Edgar Filing: LUNA INNOVATIONS INC

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

_____________________________________

FORM 10-Q

_____________________________________



ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2017



¨	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 000-52008

_____________________________________

LUNA INNOVATIONS INCORPORATED

(Exact name of registrant as specified in its charter)

_____________________________________



Delaware		54-1560050
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)

301 First Street SW, Suite 200

Roanoke, VA 24011

(Address of Principal Executive Offices)

(540) 769-8400

(Registrant’s Telephone Number, Including Area Code)

_____________________________________

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ý Yes ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company ý

Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: As of August 8, 2017, there were 28,226,436 shares of the registrant’s common stock outstanding.

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LUNA INNOVATIONS INCORPORATED

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2017

TABLE OF CONTENTS



PART I. FINANCIAL INFORMATION		3
ITEM 1.	FINANCIAL STATEMENTS	3
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	16
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	24
ITEM 4.	CONTROLS AND PROCEDURES	25
PART II. OTHER INFORMATION		26
ITEM 1.	LEGAL PROCEEDINGS	26
ITEM 1A.	RISK FACTORS	26
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	43
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	43
ITEM 4.	MINE SAFETY DISCLOSURES	43
ITEM 5.	OTHER INFORMATION	43
ITEM 6.	EXHIBITS	43
SIGNATURES		45
EXHIBIT INDEX		46

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PART I. FINANCIAL INFORMATION



ITEM 1.	FINANCIAL STATEMENTS

Luna Innovations Incorporated

Consolidated Balance Sheets



	June 30, 2017			December 31, 2016
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	10,291,255		$	12,802,458
Accounts receivable, net	13,150,291			14,297,725
Inventory	9,540,754			8,370,235
Prepaid expenses and other current assets	1,266,090			1,627,175
Total current assets	34,248,390			37,097,593
Property and equipment, net	6,882,576			6,780,838
Intangible assets, net	8,003,009			8,681,263
Goodwill	2,348,331			2,348,331
Other assets	68,778			88,948
Total assets	$	51,551,084		$	54,996,973
Liabilities and stockholders’ equity
Liabilities:
Current liabilities:
Current portion of long-term debt obligations	$	1,833,333		$	1,833,333
Current portion of capital lease obligations	52,404			52,128
Accounts payable	3,958,144			4,466,192
Accrued liabilities	8,131,316			8,667,100
Deferred revenue	946,146			949,603
Total current liabilities	14,921,343			15,968,356
Long-term deferred rent	1,337,893			1,403,957
Long-term debt obligations	1,511,520			2,420,032
Long-term capital lease obligations	89,054			114,940
Total liabilities	17,859,810			19,907,285
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at June 30, 2017 and December 31, 2016	1,322			1,322
Common stock, par value $0.001, 100,000,000 shares authorized, 28,226,436 and 27,988,104 shares issued, 27,688,710 and 27,541,277 shares outstanding at June 30, 2017 and December 31, 2016	28,878			28,600
Treasury stock at cost, 537,727 and 446,827 shares at June 30, 2017 and December 31, 2016	(661,253		)	(517,987		)
Additional paid-in capital	82,837,888			82,451,958
Accumulated deficit	(48,515,561		)	(46,874,205		)
Total stockholders’ equity	33,691,274			35,089,688
Total liabilities and stockholders’ equity	$	51,551,084		$	54,996,973

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

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Luna Innovations Incorporated

Consolidated Statements of Operations



	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
	(unaudited)						(unaudited)
Revenues:
Technology development	$	4,625,175		$	4,137,382		8,901,624			$	7,860,644
Products and licensing	8,951,296			10,509,522			17,793,232			20,773,273
Total revenues	13,576,471			14,646,904			26,694,856			28,633,917
Cost of revenues:
Technology development	3,439,118			3,181,447			6,661,474			6,061,282
Products and licensing	5,056,449			6,294,607			10,277,225			12,558,180
Total cost of revenues	8,495,567			9,476,054			16,938,699			18,619,462
Gross profit	5,080,904			5,170,850			9,756,157			10,014,455
Operating expense:
Selling, general and administrative	3,936,207			4,581,776			8,431,911			9,227,060
Research, development and engineering	1,263,911			1,240,655			2,708,738			2,791,146
Total operating expense	5,200,118			5,822,431			11,140,649			12,018,206
Operating loss	(119,214		)	(651,581		)	(1,384,492		)	(2,003,751		)
Other income/(expense):
Other expense	(1,225		)	(39,489		)	(869		)	(35,545		)
Interest expense	(60,386		)	(78,906		)	(124,760		)	(165,079		)
Total other expense	(61,611		)	(118,395		)	(125,629		)	(200,624		)
Loss before income taxes	(180,825		)	(769,976		)	(1,510,121		)	(2,204,375		)
Income tax expense	40,937			1,000			67,627			26,175
Net loss	(221,762		)	(770,976		)	(1,577,748		)	(2,230,550		)
Preferred stock dividend	29,536			24,580			63,632			45,790
Net loss attributable to common stockholders	$	(251,298	)	$	(795,556	)	$	(1,641,380	)	$	(2,276,340	)
Net loss per share attributable to common stockholders:
Basic and diluted	$	(0.01	)	$	(0.03	)	$	(0.06	)	$	(0.08	)
Weighted average common shares and common equivalent shares outstanding:
Basic and diluted	27,600,147			27,557,960			27,570,919			27,517,792

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

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Luna Innovations Incorporated

Consolidated Statements of Cash Flows



	Six Months Ended June 30,
	2017			2016
	(unaudited)
Cash flows provided by/(used in) operating activities
Net loss	$	(1,577,748	)	$	(2,230,550	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization	1,753,748			1,861,603
Share-based compensation	321,756			465,028
Bad debt expense	40,753			50,515
Gain on disposal of fixed assets	(670		)	—
Change in assets and liabilities
Accounts receivable	1,106,681			(167,749		)
Inventory	(1,170,519		)	474,072
Other current assets	325,005			(306,371		)
Accounts payable and accrued expenses	(1,109,870		)	(1,076,784		)
Deferred revenue	(3,457		)	(81,830		)
Net cash used in operating activities	(314,321		)	(1,012,066		)
Cash flows provided by/(used in) investing activities
Acquisition of property and equipment	(796,217		)	(1,294,775		)
Intangible property costs	(318,942		)	(244,198		)
Proceeds from sale of property and equipment	3,000			—
Net cash used in investing activities	(1,112,159		)	(1,538,973		)
Cash flows provided by/(used in) financing activities
Payments on capital lease obligations	(25,611		)	(32,149		)
Payments of debt obligations	(916,666		)	(916,667		)
Repurchase of common stock	(143,266		)	(156,386		)
Proceeds from the exercise of options	820			—
Net cash used in financing activities	(1,084,723		)	(1,105,202		)
Net decrease in cash and cash equivalents	(2,511,203		)	(3,656,241		)
Cash and cash equivalents—beginning of period	12,802,458			17,464,040
Cash and cash equivalents—end of period	$	10,291,255		$	13,807,799
Supplemental disclosure of cash flow information
Cash paid for interest	$	120,191		$	157,371
Cash paid for income taxes	$	40,937		$	198,425
Non-cash investing and financing activities
Dividend on preferred stock, 39,646 shares of common stock issuable for the six months ended June 30, 2017 and 2016	$	63,632		$	45,790
Capital expenditures funded by capital lease borrowings	$	—		$	157,246

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

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Luna Innovations Incorporated

Notes to Unaudited Consolidated Financial Statements


1.	Basis of Presentation and Significant Accounting Policies

Nature of Operations

Luna Innovations Incorporated (“we,” “Luna Innovations” or the “Company”), headquartered in Roanoke, Virginia, was incorporated in the Commonwealth of Virginia in 1990 and reincorporated in the State of Delaware in April 2003. We are a leader in advanced optical technology, providing unique capabilities in high speed optoelectronics and high performance fiber optic test products for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. We are organized into two reportable segments, which work closely together to turn ideas into products: our Technology Development segment and our Products and Licensing segment. Our business model is designed to accelerate the process of bringing new and innovative technologies to market. We have a history of net losses from operations beginning in 2005. We have historically managed our liquidity through cost reduction initiatives, debt financings, capital markets transactions and the sale of assets.

Unaudited Interim Financial Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United Stated of America (“U.S. GAAP”) for interim financial statements and Article 10 of Regulation S-X of the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for annual financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the annual financial statements and in the opinion of management reflect all adjustments, consisting of only normal recurring accruals considered necessary to present fairly our financial position at June 30, 2017, results of operations for the three and six months ended June 30, 2017 and 2016, and cash flows for the six months ended June 30, 2017 and 2016. The results of operations for the three and six months ended June 30, 2017, are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.

The consolidated interim financial statements, including our significant accounting policies, should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto for the year ended December 31, 2016, included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”) on March 20, 2017.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:


•	Level 1—Quoted prices for identical instruments in active markets


•	Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets


•	Level 3—Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable

The carrying values of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term nature of these instruments. The carrying value of our debt approximates fair value, as we consider the floating interest rate on our credit facilities with Silicon Valley Bank ("SVB") to be at market for similar instruments. Certain nonfinancial assets and liabilities are measured at fair value on a nonrecurring basis in accordance with U.S. GAAP. This includes items such as nonfinancial assets and liabilities initially measured at fair value in a business combination and nonfinancial long-lived asset groups measured at fair value for an impairment assessment. In general, nonfinancial assets including intangible assets and property and equipment are measured at fair value when there is an indication of impairment and are recorded at fair value only when any impairment is recognized.

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Net Loss Per Share

Basic per share data is computed by dividing our net loss by the weighted average number of shares outstanding during the period. Diluted per share data is computed by dividing net income, if applicable, by the weighted average shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have been outstanding if potential shares of common stock had been issued using the treasury stock method. Diluted per share data would also include the potential common share equivalents relating to convertible securities by application of the if-converted method.

The effect of 5.0 million and 5.8 million common stock equivalents (which include outstanding warrants, preferred stock and stock options) are not included for the three months ended June 30, 2017 and 2016, respectively, as they are anti-dilutive to earnings per share due to our net loss. The effect of 4.6 million and 5.7 million common stock equivalents are not included for the six months ended June 30, 2017 and 2016, respectively, as they are considered anti-dilutive to earnings per share due to our net loss.

Recently Issued Accounting Pronouncements

Effective January 1, 2017, we adopted Accounting Standards Update ("ASU") No. 2016-09, Improvements to Employee Share-Based Payment Accounting. These amendments apply to several aspects of accounting for share-based compensation including the recognition of excess tax benefits and deficiencies and their related presentation in the statement of cash flows as well as accounting for forfeitures. The adoption of ASU No. 2016-09 did not have a significant impact on our financial condition, results of operations or cash flows.

Effective January 1, 2017, we adopted ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes, which simplifies the presentation of deferred taxes by requiring that deferred tax assets and liabilities be classified as noncurrent in any classified balance sheet rather than being separated into current and non-current amounts. The adoption of ASU No. 2015-17 did not have a significant impact on our consolidated financial statements.

In January 2017, the Financial Accounting Standards Board ("FASB") issued ASU No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This update simplifies the subsequent measurement of goodwill. The guidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. The accounting standard will be effective for reporting periods beginning after December 15, 2019. We do not expect ASU 2017-04 will have a material impact on our financial statements.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice in how cash receipts and cash payments are presented in the statement of cash flows. ASU 2016-15 is effective for public entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. The amendments should be applied retrospectively to all periods presented. We do not expect ASU 2016-15 will have a material impact on our financial statements.

In April 2016, the FASB amended the FASB Accounting Standards Codification and created a new Topic 606, and issued ASU No. 2016-10, Revenue from contracts with customers: Identifying Performance Obligations and Licensing. This amendment prescribes that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendment supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the Accounting Standards Codification, and is effective for annual and interim reporting periods beginning after December 15, 2017. We are currently determining the transition method and assessing the impact the amendments may have on our financial condition, results of operations or cash flows as a result of adopting this standard.

In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires a lessee to recognize in its statement of financial position an asset and liability for most leases with a term greater than 12 months. Lessees should recognize a liability to make lease payments and a right-of-use asset representing the lessee's right to use the underlying asset for the lease term. The amendment is effective for fiscal years ending after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating the impact the adoption of this standard will have on our consolidated financial statements.


2.	Subsequent Event- Sale of High Speed Optical Receivers Business

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On August 9, 2017, we sold the assets and operations related to our high speed optical receivers ("HSOR") business, which was part of our Products and Licensing segment, to an unaffiliated third party for an initial purchase price of $33.5 million, of which $29.5 million was received at closing and $4.0 million was placed into escrow until December 15, 2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations (the "Transaction"). The purchase price is subject to adjustment in the future based upon a determination of final working capital, as defined in the asset purchase agreement. The HSOR business was a component of the operations of Advanced Photonix, Inc., which we acquired in May 2015. As part of the Transaction, the buyer is also expected to hire approximately 49 of our employees who were engaged in the development, manufacture, and sale of HSOR products in addition to certain corporate administrative functions. The buyer will provide certain transition services to us with respect to infrastructure and administration for which we will pay $0.3 million per month for a period of five months following the date of the Transaction.

As the HSOR assets were not considered "held for sale" as of June 30, 2017, such assets are included within the assets held and used in our consolidated balance sheets as of June 30, 2017 and December 31, 2016. The following schedule sets forth the carrying amounts of major classes of assets and liabilities associated with the Transaction as of June 30, 2017 and December 31, 2016.



			June 30, 2017		December 31, 2016
Current assets			(unaudited)
	Accounts receivable		$	4,263,448	$	4,028,713
	Inventory		2,262,316		1,521,398
	Prepaid expenses and other current assets		122,599		251,516
		Total current assets	6,648,363		5,801,627
Property and equipment, net			3,667,273		3,298,110
Intangible assets, net			4,673,792		5,314,045
Goodwill			2,348,331		2,348,331
Other assets			50,754		50,754
Total assets of the disposal group			$	17,388,513	$	16,812,867

Current liabilities
	Accounts payable		$	1,149,062	$	1,511,450
	Accrued compensation		313,725		504,719
	Other accrued liabilities		468,124		248,837
	Total current liabilities		1,930,911		2,265,006
Deferred rent			77,719		84,555
Total liabilities of the disposal group			$	2,008,630	$	2,349,561

The following schedule sets forth the revenues and expenses associated with the HSOR operations as well as the employees and other costs expected to be assumed by the buyer for the three and six months ended June 30, 2017 and 2016. Although these costs are expected to be assumed by the buyer, we may subsequently replace certain of these resources in support of our remaining operations.

