U. S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
AMENDMENT NO. 1 TO
 
FORM 10-KSB
 
(Mark One)
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2007
 
o
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 000-30291
 
SHUMATE INDUSTRIES, INC.
(Name of small business issuer as specified in its charter)
 
Delaware
03-0453686
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)

12060 FM 3083
Conroe, Texas 77301
 (Address of principal executive offices, including zip code)
 
Registrant’s telephone number, including area code: (936) 539-9533
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 par value
 

 
Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the past 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 o
 
Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. o
 
The issuer’s revenues for the most recent fiscal year were $9,033,614.
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $3,902,500 as of May 14, 2008. Shares of common stock held by each officer and director and by each person or group who owns 10% or more of the outstanding common stock amounting to 5,337,077 shares have been excluded in that such persons or groups may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
 
As of May 14, 2008, 20,947,071 shares of our common stock were issued and outstanding.
 
Documents Incorporated by Reference: None.
 
Transitional Small Business Disclosure Format: No.
 


EXPLANATORY NOTE
 
This Amendment No. 1 to annual report on Form 10-KSB is being filed to provide the financial statements required by Item 310 of Regulation S-B; management’s discussion and analysis required by Item 303 of Regulation S-B; disclosure controls and procedures required by Item 307 of Regulation S-B; internal control over financial reporting required by Item 308 of Regulation S-B; directors, executive officer, control persons and corporate governance; compliance with Section 16(a) of the Exchange Act required by Items 401, 405, 406 and 407(c)(3), (d)(4) and (d)(5) of Regulation S-B; executive compensation required by Item 402 of Regulation S-B; security ownership of certain beneficial owners and management and related stockholder matters required by Item 201(d) of Regulation S-B and by Item 403 of Regulation S-B; certain relationships and related transactions, and director independence required by Item 404 of Regulation S-B and Item 407(a) of Regulations S-B and certifications required under Rule 13a-14 of the Securities Exchange Act of 1934, as amended, and Section 1350 of the Sarbanes-Oxley Act of 2002. These items were not available for filing with the annual report on Form 10-KSB filed by us on April 15, 2008. 
 
PART I
 
Shumate Industries, Inc., including all its subsidiaries, are collectively referred to herein as “Shumate Industries,” “Shumate,” “the Company,” “us,” or “we”.
 
Item 1. DESCRIPTION OF BUSINESS
 
Overview

Shumate Industries, Inc. is a Texas based energy field services company. Shumate is a holding company that, through its subsidiaries, operates in two principal businesses: contract machining and manufacturing and a valve product line. Shumate seeks to leverage its existing infrastructure, expertise, and customer channels to grow its business and introduce new technologies to the energy markets.

We currently employ 87 people at two plants totaling approximately 90,000 square feet in Conroe, Texas, just north of Houston. Our executive offices are located at 12060 FM 3083, Conroe, Texas 77301. Our telephone number is (936) 539-9533 and our Internet address is www.shumateinc.com.

Contract Machining and Manufacturing - Shumate Machine Works, Inc.

Our contract machining and manufacturing division, Shumate Machine Works, Inc., focuses in the energy field services market. We manufacture products, parts, components, and assemblies for our customers designed to their specifications. We provide state of the art 3-D modeling software, computer numeric-controlled, or CNC, machinery and manufacturing expertise to our customers’ research and development, engineering, and manufacturing departments for desired results with their products.  

The diverse line of products we manufacture include the following:

·
Expandable tubular products including liner hangers, launchers and sand screens for energy field service applications;
·
Top drive assemblies, sub-assemblies and spare service parts;
·
Measurement while drilling (MWD) products;
·
Directional drilling products;
·
Completion tools;
·
Exploration products for research and development;
·
Natural gas measurement equipment, including fittings and valves;
·
Power frames for centrifugal pumps and mud motors; and
·
Sub-sea control equipment.
 
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Our investment in capital equipment and software provides us capabilities to perform close tolerance highly specialized work for oil field equipment and tools, process controls, formation evaluation tools, and exploration and production products. Our capabilities include producing large-diameter products and close tolerance machined parts that range up to thirty-four feet in length using a myriad of materials of construction including high grade carbon steel, high grade stainless steel, nickel, and chrome based alloys. We use state of the art, large part CNC equipment in the production of these parts and have developed in-house trade secrets and processes with respect to the manufacture of certain products. We produce complex assemblies, including expandable tubing technology products that are used in field service operations under extreme environmental conditions for oil and gas exploration.
 
Our customers include, without limitation, Baker Hughes, BJ Services Company, Canrig Drilling Technology, a Nabors Industries company, Enventure Global Technologies, FMC Technologies, Halliburton Energy Services, National Oil Well Varco, Oceaneering Intervention Engineering, Shell Development, Smith International, and Weatherford International.

Valve Product Technology - Hemiwedge Valve Corporation

We formed Hemiwedge Valve Corporation as a wholly-owned subsidiary to develop and commercialize a new patented technology addressing what we believe to be a significant opportunity in the global valve market.
Our first product line, known as the Hemiwedge® Cartridge valve, is a quarter-turn hemispherical wedge valve engineered to provide what we believe are substantial technological improvements compared with what is available in the marketplace today, such as traditional butterfly, ball, and gate valve designs.

We believe that the patented design of the Hemiwedge® Cartridge valve combines the benefits of quarter-turn valves with the durability of gate valves. The Hemiwedge® Cartridge valve has a non-rotating core which guides the fluid flow through the valve to the Hemiwedge® itself. This is a hollow hemisphere where the inner and outer walls are slightly offset, having non-concentric centers, producing a hemispherical wedge shape - the “Hemiwedge®.” Operation of the valve rotates the Hemiwedge®, a quarter-turn, moving it between the core and valve seat, thus controlling the flow. We believe that these design features in the combination of the Hemiwedge® shut off and stationary core make the Hemiwedge® Cartridge valve unique.

We believe that the Hemiwedge® Cartridge valve will offer substantial improvements over currently available valve technologies offered by our competition as well as a great value proposition to future customers as a result of the following improvements:

New cartridge replacement design reduces maintenance downtime and minimizes supply disruptions

Our new top-entry cartridge design has all of the internal parts of the valve affixed to the bonnet. Therefore, once the bonnet is removed with top-entry ease for in-field maintenance, all the internals are removed as well, including the seals. A new pre-certified replacement cartridge can be installed without removing the valve body from its line of service. We believe this represents a substantial reduction in maintenance and service downtime from a few days to a few hours, depending on the application, location and size. We also believe this is a significant cost-reduction benefit to users, especially in severe service applications such as entrained solids, sour gas gathering, and CO2 flooding where valves fail frequently and supply disruption from shutting down a line during service may result in significant costs and loss of revenues.
 
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Reduced failure frequency rates from superior design

We believe many times when valves “break,” it is usually due to leaks caused by leaking seals within a valve. Most ball valves, by example (see “Figure 2”), have more turbulent flow patterns where the fluid within the valve comes into direct contact with the seals during modulation, actuation and service. Our Hemiwedge® Cartridge valve seals (see “Figure 1”) are not placed within the flow path and therefore we believe our valve is more durable, lasts longer, and will not encounter seal damage as frequently as currently available valve products as a result of its protected sealing surfaces. We believe that this product advantage will be more evident in severe and critical service applications.
 
 
 
 
 
 
 
Figure 1, shows the transition between on and off in a Hemiwedge® Cartridge valve. This demonstrates how the stationary core and moving Hemiwedge® guides the flow past the seal face with a minimum of flow turbulence. This protects the sealing surfaces when handling abrasive or corrosive fluids.
 
Figure 2, shows the flow through a ball or plug valve. Both the inlet and the outlet flow pass across the sealing surfaces, with the ball moving across the main flow path. This highly turbulent flow action causes premature failure of the seals in most severe applications.

Hemiwedge® Down hole Isolation valve
 
We executed a two year development agreement in July 2006 with a subsidiary of Shell Technology Ventures known as At Balance Americas. At Balance is not a related party and the development agreement was negotiated on an arm’s length basis. As a leading drilling services company focused in managed pressure drilling (MPD), At Balance sought development of a totally new design and prototype down hole valve to be used in drilling applications in connection with managed pressure drilling. Throughout 2007, we designed, engineered, manufactured and performed above-ground testing on the first size of a product line. We have determined that as of the date of this report the product in development for At Balance is developed substantially enough to enter into licensing discussions for purposes of commercialization.

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Hemiwedge® Sub sea high pressure valve

We have developed additional Hemiwedge® technology now in prototype stage, of a 20,000 PSI high pressure valve utilizing a metal-to-metal or all metal seal for chemical injection applications sub-sea. We intend to exclusively or non-exclusively license this technology for the specific market vertical of sub-sea and below two inch bore size for a high pressure chemical injection valve product line.

Fiscal 2007 and Fiscal 2008 Developments

In 2007, we continued to experience increased revenues in our Shumate Machine Works division. Increases in commodity prices, particularly in the energy sector, and in activity level in the energy field services industry resulted in increased demand for our products from our existing customers. In particular, we received increased orders for drilling tools, liner hangers, top-drive units and components in 2007. As a result, we increased revenues by approximately $525,000, or 7%.

While we have achieved certain milestones our results from operations in 2007, we continue to have substantial indebtedness outstanding. As of December 31, 2007, we had outstanding indebtedness to Stillwater National Bank of approximately $3.8 million.
.
March 2007 Warrant Solicitation

On March 14, 2007, we agreed that we would issue new Class B Warrants to any holders of Class A Warrants (issued in our December 2006 offering) who exercised all or a portion of their Class A Warrants by no later than 5:00 p.m. Central Daylight Time on March 31, 2007. The Class B Warrants have a term of five years, expiring on March 31, 2012, and an exercise price of $2.00 per share. The Class B Warrants include piggy-back registration rights, subject to customary underwriter cutbacks. Since the common stock underlying the Class B Warrants was not registered by March 31, 2008, the holders are entitled to exercise the Class B Warrants on a cashless basis at any time that there is not an effective registration statement covering the resale of the common stock underlying the Class B Warrants. As of March 31, 2007, an aggregate of 536,300 of our Class A warrants were exercised in connection herewith and we received gross proceeds of $670,375 therefrom. In addition, we issued 536,300 shares of our common stock and 536,300 Class B Warrants in connection with the exercise of the 536,300 Class A Warrants.

2007 Bridge Notes

Between July 10, 2007 and November 1, 2007, we sold $3,050,000 of principal amount of Bridge Notes with warrants to purchase 610,000 shares of our common stock to accredited investors in a private offering pursuant to an exemption from registration provided by Section 4(2) of the Securities Act. The Bridge Notes have a 1 year term and bear interest at ten percent (10%); payable monthly in arrears, however we have the right to defer any interest payment and accrue same to principal. As of December 31, 2007, approximately $116,000 in interest was accrued to principal. At the election of the holders, the Bridge Notes are convertible into our common stock at a fixed conversion price of $1.89 or into our next Offering. If not otherwise converted, we will be required to prepay the Bridge Notes upon consummation an Offering or its maturity. An NASD member firm, acted as primary placement agent in connection with the offering and received $210,000 in commissions while another NASD member firm received $5,000 in placement agents fees. Our net proceeds of this offering after the payment of commissions, fees and other expenses of the offering were approximately $2,825,000.

Amended Stillwater Credit Facility

On January 25, 2008, we entered into an Amended and Restated Loan Agreement with Stillwater National Bank and Trust Company (the “Amended Loan Agreement”). On October 19, 2005 we entered into that certain Agreement (as reported in our Current Report on Form 8-K dated October 19, 2005) with Stillwater, which Agreement was amended by a certain First Amendment to Agreement and Guarantors’ Consent dated October 19, 2006, as amended by a certain Second Amendment to Agreement dated effective January 19, 2007 (collectively, the “Prior Agreement”).

The Amended Loan Agreement amends and restates the Prior Agreement as follows:

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1. Term Loan. Our prior Term Note dated October 19, 2005 in favor of Stillwater had an outstanding principal balance of $3,003,998 (as of January 25, 2008) and a maturity date of April 19, 2008. Stillwater loaned us (along with our co-borrowers Shumate Machine Works, Inc. and Hemiwedge Valve Corporation) $3,329,000 pursuant to a new term note dated January 25, 2008, which funds advanced under the new term note were used to refinance the old term note and provide working capital. The new term note requires us to make 26 equal monthly payments (beginning on February 28, 2008) in an amount sufficient to fully amortize principal and interest on the amended and restated note over 64 months. The new term note is due and payable on April 19, 2010. The new term note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets as well as a security interest in certain personal assets of Larry Shumate.

2. Revolving Loan. Our prior revolving promissory note dated October 19, 2005 in favor of Stillwater, had an outstanding principal balance of $893,676 (as of January 25, 2008) and a maturity date of April 19, 2008. Stillwater loaned us (and the other co-borrowers set forth above) $1,000,000 pursuant to a new revolving promissory note dated January 25, 2008, which funds advanced under the new revolving promissory were used to refinance the old revolving promissory note and provide working capital. The initial balance on the new line of credit was equal to the balance of our previous line of credit with Stillwater ($893,676 principal balance as of January 25, 2008). The advances available under the new revolving promissory note are limited to a borrowing base of the sum of (a) 85% of eligible accounts receivable, and (b) 50% of eligible inventory. The new revolving promissory note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets as well as a security interest in certain personal assets of Larry Shumate. On the 28th day of each month, beginning January 28, 2008, we will pay all interest accrued on the new revolving promissory note. The amount we can borrow on the line of credit is subject to qualifying accounts receivable and inventory. The new revolving promissory note will mature and become fully due and payable on April 19, 2009.

The loan documents for the Stillwater line of credit and term loan require us to meet certain financial ratios and tests. Stillwater issued waivers under the original credit facility for periods tested where were not in compliance with certain covenants thereunder. However, we have not received a waivers for the March 31, 2008 period under the Amended Stillwater Credit Facility where we were not in compliance with certain covenants thereunder. As of the date of this report, we have not received a notice of default from Stillwater. Should Stillwater decide to declare a default, it would result in an acceleration of the related debt and could result in Stillwater foreclosing on our assets.

We anticipate that increasing energy commodity prices, including prices of oil and natural gas, should continue to cause our customers to increase their drilling and other exploration activities. As a result, we anticipate seeing increased oil rig counts as well as a renewal of drilling and production activity in previously dormant areas. We believe that such an increase in activity would result in increased demand for our energy related field service products during the 2008 fiscal year. In addition, we anticipate that our recent commercialization of the Hemiwedge® Cartridge valve product line will enhance our profitability, although there can be no assurance thereof.

Transactions Relating to Beach Road Facility

On May 15, 2008, our wholly owned subsidiary, Shumate Machine Works entered into a series of simultaneous transactions pursuant to which it purchased the property located at 1011 Beach Airport Road, Conroe, Texas 77301, underlying its lease (the “Original Lease”) with Brewer Family Charitable Remainder Annuity Trust #1. The terms of the Original Lease included an option to purchase the underlying property. Shumate Machine Works purchased the property for $1,726,949 pursuant to a warranty deed.

Concurrently with the purchase of the property, Shumate Machine Works sold this property to Trader Properties LLC, which Trader Properties immediately leased to Hemiwedge Valve Corporation. Shumate Machine Works sold the property to Trader Properties for an aggregate purchase price of $2,180,000 pursuant to a general warranty deed with vendor’s lien. As such, Shumate Machine Works received net cash of $319,617. These proceeds were used to pay back certain indebtedness.

The terms of the Commercial Lease Agreement between Hemiwedge Valve Corporation and Trader Properties is for a term of 10 years with a monthly rent of $24,000 per month, which shall be increased by 2% each year for the term of the lease. Hemiwedge Valve Corporation is required to maintain public liability insurance of not less than $1,000,000 during the term of the lease. To secure performance under the commercial lease, Hemiwedge Valve Corporation granted Trader Properties a lien and security interest against all of its’ non-exempt personal property that is in the leased premises.

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Shumate Industries has guaranteed payment and performance of the lease pursuant to a Guaranty Agreement. In addition, Shumate Industries agreed to issue Trader Properties a five year warrant to purchase 100,000 shares of its common stock at an exercise price of $0.25 per share prior to June 15, 2008.

Business Development

Organization

Our predecessor, Global Realty Management Group, Inc., or GRMG, was incorporated in the State of Florida in 1997. In June 2002, GRMG reincorporated under the laws of the State of Delaware from the State of Florida pursuant to a merger with a newly formed Delaware corporation. Under the terms of this reincorporation merger, GRMG changed its name from “Global Realty Management Group, Inc.” to “Excalibur Industries, Inc.” In October 2005, we changed our name from “Excalibur Industries, Inc.” to “Shumate Industries, Inc.”

Acquisition of Hemiwedge Assets

On December 5, 2005, we acquired the intellectual property rights to the Hemiwedge® line of products, including the Hemiwedge® valve, from Soderberg Research and Development, Inc. and certain of its affiliates. The intellectual property rights acquired consist of all patents, trademarks, and internet website relating to the Hemiwedge® product line. For these intellectual property rights, we paid $138,500 in cash and a two-year, six percent (6%) promissory note in the principal amount of $100,000, payable in 24 equal installments of principal and interest. In addition, we agreed to deposit: (a) $72,000 into an escrow account, the property of Soderberg Research Inc., to be paid in the form of a monthly advance in the amount of $3,000 for each month of the 24 month period beginning with the month immediately following the closing date; and (b) three percent (3%) of the net sales proceeds collected from customers from: (i) gross revenue from sales of products to which the acquired intellectual property relates, less (ii) sales and/or use taxes, import and/or export duties, outbound transportation costs, and amounts allowed or credited due to returns, which payments shall begin two years after the closing date and continue until March 29, 2013. The $72,000 in monthly advances shall be credited against the three percent (3%) of the net sales proceeds.

Reorganization

On October 19, 2005, we completed a restructuring of our company, resulting in a significant reduction of our outstanding debt and providing us with a strengthened balance sheet and reduced debt servicing requirement. The restructuring was effected through an out-of-court restructuring, or “recapitalization plan,” which consisted of the following:

·
an agreement to amend and restate a series of notes issued to Stillwater National Bank, or Stillwater, into one term note;
·
the extension of our current line of credit with Stillwater;
·
the issuance of a convertible note to Stillwater;
·
the issuance of a note, by Stillwater, to our Chief Financial Officer to advance funds to purchase shares of our common stock for $250,000;
·
the conversion of a portion of our debt to Stillwater into 20% of our then-outstanding common stock after giving effect to the restructuring;
·
our reacquisition of the capital stock of our operating subsidiary, Shumate Machine Works;
·
a release from Stillwater for any indebtedness not covered above;
·
the exchange of our outstanding unsecured notes, including principal and accrued interest, for our common stock; and
·
the grant of restricted stock awards to our executive officers, in return for their personal guarantees on new bank debt, and to our non-employee directors.
 
