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Table of Contents

 
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, 2018
OR
¨
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 July 30, 2018, there were 27,932,271 shares of the registrant’s common stock outstanding.
 




Table of Contents

LUNA INNOVATIONS INCORPORATED
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2018
TABLE OF CONTENTS

ITEM 1.
ITEM 2.
ITEM 3.
ITEM 4.
ITEM 1.
ITEM 1A.
ITEM 2.
ITEM 3.
ITEM 4.
ITEM 5.
ITEM 6.


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PART I. FINANCIAL INFORMATION
 
ITEM 1.
FINANCIAL STATEMENTS
Luna Innovations Incorporated
Consolidated Balance Sheets
 
June 30, 2018
 
December 31, 2017
 
(unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
33,292,800

 
$
36,981,533

Accounts receivable, net
9,385,772

 
7,869,168

Receivable from sale of HSOR business
4,001,833

 
4,000,976

Contract assets
3,231,770

 
1,778,142

Inventory
6,906,998

 
6,951,110

Prepaid expenses and other current assets
1,054,984

 
1,220,650

Total current assets
57,874,157

 
58,801,579

Long-term contract assets
308,093

 
209,699

Property and equipment, net
3,323,749

 
3,453,741

Intangible assets, net
3,137,083

 
3,237,593

Goodwill
502,000

 
502,000

Other assets
18,024

 
18,024

Total assets
$
65,163,106

 
$
66,222,636

Liabilities and stockholders’ equity
 
 
 
Liabilities:
 
 
 
Current liabilities:
 
 
 
Current portion of long-term debt obligations
$
1,527,828

 
$
1,833,333

Current portion of capital lease obligations
34,661

 
43,665

Accounts payable
3,787,701

 
2,962,863

Accrued liabilities
5,554,481

 
6,557,649

Contract liabilities
1,400,922

 
3,428,625

Total current liabilities
12,305,593

 
14,826,135

Long-term deferred rent
1,109,397

 
1,184,438

Long-term debt obligations

 
603,007

Long-term capital lease obligations
54,970

 
71,275

Total liabilities
13,469,960

 
16,684,855

Commitments and contingencies

 

Stockholders’ equity:
 
 
 
Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at June 30, 2018 and December 31, 2017
1,322

 
1,322

Common stock, par value $0.001, 100,000,000 shares authorized, 29,025,529 and 28,354,822 shares issued, 27,772,424 and 27,283,918 shares outstanding at June 30, 2018 and December 31, 2017
29,897

 
29,186

Treasury stock at cost, 1,253,105 and 1,070,904 shares at June 30, 2018 and December 31, 2017
(2,116,640
)
 
(1,649,746
)
Additional paid-in capital
84,742,385

 
83,563,208

Accumulated deficit
(30,963,818
)
 
(32,406,189
)
Total stockholders’ equity
51,693,146

 
49,537,781

Total liabilities and stockholders’ equity
$
65,163,106

 
$
66,222,636

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,
 
2018
 
2017
 
2018
 
2017
 
(unaudited)
 
(unaudited)
Revenues:
 
 
 
 
 
 
 
Technology development
$
5,466,281

 
$
4,602,272

 
$
10,103,056

 
$
8,838,375

Products and licensing
8,306,367

 
6,690,759

 
15,862,763

 
12,541,554

       Total revenues
13,772,648

 
11,293,031

 
25,965,819

 
21,379,929

Cost of revenues:
 
 
 
 

 
 
Technology development
3,945,126

 
3,443,954

 
7,298,628

 
6,553,423

Products and licensing
4,155,054

 
3,482,867

 
7,968,605

 
6,583,913

       Total cost of revenues
8,100,180

 
6,926,821

 
15,267,233

 
13,137,336

Gross profit
5,672,468

 
4,366,210

 
10,698,586

 
8,242,593

Operating expense:
 
 
 
 

 
 
Selling, general and administrative
3,767,456

 
3,367,716

 
7,577,072

 
7,089,889

Research, development and engineering
1,003,863

 
818,891

 
2,105,352

 
1,747,662

       Total operating expense
4,771,319

 
4,186,607

 
9,682,424

 
8,837,551

Operating income/(loss)
901,149

 
179,603

 
1,016,162

 
(594,958
)
Other income/(expense):
 
 
 
 

 
 
Investment income
100,846

 

 
175,756

 

Other income/(expense)
1,187

 
(1,225
)
 
2,583

 
(869
)
Interest expense
(33,988
)
 
(60,386
)
 
(75,234
)
 
(124,760
)
Total other income/(expense)
68,045

 
(61,611
)
 
103,105

 
(125,629
)
Income/(loss) from continuing operations before income taxes
969,194

 
117,992

 
1,119,267

 
(720,587
)
Income tax (benefit)/expense
(98,133
)
 
40,937

 
(96,736
)
 
67,627

Net income/(loss) from continuing operations
1,067,327

 
77,055

 
1,216,003

 
(788,214
)
Loss from discontinued operations, net of income tax of $0

 
(298,817
)
 

 
(789,534
)
Net loss from discontinued operations

 
(298,817
)
 

 
(789,534
)
Net income/(loss)
1,067,327

 
(221,762
)
 
1,216,003

 
(1,577,748
)
Preferred stock dividend
63,235

 
29,536

 
127,660

 
63,632

Net income/(loss) attributable to common stockholders
$
1,004,092

 
$
(251,298
)
 
$
1,088,343

 
$
(1,641,380
)
Net income/(loss) per share from continuing operations:
 
 
 
 
 
 
 
       Basic
$
0.04

 
$

 
$
0.04

 
$
(0.03
)
       Diluted
$
0.03

 
$

 
$
0.04

 
$
(0.03
)
Net loss per share from discontinued operations:
 
 
 
 
 
 
 
       Basic
$

 
$
(0.01
)
 
$

 
$
(0.03
)
       Diluted
$

 
$
(0.01
)
 