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	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
	(unaudited)						(unaudited)
Revenues	$	2,283,440		$	4,745,999		$	5,314,927		$	9,744,708
Cost of revenues	1,568,746			3,202,491			3,801,363			6,505,287
Gross profit	714,694			1,543,508			1,513,564			3,239,421
Operating expense
Research, development and engineering	445,020			362,999			961,077			813,396
Selling, general and administrative	656,323			1,035,066			1,487,378			2,017,071
Total operating expense	1,101,343			1,398,065			2,448,455			2,830,467
Operating (loss)/income	(386,649		)	145,443			(934,891		)	408,954
Other (income)/expense	—			(3,548		)				35,036
(Loss)/income before income taxes	(386,649		)	148,991			(934,891		)	373,918
Income tax benefit/(expense)	—			56,557			—			141,939
(Loss)/income attributable to disposal group	$	(386,649	)	$	92,434		$	(934,891	)	$	231,979


3.	Inventory

Inventory consists of finished goods, work-in-process and raw materials valued at the lower of cost (determined on the first-in, first-out basis) or market. We write down inventory for estimated obsolescence or unmarketable inventory in an amount equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions.

Components of inventory were as follows:



	June 30, 2017		December 31, 2016
	(unaudited)
Finished goods	$	2,630,986	$	1,993,543
Work-in-process	1,445,377		1,098,173
Raw materials	5,464,391		5,278,519
Total inventory	$	9,540,754	$	8,370,235

4. Accrued Liabilities

Accrued liabilities at June 30, 2017 and December 31, 2016 consisted of the following:

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	June 30, 2017		December 31, 2016
	(unaudited)
Accrued compensation	$	4,779,817	$	5,442,723
Claims reserve	1,727,123		1,577,123
Accrued sub-contracts	464,961		483,477
Accrued professional fees	57,153		67,719
Deferred rent	154,396		155,138
Royalties	160,801		345,895
Warranty reserve	419,196		185,125
Accrued liabilities - other	367,869		409,900
Total accrued liabilities	$	8,131,316	$	8,667,100


5.	Debt

Silicon Valley Bank Facility

We currently have a Loan and Security Agreement with SVB (the "Credit Facility") under which, as amended on May 8, 2015, we have a term loan with an original borrowing amount of $6.0 million (the “Original Term Loan”). The Original Term Loan is repayable in 48 monthly installments of $125,000, plus accrued interest payable monthly in arrears, and unless earlier terminated, is scheduled to mature in May 2020. The Original Term Loan carries a floating annual interest rate equal to SVB’s prime rate then in effect plus 2%. We may prepay amounts due under the Original Term Loan at any time, subject to an early termination fee of up to 2% of the amount of prepayment.

In September 2015, we entered into the Waiver and Seventh Loan Modification Agreement, which provided an additional $1 million of available financing for purchases of equipment through December 31, 2015, which we fully borrowed in December 2015 (the "Second Term Loan" and, together with the Original Term Loan, the "Term Loans"). The Second Term Loan also bears interest at a floating prime rate plus 2% and is to be repaid in 35 monthly installments of $27,778 plus accrued interest.

The Credit Facility requires us to maintain a minimum cash balance of $5.0 million and to maintain at each month end a ratio of cash plus 60% of accounts receivable greater than or equal to 1.5 times the outstanding principal of the Term Loans. The Credit Facility also requires us to observe a number of additional operational covenants, including protection and registration of intellectual property rights, and certain customary negative covenants. As of June 30, 2017, we were in compliance with all covenants under the Credit Facility.

Amounts due under the Credit Facility are secured by substantially all of our assets, including intellectual property, personal property and bank accounts. In addition, the Credit Facility contains customary events of default, including nonpayment of principal, interest or other amounts, violation of covenants, material adverse change, an event of default under any subordinated debt documents, incorrectness of representations and warranties in any material respect, bankruptcy, judgments in excess of a threshold amount, and violations of other agreements in excess of a threshold amount. If any event of default occurs SVB may declare due immediately all borrowings under the Credit Facility and foreclose on the collateral. Furthermore, an event of default under the Credit Facility would result in an increase in the interest rate on any amounts outstanding. As of June 30, 2017, there were no events of default on the Credit Facility.

The aggregate balance under the Term Loans at June 30, 2017 and December 31, 2016, was $3.4 million and $4.3 million, respectively. The effective rate of our Term Loan at June 30, 2017 was 6.25%.

The following table presents a summary of debt outstanding as of June 30, 2017 and December 31, 2016:



	June 30, 2017		December 31, 2016
	(unaudited)
Silicon Valley Bank Term Loan	$	3,375,000	$	4,291,666
Less: unamortized debt issuance costs	30,147		38,301
Less: current portion	1,833,333		1,833,333
Total long-term debt	$	1,511,520	$	2,420,032

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The schedule of remaining principal payments under our Term Loans as of June 30, 2017 was as follows:



2017	$	916,667
2018	1,833,333
2019	625,000
	$	3,375,000


6.	Capital Stock and Share-Based Compensation

We recognize share-based compensation expense based upon the fair value of the underlying equity award on the date of the grant. For restricted stock awards and restricted stock units, we recognize expense based upon the price of our underlying stock at the date of the grant. We have elected to use the Black-Scholes-Merton option pricing model to value any option or warrant awards granted. We recognize share-based compensation for such awards on a straight-line basis over the requisite service period of the awards. The risk-free interest rate is based on U.S. Treasury interest rates, the terms of which are consistent with the expected life of the stock options. The expected life and estimated post-employment termination behavior is based upon historical experience of homogeneous groups within our company. We also assume an expected dividend yield of zero for all periods, as we have never paid a dividend on our common stock and do not have any plans to do so in the future.

A summary of the stock option activity for the six months ended June 30, 2017 is presented below:



	Options Outstanding							Options Exercisable
	Number of Shares		Price per Share Range	Weighted Average Exercise Price		Aggregate Intrinsic Value (1)		Number of Shares	Weighted Average Exercise Price		Aggregate Intrinsic Value (1)
Balance, January 1, 2017	2,857,114		$0.61 - $6.83	$	1.89	$	107,063	2,367,630	$	1.93	$	101,071
Granted	80,000		$1.51 - $1.54	$	1.53
Exercised	(1,000	)	$0.82	$	0.82
Canceled	(117,623	)	$1.40 - $3.69	$	2.26
Balance, June 30, 2017	2,818,491		$0.61 - $6.83	$	1.86	$	356,221	2,584,839	$	1.90	$	334,031


(1)	The intrinsic value of an option represents the amount by which the market value of the stock exceeds the exercise price of the option of in-the-money options only. The aggregate intrinsic value is based on the closing price of our common stock on the NASDAQ Capital Market, as applicable, on the respective dates.

At June 30, 2017, the outstanding stock options to purchase an aggregate of 2.8 million shares had a weighted-average remaining contractual term of 4.8 years, and the exercisable stock options to purchase an aggregate of 2.6 million shares had a weighted-average remaining contractual term of 4.5 years.

For the six months ended June 30, 2017 and 2016 we recognized $0.3 million and $0.5 million in share-based compensation expense, respectively, which is included in our selling, general and administrative expense in the accompanying consolidated financial statements. We expect to recognize $0.2 million in share-based compensation expense over the weighted-average remaining service period of 1.7 years for stock options outstanding as of June 30, 2017.

The following table summarizes the value of our unvested restricted stock awards:

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	Number of Unvested Shares		Weighted Average Grant Date Fair Value		Aggregate Value of Unvested Shares
Balance, January 1, 2017	743,042		$	1.20	$	888,764
Granted	289,000		$	1.54	445,060
Vested	(355,542	)	$	1.21	(431,854		)
Repurchased			$	—	—
Forfeitures	(51,667	)	$	1.14	(58,917		)
Balance, June 30, 2017	624,833		$	1.35	$	843,053

Restricted Stock Units

We issue restricted stock units ("RSUs"), to our non-employee directors for service on our board of directors. Under our non-employee director compensation policy, continuing non-employee directors receive an annual RSU grant at the time of our annual meeting of stockholders, which grant vests on the earlier of the one year anniversary of the grant or the following annual meeting of stockholders. Under our non-employee director deferred compensation plan, as amended (the "NEDCP") non-employee directors may also elect to receive their annual cash retainers for board and committee service in RSUs which are issued quarterly and vest immediately upon their issuance, subject to deferred settlement in accordance with the NEDCP. The following is a summary of our RSU activity for the six months ended June 30, 2017:



	Number of RSUs				Intrinsic Value
	Issued	Unvested		Weighted Average Grant Date Fair Value per Share	Outstanding		Unvested
Balance, January 1, 2017	528,510	86,956		$1.29	$	776,910	$	127,825
Granted	165,143	129,865		$1.56
Vested	—	(86,956	)	$1.15
Forfeitures	—	—		$0.00
Converted	—	—		$0.00
Balances, June 30, 2017	693,653	129,865		$1.36	$	1,047,416	$	196,096

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The following details our equity transactions during the six months ended June 30, 2017:



	Preferred Stock		Common Stock				Treasury Stock			Additional Paid-in Capital
	Shares	$	Shares		$		Shares	$		$
Balance, January 1, 2017	1,321,514	1,322	27,541,277		28,600		446,827	(517,987	)	82,451,958
Exercise of stock options	—	—	1,000		1		—	—		819
Share-based compensation	—	—	289,000		289		—	—		321,467
Non-cash compensation	—	—	—		—		—	—		—
Stock dividends to Carilion Clinic⁽¹⁾	—	—	—		40		—	—		63,592
Forfeitures of restricted stock grants	—	—	(51,667	)	(52	)	—	—		52
Repurchase of common stock	—	—	(90,900	)	—		90,900	(143,266	)	—
Balances, June 30, 2017	1,321,514	1,322	27,688,710		28,878		537,727	(661,253	)	82,837,888

(1)

The stock dividends payable in connection with Carilion Clinic’s Series A Preferred Stock will be issued subsequent to June 30, 2017. For the period from January 12, 2010, the original issue date of the Series A Preferred Stock, through June 30, 2017, the Series A Preferred Stock issued to Carilion has accrued $1,077,074 in dividends. The accrued and unpaid dividends as of June 30, 2017 will be paid by the issuance of 592,047 shares of our common stock upon Carilion’s written request.

Stock Repurchase Program

In May 2016, our board of directors authorized us to repurchase up to $2.0 million of our common stock through May 31, 2017. Our stock repurchase program does not obligate us to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. We did not repurchase any shares during the six months ended June 30, 2017. As of May 31, 2017, we had repurchased a total of 205,500 shares for an aggregate purchase price of $0.2 million, after which the stock repurchase program expired. We currently maintain these repurchased shares as treasury stock.


7.	Operating Segments

Our operations are divided into two operating segments—“Technology Development” and “Products and Licensing”.

The Technology Development segment provides applied research to customers in our areas of focus. Our engineers and scientists collaborate with our network of government, academic and industry experts to identify technologies and ideas with promising market potential. We then compete to win fee-for-service contracts from government agencies and industrial customers who seek innovative solutions to practical problems that require new technology. The Technology Development segment derives its revenues primarily from services.

The Products and Licensing segment derives its revenues from product sales, funded product development and technology licenses.

Through June 30, 2017, our Chief Executive Officer and his direct reports collectively represented our chief operating decision makers, and they evaluated segment performance based primarily on revenues and operating income or loss. The accounting policies of our segments are the same as those described in the summary of significant accounting policies (see Note 1 to our Financial Statements, “Organization and Summary of Significant Accounting Policies,” presented in our Annual Report on Form 10-K as filed with the SEC on March 20, 2017).

The table below presents revenues and operating loss for reportable segments:

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	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
	(unaudited)						(unaudited)
Revenues:
Technology development	$	4,625,175		$	4,137,382		$	8,901,624		$	7,860,644
Products and licensing	8,951,296			10,509,522			17,793,232			20,773,273
Total revenues	$	13,576,471		$	14,646,904		$	26,694,856		$	28,633,917
Technology development operating income/(loss)	$	60,659		$	313,208		$	(304,901	)	$	(177,108	)
Products and licensing operating loss	(179,873		)	(964,789		)	(1,079,591		)	(1,826,643		)
Total operating loss	$	(119,214	)	$	(651,581	)	$	(1,384,492	)	$	(2,003,751	)
Depreciation, technology development	$	88,698		$	91,127		$	176,918		$	186,784
Depreciation, products and licensing	$	240,504		$	263,514		$	571,480		$	517,011
Amortization, technology development	$	26,169		$	44,501		$	66,605		$	117,838
Amortization, products and licensing	$	437,612		$	522,660		$	930,590		$	1,039,969

The table below presents assets for reportable segments:



	June 30, 2017		December 31, 2016
	(unaudited)
Total segment assets:
Technology development	$	16,608,820	$	16,923,090
Products and licensing	34,942,264		38,073,883
Total assets	$	51,551,084	$	54,996,973
Property plant and equipment, and intangible assets, technology development	$	2,462,428	$	2,602,803
Property plant and equipment, and intangible assets, products and licensing	$	14,771,488	$	15,207,630

There are no material inter-segment revenues for any period presented.

The U.S. government accounted for 38% and 28% of total consolidated revenues for the three months ended June 30, 2017 and 2016, respectively, and for 36% and 28% of total consolidated revenues for the six months ended June 30, 2017 and 2016, respectively.

International revenues (customers outside the United States) accounted for 28% and 29% of total consolidated revenues for the three months ended June 30, 2017 and 2016, respectively, and 27% and 32% of the total consolidated revenues for the six months ended June 30, 2017 and 2016, respectively. Revenues from customers in China represented 7% and 19% of total revenues for the three months ended June 30, 2017 and 2016, respectively, and 10% and 19% for the six months ended June 30, 2017 and 2016, respectively. No other single country, outside of the United States, represented more than 10% of total revenues in the three and six months ended June 30, 2017 and 2016. In addition, we had one commercial customer whose revenues accounted for 0% and 14% of our total consolidated revenues for the three months ended June 30, 2017 and 2016, respectively, and 5% and 15% for the six months ended June 30, 2017 and 2016, respectively.


8.	Contingencies and Guarantees

We are from time to time involved in certain legal proceedings in the ordinary course of conducting our business. While the ultimate liability pursuant to these actions cannot currently be determined, we believe it is not reasonably possible that these legal proceedings will have a material adverse effect on our financial position or results of operations.