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In addition, in connection with the recapitalization, we changed our name to “Shumate Industries, Inc.” and effected a 1-for-7 reverse stock split of our then outstanding shares of common stock. The recapitalization plan, the name change, the reverse stock split, the adoption of our 2005 Stock Incentive Plan, and the re-election of our directors were all approved at a special meeting of our stockholders on October 19, 2005.

The recapitalization plan for achieving our financial goals closed on October 19, 2005 and consisted of the following transactions (the “restructuring transactions”):

Amended and Restated Term Note. Stillwater has amended and restated a series of notes in the current aggregate principal amounts of approximately $9,413,000 into an amended and restated note in the principal amount of approximately $5,600,000. The amended and restated note requires interest only payments for the six months following closing, and thereafter, requires us to make 24 equal monthly payments in an amount sufficient to fully amortize principal and interest on the amended and restated note over 120 months. The amended and restated note is due and payable 30 months after closing, at which time, we will be required to make a balloon payment of the entire outstanding principal balance and all accrued interest. The note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets. The proceeds of this note were applied as follows: $303,000 to purchase machines from Larry C. Shumate, our President and Chief Executive Officer, and from A. Earl Swift, a former director; $100,000 to purchase the capital stock of Shumate Machine Works; and the remainder was applied to our existing indebtedness to Stillwater.

Revised Line of Credit. Stillwater has extended our current revolving line of credit in an amount of up to $1,000,000 for one year. The initial balance on the line of credit is the balance of our existing line of credit with Stillwater, less the excess transferred to the amended and restated note. The advances available under the line of credit are limited to a borrowing base of the sum of (a) 80% of eligible accounts receivable, and (b) 50% of eligible inventory. The line of credit bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets. We failed to repay the line of credit on October 19, 2006, as we were required to do by our agreement with Stillwater. As of October 19, 2006 we and Stillwater entered into a First Amendment to Agreement and Guarantors’ Consent pursuant to which Stillwater agreed to redefine the line of credit maturity date to January 19, 2007, which was subsequently extended to April 19, 2008.

Convertible Note. We issued a convertible note to Stillwater in the principal amount of $2,500,000. The principal and accrued interest on the convertible note is convertible, at Stillwater’s option, into shares of our common stock at a conversion rate of $1.00 per share (on a post reverse stock split basis). The convertible note matures on the earlier of 60 months from the date of issuance or the date on which it is fully converted into our common stock. Interest on the convertible note shall accrue from the date of closing until the earlier of conversion or 24 months, at which time the accrued interest was capitalized into principal. Beginning at the end of the ninth quarter, we are obligated to make quarterly interest payments on the convertible note. The convertible note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our assets. We have agreed to include the shares of common stock underlying the convertible note on any eligible registration statement that we may file with the Securities and Exchange Commission under the Securities Act of 1933 in the next five years.

On April 13, 2006, we entered into a letter agreement with Stillwater pursuant to which Stillwater agreed to accept $500,000 from us in full satisfaction of the secured convertible promissory note, subject to certain conditions. On August 9, 2006, the letter agreement was amended to increase the payment by $25,000 to $525,000 if payment was made between September 2, 2006 and December 1, 2006 and by $50,000 to $550,000 if payment was made between December 2, 2006 and March 1, 2007. On December 1, 2006 we repaid the secured convertible promissory note in full.

CFO Note. Stillwater has loaned $350,000 to our Chief Financial Officer, Matthew C. Flemming, to purchase an aggregate of 250,000 newly issued shares (post reverse stock split) of our common stock, representing approximately 2.16% of our outstanding common stock after giving effect to the restructuring, for a total purchase price of $250,000. The balance was applied to the existing personal indebtedness of Mr. Flemming to Stillwater of approximately $10,000,000 under a personal guarantee of our indebtedness to Stillwater. Stillwater has released Mr. Flemming from the remainder of his personal guarantee.

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Conversion of Prior Bank Debt. Stillwater has exchanged $2,368,000 of our outstanding indebtedness to Stillwater for 2,368,000 newly issued shares of our common stock (on a post reverse-split basis), representing not less than 20% of the outstanding shares of our common stock after giving effect to the restructuring. We have agreed to include these shares of common stock on any eligible registration statement that we may file with the Securities and Exchange Commission under the Securities Act of 1933 in the next five years.

Releases. Stillwater has released us and our Chief Financial Officer, Matthew C. Flemming, from our respective obligations of the prior debt to Stillwater, except to the extent that such prior debt is amended and restated, issued, or guaranteed as set forth above.

Unsecured Note Exchange Offer. Our unsecured note holders have exchanged all of our outstanding unsecured notes, with interest rates ranging from 6% to 12% and all currently due and owing, for approximately 1,691,310 newly issued shares of our common stock (on a post reverse-split basis), representing approximately 14.61% of the outstanding shares of our common stock after giving effect to the restructuring.

Restricted Stock Awards. Our board of directors have granted restricted stock awards of approximately 3,950,000 shares of newly issued common stock (on a post reverse-split basis) to our executive officers and our non-employee directors, representing approximately 34.12% of the outstanding shares of our common stock after giving effect to the restructuring. These shares vested on the closing of the restructuring.

As previously reported on a current report on Form 8-K, on April 28, 2005, Excalibur Holdings, our bankrupt subsidiary and holder of 100% of the common stock of Shumate Machine Works, Inc., our sole operating subsidiary, received notice from Stillwater National Bank that Stillwater intends to dispose of the capital stock of Shumate Machine Works in a private sale after May 9, 2005 pursuant to the Oklahoma Uniform Commercial Code. As part of the restructuring, Stillwater transferred 100% of the capital stock of Shumate Machine Works to us.

A complete description of the restructuring plan is set forth in our definitive proxy statement for the October 19, 2005 special meeting of stockholders, which has been filed with the Securities and Exchange Commission.

Bankruptcies

On December 31, 2003, three of our operating subsidiaries, Excalibur Steel, Excalibur Services, and Excalibur Aerospace, each filed a voluntary petition for protection under Chapter 7 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas. On July 26, 2004, the United States Bankruptcy Court, Southern District of Texas, discharged Excalibur Steel and Excalibur Aerospace of all of its debts and liabilities pursuant to Chapter 7 of the U.S. Bankruptcy Code, and on August 3, 2004, the United States Bankruptcy Court, Southern District of Texas, discharged Excalibur Services of all of its debts and liabilities pursuant to Chapter 7 of the U.S. Bankruptcy Code. As a result of the discharge of these liabilities, we recorded $5,218,883 in debt forgiveness income in 2004.

On March 9, 2005, Excalibur Holdings, Inc., our wholly-owned subsidiary and the former parent corporation of Shumate Machine Works, Inc., filed a voluntary petition for protection under Chapter 7 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas. On November 30, 2005, the United States Bankruptcy Court, Southern District of Texas, discharged Excalibur Holdings of all of its debts and liabilities pursuant to Chapter 7 of the U.S. Bankruptcy Code. As a result of the discharge of these liabilities, we recorded $1,837,295 in debt forgiveness income in 2005.

The Company currently has two wholly-owned subsidiaries. Each of the following former subsidiaries of the Company has been dissolved: Excalibur Steel, Excalibur Services, Excalibur Aerospace and Excalibur Holdings.

Our Markets

The energy field services market is comprised of several market segments including oil & gas field services, pipeline and transportation, process controls, fluid management and controls, sub-sea, refining, and maintenance services for these areas. We currently manufacture products, spare parts, and assemblies for the oil & gas field services market segment. With our new Hemiwedge® Cartridge valve product line, we intend to expand into process controls, which is sometimes known as the energy flow control market. We may also expand into other areas of the energy field services market to pursue growth strategies that complement and/or leverage our current business and expertise.

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Contract Machining and Manufacturing - Shumate Machine Works

The dollar size of the United States (U.S.) oil & gas field services market can be measured by the U.S. drilling and completion activity spending and the total U.S. well service and work-over spending. In its March 2008 Drilling and Production Outlook report, Spears and Associates, a leading energy market research firm, stated that U.S. drilling and completion spending was $116.9 billion for 2007, up 12% from the year 2006, and that U.S. well service and work-over or production spending was $16.2 billion in 2007, approximately equal to 2006.

Valve Product Technology - Hemiwedge Valve Corporation

We believe that the industrial valve market is large and growing. According to a recent report from The McIlvaine Company, the dollar value of industrial valve shipments in 2007 was projected at approximately $8.5 billion in the United States, up almost 4% from 2006, and $44.8 billion worldwide, up approximately 4% from 2006. 

Neither the Spears and Associates report nor the McIlvaine Company report was prepared for us nor has either company consented to the use of this information in our report; rather, these reports are available for public use. 

Our Strategy 

Strategies to achieve our growth objectives include the following:

Commercializing and growing our proprietary new Hemiwedge® valve technology via the Cartridge valve product line, Down-hole isolation valve and licensing agreements for sub-sea applications of the valve. In late December 2006 we launched our Hemiwedge® technology with the Hemiwedge® Cartridge valve product line, a surface-level engineered valve, targeting oil and gas, process and pipeline applications.

Generating more revenues and increasing our profit margins by expanding our contract machining and manufacturing business and through investing in additional state-of-the art CNC equipment which offers us the ability to make increasingly complex tools as required by our customers. As a result of higher commodity prices, activity levels and pricing for our customers, we will continue to expand our operations at Shumate Machine Works and invest in additional computer-numeric controlled machinery that allows us to manufacture higher precision critical components for our customers growing demand of energy equipment.

Developing strategic alliances with other companies to leverage our valve technology into market segments where we have little or no expertise. We intend to license and partner our Hemiwedge® technology in market verticals where we have little or no expertise to maximize the technology’s value. For example, our Hemiwedge® technology has been tested in severe service applications and the company may partner with another company dominate in a particular market vertical such as tar sands or mining utilizing their strengths to commercialize further Hemiwedge® technology. In addition, our Hemiwedge® technology has been tested at very high pressures and demonstrated “bubble-tight” sealing capability and functionality for sub-sea applications, providing a proof of concept needed to pursue licensing discussions with larger energy companies with a presence in those markets.

Acquiring other technology-oriented products to leverage our asset base, manufacturing infrastructure, market presence and experienced personnel. We have extensive experience in manufacturing and machining products, and we have a reputation for providing quality products and services in the energy field services market. We have an existing base of customers and existing distribution channels in this market. We intend to combine our experience, reputation, customer base, and distribution channels with our expertise and knowledge of the industry to market and distribute other technology-oriented product lines for this customer base and through these distribution channels.

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Sales and Marketing; Customers

In our contract machining and manufacturing division, we have developed and maintained long-term relationships with our customers. We use a variety of methods to identify target customers, including the utilization of databases, direct mail, and participation in manufacturers’ trade shows. The energy field service target market usually consists of larger, well capitalized companies as well as smaller firms. These efforts supplement our traditional sales and marketing efforts of customer referrals and territory canvassing. In 2007, we expended approximately $467,000 on sales and marketing, which included the salaries, commissions, and expenses of our sales department.

Nearly all of our sales are on a negotiated price basis. In some cases, sales are the result of a competitive bid process where a customer sends to us and other competitors a list of products required, and we submit a bid on each job. Frequently, the ability to meet customer delivery schedules as well as plant capacities and capabilities are a significant aspect of winning any bid or purchase order.

For our valve division, we intend to target the severe service applications in oil and gas, process and pipeline markets where there is a demand for engineered valves. These target markets seek supply disruption mitigation and rapid maintenance benefits that our Hemiwedge® Cartridge valve system is designed to provide. Although we believe that our valve product line provides significantly improved functionality for higher-end or engineered severe service applications, we intend to price our valves competitively relative to other engineered valve manufacturers to establish market share. In addition to leveraging our existing customer base and distribution channels to market and distribute the valve product line, we have identified a network of established independent representative companies to market and distribute the valves on a success fee basis. We intend to complement this effort with direct employee salespersons, product catalogs, web site, direct mail, trade shows and sales support professionals that can travel to sales locations to consummate sales.

We have a customer base of more than 20 customers. Two of these customers represented approximately 71% percent of our revenues for fiscal year 2007. We continually focus on developing more volume from secondary and tertiary customers and with new customers to reduce customer concentration risk. We believe that long-term relationships with many of our customers will contribute to our success. While we intend to leverage our existing customer relationships to market the valve product, we also will seek additional new customers for the valve product line, which we anticipate would result in reduced revenue and account receivables concentrations.

Raw Materials

The principal raw materials that we use are carbon steel, aluminum, stainless steel, nickel, brass, titanium and various special alloys and other metals. The metals industry as a whole is cyclical, and at times pricing and availability of raw materials in the metals industry can be volatile due to numerous factors beyond our control, including general, domestic and international economic conditions, labor costs, production levels, competition, import duties and tariffs and currency exchange rates. This volatility can significantly affect the availability and cost of raw materials, and may, therefore, adversely affect our net sales, operating margin, and profitability. On average, pricing for raw materials has fluctuated about thirty percent annually on a historical basis. During periods of rising raw materials pricing, we have been able to pass through the increase in cost to our customers approximately ninety percent of the time. The remaining ten percent reflects down-time between reviewing costs on standardized repetitive work that is not quoted on a monthly basis. Accordingly, the increase in the cost of raw materials has had an immaterial effect on our operations; however, it is possible that we may not be able to pass any portion of such increases on to our customers in the future.

Competition

Both the machining and manufacturing business and the valve product business are engaged in fragmented and highly competitive industry segments. We estimate that there are more than 100 machine shops in the metro-Houston area alone, and that there are more than 4,000 valve product manufacturers and distributors within the United States alone. We estimate that our share of the market, based on 2007 revenues, is less than one percent (1%). Competition is based primarily on quality, service, price, performance timeliness and geographic proximity. We compete with a large number of other machining and manufacturing operators on a national, regional and local basis, most of which have greater financial resources than we do, and several of which are public companies. We also compete with overseas competitors whose labor costs may be significantly lower than our costs. We anticipate the valve product, when launched, will compete with a large number of companies with international and national capabilities that will possess greater financial resources.

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We believe that we are able to compete by defining and understanding customer needs and by using our equipment and machinery base to manufacture products with difficult specifications and tolerances.

Intellectual Property

As part of our ongoing research, development, and manufacturing activities, we intend to seek patents when appropriate on inventions involving new products and product improvements. In December 2005, we acquired the intellectual property rights to the Hemiwedge® line of products, including the Hemiwedge® Cartridge valve, from Soderberg Research and Development, Inc. and certain of its affiliates. These intellectual property rights consisted of two (2) unexpired United States patents, one (1) expired United States patent, several pending United States patent applications, and one (1) registered United States trademark. We have developed several new inventions to the technology which have been propagated within numerous new patent applications during 2006 and 2007.  We have also filed international patent applications for the inventions embodied in the pending United States patent application.

These intellectual property rights are of considerable importance to the Hemiwedge® Cartridge valve product line (including the development stage down-hole isolation valve and sub sea high pressure valve), and we consider them, in the aggregate, to be material to our valve technology commercialization plans. It is possible that these intellectual property rights may later be invalidated by a court of competent jurisdiction, and it is also possible that our products or proposed products may be found to infringe upon the intellectual property rights of others.

We also rely on trade secret protection for our confidential and proprietary information. We seek to enter into confidentiality agreements with our employees, partners, and suppliers. It is possible, however, that others will independently obtain similar information or otherwise gain access to our trade secrets.

Government Regulation and Environmental Matters

Our operations are subject to a number of federal, state and local regulations relating to the protection of the environment and to workplace health and safety. In particular, our operations are subject to extensive federal, state and local laws and regulations governing waste disposal, air and water emissions, the handling of hazardous substances, painting product on premises, environmental protection, remediation and workplace exposure. Hazardous materials used in our operations include lubricants and cleaning solvents.

We believe that we are in substantial compliance with all such laws and do not currently anticipate that we will be required to expend any substantial amounts in the foreseeable future in order to meet current environmental or workplace health and safety requirements.

Although no environmental claims have been made against us and we have not been named as a potentially responsible party by the Environmental Protection Agency or any other entity, it is possible that we could be identified by the EPA, a state agency or one or more third parties as a potentially responsible party under CERCLA or under analogous state laws. If so, we could incur substantial litigation costs to prove that we were not responsible for the environmental damage.

Safety

We are committed to emphasizing and focusing on safety in the workplace. We currently have a variety of safety programs in place, which include periodic safety meetings and training sessions to teach proper safety work procedures. We have established “best practices” processes throughout most of our operations to ensure that our employees comply with safety standards that we establish and to ensure full compliance with federal, state and local laws and regulations. In addition, we intend to continue to emphasize the need for an accident-free workplace.

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Risk Management and Insurance

The primary risks in our operations are property damage, workers’ compensation, and third-party bodily injury. We maintain insurance above certain self-insured limits for liability for bodily injury, third-party property damage, and workers’ compensation, all of which we consider sufficient to insure against these risks.

Employees

We currently employ 87 people in Conroe, Texas. Of the total, approximately 22 are in administration, 6 are in engineering and drafting, 2 are in sales, marketing and distribution, and 57 are in machining, manufacturing and production. None of our employees are represented by a labor union, and we have not entered into a collective bargaining agreement with any union. We have not experienced any work stoppages and consider the relations with our employees to be good.

Item 1A. RISK FACTORS AND CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below and the other information in this annual report, including our financial statements and the notes to those statements, before you purchase our common stock. The risks and uncertainties described below are those that we currently believe may materially adversely affect our company. Additional risks and uncertainties may also impair our business operations. If the following risks actually occur, our business, financial condition and results of operations could be seriously harmed, the trading price of our common stock could decline and you could lose all or part of your investment.

Our business might fail, even after our 2005 restructuring.

Although we completed a restructuring of our debt in October 2005, and although we have increased revenues in each of the last three years, we have still incurred operating losses in each of the last three fiscal years. Our ability to become profitable will depend upon several factors, including whether we can continue to increase our revenues in Shumate Machine Works, Inc., and whether our Hemiwedge® valve products are successful in the marketplace. We cannot estimate with any certainty the long-term demand for our products and services or the degree to which we will meet that demand. If demand for our products and services does not increase, or if the market for our products and services declines, we may not be able to earn enough revenue to generate profits from operations or positive cash flow.