$

 
$
(0.03
)
Net income/(loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
        Basic
$
0.04

 
$
(0.01
)
 
$
0.04

 
$
(0.06
)
        Diluted
$
0.03

 
$
(0.01
)
 
$
0.03

 
$
(0.06
)
Weighted average common shares and common equivalent shares outstanding:
 
 
 
 
 
 
 
        Basic
27,531,361

 
27,600,147

 
27,368,185

 
27,570,919

        Diluted
31,506,745

 
32,579,379

 
31,257,277

 
27,570,919

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,
 
2018
 
2017
 
(unaudited)
Cash flows used in operating activities
 
 
 
Net income/(loss)
$
1,216,003

 
$
(1,577,748
)
Adjustments to reconcile net income/(loss) to net cash used in operating activities
 
 

Depreciation and amortization
622,577

 
1,753,748

Share-based compensation
212,149

 
321,756

Bad debt expense
6,000

 
40,753

Gain on disposal of fixed assets
(1,000
)
 
(670
)
Change in assets and liabilities
 
 

Accounts receivable
(1,522,604
)
 
1,433,014

Contract assets
(645,824
)
 
(326,333
)
Inventory
(482,194
)
 
(1,170,519
)
Other current assets
164,809

 
325,005

Accounts payable and accrued expenses
(253,372
)
 
(894,315
)
Contract liabilities
(2,053,566
)
 
(215,555
)
Net cash used in operating activities
(2,737,022
)
 
(314,321
)
Cash flows used in investing activities
 
 
 
Acquisition of property and equipment
(198,012
)
 
(796,217
)
Intangible property costs
(185,909
)
 
(318,942
)
       Proceeds from sale of property and equipment
1,000

 
3,000

Net cash used in investing activities
(382,921
)
 
(1,112,159
)
Cash flows used in financing activities
 
 
 
Payments on capital lease obligations
(25,309
)
 
(25,611
)
Payments of debt obligations
(916,665
)
 
(916,666
)
Repurchase of common stock
(466,894
)
 
(143,266
)
Proceeds from the exercise of options and warrants
840,078

 
820

Net cash used in financing activities
(568,790
)
 
(1,084,723
)
Net decrease in cash and cash equivalents
(3,688,733
)
 
(2,511,203
)
Cash and cash equivalents—beginning of period
36,981,533

 
12,802,458

Cash and cash equivalents—end of period
$
33,292,800

 
$
10,291,255

Supplemental disclosure of cash flow information
 
 
 
Cash paid for interest
$
72,127

 
$
120,191

Cash paid for income taxes
$
8,156

 
$
40,937

Non-cash investing and financing activities
 
 
 
Dividend on preferred stock, 39,646 shares of common stock issuable for the six months ended June 30, 2018 and 2017
$
127,660

 
$
63,632

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 performance fiber optic test products for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. Prior to the sale of our optoelectronics business in July 2018 (See Note 10), we also developed and manufactured custom optoelectronic components and sub-assemblies for various industrial applications. 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.
Unaudited Interim Financial Information
The accompanying unaudited consolidated interim 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 interim 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, 2018, results of operations for the three and six months ended June 30, 2018 and 2017, and cash flows for the six months ended June 30, 2018 and 2017. The results of operations for the three and six months ended June 30, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. The consolidated balance sheet as of December 31, 2017 was derived from our audited consolidated financial statements.
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, 2017, included in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”) on March 21, 2018.
Reclassifications
Certain amounts in the prior period have been reclassified to conform to current presentation. As a result of the adoption of Accounting Standards Codification ("ASC") 2014-09, Revenue from Contracts with Customers (Topic 606), we presented balances entitled contract assets and contract liabilities within the consolidated balance sheet as well as the impact of the changes in these balances within the consolidated statement of cash flows. We reclassified comparable balances within the December 31, 2017 consolidated balance sheet as well as the impact of changes in those balances within the consolidated statement of cash flows in order to enhance comparability. These reclassifications had no effect on our reported financial condition, results of operations, or cash flows. Any other reclassifications were immaterial to the consolidated interim financial statements taken as a whole.
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

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rate on our credit facilities with Silicon Valley Bank ("SVB") to be at market for similar instruments. Certain non-financial assets and liabilities are measured at fair value on a nonrecurring basis in accordance with U.S. GAAP. This includes items such as non-financial assets and liabilities initially measured at fair value in a business combination and non-financial long-lived asset groups measured at fair value for an impairment assessment. In general, non-financial 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.
Net Income/(Loss) Per Share
Basic per share data is computed by dividing our net income/(loss) by the weighted average number of shares outstanding during the period. Diluted per share data is computed by dividing net income/(loss), 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 4.0 million and 5.0 million common stock equivalents (which include outstanding warrants, preferred stock and stock options) are included for the diluted per share data for the three months ended June 30, 2018 and 2017, respectively. The effect of 3.9 million common stock equivalents are included for the diluted per share data for the six months ended June 30, 2018. The effect of 4.6 million common stock equivalents are not included for the six months ended June 30, 2017, as they are anti-dilutive to earnings per share due to our net loss from continuing operations.
Recently Issued Accounting Pronouncements

Effective January 1, 2018, we adopted Revenue from Contracts with Customers (Topic 606), using the modified retrospective transition method. Under the modified retrospective approach, we apply the standards to new contracts and those that were not completed as of January 1, 2018. For those contracts not completed as of January 1, 2018, this method resulted in a cumulative adjustment to decrease the accumulated deficit in the net amount of $0.4 million. Prior periods will not be retrospectively adjusted, but we will maintain dual reporting for the year of initial application in order to maintain comparability of the periods presented. The cumulative effect of the changes made to our January 1, 2018 unaudited consolidated balance sheet for the adoption of Topic 606 was as follows:

 
Balance at
 
Adjustment for
 
Adjusted balance at
 
December 31, 2017
 
Topic 606
 
January 1, 2018
Assets:
 
 
 
 
 
Contract assets
$
1,778,142

 
$
906,197

 
$
2,684,339

Inventory
$
6,951,110

 
$
(526,306
)
 
$
6,424,804

 
 
 
 
 
 
Liabilities:
 
 
 
 
 
Contract liabilities
$
3,428,625

 
$
25,863

 
$
3,454,488

 
 
 
 
 
 
Stockholders' equity:
 
 
 
 
 
Accumulated deficit
$
(32,406,189
)
 
$
354,028

 
$
(32,052,161
)

Contract assets were formerly reported as unbilled accounts receivable. Contract liabilities were formerly reported as accrued liabilities or deferred revenue. Inventory was also impacted by the adoption of the new guidance. The titles have been changed in the table below to be consistent with accounts currently used under the new standard.


