to the initial warrant, the Company was obligated to issue an
additional five-year warrant to Laurus to purchase one share of common stock at
an exercise price equal to 125% of the Adjusted Fixed Conversion Price for every
ten dollars ($10) in principal of the Convertible Note converted into common
stock if and when over $1 million was converted under the revolving credit
facility. On June 18, 2004, the Company issued an additional warrant to purchase
50,000 shares at an exercise price of $1.0625 per share in relation to the March
31, 2004 credit facility modification. This additional warrant was exercised by
Laurus in April 2005 and resulted in a non-cash interest expense of $28,875 for
the nine months ended September 30, 2005. Since no more than an aggregate of
100,000 shares of the Company's common stock were authorized as additional
warrants under the Laurus Agreements, on August 25, 2004, the Company issued an
additional warrant to purchase 50,000 shares at an exercise price of $1.925 per
share in relation to the August 25, 2004 credit facility modification, i.e.,
there was a 100,000 share ceiling on the number of warrants to be issued
regardless of the amount converted under the revolving credit facility.

The Company may terminate its agreements with Laurus before the end of the
initial three-year term, i.e., June 3, 2006, and Laurus will release its
security interests upon payment to Laurus of all obligations, if the Company
has: (i) provided Laurus with an executed release of all claims which the
Company may have under the agreements; and, (ii) paid to Laurus an early payment
fee in an amount equal to two percent (2%) of the total amount available under

PAGE 8

the revolving credit facility if such payment occurs after June 3, 2005 and
prior to June 3, 2006. The early payment fee is also due and payable by the
Company to Laurus if the Company terminates its Agreement after the occurrence
of an Event of Default, as defined in the agreements.

As a result of the amendments and modifications discussed above, at September
30, 2005 the revolving credit facility provided for up to a maximum of $1.5
million in principal amount of aggregate borrowing The fixed conversion price
for future amounts under the revolving credit facility will be set at 103% of
the fair market value of our common stock. There was no balance on the revolving
credit facility for the nine months ended September 30, 2005.

4. STOCKHOLDER'S EQUITY - PREFERRED STOCK, COMMON STOCK AND WARRANTS

PREFERRED STOCK

In August 2004, the Company entered into a Securities Purchase Agreement with
Laurus, whereby the Company issued 250,000 shares of its Series C Convertible
Preferred Stock, par value $0.001 per share, to Laurus for an aggregate purchase
price of $2,500,000 or $10.00 per share (the "Stated Value"). The preferred
shares are convertible into shares of the Company's common stock at a rate of
$1.54 per share at any time after the date of issuance, and are entitled to
quarterly, cumulative dividends at a rate of 6.85% beginning on January 1, 2005.
For the nine months ended September 30, 2005, approximately $128,000 has been
accrued for dividends earned in 2005. Approximately $175,000 of accrued
dividends were satisfied by the issuance of the Company's common stock during
the nine months ended September 30, 2005. Dividends are payable in cash or
shares of the Company's common stock at the holder's option with the exception
that dividends must be paid in shares of the Company's common stock for up to
25% of the aggregate dollar trading volume if the fair market value of the
Company's common stock for the 20-days preceding the conversion date exceeds
$1.85 per share. In January 2005, $60,967 was converted into 39,589 shares of
the Company's common stock from previous dividend accruals. In May 2005, $56,300
was converted into 36,559 shares of the Company's common stock from dividends
accrued from January through April 2005 and in September 2005, $57,708 was
converted into 37,473 shares of the Company's common stock from dividends
accrued from May through August 2005. The preferred shares are redeemable by the
Company in whole or in part at any time after issuance for (a) 115% of the
Stated Value if the average closing price of the common stock for the 22 days
immediately preceding the date of conversion does not exceed the conversion rate
or (b) the Stated Value if the average closing price of the common stock for the
22 days immediately preceding the date of preferred stock conversion exceeds the
Stated Value. The preferred shares have a liquidation preference equal to the
Stated Value upon the Company's dissolution, liquidation or winding-up. The
preferred shares have no voting rights. As of September 30, 2005, 1,540
preferred shares had been converted into 10,000 shares of the Company's common
stock

In conjunction with the preferred stock, the Company issued a five-year common
stock purchase warrant to Laurus for the purchase of 487,000 shares of the
Company's common stock at an exercise price of $1.77 per share. The Company
filed a registration statement for the resale of all of the shares of its common
stock issuable upon conversion of the preferred shares and the warrant, as well
as an estimated number of shares payable as dividends on the preferred shares,
which was declared effective in November 2004.

COMMON STOCK AND WARRANTS

The Company has elected to account for its stock-based compensation plans under
APB 25. However, the Company has computed, for pro forma disclosure purposes,
the value of all options granted during the nine months ended September 30, 2005
and 2004 using the minimum value method as prescribed by SFAS 123 and amended by
SFAS 148. Under this method, the Company used the risk-free interest rate at the
date of grant, the expected volatility, the expected dividend yield and the
expected life of the options to determine the fair value of options granted. The
risk-free interest rates ranged from 6.0% to 6.5%, expected volatility was 117%,

PAGE 9

the dividend yield was assumed to be zero, and the expected life of the options
was assumed to be three to five years based on the average vesting period of
options granted.

If the Company had accounted for these options in accordance with SFAS 123, the
total value of options granted during the nine months ended September 30, 2005
and 2004 would be amortized on a pro forma basis over the vesting period of the
options. Thus, the Company's consolidated net income (loss) would have been as
follows:

===================================================================== ========== ============
NET INCOME (LOSS). . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2004
===================================================================== ========== ============

As reported. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 348,412 $(2,332,304)
Add: Stock based employee compensation
expense included in reported net income. . . . . . . . . . . . . . . $ - $ -
Deduct: Stock based employee compensation expense determined under
the fair value based method for all awards . . . . . . . . . . . . . $ 553,989 $ 303,425
--------------------------------------------------------------------- ---------- ------------
Pro forma. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(205,577) $(2,635,729)
===================================================================== ========== ============
NET INCOME (LOSS) PER SHARE:

As reported. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.02 $ (0.13)
Pro forma. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.01) $ (0.15)
===================================================================== ========== ============

Beginning January 2006, the Company plans to adopt SFAS 123R as currently
required by the Securities and Exchange Commission. See Note 7 below. As of
September 30, 2005, the Company had not yet determined the impact of SFAS 123(R)
on its financial statements.

November 1997, the Company entered into a five-year employment agreement with
Mr. James W. Benson, its CEO. On July 16, 2000, the Company amended the
employment agreement with Mr. Benson extending the term until July 16, 2005. As
part of the original employment agreement, the Company granted options to Mr.
Benson to purchase up to 2,500,000 of non-plan, non-registered shares of the
Company's common stock. Options for 500,000 of these shares were vested prior to
the expiration of Mr. Benson's employment agreement and those options remain
outstanding, and the balance expired unvested. The vested options have an
exercise price of $1.00 and expire in July 2010. The Compensation Committee of
the Board of Directors is currently negotiating a new agreement with Mr.
Benson.. Mr. Benson is currently continuing as an employee "at will" under the
laws of the State of California.

The options previously granted to Mr. Benson, as part of his employment contract
were subject to the following vesting conditions, which were amended in January
2000 and later ratified by the Board in July 2000. The agreement provided the
Board flexibility to award options for an additional 1,500,000 of non-plan,
non-registered shares of [restricted] common stock to Mr. Benson, which
additional options were not granted.

5. NOTES RECEIVABLE

On September 8, 2005, the Company made a secured loan in the principal amount of
$1.2 million to Starsys Research Corporation ("Starsys"), a design, engineering,
and manufacturing company located in Boulder, Colorado which provides mechanical
systems to the aerospace industry. The loan accrues interest at 8% per annum and
matures on December 31, 2005 or earlier in certain circumstances. No principal
or interest payments are due before maturity. The maturity date may be
accelerated upon the occurrence of certain events of default. The loan is
secured by a security interest in all of the assets of Starsys, subject to an
intercreditor agreement with Vectra Bank Colorado, National Association

PAGE 10

("Vectra"), described below. In addition, Starsys has agreed to pay the Company
a placement agent fee and to reimburse the Company expenses in the aggregate
amount of $120,000. This amount was deferred until the closing of the Plan of
Merger (see Note 7) and added to the principal balance of the note evidencing
the loan.

In connection with making the loan, the Company entered into an exclusivity
agreement with Starsys which provides that Starsys will not discuss a material
sale of its assets, a material sale of its stock, a merger, or similar
transaction with any other party until October 31, 2005. Prior to completion of
the loan described above, the Company and Starsys entered into a non-binding
letter of intent concerning a transaction of the nature described in the
exclusivity agreement. The structure and economic terms of a potential
transaction, however, remained subject to further negotiations and due diligence
by both parties; however, on October 26, 2005, the Company and Starsys entered
into a definitive merger agreement (see Note 7, Subsequent Events).

6. NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 153, Exchanges of Nonmonetary Assets- An Amendment of APB Opinion No. 29.
The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is
based on the principle that exchanges of nonmonetary assets should be measured
based on the fair value of the assets exchanged. The guidance in that Opinion,
however, included certain exceptions to that principle. SFAS No. 153 amends
Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. A nonmonetary exchange
has commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. The provisions of SFAS No. 153
are effective for nonmonetary asset exchanges occurring in fiscal periods
beginning after June 15, 2005. Early application was permitted and companies
must apply the standard prospectively. The adoption of this standard is not
expected to have a material effect on the Company's financial position or
results of operations.

In December 2004, FASB issued Statement of Financial Accounting Standards No.
123 (revised 2004), Share-Based Payment (SFAS No. 123R). FAS No. 123R revised
SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees, and its related
implementation guidance. SFAS No. 123R will require compensation costs related
to share-based payment transactions to be recognized in the financial statement
(with limited exceptions). The amount of compensation cost will be measured
based on the grant-date fair value of the equity or liability instruments
issued. Compensation cost will be recognized over the period that an employee
provides service in exchange for the award.