We may be unable to continue as a going concern in which case our securities will have little or no value.

Our independent auditor has noted in its report concerning our financial statements as of December 31, 2007 and 2006 that we have incurred recurring losses from operations and have a working capital deficiency, which raises substantial doubt about our ability to continue as a going concern. We have incurred recurring losses from operations in 2007 and 2006, respectively and, we have negative working capital as of December 31, 2007. These conditions raise substantial doubt as to our ability to continue as a going concern. We cannot assure you that we will achieve operating profits in the future.

We have substantial indebtedness outstanding, and our operations are significantly leveraged. If we are unable to repay our debt obligations in a timely fashion, it could have a material adverse effect on our business and prospects.

In order to finance our operations we have incurred substantial indebtedness, including the debt with Stillwater National Bank which consists of a line of credit and a term loan, as well as our recent 2007 bridge financing. As of December 31, 2007, we owed total indebtedness of approximately $3.8 million (not including accrued interest) to Stillwater National Bank, our senior lender. Additionally, we owe our recent bridge loan investors $3.05 million (not including accrued interest accreted to principal) and various lenders such as a premium finance note for the annual premium of approximately $55,000 for our directors and officers liability policy. Our cash flows from operations are currently not sufficient to service our debt obligations. If we fail to pay our debt obligations in a timely fashion, we will be in default under one or more of our loan agreements. If we default on our loan obligations with Stillwater National Bank, it could exercise its rights and remedies under the loan agreement, which could include foreclosing on all of our assets. Any such action would have a material adverse effect on our business and prospects.

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We will likely need to finance our operations and a full-scale launch of the Hemiwedge® products through additional bank borrowings or other capital financings. If we are unable to obtain additional capital, we may not be able to adequately fund our Hemiwedge Valve Corporation subsidiary or continue our business.

We had working capital of $338,874 as of December 31, 2006 and we had a working capital deficit of $4,647,597 as of December 31, 2007. Since December 31, 2006, we have completed a private placement of our convertible notes which resulted in net proceeds to us of approximately $2.74 million, providing us with working capital for the immediate future. Currently, we believe that we will not be able to fund our operations, working capital requirements, and debt service requirements throughout the 2008 fiscal year with existing working capital and cash flows generated from operations. In addition, we will need additional capital to be able to fund the further development of the Hemiwedge® technology and the operations of the Hemiwedge® Cartridge valve products. In addition, we do not believe that we will be able to conduct a full-scale expansion of the Hemiwedge® product, including an inventory buildup or an expansion of the product line, without obtaining additional financing.

We currently have a $1,000,000 secured revolving line of credit facility with Stillwater National Bank. This loan is subject to a borrowing base that is computed on our qualifying accounts receivable and inventory. The outstanding balance on this line of credit was approximately $526,206 at May 14, 2008, which, at the time, $1,000,000 was the maximum allowed due to the amount of the qualifying accounts receivable and inventory, also referred to as our borrowing base. The outstanding balance on the line of credit and the borrowing base fluctuate based on our available working capital and our qualifying accounts receivable and inventory. As such, we may not have the ability to borrow additional funds on this line of credit.

In the event we seek to expand the rate of Hemiwedge® Cartridge valve’s growth and scale up of the product line, or in the event that our cash flows from operations are insufficient to fund our operations, working capital requirements, and debt service requirements, we would need to raise additional capital, either by borrowing more money, if possible, or by selling our securities or seeking out joint venture opportunities. Any material additional borrowing or significant capital expenditures require the written consent of our lender, Stillwater National Bank. We may not be successful in raising additional financing as and when we need it. If we are unable to obtain additional financing in sufficient amounts or on acceptable terms, our operating results and prospects could be adversely affected.

The majority of our revenues are generated from a small number of customers, and our results of operations and cash flows will be adversely affected if any of our major customers either fail to pay on a timely basis or cease to purchase our products.

In 2007, two of our customers accounted for approximately 71% of our sales. At December 31, 2007, two customers accounted for approximately 30% of our trade accounts receivable balance. These customers do not have any ongoing commitment to purchase our products and services. We generally do not require collateral from our customers, although we do perform ongoing credit evaluations of our customers and maintain allowances for potential credit losses which, when realized, have been within the range of our expectations. If one or more of our major customers stops purchasing our products or defaults in its obligation to pay us, our results of operations as well as our cash flows will be adversely affected.

Our Hemiwedge Valve Corporation subsidiary is an early stage company with no significant operating history.

One of our subsidiaries, Hemiwedge Valve Corporation, is an early stage company that has not had significant operations. Its primary business purpose is to develop, manufacture, and market applications of its new valve technology known as the Hemiwedge® valve. The Hemiwedge® Cartridge valve, our surface-level valve product line targeting the oil and gas, process and pipeline markets, was launched in late December 2006. Other applications of the Hemiwedge® technology are still in the engineering, design, and development stage. This subsidiary only began generating product revenue in the late fourth quarter of 2006, and has incurred losses since its formation. As an early stage company, the prospects for Hemiwedge Valve Corporation are subject to all of the risks, uncertainties, expenses, delays, problems, and difficulties typically encountered in the establishment of a new business. We expect that unanticipated expenses, problems, and technical difficulties may occur which would result in material delays in the development and growth of the Hemiwedge® valve. We may not be able to successfully implement our plans for Hemiwedge Valve Corporation and achieve a significant level of operations.

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If we do not successfully commercialize the Hemiwedge® Cartridge valve product, we may never achieve profitability in this subsidiary.

We have incurred substantial expenses to acquire and fund the development of our Hemiwedge® Cartridge valve product. We only began generating product revenue in the late fourth quarter of 2006 in this subsidiary in connection with the Hemiwedge® Cartridge valve launch in December 2006. Many of our research and development programs for applications of the Hemiwedge® technology are at an early stage. Early stage product lines are subject to inherent risks of failure. These risks include the possibilities that the Hemiwedge® valve may not last as long as the products of our competitors or may not reduce torque as anticipated. Even if the Hemiwedge® valve technology operates as anticipated, it may not be commercially successful. If we are unable to develop the Hemiwedge® product as anticipated, or if the product is successfully developed but not accepted in the marketplace, Hemiwedge Valve Corporation may never be profitable.

Our ability to achieve any significant revenue in Hemiwedge Valve Corporation may depend on our ability to establish effective sales and marketing capabilities.

As a result of the launch of the Hemiwedge® Cartridge valve in the late fourth quarter of 2006, we need to build a sales and marketing infrastructure and customer channels which may include independent sales representative firms, distributors and/or employees. If we fail to establish an effective internal marketing and sales force or to make alternative arrangements to have these products marketed and sold by others, our ability to commercialize our valve product line and to enter new or existing markets will be impaired.

The line of credit and term loan with Stillwater National Bank contain numerous restrictive covenants which limit management’s discretion to operate our business.

In order to obtain the line of credit and term loan from Stillwater National Bank, we will agree to certain covenants that place significant restrictions on, among other things, our ability to incur additional indebtedness, to create liens or other encumbrances, to make certain payments and investments, and to sell or otherwise dispose of assets and merge or consolidate with other entities. The Stillwater line of credit and term loan also require us to meet certain financial ratios and tests and require us to obtain consent from Stillwater in order to change our senior management. For the year ended December 31, 2006 and 2007 and the fiscal periods ended March 31, June 30, September 30, December 31, 2007 and March 31, 2008, we were not in compliance with certain covenants under the credit facility. Our lender issued waivers for the periods tested, except for the December 31, 2007 and March 31, 2008 periods. However, we have no reason to believe that such waiver will not ultimately be granted, and on January 25, 2008, we entered into an Amended and Restated Loan Agreement with Stillwater National Bank and Trust Company that extended both credit facilities. There can be no assurance that we will be in compliance with the financial covenants in future periods or that Stillwater will issue a waiver for the past periods we were not in compliance or any future periods in which we are not in compliance with these covenants. Our failure to comply with the covenants included in the Stillwater National Bank loan agreements could result in an event of default, which could trigger an acceleration of the related debt. If we were unable to repay the debt upon any such acceleration, Stillwater could seek to foreclose on our assets in an effort to seek repayment under the loans. If Stillwater were successful, we would be unable to conduct our business as it is presently conducted and our ability to generate revenues and fund our ongoing operations would be materially adversely affected. We have not yet received a waiver for the period from Stillwater National Bank.

The interest rate on a significant portion of our indebtedness varies with the market rate of interest. An increase in the interest rate could have a material adverse effect on our results of operations.

The interest on the line of credit and term loan from Stillwater National Bank is payable monthly at the prime rate plus two percent. The base rates on the line of credit and term loan will fluctuate over time, and if the base rates significantly increase, our interest expense will increase. This would have a material adverse affect on our results of operations. As an example, based on the amounts outstanding under the line of credit and term loan at December 31, 2007, a one percent increase in Stillwater’s prime rate would increase our annual debt service by approximately $43,000.

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We may not be able to successfully increase our sales. If we do not increase our sales, we may never become profitable.

It is possible that we may be unable to successfully implement any of our strategies to increase sales, including expanding the range of processes and services that we offer, developing long-term partnering relationships with customers and adding new customers. Our ability to increase our sales will be affected by many factors which are beyond our control, such as falling commodity prices which will decrease demand for our products or the failure of the marketplace to respond positively to our Hemiwedge® valve technology. We cannot assure you that our strategies to increase our sales will be successful. If they are not, we may never become profitable.

We want to develop additional new energy field services products, but we may not have the financial ability to do so.

We are currently seeking opportunities to develop or acquire energy field services products and technologies through acquisitions or licensing agreements. We believe acquiring our own product lines would leverage our expertise in manufacturing and marketplace knowledge and complement our current contract machining business and customer relationships. However, the energy field services market has numerous manufacturers that are larger than we are and have greater financial resources than we do. Even if we were to acquire or design our own products, it is possible that we may not have the financial capacity to enter this market.

We face significant competition in our markets. Our inability to compete successfully could have a material adverse effect on our business and results of operations.

The energy field services industry, including both the machining and manufacturing industry and the commercial valve industry, is highly competitive. Competition in the sale of our products is primarily based on engineering, product design, process capability, quality, cost, delivery and responsiveness. Many of our competitors are entities that are larger and have greater financial and personnel resources than we do. We also compete with foreign manufacturers that have substantially cheaper labor costs than we do. We may not be able to compete successfully. If we do not compete successfully, our business and results of operations will be materially adversely affected.

Failure to protect our proprietary technology could impair our competitive position.

We have obtained or are in the process of obtaining U.S. and foreign patents and patent applications for our Hemiwedge® technology. Our success will depend in part on our ability to obtain patent protection for our Hemiwedge® technology, preserve our trade secrets, and operate without infringing the proprietary rights of third parties.

Although we place considerable importance on obtaining patent protection for our technologies, products and processes, the enforceability of our patents is uncertain and involves complex legal and factual questions. The applicant or inventors of subject matter covered by patent applications or patents owned by us may not have been the first to invent or the first to file patent applications for such inventions.

Furthermore, enforcement of patents and proprietary rights in many other countries may be problematic or unpredictable. The issuance of a patent in one country does not assure the issuance of a similar patent in another country. Claim interpretation and infringement laws vary by nation, so the extent of any patent protection is uncertain and may vary in different jurisdictions.

Due to uncertainties regarding patent law and the circumstances surrounding our patent applications, the pending or future patent applications we own may not result in the issuance of any patents. Existing or future patents owned by us may be challenged, infringed upon, invalidated, found to be unenforceable or circumvented by others. Further, any rights we may have under any issued patents may not provide us with sufficient protection against competitive products or otherwise cover commercially valuable products or processes.

Litigation or other disputes regarding patents and other proprietary rights may be expensive, cause delays in bringing products to market and harm our ability to operate.

The manufacture, use or sale of our Hemiwedge® product candidates may infringe on the patent rights of others. If we are unable to avoid infringement of the patent rights of others, we may be required to seek a license, defend an infringement action, or challenge the validity of the patents in court. Patent litigation is costly and time consuming. We may not have sufficient resources to bring these actions to a successful conclusion. In addition, if we do not obtain a license, develop or obtain non-infringing technology, or fail to successfully defend an infringement action or have the patents we are alleged to infringe declared invalid, we may incur substantial money damages, encounter significant delays in bringing our Hemiwedge® products to market, be precluded from participating in the manufacture, use, or sale of our Hemiwedge® products without first obtaining licenses to do so, or not be able to obtain any required license on favorable terms, if at all. In addition, if another party claims the same subject matter (or subject matter overlapping with the subject matter) that we have claimed in a U.S. patent application or patent, we may decide or be required to participate in interference proceedings in the United States Patent and Trademark Office in order to determine the priority of invention. Loss of such an interference proceeding would deprive us of patent protection sought or previously obtained and could prevent us from commercializing our products. Participation in such proceedings could result in substantial costs, whether or not the eventual outcome is favorable. These additional costs could adversely affect our financial results.

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Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

In order to protect our proprietary technology and processes, we rely in part on confidentiality agreements with our employees, consultants, outside collaborators, and other advisors. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.

We purchase metals in the open market, and our profitability may vary if prices of metals fluctuate.

The principal raw materials that we use are carbon steel, aluminum, stainless steel, nickel, brass, titanium and various special alloys and other metals. The metals industry as a whole is cyclical, and at times pricing and availability of raw materials in the metals industry can be volatile due to numerous factors beyond our control, including general, domestic and international economic conditions, labor costs, production levels, competition, import duties and tariffs and currency exchange rates. This volatility can significantly affect the availability and cost of raw materials, and may, therefore, adversely affect our net sales, operating margin and net income. During periods of rising raw materials pricing, there can be no assurance that we will be able to pass any portion of such increases on to our customers. When raw material prices decline, customer demands for lower prices could result in lower sale prices and, as we use existing inventory, result in lower margins. Changing metal prices could adversely affect our ability to attain profitably.

The oil & gas industry is subject to fluctuations in demand, which results in fluctuations in our results of operations.

Most of our products are sold to oil and gas field services companies that experience significant fluctuations in demand based on economic conditions, energy prices, domestic and international drilling rig counts, consumer demand, and other factors beyond our control. In 2006 and 2007, we experienced increased activity levels driven by increases in energy commodity prices and increased demand for oil field drilling products. However, the increase in demand could be temporary as commodity prices fluctuate daily. Reduced demand for oil field drilling products would result in lower activity levels for our company. These changes can happen very quickly and without forecast or notice, and may have a material adverse effect on our results of operations.

We may need to recruit additional personnel for Hemiwedge Valve Corporation. If we are unable to attract qualified personnel, we may be unable to operate the business as planned.

Our ability to implement our business plan and develop Hemiwedge Valve Corporation may depend on our ability to attract and retain other qualified management, engineering, machinists, project development, and sales and marketing personnel. We compete for such persons with other companies, some of which have substantially greater capital resources and facilities than we have. Further, demand for such personnel during periods of increased demand for energy products is very strong. We may not be able to recruit or retain personnel of the requisite caliber or in adequate numbers to enable us to conduct the Hemiwedge® business as planned.

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Our operations are subject to a number of federal, state and local regulations relating to the protection of the environment and to workplace health and safety. If we were found to be responsible for significant damages related to such regulation, it could have a material adverse effect on our business and results of operation.

Our operations are subject to extensive federal, state and local laws and regulations governing waste disposal, air and water emissions, the handling of hazardous substances, environmental protection, remediation, workplace exposure, and other matters. Hazardous materials that we use in our operations primarily include lubricants and cleaning solvents. Our leased facility is located in an industrial area close to properties with histories of heavy industrial use. Although no environmental claims have been made against us and we have not been named as a potentially responsible party by the EPA or any other party, it is possible that we could be identified by the EPA, a state agency or one or more third parties as a potentially responsible party under CERCLA or under analogous state laws. If so, we could incur substantial litigation costs to prove we are not responsible for the environmental damage, or, if we were found to be a responsible party, we could be liable for significant damages. This could have a material adverse effect on our business and results of operations.
 
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INVESTMENT RISKS

There is a limited trading market for our shares. You may not be able to sell your shares if you need money.

Our common stock is traded on the Over-The-Counter Bulletin Board, an inter-dealer automated quotation system for equity securities. During the 30 trading days ended March 31, 2008, the average daily trading volume of our common stock was approximately 41,000 shares. As of March 31, 2008, we had approximately 400 record holders of our common stock (not including an indeterminate number of stockholders whose shares are held by brokers in “street name”). There has been limited trading activity in our stock, and when it has traded, the price has fluctuated widely. We consider our common stock to be “thinly traded” and any last reported sale prices may not be a true market-based valuation of the common stock. Stockholders may experience difficulty selling their shares if they choose to do so because of the illiquid market and limited public float for our common stock.

We are subject to the penny stock rules and these rules may adversely affect trading in our common stock.

Our common stock is a “low-priced” security under rules promulgated under the Securities Exchange Act of 1934. In accordance with these rules, broker-dealers participating in transactions in low-priced securities must first deliver a risk disclosure document which describes the risks associated with such stocks, the broker-dealer’s duties in selling the stock, the customer’s rights and remedies and certain market and other information. Furthermore, the broker-dealer must make a suitability determination approving the customer for low-priced stock transactions based on the customer’s financial situation, investment experience and objectives. Broker-dealers must also disclose these restrictions in writing to the customer, obtain specific written consent from the customer, and provide monthly account statements to the customer. The effect of these restrictions probably decreases the willingness of broker-dealers to make a market in our common stock, decreases liquidity of our common stock and increases transaction costs for sales and purchases of our common stock as compared to other securities.

Transfers of our securities may be restricted by virtue of state securities “blue sky” laws which prohibit trading absent compliance with individual state laws. These restrictions may make it difficult or impossible to sell shares in those states.

Transfers of our common stock may be restricted under the securities or securities regulations laws promulgated by various states and foreign jurisdictions, commonly referred to as “blue sky” laws. Absent compliance with such individual state laws, our common stock may not be traded in such jurisdictions. Because the securities registered hereunder have not been registered for resale under the blue sky laws of any state, the holders of such shares and persons who desire to purchase them should be aware that there may be significant state blue sky law restrictions upon the ability of investors to sell the securities and of purchasers to purchase the securities. These restrictions may prohibit the secondary trading of our common stock. Investors should consider the secondary market for our securities to be a limited one.

There are options and warrants to purchase shares of our common stock currently outstanding.

As of December 31, 2007, we have granted options and warrants to purchase an aggregate of 4,636,120 shares of our common stock to various persons and entities, of which options and warrants to purchase up to 4,350,787 shares of our common stock are currently exercisable. The exercise prices on these options and warrants range from $0.63 per share to $4.20 per share. If issued, the shares underlying options and warrants would increase the number of shares of our common stock currently outstanding and will dilute the holdings and voting rights of our then-existing shareholders.