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December 31, 2017
 
As Reported
As Adopted
Accounts receivables, net
$
9,857,009

$
7,869,168

Contract assets

1,778,142

Long-term contract assets

209,699

Accrued liabilities
8,959,935

6,557,649

Contract liabilities

3,428,625

Deferred revenue
1,026,339




Under the new standard, contracts in our Technology Development segment, which primarily provide research services, are not materially impacted upon the adoption of Topic 606 as revenue will continue to be recognized over time using an input model.  Contracts in our Products and Licensing segment generally provide for the following revenue sources: standard product sales, custom product development and sales, product rental, extended warranties, training/service, and certain royalties.  Revenues for this segment are recognized using either the “point in time” or “over time” methods of Topic 606, depending upon the revenue source.  The major change in revenue recognition for the Products and Licensing segment related to custom optoelectronic products which changed from “point in time” to “over time” upon the adoption of Topic 606. Our revenue recognized specific to custom products approximates $10 million annually.   This change results in the acceleration of revenue when compared to existing standards with the cumulative adjustment relating to contracts that are not complete as of December 31, 2017 recognized as an adjustment to opening accumulated deficit on January 1, 2018.   Our revenue for our standard products will continue to be recognized using the "point in time" model of Topic 606, and the timing of such revenue recognition is not expected to differ materially from our historical revenue recognition. Other immaterial adjustments related to the Products and Licensing segment that are sometimes offered to customers include discounts on future purchases related to rental agreements, customer rights of return, and volume discounts.

Technology Development Revenues

We perform research and development for U.S. Federal government agencies, educational institutions and commercial organizations. We account for a research contract when a contract has been executed, the rights of the parties are identified, payment terms are identified, the contract has commercial substance, and collectability of the contract price is considered probable. Revenue is earned under cost reimbursable, time and materials and fixed price contracts. Direct contract costs are expensed as incurred.

Our contracts with agencies of the U.S. government are subject to periodic funding by the respective contracting agency. Funding for a contract may be provided in full at inception of the contract or ratably throughout the contract as the services are provided. In evaluating the probability of funding for purposes of assessing collectability of the contract price, we consider our previous experience with our customers, communication with our customers regarding funding status and our knowledge of available funding for the contract or program. If funding is not assessed as probable, revenue recognition is deferred until realization is reasonably assured.

Under the typical payment terms of our U.S. government contracts, the customer pays us either performance-based payments ("PBPs") or progress payments. PBPs, which are typically used in the firm fixed price contracts, are interim payments based on quantifiable measures of performance or on the achievement of specified events or milestones. Progress payments, which are typically used in our cost type contracts, are interim payments based on costs incurred as the work progresses. For our U.S. government cost-type contracts, the customer generally pays us during the performance period for 80%-90% of our actual costs incurred. Because the customer retains a small portion of the contract price until completion of the contract and audit of allowable costs, cost type contracts generally result in revenue recognized in excess of billings which we present as contract assets on the balance sheet. Amounts billed and due from our customers are classified as receivables on the balance sheet. For non-U.S. government contracts, we typically receive interim payments as work progresses, although for some contracts, we may be entitled to receive an advance payment. We recognize a liability for these advance payments and PBPs paid in advance which are in excess of the revenue recognized and present these amounts as contract liabilities on the balance sheet.

To determine the proper revenue recognition method for research and development contracts, we evaluate whether two or more contracts should be combined and accounted for as one single modified contract and whether the combined or single contract should be accounted for as more than one performance obligation. For instances where a contract has options that were bid with the initial contract and awarded at a later date, we combine the options with the original contract when options are awarded. For most of our contracts, the customer contracts for research with multiple milestones that are interdependent. Consequently, the entire contract is accounted for as one performance obligation. The effect of the combined or modified contract on the transaction price and measure of

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progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis.

Contract revenue recognition is measured over time as we perform because of continuous transfer of control to the customer. For U.S. government contracts which are typically subject to the Federal Acquisition Regulation ("FAR"), this continuous transfer of control to the customer is supported by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay us for cost incurred plus a reasonable profit and take control of any work in process. From time to time, as part of normal management processes, facts may change, causing revisions to estimated total costs or revenues expected. The cumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period in which they become known.

Because of control transferring over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the services to be provided. We generally use the input method, more specifically the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. The underlying bases for estimating our contract research revenues are measurable expenses, such as labor, subcontractor costs and materials, and data that are updated on a regular basis for purposes of preparing our cost estimates. Our research contracts generally have a period of performance of six months to three years, and our estimates of contract costs have historically been consistent with actual results. Revisions in these estimates between accounting periods to reflect changing facts and circumstances have not had a material impact on our operating results, and we do not expect future changes in these estimates to be material. The cumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period in which they become known.

Under cost reimbursable contracts, we are reimbursed for costs that are determined to be reasonable, allowable and allocable to the contract and paid a fixed fee representing the profit negotiated between us and the contracting agency. Revenue from cost reimbursable contracts is recognized as costs are incurred plus an estimate of applicable fees earned. We consider fixed fees under cost reimbursable contracts to be earned in proportion to the allowable costs incurred in performance of the contract.