In March 2005, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 107 (SAB No. 107), Share-Based Payment, providing guidance on
option valuation methods, the accounting for income tax effects of share-based
payment arrangements upon adoption of SFAS No. 123R, and the disclosures in MD&A
subsequent to the adoption. In April 2005, the Securities and Exchange
Commission adopted a rule which delayed the compliance date for small business
issuers to the start of the first fiscal year beginning after December 15, 2005.
The Company will provide SAB No. 107 required disclosures upon adoption of SFAS
No. 123R in January 2006 and is currently evaluating the impact the adoption of
the standard will have on the Company's financial condition and results of
operations.

In June 2005, FASB issued SFAS No. 154, Accounting Changes and Errors
Corrections, a replacement of APB Opinion No. 20 and FAS No. 3. The Statement
applies to all voluntary changes in accounting principle, and changes the
requirements for accounting for and reporting of a change in accounting
principle. SFAS No. 154 requires retrospective application to prior periods'
financial statements of a voluntary change in accounting principle unless it is
impractical. APB Opinion No. 20 previously required that most voluntary changes
in accounting principle be recognized by including in net income of the period
of the change the cumulative effect of changing to the new accounting principle.
SFAS No.154 is not expected to have a material adverse effect on the Company's
financial position or results of operations.

PAGE 11

7. SUBSEQUENT EVENTS

In October 2005, the Company entered into an Agreement and Plan of Merger and
Reorganization ("merger agreement"), with Starsys Research Corporation
("Starsys"), a Colorado corporation, and Scott Tibbitts, its largest
shareholder. Pursuant to the merger agreement, Starsys will merge with and into
a newly-created, wholly-owned subsidiary of the Company. Holders of Starsys
common stock will become holders of the Company's common stock following the
merger. The merger agreement is subject to a number of conditions described
below, including effectiveness of a Form S-4 registration statement and approval
of the respective shareholders of SpaceDev and Starsys.

Merger Consideration. The Company will pay and issue the following
consideration at the effective time of the merger, subject to adjustment as
provided in the merger agreement:

- cash in the aggregate amount of $1,500,000; and

- an aggregate number of shares of the Company's common stock equal to the
quotient of (A) $7,500,000 divided by (B) the greater of (1) $1.40 and (2)
the lesser of (x) $1.90 and (y) the volume weighted average price of the
Company's common stock for the preceding 20 trading days.

Fifty percent (50%) of the number of shares of the Company's common stock issued
at closing will be deposited in escrow as security for the payment of
indemnification claims under the merger agreement, which escrow will generally
last until ten (10) days following the date of audited financial statements
prepared for the surviving corporation for the fiscal year ending 2006 (i.e.,
approximately April 2007).

Following the merger, Starsys shareholders may also be entitled to receive,
based on the achievement by the surviving corporation of certain performance
criteria for each of the fiscal years ending December 31, 2005, December 31,
2006 and December 31, 2007, additional earnout consideration consisting of up
to:

- For the fiscal year ended December 31, 2005, $350,000 in cash and an
aggregate number of shares of the Company's common stock equal to the
quotient of (A) $3,000,000 divided by (B) the greater of (1) $2.00
and (2) the volume weighted average price of the Company's common stock for
the twenty (20) trading days preceding the date of the audit opinion for
Starsys' fiscal year ended December 31, 2005;

- For the fiscal year ended December 31, 2006, $350,000 in cash and an
aggregate number of shares of the Company's common stock equal to the
quotient of (A) $7,500,000 divided by (B) the greater of (1) $2.50 and (2)
the volume weighted average price of the Company's common stock for the
twenty (20) trading days preceding the date of the audit opinion for
Starsys' fiscal year ended December 31, 2006; and,

- For the fiscal year ended December 31, 2007, $350,000 in cash and an
aggregate number of shares of the Company's common stock equal to the
quotient of (A) $7,500,000 divided by (B) the greater of (1) $3.00 and (2)
the volume weighted average price of the Company's common stock for the
twenty (20) trading days preceding the date of the audit opinion for
Starsys' fiscal year ended December 31, 2007.

If any shares of the Company's common stock are payable as earnout consideration
for the fiscal year ending December 31, 2005, fifty percent (50%) of those
shares will be deposited in the escrow described above.

Each outstanding share of the Company's common stock will remain unchanged in
the merger.

Working Capital Contribution. The Company will contribute $2.5 million to the
working capital of the surviving corporation through the end of 2006.

PAGE 12

Treatment of Stock Options and Warrants. The holders of options, warrants and
other rights to purchase Starsys common stock must exercise such rights on or
before the closing of the merger. Any options, warrants or other rights to
purchase Starsys common stock which are not exercised prior to the closing of
the merger will be cancelled and will terminate and expire as of that closing of
the merger. The Company will assume no options, warrants or other rights to
purchase Starsys common stock pursuant to the merger.

Loan Repayments. At the closing of the merger, the Company will (i) pay off the
remaining principal and interest of all loans to Starsys from Vectra Bank
Colorado, together with any other costs incurred in connection with those loans,
(ii) cancel and terminate the secured loan of $1.2 million and all accrued
interest and fees, from the Company to Starsys (the "SpaceDev loan"), and (iii)
pay off subordinated loans in the aggregate amount of approximately $920,000
owed by Starsys to certain Starsys shareholders. The Company will not be
obligated to pay off more than $4,600,000 in the aggregate (excluding the amount
of the SpaceDev loan) for all of the loans and related costs described above.

Reservation of Options. The Company has agreed to reserve for issuance to
Starsys officers, employees and consultants options to buy a number of shares of
the Company's common stock equal to at least 15% of the number of shares of the
Company's common stock issued at the closing and as earnout consideration. The
Company will seek approval of its shareholders to increase the amount of shares
available under the Company's 2004 Equity Incentive Plan, or under a new stock
or equity plan to be adopted, to provide sufficient reserves for the issuance of
the options referenced above.

Representations, Warranties and Covenants. The Company and Starsys have made
customary representations, warranties and covenants in the merger agreement,
including, among others, covenants (i) not to (A) solicit proposals relating to
alternative business combination transactions or (B) subject to certain
exceptions, enter into discussions concerning or provide information in
connection with alternative business combination transactions, (ii) to cause
shareholder meetings to be held to consider approval of the merger agreement (in
the case of Starsys and the Company), and (iii) subject to certain exceptions,
for the board of directors of Starsys to recommend adoption by its shareholders
of the merger agreement and for our board of directors to recommend adoption by
its shareholders of the merger agreement.

Conditions to Closing. Consummation of the merger is subject to certain closing
conditions, including, among others, shareholder approvals, absence of
governmental restraints, effectiveness of a Form S-4 registration statement, and
accuracy of representations. The merger agreement allows Starsys and us to
terminate the merger agreement upon the occurrence (or non-occurrence) of
certain events.

Following the effective time of the merger, Scott Tibbitts, who is currently the
Chief Executive Officer of Starsys, will become a director and executive officer
of the Company.

In October 2005, the Company entered into a Securities Purchase Agreement with
Laurus Master Fund, Ltd. whereby the Company issued 2,032,520 shares of its
common stock to Laurus for an aggregate purchase price of $2,500,000, or $1.23
per share, representing 80% of the 20-day volume weighted average price of the
Company's common stock through October 28, 2005. In conjunction with the
Securities Purchase Agreement, the Company issued a five-year common stock
purchase warrant to Laurus for the purchase of 450,000 shares of common stock at
an exercise price of $1.93 per share. The Company has committed to register all
of the shares of stock underlying the common stock and the warrant after the
Form S-4 (described above) becomes effective. Also in conjunction with the
agreement, the Company has agreed to pay Laurus a fee equal to 3.5% of the
proceeds raised from them, exclusive of the proceeds obtained from the exercise
of the warrants.

PAGE 13

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

THIS QUARTERLY REPORT ON FORM 10-QSB CONTAINS FORWARD-LOOKING STATEMENTS WITHIN
THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, WHICH
REFLECT MANAGEMENT'S CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND FINANCIAL
PERFORMANCE. IN THIS REPORT, THE WORDS "ANTICIPATES," "BELIEVES," "EXPECTS,"
"INTENDS," "FUTURE," "MAY," "SHOULD," "PLAN," "CONTINUE," OR "WILL," AND SIMILAR
EXPRESSIONS IDENTIFY FORWARD-LOOKING STATEMENTS. THESE AND OTHER FORWARD-LOOKING
STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES, INCLUDING THOSE
DISCUSSED IN THE BUSINESS RISKS SECTION OF THIS ITEM 2 AND ELSEWHERE IN THIS
FORM 10-QSB, THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM
HISTORICAL RESULTS OR THOSE ANTICIPATED. READERS ARE CAUTIONED NOT TO PLACE
UNDUE RELIANCE ON THESE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF THE
DATE HEREOF. WE UNDERTAKE NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT
EVENTS OR CIRCUMSTANCES OCCURRING SUBSEQUENT TO THE FILING OF THE FORM 10-QSB
WITH THE SECURITIES AND EXCHANGE COMMISSION.

OVERVIEW

We are engaged in the conception, design, development, manufacture, integration
and operation of space technology systems, products and services. We are
currently focused on the commercial and military development of low-cost
microsatellites, nanosatellites and related subsystems, hybrid rocket propulsion
for space, launch and human flight vehicles as well as associated engineering
and technical services which are provided primarily to government agencies, and
specifically the Department of Defense. Our products and solutions are sold,
mainly on a project-basis, directly to these customers and include sophisticated
micro- and nanosatellites, hybrid rocket-based launch vehicles, maneuvering and
orbital transfer vehicles and safe sub-orbital and orbital hybrid rocket-based
propulsion systems. Although we believe there will be a commercial market for
our microsatellite and nanosatellite products and services in the future,
virtually all of our current work is for branches of the United States military.
We are also developing commercial hybrid rocket motors for use in small launch
vehicles, targets and sounding rockets, and small, high-performance space
vehicles and subsystems for commercial customers.

During the first nine months of 2005, 93% of our net sales were generated from
direct government contracts and 7% were generated from government-related work
through subcontracts with others. In 2004, approximately 90% of our net sales
were generated by government or government-related work. We anticipate that over
90% of net sales generated during the remainder of 2005 will be generated by
government or government-related work. We will continue to seek both government
and commercial business and anticipate that net sales from government sources
will to continue to represent in excess of 70% of our net sales for the next
several years as we increase our government and commercial marketing efforts for
both of our technology and product areas. Currently, we are focusing on the
domestic United States government market, which we believe is only about
one-half of the global government market for our technology, products and
services. Although we are interested in exploring international revenue and
contract opportunities, we are restricted by export control regulations,
including International Traffic in Arms Regulations, which may limit our ability
to develop market opportunities outside the United States.