We have no immediate plans to pay dividends.

We have not paid any cash dividends to date and do not expect to pay dividends for the foreseeable future. In addition, the terms of our line of credit and term loan from Stillwater National Bank prohibit us from declaring or paying dividends or purchasing or redeeming any of our capital stock without the approval of Stillwater National Bank. We intend to retain earnings, if any, as necessary to finance the operation and expansion of our business.

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Our officers and directors collectively own a substantial portion of our outstanding common stock, and as long as they do, they may be able to control the outcome of stockholder voting.

Our officers and directors are collectively the beneficial owners of approximately 27% of the outstanding shares of our common stock as of the date of this report. As long as our officers and directors collectively own a significant percentage of our common stock, our other shareholders may generally be unable to affect or change the management or the direction of our company without the support of our officers and directors. As a result, some investors may be unwilling to purchase our common stock. If the demand for our common stock is reduced because our officers and directors have significant influence over our company, the price of our common stock could be materially depressed. The officers and directors will be able to exert significant influence over the outcome of all corporate actions requiring stockholder approval, including the election of directors, amendments to our certificate of incorporation and approval of significant corporate transactions.

We have the ability to issue additional shares of our common stock and shares of preferred stock without asking for stockholder approval, which could cause your investment to be diluted.

Our Certificate of Incorporation authorizes the Board of Directors to issue up to 50,000,000 shares of common stock and up to 10,000,000 shares of preferred stock. The power of the Board of Directors to issue shares of common stock, preferred stock or warrants or options to purchase shares of common stock or preferred stock is generally not subject to stockholder approval. Accordingly, any additional issuance of our common stock, or preferred stock that may be convertible into common stock, may have the effect of diluting your investment.

By issuing preferred stock, we may be able to delay, defer or prevent a change of control.

Our Certificate of Incorporation permits us to issue, without approval from our shareholders, a total of 10,000,000 shares of preferred stock. Our Board of Directors can determine the rights, preferences, privileges and restrictions granted to, or imposed upon, the shares of preferred stock and to fix the number of shares constituting any series and the designation of such series. It is possible that our Board of Directors, in determining the rights, preferences and privileges to be granted when the preferred stock is issued, may include provisions that have the effect of delaying, deferring or preventing a change in control, discouraging bids for our common stock at a premium over the market price, or that adversely affect the market price of and the voting and other rights of the holders of our common stock.

Our stock price is volatile.

The trading price of our common stock has been and continues to be subject to fluctuations. The stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, the operating and stock performance of other companies that investors may deem as comparable and news reports relating to trends in the marketplace, among other factors. Significant volatility in the market price of our common stock may arise due to factors such as:
 
 
·
our developing business;

 
·
a continued negative cash flow;

 
·
relatively low price per share;

 
·
relatively low public float;

 
·
variations in quarterly operating results;

 
·
general trends in the industries in which we do business;

 
·
the number of holders of our common stock; and

 
·
the interest of securities dealers in maintaining a market for our common stock.

20


As long as there is only a limited public market for our common stock, the sale of a significant number of shares of our common stock at any particular time could be difficult to achieve at the market prices prevailing immediately before such shares are offered, and could cause a severe decline in the price of our common stock.

There are limitations in connection with the availability of quotes and order information on the OTCBB.

Trades and quotations on the OTCBB involve a manual process and the market information for such securities cannot be guaranteed. In addition, quote information, or even firm quotes, may not be available. The manual execution process may delay order processing and intervening price fluctuations may result in the failure of a limit order to execute or the execution of a market order at a significantly different price. Execution of trades, execution reporting and the delivery of legal trade confirmation may be delayed significantly. Consequently, one may not be able to sell shares of our Common Stock at the optimum trading prices.

There are delays in order communication on the OTCBB.

Electronic processing of orders is not available for securities traded on the OTCBB and high order volume and communication risks may prevent or delay the execution of one's OTCBB trading orders. This lack of automated order processing may affect the timeliness of order execution reporting and the availability of firm quotes for shares of our Common Stock. Heavy market volume may lead to a delay in the processing of OTCBB security orders for shares of our Common Stock, due to the manual nature of the market. Consequently, one may not able to sell shares of our Common Stock at the optimum trading prices.

There is a risk of market fraud on the OTCBB.

OTCBB securities are frequent targets of fraud or market manipulation. Not only because of their generally low price, but also because the OTCBB reporting requirements for these securities are less stringent than for listed or NASDAQ traded securities, and no exchange requirements are imposed. Dealers may dominate the market and set prices that are not based on competitive forces. Individuals or groups may create fraudulent markets and control the sudden, sharp increase of price and trading volume and the equally sudden collapse of the market price for shares of our Common Stock.

There is a limitation in connection with the editing and canceling of orders on the OTCBB.

Orders for OTCBB securities may be canceled or edited like orders for other securities. All requests to change or cancel an order must be submitted to, received and processed by the OTCBB. Due to the manual order processing involved in handling OTCBB trades, order processing and reporting may be delayed, and one may not be able to cancel or edit one's order. Consequently, one may not able to sell its shares of our Common Stock at the optimum trading prices.

Increased dealer compensation could adversely affect our stock price.

The dealer's spread (the difference between the bid and ask prices) may be large and may result in substantial losses to the seller of shares of our Common Stock on the OTCBB if the stock must be sold immediately. Further, purchasers of shares of our Common Stock may incur an immediate "paper" loss due to the price spread. Moreover, dealers trading on the OTCBB may not have a bid price for shares of our Common Stock on the OTCBB. Due to the foregoing, demand for shares of our Common Stock on the OTCBB may be decreased or eliminated.
 
21


Cautionary Statement Concerning
Forward-Looking Information

This annual report and the documents to which we refer you and incorporate into this annual report by reference contain forward-looking statements. In addition, from time to time, we, or our representatives, may make forward-looking statements orally or in writing. These are statements that relate to future periods and include statements regarding our future strategic, operational and financial plans, potential acquisitions, anticipated or projected revenues, expenses and operational growth, markets and potential customers for our products and services, plans related to sales strategies and efforts, the anticipated benefits of our relationships with strategic partners, growth of our competition, our ability to compete, the adequacy of our current facilities and our ability to obtain additional space, use of future earnings, and the feature, benefits and performance of our current and future products and services.

You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “should,” “expects,” “anticipates,” “contemplates,” “estimates,” “believes,” “plans,” “projected,” “predicts,” “potential,” “seek” or “continue” or the negative of these or similar terms. In evaluating these forward-looking statements, you should consider various factors, including those described in this annual report under the heading “Risk Factors.” These and other factors may cause our actual results to differ materially from any forward-looking statement. We caution you not to place undue reliance on these forward-looking statements.

We base these forward-looking statements on our expectations and projections about future events, which we derive from the information currently available to us. Such forward-looking statements relate to future events or our future performance. Forward-looking statements are only predictions. The forward-looking events discussed in this annual report, the documents to which we refer you and other statements made from time to time by us or our representatives, may not occur, and actual events and results may differ materially and are subject to risks, uncertainties and assumptions about us. For these statements, we claim the protection of the “bespeaks caution” doctrine. The forward-looking statements speak only as of the date hereof, and we expressly disclaim any obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date of this filing.
 
22


Item 2. PROPERTIES  
 
We lease approximately 90,000 square feet of manufacturing space in Conroe, Texas.

Approximately 30,000 square feet is used by Shumate Machine Works for its operations. On April 1, 2006, Shumate Machine Works and the lessor terminated the existing lease for these premises and entered into a new lease. The lease term ends on March 31, 2011. The base rent is $18,600 per month, representing a reduction of rent of $4,000 per month. The new lease grants to Shumate Machine Works an option to purchase the premises at the end of the lease term for an agreed-upon purchase price or current appraised price. If it exercises this option, Shumate Machine Works is entitled to a credit in an amount equal to 5% of all lease payments paid during the term. Effective February 1, 2007, our rent increased to $22,100 in connection with a 5,000 square foot expansion.

In December 2005, Shumate Machine Works entered into a lease agreement for a manufacturing facility of approximately 60,000 square feet to be used by Hemiwedge Valve Corporation. The term of the lease is three years and the rent is approximately $14,000 per month. The lease agreement grants to Shumate Machine Works an option to purchase the premises covered under the lease for a purchase price of approximately $1,825,000 before lease. Shumate Machine Works will be entitled to a credit against the purchase price in an amount equal to the amount necessary to amortize the purchase price at 7% over a period of 240 months. The option to purchase expires on September 1, 2009. On May 15, 2008, Shumate Machine Works exercised the aforementioned option and purchased the property for $1,726,949 pursuant to a warranty deed. Concurrently with the purchase, the property was sold to Trader Properties LLC and immediately leased to Hemiwedge Valve Corporation. The Commercial Lease Agreement between Hemiwedge Valve Corporation and Trader Properties is for a term of 10 years with a monthly rent of $24,000 per month, which rent is increased by 2% each year for the term of the lease. Hemiwedge Valve Corporation is required to maintain public liability insurance of not less than $1,000,000 during the term of the lease. To secure performance under this lease, Hemiwedge Valve Corporation granted Trader Properties a lien and security interest against all of its’ non-exempt personal property that is in the leased premises Shumate Industries guaranteed payment and performance of the lease pursuant to a Guaranty Agreement. In addition, Shumate Industries agreed to issue Trader Properties a warrant to purchase 100,000 shares of its common stock at an exercise price of $0.25 per share prior to June 15, 2008.

The existing facilities are adequate for our current operations. We anticipate that additional facilities may be leased or purchased as needed and that facilities that are adequate for our needs are readily available.

Item 3. LEGAL PROCEEDINGS

We are not a party to material legal proceedings as of the date of this report. In April 2008, Sunbelt Machine Works threatened litigation against us relating to the to the $150,000 termination payment due under (and in connection with the termination of) that certain Stock Purchase Agreement dated August 17, 2007.  We have failed to make the first 2 installment payments of $37,500 as required under the Stock Purchase Agreement.  The parties are currently in settlement discussions regarding this matter and no lawsuit has been formally filed. We have recorded $178,995 in accrued expenses in our financial statements to reflect this contingency.

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

None.
 
23


PART II
 
Item 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
Our common stock has traded on the OTC Bulletin Board under the symbol “SHMT.OB” since October 20, 2005. Before that date, our common stock traded on the OTC Bulletin Board under the symbol “EXCB.OB” since June 10, 2002. Before that date, our common stock traded on the OTC Bulletin Board under the symbol “GRMA.OB,” and before that, it traded on the OTC Bulletin Board under the symbol “GRMG.OB.” The following table shows the high and low bid prices for our common stock for each quarter since January 1, 2006 as reported by the OTC Bulletin Board. All share prices have been adjusted to provide for the one for seven reverse split which was effected on October 19, 2005 (i.e. they have been increased seven times to compare them to current prices).

We consider our stock to be “thinly traded” and any reported sale prices may not be a true market-based valuation of our stock. Some of the bid quotations from the OTC Bulletin Board set forth below may reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

2006 (OTC Bulletin Board)
 
High Bid
 
Low Bid
 
First quarter
 
$
1.30
 
$
0.65
 
Second quarter
   
1.60
   
0.71
 
Third quarter
   
1.65
   
1.00
 
Fourth quarter
   
1.53
   
0.90
 
               
2007 (OTC Bulletin Board)
   
High Bid
   
Low Bid
 
First quarter
 
$
2.30
 
$
1.17
 
Second quarter
   
2.14
   
1.30
 
Third quarter
   
2.03
   
1.37
 
Fourth quarter
   
1.64
   
0.60
 

As of May 14, 2008 there were 379 record holders of our common stock. This does not include an indeterminate number of shareholders whose shares are held by brokers in street name.

We have not paid cash dividends since our inception and we do not contemplate paying dividends in the foreseeable future. Furthermore, the terms of our line of credit and term loan with Stillwater National Bank prohibit us from declaring or paying dividends or purchasing or redeeming any of our capital stock without the approval of Stillwater National Bank. We anticipate that earnings, if any, will be retained to retire debt and for the operation of our business.

Shares eligible for future sale could depress the price of our common stock and lower the value of your investment. Sales of substantial amounts of our common stock, or the perception that such sales could occur, could adversely affect prevailing market prices for shares of our common stock.
 
24


Securities Authorized for Issuance Under Equity Compensation Plans. The following provides information concerning compensation plans under which our equity securities are authorized for issuance as of December 31, 2007:

   
(a)
 
(b)
 
(c)
 
Plan Category
 
Number of 
securities to be 
issued upon 
exercise of 
outstanding 
options, warrants 
and rights
 
Weighted-average 
exercise price of 
outstanding 
options, warrants 
and rights
 
Number of securities 
remaining available 
for future issuance 
under equity 
compensation plans 
(excluding securities 
reflected in column 
(a))
 
Equity compensation plans approved by security holders (1)(2)
   
1,535,810
 
$
1.42
   
3,683,643
 
Equity compensation plans not approved by security holders (3)(4)(5)(6)
   
120,000
 
$
1.50
   
 
Total
   
1,547,810
 
$
1.43
   
3,683,643
 

(1)
2005 Stock Incentive Plan. On April 29, 2005, our board of directors adopted, and on October 19, 2005, our stockholders approved, our 2005 Stock Incentive Plan. The purpose of the plan is to further align the interests of employees, directors and non-employee consultants with those of the stockholders by providing incentive compensation opportunities tied to the performance of the common stock and by promoting increased ownership of the common stock by such individuals. The plan is also intended to advance the interests of the company and its shareholders by attracting, retaining and motivating key personnel upon whose judgment, initiative and effort the successful conduct of the company’s business is largely dependent. We are permitted to grant awards of stock options, stock awards, and restricted stock awards under the plan. The maximum aggregate number of shares of common stock that may be issued and sold under all awards granted under the plan is 10,000,000 shares, and as of December 31, 2007, we have issued 4,783,690 shares under the plan, and there are options to purchase 1,532,667 shares outstanding under this plan.
 
(2)
2001 Stock Option Plan. On April 8, 2002, we assumed the 2001 Excalibur Holdings, Inc. Stock Option Plan, which was approved by the securities holders of Excalibur Holdings prior to our assumption of the plan. We are authorized to issue options to purchase up to 285,714 shares under this plan. As of December 31, 2007, there were options to purchase 3,143 shares outstanding under this plan.
 
(3)
Individual Option and Warrant Grants. We have granted warrants on an individual basis. We have granted no options on an individual basis. Of the warrants we have granted on an individual basis for compensatory services, there are currently warrants to purchase in the aggregate up to 12,000 shares of our common stock at a weighted average price of $1.50 per share.
 
(4)
Stock Grant Plan. Our board of directors adopted our 2003 Stock Grant Plan on June 25, 2003. The purpose of this plan was to encourage and enable our officers, employees, directors, consultants, advisors, and other key persons upon whose judgment, initiative and efforts we largely depends for the successful conduct of our business to acquire a proprietary interest in us. We were permitted to issue up to 428,157 shares of common stock under this plan, and to date, we had issued 232,063 shares. On April 20, 2006, our board of directors terminated this plan.
 
(5)
Employee Stock Incentive Plan. Our board of directors adopted our 2003 Employee Stock Incentive Plan on July 17, 2003. The purpose of this plan was to allow designated officers and employees of us and our subsidiaries to receive options to purchase our common stock and to receive grants of common stock subject to certain restrictions. We were permitted to issue up to 1,071,429 shares of common stock under this plan, and to date, we issued no shares or options to purchase shares under this plan. On April 20, 2006, our board of directors terminated this plan.

25


(6)
Non-Employee Directors and Consultants Retainer Stock Plan. Our board of directors adopted our 2003 Non-Employee Directors and Consultants Retainer Stock Plan on July 17, 2003. The purposes of this plan was to enable us to promote the interests of us and our stockholders by attracting and retaining non-employee directors and consultants capable of furthering our future success and by aligning their economic interests more closely with those of our stockholders, by paying their retainer or fees in the form of shares of our common stock. We were permitted to issue up to 357,143 shares of common stock under this plan, and to date, we issued no shares under this plan. On April 20, 2006, our board of directors terminated this plan.
 
Recent Sales of Unregistered Securities

1.
On November 1, 2007, we entered into a Note Purchase Agreement with a single accredited investor pursuant to which we issued a $1,000,000 of principal amount of convertible promissory note and a warrant to purchase 200,000 shares of our common stock (the “Purchase Agreement”). The note has a 1 year term and bears interest at ten percent (10%); provided, however, that we are required to prepay the note if we consummate of a subsequent equity financing (as defined) within the next 12 months. Interest is payable monthly in arrears, however we have right to defer any interest payment and accrue same to principal. The note is convertible into our common stock at a fixed conversion price of $1.89. In addition, if we close a subsequent equity financing within the next 12 months, the note holder has the option to convert the outstanding balance of the note into such financing on the same terms as the other investors in such financing.

Under the terms of this note and the related warrant, the note and the warrant are convertible/exercisable by any holder only to the extent that the number of shares of common stock issuable pursuant to such securities, together with the number of shares of common stock owned by such holder and its affiliates (but not including shares of common stock underlying unconverted shares of the note or unexercised portions of the warrants) would not exceed 4.99% of our then outstanding common stock as determined in accordance with Section 13(d) of the Securities Exchange Act of 1934, as amended

The note was issued with a warrant to purchase up to 200,000 shares of our common stock at an exercise price of $1.89 per share, subject to adjustment. The warrant holder may designate a "cashless exercise option." This option entitles the warrant holders to elect to receive fewer shares of common stock without paying the cash exercise price. The number of shares to be determined by a formula based on the total number of shares to which the warrant holder is entitled, the current market value of the common stock and the applicable exercise price of the warrant.

We granted the investor in the offering “piggyback” registration rights for the resale of the shares issuable upon conversion of the note and upon exercise of the warrant.

We relied on the exemption from registration provided by Regulation D and/or Section 4(2) of the Securities Act of 1933, as amended, for the offer and sale of the note and the warrant.

The net proceeds from the financing for working capital and general corporate purposes. An NASD member firm, acted as placement agent in connection with the offering and received $140,000 in commissions. Our net proceeds of this offering after the payment of commissions, fees and other expenses of the offering were approximately $850,000.

2.
In March 2008, we issued $150,000 in 12% demand promissory notes to three accredited investors in equal $50,000 notes. The proceeds were used for working capital and general corporate purposes. The issuance was exempt under Section 4(2) of the Securities Act of 1933, as amended.