Revenue from time and materials contracts is recognized based on direct labor hours expended at contract billing rates plus other billable direct costs.

Fixed price contracts may include either a product delivery or specific service performance throughout a period. For fixed price contracts that are based on the proportional performance method and involve a specified number of deliverables, we recognize revenue based on the proportion of the cost of the deliverables compared to the cost of all deliverables included in the contract as this method more accurately measures performance under these arrangements. For fixed price contracts that provide for the development and delivery of a specific prototype or product, revenue is recognized based upon the percentage of completion method.

Whether certain costs under government contracts are allowable is subject to audit by the government. Certain indirect costs are charged to contracts using provisional or estimated indirect rates, which are subject to later revision based on government audits of those costs. Management is of the opinion that costs subsequently disallowed, if any, would not likely have a significant impact on revenues recognized for those contracts.

Products and Licensing Revenues

We produce standard and customized products for commercial organizations, educational institutions, and U.S. Federal government agencies. In addition we will also offer extended warranties, product rentals, and services which include testing, training, or repairs for specific products. Customers also pay royalties as agreed based on sales or usage. We account for product and related items when a contract has been executed, the rights of the parties are identified, payment terms are identified, the contract has commercial substance, and collectability of the contract price is considered probable.

To determine the proper revenue recognition method for Products and Licensing contracts, we evaluate whether two or more contracts should be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performance obligation. We recognize revenue when the performance obligation has been satisfied by transferring the control of the product or service to the customer. For tangible products that contain software that is essential to the tangible product’s functionality, we consider the product and software to be a single performance obligation and recognize revenue accordingly. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation based on their relative stand-alone selling prices. In such circumstances, we use the observable price of goods or services

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which are sold separately in similar circumstances to similar customers. If these prices are not observable, then we will estimate the stand-alone selling price using information that is reasonably available. For the majority of our standard products and services, price list and discount structures related to customer type are available. For products and services that do not have price list and discount structures, we may use one or more of the following: (i) adjusted market assessment approach, (ii) expected cost plus a margin approach, and (iii) residual approach. The adjusted market approach requires us to evaluate the market in which we sell goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. The expected cost plus margin approach requires us to forecast our expected costs of satisfying the performance obligation and then add a reasonable margin for that good or service. The residual approach decreases the total transaction price by the sum of the observable standalone selling prices if either the company sells the same good or services to different customers for a broad range of amounts or the company has not established a price for the good or service and that good or service has not been sold on a standalone basis. Shipping and handling activities primarily occur after a customer obtains control and are considered fulfillment cost rather than separate performance obligations. Similarly, sales and similar taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customer are excluded from the measurement of the transaction price.

For standard products, we recognize revenue at a point in time when control passes to the customer. Absent substantial product acceptance clauses, this is based on the shipping terms. For custom products that require engineering and development based on customer requirements, we will recognize revenue over time using the output method for any items shipped and any finished goods or work in process that is produced for balances of open sales orders. For any finished goods or work in process that has been produced for the balance of open sales orders we recognize revenue by applying the average selling price for such open order to the lesser of the on hand balance in finished goods or open sales order quantity which we present as a contract asset on the balance sheet. Cost of sales is recognized based on the standard cost of the finished goods and work in process associated with this revenue and inventory balances are reduced accordingly. For extended warranties and product rentals, revenue is recognized over time using the output method based on the time elapsed for the warranty or service period. In the case of warranties, we record a contract liability for amounts billed but that are not recognized until subsequent period. A separate contract liability is recorded for the cost associated with warranty repairs based on our estimate of future expense. For testing services where we are performing testing on an asset the customer controls, revenue is recognized over time by the output method using the performance to date. For training where the customer is receiving the benefit of training as it is occurring and for repairs to a customer controlled asset, revenue is recognized over time by the output method using the performance to date. For royalty revenue, we apply the practical expedient “royalty exception” recognizing revenue based on the royalty agreement which specifies an amount based on sales or minimum amount, whichever is greater.

In some product rental contracts, a customer may be offered a discount on the purchase of an item that would provide for a material right. When a material right has been provided to a customer, a separate performance obligation is established and a portion of the rental revenue will be deferred until the future product is purchased or the option expires. This deferred revenue is recognized as a contract liability on the balance sheet. In certain circumstances we may offer a "right of return" to a distributor of our products, in which case a contract liability is calculated based on the terms of the agreement and recorded as a reduction to revenue. In addition, a contract asset for the rights to recover products from customers and a reduction of cost of sales is also calculated and recorded.

Unfulfilled performance obligations represent amounts expected to be earned on executed contracts. Indefinite delivery and quantity contracts and unexercised options are not reported in total unfulfilled performance obligations. Unfulfilled performance obligations include funded obligations, 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 obligations, representing firm orders for which funding has not yet been appropriated. The approximate value of our Technology Development segment unfulfilled performance obligations was $19.3 million at June 30, 2018. We expect to satisfy 48% of the performance obligations in 2018, 41% in 2019 and the remaining by 2022. The approximate value of our Products and Licensing segment unfulfilled performance obligations was $5.5 million at June 30, 2018. We expect to satisfy 69% of the performance obligations in 2018, 28% in 2019 and the remaining by 2023.

We disaggregate our revenue from contracts with customers by geographic locations, customer-type, contract type, timing of recognition, and major categories for each of our segments, as we believe it best depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected by economic factors. See details in the tables below.