At this time, over 90% of our forecasted sales for 2005 are under contract or
near contract award. We may not be able to win enough new business to achieve
our targeted growth projection or to maintain a positive cash flow position.
During the first nine months of 2005, we submitted five bids for government or
commercial programs and continued our work with the United States Congress to
identify directed funding for our programs.

In order to perform the Missile Defense Agency contract on schedule and
successfully execute other existing and new business opportunities, we must
substantially increase our staff and hire new engineers or subcontract the work
to third parties. We are actively seeking to hire spacecraft and propulsion
engineers, and we are investigating various partnership arrangements to increase
resource availability.

PAGE 14

RECENT DEVELOPMENTS

In October 2005, we entered into an Agreement and Plan of Merger and
Reorganization, which we refer to as the merger agreement, with Starsys Research
Corporation, a Colorado corporation, and Scott Tibbitts, its largest
shareholder. Pursuant to the merger agreement, Starsys will merge with and into
a newly-created, wholly-owned subsidiary of SpaceDev. Holders of Starsys common
stock will become holders of our common stock following the merger. The merger
agreement is subject to a number of conditions described below, including
effectiveness of a Form S-4 registration statement and approval of the
respective shareholders of SpaceDev and Starsys.

Merger Consideration. We will pay and issue the following consideration at the
effective time of the merger, subject to adjustment as provided in the merger
agreement:

- cash in the aggregate amount of $1,500,000; and

- an aggregate number of shares of our common stock equal to the quotient of
(A) $7,500,000 divided by (B) the greater of (1) $1.40 and (2) the lesser
of (x) $1.90 and (y) the volume weighted average price
of our common stock for the preceding 20 trading days.

Fifty percent (50%) of the number of shares of our common stock issued at
closing will be deposited in escrow as security for the payment of
indemnification claims under the merger agreement, which escrow will generally
last until ten days following the date of audited financial statements prepared
for the surviving corporation for the fiscal year ending 2006 (i.e.,
approximately April 2007).

- For the fiscal year ended December 31, 2005, $350,000 in cash and an
aggregate number of shares of our common stock equal to the quotient of (A)
$3,000,000 divided by (B) the greater of (1) $2.00 and (2) the
volume weighted average price of our common stock for the twenty trading
days preceding the date of the audit opinion for Starsys' fiscal year ended
December 31, 2005;

- For the fiscal year ended December 31, 2006, $350,000 in cash and an
aggregate number of shares of our common stock equal to the quotient of (A)
$7,500,000 divided by (B) the greater of (1) $2.50 and (2) the volume
weighted average price of our common stock for the twenty trading days
preceding the date of the audit opinion for Starsys' fiscal year ended
December 31, 2006; and,

- For the fiscal year ended December 31, 2007, $350,000 in cash and an
aggregate number of shares of our common stock equal to the quotient of (A)
$7,500,000 divided by (B) the greater of (1) $3.00 and (2) the volume
weighted average price of our common stock for the twenty trading days
preceding the date of the audit opinion for Starsys' fiscal year ended
December 31, 2007.

If any shares of our common stock are payable as earnout consideration for the
fiscal year ending December 31, 2005, fifty percent (50%) of those shares will
be deposited in the escrow described above.

Each outstanding share of our common stock will remain unchanged in the merger.

Working Capital Contribution. We will contribute $2.5 million to the working
capital of the surviving corporation through the end of 2006.

PAGE 15

the merger will be cancelled and will terminate and expire as of that closing of
the merger. We will assume no options, warrants or other rights to purchase
Starsys common stock pursuant to the merger.

Loan Repayments. At the closing of the merger, we will (i) pay off the remaining
principal and interest of all loans to Starsys from Vectra Bank Colorado,
together with any other costs incurred in connection with those loans, (ii)
cancel and terminate the secured loan of $1.2 million and all accrued interest
and fees, from us to Starsys, and (iii) pay off subordinated loans in the
aggregate amount of approximately $920,000 owed by Starsys to certain Starsys
shareholders. We will not be obligated to pay off more than $4,600,000 in the
aggregate (excluding the amount of our loan to Starsys) for all of the loans and
related costs described above.

Reservation of Options. We have agreed to reserve for issuance to Starsys
officers, employees and consultants options to buy a number of shares of our
common stock equal to at least 15% of the number of shares of our common stock
issued at the closing and as earnout consideration. We will seek approval of our
shareholders to increase the amount of shares available under our 2004 Equity
Incentive Plan, or under a new stock or equity plan to be adopted, to provide
sufficient reserves for the issuance of the options referenced above. In
September 2005, we made a secured loan to Starsys in the principal amount of
$1.2 million. The loan accrues interest at 8% per annum and matures on December
31, 2005, or earlier in certain circumstances. Principal or interest payments
are due before maturity. The maturity date may be accelerated upon the
occurrence of certain events of default. The loan is secured by a security
interest in all of the assets of Starsys, subject to an intercreditor agreement
with Vectra Bank Colorado, National Association.

Our proposed acquisition of Starsys exposes us to a number of risks, including
those described below under "Risks Related to the Proposed Acquisition of
Starsys."

In July 2005, we were awarded a small contract by Lunar Enterprise Corporation,
a wholly owned subsidiary of Space Age Publishing Company to perform the work
necessary to create a conceptual mission architecture and mission design for a
human servicing mission to the Lunar south pole targeted for the period of 2010
to 2015. We were awarded an earlier phase by Lunar Enterprise for a conceptual
mission and spacecraft design for a lunar lander program to further analyze
launch opportunities, spacecraft design, trajectory possibilities, potential
landing areas, available technologies for a small radio astronomy system, and
communications and data handling requirements. These contracts are expected to
result in revenues of $125,000 and $150,000, respectively. The current contract
calls for us to identify and evaluate existing technology, technology currently
under development, and proposed technology that could be developed by NASA,
other countries or the private sector in time to be incorporated into the
mission.

On July 18, 2005, we were awarded a subcontract to provide scientific,
engineering, development and programmatic support to the development and
demonstration of innovative SSA (space situational awareness) nanosatellite
(<15kg) spacecraft. SSA is the ability to search, identify and monitor
spacecrafts for the purpose of obtaining space superiority. The subcontract
covers the conceptual/preliminary phase of development and includes all aspects
of potential systems from the platforms and associated payloads to the links and
nodes and ground support. The cost plus fixed fee subcontract is expected to
result in revenues of approximately $400,000, but only $120,000 has been funded
at this time. We expect to complete this subcontract by December 2005. We
believe a subcontract for the next phase of the project will be awarded at the
beginning of 2006 to complete the system requirements review of the development
phase. We will need to bid and compete for the next-phase subcontract if it is
awarded.

On June 27, 2005, we were awarded a $1.25 million fixed price subcontract by
Andrews Space, Inc. to design a small spacecraft that will travel to the
vicinity of the Moon through a gravity tunnel that is part of the InterPlanetary
Superhighway, a route which requires significantly less fuel than conventional
trajectories. In early June 2005, we were awarded a letter subcontract not to
exceed $100,000 by Andrews for the same program. The overall program, which
Andrews has signed with NASA, is to design, develop, launch, and operate a small
low-cost spacecraft, called SmallTug, on a mission to the Lunar L1 point to
demonstrate key technologies and advanced orbital mechanics in support of NASA's
human and robotic exploration of the Moon and Mars. On September 14, 2005, we

PAGE 16

were notified by Andrews that the subcontract was cancelled. Revenues for the
nine months ended September 30, 2005 were approximately $400,000, including our
final invoice to Andrews.

For a description of our other material ongoing contracts, please see our Form
10-KSB for the year ended December 31, 2004.

CRITICAL ACCOUNTING STANDARDS

Our revenues transitioned in 2003 and early 2004 from being based primarily on
fixed-price contracts, where revenues are recognized using the percentage
-of-completion method of contract accounting based on the ratio of total costs
incurred to total estimated costs, to primarily cost plus fixed fee contracts,
where revenues are recognized as costs are incurred and services are performed.
Losses on contracts are recognized when they become known and reasonably
estimable (see Notes to the Consolidated Financial Statements). Actual results
of contracts may differ from management's estimates and such differences could
be material to the consolidated financial statements. Professional fees are
billed to customers on a time-and-materials basis, a fixed-price basis or a
per-transaction basis. Time-and-materials revenues are recognized as services
are performed. Deferred revenue represents amounts collected from customers for
services to be provided at a future date. Research and development costs are
expensed as incurred.

RESULTS OF OPERATIONS

NINE MONTHS ENDED SEPTEMBER 30, 2005 -VS.- NINE MONTHS ENDED SEPTEMBER 30, 2004

Net Sales

Our net sales increased by approximately 72% to $5,943,000 for the nine months
ended September 30, 2005 compared to net sales of $3,446,000 for the same period
in 2004. Net sales increased due to our acquisition of and performance under new
and existing government contracts. Net sales in the 2005 period reflected our
continued work on the Missile Defense Agency Task Order 2 contract of
approximately $4,114,000 which is part of our March 31, 2004 Missile Defense
Agency contract described below. We also recorded net sales on ongoing Small
Business Innovation Research contracts with the Air Force Research Laboratory.
These contracts are both for Phase II efforts, and are for SpaceDev's Small
Launch Vehicle and our micro and nanosatellite bus and subsystem designs work.
Net sales for these contracts totaled $592,000 and $509,000 for the nine months
ended September 30, 2005 and 2004, respectively. In addition, we started our
Phase I effort with Andrews Space which had revenues for the nine months ended
September 30, 2005 of $393,000.

Net sales for the nine months ended September 30, 2004 included $957,000 from
the Air Force Research Laboratory Phase II contract, $1,141,000 from the Missile
Defense Agency Phase I, $318,000 also from the Missile Defense Agency Phase 0
contract (which was the precursor to Phase I contract), $610,000 from the
SpaceShipOne program and $200,000 from our Defense Advanced Research Projects
Agency contract for the study of Novel Satcom Microsat Constellation Deployment.