3.
In March and April, 2008, we issued $25,000 and $75,000, respectively, 12% demand promissory note to a single investor. The proceeds were used for working capital and general corporate purposes. The issuance was exempt under Section 4(2) of the Securities Act of 1933, as amended.
 
26


Item 6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS

The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and related notes included in this report. This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The statements contained in this report that are not historic in nature, particularly those that utilize terminology such as “may,” “will,” “should,” “expects,” “anticipates,” “estimates,” “believes,” or “plans” or comparable terminology are forward-looking statements based on current expectations and assumptions.

Various risks and uncertainties could cause actual results to differ materially from those expressed in forward-looking statements. Factors that could cause actual results to differ from expectations include, but are not limited to, those set forth under the section “Risk Factors” set forth in this report.

The forward-looking events discussed in this annual report, the documents to which we refer you and other statements made from time to time by us or our representatives, may not occur, and actual events and results may differ materially and are subject to risks, uncertainties and assumptions about us. For these statements, we claim the protection of the “bespeaks caution” doctrine. All forward-looking statements in this document are based on information currently available to us as of the date of this report, and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

General

Shumate Industries is a Texas based energy field services company. Shumate is a holding company that, through its subsidiaries, operates in two principal businesses: contract machining and manufacturing and a valve product line. Shumate seeks to leverage its existing infrastructure, expertise, and customer channels to grow its business and introduce new technologies to the energy markets.

We currently employ 87 people at two plants totaling approximately 90,000 square feet in Conroe, Texas, north of Houston. Our executive offices are located at 12060 FM 3083, Conroe, Texas 77301. Our telephone number is (936) 539-9533 and our Internet address is www.shumateinc.com.

Contract Machining and Manufacturing - Shumate Machine Works, Inc.

Our contract machining and manufacturing division, Shumate Machine Works, Inc., focuses in the energy field services market. We manufacture products, parts, components, and assemblies for our customers designed to their specifications. We provide state of the art 3-D modeling software, computer numeric-controlled, or CNC, machinery and manufacturing expertise to our customers’ research and development, engineering, and manufacturing departments for desired results with their products.  

The diverse line of products we manufacture include the following:

·
Expandable tubular products including liner hangers, launchers and sand screens for energy field service applications;
·
Top drive assemblies, sub-assemblies and spare service parts;
·
Measurement while drilling (MWD) products;
·
Directional drilling products;
·
Completion tools;
·
Exploration products for research and development;
·
Natural gas measurement equipment, including fittings and valves;
·
Power frames for centrifugal pumps and mud motors; and
·
Sub-sea control equipment.

Our investment in capital equipment and software provides us capabilities to perform close tolerance highly specialized work for oil field equipment and tools, process controls, formation evaluation tools, and exploration and production products. Our capabilities include producing large-diameter products and close tolerance machined parts that range up to thirty-four feet in length using a myriad of materials of construction including high grade carbon steel, high grade stainless steel, nickel, and chrome based alloys. We use state of the art, large part CNC equipment in the production of these parts and have developed in-house trade secrets and processes with respect to the manufacture of certain products. We produce complex assemblies, including expandable tubing technology products that are used in field service operations under extreme environmental conditions for oil and gas exploration.

27


Our customers include, without limitation, Baker Hughes, BJ Services Company, Canrig Drilling Technology, a Nabors Industries company, Enventure Global Technologies, FMC Technologies, Halliburton Energy Services, National Oil Well Varco, Oceaneering Intervention Engineering, Shell Development, Smith International, and Weatherford International.

Valve Product Technology - Hemiwedge Valve Corporation

We formed Hemiwedge Valve Corporation as a wholly-owned subsidiary to develop and commercialize a new patented technology addressing what we believe to be a significant opportunity in the global valve market.
Our first product line, known as the Hemiwedge® Cartridge valve, is a quarter-turn hemispherical wedge valve engineered to provide what we believe are substantial technological improvements compared with what is available in the marketplace today, such as traditional butterfly, ball, and gate valve designs.

We believe that the patented design of the Hemiwedge® Cartridge valve combines the benefits of quarter-turn valves with the durability of gate valves. The Hemiwedge® Cartridge valve has a non-rotating core which guides the fluid flow through the valve to the Hemiwedge® itself. This is a hollow hemisphere where the inner and outer walls are slightly offset, having non-concentric centers, producing a hemispherical wedge shape - the “Hemiwedge®.” Operation of the valve rotates the Hemiwedge®, a quarter-turn, moving it between the core and valve seat, thus controlling the flow. We believe that these design features in the combination of the Hemiwedge® shut off and stationary core make the Hemiwedge® Cartridge valve unique.

Reorganization/Debt Forgiveness

On October 19, 2005, we completed a restructuring of our company, resulting in a significant reduction of our outstanding debt and providing us with a strengthened balance sheet and reduced debt servicing requirement. The restructuring was effected through an out-of-court restructuring, or “recapitalization plan,” which consisted of, among other things, a restructuring of debt we owed to Stillwater National Bank, or Stillwater, the issuance of stock in exchange for the cancellation and conversion of debt, the issuance of restricted stock awards, the change of our name to “Shumate Industries, Inc.”, and a 1-for-7 reverse stock split. A detailed description of the restructuring plan is set forth in the Description of Business in our Annual Report on Form 10-KSB as filed with the Securities and Exchange Commission for the year ended December 31, 2005.

As a result of the reorganization, in 2005, we recognized $4,222,743 in debt forgiveness income from Stillwater and $204,414 in debt forgiveness income related to the exchange of the unsecured notes for common stock.

On March 31, 2006, we entered into a First Amendment to Loan Agreement and Guarantor’s Consent with Stillwater National Bank, or Stillwater, pursuant to which Stillwater agreed to forgive $2,000,000 of indebtedness under an amended and restated term promissory note which we had previously delivered to Stillwater in connection with our October 19, 2005 reorganization. In connection with this first amendment, we executed and delivered a new amended and restated term promissory note in the principal face amount of $3,633,053.

The new amended and restated note requires one interest only payment on March 31, 2006, and thereafter, requires us to make 24 equal monthly payments in an amount sufficient to fully amortize principal and interest on the amended and restated note over 84 months. The amended and restated note is due and payable on April 19, 2008, at which time we will be required to make a balloon payment of the entire outstanding principal balance and all accrued interest. The note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets.

28


As a result of this amendment, we recorded debt forgiveness income in the amount of $2,000,000 in the first quarter of 2006.

On April 13, 2006, we entered into a letter agreement with Stillwater National Bank, or Stillwater, pursuant to which Stillwater agreed to accept $500,000 from us in full satisfaction of a secured convertible promissory note in the principal amount of $2,500,000 that we had previously issued to Stillwater in connection with our October 19, 2005 reorganization. Stillwater’s agreement to accept this reduced amount was subject to the following conditions: (i) the $500,000 payment must come from new equity funds and cannot be borrowed or in any way become our obligation or an obligation of our related concerns, (ii) Stillwater will not assign the rights in the note to another party and the terms of the new equity investment must contain no terms which allow the investor(s) of the new equity funds to gain any special benefit resulting from the spread between the $500,000 and the face amount of the note, (iii) the new equity funds must be raised upon terms to the investors no better than those recently approved by Stillwater for dilution of its equity interest, (iv) a breach of (i)-(iii) above will constitute a breach of the reorganization agreement dated October 19, 2005 between us, Stillwater, and other parties, and (iv) payment of the full $500,000 must be made on or before September 1, 2006. On August 9, 2006, the letter agreement was amended to increase the payment by $25,000 to $525,000 if payment is made between September 2, 2006 and December 1, 2006 and by $50,000 to $550,000 if payment is made between December 2, 2006 and March 1, 2007. All other conditions as set forth above remain the same. On December 1, 2006, we delivered $525,000 to Stillwater as full payment of the $2.5 million debenture. In connection with this payment, Stillwater agreed to the cancellation of the entire remaining outstanding principal and approximately $272,000 of accrued interest due and owing under the terms of the debenture at December 1, 2006.

Critical Accounting Policies

Our discussion and analysis of our financial conditions and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of financial statements requires managers to make estimates and disclosures on the date of the financial statements. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition. We use authoritative pronouncements, historical experience, and other assumptions as the basis for making judgments. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant judgments and estimates in the preparation of our consolidated financial statements.

Revenue Recognition

Revenues of Shumate Machine Works are derived primarily from machining of oil field drilling parts, components, and tools for our customers. Shumate Machine Works’ revenue is recognized when persuasive evidence of an arrangement exists, the service or sale is complete, the price is fixed or determinable, and collectibility is reasonably assured. This typically occurs when the order is shipped. Shipping terms are FOB shipping and title passes to the customer at the time the product is shipped. Customers have the right to inspection and acceptance for generally up to five days after taking delivery. Orders may not be returned by customers due to the custom specifications of each product, but rework on items is sometimes necessary if the product was not within the original order specifications. We test all orders against the customer’s order specifications prior to shipment. Customer requests for rework and customer rejection of shipments have been historically low.

Revenues of Hemiwedge Valve Corporation are derived from Hemiwedge® Cartridge valve product sales and an agreement to perform contractual research and development services. The research and development services revenue is recognized as the services are performed and related costs are incurred and recorded. The valve product sales revenue is recognized when persuasive evidence of an arrangement exists, the sale is complete, the price is fixed or determinable, and collectibility is reasonably assured. This typically occurs when the order is shipped. Shipping terms are FOB shipping and title passes to the customer at the time the product is shipped. Customers have the right to inspection and acceptance for generally up to five days after taking delivery.

Accounts Receivable
 
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts represents our estimate of the amount of possible credit losses existing in our accounts receivable. We determine the allowance based on management’s estimate of likely losses based on a review of current open receivables and our historical write-off experience. We review the adequacy of our allowance for doubtful accounts quarterly. Significant individual accounts receivable balances and balances which have been outstanding greater than 90 days are reviewed individually for collectibility. Account balances, when determined to be uncollectible, are charged against the allowance.

29

 
Concentration of credit risk

At December 31, 2007, two customers accounted for 30% of our trade accounts receivable balance. Because management believes that all such amounts are collectible due to the nature of the customers and our collection experience with the payers, we have not recorded an allowance for doubtful accounts for these receivables.

Inventory

Inventory is stated at the lower of cost (first-in, first-out for raw materials and specific job cost for work-in-process and finished goods) or market. Slow-moving inventories are periodically reviewed for impairment in value. Work-in-process and finished goods include labor, materials and production overhead.

Results of Continuing Operations

Basis of Presentation

The results of operations set forth below for the years ended December 31, 2007 and 2006 are those of the continuing operations of Shumate Industries, which include Shumate Machine Works and Hemiwedge Valve Corporation on a consolidated basis.

The following table sets forth, for the periods indicated, certain selected financial data expressed as a percentage of net sales from continuing operations:
 
   
Year Ended
 
   
December 31,
 
   
2007
 
2006
 
Net sales
   
100.0
%
 
100.0
%
Cost of sales
   
(77.7
)
 
(78.2
)
Gross profit
   
22.3
   
21.8
 
               
Selling, general and administrative
   
(70.8
)
 
(44.4
)
Depreciation
   
(2.1
)
 
(1.1
)
Bad debt recovery (expense)
   
-
   
0.3
 
Research and development
   
(19.3
)
 
(9.7
)
Operating loss
   
(69.9
)%
 
(33.1
)%
 
Comparison of the Years ended December 31, 2007 and 2006

Net sales.  Net sales increased by $1,313,732 or an increase of 17% to $9,033,614 for the year ended December 31, 2007 from $7,719,882 for the year ended December 31, 2006.

On a segmental reporting basis, Shumate Machine Works sales increased by $524,961, or an increase of 7%, to $7,928,763 for the year ended December 31, 2007, compared to $7,403,802 for the year ended December 31, 2006. Continued increases in commodity prices, particularly in the energy sector, and activity levels in the energy field services industry resulted in a 30% increase in volume for the products we manufacture. As a result of this increased demand, volumes have increased for Shumate products and components including expandable liner hangers and top drive assemblies. Our customers and market trends such as current rig count and commodities futures prices indicate that this activity level in the energy field services industry will remain in fiscal year 2008.

30


Hemiwedge Valve Corporation sales increased by $788,771, or an increase of 250%, to $1,104,851 for the year ended December 31, 2007, compared to $316,080 for the year ended December 31, 2006. These revenues reflect amounts earned for services completed under the development agreement with At Balance Americas, LLC. as well as Hemiwedge® Cartridge valve sales. Many of our customers entered into trial test programs for our Hemiwedge® Cartridge valve during 2007 and as such, we believe will become larger purchasing customers in 2008 and thereafter. We believe the industrial valve market to continue to grow in 2008 based on peer company announcements and industry forecasts.

Cost of Sales. Consolidated cost of sales increased by $985,524 or 16%, to $7,021,894, for the year ended December 31, 2007, from $6,033,370 for the year ended December 31, 2006. As a percentage of net sales, cost of sales decreased to 77.7% of net sales for the year ended December 31, 2007 versus 78.2% of sales for the year ended December 31, 2006. Cost of sales for Shumate Machine Works increased by $1,011,377, while cost of sales for Hemiwedge Valve Corporation increased by $345,274. Cost of sales includes various allocated overhead items such as facility lease, utilities, and indirect labor costs with related payroll tax and employee benefits expense. The decrease in cost of sales as a percentage of net sales resulted primarily from higher volumes of our products covering more of our fixed costs within cost of sales, partially offset by wage inflation of our direct labor. In 2007, our 30% increase in sales volume covered a 3% increase in our fixed costs and a 29% increase in wage inflation for our direct labor. As a result, we generated a gross profit of $2,011,720, with a gross profit margin of 22.3%, for fiscal 2007. We are focused on increasing revenues and seeking to improve gross margins by generating more sales with higher pricing for Shumate products and components. We believe that continued improvement in the energy markets resulting from higher commodity prices will continue to lead to better pricing, volumes and gross margins.

Selling, general, and administrative. Selling, general and administrative expenses increased by $2,969,061 to $6,396,410 for the year ended December 31, 2007, from $3,427,349 for the year ended December 31, 2006. As a percentage of net sales, selling, general and administrative expenses were 70.8% for the year ended December 31, 2007, as compared to 44.4% for the comparable period in 2006. Our selling, general, and administrative expenses have increased from professional accounting, lawyer and consulting fees associated with public company costs and Sarbanes-Oxley requirements which increased by $369,000 in 2007. Additionally, expenses have increased by $554,000 from higher wage expense relating to executives and sales and marketing personnel hired at Hemiwedge Valve Corporation in connection with the increased operations and activities during 2007. Other increases were related to product advertising, travel and marketing expenses of $247,000 at Hemiwedge Valve Corporation. We also incurred approximately $662,872 in non-cash stock and option awards associated with FASB 123R in the fiscal year ended December 31, 2007. Additionally, we recorded an expense of $333,575 in the quarter ending September 30, 2007 for acquisition related costs associated with the failed acquisition of Sunbelt Machine Works, Inc. Our firm also expensed approximately $374,000 from the cost of our shares issued in connection with the hiring of our investment relations firm. The Board also agreed to indemnify an officer of the Company, and record an accrued expense of approximately $580,000 in connection with a judgment personally assessed on our officer from a previously discharged corporate liability.

Depreciation. Depreciation expense increased by $157.961 to $608,448 for the year ended December 31, 2007 from $450,487 for the year ended December 31, 2006, primarily due to $564,000 of new equipment purchases and $57,000 in leasehold improvements to our Hemiwedge Valve Corporation facility.

Bad debt expense. During the year ended December 31, 2006, we reduced our allowance for bad debts by $20,000, to $40,000. We did not charge off any accounts receivable in the fiscal year ended December 31, 2007.
 
Research and development. Research and development expense increased by $990,795 to $1,741,434 for the year ended December 31, 2007 from $750,639 for the year ended December 31, 2006. We anticipate that we will continue to incur research and development expenses as we continue the development of the Hemiwedge® valve technology and implement additional product forms and applications of the valve technology. We expect that these expenses will include consulting fees, engineering fees, design fees and costs, development fees and costs, third party testing costs, patent and other intellectual property filing costs, legal fees, prototyping costs, costs of new materials, and other research and development costs.

31

 
Operating loss. We incurred an operating loss of $6,318,036 for the year ended December 31, 2007, a increase of $3,764,200 as compared to an operating loss of $2,553,836 for the year ended December 31, 2006.

On a segmental reporting basis, Shumate Machine Works recorded $571,263 in operating income for the year ended December 31, 2007. This operating income resulted from increased revenues at Shumate Machine Works.

Hemiwedge Valve Corporation recorded an operating loss of $3,525,693 for the year ended December 31, 2007. This operating loss was primarily due to the scale -up of the Hemiwedge Valve Corporation operations, including significant expenses of $380,000 for new executives and sales and marketing personnel additions and $38,000 related to recruiting costs. Additionally, we incurred $1,741,434 in research and development expenses.

In addition, we incurred general corporate overhead expenses of $3,363,606 for the year ended December 31, 2007 resulting from the costs of operating a publicly reporting company including $733,000 for accounting, legal and professional fees, for Sarbanes-Oxley consulting costs, filing costs, $530,000 for investor relations and shareholder meeting costs.

We have not reduced our fixed costs or our research and development costs significantly enough to bring them below the revenues we generated in the period. In the event that we successfully commercialize our Hemiwedge® products, we anticipate that increased revenues from the sales of our Hemiwedge® products will improve our results of operations.

Debt forgiveness income. We recognized $2,000,000 in debt forgiveness income during the year ended December 31, 2006 as a result of the amendment of our loan agreement with Stillwater National Bank.

Interest expense. Interest expense increased by $137,453 to $892,748 for the year ended December 31, 2007, from $755,295 for the year ended December 31, 2006. Our interest expense increased due to increased amount of debt from the convertible notes issued in 2007 along with our senior credit facility costs.

Provision for income taxes. We generated a net loss of $7,210,784 for the year ended December 31, 2007 compared to a net loss of $1,309,131 for the year ended December 31, 2006. We have made no provision for income taxes due to our tax loss carry-forward from previous years.

Liquidity and Capital Resources

We have financed our operations, acquisitions, debt service, and capital requirements through cash flows generated from operations, debt financing, capital leases, and issuance of equity securities. We had a working capital deficit of $4,647,597 at December 31, 2007. We had cash of $83,591 as of December 31, 2007, compared to having cash of $1,547,326 at December 31, 2006.