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Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
 
 
(unaudited)
 
(unaudited)
 
 
Technology Development
Products and Licensing
Total
 
Technology Development
Products and Licensing
Total
Total Revenue by Geographic Location
 
 
 
 
 
 
 
United States
$
5,466,281

$
4,992,300

$
10,458,581

 
$
10,103,056

$
9,837,137

$
19,940,193

 
Asia

1,762,578

1,762,578

 

3,188,925

3,188,925

 
Europe

1,421,279

1,421,279

 

2,607,288

2,607,288

 
Canada, Central and South America

127,150

127,150

 

224,353

224,353

 
All Others

3,060

3,060

 

5,060

5,060

 
Total
$
5,466,281

$
8,306,367

$
13,772,648

 
$
10,103,056

$
15,862,763

$
25,965,819

 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Total Revenue by Major Customer Type
 

 
 
 
 
 
Sales to the U.S. government
$
5,463,117

$
885,133

$
6,348,250

 
$
10,068,270

$
1,275,202

$
11,343,472

 
U.S. direct commercial sales and other
3,164

4,107,167

4,110,331

 
34,786

8,572,516

8,607,302

 
Foreign commercial sales & other

3,314,067

3,314,067

 

6,015,045

6,015,045

 
Total
$
5,466,281

$
8,306,367

$
13,772,648

 
$
10,103,056

$
15,862,763

$
25,965,819

 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Total Revenue by Contract Type
 

 
 
 
 
 
Fixed-price contracts
$
2,375,939

$
8,306,367

$
10,682,306

 
$
4,607,592

$
15,862,763

$
20,470,355

 
Cost-type contracts
3,090,342


3,090,342

 
5,495,464


5,495,464

 
  Total
$
5,466,281

$
8,306,367

$
13,772,648

 
$
10,103,056

$
15,862,763

$
25,965,819

 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
Total Revenue by Timing of Recognition
 

 
 
 
 
 
Goods transferred at a point in time
$

$
5,938,992

$
5,938,992

 
$

$
11,813,318

$
11,813,318

 
Goods/services transferred over time
5,466,281

2,367,375

7,833,656

 
10,103,056

4,049,445

14,152,501

 
Total
$
5,466,281

$
8,306,367

$
13,772,648

 
$
10,103,056

$
15,862,763

$
25,965,819

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Revenue by Major Products/Services
 
 
 
 
 
 
 
Technology development
$
5,466,281

$

$
5,466,281

 
$
10,103,056

$

$
10,103,056

 
Optical test and measurement systems

3,971,510

3,971,510

 

7,659,519

7,659,519

 
Optical components and sub-assemblies

3,849,283

3,849,283

 

7,273,925

7,273,925

 
Other

485,574

485,574

 

929,319

929,319

 
Total
$
5,466,281

$
8,306,367

$
13,772,648

 
$
10,103,056

$
15,862,763

$
25,965,819



The following tables summarize the impacts of adopting Topic 606 on our consolidated financial statements as of and for the three and six months ended June 30, 2018.

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Impact of changes in accounting policies
 
As Reported
 
Adjustments
 
Balances without adoption of Topic 606
 
(unaudited)
 
(unaudited)
 
(unaudited)
Assets
 
 
 
 
 
Current assets:
 
 
 
 
 
Cash and cash equivalents
$
33,292,800

 
$

 
$
33,292,800

Accounts receivable, net
9,385,772

 

 
9,385,772

Receivable from sale of HSOR business
4,001,833

 

 
4,001,833

Contract assets
3,231,770

 
(1,249,551
)
 
1,982,219

Inventory
6,906,998

 
725,351

 
7,632,349

Prepaid expenses and other current assets
1,054,984

 
7,175

 
1,062,159

Total current assets
57,874,157

 
(517,025
)
 
57,357,132

Long-term contract assets
308,093

 

 
308,093

Property and equipment, net
3,323,749

 

 
3,323,749

Intangible assets, net
3,137,083

 

 
3,137,083

Goodwill
502,000

 

 
502,000

Other assets
18,024

 

 
18,024

Total assets
$
65,163,106

 
$
(517,025
)
 
$
64,646,081

Liabilities and stockholders’ equity
 
 
 
 
 
Liabilities:
 
 
 
 
 
Current liabilities:
 
 
 
 
 
Current portion of long-term debt obligations
$
1,527,828

 
$

 
$
1,527,828

Current portion of capital lease obligations
34,661

 

 
34,661

Accounts payable
3,787,701

 

 
3,787,701

Accrued liabilities
5,554,481

 

 
5,554,481

Contract liabilities
1,400,922

 
(18,270
)
 
1,382,652

Total current liabilities
12,305,593

 
(18,270
)
 
12,287,323

Long-term deferred rent
1,109,397

 

 
1,109,397

Long-term debt obligations

 

 

Long-term capital lease obligations
54,970

 

 
54,970

Total liabilities
13,469,960

 
(18,270
)
 
13,451,690

Commitments and contingencies
 
 
 
 
 
Stockholders’ equity:
 
 
 
 
 
Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at June 30, 2018 and December 31, 2017
1,322

 

 
1,322

Common stock, par value $0.001, 100,000,000 shares authorized, 29,025,529 and 28,354,822 shares issued, 27,772,424 and 27,283,918 shares outstanding at June 30, 2018 and December 31, 2017
29,897

 

 
29,897

Treasury stock at cost, 1,253,105 and 1,070,904 shares at June 30, 2018 and December 31, 2017
(2,116,640
)
 

 
(2,116,640
)
Additional paid-in capital
84,742,385

 

 
84,742,385

Accumulated deficit
(30,963,818
)
 
(498,755
)
 
(31,462,573
)
Total stockholders’ equity
51,693,146

 
(498,755
)
 
51,194,391

Total liabilities and stockholders’ equity
$
65,163,106

 
$
(517,025
)
 
$
64,646,081





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Table of Contents


 
Impact of changes in accounting policies
 
Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
 
As reported
 
Adjustments
 
Balances without adoption of Topic 606
 
As reported
 
Adjustments
 
Balances without adoption of Topic 606
 
(unaudited)
 
(unaudited)
 
(unaudited)
 
(unaudited)
 
(unaudited)
 
(unaudited)
Revenues:
 
 
 
 
 
 
 
 
 
 
 
Technology development
$
5,466,281

 
$

 
$
5,466,281

 
$
10,103,056

 
$

 
$
10,103,056

Products and licensing
8,306,367

 
(231,975
)
 