In September 2014, we received a preliminary audit report from the Defense Contract Audit Agency (the "DCAA"), with respect to our 2007 incurred cost submission and questioning $0.8 million of claimed costs that the DCAA believes are expressly unallowable under the Federal Acquisition Regulations and, therefore, subject to potential penalty. In June 2015, we received from the Defense Contract Management Agency ("DCMA") a final determination and demand for payment of penalties, interest, and over billing in the aggregate amount of $1.1 million. In July 2015, we filed an appeal with the Armed Services Board of Contract Appeals ("ABSCA"). In January 2017, a hearing was held before the ASBCA. No ruling has yet been issued with respect to our appeal. In April 2017, we made a settlement offer of $150,000 to the DCMA, and we have

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accrued that amount in our financial statements as of June 30, 2017. The DCMA notified us in May 2017 that it has declined our settlement offer. The appeals process remains ongoing.

In the third quarter of 2016 we executed two non-cancelable purchase orders totaling $1.4 million for multiple shipments of tunable lasers to be delivered over an 18-month period. At June 30, 2017, approximately $0.5 million of this commitment remained. In addition, as of June 30, 2017, we had $0.7 million in outstanding purchase orders for multiple shipments of certain amplifiers utilized in our integrated coherent receiver products.

We have entered into indemnification agreements with our officers and directors, to the extent permitted by law, pursuant to which we have agreed to reimburse the officers and directors for legal expenses in the event of litigation and regulatory matters. The terms of these indemnification agreements provide for no limitation to the maximum potential future payments. We have a directors and officers insurance policy that may, in certain instances, mitigate the potential liability and payments.

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

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

This Quarterly Report on Form 10-Q, including the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk” under Items 2 and 3, respectively, of Part I of this report, and the section entitled “Risk Factors” under Item 1A of Part II of this report, may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. All statements other than statements of historical fact are “forward-looking statements” for purposes of these statutes, including those relating to future events or our future financial performance. In some cases, you can identify these forward looking statements by words such as “intends,” “will,” “plans,” “anticipates,” “expects,” “may,” “might,” “estimates,” “believes,” “should,” “projects,” “predicts,” “potential” or “continue,” or the negative of those words and other comparable words, and other words or terms of similar meaning in connection with any discussion of future operating or financial performance. Similarly, statements that describe our business strategy, goals, prospects, opportunities, outlook, objectives, plans or intentions are also forward-looking statements. These statements are only predictions and may relate to, but are not limited to, expectations of future operating results or financial performance, capital expenditures, introduction of new products, regulatory compliance and plans for growth and future operations, as well as assumptions relating to the foregoing.

These statements are based on current expectations and assumptions regarding future events and business performance and involve known and unknown risks, uncertainties and other factors that may cause actual events or results to be materially different from any future events or results expressed or implied by these statements. These factors include those set forth in the following discussion and within Item 1A “Risk Factors” of this Quarterly Report on Form 10-Q and elsewhere within this report.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under “Risk Factors” and elsewhere in this report.

Overview of Our Business

We are a leader in advanced optical technology, providing unique capabilities in high speed optoelectronics and high performance fiber optic test products for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. Our distributed fiber optic sensing products provide critical stress, strain and temperature information to designers and manufacturers working with advanced materials. Our custom optoelectronic products are sold to scientific instrumentation manufacturers for various applications such as metrology, missile guidance, flame monitoring, and temperature sensing. In addition, we provide applied research services, typically under research programs funded by the U.S. government, in areas of advanced materials, sensing, and healthcare applications. Our business model is designed to accelerate the process of bringing new and innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research services for companies and for government funded projects. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth.

We are organized into two main business segments, the Products and Licensing segment and the Technology Development segment. Our Products and Licensing segment develops, manufactures and markets fiber optic sensing products, as well as test & measurement products, and also conducts applied research in the fiber optic sensing area for both corporate and government customers. On August 9, 2017, we sold our high speed optical receiver ("HSOR") business to a third party, as described more fully below. We are continuing to develop and commercialize our fiber optic technology for strain and temperature sensing applications for the aerospace, automotive, and energy industries. Our Products and Licensing segment revenues represented 66% and 72% of our total revenues for the three months ended June 30, 2017 and 2016, respectively, and 67% and 73% of our total revenues for the six months ended June 30, 2017 and 2016, respectively. The change in revenue mix was primarily a result of lower sales of our 100G integrated coherent receivers during the three and six months ended June 30, 2017, and continued growth of our Technology Development business segment. The approximate value of our Products and Licensing segment backlog was $8.8 million at June 30, 2017 and $10.4 million at December 31, 2016.

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The Technology Development segment performs applied research principally in the areas of sensing and instrumentation, advanced materials and health sciences. This segment comprised 34% and 28% of total revenues for the three months ended June 30, 2017 and 2016, respectively, and 33% and 27% of our total revenues for the six months ended June 30, 2017 and 2016, respectively. Most of the government funding for our Technology Development segment is derived from the Small Business Innovation Research ("SBIR") program coordinated by the U.S. Small Business Administration ("SBA"). The Technology Development segment revenues have historically accounted for a large portion of total revenues, and we expect that they will continue to represent a significant portion of total revenues for the foreseeable future. The Technology Development segment revenues were $4.6 million and $4.1 million for the three months ended June 30, 2017 and 2016, respectively, and $8.9 million and $7.9 million for the six months ended June 30, 2017 and 2016, respectively. Within the Technology Development segment, we have historically had a backlog of contracts for which work has been scheduled, but for which a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. Total backlog includes funded backlog, which is the amount for which money has been directly authorized by the U.S. government and for which a purchase order has been received by a commercial customer, and unfunded backlog, representing firm orders for which funding has not yet been appropriated. Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. The approximate value of our Technology Development segment backlog was $23.6 million at June 30, 2017 and $17.6 million at December 31, 2016.

Revenues from product sales have historically been mostly derived from the sales of our optoelectronic components and from the sales of sensing systems and products that make use of light-transmitting optical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues to represent a significant portion of revenues in the near term. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenues from product sales and product development to be primarily in areas associated with our fiber optic instrumentation, test & measurement and sensing platforms. In the long term, we expect that revenues from product sales will represent a larger portion of our total revenues and, as we develop and commercialize new products, we expect these revenues will reflect a broader and more diversified mix of products.

We may also grow our business in part through acquisitions of additional companies and complementary technologies, which could cause us to incur transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses.

Reductions in government spending may impact the availability of new program awards in the future. For example, the Budget Control Act commits the U.S. government to reduce the federal deficit by $1.2 trillion over ten years through a combination of automatic, across-the-board spending cuts and caps on discretionary spending, or sequestration. Automatic across-the-board cuts required by sequestration could have a material adverse effect on our Technology Development segment revenues and, consequently, our results of operations. While the exact manner in which sequestration will impact our business is unclear, funding for programs in which we participate could be reduced, delayed or canceled. Our ability to obtain new contract awards also could be negatively affected.

Recent Developments

On August 9, 2017, we sold our assets associated with the HSOR business to a third party, for total cash consideration of $33.5 million, including $29.5 million received at closing and $4.0 million placed into escrow until December 15, 2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations. As part of the transaction, the buyer is also expected to hire approximately 49 of our employees who were engaged in the development, manufacture, and sale of HSOR products in addition to certain corporate administrative functions. The buyer will provide certain transition services to us with respect to infrastructure and administration for which we will pay $0.3 million per month for a period of five months following the date of the transaction.

Our revenues recognized related to the HSOR business were $2.3 million and $4.7 million for the three months ended June 30, 2017 and 2016, respectively, and $5.3 million and $9.7 million for the six months ended June 30, 2017 and 2016, respectively.

Our sale of the HSOR business has significantly increased our capital resources, and we currently intend to use a portion of the proceeds from the sale to invest in expanding our fiber optic sensing business. However, the sale of the HSOR business is expected to result in lower revenues, primarily from reduced product sales, than we have experienced in prior periods until, if ever, we can increase revenues from our remaining businesses significantly. As a result, we may incur greater net losses and reduced cash flows from operations than we have in recent periods.

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Description of Revenues, Costs and Expenses

Explanatory Note Regarding HSOR Business

The sale of the assets associated with our HSOR business described above was completed on August 9, 2017. Because those assets were not considered to be held for sale as of June 30, 2017, our Consolidated Statements of Operations included elsewhere in this report and the discussion of our operations set forth below include the results from the HSOR business. The sale of the HSOR business will have a material impact on our future results of operations, and when reviewing our consolidated financial statements and the discussion below, readers should carefully consider this expected impact on the results of operations in future periods.

Revenues

We generate revenues from technology development, product sales and commercial product development and licensing activities. We derive Technology Development segment revenues from providing research and development services to third parties, including government entities, academic institutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we complete contracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred. The Technology Development segment revenues represented 34% and 28% of total revenues for the three months ended June 30, 2017 and 2016, respectively, and 33% and 27% of our total revenues for the six months ended June 30, 2017 and 2016, respectively.

The Products and Licensing segment revenues reflect amounts that we receive from sales of our products or development of products for third parties and, to a lesser extent, fees paid to us in connection with licenses or sub-licenses of certain patents and other intellectual property, and represented 66% and 72% of our total revenues for the three months ended June 30, 2017 and 2016, respectively, and 67% and 73% of our total revenues for the six months ended June 30, 2017 and 2016, respectively. Product and licensing revenues decreased as a percentage of our total revenues due to lower revenues from sales of 100G coherent receivers during the three and six months ended June 30, 2017 compared to the three and six months ended June 30, 2016.

Cost of Revenues

Cost of revenues associated with our Technology Development segment revenues consists of costs associated with performing the related research activities including direct labor, amounts paid to subcontractors and overhead allocated to Technology Development segment activities.

Cost of revenues associated with our Products and Licensing segment revenues consists of license fees for use of certain technologies, product manufacturing costs including all direct material and direct labor costs, amounts paid to our contract manufacturers, manufacturing, shipping and handling, provisions for product warranties, and inventory obsolescence as well as overhead allocated to each of these activities.

Operating Expense

Operating expense consists of selling, general and administrative expenses, as well as expenses related to research, development and engineering, depreciation of fixed assets and amortization of intangible assets. These expenses also include compensation for employees in executive and operational functions including certain non-cash charges related to expenses from option grants, facilities costs, professional fees, salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities, costs of marketing programs and promotional materials, salaries, bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Technology Development segment, product development activities not provided under contracts with third parties, and overhead costs related to these activities.

Interest Expense

Interest expense is composed of interest paid under our term loans as well as interest accrued on our capital lease obligations.

Critical Accounting Policies and Estimates

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Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or judgments.

Our critical accounting policies are described in the Management’s Discussion and Analysis section and the notes to our audited consolidated financial statements previously included in our Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the Securities and Exchange Commission ("SEC") on March 20, 2017. Effective January 1, 2017, we adopted Accounting Standards Update ("ASU") No. 2016-09, Improvements to Employee Share-Based Payment Accounting. The amendments apply to several aspects of accounting for share-based compensation including the recognition of excess tax benefits and deficiencies and their related presentation in the statement of cash flows as well as accounting for forfeitures. The adoption of ASU No. 2016-09 did not have a significant impact on our financial condition, results of operations or cash flows. There have been no other material changes to the description of our critical accounting policies as described in our Form 10-K as filed with the SEC on March 20, 2017.

Results of Operations

Three Months Ended June 30, 2017 Compared to Three Months Ended June 30, 2016

Revenues



	Three Months Ended June 30,
	2017		2016		$ Difference			% Difference
Revenues:
Technology development	$	4,625,175	$	4,137,382	$	487,793		12	%
Products and licensing	8,951,296		10,509,522		(1,558,226		)	(15	)%
Total revenues	$	13,576,471	$	14,646,904	$	(1,070,433	)	(7	)%

Revenues from our Technology Development segment for the three months ended June 30, 2017 increased $0.5 million, or 12%, to $4.6 million compared to $4.1 million for the three months ended June 30, 2016. The increase in Technology Development segment revenues continues a growth trend experienced throughout 2016 and into 2017 largely driven by successes in Phase 2 SBIR awards. The increase for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 was realized primarily in our intelligent systems research and nanomaterials groups. As Phase 2 contracts generally have a performance period of a year or more, we currently expect revenues to remain at a similar level for the near term.

Our Products and Licensing segment included revenues from sales of test & measurement systems, primarily representing sales of our ODiSI, Optical Vector Analyzer, and Optical Backscatter Reflectometer platforms, sales of HSOR products and other optical components and sub-assemblies and sales of Terahertz sensing systems. Products and Licensing segment revenues decreased $1.6 million, or 15%, to $9.0 million for the three months ended June 30, 2017 compared to $10.5 million for the three months ended June 30, 2016. The decrease in Products and Licensing segment revenues was primarily driven by lower sales of our 100G integrated coherent receivers to one international customer partially offset by an increase in our sales of test and measurement systems. For the three months ended June 30, 2017, revenues from our HSOR products were $2.3 million, compared to $4.7 million for the three months ended June 30, 2016. As described above, as a result of our recent sale of the HSOR business, we expect that revenues from our Products and Licensing segment will materially decline in future periods.

Cost of Revenues and Gross Profit

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	Three Months Ended June 30,
	2017		2016		$ Difference			% Difference
Cost of revenues:
Technology development	$	3,439,118	$	3,181,447	$	257,671		8	%
Products and licensing	5,056,449		6,294,607		(1,238,158		)	(20	)%
Total cost of revenues	8,495,567		9,476,054		(980,487		)	(10	)%
Gross profit	$	5,080,904	$	5,170,850	$	(89,946	)	(2	)%

The cost of Technology Development segment revenues for the three months ended June 30, 2017 increased $0.3 million, or 8%, to $3.4 million compared to $3.2 million for the three months ended June 30, 2016. The increase in cost of Technology Development segment revenues was attributable to increased utilization of subcontractors for our research contracts.

The cost of revenues associated with our Products and Licensing segment decreased by $1.2 million, or 20%, to $5.1 million for the three months ended June 30, 2017 compared to $6.3 million for the three months ended June 30, 2016. Products and Licensing segment cost of revenues decreased due to lower sales of 100G integrated coherent receivers partially offset by an increase in cost of revenues of our testing and measurement systems. Our overall gross margin for the three months ended June 30, 2017 was 37% compared to 35% for the three months ended June 30, 2016. For the three months ended June 30, 2017, cost of revenues from our HSOR products were $1.6 million, compared to $3.2 million for the three months ended June 30, 2016. The gross margin on our HSOR products was 31% for the three months ended June 30, 2017, compared to 33% for the three months ended June 30, 2016. As a result of our recent sale of our HSOR business, we expect that cost of revenues from our Products and Licensing segment will decline in future periods, while we expect our gross margin to initially increase.