On March 31, 2004, we were awarded a five-year, cost-plus-fixed fee indefinite
delivery/indefinite quantity contract to conduct a microsatellite distributed
sensing experiment, an option for a laser communications experiment, and other
microsatellite studies and experiments as required in support of the Advanced
Systems Deputate of the Missile Defense Agency. The total five-year contract
provides for a maximum of $43,362,271 in aggregate payments. We expect to
complete the work under the contract before March 2009. The contract is a
milestone-based, multiyear, multiphase contract and had an effective start date
of March 1, 2004. The first phase was completed on September 30, 2004 and
generated approximately $1.14 million of revenue. The second phase of the
contract began in October 2004, and is expected to generate a total of
approximately $8.3 million of revenue over approximately 16 months. During the

PAGE 17

nine months ended September 30, 2005, we recognized approximately $4,114,000 of
revenue from this second phase. The overall contract called for us to analyze,
design, develop, fabricate, integrate, test, operate and support a networked
cluster of three formation-flying boost phase and midcourse tracking
microsatellites, with an option to design, develop, fabricate, integrate, test,
operate and support a second cluster of three formation-flying microsats to be
networked on-orbit with high speed laser communications technology. In addition
to the three networked microsat under our Phase II task order, the $43 million
contract also envisioned an option for a second three microsats using laser
communication technology. We were recently informed that the Missile Defense
Agency had re-routed the laser communications experiment that would use this
option to another program and that they would not be exercising their option for
the additional microsats at this time; however, the contract vehicle remains at
$43 million and leaves open the opportunity for some other purchase to take its
place. We continue on-time and on-budget for delivery of the first three
microsats. We estimate that the second cluster would have represented
approximately $10 million of the $43 million contract, and have reduced our
current backorder accordingly. We believe the remaining unbilled contract
backlog amount of $33 million to be secure. We are currently proposing our Phase
III task order and the Missile Defense Agency continues to be very pleased with
our progress on the three microsat distributed sensing experiment and while we
cannot be assured of any new business, the Missile Defense Agency was
encouraging and excited about continuing a productive business relationship with
us.

Cost of Sales

For the nine months ended September 30, 2005, cost of sales were approximately
$4,572,000, or 76.9% of net sales, as compared to approximately $2,703,000, or
78.4% of net sales, during the same period in 2004. Cost of sales consists of
direct and allocated costs associated with individual contracts. The increase in
cost of sales was directly tied to increases in net sales, and the decrease in
cost of sales as a percentage of net sales was due to improved systems and
processes for management of our projects and improved labor productivity. Gross
margin improvement is limited due to the cost plus fixed fee nature of our
contracts.

Operating Expenses

Operating expenses increased from $649,000, or 18.8% of net sales, for the nine
months ended September 30, 2004 to approximately $1,148,000, or 19.3% of net
sales, for the nine months ended September 30, 2005. Operating expenses include
general and administrative expenses and marketing and sales expenses.

- Marketing and sales expenses increased from approximately $336,000, or 9.7%
of net sales, for the nine months ended September 30, 2004, to
approximately $493,000, or 8.3% of net sales, during the same period in
2005. The increase was attributable to the allocation of a portion of the
personnel costs of our Vice President of New Business Development and our
Chief Executive Officer to marketing and sales expenses as well as costs
associated with the preparation and submission of bids for new projects.

- General and administrative expenses increased from $314,000, or 9.1% of net
sales, for the nine months ended September 30, 2004 to $655,000, or 11.0%
of net sales, for the nine months ended September 30, 2005. The increase
was attributable to the increase in personnel, including a human resources
director and a contract administrator, and upcoming SEC compliance efforts,
including those related to the Sarbanes-Oxley Act of 2002 and FASB 123(R).
Research and development costs are included in general and administrative
expenses and did not comprise a significant portion of general and
administrative expenses for the nine months ended September 30, 2004 and
2005.

Non-Operating Expense (Income)

PAGE 18

the nine months ended September 30, 2004 or 2005. We recorded non-operating
income for the nine months ended September 30, 2005.

- We recognized approximately $88,000 of deferred gain on the sale of our
building during each of the nine month periods ended September 30, 2005 and
2004, and we will continue to amortize the remaining deferred gain of
approximately $860,000 into non-operating income over the remainder of the
lease of the building, which is schedule to expire in 2013.

- We recorded loan fees related to our revolving credit facility of $29,000
and $2,457,000 for the nine months ended September 30, 2005 and 2004,
respectively. Although we did not have a balance on our revolving credit
facility during the nine months ended September 30, 2005, we recorded
$29,000 in non-cash loan fees upon Laurus's exercise of warrants to acquire
50,000 shares of our common stock, which were granted in 2004 in connection
with the revolving credit facility. Additional non-cash loan fees will be
recorded as the warrants granted to Laurus related to the revolving credit
facility are exercised.

Net Income and EBITDA

Net income was approximately $348,000, or 5.9% of net sales, compared to a net
loss of approximately $2,332,000, or 67.7% of net sales, for the nine months
ended September 30, 2005 and 2004, respectively. During the nine months ended
September 30, 2005, we had earnings before interest, taxes, depreciation and
amortization, or EBITDA, of approximately $331,000, or 5.6% of net sales,
compared to approximately $149,000, or 4.3% of net sales, for the nine months
ended September 30, 2005 and 2004.

The following table reconciles EBITDA to net income (loss) for the nine months
ended September 30, 2005 and 2004:

FOR THE NINE-MONTHS ENDING . . SEPTEMBER 30, 2005 September 30, 2004
(UNAUDITED) (Unaudited)
NET INCOME (LOSS). . . . . . . $ 348,412 $ (2,332,304)
------------------------------ -------------------- --------------------

Interest Income. . . . . . . . (69,632) (5,619)
Interest Expense . . . . . . . 2,283 62,633
Gain on Building Sale. . . . . (87,953) (87,954)
Loan Fee - Equity Conversion. 28,875 2,456,794
Provision for income taxes . . 1,200 -
Depreciation and Amortization. 108,265 55,236
------------------------------ -------------------- --------------------
EBITDA . . . . . . . . . . . . $ 331,450 $ 148,786
------------------------------ -------------------- --------------------

EBITDA is a non-GAAP financial measure and should not be considered as an
alternative to net income (as an indicator of operating performance) or as an
alternative to cash flow (as a measure of liquidity or ability to service debt
obligations). We believe that EBITDA provides an important additional
perspective on our operating results, our ability to service our long-term
obligations, our ability to fund continuing growth, and our ability to continue
as a going concern. Our management regularly evaluates our progress based on
EBITDA. Beginning in 2003 through the quarter ended September 30, 2005, we
showed continued improvement in net sales as well as in EBITDA.

PAGE 19

[GRAPHIC OMITED]

PAGE 20

THREE MONTHS ENDED SEPTEMBER 30, 2005 -VS.- THREE MONTHS ENDED SEPTEMBER 30,
2004

Net Sales

Net sales increased by approximately 82% to approximately $2,234,000 for the
three months ended September 30, 2005, compared to net sales of approximately
$1,230,000 for the same period in 2004. Net sales increased due to our
acquisition of and performance under new and existing government contracts. Net
sales in the 2005 period reflected our continued work on our Missile Defense
Agency Task Order 2 contract of approximately $1,432,000, which is part of our
March 31, 2004 Missile Defense Agency contract. We also recorded net sales on
Small Business Innovation Research contracts with the Air Force Research
Laboratory. These contracts are both for Phase II efforts, and are for
SpaceDev's Small Launch Vehicle and our micro and nanosatellite bus and
subsystem designs work. Net sales for these contracts totaled $178,500 and
$140,000for the three months ended September 30, 2005, respectively. We also had
some ongoing smaller programs with Andrews Space, which had revenues for the
three months ended September 30, 2005 of $293,000. We expect to generate a total
of approximately $8 million in revenue in 2005 from the Missile Defense Agency
program, $4,114,000 of which has already been recorded.

Net sales for the three months ended September 30, 2004 included approximately
$584,000 from the Missile Defense Agency Phase I contract, $283,000 from the Air
Force Research Laboratory Phase II contract and $216,000 from the SpaceShipOne
program.

Cost of Sales

For the three months ended September 30, 2005, cost of sales was approximately
$1,709,000 or 76.5% of net sales, compared to approximately $953,000, or 77.5%
of net sales, during the same period in 2004. Cost of sales consists of our
direct and allocated costs associated with individual contracts. The increase in
cost of sales was directly tied to increases in net sales, and the decrease in
cost of sales as a percentage of net sales was due to improved systems and
processes for management of our projects and improved labor productivity. Gross
margin improvement is limited due to the cost plus fixed fee nature of our
contracts.

Operating Expenses

Operating expenses increased from approximately $228,000, or 18.6% of net sales,
for the three months ended September 30, 2004 to approximately $442,000, or
19.8% of net sales, for the three months ended September 30, 2005. Operating
expenses include general and administrative expenses and marketing and sales
expenses.

- Marketing and sales expenses increased from approximately $120,000, or 9.8%
of net sales, for the three months ended September 30, 2004, to
approximately $189,000, or 8.4% of net sales, during the same period in
2005. The increase was attributable to the allocation of a portion of the
personnel costs of our Vice President of New Business Development and our
Chief Executive Officer to marketing and sales expenses as well as costs
associated with the preparation and submission of bids for new projects.

- General and administrative expenses increased from approximately $108,000,
or 8.8% of net sales, for the three months ended September 30, 2004 to
approximately $253,000, or 11.3% of net sales, for the same period in 2005.
The increase was attributable to the increase in personnel, including a
human resources director and a contract administrator, and upcoming SEC
compliance efforts, including those related to the Sarbanes-Oxley Act of
2002 and FASB 123(R). Research and development costs are included in
general and administrative expenses and did not comprise a
significant portion of general and administrative expenses for the nine
months ended September 30, 2004 and 2005.

PAGE 21

Non-Operating Expense (Income)

Non-operating expense (income) consisted of deferred gain on the sale of our
building, other non-cash loan fees and expenses and interest expense. Interest
expense did not comprise a significant portion of non-operating expense during
the three months ended September 30, 2005. We recorded non-operating income for
the three months ended September 30, 2005.

- We recognized approximately $29,000 of the deferred gain on the sale of our
building during each of the three month periods ending September 30, 2005
and 2004, respectively, and we will continue to amortize the remaining
deferred gain of approximately $860,000 into non-operating income over the
remainder of the lease of the building, which is schedule to expire in
2013.