8,074,392

 
15,862,763

 
(357,752
)
 
15,505,011

       Total revenues
13,772,648

 
(231,975
)
 
13,540,673

 
25,965,819

 
(357,752
)
 
25,608,067

Cost of revenues:

 

 

 
 
 

 

Technology development
3,945,126

 

 
3,945,126

 
7,298,628

 

 
7,298,628

Products and licensing
4,155,054

 
(63,680
)
 
4,091,374

 
7,968,605

 
(213,025
)
 
7,755,580

       Total cost of revenues
8,100,180

 
(63,680
)
 
8,036,500

 
15,267,233

 
(213,025
)
 
15,054,208

Gross profit
5,672,468

 
(168,295
)
 
5,504,173

 
10,698,586

 
(144,727
)
 
10,553,859

Operating expense:

 

 

 
 
 

 

Selling, general and administrative
3,767,456

 

 
3,767,456

 
7,577,072

 

 
7,577,072

Research, development and engineering
1,003,863

 

 
1,003,863

 
2,105,352

 

 
2,105,352

       Total operating expense
4,771,319

 

 
4,771,319

 
9,682,424

 

 
9,682,424

Operating income
901,149

 
(168,295
)
 
732,854

 
1,016,162

 
(144,727
)
 
871,435

Other income:

 

 

 
 
 

 

Investment income
100,846

 

 
100,846

 
175,756

 

 
175,756

Other income
1,187

 

 
1,187

 
2,583

 

 
2,583

Interest expense
(33,988
)
 

 
(33,988
)
 
(75,234
)
 

 
(75,234
)
Total other income
68,045

 

 
68,045

 
103,105

 

 
103,105

Income from continuing operations before income taxes
969,194

 
(168,295
)
 
800,899

 
1,119,267

 
(144,727
)
 
974,540

Income tax expense
(98,133
)
 

 
(98,133
)
 
(96,736
)
 

 
(96,736
)
Net income from continuing operations
$
1,067,327

 
$
(168,295
)
 
$
899,032

 
$
1,216,003

 
$
(144,727
)
 
$
1,071,276



Effective January 1, 2018, we adopted Accounting Standards Update ("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. The adoption of ASU No. 2016-15 did not have a significant impact on our consolidated financial statements.
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.

In February 2018, the FASB issued ASU 2018-02: Income Statement – Reporting Comprehensive Income (Topic 220) (ASU 2018-02). Under current accounting guidance, the income tax effects for changes in income tax rates and certain other transactions are recognized in income from continuing operations resulting in income tax effects recognized in AOCI that do not reflect the current tax rate of the entity (“stranded tax effects”). The new guidance allows us the option to reclassify these stranded tax effects to accumulated deficit that relate to the change in the federal tax rate resulting from the passage of the Tax Cuts and Jobs Act. This update is effective for fiscal years beginning after December 15, 2018, including interim periods therein, and early adoption is permitted. We do not expect the adoption of this standard will have a significant impact on our consolidated financial statements.

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In January 2017, the 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.    


2.    Discontinued Operations
On August 9, 2017, we completed the sale of 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 in cash has been received, and $4.0 million was placed into escrow until December 15, 2018 for potential satisfaction of certain post-closing indemnification obligations (the "Transaction"). The HSOR business was a component of the operations of Advanced Photonix, Inc., which we acquired in May 2015. The HSOR business accounted for 16.8% of revenues and 18.5% of our cost of revenues for the three months ended June 30, 2017 and 17.0% of revenues and 19.9% of our cost of revenues for the six months ended June 30, 2017.
    We have reported the results of operations of our HSOR business as discontinued operations in our consolidated interim financial statements. We allocated a portion of the consolidated tax expense to discontinued operations based on the ratio of the discontinued business's loss before allocations.
The key components of net loss from discontinued operations were as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(unaudited)
 
(unaudited)
Net revenues

 
$
2,283,440

 

 
$
5,314,927

Cost of revenues

 
1,568,746

 

 
3,801,363

Operating expenses

 
1,013,511

 

 
2,303,098

Other expenses

 

 

 

Loss before income taxes

 
(298,817
)
 

 
(789,534
)
Allocated tax expense

 

 

 

Net loss from discontinued operations
$

 
$
(298,817
)
 
$

 
$
(789,534
)

For the six months ended June 30, 2017, cash flows used in operating activities for discontinued operations were $1.0 million. For the six months ended June 30, 2017, cash flows used in investing activities for discontinued operations were $0.8 million.

3.
Contract Balances
Our contract assets consist of unbilled amounts for technology development contracts as well as custom product contracts. Also included in contract assets are royalty revenue and carrying amounts of right of returned inventory. Long-term contract assets include the fee withholding on cost reimbursable contracts that will not be billed within a year. Contract liabilities include excess billings, subcontractor accruals, warranty expense, extended warranty revenue, right of return refund, and customer deposits.

The following table shows the significant changes in contract balances for the six month period ending June 30, 2018:

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Table of Contents

 
 Contract Assets
 
 Contract Liabilities
Opening Balance as of January 1, 2018
$
2,894,038

 
$
3,454,488

Revenue recognized that was included in the contract liabilities balance at the beginning of the period

 
(855,906
)
Transferred to payables from contract liabilities recognized at the beginning of the period

 
(2,041,792
)
Increases due to cash received or adjustment of estimates, excluding amounts recognized as revenue during the period

 
844,132

Transferred to receivables from contract assets recognized at the beginning of the period
(2,245,515
)
 

Increases as a result of cumulative catch-up adjustment arising from changes in the estimate of the stage of completion
2,891,340

 

Balance as of June 30, 2018
$
3,539,863

 
$
1,400,922

  

4.
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,
2018
 
December 31,
2017
 
(unaudited)
 