Operating Expense



	Three Months Ended June 30,
	2017		2016		$ Difference			% Difference
Operating expense:
Selling, general and administrative	$	3,936,207	$	4,581,776	$	(645,569	)	(14	)%
Research, development and engineering	1,263,911		1,240,655		23,256			2	%
Total operating expense	$	5,200,118	$	5,822,431	$	(622,313	)	(11	)%

Our selling, general and administrative expense decreased $0.6 million, or 14%, to $3.9 million for the three months ended June 30, 2017 compared to $4.6 million for the three months ended June 30, 2016. The decrease in selling, general and administrative expense was due to a $0.2 million decrease in incentive compensation, a $0.1 million reduction in share-based compensation expense, a $0.2 million reduction in sales-related compensation associated with lower revenue, and a $0.1 million reduction in amortization expense. For the three months ended June 30, 2017, selling, general and administrative expense associated with our HSOR business was $0.7 million, compared to $1.0 million for the three months ended June 30, 2016.

Research, development and engineering expense remained substantially unchanged at $1.3 million for the three months ended June 30, 2017 compared to $1.2 million for the three months ended June 30, 2016. For the three months ended June 30, 2017 and 2016, research, development and engineering expense associated with our HSOR business was $0.4 million. As a result of our recent sale of the HSOR business, we expect that research, development and engineering expense will initially decline in future periods, although as described elsewhere in this report, we may use a portion of the proceeds from the sale of the HSOR business to invest in expanding our fiber optic sensing business, which may result in an increase in research, development and engineering expenses.

Interest Expense

Interest expense for the three months ended June 30, 2017 was $60,386 compared to interest expense of $78,906 during the three months ended June 30, 2016. During the three months ended June 30, 2017, our average outstanding balance on our term loans was $3.5 million as compared to $5.5 million for the three months ended June 30, 2016.

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Six Months Ended June 30, 2017 Compared to Six Months Ended June 30, 2016

Revenues



	Six Months Ended June 30,
	2017		2016		$ Difference			% Difference
Revenues:
Technology development	$	8,901,624	$	7,860,644	$	1,040,980		13	%
Products and licensing	17,793,232		20,773,273		(2,980,041		)	(14	)%
Total revenues	$	26,694,856	$	28,633,917	$	(1,939,061	)	(7	)%

Technology Development segment revenues increased $1.0 million, or 13%, to $8.9 million for the six months ended June 30, 2017 compared to $7.9 million for the six months ended June 30, 2016. The increase for the six months ended June 30, 2017 compared to the six months ended June 30, 2016 was realized primarily in our intelligent systems and nanomaterials groups.

Products and Licensing segment revenues decreased $3.0 million, or 14%, to $17.8 million for the six months ended June 30, 2017 compared to $20.8 million for the six months ended June 30, 2016. The decrease in Products and Licensing segment revenues was primarily driven by lower sales of our 100G integrated coherent receivers to one international customer partially offset by an increase in our sales of test and measurement systems. For the six months ended June 30, 2017, revenues from our HSOR products were $5.3 million, compared to $9.7 million for the six months ended June 30, 2016. As described above, as a result of our recent sale of the HSOR business, we expect that revenues from our Products and Licensing segment will materially decline in future periods.

Cost of Revenues and Gross Profit



	Six Months Ended June 30,
	2017		2016		$ Difference			% Difference
Cost of revenues:
Technology development	$	6,661,474	$	6,061,282	$	600,192		10	%
Products and licensing	10,277,225		12,558,180		(2,280,955		)	(18	)%
Total cost of revenues	16,938,699		18,619,462		(1,680,763		)	(9	)%
Gross profit	9,756,157		$	10,014,455	$	(258,298	)	(3	)%

Costs of Technology Development segment revenues increased $0.6 million, or 10%, to $6.7 million for the six months ended June 30, 2017, compared to $6.1 million the six months ended June 30, 2016. This increase was primarily driven by an increase in subcontractor costs over the same period.

Costs of Products and Licensing segment revenues decreased $2.3 million, or 18%, to $10.3 million for the six months ended June 30, 2017 compared to $12.6 million for the six months ended June 30, 2016. Products and Licensing segment costs decreased in accordance with the decrease in Products and Licensing segment revenues over the same period, taking into account the gross margin effect of the product mix. Our overall gross margin for the six months ended June 30, 2017 increased to 37% compared to 35% for the six months ended June 30, 2016. For the six months ended June 30, 2017, cost of revenues from our HSOR products were $3.8 million compared to $6.5 million for the six months ended June 30, 2016. The gross margin on our HSOR products was 28% for the six months ended June 30, 2017, compared to 33% for the six months ended June 30, 2016. As a result of our recent sale of the HSOR business, we expect that cost of revenues from our Products and Licensing segment will decline in future periods, while we expect our gross margin to initially increase.

Operating Expense

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	Six Months Ended June 30,
	2017		2016		$ Difference			% Difference
Operating expense:
Selling, general and administrative	$	8,431,911	$	9,227,060	$	(795,149	)	(9	)%
Research, development and engineering	2,708,738		2,791,146		(82,408		)	(3	)%
Total operating expense	$	11,140,649	$	12,018,206	$	(877,557	)	(7	)%

Selling, general and administrative expenses decreased $0.8 million, or 9%, to $8.4 million for the six months ended June 30, 2017 compared to $9.2 million for the six months ended June 30, 2016. The decrease in selling, general and administrative expenses year to date is related to a $0.5 million reduction in selling expenses associated with lower revenues, a $0.1 million reduction in amortization expenses related to intangibles, and a $0.2 million reduction in share-based compensation expense. For the six months ended June 30, 2017, selling, general and administrative expense associated with our HSOR business was $1.5 million, compared to $2.0 million for the six months ended June 30, 2016.

Research, development and engineering expense decreased $0.1 million, or 3%, to $2.7 million for the six months ended June 30, 2017 compared to $2.8 million for the six months ended June 30, 2016. The decrease in research, development and engineering expense was related to lower personnel costs during the six months ended June 30, 2017. For the six months ended June 30, 2017, research, development and engineering expense associated with our HSOR business was $1.0 million, compared to $0.8 million for the six months ended June 30, 2016. As a result of our recent sale of the HSOR business, we expect that research, development and engineering expense will initially decline in future periods, although as described elsewhere in this report, we currently intend to use a portion of the proceeds from the sale of the HSOR business to invest in expanding our fiber optic sensing business, which may result in an increase in research, development and engineering expenses.

Interest Expense

Interest expense for the six months ended June 30, 2017 was $0.1 million compared to interest expense of $0.2 million for the six months ended June 30, 2016. The decrease in interest expense was due to a decreasing outstanding loan balance. During the first six months of 2017, our average outstanding loan balance was $3.8 million as compared to $5.6 million for the six months ended June 30, 2016.

Liquidity and Capital Resources

At June 30, 2017, our total cash and cash equivalents were $10.3 million.

We currently have a Loan and Security Agreement with Silicon Valley Bank ("SVB") under which we have two term loans with an aggregate original borrowing amount of $7.0 million. As of June 30, 2017, these term loans had an aggregate outstanding principal balance of $3.4 million. One term loan, with a balance of $.5 million as of June 30, 2017, matures on December 1, 2018. The other term loan, with a balance of $2.9 million as of June 30, 2017, matures on May 1, 2019. The term loans bear interest at a floating prime rate plus 2%. We may prepay amounts due under the term loans at any time, subject to prepayment penalties of up to 2% of the amount of prepayment. Amounts due under the term loans are secured by substantially all of our assets, including intellectual property, personal property and bank accounts. The term loans contain customary events of default, including nonpayment of principal, interest or other amounts, violation of covenants, material adverse change, an event of default under any subordinated debt documents, incorrectness of representations and warranties in any material respect, bankruptcy, judgments in excess of a threshold amount, and violations of other agreements in excess of a threshold amount. If any event of default occurs, SVB may declare due immediately all borrowings under the credit facility and foreclose on the collateral. Furthermore, an event of default under the credit facility would result in an increase in the interest rate on any amounts outstanding. As of June 30, 2017, we were in compliance with all covenants under the Loan and Security Agreement.

On August 9, 2017, we completed a sale of our HSOR business to a third party. Under the terms of the asset purchase agreement, we received $29.5 million in August 2017 and the remaining $4.0 million was placed in escrow for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations. Subject to any such adjustment and indemnification obligations, we expect to receive these escrowed proceeds in December 2018. The proceeds from the sale of the HSOR business significantly expands our capital resources and we intend to use a portion of the proceeds from this sale to invest in expanding our fiber optic sensing business.

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We believe that our cash balance as of June 30, 2017, together with the proceeds from the sale of our HSOR business, will provide adequate liquidity for us to meet our working capital needs over the next twelve months. Additionally, we believe that should we have the need for increased capital spending to support our planned growth, we will be able to fund such growth through either third-party financing on competitive market terms or through our available cash.

Discussion of Cash Flows

Recent Activity



	Six Months Ended June 30,
	2017			2016			$ Difference
Net cash used in operating activities	$	(314,321	)	$	(1,012,066	)	$	697,745
Net cash used in investing activities	(1,112,159		)	(1,538,973		)	426,814
Net cash used in financing activities	(1,084,723		)	(1,105,202		)	20,479
Net decrease in cash and cash equivalents	$	(2,511,203	)	$	(3,656,241	)	$	1,145,038

During the first six months of 2017, operations used $0.3 million of cash, as compared to the same period in 2016 in which operations used $1.0 million of cash. During the first six months of 2017, net cash used in operating activities consisted of our net loss of $1.6 million, which included non-cash charges for depreciation and amortization of $1.8 million and share-based compensation of $0.3 million, and a net cash outflow of $0.9 million from changes in working capital (principally driven by a decrease in accounts payable and accrued expenses of $1.1 million and an increase in inventory of $1.2 million, partially offset by a reduction in accounts receivable of $1.1 million ).

During the first six months of 2016, the $1.0 million of cash used in operating activities consisted of our net loss of $2.2 million which was primarily the result of charges for depreciation and amortization of $1.9 million and share-based compensation of $0.5 million. Additionally, changes in working capital resulted in a net cash outflow of $1.2 million, principally driven by a reduction in accounts payable and accrued liabilities of $1.1 million, resulting primarily from the payment of the settlement of shareholder litigation related to the merger and the payment of accrued royalties for product sales in 2015, an increase in other assets of $0.3 million, an increase in deferred revenue of $0.1 million and an increase of $0.2 million in accounts receivable due to the timing differences between recognizing a sale and collecting the cash payment for the sales.

Our cash used in investing activities for the six months ended June 30, 2017 and 2016 included purchases of equipment and capitalized costs associated with the prosecution of patents. Cash used in investing activities included $0.8 million of fixed asset additions and $0.3 million of capitalized intellectual property costs for the six months ended June 30, 2017 compared to fixed asset additions of $1.3 million and capitalized intellectual property costs of $0.2 million for the six months ended June 30, 2016.

Net cash used in financing activities during the six months ended June 30, 2017 and 2016 included the repayment of the long term debt and repayments of capital lease obligations. In the aggregate, these activities resulted in net cash outflows of $1.1 million for each of the first six months of 2017 and 2016.

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4)(ii).

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ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. We do not hold or issue financial instruments for trading purposes or have any derivative financial instruments. Our exposure to market risk is limited to interest rate fluctuations due to changes in the general level of U.S. interest rates.

Interest Rate Risk

We do not use derivative financial instruments as a hedge against interest rate fluctuations, and, as a result, interest income earned on our cash and cash equivalents and short-term investments is subject to changes in interest rates. However, we believe that the impact of these fluctuations does not have a material effect on our financial position due to the immediately available liquidity or short-term nature of these financial instruments.

We are exposed to interest rate fluctuations as a result of our term loans with SVB having a variable interest rate. We do not currently use derivative instruments to alter the interest rate characteristics of our debt. For the principal amount of $3.4 million outstanding under the term loans as of June 30, 2017, a change in the interest rate by one percentage point for one year would result in a change in our annual interest expense of $33,750.

Although we believe that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in our credit quality, composition of our balance sheet and other business developments that could affect our interest rate exposure. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate.

Foreign Currency Exchange Rate Risk

As of June 30, 2017, all payments made under our research contracts have been denominated in U.S. dollars. Our product sales to foreign customers are also generally denominated in U.S. dollars, and we generally do not receive payments in foreign currency. As such, we are not directly exposed to significant currency gains or losses resulting from fluctuations in foreign exchange rates.

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ITEM 4.	CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which are controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures also include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In addition, the design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected.

Under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report. Based on this evaluation, our principal executive officer and our principal financial officer have concluded that, as of June 30, 2017, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the three months ended June 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION



ITEM 1.	LEGAL PROCEEDINGS

In June 2015, we received a letter of final determination from the Defense Contract Management Agency ("DCMA") regarding the allowability of certain costs we included in our billings under cost-plus type research contracts during 2007. In conjunction with the DCMA's determination of those costs as expressly unallowable under the provisions of the Federal Acquisition Regulations, the DCMA assessed penalties and interest to us totaling $1.1 million. In July 2015, we filed an appeal of the assessed penalties and interest with the Armed Services Board of Contract Appeals ("ASBCA"). A hearing was held with respect to this appeal in January 2017, and a decision has not yet been reached by ASBCA. In April 2017, we made a settlement offer of $150,000 to DCMA, and we have accrued that amount in our financial statements as of June 30, 2017. In May 2017, the DCMA declined our settlement offer. The appeals process remains ongoing.

For additional information regarding our legal proceedings, please refer to our Annual Report on Form 10-K for the year ended December 31, 2016, as filed with the SEC on March 20, 2017.



ITEM 1A.	RISK FACTORS

You should carefully consider the risks described below before deciding whether to invest in our common stock. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations and financial results. If any of the following risks actually occurs, our business, financial condition or results of operations could be adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment. Our filings with the SEC also contain forward-looking statements that involve risks or uncertainties. Our actual results could differ materially from those anticipated or contemplated by these forward-looking statements as a result of a number of factors, including the risks we face described below, as well as other variables that could affect our operating results. Past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

RISKS RELATING TO OUR BUSINESS GENERALLY

Our technology is subject to a license from Intuitive Surgical, Inc., which is revocable in certain circumstances. Without this license, we cannot continue to market, manufacture or sell our fiber-optic products.

As a part of the sale of certain assets to Intuitive Surgical, Inc. ("Intuitive") in 2014, we entered into a license agreement with Intuitive pursuant to which we received rights to use all of our transferred technology outside the field of medicine and in respect of our existing non-shape sensing products in certain non-robotic medical fields. This license back to us is revocable if after notice and certain time periods, we were to (i) challenge the validity or enforceability of the transferred patents and patent applications, (ii) commercialize our fiber optical shape sensing and localization technology in the field of medicine (except to perform on a development and supply project for Hansen Medical, Inc.), (iii) violate our obligations related to our ability to sublicense in the field of medicine or (iv) violate our confidentiality obligations in a manner that advantages a competitor in the field of medicine and not cure such violation. Maintaining this license is necessary for us to conduct our fiber-optic products business, both for our telecom products and our ODiSI sensing products. If this license were to be revoked by Intuitive, we would no longer be able to market, manufacture or sell these products which would severely limit our ability to continue operations.