- We recorded loan fees related to our revolving credit facility of
approximately $0 and $663,000 for the three months ended September 30, 2005
and 2004, respectively. Additional loan fees will be recorded as the
warrants granted to Laurus related to the revolving credit facility are
exercised.

Net Income and EBITDA

Net income was approximately $136,000, or 6.1% of net sales for the three months
ended September 30, 2005, compared to a net loss of approximately $603,000, or
49.0% of net sales, for the same three-month period in 2004. We had EBITDA of
approximately $127,000, or 5.7% of net sales for the three months ended
September 30, 2005, compared to EBITDA of approximately $72,000, or 5.8% of net
sales, for the three months ended September 30, 2004.

The following table reconciles EBITDA to net income (loss) for the three months
ended September 30, 2005 and 2004:

FOR THE THREE MONTHS ENDED . . . . . . SEPTEMBER 30, 2005 September 30, 2004
(UNAUDITED) (Unaudited)
NET INCOME (LOSS). . . . . . . . . . . $ 136,251 $ (602,888)
-------------------------------------- -------------------- --------------------

Interest Income. . . . . . . . . . . . (24,848) (5,619)
Interest Expense . . . . . . . . . . . 452 23,110
Non-Cash Interest exp. (Debt Discount) - -
Gain on Building Sale. . . . . . . . . (29,318) (29,318)
Loan Fee - Equity Conversion. . . . . - 663,481
Provision for income taxes . . . . . . 452 -
Depreciation and Amortization. . . . . 244,128 22,749
-------------------------------------- -------------------- --------------------
EBITDA . . . . . . . . . . . . . . . . $ 127,065 $ 71,515
-------------------------------------- -------------------- --------------------

Please see the disclosure above concerning the use, and limitations, of EBITDA
as a non-GAAP financial measure.

PAGE 22

LIQUIDITY AND CAPITAL RESOURCES

Overview

Although we remained cash flow positive during the first nine months of 2005, we
will need to raise additional capital to fulfill our obligations, estimated
between $2.5 million and $5 million, in connection with the Starsys acquisition.
We anticipate that such funds will come from public or private sales of equity
or debt securities. In October 2005, we entered into a Securities Purchase
Agreement with Laurus pursuant to which we issued and sold 2,032,520 shares of
our common stock to Laurus for an aggregate purchase price of $2,500,000 or
$1.23 per share. (See Note 8 to the Financial Statements for more information
regarding the October 2005 financing.) In addition to amounts required in
connection with the Starsys acquisition, we may require investor or customer
funding of $10 to $30 million in the near future in order to execute our current
business plan. Such funds could come from further public or private sales of
equity or debt securities, or government and commercial customers, or a
combination of both.

Our plan to increase cash generation from operations depends upon our ability to
ultimately implement our business plan, which includes (but is not limited to)
generating substantial new revenue from the Missile Defense Agency program by
successfully performing under our existing contract and continuing to attract
and successfully complete other government and commercial contracts. The Missile
Defense Agency contract is staged, and we cannot guarantee that all subsequent
phases will be awarded or will be awarded to us. Recent budget cuts may affect
government spending on these space-based contracts.

With the exception of our investment in a fabrication facility for our hybrid
rocket motor testing, for which we expect to incur approximately $1.5 million
over the next twelve months, we do not believe that significant capital
expenditures will be required to increase sales; however, additional capital may
be required to support and sustain our growth. We may also be required to make
certain capital expenditures to bring our facilities into compliance with
classified government projects if and when awarded to us, although at this time
we have insufficient information to estimate the cost of any such measures.

During the nine months ended September 30, 2005, we raised approximately
$648,000 through the exercise of options and warrants and from participation in
our Employee Stock Purchase Plan. During the nine months ended September 30,
2004, we raised approximately $5,258,000 through a combination of conversions on
our revolving credit facility and exercises of options and warrants.

On March 31, 2004, we negotiated an amendment to our Secured Convertible Note
dated June 3, 2003 with Laurus to add a fixed conversion price at $0.85 per
share for the next $500,000 converted under the revolving credit facility after
the initial $1 million conversion. In exchange for the amendment, Laurus granted
us a six-month waiver to utilize the full revolving credit facility in advance
of our obtaining sufficient eligible accounts receivable. On August 25, 2004, we
negotiated an amendment to our Secured Convertible Note to add a fixed
conversion price at $1.00 per share for the next $1 million converted under the
revolving credit facility after the $500,000 mentioned above. In exchange for
the amendment, Laurus granted us a waiver to utilize the full revolving credit
facility in advance of our obtaining sufficient eligible accounts receivable and
committed to convert the entire $1 million into equity by the end of 2004. At
December 31, 2004, Laurus had converted approximately $2,272,000 of debt into
2,990,000 shares under the revolving credit facility.

There are no outstanding borrowings under the Laurus revolving credit facility.
We currently have available borrowing capacity of approximately $1.5 million
under the revolving credit facility, subject to certain accounts receivable
limitation or subsequent waivers with Laurus. The borrowing limit under the
revolving credit facility varies based upon our eligible outstanding accounts
receivable. The credit facility will expire in June 2006, unless sooner
terminated by either party. We would be required to pay Laurus a termination fee
for early termination of the revolving credit facility.

PAGE 23

Other than cash on hand and amounts available under the Laurus revolving credit
facility, we have no unused sources of liquidity at this time.

CASH FLOWS

Net decrease in cash during the nine months ended September 30, 2005 was
approximately $1,046,000 compared to a net increase of approximately $3,487,000
for the same nine-month period in 2004. Net cash provided by operating
activities totaled approximately $313,000 for the nine months ended September
30, 2005, an increase of approximately $247,000 compared to approximately
$66,000 provided by operating activities during the same nine-month period in
2004. The improvement in cash from operating activities resulted from our
acquisition of and performance under new and existing government contracts.

Net cash used in investing activities totaled approximately $1,978,000 for the
nine months ended September 30, 2005, compared to approximately $166,000 used in
investing activities during the same nine-month period in 2004. The increase in
cash used in investing activities was attributable to the $1.2 million bridge
loan we entered into with Starsys, our purchase of certain fixed assets related
to the construction of our fabrication and test facility for hybrid rocket
motors and the purchase of additional computer hardware and software tools .

Net cash provided by financing activities totaled approximately $619,000 for the
nine months ended September 30, 2005, which is a decrease of approximately
$2,967,000 from the approximately $3,586,000 provided by financing activities
during the same nine-month period in 2004. The difference is attributable to
warrant and option exercises and the receipt of $2.5 million from the sale of
preferred stock to Laurus in August 2004.

Our cash, cash reserves and cash available for investment decreased slightly to
approximately $4,022,000 at September 30, 2005, compared to approximately
$4,079,000 at September 30, 2004. The decrease was attributable to cash
generated from operations, the receipt of $2.5 million from the issuance of
preferred stock to Laurus in August 2004, the exercise of stock options and
warrants throughout the first nine months of 2005 of approximately $600,000 as
well as those exercised during the same period in 2004 and advances/conversions
under our revolving credit facility in 2004, which offset the bridge loan to
Starsys on September 14, 2005. Cash plus accounts receivable increased
approximately 14% from approximately $4.5 million at September 30, 2004 to
approximately $5.1 million at September 30, 2005.

Our backlog of funded and non-funded business was approximately $33 million at
September 30, 2005, compared to approximately $44 million at September 30, 2004.
With respect to the Missile Defense Agency program, we expect to generate a
total of approximately $8 million in revenue in 2005. We were informed in
September 2005 that the Missile Defense Agency had re-routed the laser
communications experiment to another program and that they would not be
exercising their option for a second cluster, at this time; however, the Missile
Defense Agency also informed us of several other opportunities that might
replace the laser communications experiment and while we cannot be assured of
any new business, the Missile Defense Agency was encouraging and excited about
continuing a productive business relationship with us. As a result of this
notification, we reduced our backlog by approximately $10 million. The Missile
Defense Agency contract is an IDIQ contract, meaning it is an indefinite
delivery, indefinite quantity contract which can be re-funded up to the $43
million ceiling with other microsatellites or new business without further
signature authority. Although the Missile Defense Agency contract was awarded to
us, there can be no assurance that the contract will be continued through all
phases, and, if continued, that it will generate the amounts anticipated.

We had a net deferred tax asset of approximately $2,193,000 and $2,218,000 at
September 30, 2005 and 2004, respectively, which consisted primarily of the
income tax benefits from net operating loss and capital loss carryforwards,
amortization of deferred gain on sale of building and research and development
credits. Deferred income taxes represent temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes. A
valuation allowance has been recorded to fully offset the deferred tax asset as
it is more likely than not that the assets will not be utilized. The valuation

PAGE 24

allowance decreased from $2,318,000 at December 31, 2004 to $2,193,000 at
September 30, 2005.

We had federal and state tax net operating loss and capital loss carryforwards
of approximately $4,325,000 and $1,629,000 at September 30, 2005 respectively.
The federal and state tax loss carryforwards will expire in 2023 and 2013,
respectively, unless previously utilized. The State of California suspended the
utilization of net operating loss for 2002 and 2003, and limited them for 2004.

RECENT ACCOUNTING PRONOUNCEMENTS

A number of new accounting pronouncements have been issued for future
implementation as discussed in the footnotes to our interim financial statements
(see Note 7).

OFF BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements, as defined in Item303(c)(2)
of Regulation S-B.

BUSINESS RISKS

The following is a summary of the many risks and uncertainties we face in our
business. You should carefully read these risks and uncertainties as well as the
other information in this report in evaluating our business and its prospects.

SOME OF OUR GOVERNMENT CONTRACTS ARE STAGED AND WE CANNOT GUARANTEE THAT
ALL STAGES OF THE CONTRACTS WILL BE AWARDED TO US OR AT ALL.

Some of our government contracts, including our March 31, 2004 Missile Defense
Agency contract, are phased contracts, in which the customer may determine to
terminate the contract between phases for any reason. For example, we were
informed in September 2005 that the Missile Defense Agency had re-routed the
laser communications experiment to another program and that they would not be
exercising their option for a second cluster, at this time; however, the Missile
Defense Agency also informed us of several other opportunities that might
replace the laser communications experiment and while we cannot be assured of
any new business, the Missile Defense Agency was encouraging and excited about
continuing a productive business relationship with us. Accordingly, the entire
contract amount may not be realized by us. In the event that subsequent phases
of some of our government contracts, including but not limited to the Missile
Defense Agency contract, are not awarded to us, it could have a material adverse
effect on our and financial position and results of operations.