We used $4,475,529 of net cash in operating activities for the year ended December 31, 2007, compared to using $1,885,632 in the year ended December 31, 2006. Cash used in operating activities is primarily due to an increase in inventory of $365,000 and $220,000 in other assets This was offset by non-cash charges of $608,000 for amortization and depreciation and $1,346,000 for issuances of stock, stock options and warrants.

Net cash flows used in investing activities was $450,849 for the year ended December 31, 2007, compared to $895,087 in the year ended December 31, 2006. Cash of $388,773 was used for the purchase of property and equipment and $62,076 was used for patent investments.

Net cash flows provided by financing activities were $3,462,643 for the year ended December 31, 2007, compared to net cash provided by financing activities of $4,113,827 in the year ended December 31, 2006. Cash provided by financing activities is primarily due to proceeds from notes payable of $3,300,000, offset by payments on notes payable of $460,473 and net decrease in draws on bank credit line of $14,310.

32

 
Bank Credit Facility

The primary source of our financing has been our credit facility with Stillwater National Bank. Our credit facility with Stillwater National Bank was restructured on October 19, 2005 and further amended as set forth below.

On February 8, 2007 and effective January 19, 2007, we renewed our $1,000,000 secured revolving line of credit facility with Stillwater. The amount we can borrow on the line of credit subject to qualifying accounts receivable and inventory. The advances available under the line of credit are limited to a borrowing base of the sum of (a) 85% of eligible accounts receivable, and (b) 50% of eligible inventory. The line of credit bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets. The line of credit expires on April 19, 2008.
 
On January 25, 2008, we entered into an Amended and Restated Loan Agreement with Stillwater National Bank and Trust Company (the “Amended Loan Agreement”.). On October 19, 2005 we entered into that certain Agreement (as reported in our Current Report on Form 8-K dated October 19, 2005) with Stillwater, which Agreement was amended by a certain First Amendment to Agreement and Guarantors’ Consent dated October 19, 2006, as amended by a certain Second Amendment to Agreement dated effective January 19, 2007 (collectively, the “Prior Agreement”).

The Amended Loan Agreement amends and restates the Prior Agreement as follows:
 
1. Term Loan. Our prior Term Note dated October 19, 2005 in favor of Stillwater had an outstanding principal balance of $3,003,998 (as of January 25, 2008) and a maturity date of April 19, 2008. Stillwater loaned us (along with our co-borrowers Shumate Machine Works, Inc. and Hemiwedge Valve Corporation) $3,329,000 pursuant to a new term note dated January 25, 2008, which funds advanced under the new term note were used to refinance the old term note and provide working capital. The new term note requires us to make 26 equal monthly payments (beginning on February 28, 2008) in an amount sufficient to fully amortize principal and interest on the amended and restated note over 64 months. The new term note is due and payable on April 19, 2010. The new term note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets as well as a security interest in certain personal assets of Larry Shumate.

2. Revolving Loan. Our prior revolving promissory note dated October 19, 2005 in favor of Stillwater, had an outstanding principal balance of $893,676 (as of January 25, 2008) and a maturity date of April 19, 2008. Stillwater loaned us (and the other co-borrowers set forth above) $1,000,000 pursuant to a new revolving promissory note dated January 25, 2008, which funds advanced under the new revolving promissory were used to refinance the old revolving promissory note and provide working capital. The initial balance on the line of credit was equal to the balance of our prior line of credit with Stillwater ($893,676 principal balance as of January 25, 2008). The advances available under the new revolving promissory note are limited to a borrowing base of the sum of (a) 85% of eligible accounts receivable, and (b) 50% of eligible inventory. The new revolving promissory note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of our existing and future assets as well as a security interest in certain personal assets of Larry Shumate. On the 28th day of each month, beginning January 28, 2008, we will pay all interest accrued on the new revolving promissory note. The amount we can borrow on the line of credit is subject to qualifying accounts receivable and inventory. The new revolving promissory note will mature and become fully due and payable on April 19, 2009.

The loan documents for the Stillwater line of credit and term loan require us to meet certain financial ratios and tests. Stillwater issued waivers under the original credit facility for periods tested where were not in compliance with certain covenants thereunder. However, we have not received a waivers for the March 31, 2008 period under the Amended Stillwater Credit Facility where we were not in compliance with certain covenants thereunder. As of the date of this report, we have not received a notice of default from Stillwater. Should Stillwater decide to declare a default, it would result in an acceleration of the related debt and could result in Stillwater foreclosing on our assets.

Convertible Promissory Notes
 
Since July 1, 2007, we have sold $3,050,000 of principal amount of convertible promissory notes with warrants to purchase 610,000 shares of its common stock to accredited investors. The notes have a 1 year term and bear interest at ten percent (10%); provided, however, that we are required to prepay the note if we consummate a subsequent equity financing (as defined) within the next 12 months. Interest is payable monthly in arrears; however, we have the right to defer any interest payment and accrue same to principal. The notes are convertible into our common stock at a fixed conversion price of $1.89. In addition, if we close a subsequent equity financing within the next 12 months, the note holders have the option to convert the outstanding balance of such note into such financing on the same terms as the other investors in such financing.

33

 
Under the terms of the notes and the related warrants, the notes and the warrants are convertible/exercisable by any holder only to the extent that the number of shares of common stock issuable pursuant to such securities, together with the number of shares of common stock owned by such holder and its affiliates (but not including shares of common stock underlying unconverted shares of the note or unexercised portions of the warrants) would not exceed 4.99% of our then outstanding common stock as determined in accordance with Section 13(d) of the Securities Exchange Act of 1934, as amended.
 
The notes were issued with warrants to purchase up to 610,000 shares of our common stock at an exercise price of $1.89 per share, subject to adjustment. The warrant holders may designate a “cashless exercise option.” This option entitles the warrant holders to elect to receive fewer shares of common stock without paying the cash exercise price. The number of shares to be determined by a formula based on the total number of shares to which the warrant holder is entitled, the current market value of the common stock and the applicable exercise price of the warrant.
 
Shumate determined that the conversion feature of the note and the warrants issued were not derivative instruments pursuant to SFAS No. 133, Accounting for Derivatives, as amended. Under the provisions of EITF Issue 98-5, Shumate estimated that fair value of the beneficial conversion feature and warrants at the issuances of the notes using Black-Scholes option pricing model to exceed the principal vale of the note. The resulting discount of $552,495 is being amortized over the life of the notes using the effective interest method. The amortized amount for the year ended December 31, 2007 is $187,589.
 
We granted the investors in the offering registration rights for the resale of the shares issuable upon conversion of the note and upon exercise of the warrant. To the extent that all such shares are not registered pursuant to the granted piggyback registration rights, Shumate agreed to register the remaining underlying shares, if any, by January 6, 2008. We accrued approximately $26,000 at December 31, 2007 for estimated liquidated damages penalties expected to be due such investors for failure to timely register their shares as required under the registration rights agreement.
 
We used the net proceeds from the financing for working capital and general corporate purposes. An NASD member firm acted as primary placement agent in connection with the offering and received $210,000 in commissions while another NASD member firm received $5,000 in placement agent fees. . In addition, another $10,000 in legal fees were incurred. The net proceeds of this offering after the payment of commissions, fees and other expenses of the offering were approximately $2,825,000.
 
Liquidity and Capital Requirements

In 2005, we successfully restructured our outstanding indebtedness with Stillwater National Bank and our unsecured creditors. In addition, we have seen an increase in pricing for our oil and gas drilling products and components, which allowed us to generate gross profits since the third quarter of 2005, as discussed within this report. Even with these improvements in our capital structure and results of operations, we are still operating on a net loss basis, and we will need to continue to service our debt obligations from our continuing operations.

In addition, we have a $1,000,000 secured revolving line of credit facility, subject to qualifying accounts receivable and inventory, with Stillwater National Bank. The outstanding balance on this line of credit was approximately $526,206 at May 14, 2008, and at the time, $1,000,000 was the maximum allowed due to the amount of the qualifying accounts receivable and inventory, also referred to as our borrowing base. The outstanding balance on the line of credit and the borrowing base fluctuate based on our available working capital, our qualifying accounts receivable and inventory, and at various points in time we may have the ability to borrow additional funds on this line of credit.

As of the date of this report, we do not believe that we will be able to fund our operations, working capital requirements, and debt service requirements in Shumate Machine Works through fiscal year 2008 through existing working capital and cash flows generated from operations, although our working capital position may fluctuate depending on the timing of our receipt of research and development milestone payments under the Hemiwedge Valve Corporation’s development agreement with At Balance Americas, LLC. It is possible that we may not achieve any further milestones set forth in the development agreement, in which case our working capital will be materially compromised.

34

 
In addition, we have completed the beta development of the Hemiwedge® Cartridge valve technology and have commenced the commercialization of the Hemiwedge® Cartridge valve product. We have funded the initial launch of the Hemiwedge® valve products through existing working capital, cash flows generated from operations, the equity raises completed in 2006, the proceeds from the exercise of warrants in March 2007, and the convertible debt raise referenced above. Our revolving line of credit does not allow permit us to borrow against inventory and accounts receivable of Hemiwedge Valve Corporation. Additionally, our existing working capital and cash flows generated from operations will not be sufficient to conduct full implementation of the Hemiwedge® Cartridge valve product line.

Accordingly, we will need to finance our operations through additional bank borrowings under our Stillwater line of credit or other capital financings. Since our collateral may not be sufficient to borrow additional amounts under the Stillwater line of credit at such time, particularly since we may not borrow against Hemiwedge accounts receivable or inventory under our current line of credit, we will need to seek additional debt or equity financing, in the form of a private placement or a public offering, a strategic alliance, or a joint venture. Such additional financing, alliances, or joint venture opportunities might not be available to us, when and if needed, on acceptable terms or at all. If we are unable to obtain additional financing in sufficient amounts or on acceptable terms under such circumstances, our operating results and prospects could be adversely affected. In addition, any debt financings or significant capital expenditures require the written consent of our lender, Stillwater National Bank.

Our management has also contemplated monetizing certain assets to address our capital needs. Presently, the assets held by our Shumate Machine Works subsidiary are one opportunity available for sale which we are considering to address our capital needs. As such, our management is currently searching for suitable acquisition partners to purchase all, or substantially all of the assets of Shumate Machine Works on an informal basis. Such a sale, if consummated, could enable us to retire our senior debt. This, coupled with the continued growth of our Hemiwedge® valve product lines, could result in the remaining company being a more attractive candidate for additional future debt and/or equity financing.

In addition, we have initiated a formal search program for other technology-oriented products or companies, targeting complementary market segments. The acquisition of such products may also require us to obtain additional debt or equity financing, and we may issue our common stock as all or part of the purchase price for any such acquisition.

We may continue to incur operating losses if the energy field services market deteriorates or softens. Such losses could require us to renegotiate our affirmative covenants with our lender, including the liquidity ratio and debt service ratios. Our ability to comply with these covenants in the future will depend on whether we can obtain additional capital financing or increase our cash flows from operations.

In addition to the 2005 recapitalization and fiscal 2006 and 2007 equity and convertible debt financings, we anticipate that, due in part to increasing energy prices, demand for our energy related field service products will continue to increase in the coming fiscal year. The fiscal 2005 reorganization, debt restructuring during 2005 and 2006, equity and convertible debt financings during 2006 and 2007, operating expense reductions, and our intent to capitalize on anticipated increase in demand are the steps that we have been taking to try to return to profitability.  However, it is possible that none of these steps will be completed and that we may never return to profitability.

We intend to retain any future earnings to retire debt, finance the expansion of our business and any necessary capital expenditures, and for general corporate purposes. All of our bank debt contains restrictions as to the payment of dividends.
 
35


Off-Balance Sheet Arrangements

None.
 
36


Item 7. FINANCIAL STATEMENTS
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors
Shumate Industries, Inc.
Conroe, Texas
 
We have audited the accompanying consolidated balance sheets of Shumate Industries, Inc., as of December 31, 2007 and 2006 and the related consolidated statements of operations, changes in stockholders’ equity (deficit) and cash flows for the years ended December 31, 2007and 2006. These consolidated financial statements are the responsibility of Shumate’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatements. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Shumate as of December 31, 2007 and 2006 and the results of its consolidated operations and its consolidated cash flows for the periods described in conformity with accounting principles generally accepted in the United States of America.
 
As discussed in Note 2 to the consolidated financial statements, the accompanying consolidated financial statements have been prepared assuming that Shumate will continue as a going concern. Shumate requires significant amount of cash in its operations and does not have sufficient cash to fund its operations for the next twelve months, which raises substantial doubt about its ability to continue as a going concern. Management’s plans regarding those matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
MALONE & BAILEY, PC
www.malone-bailey.com
Houston, Texas

June 2, 2008

37


SHUMATE INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS
 
   
December 31,
 
December 31,
 
   
2007
 
2006
 
ASSETS
             
Current assets:
             
Cash and cash equivalents
 
$
83,591
 
$
1,547,326
 
Accounts receivable, net of allowance for doubtful accounts of $40,000 and $40,000
   
502,383
   
554,134
 
Inventory
   
1,259,166
   
893,650
 
Prepaid expense and other current assets
   
497,245
   
198,753
 
               
Total current assets
   
2,342,385
   
3,193,863
 
               
Fixed assets, net of accumulated depreciation of $2,502,132 and $1,922,242
   
2,376,061
   
2,303,372
 
Patents, net of accumulated amortization of $58,078 and $29,038
   
340,366
   
307,331
 
Deposits
   
84,320
   
104,140
 
               
Total assets
 
$
5,143,132
 
$
5,908,706
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
             
Current liabilities:
             
Accounts payable
 
$
1,065,656
 
$
652,980
 
Accounts payable - related party
   
105,000
   
-
 
Accrued expenses
   
1,548,504
   
435,234
 
Deferred revenue
   
-
   
400,000
 
Current portion of notes payable - other
   
8,798
   
75,370
 
Current portion of capital lease obligation
   
51,586
   
31,924
 
Current portion of equipment notes payable
   
5,578
   
-
 
Current portion of convertible notes payable, net of discount of $364,290
   
2,800,535
   
-
 
Current portion of term note payable - T Swift
   
250,000
   
-
 
Current portion of term note payable - Stillwater National Bank
   
389,719
   
480,565
 
Line of credit - Stillwater National Bank
   
764,606
   
778,916
 
               
Total current liabilities
   
6,989,982
   
2,854,989
 
               
Long term liabilities:
             
Long term portion of capital lease obligation
   
-
   
51,838
 
Long term portion of equipment notes payable
   
24,479
   
-
 
Term note payable - Stillwater National Bank
   
2,614,279
   
2,883,392
 
               
Total long term liabilities
   
2,638,758
   
2,935,230
 
               
Total liabilities
   
9,628,740
   
5,790,219
 
               
Commitments and contingencies
   
-
   
-
 
               
Stockholders' equity (deficit)
             
Preferred stock, $.001 par value, 10,000,000 shares authorized, no shares issued or outstanding
   
-
   
-
 
Common stock, $.001 par value, 50,000,000 shares authorized, 20,578,071 and 19,322,277 shares issued and outstanding
   
20,578
   
19,322
 
Additional paid-in-capital
   
22,581,595
   
20,015,762
 
Deferred compensation
   
-
   
(39,600
)
Accumulated deficit
   
(27,087,781
)
 
(19,876,997
)
               
Total stockholders' equity (deficit)
   
(4,485,608
)
 
118,487
 
               
Total liabilities and stockholders' equity (deficit)
 
$
5,143,132
 
$
5,908,706
 
 
See summary of accounting policies and accompanying notes to consolidated financial statements
 
38


SHUMATE INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
 
   
For the Years
 
   
ended December 31,
 
   
2007
 
2006
 
           
REVENUES
 
$
9,033,614
 
$
7,719,882
 
               
COST OF REVENUES
             
Cost of revenues
   
6,605,358
   
5,665,243
 
Depreciation expense
   
416,536
   
368,127
 
               
Total cost of revenues
   
7,021,894
   
6,033,370
 
               
GROSS PROFIT
   
2,011,720
   
1,686,512
 
               
OPERATING EXPENSES:
             
Selling, general and administrative
   
6,396,410
   
3,427,349
 
Depreciation expense
   
191,912
   
82,360
 
Bad debt expense (recovery)
   
-
   
(20,000
)
Research and development
   
1,741,434
   
750,639
 
               
Total operating expenses
   
8,329,756
   
4,240,348
 
               
LOSS FROM OPERATIONS
   
(6,318,036
)
 
(2,553,836
)
               
OTHER INCOME (EXPENSE)
             
Debt forgiveness income
   
-
   
2,000,000
 
Interest expense
   
(892,748
)
 
(755,295
)
               
NET LOSS
 
$
(7,210,784
)
$
(1,309,131
)
               
Basic net income (loss) per share
 
$
(0.36
)
$
(0.09
)
Diluted net income (loss) per share
   
(0.36
)
 
(0.09
)
               
Weighted average shares outstanding-Basic
   
20,061,282
   
15,367,674
 
Weighted average shares outstanding-Diluted
   
20,061,282
   
15,367,674
 

See summary of accounting policies and accompanying notes to consolidated financial statements
 
39


SHUMATE INDUSTRIES, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
For the Years Ended December 31, 2007 and 2006
 
           
Additional
             
   
Common Stock
 
Paid-In
 
Deferred
 
Accumulated
     
   
Shares
 
Par
 
Capital
 
Compensation
 
Deficit
 
Total
 
                           
Balances at December 31, 2005
   
12,116,394
 
$
12,116
 
$
12,278,742
 
$
-
 
$
(18,567,866
)
$
(6,277,008
)
                                       
Common stock issued for services
   
85,000
   
85
   
99,415
   
-
   
-
   
99,500
 
Common stock issued for cash
   
7,120,883
   
7,121
   
5,590,429
   
-
   
-
   
5,597,550
 
Costs of raising capital
   
-
   
-
   
(537,538
)
 
-
   
-
   
(537,538
)
Options and warrants issued
   
-
   
-
   
337,075
   
-
   
-
   
337,075
 
Related party debt forgiveness
   
-
   
-
   
2,247,639
   
-
   
-
   
2,247,639
 
Deferred compensation
   
-
   
-
   
-
   
(39,600
)
 
-
   
(39,600
)
                                       
Net loss
   
-
   
-
   
-
   
-
   
(1,309,131
)
 
(1,309,131
)
                                       
Balances at December 31, 2006
   
19,322,277
   
19,322
   
20,015,762
   
(39,600
)
$
(19,876,997
)
 