We depend on third-party vendors for specialized components in our manufacturing operations, making us vulnerable to supply shortages and price fluctuations that could harm our business.

We primarily rely on third-party vendors for the manufacture of the specialized components used in our products. The highly specialized nature of our supply requirements poses risks that we may not be able to locate additional sources of the specialized components required in our business. For example, there are few manufacturers who produce the special lasers used in our optical test equipment. Our reliance on these vendors subjects us to a number of risks that could negatively affect our

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ability to manufacture our products and harm our business, including interruption of supply. Although we are now manufacturing tunable lasers in low-rate initial production, we expect our overall reliance on third-party vendors to continue. Any significant delay or interruption in the supply of components, or our inability to obtain substitute components or materials from alternate sources at acceptable prices and in a timely manner could impair our ability to meet the demand of our customers and could harm our business.

We depend upon outside contract manufacturers for a portion of the manufacturing process for some of our products. Our operations and revenue related to these products could be adversely affected if we encounter problems with these contract manufacturers.

Many of our products are manufactured internally. However, we also rely upon contract manufacturers to produce the finished portion of some of our optoelectronic components and certain lasers. Our reliance on contract manufacturers for these products makes us vulnerable to possible capacity constraints and reduced control over delivery schedules, manufacturing yields, manufacturing quality control and costs. If the contract manufacturer for our products were unable or unwilling to manufacture our products in required volumes and at high quality levels or to continue our existing supply arrangement, we would have to identify, qualify and select an acceptable alternative contract manufacturer or move these manufacturing operations to internal manufacturing facilities. An alternative contract manufacturer may not be available to us when needed or may not be in a position to satisfy our quality or production requirements on commercially reasonable terms, including price. Any significant interruption in manufacturing our products would require us to reduce the supply of products to our customers, which in turn would reduce our revenue, harm our relationships with the customers of these products and cause us to forego potential revenue opportunities.

As a provider of contract research to the U.S. government, we are subject to federal rules, regulations, audits and investigations, the violation or failure of which could adversely affect our business.

We must comply with and are affected by laws and regulations relating to the award, administration and performance of U.S. government contracts. Government contract laws and regulations affect how we do business with our government customers and, in some instances, impose added costs on our business. A violation of a specific law or regulation could result in the imposition of fines and penalties, termination of our contracts or debarment from bidding on contracts. In some instances, these laws and regulations impose terms or rights that are more favorable to the government than those typically available to commercial parties in negotiated transactions. For example, the U.S. government may terminate any of our government contracts and, in general, subcontracts, at their convenience, as well as for default based on performance.

In addition, U.S. government agencies, including the Defense Contract Audit Agency and the Department of Labor, routinely audit and investigate government contractors. These agencies review a contractor’s performance under its contracts, cost structure and compliance with applicable laws, regulations and standards. The U.S. government also may review the adequacy of, and a contractor’s compliance with, its internal control systems and policies, including the contractor’s purchasing, property, estimating, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not be reimbursed, while such costs already reimbursed must be refunded. If an audit uncovers the inclusion of certain claimed costs deemed to be expressly unallowable, or improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. government. In addition, our reputation could suffer serious harm if allegations of impropriety were made against us. In June 2015, we received a determination from the Defense Contract Management Agency ("DCMA") of expressly unallowable costs included in our claimed costs for the 2007 contract year. As a result of that determination, the DCMA assessed us penalties, interest and over billings of $1.1 million. We have appealed that assessment, and our appeal is currently pending. In April 2017, we also made a settlement offer of $150,000 to the DCMA, which the DCMA subsequently declined. Depending on the outcome of this appeal and the response to our settlement offer, we could be required to make payments that have a material adverse effect on our financial position.

In addition to the risk of government audits and investigations, U.S. government contracts and grants impose requirements on contractors and grantees relating to ethics and business practices, which carry civil and criminal penalties including monetary fines, assessments, loss of the ability to do business with the U.S. government and certain other criminal penalties.

We may also be prohibited from commercially selling certain products that we develop under our Technology Development segment or related products based on the same core technologies if the U.S. government determines that the commercial availability of those products could pose a risk to national security. For example, certain of our wireless technologies have been classified as secret by the U.S. government and as a result we cannot sell them commercially. Any of these determinations would limit our ability to generate product sales and license revenues.

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We rely and will continue to rely on contracts and grants awarded under the SBIR program for a significant portion of our revenues. A finding by the SBA that we no longer qualify to receive SBIR awards could adversely affect our business.

We compete as a small business for some of our government contracts. Our revenues derived from the SBIR program account for a significant portion of our consolidated total revenues, and contract research, including SBIR contracts, will remain a significant portion of our consolidated total revenues for the foreseeable future. For the six months ended June 30, 2017 and 2016, revenues generated under the SBIR program represented 30% and 23%, respectively, of our total revenues.

We may not continue to qualify to participate in the SBIR program or to receive new SBIR awards from federal agencies. In order to qualify for SBIR contracts and grants, we must meet certain size and ownership eligibility criteria. These eligibility criteria are applied as of the time of the award of a contract or grant. A company can be declared ineligible for a contract award as a result of a size challenge filed with the SBA by a competitor or a federal agency.

In order to be eligible for SBIR contracts and grants, under current SBA rules we must be more than 50% owned and controlled by individuals who are U.S. citizens or permanent resident aliens, and/or other small business concerns (each of which is more than 50% owned and controlled by individuals who are U.S. citizens or permanent resident aliens) or certain qualified investment companies. In the event our institutional ownership significantly increases, either because of increased buying by institutions or selling by individuals, we could lose eligibility for new SBIR contracts and grants.

Also, in order to be eligible for SBIR contracts and grants, the number of our employees, including those of any entities that are considered to be affiliated with us, cannot exceed 500. As of June 30, 2017, we had approximately 240 full-time employees. In determining whether we are affiliated with any other entity, the SBA may analyze whether another entity controls or has the power to control us. Carilion Clinic is our largest institutional stockholder. Since early 2011, a formal size determination by the SBA that focused on whether or not Carilion is or was our affiliate has been outstanding. Although we do not believe that Carilion has or had the power to control our company, we cannot assure you that the SBA will interpret its regulations in our favor on this question. If the SBA were to make a determination that we are or were affiliated with Carilion, we would exceed the size limitations, as Carilion has over 500 employees. In that case, we would lose eligibility for new SBIR contracts and grants and other awards that are set aside for small businesses based on the criterion of number of employees, and the relevant government agency would have the discretion to suspend performance on existing SBIR grants. The loss of our eligibility to receive SBIR awards would have a material adverse impact on our revenues, cash flows and our ability to fund our growth.

Moreover, as our business grows, it is foreseeable that we will eventually exceed the SBIR size limitations, in which case we may be required to seek alternative sources of revenues or capital.

A decline in government research contract awards or government funding for existing or future government research contracts, including SBIR contracts, could adversely affect our revenues, cash flows and ability to fund our growth.

Technology Development segment revenues, which consist primarily of government-funded research, accounted for 33% and 27% of our consolidated total revenues for the six months ended June 30, 2017 and 2016, respectively. As a result, we are vulnerable to adverse changes in our revenues and cash flows if a significant number of our research contracts and subcontracts were to be simultaneously delayed or canceled for budgetary, performance or other reasons. For example, the U.S. government may cancel these contracts at any time without cause and without penalty or may change its requirements, programs or contract budget, any of which could reduce our revenues and cash flows from U.S. government research contracts. Our revenues and cash flows from U.S. government research contracts and subcontracts could also be reduced by declines or other changes in U.S. defense, homeland security and other federal agency budgets. In addition, we compete as a small business for some of these contracts, and in order to maintain our eligibility to compete as a small business, we, together with any affiliates, must continue to meet size and revenue limitations established by the U.S. government.

Our contract research customer base includes government agencies, corporations and academic institutions. Our customers are not obligated to extend their agreements with us and may elect not to do so. Also, our customers’ priorities regarding funding for certain projects may change and funding resources may no longer be available at previous levels.

In addition, the Budget Control Act commits the U.S. government to reduce the federal deficit by $1.2 trillion over ten years through a combination of automatic, across-the-board spending cuts and caps on discretionary spending. This “sequestration” under the Budget Control Act, which is split equally between defense and non-defense programs, went into effect on March 1, 2013. Any spending cuts required by “sequestration” could have a material adverse effect on our Technology Development revenues and, consequently, our results of operations. While the exact manner in which this “sequestration” may impact our business remains unclear, funding for programs in which we participate could be reduced, delayed or canceled. Our ability to obtain new contract awards also could be negatively affected.

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In addition to contract cancellations and changes in agency budgets, our future financial results may be adversely affected by curtailment of or restrictions on the U.S. government’s use of contract research providers, including curtailment due to government budget reductions and related fiscal matters or any legislation or resolution limiting the number or amount of awards we may receive. These or other factors could cause U.S. defense and other federal agencies to conduct research internally rather than through commercial research organizations or direct awards to other organizations, to reduce their overall contract research requirements or to exercise their rights to terminate contracts. Alternatively, the U.S. government may discontinue the SBIR program or its funding altogether. Also, SBIR regulations permit increased competition for SBIR awards from companies that may not have previously been eligible, such as those backed by venture capital operating companies, hedge funds and private equity firms. Any of these developments could limit our ability to obtain new contract awards and adversely affect our revenues, cash flows and ability to fund our growth.

Our narrowed scope and focus may make it more difficult for us to achieve or maintain operating profitability

Through the recent sale of our HSOR business to a third party, we have reduced our overall size and narrowed our focus. Although we anticipate realizing cost savings as a result of the sale of the HSOR operations, we will continue to incur significant operating expenses associated with our public company infrastructure. Accordingly, we will need to significantly increase the revenue we generate from our remaining operations in order to achieve or maintain operating profitability. While we intend to use a portion of the proceeds from the sale of the HSOR business to invest in our fiber optic sensing business, there can be no guarantee that these efforts will result in increased revenues sufficient to achieve or maintain profitability.

Our failure to attract, train and retain skilled employees or members of our senior management and to obtain necessary security clearances for such persons or maintain a facility security clearance would adversely affect our business and operating results.

The availability of highly trained and skilled technical and professional personnel is critical to our future growth and profitability. Competition for scientists, engineers, technicians and professional personnel is intense and our competitors aggressively recruit key employees. In the past, we have experienced difficulties in recruiting and hiring these personnel as a result of the tight labor market in certain fields. Any difficulty in hiring or retaining qualified employees, combined with our growth strategy and future needs for additional experienced personnel, particularly in highly specialized areas such as nanomaterial manufacturing and fiber optic sensing technologies, may make it more difficult to meet all of our needs for these employees in a timely manner. Although we intend to continue to devote significant resources to recruit, train and retain qualified employees, we may not be able to attract and retain these employees, especially in technical fields in which the supply of experienced qualified candidates is limited, or at the senior management level. Any failure to do so would have an adverse effect on our business. Any loss of key personnel could have a material adverse effect on our ability to meet key operational objectives, such as timely and effective project milestones and product introductions, which in turn could adversely affect our business, results of operations and financial condition.

We provide certain services to the U.S. government that require us to maintain a facility security clearance and for certain of our employees and our board chairman to hold security clearances. In general, the failure for necessary persons to obtain or retain sufficient security clearances, any loss by us of a facility security clearance or any public reprimand related to security matters could result in a U.S. government customer terminating an existing contract or choosing not to renew a contract or prevent us from bidding on or winning certain new government contracts.

In addition, our future success depends in a large part upon the continued service of key members of our senior management team. We do not maintain any key-person life insurance policies on our officers. The loss of any members of our management team or other key personnel could seriously harm our business.

Our business is subject to the cyclical nature of the markets in which we compete and any future downturn may reduce demand for our products and revenue.

Many factors beyond our control affect our business, including consumer confidence in the economy, interest rates, fuel prices and the general availability of credit. The overall economic climate and changes in Gross National Product growth have a direct impact on some of our customers and the demand for our products. We cannot be sure that our business will not be adversely affected as a result of an industry or general economic downturn.

Our customers may reduce capital expenditures and have difficulty satisfying liquidity needs because of continued turbulence in the U.S. and global economies, resulting in reduced sales of our products and harm to our financial condition and results of operations.

In particular, our historical results of operations have been subject to substantial fluctuations, and we may experience substantial period-to-period fluctuations in future results of operations. Any future downturn in the markets in which we

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compete could significantly reduce the demand for our products and therefore may result in a significant reduction in revenue or increase the volatility of the price of our common stock. Our revenue and results of operations may be adversely affected in the future due to changes in demand from customers or cyclical changes in the markets utilizing our products.

In addition, the telecommunications industry has, from time to time, experienced, and may again experience, a pronounced downturn. To respond to a downturn, many service providers may slow their capital expenditures, cancel or delay new developments, reduce their workforces and inventories and take a cautious approach to acquiring new equipment and technologies from original equipment manufacturers, which would have a negative impact on our business. Weakness in the global economy or a future downturn in the telecommunications industry may cause our results of operations to fluctuate from quarter-to-quarter and year-to-year, harm our business, and may increase the volatility of the price of our common stock.

Customer acceptance of our products is dependent on our ability to meet changing requirements, and any decrease in acceptance could adversely affect our revenue.

Customer acceptance of our products is significantly dependent on our ability to offer products that meet the changing requirements of our customers, including telecommunication, military, medical and industrial corporations, as well as government agencies. Any decrease in the level of customer acceptance of our products could harm our business.

Our products must meet exacting specifications, and defects and failures may occur, which may cause customers to return or stop buying our products.

Our customers generally establish demanding specifications for quality, performance and reliability that our products must meet. However, our products are highly complex and may contain defects and failures when they are first introduced or as new versions are released. Our products are also subject to rough environments as they are integrated into our customer products for use by the end customers. If defects and failures occur in our products, we could experience lost revenue, increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments, product returns or discounts, diversion of management resources or damage to our reputation and brand equity, and in some cases consequential damages, any of which would harm our operating results. In addition, delays in our ability to fill product orders as a result of quality control issues may negatively impact our relationship with our customers. We cannot assure you that we will have sufficient resources, including any available insurance, to satisfy any asserted claims.

Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and results of operations to suffer.

We design products to conform to our customers’ requirements and our customers’ systems may be subject to regulations established by governments or industry standards bodies worldwide. Because some of our products are designed to conform to current specific industry standards, if competing or new standards emerge that are preferred by our customers, we would have to make significant expenditures to develop new products. If our customers adopt new or competing industry standards with which our products are not compatible, or the industry groups adopt standards or governments issue regulations with which our products are not compatible, our existing products would become less desirable to our customers and our revenue and results of operations would suffer.