HISTORICALLY, OUR REVENUES FROM OPERATIONS HAVE NOT BEEN SUFFICIENT TO
SUPPORT OUR BUSINESS.

In prior years, our revenues from operations have not been sufficient to fund
our operations. The success of our business depends upon our ability to generate
revenue from existing contracts and continuing to attract and successfully
complete additional government and commercial contracts, and the receipt of
additional financing. Successful execution of existing contracts and the
acquisition of new business depends, in part, on our development of project
management expertise to profitably execute on current and future contracts. Our
new business opportunities may come from a variety of sources, including state
and federal grants and government and commercial customer programs. However, if
we are in need of further funding, we may be unable to obtain such funding or
contracts as needed or on terms favorable to us. The likelihood of our success
must be considered in light of the expenses, difficulties and delays frequently
encountered in connection with the developing businesses, those historically
encountered by us, and the competitive environment in which we operate.

PAGE 25

IF WE ARE UNABLE TO RAISE CAPITAL, WE MAY BE UNABLE TO FUND OPERATING CASH
SHORTFALLS.

We will need additional financing to fund our obligations in connection with the
Starsys acquisition. In the past, we have not been able to generate sufficient
cash from our operating activities and have relied upon cash from financing
activities to fund part of the cash requirements of our business. Additional
financing may not be available to us on acceptable terms, or at all. Any
inability to obtain needed financing would hinder our ability to close the
Starsys acquisition while funding our projected operating needs. Any financing
may cause significant dilution to existing shareholders. Any debt financing or
other financing of securities senior to common stock likely will include
financial and other covenants that will restrict our operating flexibility and
our ability to pay dividends to shareholders.

WE FACE SIGNIFICANT COMPETITION AND MANY OF OUR COMPETITORS HAVE GREATER
RESOURCES THAN WE DO.

We face significant competition for our government and commercial contracts.
Many of our competitors have greater resources than we do and may be able to
devote greater resources than us to research and development, and marketing.
Given the sophistication inherent in our operations, larger competitors may have
a significant advantage and may be able to more efficiently adapt and implement
technological advances.

WE MAY NOT SUCCESSFULLY OR TIMELY DEVELOP PRODUCTS.

Many of our products and technologies (including our hybrid rocket technology)
are currently under various stages of development. Further development and
testing of our products and technologies will be required to prove additional
performance capability beyond current levels and to confirm commercial
viability. Additionally, the final cost of development cannot be determined
until development is complete. Our ongoing and future product development will
depend, in part, on the ability to timely complete our projects within estimated
cost parameters and ultimately deploy the product in a cost-effective manner.

THE MARKETPLACE FOR OUR TECHNOLOGY AND PRODUCTS IS UNCERTAIN.

The demand for our technology, products and services is uncertain and we may not
obtain in a sufficient market share to sustain our business or to increase
profitability. Our business plan assumes that near-term revenues will be
generated largely from government contracts for microsatellites with a long-term
commercial market developing for private manned and unmanned space exploration.
Because microsatellites and commercial space exploration are still relatively
new concepts, it is difficult to accurately predict the ultimate size of the
market. Many of our products and services are new and unproven, and the true
level of consumer demand is uncertain. Lack of significant market acceptance of
our products and services, delays in such acceptance, or failure of markets to
develop could negatively affect our business, financial condition, and results
of operations.

A SUBSTANTIAL PORTION OF OUR NET SALES ARE GENERATED FROM GOVERNMENT
CONTRACTS, WHICH MAKES US SUSCEPTIBLE TO THE UNCERTAINTIES INHERENT IN THE
GOVERNMENT BUDGETING PROCESS. IN ADDITION, MANY OF OUR CONTRACTS CAN BE
TERMINATED BY THE CUSTOMER.

Our concentration of government work makes us susceptible to government budget
cuts and policy changes, which may impact the award of new contracts or future
phases of existing contracts. Government budgets are subject to the prevailing
political climate, which is subject to change at any time. Additionally,
awarded contracts could be altered or terminated prior to the time we recognize
our projected revenue. Many contracts have "exit ramp" provisions, which
provide the customer the right to terminate the contract for any of a variety of
reasons, including but not limited to, non-performance by us. Many contracts
are awarded in phases where future phases are not guaranteed to us.

PAGE 26

OUR LIMITED OPERATING HISTORY AND LACK OF EXPERIENCE IN OUR NEW OR PROPOSED
LINES OF BUSINESS MAKES IT DIFFICULT TO PREDICT OUR FUTURE SUCCESS.

We launched our first microsatellite, CHIPSat, in January 2003 and, on June
21st, September 29th and October 4th, 2004, our hybrid rocket technology was
first utilized in connection with the SpaceShipOne launch. We intend to provide
microsatellites to early adopters, primarily the U.S. military (e.g., the
Missile Defense Agency), and hybrid rocket motors to government and commercial
customers (e.g., the Air Force Research Laboratory and Scaled Composites).
However, we have limited operating history and, as a result, our historical
financial information is of limited value in projecting our future success in
these markets.

OUR PRODUCTS AND SERVICES ARE TECHNOLOGICALLY ADVANCED AND MAY NOT FUNCTION
UNDER CERTAIN CONDITIONS.

Most of our products are technologically advanced and sometimes novel systems
that must function under demanding operating conditions. Our products may not be
successfully launched or operated, or perform as intended. Like most
organizations that have launched satellite programs, we, in the future, will
likely, experience some product and service failures, schedule delays, and other
problems in connection with our products. Our products and services are and will
continue to be subject to significant technological change and innovation. Our
success will generally depend on our ability to continue to conceive, design,
manufacture and market new products and services on a cost-effective and timely
basis. We anticipate that we will incur significant expenses in the design and
initial manufacture and marketing of new products and services.

LAUNCH FAILURES COULD HAVE SERIOUS ADVERSE AFFECTS ON OUR BUSINESS.

A launch failure of one of our microsatellites could have series adverse effects
on our business because a large portion of contract payment is often contingent
on a successful launch. Microsatellite launches are subject to significant risks
the realization of which can cause disabling damage to or total loss of a
microsatellite. Delays in the launch could also adversely affect our net sales
as the customer may have timing requirements for milestone payments or we may
have guarantee requirements. Delays could be caused by a number of factors,
including:

- designing, constructing, integrating, or testing the microsatellite,
microsatellite components, or related ground systems;
- delays in receiving the license necessary to operate the microsatellite
systems;
- delays in obtaining the customer's payload;
- delays related to the launch vehicle;
- weather; and
- other events beyond our control.

Delays and the perception of potential delay could negatively affect our
marketing efforts and limit our ability to obtain new contracts and projects.

OUR EXPANSION INTO OTHER NEW LINES OF BUSINESS MAY DIVERT MANAGEMENT'S
ATTENTION FROM OUR EXISTING OPERATIONS AND PROVE TO BE TOO COSTLY.

Our current business plan contemplates the migration of our technology from
projects into products for microsatellites and hybrid rocket motors over the
next several years. In the meantime, we are investigating other applications of
our technology and other markets for our technologies and prospective products.
Our expansion into new lines of business may be difficult for us to manage
because they may involve different disciplines and require different expertise
than our core business. Consequently, this expansion may divert management's
time and attention away from our core business, and we may need to incur
significant expenses in order to develop the expertise, and reputation we
desire. Any revenues generated by new lines of business may not be significant
enough to offset the expenditures required to enter such business, or provide
the anticipated return on investment.

PAGE 27

OUR SUCCESS DEPENDS ON OUR ABILITY TO RETAIN OUR KEY PERSONNEL.

Our success is dependent upon the efforts of certain key members of our
management and engineering team, including our chief executive officer, James W.
Benson, our president and Chief Financial Officer, Richard B. Slansky, our vice
president of engineering, Frank Macklin and our vice president of programs and
new business development, Randall K. Simpson. The loss of any of these persons
could have a material adverse effect on us. Our future success is likely to
depend substantially on our continued ability to attract and retain highly
qualified personnel. The competition for such personnel is intense, and our
inability to attract and retain such personnel could have a material adverse
effect on us. We do not maintain key man life insurance on any of our key
personnel.

WE ARE SUBJECT TO SUBSTANTIAL REGULATION. ANY FAILURE TO COMPLY WITH
EXISTING REGULATIONS, OR INCREASED LEVELS OF REGULATION, COULD HAVE A MATERIAL
ADVERSE EFFECT ON US.

Our business activities are subject to substantial regulation by various
agencies and departments of the United States government and, in certain
circumstances, the governments of other countries. Several government agencies,
including NASA and the U.S. Air Force, maintain Export Control Offices to ensure
that any disclosure of scientific and technical information complies with the
Export Administration Regulations and the International Traffic in Arms
Regulations or, "ITAR." Exports of our products, services and technical
information require either Technical Assistance Agreements or licenses from the
U.S. Department of State depending on the level of technology being transferred.
This includes recently published regulations restricting the ability of
U.S.-based companies to complete offshore launches, or to export certain
satellite components and technical data to any country outside the United
States. The export of information with respect to ground-based sensors,
detectors, high-speed computers, and national security and missile technology
items are controlled by the Department of Commerce. The government has indicated
that failure to comply with the ITAR and/or the Commerce Department regulations
may subject guilty parties to fines of up to $1 million and/or up to 10 years
imprisonment per violation. Failure to comply with any of the above mentioned
regulations could have serious adverse effects as dictated by the rules
associated with compliance to the ITAR regulations.

In addition, the space industry has specific regulations with which we must
comply. Command and telemetry frequency assignments for space missions are
regulated internationally by the International Telecommunications Union, or
"ITU". In the United States, the Federal Communications Commission, or "FCC,"
and the National Telecommunications Information Agency, or "NTIA," regulate
command and telemetry frequency assignments. All launch vehicles that are
launched from a launch site in the United States must pass certain launch range
safety regulations that are administered by the U.S. Air Force. In addition, all
commercial space launches that we would perform require a license from the
Department of Transportation. Satellites that are launched must obtain approvals
for command and frequency assignments. For international approvals, the FCC and
NTIA obtain these approvals from the ITU. These regulations have been in place
for a number of years to cover the large number of non-government commercial
space missions that have been launched and put into orbit in the last 15 to 20
years. Any commercial deep space mission that we would perform would be subject
to these regulations.