118,487
 
                                       
Common stock issued for cash
   
680,520
   
681
   
769,079
               
769,760
 
Common stock issued for services
   
480,050
   
480
   
643,377
               
643,857
 
Costs of raising capital
               
(132,333
)
             
(132,333
)
Cashless exercise of warrants
   
95,224
   
95
   
(95
)
             
-
 
Options and warrants issued
               
733,310
               
733,310
 
Discount on beneficial conversion feature related to convertible notes payable
               
552,495
               
552,495
 
Deferred compensation
                     
39,600
         
39,600
 
                                       
Net loss
                               
(7,210,784
)
 
(7,210,784
)
                                       
Balances at December 31, 2007
   
20,578,071
 
$
20,578
 
$
22,581,595
 
$
-
 
$
(27,087,781
)
$
(4,485,608
)

See summary of accounting policies and accompanying notes to consolidated financial statements
 
40



SHUMATE INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2007 and 2006
 
   
2007
 
2006
 
           
CASH FLOWS FROM OPERATING ACTIVITIES:
             
Net loss
 
$
(7,210,784
)
$
(1,309,131
)
Adjustments to reconcile net loss to net cash used in operating activities:
             
Debt forgiveness income
   
-
   
(2,000,000
)
Depreciation and amortization expense
   
608,448
   
450,487
 
Bad debt expense (recovery)
   
-
   
(20,000
)
Amortization of beneficial conversion feature discount
   
187,589
   
-
 
Stock-based compensation
   
1,346,332
   
396,975
 
Changes in:
             
Accounts receivable
   
51,751
   
425,782
 
Inventory
   
(365,516
)
 
(611,550
)
Other assets
   
(220,133
)
 
(107,111
)
Accounts payable
   
412,673
   
189,839
 
Accounts payable - related party
   
105,000
   
-
 
Accrued expenses
   
1,009,111
   
299,077
 
Deferred revenue
   
(400,000
)
 
400,000
 
Net cash used in operating activities
   
(4,475,529
)
 
(1,885,632
)
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
Purchase of fixed assets
   
(388,773
)
 
(916,735
)
Proceeds from sale of fixed assets
   
-
   
75,000
 
Purchase of patents
   
(62,076
)
 
(53,352
)
Net cash used in investing activities
   
(450,849
)
 
(895,087
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
Net change in bank credit line
   
(14,310
)
 
(58,699
)
Payments on notes payable
   
(100,514
)
 
(887,486
)
Payments on notes payable - related party
   
(359,959
)
 
-
 
Proceeds from notes payable
   
3,300,000
   
-
 
Proceeds from sales of common stock, net of offering cost
   
637,426
   
5,060,012
 
Net cash provided by financing activities
   
3,462,643
   
4,113,827
 
               
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
   
(1,463,735
)
 
1,333,108
 
               
CASH AND CASH EQUIVALENTS, beginning of period
   
1,547,326
   
214,218
 
               
CASH AND CASH EQUIVALENTS, end of period
 
$
83,591
 
$
1,547,326
 
               
Supplemental disclosures:
             
Cash paid for income taxes
 
$
-
 
$
-
 
Cash paid for interest
   
422,712
   
500,302
 
               
Non-cash investing and financing transactions:
             
Cashless exercise of options
   
97,500
   
-
 
Note payable for purchase of fixed assets
   
31,823
   
-
 
Accrued interest on bridge loan
   
115,441
   
-
 
Discount on warrants
   
413,571
       
Discount for beneficial conversion feature related to convertible notes payable
   
138,924
   
-
 
Amount accrued for purchase of fixed assets
   
231,500
   
-
 
Related party debt foregiveness income
   
-
   
2,247,639
 

See summary of accounting policies and accompanying notes to consolidated financial statements
 
41


SHUMATE INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF ACCOUNTING POLICIES

Description of Business. Shumate Industries, Inc. (“Shumate”) is a Texas based energy field services company. Shumate is a holding company that, through its subsidiaries, operates in two principal businesses: Shumate Machine Works, Inc. (“Shumate Machine”), a contract machining and manufacturing company, and Hemiwedge Valve Corporation (“Hemiwedge”), a company formed to launch a proprietary valve product line. Shumate seeks to leverage its existing infrastructure, expertise, and customer channels to grow its business and introduce new technologies to the energy markets.

Basis of Presentation. The consolidated financial statements include the accounts of Shumate and its wholly-owned subsidiaries, Shumate Machine and Hemiwedge. Significant inter-company accounts and transactions have been eliminated.

Reclassifications. Certain amounts in the consolidated financial statements of the prior year have been reclassified to conform to the presentation of the current year for comparative purposes.

Use of Estimates in Financial Statement Preparation. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition. Revenues of Shumate Machine are derived primarily from machining of oil field drilling parts, components and tools. All revenue is recognized when persuasive evidence of an arrangement exists, the service or sale is complete, the price is fixed or determinable and collectibility is reasonably assured. This typically occurs when the order is shipped. Shipping terms are FOB shipping and title passes to the customer at the time the product is shipped. Customers have the right to inspection and acceptance for generally up to five days after taking delivery. Returns are not accepted due to the custom specifications of each product, but rework on items is necessary if the product was not within the original order specifications. Customer requests for rework and customer rejection of shipments has been historically low.

Revenues of Hemiwedge Valve Corporation are derived from Hemiwedge® Cartridge valve product sales and an agreement to perform contractual research and development services. The research and development services revenue is recognized as the services are performed and related costs are incurred and recorded. The valve product sales revenue is recognized when persuasive evidence of an arrangement exists, the sale is complete, the price is fixed or determinable, and collectibility is reasonably assured. This typically occurs when the order is shipped. Shipping terms are FOB shipping and title passes to the customer at the time the product is shipped. Customers have the right to inspection and acceptance for generally up to five days after taking delivery.

Cash and Cash Equivalents. For purposes of the statements of cash flows, cash equivalents include all highly liquid investments with original maturities of three months or less.

Allowance for Doubtful Accounts. Bad debt expense is recognized based on management’s estimate of likely losses per year, based on past experience and an estimate of current year uncollectible amounts. The allowance was $40,000 and $40,000 as of December 31, 2007 and December 31, 2006, respectively.

Inventory. Inventory is stated at the lower of cost (first-in, first-out for raw materials and specific job cost for work-in-process and finished goods) or market. Slow-moving inventories are periodically reviewed for impairment in value. Work-in-process and finished goods include labor, materials and production overhead.

Property and Equipment. Property and equipment is valued at cost. Additions are capitalized and maintenance and repairs are charged to expense as incurred. Gains and losses on dispositions of equipment are reflected in operations.

42


Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which are three to twelve years.

Patents. Patents are initially measured based on their fair values. Patents are being amortized on a straight-line basis over a period of 8 to 10 years and are stated net of accumulated amortization at $58,078 and $29,038 at December 31, 2007 and 2006, respectively. Amortization expense of $29,041 and $29,041 was charged to operations during 2007 and 2006, respectively.

Impairment of Long-Lived Assets. Shumate reviews the carrying value of its long-lived assets annually or whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be appropriate. Shumate assesses recoverability of the carrying value of the asset by estimating the future net cash flows expected to result from the asset, including eventual disposition. If the future net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and fair value.

Income Taxes. Income tax expense is based on reported earnings before income taxes. Deferred income taxes reflect the impact of temporary differences between assets and liabilities recognized for consolidated financial reporting purposes and such amounts recognized for tax purposes, and are measured by applying enacted tax rates in effect in years in which the differences are expected to reverse.

Stock-Based Compensation. Effective January 1, 2006, Shumate began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to January 1, 2006, Shumate had accounted for stock options according to the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value. Shumate adopted the modified prospective transition method provided for under SFAS No. 123R, and, consequently, have not retroactively adjusted results from prior periods.

There were 991,000 and 805,000 options issued to employees and non-employee directors during the year ending December 31, 2007 and 2006, respectively. See Note 13 for details.

Accounting for Derivative Instruments. Shumate does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks. Shumate evaluates all of it financial instruments under the application of SFAS 133 and EITF 00-19 to determine if such the financial instruments are derivatives or contain features that qualify as embedded derivatives. There are no derivative instruments outstanding as of December 31, 2007 and 2006.

Basic and Diluted Net Income per Share. Basic loss per share is computed using the weighted average number of shares of common stock outstanding during each period. Diluted loss per share includes the dilutive effects of common stock equivalents on an “as if converted” basis. For the years ended 2007 and 2006, potential dilutive securities had an anti-dilutive effect and were not included in the calculation of diluted net loss per common share.

Research and Development. All costs for research and development activities are expensed as incurred.

Recently Issued Accounting Pronouncements. In September 2006, the FASB issued FASB Statement No. 157, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, and is effective for fiscal years beginning after November 15, 2007.

Shumate does not expect the adoption of this or any other recently issued accounting pronouncements to have a significant impact on their consolidated financial position, results of operations, or cash flows.
 
43


NOTE 2 - GOING CONCERN

As shown in the accompanying consolidated financial statements, Shumate incurred recurring losses from operations of $5,711,806 and $2,553,836 in 2007 and 2006, respectively, and has an accumulated deficit of $27,087,780. These conditions raise substantial doubt as to Shumate’s ability to continue as a going concern. To address these concerns, Shumate has raised proceeds of approximately $3,050,000 through a convertible note private offering in 2007. Additionally, Shumate has sought recapitalization in debt or equity during 2008, however there can be no assurance that it will successfully recapitalize. In addition, management is trying to continue to increase Shumate’s revenues and improve its results of operations to a level of profitability including revenues and cash flow from the Hemiwedge Valve Corporation subsidiary. New sales representative agreements have been executed during 2008 to assist in the sales and marketing efforts to improve our results of operations. As of the date of this report, Shumate believes that it will not be able to fund its operations, working capital requirements, and debt service requirements through fiscal year 2008 through cash flows generated by operations. Management may also seek to raise additional capital in the future if Shumate’s results of operations do not continue to improve or if the need otherwise arises. The financial statements do not include any adjustments that might be necessary if Shumate is unable to continue as a going concern.
 
NOTE 3 - SEGMENT INFORMATION

Shumate’s reportable segments consist of its contract machining and manufacturing entity, Shumate Machine Works, and its valve product technology entity, Hemiwedge Valve Corporation. Segment financial information is summarized as follows:

 
 
Shumate
 
Hemiwedge
 
Corporate
 
 
 
Year Ended December 31, 2007
 
Machine Works
 
Valve Corp.
 
Allocation
 
Total
 
Revenues
 
$
7,928,763
 
$
1,104,851
 
$
-
 
$
9,033,614
 
Cost of revenues
   
6,456,678
   
565,216
   
-
   
7,021,894
 
Gross profit
   
1,472,085
   
539,635
   
-
   
2,011,720
 
Interest expense
   
547,845
   
7,841
   
337,062
   
892,748
 
Depreciation and amortization
   
373,909
   
234,539
   
-
   
608,448
 
Net income (loss)
   
23,419
   
(3,533,534
)
 
(3,700,669
)
 
(7,210,784
)
Total assets
   
2,736,478
   
2,177,155
   
229,499
   
5,143,132
 
Expenditures for long-lived assets
   
495,029
   
219,625
   
-
   
714,654
 
                           
 
 
 
Shumate
 
 
Hemiwedge
 
 
Corporate
 
 
 
 
Year Ended December 31, 2006
 
 
Machine Works
 
 
Valve Corp.
 
 
Allocation
 
 
Total
 
Revenues
 
$
7,403,802
 
$
316,080
 
$
-
 
$
7,719,882
 
Cost of revenues
   
5,813,428
   
219,942
   
-
   
6,033,370
 
Gross profit
   
1,597,217
   
89,295
   
-
   
1,686,512
 
Interest expense
   
501,271
   
4,681
   
249,343
   
755,295
 
Depreciation and amortization
   
369,557
   
80,930
   
-
   
450,487
 
Debt forgiveness income
   
2,000,000
   
-
   
-
   
2,000,000
 
Net income (loss)
   
2,052,936
   
(1,984,776
)
 
(1,377,291
)
 
(1,309,131
)
Total assets
   
3,181,994
   
1,873,883
   
852,829
   
5,908,706
 
Expenditures for long-lived assets
   
284,173
   
685,914
   
-
   
970,087
 
 
44

 
NOTE 4 - RESEARCH AND DEVELOPMENT CONTRACT

In July 2006, Hemiwedge Valve Corporation entered into an agreement with At Balance Americas, LLC, a Houston-based Managed Pressure Drilling, or MPD, services company. At Balance Americas, LLC is an affiliate of Shell Technology Ventures, a leading energy-focused venture capital firm with offices in Houston, Texas. At Balance is not a related party and the development agreement was negotiated on an arm’s length basis. The agreement provides Hemiwedge Valve Corporation with funding of up to $1.4 million and expertise to develop a down-hole isolation valve, or DIV, using our Hemiwedge® valve technology. The contract includes three major phases with partial funding in advance of each phase, and progress payments throughout each phase. The table below includes revenue and expenses recognized by Hemiwedge Valve Corporation during the respective years ended December 31.

   
2007
 
2006
 
           
Contractual Research and Development Revenue
 
$
1,084,629
 
$
-
 
               
Contractual Research and Development Expense
   
347,727
   
-
 
               
Payments Received
   
495,219
   
400,000
 
 
NOTE 5 - PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at December 31, 2007 and 2006:

Description
 
Life
 
2007
 
2006
 
               
Shop equipment
   
5-12 years
 
$
4,281,177
 
$
3,786,624
 
Other equipment and furniture
   
3 years
   
317,912
   
224,823
 
Leasehold improvements
   
5 years
   
279,104
   
214,167
 
                     
           
4,878,193
   
4,225,614
 
Less: accumulated depreciation
         
(2,502,132
)
 
(1,922,242
)
                     
Property and equipment, net
       
$
2,376,061
 
$
2,303,372
 
 
Depreciation expense in continuing operations totaled $608,448 and $450,487 in 2007 and 2006, respectively.

NOTE 6 - INTELLECTUAL PROPERTY

On December 5, 2005, Shumate acquired $238,500 the intellectual property rights to the HemiwedgeÒ line of products, including the HemiwedgeÒ valve, from Soderberg Research and Development, Inc. and certain of its affiliates. Shumate contributed these intellectual property rights to Hemiwedge as a capital contribution. The intellectual property rights acquired consist of all patents, trademarks, and the internet website relating to the HemiwedgeÒ product line. The aggregate consideration paid for the intellectual property rights consisted of $138,500 in cash and a two-year six percent promissory note in the principal amount of $100,000, payable in 24 equal installments of principal and interest. In addition, Shumate agreed to deposit (a) $72,000 into an escrow account, the property of Soderberg Research Inc., to be paid in the form of a monthly advance in the amount of $3,000 for each month of the 24 month period beginning in January 2006 and (b) three percent of the net sales proceeds collected from customers from (i) gross revenue from sales of products to which the acquired intellectual property relates, less (ii) sales and/or use taxes, import and/or export duties, outbound transportation costs, and amounts allowed or credited due to returns, which payments shall begin two years after December 2005 and continue until March 29, 2013. The $72,000 in monthly advances shall be credited against the three percent of the net sales proceeds. Amortization expense in continuing operations totaled $29,042 and $29,038 in 2007 and 2006, respectively.
 
45

 
NOTE 7 - NOTES PAYABLE - STILLWATER NATIONAL BANK

   
2007
 
2006
 
$1,000,000 line of credit with Stillwater National Bank secured by a first priority security interest in all of Shumate’s existing and future assets. The line of credit bears interest at a rate equal to the prime rate plus two percent. The advances available under the line of credit are limited to a borrowing base of the sum of (a) 80% of eligible accounts receivable, and (b) 50% of eligible inventory. This line of credit is secured by a first priority security interest in all of Shumate’s existing and future assets. The line of credit was amended January 25, 2008.
 
$
764,606
 
$
778,916
 
               
$3,633,053 term note dated March 31, 2006 with Stillwater National Bank. The note is an amendment and restatement of a promissory note in the original amount of $5,633,053 delivered to Stillwater in connection with the October 19, 2005 reorganization (at which time Stillwater was not considered a related party), and reflects $2,000,000 of debt forgiveness by Stillwater agreed to at the time of the October 2005 reorganization. The note requires one interest only payment on March 31, 2006, and thereafter requires Shumate to make 24 equal monthly payments in an amount sufficient to fully amortize principal and interest on the note over 84 months. The note is due and payable on April 19, 2008, at which time Shumate will be required to make a balloon payment of the entire outstanding principal balance and all accrued interest. The note bears interest at a rate equal to the prime rate plus two percent, and it is secured by a first priority security interest in all of Shumate’s existing and future assets. The term note was amended January 25, 2008.
   
3,003,998
   
3,363,957
 
               
Total
 
$
3,768,604
 
$
4,142,873
 
 
NOTE 8 - ACCRUED EXPENSES

Accrued expenses as of December 31, 2007 and 2006 included the following:

   
2007
 
2006
 
           
Accrued interest on notes payable
 
$
30,800
 
$
-
 
Payroll taxes and estimated penalties
   
216,288
   
190,349
 
Accrued vacation
   
-
   
75,048
 
Accrued salaries and commissions
   
64,435
   
44,726
 
Rebates
   
66,541
   
60,105
 
Failed Acquisition Contingency
   
178,995
   
-
 
Officer Indemnification
   
580,000
       
Accrued capital expenditure
   
219,600
   
-
 
Other
   
191,845
   
65,006
 
               
   
$
1,548,504
 
$
435,234
 
 
On November 5, 2007, Sunbelt Machine Works Corporation terminated that certain Stock Purchase Agreement dated as of August 17, 2007 by and among Shumate Industries, Inc., Sunbelt Machine Works Corporation and each of the stockholders of Sunbelt. In connection therewith, Shumate was required to pay Sunbelt a termination fee of $150,000 for which we have recorded an accrued expense of $178,995 for such contingency.

During the year ended December 31, 2007, Shumate agreed to indemnify one of its officers in connection with a judgment assessed against him personally resulting from a previously discharged corporate tax liability. This resulted in an accrued expense of $580,000 in the 4th quarter of 2007.

46

 
NOTE 9 - NOTES PAYABLE AND CAPITAL LEASE

During the year ended December 31, 2007, Shumate sold $3,050,000 of principal amount of convertible promissory notes with warrants to purchase 610,000 shares of its common stock to two accredited investors. The notes have a 1 year term and bear interest at ten percent (10%); provided, however, that Shumate is required to prepay the note if Shumate consummates a subsequent equity financing (as defined) within the next 12 months. Interest is payable monthly in arrears, however Shumate has the right to defer any interest payment and accrue same to principal. The notes are convertible into Shumate common stock at a fixed conversion price of $1.89. In addition, if Shumate closes a subsequent equity financing within the next 12 months, the note holders have the option to convert the outstanding balance of such note into such financing on the same terms as the other investors in such financing.