The markets for many of our products are characterized by changing technology which could cause obsolescence of our products, and we may incur substantial costs in delivering new products.

The markets for many of our products are characterized by changing technology, new product introductions and product enhancements, and evolving industry standards. The introduction or enhancement of products embodying new technology or the emergence of new industry standards could render existing products obsolete, and result in a write down to the value of our inventory, or result in shortened product life cycles. Accordingly, our ability to compete is in part dependent on our ability to continually offer enhanced and improved products.

The success of our new product offerings will depend upon several factors, including our ability to:


•	accurately anticipate customer needs;


•	innovate and develop new technologies and applications;


•	successfully commercialize new technologies in a timely manner;


•	price products competitively and manufacture and deliver products in sufficient volumes and on time; and


•	differentiate our product offerings from those of our competitors.

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Some of our products are used by our customers to develop, test and manufacture their products. We therefore must anticipate industry trends and develop products in advance of the commercialization of our customers’ products. In developing any new product, we may be required to make a substantial investment before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in research and development of products that do not lead to significant revenues.

Our inability to find new customers or retain existing customers could harm our business.

Our business is reliant on our ability to find new customers and retain existing customers. In particular, customers normally purchase certain of our products and incorporate them into products that they, in turn, sell in their own markets on an ongoing basis. As a result, the historical sales or these products have been dependent upon the success of our customers’ products and the future performance of our business is dependent upon our success in finding new customers and receiving new orders from existing customers.

In several markets, the quality and reliability of our products are a major concern for our customers, not only upon the initial manufacture of the product, but for the life of the product. Many of our products are used in remote locations for higher value assembly, making servicing of our products unfeasible. Any failure of the quality or reliability of our products could harm our business.

If our customers do not qualify our products or if their customers do not qualify their products, our results of operations may suffer.

Most of our customers do not purchase our optoelectronics products prior to qualification of the products and satisfactory completion of factory audits and vendor evaluation. Our existing products, as well as each new product, must pass through varying levels of qualification with our customers. In addition, because of the rapid technological changes in some markets, a customer may cancel or modify a design project before we begin large-scale manufacturing and receiving revenues from the customer. It is unlikely that we would be able to recover the expenses for cancelled or unutilized custom design projects. It is difficult to predict with any certainty whether our customers will delay or terminate product qualification or the frequency with which customers will cancel or modify their projects. Any such delay, cancellation or modification could have a negative effect on our results of operations.

In addition, once a customer qualifies a particular supplier’s product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as doing so could involve significant additional redesign efforts and increased costs. If we fail to achieve design-in wins in potential customers’ qualification processes, we will likely lose the opportunity for significant sales to those customers for a lengthy period of time.

If the end user customers that purchase systems from our customers fail to qualify or delay qualifications of any products sold by our customers that contain our products, our business could be harmed. The qualification and field testing of our customers’ systems by end user customers is long and unpredictable. This process is not under our control or that of our customers and, as a result, the timing of our sales may be unpredictable. Any unanticipated delay in qualification of one of our customers’ products could result in the delay or cancellation of orders from our customers for products included in their equipment, which could harm our results of operations.

Customer demand for our products is difficult to accurately forecast and, as a result, we may be unable to optimally match production with customer demand, which could adversely affect our business and financial results.

We make planning and spending decisions, including determining the levels of business that we will seek and accept, production schedules, inventory levels, component procurement commitments, personnel needs and other resource requirements, based on our estimates of customer requirements. The short-term nature of commitments by many of our customers and the possibility of unexpected changes in demand for their products reduce our ability to accurately estimate future customer requirements. On occasion, customers may require rapid increases in production, which can strain our resources, cause our manufacturing to be negatively impacted by materials shortages, necessitate higher or more restrictive procurement commitments, increase our manufacturing yield loss and scrapping of excess materials, and reduce our gross margin. We may not have sufficient capacity at any given time to meet the volume demands of our customers, or one or more of our suppliers may not have sufficient capacity at any given time to meet our volume demands. Conversely, a downturn in the markets in which our customers compete can cause, and in the past have caused, our customers to significantly reduce or delay the amount of products ordered or to cancel existing orders, leading to lower utilization of our facilities. Because many of our

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costs and operating expenses are relatively fixed, reduction in customer demand due to market downturns or other reasons would have a negative effect on our gross margin, operating income and cash flow.

Customer orders and forecasts are subject to cancellation or modification at any time which could result in higher manufacturing costs.

Our sales are made primarily pursuant to standard purchase orders for delivery of products. However, by industry practice, some orders may be canceled or modified at any time. When a customer cancels an order, they are responsible for all finished goods, all costs, direct and indirect, incurred by us, as well as a reasonable allowance for anticipated profits. No assurance can be given that we will receive these amounts after cancellation. Furthermore, uncertainty in customer forecasts of their demands and other factors may lead to delays and disruptions in manufacturing, which could result in delays in product shipments to customers and could adversely affect our business.

Fluctuations and changes in customer demand are common in our business. Such fluctuations, as well as quality control problems experienced in manufacturing operations, may cause delays and disruptions in our manufacturing process and overall operations and reduce output capacity. As a result, product shipments could be delayed beyond the shipment schedules requested by our customers or could be canceled, which would negatively affect our sales, operating income, strategic position at customers, market share and reputation. In addition, disruptions, delays or cancellations could cause inefficient production which in turn could result in higher manufacturing costs, lower yields and potential excess and obsolete inventory or manufacturing equipment. In the past, we have experienced such delays, disruptions and cancellations.

The results of our operations could be adversely affected by economic and political conditions and the effects of these conditions on our customers’ businesses and levels of business activity.

Global economic and political conditions affect our customers’ businesses and the markets they serve. A severe or prolonged economic downturn or a negative or uncertain political climate could adversely affect our customers’ financial conditions and the timing or levels of business activity of our customers and the industries we serve. This may reduce the demand for our products or depress pricing for our products and have a material adverse effect on our results of operations. Changes in global economic conditions could also shift demand to products or services for which we do not have competitive advantages, and this could negatively affect the amount of business we are able to obtain. In addition, if we are unable to successfully anticipate changing economic and political conditions, we may be unable to effectively plan for and respond to those changes, and our business could be negatively affected as a result.

We have a history of losses, and because our strategy for expansion may be costly to implement, we may experience continuing losses and may never achieve or maintain profitability or positive cash flow.

We realized a net loss of $1.6 million and $2.2 million for the six months ended June 30, 2017 and 2016, respectively. We expect to continue to incur significant expenses as we pursue our strategic initiatives, including increased expenses for research and development, sales and marketing and manufacturing. We may also grow our business in part through acquisitions of additional companies and complementary technologies which could cause us to incur greater than anticipated transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we may incur net losses for the foreseeable future, and these losses could be substantial. At a certain level, continued net losses could impair our ability to comply with NASDAQ continued listing standards, as described further below.

We have obtained capital by borrowing money under term loans and we might require additional capital to support and expand our business; our term loan has various loan covenants with which we must comply.

We intend to continue to make investments to support our business growth, including developing new products, enhancing our existing products, obtaining important regulatory approvals, enhancing our operating infrastructure, completing our development activities and building our commercial scale manufacturing facilities. To the extent that we are unable to become or remain profitable and to finance our activities from continuing operations, we may require additional funds to support these initiatives and to grow our business.

If we are successful in raising additional funds through issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, including as the result of the issuance of warrants in connection with the financing, and any new equity securities we issue could have rights, preferences and privileges superior to those of our existing common stock. Furthermore, such financings may jeopardize our ability to apply for SBIR grants or qualify for SBIR contracts or grants, and our dependence on SBIR grants may restrict our ability to raise additional outside capital. If we raise additional funds through debt financings, these financings may involve significant cash payment obligations and covenants that restrict our ability to operate our business and make distributions to our stockholders.

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We have term loans with Silicon Valley Bank ("SVB"), which requires us to observe certain financial and operational covenants, including maintenance of a minimum cash balance of $5.0 million, protection and registration of intellectual property rights, and certain customary negative covenants, as well as other customary events of default. If any event of default occurs SVB may declare due immediately all borrowings under our term loans and foreclose on the collateral. Furthermore, an event of default would result in an increase in the interest rate on any amounts outstanding.

If we are unable to obtain adequate financing or financing terms satisfactory to us when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

Our nanotechnology-enabled products are new and may be, or may be perceived as being, harmful to human health or the environment.

While we believe that none of our current products contain chemicals known by us to be hazardous or subject to environmental regulation, it is possible that our current or future products, particularly carbon-based nanomaterials, may become subject to environmental or other regulation. We intend to develop and sell carbon-based nanomaterials as well as nanotechnology-enabled products, which are products that include nanomaterials as a component to enhance those products’ performance. Nanomaterials and nanotechnology-enabled products have a limited historical safety record. Because of their size or shape or because they may contain harmful elements, such as gadolinium and other rare-earth metals, our products could pose a safety risk to human health or the environment. These characteristics may also cause countries to adopt regulations in the future prohibiting or limiting the manufacture, distribution or use of nanomaterials or nanotechnology-enabled products. Such regulations may inhibit our ability to sell some products containing those materials and thereby harm our business or impair our ability to develop commercially viable products.

The subject of nanotechnology has received negative publicity and has aroused public debate. Government authorities could, for social or other purposes, prohibit or regulate the use of nanotechnology. Ethical and other concerns about nanotechnology could adversely affect acceptance of our potential products or lead to government regulation of nanotechnology-enabled products.

We face and will face substantial competition in several different markets that may adversely affect our results of operations.

We face and will face substantial competition from a variety of companies in several different markets. As we focus on developing marketing and selling fiber optic sensing products, we may also face substantial and entrenched competition in that market.

Many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. These competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. In addition, current and potential competitors have established or may establish financial or strategic relationships among themselves or with existing or potential customers or other third parties. Accordingly, new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We cannot assure you that we will be able to compete successfully against current or new competitors, in which case our revenues may fail to increase or may decline.

Intense competition in our markets could result in aggressive business tactics by our competitors, including aggressively pricing their products or selling older inventory at a discount. If our current or future competitors utilize aggressive business tactics, including those described above, demand for our products could decline, we could experience delays or cancellations of customer orders, or we could be required to reduce our sales prices.

Decreases in average selling prices of our products may increase operating losses and net losses, particularly if we are not able to reduce expenses commensurately.

The market for optical components and subsystems continues to be characterized by declining average selling prices resulting from factors such as increased price competition among optical component and subsystem manufacturers, excess capacity, the introduction of new products and increased unit volumes as manufacturers continue to deploy network and storage systems. In recent years, we have observed a significant decline of average selling prices, primarily in the telecommunications market. We anticipate that average selling prices will continue to decrease in the future in response to product introductions by competitors or by us, or in response to other factors, including price pressures from significant customers. In order to sustain profitable operations, we must, therefore, reduce the cost of our current designs or continue to develop and introduce new products on a timely basis that incorporate features that can be sold at higher average selling prices. Failure to do so could cause our sales to decline and operating losses to increase.

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Our cost reduction efforts may not keep pace with competitive pricing pressures. To remain competitive, we must continually reduce the cost of manufacturing our products through design and engineering changes. We may not be successful in redesigning our products or delivering our products to market in a timely manner. We cannot assure you that any redesign will result in sufficient cost reductions enabling us to reduce the price of our products to remain competitive or positively contribute to operating results.

Shifts in product mix may result in declines in gross profit.

Our gross profit margins vary among our product platforms, and are generally highest on our test & measurement instruments. Our overall gross profit may fluctuate from period to period as a result of a variety of factors including shifts in product mix, the introduction of new products, and decreases in average selling prices for older products. If our customers decide to buy more of our products with low gross profit margins or fewer of our products with high gross profit margins, our total gross profits could be harmed.

Risks Relating to our Operations and Business Strategy

If we cannot successfully transition our revenue mix from contract research revenues to product sales and license revenues, we may not be able to fully execute our business model or grow our business.

Our business model and future growth depend on our ability to transition to a revenue mix that contains significantly larger product sales and revenues from the provision of services or from licensing. Product sales and these revenues potentially offer greater scalability than contract research revenues. Our current plan is to increase our sales of commercial products, our licensing revenues and our provision of non-research services to customers so as to represent a larger percentage of our total revenues. If we are unable to develop and grow our product sales and revenues from the provision of services or from licensing to augment our contract research revenues, however, our ability to execute our business model or grow our business could suffer. There can be no assurance that we will be able to achieve increased revenues in this manner.

Failure to develop, introduce and sell new products or failure to develop and implement new technologies, could adversely impact our financial results.

Our success will depend on our ability to develop and introduce new products that customers choose to buy. The new products the market requires tend to be increasingly complex, incorporating more functions and operating at faster speeds than old products. If we fail to introduce new product designs or technologies in a timely manner or if customers do not successfully introduce new systems or products incorporating our products , our business, financial condition and results of operations could be materially harmed.

If we are unable to manage growth effectively, our revenues and net loss could be adversely affected.

We may need to expand our personnel resources to grow our business effectively. We believe that sustained growth at a higher rate will place a strain on our management as well as on our other human resources. To manage this growth, we must continue to attract and retain qualified management, professional, scientific and technical and operating personnel. If we are unable to recruit a sufficient number of qualified personnel, we may be unable to staff and manage projects adequately, which in turn may slow the rate of growth of our contract research revenues or our product development efforts.

We may not be successful in identifying market needs for new technologies or in developing new products.

Part of our business model depends on our ability to correctly identify market needs for new technologies. We intend to identify new market needs, but we may not always have success in doing so in part because our contract research largely centers on identification and development of unproven technologies, often for new or emerging markets. Furthermore, we must identify the most promising technologies from a sizable pool of projects. If our commercialization strategy process fails to identify projects with commercial potential or if management does not ensure that such projects advance to the commercialization stage, we may not successfully commercialize new products and grow our revenues.

Our growth strategy requires that we also develop successful commercial products to address market needs. We face several challenges in developing successful new products. Many of our existing products and those currently under development are technologically innovative and require significant and lengthy product development efforts. These efforts include planning, designing, developing and testing at the technological, product and manufacturing-process levels. These activities require us to make significant investments. Although there are many potential applications for our technologies, our resource constraints require us to focus on specific products and to forgo other opportunities. We expect that one or more of the

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potential products we choose to develop will not be technologically feasible or will not achieve commercial acceptance, and we cannot predict which, if any, of our products we will successfully develop or commercialize. The technologies we research and develop are new and steadily changing and advancing. The products that are derived from these technologies may not be applicable or compatible with the state of technology or demands in existing markets. Our existing products and technologies may become uncompetitive or obsolete if our competitors adapt more quickly than we do to new technologies and changes in customers’ requirements. Furthermore, we may not be able to identify if and when new markets will open for our products given that future applications of any given product may not be readily determinable, and we cannot reasonably estimate the size of any markets that may develop. If we are not able to successfully develop new products, we may be unable to increase our product revenues.