We are also required to obtain permits, licenses, and other authorizations
under federal, state, local and foreign laws and regulations relating to the
environment. Our failure to comply with applicable law or government
regulations, including any of the above-mentioned regulations, could have
serious adverse effects on our business.

OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE, WHICH COULD
RESULT IN SUBSTANTIAL LOSSES FOR INVESTORS PURCHASING SHARES OF OUR COMMON
STOCK.

The market prices of securities of technology-based companies like ours are
highly volatile. The market price of our common stock has fluctuated
significantly in the past. During the 52-week period ended November 1, 2005, the
high and low closing price of a share of our common stock was $2.31 and $1.43,
respectively. Our market price may continue to exhibit significant fluctuations

PAGE 28

in response to a variety of factors, many of which are beyond our control. These
factors include, among others:

- deviations in our results of operations from estimates,
- changes in estimates of our financial performance,
- changes in market valuations of similar companies and stock market price,
- our proposed acquisition of Starsys, and
- volume fluctuations generally.

Additionally, until the full effects of our cost reduction efforts become clear,
including whether those cuts have a long-term negative impact on revenues, it is
likely that our quarter-to-quarter performance will be unpredictable and our
stock price particularly volatile.

OUR NET OPERATING LOSS CARRYFORWARDS MAY BE SUBJECT TO AN ANNUAL LIMITATION
ON THEIR UTILIZATION, WHICH MAY INCREASE OUR TAXES AND DECREASE NET INCOME AND
CASH FLOWS.

At December 31, 2004 and September 30, 2005, we had federal and state tax net
operating loss and capital loss carryforwards of approximately $2,218,000 and
$2,193,000, respectively. The federal and state tax loss carryforwards will
expire in 2023 and 2013, respectively, unless previously utilized. The State of
California suspended the utilization of net operating loss for 2002 and 2003 and
limited them for 2004. If our net operating loss carryforwards are subject to
an annual limitation on their utilization, our taxes may increase and our cash
flows and net income may decrease.

THE CONCENTRATION OF OWNERSHIP OF OUR COMMON STOCK GIVES A FEW INDIVIDUALS
SIGNIFICANT CONTROL OVER IMPORTANT POLICY DECISIONS AND COULD DELAY OR PREVENT
CHANGES IN CONTROL.

As of November 1, 2005, our executive officers and directors together
beneficially owned approximately 45% of the issued and outstanding shares of our
common stock. As a result, these persons could have the ability to exert
significant influence over matters concerning us, including the election of
directors, changes in the size and composition of the board of directors, and
mergers and other business combinations involving us, among other things. In
addition, through control of the board of directors and voting power, our
officers and directors may be able to control certain decisions, including
decisions regarding the qualification and appointment of officers, dividend
policy, access to capital (including borrowing from third-party lenders and the
issuance of additional equity securities), and the acquisition or disposition of
our assets. In addition, the concentration of voting power in the hands of those
individuals could have the effect of delaying or preventing a change in control
of our company, even if the change in control would benefit our shareholders. A
perception in the investment community of an anti-takeover environment at our
company could cause investors to value our stock lower than in the absence of
such a perception.

OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY IS ESSENTIAL TO THE GROWTH
AND DEVELOPMENT OF OUR PRODUCTS AND SERVICES.

We rely on patents, trade secrets and know-how to develop and maintain our
competitive position and technological advantage. We have a program and plan to
protect our intellectual property through a combination of license agreements,
patents, trademarks, service marks, copyrights, trade secrets, restricted access
and other methods. If any of these programs, plans or agreements are not
successful in protecting our intellectual property, our business prospects could
be materially adversely affected.

PAGE 29

OUR ABILITY TO SOURCE AND OBTAIN COMPONENTS AND RAW MATERIALS COULD AFFECT
OUR ABILITY TO SATISFY CUSTOMER ORDERS OR CONTRACTS.

We purchase a significant percentage of our components, including structural
assemblies, electronic equipment, and computer chips, from third parties. We
also occasionally obtain from the U.S. government parts and equipment that are
used in our projects or in the provision of our services. If our sources for
components and raw materials are unavailable to us for any reason, we may
experience increased costs and possible delays in securing alternative sources
of supply. In addition, we cannot guarantee that alternative sources of supply
would be available if and when required by us. The failure to source and obtain
needed components and raw materials could result in the loss of existing
contracts and negatively affect our prospects for entering into new contracts.

OUR LIMITED INSURANCE MAY NOT COVER ALL RISKS INHERENT IN OUR OPERATIONS.

We may find it difficult to insure certain risks involved in our operations,
including mircosatellite or launch vehicle failures. Insurance market conditions
or factors outside of our control at the time insurance is purchased could cause
premiums to be significantly higher than current estimates. Additionally, the
U.S. Department of State has published regulations which could significantly
affect the ability of brokers and underwriters to place insurance for certain
launches. These factors could cause other terms to be significantly less
favorable than those currently available, may result in limits on amounts of
coverage that we can obtain, or may prevent us from obtaining insurance at all.
Furthermore, proceeds from insurance may not be sufficient to cover losses.

OUR GROWTH MAY NOT BE MANAGEABLE AND OUR BUSINESS COULD SUFFER AS A RESULT.

Even if we are successful in obtaining new business, failure to manage the
growth could adversely affect our operations. We may experience extended periods
of very rapid growth, and our acquisition of Starsys is expected to
significantly increase our size. This growth could place a significant strain on
our management, operating, financial and other resources. Our future performance
will depend in part on our ability to manage growth effectively. We must develop
management information systems, including operating, financial, and accounting
systems and expand, train, and manage employees to keep pace with growth. Our
inability to manage growth effectively could negatively affect results of
operations and the ability to meet obligations as they come due..

OUR BUSINESS COULD BE ADVERSELY AFFECTED BY TERRORIST ATTACKS AND OTHER
NATIONAL AND INTERNATIONAL EVENTS.

Our business partially depends on activities regulated by various agencies and
departments of the U.S. government and other companies that rely on the
government. In the recent past, in response to terrorists activities and threats
aimed at the United States, transportation, mail, financial, and other services
have been slowed or stopped altogether. Further delays or stoppages in
transportation, mail, financial, or other services could have a material adverse
effect on our business, results of operations, and financial condition.
Furthermore, we may experience an increase in operating costs, including costs
for transportation, insurance, and security, as a result of terrorist activities
and threats..

WE HAVE NOT PAID DIVIDENDS ON OUR COMMON STOCK IN THE PAST AND DO NOT
ANTICIPATE PAYING DIVIDENDS ON OUR COMMON STOCK IN THE FORESEEABLE FUTURE.

We have not paid common stock dividends since our inception and do not
anticipate paying dividends in the foreseeable future. Our current business plan
provides for the reinvestment of earnings in an effort to complete development
of our technologies and products, with the goal of increasing sales and
long-term profitability and value. In addition, the revolving credit facility
with Laurus and the terms of our preferred stock currently restrict, and any
other credit or borrowing arrangements that we may enter into may in the future
restrict or limit, our ability to pay common stock dividends to our
shareholders.

PAGE 30

OUR COMMON SHAREHOLDERS MAY EXPERIENCE DILUTION IF OUR PREFERRED STOCK IS
CONVERTED OR OUR OUTSTANDING WARRANTS AND OPTIONS ARE EXERCISED

As of November 1, 2005, we are obligated to issue 3,616,226 shares of our common
stock if all of our outstanding warrants are exercised and shares of preferred
stock converted. In addition, as of November 1, 2005, we have outstanding stock
options to purchase an aggregate of 4,756,266 shares of our common stock. The
total number of shares, issuable upon the exercise of currently vested warrants,
options and preferred stock (8,372,492 shares) represents approximately 34% of
our issued and outstanding shares of common stock as of November 1, 2005. Our
common shareholders may experience dilution if additional shares are issued upon
conversion or exercise of our warrants, options and preferred stock.

BECAUSE OUR STOCK IS SUBJECT TO THE SEC'S PENNY STOCK RULES, BROKER-DEALERS
MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND TRADING
ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.

Transactions in our common stock are currently subject to the "penny stock"
rules promulgated under the Securities Exchange Act of 1934. Under these rules,
broker-dealers who recommend our securities to persons other than institutional
accredited investors must:

- make a special written suitability determination for the purchaser;

- receive the purchaser's written agreement to a transaction prior to sale;

- provide the purchaser with risk disclosure documents which identify certain
risks associated with investing in "penny stocks" and which describe the
market for these "penny stocks" as well as a purchaser's legal remedies;
and

- obtain a signed and dated acknowledgment from the purchaser demonstrating
that the purchaser has actually received the required risk disclosure
document before a transaction in a "penny stock" can be completed.

As a result of these rules, broker-dealers may find it difficult to effectuate
customer transactions and trading activity in our securities may be adversely
affected. As a result, the market price of our securities may be depressed, and
you may find it more difficult to sell our securities.

RISKS RELATED TO THE PROPOSED ACQUISITION OF STARSYS

The following risks relate to our proposed acquisition of Starsys. The
acquisition of Starsys is subject to several conditions and may not occur.

IF WE AND STARSYS FAIL TO EFFECTIVELY INTEGRATE OUR OPERATIONS, WHERE IT
MAKES SENSE TO DO SO, THE COMBINED COMPANY MAY NOT REALIZE ALL THE POTENTIAL
BENEFITS OF THE MERGER.

The integration of SpaceDev and Starsys may become a time consuming and
expensive process and may disrupt the combined company's operations if it is not
completed in a timely and efficient manner. If this integration effort is not
successful, the combined company's results of operations could be harmed,
employee morale could decline, key employees could leave, customers could cancel
existing orders or choose not to place new ones and the combined company could
have difficulty complying with regulatory requirements. In addition, the
combined company may not achieve anticipated synergies or other benefits of the
merger. Following the merger, SpaceDev and Starsys may operate as a combined
organization utilizing common information and communication systems, operating
procedures, financial controls and human resources practices. The combined
company may encounter difficulties, costs and delays involved in integrating
their operations, including the following:

PAGE 31

- failure to successfully manage relationships with customers and other
important relationships;

- failure of customers to accept new services or to continue using the
products and services of the combined company;

- difficulties in successfully integrating the management teams and employees
of the two companies;

- challenges encountered in managing larger, more geographically dispersed
operations;

- the loss of key employees;

- diversion of the attention of management from other ongoing business
concerns;

- potential incompatibilities of technologies and systems;

- potential difficulties integrating and harmonizing financial reporting
systems; and

- potential incompatibility of business cultures.