 
Finished goods
$
1,725,710

 
$
2,143,953

Work-in-process
644,696

 
578,195

Raw materials
4,536,592

 
4,228,962

Total inventory
$
6,906,998

 
$
6,951,110

 
5.    Accrued Liabilities

Accrued liabilities at June 30, 2018 and December 31, 2017 consisted of the following:
 
June 30, 2018
 
December 31, 2017
 
 
(unaudited)
 
 
 
Accrued compensation
$
4,396,462

 
$
5,274,005

 
Income tax payable
371,186

 
403,548

 
Accrued professional fees
122,626

 
117,445

 
Deferred rent
148,506

 
144,741

 
Royalties
148,433

 
290,235

 
Accrued interest
8,854

 

 
Accrued liabilities - other
358,414

 
327,675

 
Total accrued liabilities
$
5,554,481

 
$
6,557,649

 


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6.
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 $4.0 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, 2018, 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, 2018, there were no events of default on the Credit Facility.
The aggregate balance under the Term Loans at June 30, 2018 and December 31, 2017, was $1.5 million and $2.5 million, respectively. One term loan, with a balance of $0.2 million and $0.3 million as of June 30, 2018 and December 31, 2017, respectively, matures on December 1, 2018. The other term loan, with a balance of $1.4 million and $2.1 million as of June 30, 2018 and December 31, 2017, respectively, matures on May 1, 2019. The effective rate of our Term Loan at June 30, 2018 was 7%.
The following table presents a summary of debt outstanding as of June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
 
(unaudited)
 
 
 
Silicon Valley Bank Term Loan
$
1,541,667

 
$
2,458,333

 
Less: unamortized debt issuance costs
13,839

 
21,993

 
Less: current portion
1,527,828

 
1,833,333

 
Total long-term debt
$

 
$
603,007

 

The schedule of remaining principal payments under our Term Loans as of June 30, 2018 was as follows:
2018 (remaining six months)
916,666

2019
625,000

 
$
1,541,666


7.
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

16

Table of Contents

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 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.

Stock Options
A summary of the stock option activity for the six months ended June 30, 2018 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, 2018
2,714,561

 
$0.61 - $6.55
 
$
1.88

 
$
2,098,195

 
2,590,030

 
$
1.89

 
$
2,013,034

Granted
73,212

 
$2.32 - $2.67
 
$
2.46

 
 
 
 
 
 
 
 
Exercised
(53,939
)
 
$0.65 - $2.46
 
$
2.27

 
 
 
 
 
 
 
 
Canceled
(540,487
)
 
$1.21 - $6.55
 
$
2.15

 
 
 
 
 
 
 
 
Balance, June 30, 2018
2,193,347

 
$0.61 - $6.23
 
$
1.83

 
$
2,911,106

 
2,082,354

 
$
1.81

 
$
2,812,472

 
(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, 2018, the outstanding stock options to purchase an aggregate of 2.2 million shares had a weighted-average remaining contractual term of 4.0 years, and the exercisable stock options to purchase an aggregate of 2.1 million shares had a weighted-average remaining contractual term of 3.7 years. The fair value of shares underlying vested options was $6.2 million at June 30, 2018. The fair value of shares underlying options exercised during the six months ended June 30, 2018 was $172,285.
For the six months ended June 30, 2018 and 2017 we recognized $0.2 million and $0.3 million in share-based compensation expense, respectively, which is included in our selling, general and administrative expense in the accompanying consolidated interim financial statements. We expect to recognize $0.2 million in share-based compensation expense over the weighted-average remaining service period of 3.7 years for stock options outstanding as of June 30, 2018.

Restricted Stock and Stock Units

For the six months ended June 30, 2018, we issued 280,000 shares of restricted stock to certain employees. Shares of restricted stock issued to employees vest in three equal annual installments on the anniversary dates of their grant. For the six months ended June 30, 2018, 182,500 of restricted stock vested.

For the six months ended June 30, 2018, we issued 16,287 restricted stock units to certain non-employee members of our Board of Directors in respect of the annual equity grants pursuant to our non-employee director compensation policy. This amount represents the equity compensation to those non-employee directors who did not elect to defer the receipt of their equity compensation pursuant to our non-employee director deferred compensation plan described below. Restricted stock units issued to our directors vest at the earlier of the one year anniversary of their grant or the next annual stockholders' meeting. During the six months ended June 30, 2018, 129,865 restricted stock units vested.

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

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Number of Unvested Shares
 
Weighted Average Grant Date Fair Value
 
Aggregate Value of Unvested Shares
Balance, January 1, 2018
489,698

 
$
1.51

 
$
738,345

Granted
296,287

 
$
3.07

 
909,600

Vested
(312,365
)
 
$
2.75

 
(454,339
)
Balance, June 30, 2018
473,620

 
$
2.52

 
$
1,193,606

Non-employee Director Deferred Compensation Plan
We maintain a non-employee director deferred compensation plan (the “Deferred Compensation Plan”) that permits our non-employee directors to defer receipt of certain of the compensation that they receive for serving on our board and board committees. The Deferred Compensation Plan has historically permitted the participants to elect to defer cash fees to which they were entitled for board and committee service. For participating directors, in lieu of payment of cash fees, we credit their accounts under the Deferred Compensation Plan with a number of stock units based on the trading price of our common stock as of the date of the deferral. These stock units vest immediately, although the participating directors do not receive the shares represented by such units until a future qualifying event.
In December 2017, we amended and restated our Deferred Compensation Plan to also permit participating non-employee directors to elect, beginning in 2018, to defer the receipt of some or all of the equity compensation that they receive for board and committee service. Stock units representing this equity compensation vest at the earlier of the one year anniversary of their grant or the next annual stockholders' meeting.
The following is a summary of our stock unit activity under the Deferred Compensation Plan for the six months ended June 30, 2018:
 
Number of Stock Units
 
Weighted Average Grant Date Fair Value per Share
 
Intrinsic Value Outstanding
Balance, January 1, 2018
466,702

 
$1.40
 
$
1,134,086

  Granted
70,445

 
$3.00
 
 
  Forfeitures

 

 
 
  Converted

 

 
 
Balance, June 30, 2018
537,147

 
$1.61
 
$
1,600,698

As of June 30, 2018, 48,859 of the outstanding stock units had not yet vested.