We face risks associated with our international business.

We currently conduct business internationally and we might considerably expand our international activities in the future. Our international business operations are subject to a variety of risks associated with conducting business internationally, including:


•	having to comply with U.S. export control regulations and policies that restrict our ability to communicate with non-U.S. employees and supply foreign affiliates and customers;


•	changes in or interpretations of foreign regulations that may adversely affect our ability to sell our products, perform services or repatriate profits to the United States;


•	the imposition of tariffs;


•	hyperinflation or economic or political instability in foreign countries;


•	imposition of limitations on, or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries or joint ventures;


•	conducting business in places where business practices and customs are unfamiliar and unknown;


•	the imposition of restrictive trade policies;


•	the imposition of inconsistent laws or regulations;


•	the imposition or increase of investment and other restrictions or requirements by foreign governments;


•	uncertainties relating to foreign laws and legal proceedings;


•	having to comply with a variety of U.S. laws, including the Foreign Corrupt Practices Act ("FCPA"); and


•	having to comply with licensing requirements.

We do not know the impact that these regulatory, geopolitical and other factors may have on our international business in the future.

We may dispose of or discontinue existing product lines and technology developments, which may adversely impact our future results.

On an ongoing basis, we evaluate our various product offerings and technology developments in order to determine whether any should be discontinued or, to the extent possible, divested. For example, we recently sold our HSOR business to a third party. In addition, if we are unable to generate the amount of cash needed to fund the future operations of our business, we may be forced to sell one or more of our product lines or technology developments.

We cannot guarantee that we have correctly forecasted, or that we will correctly forecast in the future, the right product lines and technology developments to dispose or discontinue or that our decision to dispose of or discontinue various investments, products lines and technology developments is prudent if market conditions change. In addition, there are no assurances that the discontinuance of various product lines will reduce operating expenses or will not cause us to incur material charges associated with such decision. Furthermore, the discontinuance of existing product lines entails various risks, including the risk that we will not be able to find a purchaser for a product line or the purchase price obtained will not be equal to at least the book value of the net assets for the product line. Other risks include managing the expectations of, and maintaining good relations with, our historical customers who previously purchased products from a disposed or discontinued product line, which could prevent us from selling other products to them in the future. We may also incur other significant liabilities and costs associated with disposal or discontinuance of product lines, including employee severance costs and excess facilities costs.

We may be liable for damages based on product liability claims relating to defects in our products, which might be brought against us directly, or against our customers in their end-use markets. Such claims could result in a loss of customers in addition to substantial liability in damages.

Our products are complex and undergo quality testing as well as formal qualification, both by our customers and by us. However, defects may occur from time to time. Our customers’ testing procedures may be limited to evaluating our products

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under likely and foreseeable failure scenarios and over varying amounts of time. For various reasons, such as the occurrence of performance problems that are unforeseeable in testing or that are detected only when products age or are operated under peak stress conditions, our products may fail to perform as expected long after customer acceptance. Failures could result from faulty components or design, problems in manufacturing or other unforeseen reasons. As a result, we could incur significant costs to repair or replace defective products under warranty, particularly when such failures occur in installed systems. In addition, we may in certain circumstances honor warranty claims after the warranty has expired or for problems not covered by warranty in order to maintain customer relationships. Any significant product failure could result in lost future sales of the affected product and other products, as well as customer relations problems, litigation and damage to our reputation.

In addition, many of our products are embedded in, or deployed in conjunction with, our customers’ products, which incorporate a variety of components, modules and subsystems and may be expected to interoperate with modules produced by third parties. As a result, not all defects are immediately detectable, and, when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant damages or warranty and repair costs, divert the attention of our engineering personnel from internal product development efforts and cause significant customer relations problems or loss of customers, all of which would harm our business.

Furthermore, many of our products may provide critical performance attributes to our customers’ products that will be sold to end users who could potentially bring product liability suits in which we could be named as a defendant. The sale of these products involves the risk of product liability claims. If a person were to bring a product liability suit against one of our customers, this customer may attempt to seek contribution from us. A person may also bring a product liability claim directly against us. A successful product liability claim or series of claims against us in excess of our insurance coverage for payments, for which we are not otherwise indemnified, could have a material adverse effect on our financial condition or results of operations.

We could be negatively affected by a security breach, either through cyber-attack, cyber-intrusion or other significant disruption of our IT networks and related systems.

We face the risk, as does any company, of a security breach, whether through cyber-attack or cyber-intrusion over the internet, malware, computer viruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization, or other significant disruption of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber-attack or cyber-intrusion, including by computer hackers, foreign governments and cyber terrorists, has increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased.

As a technology company, and particularly as a government contractor, we may face a heightened risk of a security breach or disruption from threats to gain unauthorized access to our proprietary, confidential or classified information on our IT networks and related systems. These types of information and IT networks and related systems are critical to the operation of our business and essential to our ability to perform day-to-day operations, and, in some cases, are critical to the operations of certain of our customers. In addition, as certain of our technological capabilities become widely known, it is possible that we may be subjected to cyber-attack or cyber-intrusion as third parties seek to gain improper access to information regarding these capabilities and cyber-attacks or cyber-intrusion could compromise our confidential information or our IT networks and systems generally, as it is not practical as a business matter to isolate all of our confidential information and trade secrets from email and internet access. There can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging.

A security breach or other significant disruption involving these types of information and IT networks and related systems could disrupt the proper functioning of these networks and systems and therefore our operations, compromise our confidential information and trade secrets, or damage our reputation among our customers and the public generally. Any of these developments could have a negative impact on our results of operations, financial condition and cash flows.

Risks Relating to our Regulatory Environment

Our operations are subject to domestic and foreign laws, regulations and restrictions, and noncompliance with these laws, regulations and restrictions could expose us to fines, penalties, suspension or debarment, which could have a material adverse effect on our profitability and overall financial position.

Our operations, particularly our international sales, subject us to numerous U.S. and foreign laws and regulations, including, without limitation, regulations relating to imports, exports (including the Export Administration Regulations and the International Traffic in Arms Regulations), technology transfer restrictions, anti-boycott provisions, economic sanctions and the FCPA. The number of our various emerging technologies, the development of many of which has been funded by the

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Department of Defense, presents us with many regulatory challenges. Failure by us or our sales representatives or consultants to comply with these laws and regulations could result in administrative, civil, or criminal liabilities and could result in suspension of our export privileges, which could have a material adverse effect on our business. Changes in regulation or political environment may affect our ability to conduct business in foreign markets including investment, procurement and repatriation of earnings.

Environmental regulations could increase operating costs and additional capital expenditures and delay or interrupt operations.

The photonics industry, as well as the semiconductor industry, are subject to governmental regulations for the protection of the environment, including those relating to air and water quality, solid and hazardous waste handling, and the promotion of occupational safety. Various federal, state and local laws and regulations require that we maintain certain environmental permits. While we believe that we have obtained all necessary environmental permits required to conduct our manufacturing processes, if we are found to be in violation of these laws, we could be subject to governmental fines and liability for damages resulting from such violations.

Changes in the aforementioned laws and regulations or the enactment of new laws, regulations or policies could require increases in operating costs and additional capital expenditures and could possibly entail delays or interruptions of our operations.

If our manufacturing facilities do not meet Federal, state or foreign country manufacturing standards, we may be required to temporarily cease all or part of our manufacturing operations, which would result in product delivery delays and negatively impact revenues.

Our manufacturing facilities are subject to periodic inspection by regulatory authorities and our operations will continue to be regulated by the FDA for compliance with Good Manufacturing Practice requirements contained in the quality systems regulations. We are also required to comply with International Organization for Standardization ("ISO"), quality system standards in order to produce certain of our products for sale in Europe. If we fail to continue to comply with Good Manufacturing Practice requirements or ISO standards, we may be required to cease all or part of our operations until we comply with these regulations. Obtaining and maintaining such compliance is difficult and costly. We cannot be certain that our facilities will be found to comply with Good Manufacturing Practice requirements or ISO standards in future inspections and audits by regulatory authorities. In addition, if we cannot maintain or establish manufacturing facilities or operations that comply with such standards or do not meet the expectations of our customers, we may not be able to realize certain economic opportunities in our current or future supply arrangements.

Medical products are subject to various international regulatory processes and approval requirements. If we do not obtain and maintain the necessary international regulatory approvals for any such potential products, we may not be able to market and sell our medical products in foreign countries.

To be able to market and sell medical products in other countries, we must obtain regulatory approvals and comply with the regulations of those countries. These regulations, including the requirements for approvals and the time required for regulatory review, vary from country to country. Obtaining and maintaining foreign regulatory approvals are expensive, and we cannot be certain that we will have the resources to be able to pursue such approvals or whether we would receive regulatory approvals in any foreign country in which we plan to market our products. For example, the European Union requires that manufacturers of medical products obtain the right to affix the CE mark to their products before selling them in member countries of the European Union, which we have not yet obtained and may never obtain. If we fail to obtain regulatory approval in any foreign country in which we plan to market our products, our ability to generate revenues will be harmed.

We are subject to additional significant foreign and domestic government regulations, including environmental and health and safety regulations, and failure to comply with these regulations could harm our business.

Our facilities and current and proposed activities involve the use of a broad range of materials that are considered hazardous under applicable laws and regulations. Accordingly, we are subject to a number of foreign, federal, state and local laws and regulations relating to health and safety, protection of the environment and the storage, use, disposal of, and exposure to, hazardous materials and wastes. We could incur costs, fines and civil and criminal penalties, personal injury and third party property damage claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental, health and safety laws. Moreover, a failure to comply with environmental laws could result in fines and the revocation of environmental permits, which could prevent us from conducting our business. Liability under environmental laws can be joint and several and without regard to fault. There can be no assurance that violations of

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environmental and health and safety laws will not occur in the future as a result of the inability to obtain permits, human error, equipment failure or other causes. Environmental laws could become more stringent over time, imposing greater compliance costs and increasing risks and penalties associated with violations, which could harm our business. Accordingly, violations of present and future environmental laws could restrict our ability to expand facilities, pursue certain technologies, and could require us to acquire costly equipment or incur potentially significant costs to comply with environmental regulations.

Compliance with foreign, federal, state and local environmental laws and regulations represents a small part of our present budget. If we fail to comply with any such laws or regulations, however, a government entity may levy a fine on us or require us to take costly measures to ensure compliance. Any such fine or expenditure may adversely affect our development. We cannot predict the extent to which future legislation and regulation could cause us to incur additional operating expenses, capital expenditures or restrictions and delays in the development of our products and properties.

Risks Relating to our Intellectual Property

Our proprietary rights may not adequately protect our technologies.

Our commercial success will depend in part on our obtaining and maintaining patent, trade secret, copyright and trademark protection of our technologies in the United States and other jurisdictions as well as successfully enforcing this intellectual property and defending it against third-party challenges. We will only be able to protect our technologies from unauthorized use by third parties to the extent that valid and enforceable intellectual property protections, such as patents or trade secrets, cover them. In particular, we place considerable emphasis on obtaining patent and trade secret protection for significant new technologies, products and processes. The degree of future protection of our proprietary rights is uncertain because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep our competitive advantage. The degree of future protection of our proprietary rights is also uncertain for products that are currently in the early stages of development because we cannot predict which of these products will ultimately reach the commercial market or whether the commercial versions of these products will incorporate proprietary technologies.

Our patent position is highly uncertain and involves complex legal and factual questions. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in our patents or in third-party patents. For example:


•	we or our licensors might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;


•	we or our licensors might not have been the first to file patent applications for these inventions;


•	others may independently develop similar or alternative technologies or duplicate any of our technologies;


•	it is possible that none of our pending patent applications or the pending patent applications of our licensors will result in issued patents;


•	patents may issue to third parties that cover how we might practice our technology;


•	our issued patents and issued patents of our licensors may not provide a basis for commercially viable technologies, may not provide us with any competitive advantages, or may be challenged and invalidated by third parties; and


•	we may not develop additional proprietary technologies that are patentable.

Patents may not be issued for any pending or future pending patent applications owned by or licensed to us, and claims allowed under any issued patent or future issued patent owned or licensed by us may not be valid or sufficiently broad to protect our technologies. Moreover, protection of certain of our intellectual property may be unavailable or limited in the United States or in foreign countries, and we have not sought to obtain foreign patent protection for certain of our products or technologies due to cost, concerns about enforceability or other reasons. Any issued patents owned by or licensed to us now or in the future may be challenged, invalidated, or circumvented, and the rights under such patents may not provide us with competitive advantages. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, and in the case of certain products no foreign patents were filed or can be filed. This could make it easier for competitors to capture or increase their market share with respect to related technologies. We could incur substantial costs to bring suits in which we may assert our patent rights against others or defend ourselves in suits brought against us. An unfavorable outcome of any litigation could have a material adverse effect on our business and results of operations.

We also rely on trade secrets to protect our technology, especially where we believe patent protection is not appropriate or obtainable. However, trade secrets are difficult to protect. We regularly attempt to obtain confidentiality agreements and contractual provisions with our collaborators, employees and consultants to protect our trade secrets and proprietary know-how. These agreements may be breached or may not have adequate remedies for such breach. While we use reasonable efforts to protect our trade secrets, our employees, consultants, contractors or scientific and other advisors, or those of our strategic partners, may unintentionally or willfully disclose our information to competitors. If we were to enforce a claim that a third

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party had illegally obtained and was using our trade secrets, our enforcement efforts would be expensive and time consuming, and the outcome would be unpredictable. In addition, courts outside the United States are sometimes unwilling to protect trade secrets. Moreover, if our competitors independently develop equivalent knowledge, methods and know-how, it will be more difficult for us to enforce our rights and our business could be harmed.

If we are not able to defend the patent or trade secret protection position of our technologies, then we will not be able to exclude competitors from developing or marketing competing technologies and we may not generate enough revenues from product sales to justify the cost of developing our technologies and to achieve or maintain profitability.

We also rely on trademarks to establish a market identity for our company and our products. To maintain the value of our trademarks, we might have to file lawsuits against third parties to prevent them from using trademarks confusingly similar to or dilutive of our registered or unregistered trademarks. Also, we might not obtain registrations for our pending trademark applications, and we might have to defend our registered trademark and pending trademark applications from challenge by third parties. Enforcing or defending our registered and unregistered trademarks might result in significant litigation costs and damages, including the inability to continue using certain trademarks.

Third parties may claim that we infringe their intellectual property, and we could suffer significant litigation or licensing expense as a result.