If the combined company's operations after the merger do not meet the
expectations of existing customers of either company, these customers may reduce
the amount of business or cease doing business with the combined company
altogether, which would harm the results of operations and financial condition
of the combined company.

If the anticipated benefits of the merger are not realized or do not meet the
expectations of financial or industry analysts, the market price of our common
stock may decline after the merger. The market price of our common stock may
decline as a result of the merger if:

- the integration of the two companies is unsuccessful;

- the combined company does not achieve the expected benefits of the merger
as quickly as anticipated or the costs of or operational difficulties
arising from the merger are greater than anticipated;

- the combined company's financial results after the merger are not
consistent with the expectations of financial or industry analysts;

- the anticipated operating and product synergies of the merger are not
realized; or

- the combined company experiences the loss of significant customers or
employees as a result of the merger.

FAILURE TO COMPLETE THE MERGER COULD ADVERSELY AFFECT OUR FUTURE BUSINESS
AND OPERATION AS WELL AS THE MARKET PRICE OF OUR COMMON STOCK.

The merger is subject to the satisfaction of closing conditions, including the
approval by both SpaceDev and Starsys shareholders, and we cannot assure you
that the merger will be successfully completed. In the event that the merger is
not completed, we may be subject to a number of risks, including:

- the price of our common stock may decline to the extent that the current
market price of our common stock reflects a market assumption that the
merger will be completed;

PAGE 32

- we could suffer the loss of customers, revenues and employees due to
uncertainties resulting from an uncompleted merger; and

- our costs related to the merger, such as legal, accounting and advisory
fees, must be paid even if the merger is not completed, and such costs
would reduce our reported earnings or increase our reported loss, for the
period when it was determined that the merger would not be consummated.

COMPLETION OF THE MERGER MAY RESULT IN DILUTION OF OUR FUTURE EARNINGS PER
SHARE.

The completion of the merger may not result in improved earnings per share or a
financial condition superior to that which would have been achieved by us on a
stand-alone basis. The merger could fail to produce the benefits that the
companies anticipate, or could have other adverse effects that we currently do
not foresee. In addition, some of the assumptions that either company has made,
such as the achievement of operating synergies, may not be realized. In this
event, the merger could result in a reduction of our earnings per share, or
increase in loss per share, as compared to the earnings per share that would
have been achieved by us if the merger had not occurred.

THE COSTS ASSOCIATED WITH THE MERGER ARE DIFFICULT TO ESTIMATE, MAY BE
HIGHER THAN EXPECTED AND MAY HARM THE FINANCIAL RESULTS OF THE COMBINED COMPANY.

We estimate that we and Starsys will incur aggregate direct transaction costs of
approximately $1.8 million associated with the merger include legal fees,
accounting fees, investment banking costs, etc. , and additional costs
associated with consolidation and integration of operations, which cannot be
estimated accurately at this time. If the total costs of the merger exceed
estimates or the benefits of the merger do not exceed the total costs of the
merger, the financial results of the combined company could be adversely
affected.

OUR BUSINESS COULD SUFFER DUE TO THE ANNOUNCEMENT AND CLOSING OF THE
MERGER.

Further disclosures concerning the merger, and closing of the merger, may have a
negative impact on our ability to sell our products and services, attract and
retain key management, technical, sales or other personnel, maintain and attract
new customers and maintain strategic relationships with third parties. For
example, we and Starsys may experience deferrals, cancellations or declines in
the size or rate of orders for their respective products or services or a
deterioration in our respective customer or business partner relationships. Any
such events could harm the operating results and financial condition of the
combined company following the merger.

OUR OPERATING RESULTS MAY SUFFER AS A RESULT OF PURCHASE ACCOUNTING
TREATMENT AND THE IMPACT OF AMORTIZATION OF INTANGIBLE ASSETS RELATED TO THE
MERGER.

In accordance with U.S. generally accepted accounting principles that apply to
us, the merger will be accounted for using the purchase method of accounting,
which will result in incremental expenses that could have an adverse impact on
the market value of our common stock following completion of the merger. Under
the purchase method of accounting, the total estimated purchase price will be
allocated to Starsys' net tangible assets and identifiable intangible assets
based on their fair values as of the date of completion of the merger. The
excess of the purchase price over those fair values will be recorded as
goodwill. Goodwill is not amortized but is tested for impairment at least
annually. The combined company will incur additional amortization expense based
on the identifiable amortizable intangible assets acquired pursuant to the
merger agreement and their relative useful lives. Additionally, to the extent
the value of goodwill or identifiable intangible assets or other long-lived
assets become impaired, the combined company may be required to record material
charges relating to the impairment. These amortization and potential impairment
charges could have a material impact on the combined company's results of
operations. Changes in earnings per share, including changes that result from
this incremental expense, could adversely affect the trading price of our common
stock.

PAGE 33

ITEM 3. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation
of our management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures. Based upon that evaluation, our Chief Executive
Officer and Chief Financial Officer have concluded that, as of September 30,
2005, our disclosure controls and procedures were effective to ensure that
information required to be disclosed by us in the reports that we file 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
and were also effective to ensure that information required to be disclosed in
the reports that we file or submit under the Exchange Act is accumulated and
communicated to management, including our Chief Executive Officer and Chief
Financial Officer, to allow timely decisions regarding required disclosure.
There has been no change in our internal control over financial reporting that
occurred during our last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.

PAGE 34

PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The annual meeting of the shareholders of SpaceDev, Inc. was held at 13855 Stowe
Drive, Poway, California 92064, on August 12, 2005, at 9:00 A.M. Out of a total
of 22,176,446 shares outstanding on the date of record, 20,759,923 shares, or
approximately 93%, were voted in person or by proxy. The following proposals
were presented and passed by the amounts indicated below:

PROPOSAL 1: To elect seven directors to hold office until the 2006 Annual
Meeting of Stockholders:

BROKER
ISSUE FOR AGAINST ABSTAIN NON-VOTES TOTAL
------------- ----- ---------- ------- --------- --------- ----------
Benson, Jim . Total 20,730,496 0 29,427 1,416,523 22,176,446
Benson, Susan Total 20,653,996 0 105,927 1,416,523 22,176,446
Blake . . . . Total 20,730,416 0 29,507 1,416,523 22,176,446
Estes . . . . Total 20,730,516 0 29,407 1,416,523 22,176,446
Huntress. . . Total 20,730,516 0 29,407 1,416,523 22,176,446
McClendon . . Total 20,729,416 0 30,507 1,416,523 22,176,446
Schaffer. . . Total 20,280,516 0 29,407 1,866,523 22,176,446
Walker. . . . Total 20,730,616 0 29,307 1,416,523 22,176,446
Slansky, R. . Total 20,730,436 0 29,507 1,416,503 22,176,446

PROPOSAL 2: To approve the appointment of PKF, Certified Public Accountants, as
our independent public accountants for the fiscal year ending December 31, 2005:

BROKER
ISSUE FOR AGAINST ABSTAIN NON-VOTES TOTAL
------------- ----- ---------- ------- --------- --------- ----------
Accountants Total 20,725,419 14,892 19,612 1,416,523 22,176,446

PROPOSAL 3: To amend the Company's 2004 Equity Incentive Plan:

BROKER
ISSUE FOR AGAINST ABSTAIN NON-VOTES TOTAL
------------- ----- ---------- ------- --------- ---------- ----------
Stock Option Total 11,470,356 345,754 42,565 10,317,771 22,176,446
Plan

ITEM 5. OTHER INFORMATION

None.

* Registrant requested confidential treatment pursuant to Rule 406 for a
portion of the referenced exhibit and has separately filed such exhibit with the
Commission.

PAGE 35

ITEM 6. EXHIBITS

Exhibits

Starsys Loan Agreement, dated as of September 8, 2005 by
and between SpaceDev Inc., and Starsys Research Corporation *** 10.1

Starsys Secured Promissory Note, dated as of September 8, 2005 by
and between SpaceDev Inc., and Starsys Research Corporation *** 10.2

Agreement and Plan of Merger Reorganization dated as of
October 24, 2005 *t 10.3

Securities Purchase Agreement, dated as of October 31,2005, by
and between SpaceDev, Inc., and Laurus Master Fund, Ltd. ** 10.4

Registration Rights Agreement, dated as of October 31, 2005, by
and between SpaceDev, Inc., and Laurus Master Fund, Ltd. ** 10.5

Common Stock Purchase Warrant of the Company, dated as of
October 31, 2005 in favor of Laurus Master Fund, Ltd. ** 10.6

Certificate of James W. Benson Pursuant to Rule 13a-14(a)promulgated
under the Securities and Exchange act of 1934 as amended 31.1

Certificate of Richard B. Slansky Pursuant to Rule 13a-14(a) promulgated
under the Securities and Exchange act of 1934 as amended 31.2

Certificate of James W. Benson Pursuant to Section 1350 of
Chapter 63 of Title 18 U.S. Code 32.1

Certificate of Richard B. Slansky Pursuant to Section 1350 of
Chapter 63 of Title 18 U.S. Code 32.2

* Incorporated by reference to the Registrant's Form 8-K filed
October 26, 2005

** Incorporated by reference to the Registrant's Form 8-K filed
November 3, 2005

*** Previously filed

t Certain exhibits and schedules have been omitted and SpaceDev agrees to
furnish to the Commission supplementally a copy of any omitted exhibits or
schedules upon request.

PAGE 36

SIGNATURES

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

SPACEDEV, INC.
Registrant

Dated: December 1, 2005 /s/ James W. Benson
--------------------------
James W. Benson
Chief Executive Officer

Dated: December 1, 2005 /s/ Richard B. Slansky
---------------------------
Richard B. Slansky
President & Chief Financial Officer

PAGE 37