Under the terms of the notes and the related warrants, the notes and the warrants are convertible/exercisable by any holder only to the extent that the number of shares of common stock issuable pursuant to such securities, together with the number of shares of common stock owned by such holder and its affiliates (but not including shares of common stock underlying unconverted shares of the note or unexercised portions of the warrants) would not exceed 4.99% of Shumate’s then outstanding common stock as determined in accordance with Section 13(d) of the Securities Exchange Act of 1934, as amended.

The notes were issued with a warrant to purchase up to 610,000 shares of Shumate’s common stock at an exercise price of $1.89 per share, subject to adjustment. The warrant holders may designate a “cashless exercise option.” This option entitles the warrant holders to elect to receive fewer shares of common stock without paying the cash exercise price. The number of shares to be determined by a formula based on the total number of shares to which the warrant holder is entitled, the current market value of the common stock and the applicable exercise price of the warrant.
Shumate determined that the conversion feature of the note and the warrants issued were not derivative instruments pursuant to SFAS No. 133, Accounting for Derivatives, as amended. Under the provisions of EITF Issue 98-5 and 00-27, Shumate discounted the fair value of warrants attached to the notes and calculated the intrinsic value of the beneficial conversion feature using the Black-Scholes Option Pricing Model to exceed the principal value of the note. The resulting discount of $552,495 is being amortized over the life of the notes using the effective interest method. The amortized amount for the year ended December 31, 2007 is $187,589. A summary of these convertible notes is as follows:

Gross proceeds from the notes
 
$
3,050,000
 
Less: discount on the warrants
   
(413,571
)
Less: beneficial conversion feature of the notes
   
(138,924
)
Add: amortization of discounts
   
187,589
 
Add: accrued interest
   
115,441
 
         
Carrying amount of notes as of December 31, 2007
 
$
2,800,535
 
 
Shumate granted the investors in the offering registration rights for the resale of the shares issuable upon conversion of the note and upon exercise of the warrant. To the extent that all such shares are not registered pursuant to the granted piggyback registration rights, Shumate agreed to register the remaining underlying shares, if any, by January 6, 2008.

In connection with the offering, the placement agents received $215,000 in fees. In addition, another $10,000 in legal fees were incurred. The net proceeds of this offering after the payment of commissions, fees and other expenses of the offering were approximately $2,825,000.

In October 2007, Shumate sold $250,000 of principal amount of a promissory note. The note was due and payable as of December 31, 2007, and bears interest at twelve percent (12%). The note has been extended as a demand loan.

47

 
In June 2006, Shumate entered into a financing agreement with an independent third party to sell and leaseback certain machinery and equipment, which is accounted for as a capital lease. This lease agreement contains a residual value guarantee at the end of the lease term. The cost of equipment under the capital lease is included in the balance sheet as shop equipment of approximately $100,000 at December 31, 2007. Amortization of the assets under the capital lease were included in the depreciation expense. Remaining payments under the capital lease equal $51,586 at December 31, 2007.

Future minimum lease payments under the capital lease are as follows:

Year Ending
       
December 31, 2008
 
$
51,586
 
Less amount representing interest
   
(11,841
)
Present value of minimum lease payments
 
$
39,745
 
 
On December 5, 2005, Hemiwedge executed a promissory note to Soderberg Research and Development, Inc. and certain of its affiliates in the amount of $100,000 in connection with the purchase of intellectual property (See Note 6). The note bears interest at the rate of six percent and is payable in twenty-four equal installments of principal and interest beginning January 1, 2006 and ending December 1, 2007. The balance as of December 31, 2007 was $8,798.
 
NOTE 10 - INCOME TAXES

Shumate uses the liability method, where deferred tax assets and liabilities are determined based on the expected future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial and income tax reporting purposes. Shumate has incurred significant net losses in past years and, therefore, has no tax liability. The net deferred tax asset generated by the loss carry-forward has been fully reserved. The cumulative net operating loss carry-forward is approximately $27,000,000 at December 31, 2007, and will expire in the years 2022 through 2027.

At December 31, 2007, deferred tax assets consisted of the following:

 
$
9,445,000
 
Valuation allowance
   
(9,445,000
)
         
Net deferred tax asset
 
$
-
 
 
Internal Revenue Section 382 restricts the ability to use these carryforwards whenever an ownership change as defined occurs. Shumate incurred such an ownership change both 2006 and 2005. As the result of the ownership change, Shumate’s use of net operating losses through the date of change is restricted. Losses subsequent to the date of change are not restricted.
 
NOTE 11 - COMMON STOCK

On February 22, 2006, Shumate sold 3,333,333 shares of its common stock to several investors in a private offering for $0.60 per share. The placement agent received $160,000 in commissions and 250,000 warrants to purchase shares of common stock at an exercise price of $0.63 per share. The net proceeds of this offering to Shumate after the payment of commissions, fees, and other expenses totaling $115,817 of the offering were approximately $1,725,000.

Shumate evaluated the freestanding warrants to determine if they were within the scope of SFAS 133 and EITF 00-19. Part of this evaluation considered the ‘Liquidated Damages’ provision in the ‘Registration Rights Agreement’ that covers both the warrants and the common stock. Shumate concluded the freestanding warrants should not be classified as a liability and therefore are not subject to SFAS 133.

Subject to certain conditions, Shumate has granted these February investors a right of first refusal, for a period of one year from June 30, 2006 to participate in any subsequent financing that Shumate conducts. As of the date of this report, these rights have expired.

48


In May and August 2006, Shumate issued 5,000 shares of its common stock to a consultant for marketing services, 5,000 shares to an employee and another 5,000 shares to an officer of a subsidiary. These shares were valued at their combined fair value of $15,500, and stock-based compensation expense was recorded as a result of this grant.

On August 8, 2006, Shumate issued 70,000 shares of its common stock to a consultant for investor relations services. These shares were valued at their fair value of $84,000. Under the terms of the consulting agreement, 4,000 shares are guaranteed while 66,000 shares are earned pro-rata over a twelve-month period commencing July 2006. Accordingly, $44,400 was recorded as consulting expense for the year ended December 31, 2006 and $39,600 is recorded as deferred compensation expense to be amortized monthly through June 2007.

Between October 30, 2006 and December 14, 2006, Shumate sold 3,787,550 shares of its common stock to several investors in a private offering for $1.00 per share. Shumate is also obligated to issue the investors 1,893,775 Class A Warrants, each exercisable at $1.25 per share. The placement agent received a 7% cash commission, a 3% non-accountable expense allowance, a 1% management fee, and 378,755 warrants to purchase shares of common stock at an exercise price of $1.25 per share. Shumate also paid legal fees of an aggregate $22,500 to counsel for the placement agent. The net proceeds of this offering to Shumate after the payment of commissions, fees and other expenses of the offering totaling $612,511 were approximately $3,350,000.

Shumate evaluated the freestanding warrants to determine if they were within the scope of SFAS 133 and EITF 00-19. Part of this evaluation considered the ‘Liquidated Damages’ provision in the ‘Registration Rights Agreement’ that covers both the warrants and the common stock. Shumate concluded the freestanding warrants should not be classified as a liability and therefore are not subject to SFAS 133.

Subject to certain conditions, Shumate has granted these investors a right of first refusal, for a period of one year from the final closing of the offering filed in connection with this transaction, to participate in any subsequent financing that Shumate conducts, subject to rights granted to previous investors. As of the dated of this report, these rights have expired.
 
In the event that during the period commencing on December 14, 2006 and ending on the earlier to occur of: (i) March 14, 2008; or (ii) the Company and At Balance Americas, a Shell Technology Ventures company, entering into a definitive distribution agreement for the Company’s Hemiwedge® DIV product, the Company sells any shares of its Common Stock or securities convertible into Common Stock or exercisable for shares of Common Stock at less than $1.00 per share, the Company shall be obligated to adjust, on a full-ratchet basis, the number of shares of Common Stock issued to Investors in this Offering as if the shares of Common Stock purchased in this Offering were purchased at such lower price. As of the date of this report, these rights have expired.

In the event that, during the period commencing on December 14, 2006 and ending on the earlier to occur of: (i) March 14, 2008; or (ii) the Company and At Balance Americas, a Shell Technology Ventures company entering into a definitive distribution agreement for the Company’s Hemiwedge® DIV product, the Company sells any shares of its Common Stock or securities convertible into Common Stock or exercisable for shares of Common Stock at less than the exercise price of the Class A Warrants, the Company shall be obligated to adjust, on a full-ratchet basis, the exercise prices thereof, as applicable. As of the date of this report, these rights have expired.

The Class A Warrants are subject to redemption by the Company upon 20 days prior written notice provided: (i) the Common Stock has traded at or above $2.50 per share during the 15 consecutive trading days prior to a written notice of redemption by the Company; (ii) there is an effective registration statement covering the resale of the shares of Common Stock underlying the Warrants at the time of redemption; and (iii) the Common Stock has traded an average of 100,000 shares per day. The redemption price shall be $0.01 per Warrant. All holders of Warrants will have the opportunity to exercise any such Warrant prior to the date of redemption.

Between March 1, 2007 and March 31, 2007, Shumate issued an aggregate of 666,768 shares of common stock for the exercise of outstanding warrants. The net proceeds of these warrant exercises to Shumate after the payment of commissions, fees, and other expenses of the offering were $735,560. Of the 666,768 warrants exercised, 536,300 were Class A Warrants. The Class A Warrants were exercised at a price of $1.25 per share and resulted in approximately $653,366 in net proceeds to Shumate after the payment of commissions, fees, and other expenses. All of the holders of the Class A Warrants that were exercised received one share of Shumate's common stock and one Class B Warrant as a result of such exercise. The Class B Warrants have a term of five years and an exercise price of $2.00 per share. The Class B Warrants include piggy-back registration rights, subject to customary underwriter cutbacks. If the common stock underlying the Class B Warrants is not registered by March 31, 2008, the holders will be entitled to exercise the Class B Warrants on a cashless basis at any time that there is not an effective registration statement covering the resale of the common stock underlying the Class B Warrants. During the nine months ended September 30, 2007, Shumate incurred $81,019 costs of raising capital that were related to the offering.

49

 
Shumate evaluated the Class B Warrants to determine if they were within the scope of SFAS 133 and EITF 00-19. Shumate concluded the Class B Warrants should not be classified as a liability and therefore are not subject to SFAS 133.

Between April 1, 2007 and December 31, 2007, Shumate issued an aggregate of 420,050 shares of common stock valued at $660,912 for consulting services, professional fees, and hiring incentives.

Between July 1, 2007 and September 30, 2007, Shumate issued an aggregate of 13,752 shares of common stock for the exercise of outstanding Class A Warrants at an exercise price of $1.25 per share, resulting in net proceeds of $17,190.

Between July 1, 2007 and September 30, 2007, Shumate issued an aggregate of 150,000 shares of common stock for the exercise of non-qualified stock options at an exercise price of $0.65 per share. The stock options were exercised by payment by the option holder of 54,776 shares of outstanding common stock valued at $97,500 on the date of exercise.

Between July 1, 2007 and September 30, 2007, Shumate incurred $24,454 in offering costs.

In December, 2007, the company issued 60,000 shares of restricted stock as a hiring incentive. 5,000 shares vest each quarter beginning in the first quarter of 2008, for a three year vesting schedule.

NOTE 12 - DISCONTINUED OPERATIONS / DEBT FORGIVENESS INCOME

On March 9, 2005, Excalibur Holdings, Inc., a wholly-owned subsidiary of Shumate and the parent corporation of Shumate Machine, filed a voluntary petition for protection under Chapter 7 of the U.S. Bankruptcy Code in the United States Bankruptcy Court, Southern District of Texas. As a result of this bankruptcy filing, 100% of the capital stock of Shumate Machine became the sole asset of the bankruptcy estate. The capital stock of Shumate Machine was pledged to secure the obligations of Excalibur Holdings to its senior lender, Stillwater. On October 19, 2005, Stillwater transferred the capital stock of Shumate Machine to Shumate as part of the reorganization of Shumate. In November 2005, the court discharged Excalibur Holdings of all of its debts and liabilities.

Under the terms of an amended and restated promissory note payable, Shumate recognized $2,000,000 in debt forgiveness income from Stillwater in 2006. See Note 7 for details.

NOTE 13 - STOCK OPTIONS AND WARRANTS

Shumate currently has two stock option plans: (a) the 2001 Stock Option Plan reserved 285,714 common shares and 300,571 stock options have been granted through December 31, 2007 of which 296,429 options have expired unexercised, and (b) the 2005 Stock Incentive Plan reserved 10,000,000 shares, of which 4,783,690 shares have been issued to date and 1,796,000 options have been granted through December 31, 2007. In addition, there were 48,571 non-plan options outstanding as of December 31, 2006.

During the year ended December 31, 2006, Shumate granted 805,000 options at exercise prices ranging from $0.65 to $1.35 per share for services rendered and valued at the options’ fair value totaling $772,734. Of this amount, $322,793 and $146,227 was recorded as compensation expense in the years ended December 31, 2006 and 2007 respectively. $142,006 of the fair value will not be recognized based on non-vested options for employees that were no longer employed as of December 31, 2007. The remaining $161,708 was deferred to recognize over the future periods in which the options vest and the services are being performed. The weighted average term in which the unrecognized expense will be amortized is 1.5 years.

50

    
During the year ended December 31, 2006, Shumate granted 12,000 warrants to consultants at the exercise price at $1.50 per share for services. These warrants have a life of seven years and vest immediately. Shumate valued and recorded these warrants at their fair value of $14,282 during the year.

During the year ended December 31, 2006, Shumate granted 250,000 warrants at the exercise prices of $0.63 per share to brokers for financing costs and services and granted 2,272,530 warrants at the exercise prices of $1.25 per share to investors associated with the private offering. These warrants vest immediately and have a life of five years. These warrants have a relative fair value of $1,984,361.

Variables used in the Black-Scholes option-pricing model during the year ended December 31, 2006 include (1) 4.19% - 4.99% risk-free interest rate, (2) 3 year option life is the expected remaining life of the options, (3) expected volatility ranged from 195% to 206%, and (4) zero expected dividends.

During 2006, 87,857 warrants were expired unexercised.

During the year ended December 31, 2007, Shumate granted 991,000 options to its employees and non-employee directors at exercise prices ranging from $1.00 to $2.25 per share for services rendered and valued at the options' fair value totaling $728,170. Of this amount, $516,645 was recorded as compensation expense during the year ended December 31, 2007 and $211,525 was deferred to recognize over the future periods in which the options vest and the services will be performed. The weighted average term in which the unrecognized expense will be amortized is 2.4 years.

During the first quarter of 2007, Shumate determined that additional working capital was needed to fund its continuing operations. Shumate decided to initiate a capital raising effort via a private offering to a limited number of accredited investors during a limited period of time. In exchange for the exercise of any or all of the investors' Class A warrants, the investors would receive the applicable shares of common stock and Class B warrants. In connection therewith, Shumate granted 536,300 warrants at an exercise prices of $2.00 per share to investors associated with the exercise of Class A Warrants. These warrants vested immediately and have a life of five years. These warrants have a fair value of $890,571.

Variables used in the Black-Scholes option-pricing model during the year ended December 31, 2007, include (1) 2.85% - 5.00% risk-free interest rate, (2) 2.5 to 3.5 year option life is the expected remaining life of the options, (3) expected volatility of 81% - 182%, and (4) zero expected dividends.

During the year ended December 31, 2007, Shumate also recognized $146,227 option expense for options granted in the prior year that vested in the current year.

During 2007, 150,000 options were exercised and 163,047 expired unexercised. In the same period 680,520 warrants were exercised and 891,045 expired unexercised.

Summary information regarding options and warrants is as follows:

51


Share Price
 
Options
 
Weighted
Average
Exercise Price
 
Aggregate 
Intrinsic 
Value
 
Warrants
 
Weighted 
Average 
Exercise Price
 
Aggregate
Intrinsic
Value
 
                           
Outstanding at December 31, 2005
   
53,857
 
$
8.95
         
201,712
 
$
7.94
       
                                       
Year ended December 31, 2006:
                                     
Granted
   
805,000
   
1.06
         
2,534,530
   
1.19
       
Forfeited
   
(1,000
)
 
4.20
         
(87,857
)
 
6.99
       
                                       
Outstanding at December 31, 2006
   
857,857
   
1.55
 
$
222,900
   
2,648,385
   
1.51
 
$
356,802
 
                                       
Year ended December 31, 2007:
                                     
Granted
   
991,000
   
1.57
         
2,023,490
   
1.69
       
Exercised
   
(150,000
)
 
0.65
         
(680,520
)
 
1.13
       
Forfeited
   
(163,047
)
 
3.66
         
(891,045
)
 
2.29
       
                                       
Outstanding at December 31, 2007
   
1,535,810
 
$
1.42
 
$
5,000
   
3,100,310
 
$
1.49
 
$
20,320
 

Options outstanding and exercisable as of December 31, 2007:

     
Outstanding
 
Exercisable
 
 
Exercise
 
Number
 
Remaining
 
Number
 
 
Price
 
of Shares
 
Life (years)
 
of Shares
 
                 
$
4.20
   
3,143
   
0.41
   
3,143
 
 
0.75
   
100,000
   
3.04
   
33,334
 
 
1.00
   
100,000
   
3.22
   
100,000
 
 
1.20
   
50,000
   
0.09
   
50,000
 
 
1.35
   
150,000
   
3.45
   
50,000
 
 
1.33
   
75,000
   
3.62
   
25,000
 
 
1.20
   
6,667
   
0.08
   
6,667
 
 
1.21
   
50,000
   
3.70
   
50,000
 
 
1.15
   
10,000
   
3.79
   
3,333
 
 
1.75
   
20,000
   
3.95
   
-
 
 
1.75
   
75,000
   
4.02
   
75,000
 
 
1.90
   
32,000
   
4.02
   
-
 
 
2.25
   
10,000
   
4.07
   
-
 
 
1.90
   
60,000
   
4.36
   
60,000
 
 
1.80
   
500,000
   
4.61
   
500,000
 
 
1.00
   
294,000
   
4.98
   
294,000
 
       
1,535,810
   
4.05
   
1,250,477
 
 
52


Warrants outstanding and exercisable as of December 31, 2007:

     
Outstanding   
 
Exercisable
 
 
Exercise
 
Number