Various U.S. and foreign issued patents and pending patent applications, which are owned by third parties, exist in our technology areas. Such third parties may claim that we infringe their patents. Because patent applications can take several years to result in a patent issuance, there may be currently pending applications, unknown to us, which may later result in issued patents that our technologies may infringe. For example, we are aware of competitors with patents in technology areas applicable to our optical test equipment products. Such competitors may allege that we infringe these patents. There could also be existing patents of which we are not aware that our technologies may inadvertently infringe. We have from time to time been, and may in the future be, contacted by third parties, including patent assertion entities or intellectual property advisors, about licensing opportunities that also contain claims that we are infringing on third party patent rights. If third parties assert these claims against us, we could incur extremely substantial costs and diversion of management resources in defending these claims, and the defense of these claims could have a material adverse effect on our business, financial condition and results of operations. Even if we believe we have not infringed on a third party’s patent rights, we may have to settle a claim on unfavorable terms because we cannot afford to litigate the claim. In addition, if third parties assert claims against us and we are unsuccessful in defending against these claims, these third parties may be awarded substantial damages as well as injunctive or other equitable relief against us, which could effectively block our ability to make, use, sell, distribute or market our products and services in the United States or abroad.

Commercial application of nanotechnologies in particular, or technologies involving nanomaterials, is new and the scope and breadth of patent protection is uncertain. Consequently, the patent positions of companies involved in nanotechnologies have not been tested, and there are complex legal and factual questions for which important legal principles will be developed or may remain unresolved. In addition, it is not clear whether such patents will be subject to interpretations or legal doctrines that differ from conventional patent law principles. Changes in either the patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our nanotechnology-related intellectual property. Accordingly, we cannot predict the breadth of claims that may be allowed or enforced in our nanotechnology-related patents or in third party patents. In the event that a claim relating to intellectual property is asserted against us, or third parties not affiliated with us hold pending or issued patents that relate to our products or technology, we may seek licenses to such intellectual property or challenge those patents. However, we may be unable to obtain these licenses on commercially reasonable terms, if at all, and our challenge of the patents may be unsuccessful. Our failure to obtain the necessary licenses or other rights could prevent the sale, manufacture or distribution of our products and, therefore, could have a material adverse effect on our business, financial condition and results of operations.

A substantial portion of our technology is subject to retained rights of our licensors, and we may not be able to prevent the loss of those rights or the grant of similar rights to third parties.

A substantial portion of our technology is licensed from academic institutions, corporations and government agencies. Under these licensing arrangements, a licensor may obtain rights over the technology, including the right to require us to grant a license to one or more third parties selected by the licensor or that we provide licensed technology or material to third parties for non-commercial research. The grant of a license for any of our core technologies to a third party could have a material and adverse effect on our business. In addition, some of our licensors retain certain rights under the licenses, including the right to grant additional licenses to a substantial portion of our core technology to third parties for non-commercial academic and research use. It is difficult to monitor and enforce such non-commercial academic and research uses, and we cannot predict whether the third-party licensees would comply with the use restrictions of such licenses. We have incurred and could incur

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substantial expenses to enforce our rights against them. We also may not fully control the ability to assert or defend those patents or other intellectual property which we have licensed from other entities, or which we have licensed to other entities.

In addition, some of our licenses with academic institutions give us the right to use certain technology previously developed by researchers at these institutions. In certain cases we also have the right to practice improvements on the licensed technology to the extent they are encompassed by the licensed patents and are within our field of use. Our licensors may currently own and may in the future obtain additional patents and patent applications that are necessary for the development, manufacture and commercial sale of our anticipated products. We may be unable to agree with one or more academic institutions from which we have obtained licenses whether certain intellectual property developed by researchers at these academic institutions is covered by our existing licenses. In the event that the new intellectual property is not covered by our existing licenses, we would be required to negotiate a new license agreement. We may not be able to reach agreement with current or future licensors on commercially reasonable terms, if at all, or the terms may not permit us to sell our products at a profit after payment of royalties, which could harm our business.

Some of our patents may cover inventions that were conceived or first reduced to practice under, or in connection with, U.S. government contracts or other federal funding agreements. With respect to inventions conceived or first reduced to practice under a federal funding agreement, the U.S. government may retain a non-exclusive, non-transferable, irrevocable, paid-up license to practice or have practiced for or on behalf of the United States the invention throughout the world. We may not succeed in our efforts to retain title in patents, maintain ownership of intellectual property or in limiting the U.S. government’s rights in our proprietary technologies and intellectual property when an issue exists as to whether such intellectual property was developed in the performance of a federal funding agreement or developed at private expense.

If we fail to obtain the right to use the intellectual property rights of others which are necessary to operate our business, and to protect their intellectual property, our business and results of operations will be adversely affected.

In the past, we have licensed certain technologies for use in our products. In the future, we may choose, or be required, to license technology or intellectual property from third parties in connection with the development of our products. We cannot assure you that third-party licenses will be available on commercially reasonable terms, if at all. Our competitors may be able to obtain licenses, or cross-license their technology, on better terms than we can, which could put us at a competitive disadvantage. Also, we often enter into confidentiality agreements with such third parties in which we agree to protect and maintain their proprietary and confidential information, including at times requiring our employees to enter into agreements protecting such information. There can be no assurance that the confidentiality agreements will not be breached by any of our employees or that such third parties will not make claims that their proprietary information has been disclosed.

RISKS RELATING TO OUR COMMON STOCK

If there are substantial sales of our common stock, or the perception that such sales may occur, our stock price could decline.

If any of our stockholders were to sell substantial amounts of our common stock, the market price of our common stock may decline, which might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. Substantial sales of our common stock, or the perception that such sales may occur, may have a material adverse effect on the prevailing market price of our common stock.

Carilion Clinic holds approximately 3.5 million shares of our common stock (including approximately 1.3 million shares issuable to Carilion upon conversion of shares of Series A Convertible Preferred Stock that Carilion holds). All of these shares have been registered for sale on a Form S-3 registration statement and, accordingly, may generally be freely sold by Carilion at any time. Any sales of these shares, or the perception that future sales of shares may occur by Carilion or any of our other significant stockholders, may have a material adverse effect on the market price of our stock. Any such continuing material adverse effect on the market price of our stock could impair our ability to comply with NASDAQ’s continuing listing standards in respect of our minimum stock price, as further described below.

We may become involved in securities class action litigation that could divert management’s attention and harm our business and our insurance coverage may not be sufficient to cover all costs and damages.

The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of technology companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, following periods of volatility in the market price of a particular company’s

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securities, securities class action litigation has often been brought against that company. Securities class litigation also often follows certain significant business transactions, such as the sale of a business division or a change in control transaction. We may become involved in this type of litigation in the future. Litigation often is expensive and diverts management’s attention and resources, which could adversely affect our business.

We may not be able to comply with all applicable listing requirements or standards of The NASDAQ Capital Market and NASDAQ could delist our common stock.

Our common stock is listed on The NASDAQ Capital Market. In order to maintain that listing, we must satisfy minimum financial and other continued listing requirements and standards. One such requirement is that we maintain a minimum bid price of at least $1.00 per share for our common stock. Although we currently comply with the minimum bid requirement, in the recent past, our minimum bid price has fallen below $1.00 per share, and it could again do so in the future. If our bid price falls below $1.00 per share for 30 consecutive business days, we will receive a deficiency notice from NASDAQ advising us that we have 180 days to regain compliance by maintaining a minimum bid price of at least $1.00 for a minimum of ten consecutive business days. Under certain circumstances, NASDAQ could require that the minimum bid price exceed $1.00 for more than ten consecutive days before determining that a company complies.

In the event that our common stock is not eligible for continued listing on NASDAQ or another national securities exchange, trading of our common stock could be conducted in the over-the-counter market or on an electronic bulletin board established for unlisted securities such as the Pink Sheets or the OTC Bulletin Board. In such event, it could become more difficult to dispose of, or obtain accurate price quotations for, our common stock, and there would likely also be a reduction in our coverage by security analysts and the news media, which could cause the price of our common stock to decline further. Also, it may be difficult for us to raise additional capital if we are not listed on a major exchange.

Our common stock price has been volatile and we expect that the price of our common stock will fluctuate substantially in the future, which could cause you to lose all or a substantial part of your investment.

The public trading price for our common stock is volatile and may fluctuate significantly. Since January 1, 2009, our common stock has traded between a high of $5.00 per share and a low of $0.26 per share. Among the factors, many of which we cannot control, that could cause material fluctuations in the market price for our common stock are:


•	sales of our common stock by our significant stockholders, or the perception that such sales may occur;


•	changes in earnings estimates, investors’ perceptions, recommendations by securities analysts or our failure to achieve analysts’ earnings estimates;


•	changes in our status as an entity eligible to receive SBIR contracts and grants;


•	quarterly variations in our or our competitors’ results of operations;


•	general market conditions and other factors unrelated to our operating performance or the operating performance of our competitors;


•	announcements by us, or by our competitors, of acquisitions, new products, significant contracts, commercial relationships or capital commitments;


•	pending or threatened litigation;


•	any major change in our board of directors or management or any competing proxy solicitations for director nominees;


•	changes in governmental regulations or in the status of our regulatory approvals;


•	announcements related to patents issued to us or our competitors;


•	a lack of, limited or negative industry or securities analyst coverage;


•	discussions of our company or our stock price by the financial and scientific press and online investor communities; and


•	general developments in our industry.

In addition, the stock prices of many technology companies have experienced wide fluctuations that have often been unrelated to the operating performance of those companies. These factors may materially and adversely affect the market price of our common stock.

If our internal control over financial reporting is found not to be effective or if we make disclosure of existing or potential material weaknesses in those controls, investors could lose confidence in our financial reports, and our stock price may be adversely affected.

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Section 404 of the Sarbanes-Oxley Act of 2002 requires us to include an internal control report with our Annual Report on Form 10-K. That report must include management’s assessment of the effectiveness of our internal control over financial reporting as of the end of the fiscal year.

We evaluate our existing internal control over financial reporting based on the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. During the course of our ongoing evaluation of the internal controls, we may identify areas requiring improvement, and may have to design enhanced processes and controls to address issues identified through this review. Remedying any deficiencies, significant deficiencies or material weaknesses that we identify may require us to incur significant costs and expend significant time and management resources. We cannot assure you that any of the measures we implement to remedy any such deficiencies will effectively mitigate or remedy such deficiencies. Investors could lose confidence in our financial reports, and our stock price may be adversely affected, if our internal controls over financial reporting are found not to be effective by management or if we make disclosure of existing or potential significant deficiencies or material weaknesses in those controls.

Anti-takeover provisions in our amended and restated certificate of incorporation and bylaws and Delaware law could discourage or prevent a change in control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.

Our amended and restated certificate of incorporation and bylaws and Delaware law contain provisions that might delay or prevent a change in control, discourage bids at a premium over the market price of our common stock and adversely affect the market price of our common stock and the voting and other rights of the holders of our common stock. These provisions include:


•	a classified board of directors serving staggered terms;


•	advance notice requirements to stockholders for matters to be brought at stockholder meetings;


•	a supermajority stockholder vote requirement for amending certain provisions of our amended and restated certificate of incorporation and bylaws; and


•	the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.

We are also subject to provisions of the Delaware General Corporation law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for three years unless the holder’s acquisition of our stock was approved in advance by our board of directors or certain other conditions are satisfied.

The existence of these provisions could adversely affect the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.

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ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(a) Unregistered Sales of Equity Securities during the Three Months Ended June 30, 2017

Common Stock Dividend Payable to Carilion

We issued 1,321,514 shares of Series A Preferred Stock, par value $0.001 per share, to Carilion Clinic in January 2010, which shares were issued in reliance on the exemptions from registration under the Securities Act provided by Sections 3(a)(9) and 4 (a)(2) thereof. The Series A Preferred Stock accrues dividends at the rate of $0.2815 per share per annum, payable quarterly in arrears. Accrued dividends are payable in shares of our common stock, with the number of shares being equal to the quotient of (i) the cumulative aggregate balance of accrued but unpaid dividends on each share of Series A Preferred Stock divided by (ii) the conversion price of the Series A Preferred Stock, which is currently $4.69159 per share. For the period from January 12, 2010, the original issue date of the Series A Preferred Stock, through June 30, 2017, the Series A Preferred Stock issued to Carilion has accrued $1,077,074 in dividends. The accrued dividend as of June 30, 2017 will be paid by the issuance of 592,047 shares of our common stock, which we will issue at Carilion’s written request. As the Series A Preferred Stock was issued in reliance on the exemption provided by Section 3(a)(9), the shares of common stock payable as dividends will also be exempt from registration in reliance on Section 3(a)(9) of the Securities Act.

(b) Use of Proceeds from Sale of Registered Equity Securities

Not applicable.

On June 9, 2016, we announced that our board of directors approved a stock repurchase program, authorizing the repurchase of up to $2.0 million of our common stock. We did not make any purchases of stock under this program during the six months ended June 30, 2017. The aggregate purchase price of $0.2 million was expended under this program as of May 31, 2017. This program was not extended and expired on May 31, 2017.

The following table summarizes repurchases of our common stock during June 2017 to satisfy tax withholding obligations triggered upon the vesting of restricted stock awards. There were no purchases during April 2017 or May 2017.



				Total Number of	Approximate Dollar
				Shares Purchased as	Value of Shares that
	Total Number of Shares	Average Price Paid per		Part of a Publicly	May Yet be Purchased
Period	Purchased	Share		Announced Program	Under the Program
6/1/2017 - 6/30/2017	90,900	$	1.58	—	$	—



ITEM 3.	DEFAULTS UPON SENIOR SECURITIES

None.



ITEM 4.	MINE SAFETY DISCLOSURES

Not applicable.



ITEM 5.	OTHER INFORMATION

None.



ITEM 6.	EXHIBITS

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The exhibits listed on the Exhibit Index hereto are filed or incorporated by reference (as stated therein) as part of this Quarterly Report on Form 10-Q.

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SIGNATURES

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



		Luna Innovations Incorporated
Date:	August 10, 2017	By:	/s/ Dale Messick
			Dale Messick
			Chief Financial Officer (principal financial and accounting officer and duly authorized officer)

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EXHIBIT INDEX



Exhibit Number		Description
31.1		Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

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

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

101		The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at June 30, 2017 and December 31, 2016, (ii) Consolidated Statements of Operations for the three and six months ended June 30, 2017 and 2016, (iii) Consolidated Statements of Cash Flows for the six months ended June 30, 2017 and 2016 and (iv) Notes to Unaudited Consolidated Financial Statements.



*	These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of the registrant, whether made before or after the date hereof, regardless of any general incorporation language in such filing.