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The following table details our equity transactions during the six months ended June 30, 2018:
 
Preferred Stock
 
Common Stock
 
Treasury Stock
 
Additional
Paid-in
Capital
 
Accumulated Deficit
 
Total
 
Shares
 
$
 
Shares
 
$
 
Shares
 
$
 
$
 
 
 
 
Balance at January 1, 2018, as previously reported
1,321,514

 
1,322

 
27,283,918

 
29,186

 
1,070,904

 
(1,649,746
)
 
83,563,208

 
(32,406,189
)
 
49,537,781

Impact of change in accounting policy

 

 

 

 

 

 

 
354,028

 
354,028

As adjusted balance at January 1, 2018
1,321,514

 
1,322

 
27,283,918

 
29,186

 
1,070,904

 
(1,649,746
)
 
83,563,208

 
(32,052,161
)
 
49,891,809

Exercise of stock options

 

 
260,842

 
261

 

 

 
639,536

 

 
639,797

Share-based compensation

 

 
280,000

 
280

 

 

 
212,150

 

 
212,430

Non-cash compensation

 

 
129,865

 
130

 

 

 
199,871

 

 
200,001

Stock dividends to Carilion Clinic(1)

 

 

 
40

 

 

 
127,620

 
(127,660
)
 

Net Income

 

 

 

 

 

 

 
1,216,003

 
1,216,003

Purchase of treasury stock

 

 
(182,201
)
 

 
182,201

 
(466,894
)
 

 


(466,894
)
Balance, June 30, 2018
1,321,514

 
1,322

 
27,772,424

 
29,897

 
1,253,105

 
(2,116,640
)
 
84,742,385

 
(30,963,818
)
 
51,693,146


(1)
The stock dividends payable in connection with Carilion Clinic’s Series A Preferred Stock will be issued subsequent to June 30, 2018. For the period from January 12, 2010, the original issue date of the Series A Preferred Stock, through June 30, 2018, the Series A Preferred Stock issued to Carilion has accrued $1,287,991 in dividends. The accrued and unpaid dividends as of June 30, 2018 will be paid by the issuance of 671,339 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. As of May 31, 2017, we had repurchased a total of 205,500 shares for an aggregate purchase price of $0.2 million under this stock repurchase program, after which this stock repurchase program expired.

In September 2017, our board of directors re-instituted the stock repurchase program and authorized us to repurchase up to $2.0 million of our common stock through September 19, 2018. 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. As of June 30, 2018, we had repurchased a total of 565,629 shares for an aggregate purchase price of $1.1 million under this stock repurchase program. We currently maintain all repurchased shares under these stock repurchase programs as treasury stock.

8.
Income Taxes

We and our subsidiaries file U.S. Federal income tax returns and income tax returns in various state, local and foreign jurisdictions.

Our quarterly tax provision, and our quarterly estimate of our annual effective tax rate, is subject to significant variation due to several factors, including the variability in accurately predicting our pre-tax and taxable income and the mix of jurisdictions to which they relate, changes in how we do business, changes in our stock price, tax law developments (including changes in statues, regulations, case law, and administrative practices), and relative changes of expenses or losses for which tax

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benefits are not recognized. Additionally, our effective tax rate can be more or less volatile based on the amount if pre-tax income or loss. For example, the impact of discrete items and non-deductible expenses on our effective tax rate is greater when our pre-tax income is lower.

For 2018, the anticipated effective income tax rate is expected to continue to differ from the Federal statutory rate of 21% primarily because of the release of valuation allowance related to net operating loss carryfowards expected to be used to offset taxable income in the period and certain discrete items.

We consider both positive and negative evidence when evaluating the recoverability of our deferred tax assets ("DTAs").  The assessment is required to determine whether based on all available evidence, it is more likely than not (i.e. greater than a 50% probability) that all or some portion of the DTAs will be realized in the future.  As of June 30, 2018 management has concluded a full valuation allowance of the DTAs is necessary because of sufficient uncertainty in our ability to realize the benefit associated with such DTAs in the future.



9.
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, 2018, 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 21, 2018).

The table below presents revenues and operating income/(loss) for reportable segments:
 
 
Three Months Ended June 30,
 
 
Six Months Ended June 30,
 
 
2018
 
2017
 
 
2018
 
2017
 
 
(unaudited)
 
 
(unaudited)
 
Revenues:
 
 
 
 
 
 
 
 
 
Technology development
$
5,466,281

 
$
4,602,272

 
 
$
10,103,056

 
$
8,838,375

 
Products and licensing
8,306,367

 
6,690,759

 
 
15,862,763

 
12,541,554

 
Total revenues
$
13,772,648

 
$
11,293,031

 
 
$
25,965,819

 
$
21,379,929

 
Technology development operating income/(loss)
$
445,042

 
$
32,920

 
 
$
544,274

 
$
(260,099
)
 
Products and licensing operating income/(loss)
456,107

 
146,683

 
 
471,888

 
(334,859
)
 
Total operating income/(loss)
$
901,149

 
$
179,603

 
 
$
1,016,162

 
$
(594,958
)
 
Depreciation, technology development
$
94,774

 
$
88,698

 
 
$
188,374

 
$
176,918

 
Depreciation, products and licensing
$
75,314

 
$
240,504

 
 
$
139,631

 
$
571,480

 
Amortization, technology development
$
40,856

 
$
26,169

 
 
$
78,062

 
$
74,759

 
Amortization, products and licensing
$
103,781

 
$
437,612

 
 
$
216,510

 
$
930,591

 
Products and licensing depreciation includes amounts from discontinued operations of $0.4 million for the six months ended June 30, 2017. Products and licensing amortization includes amounts from discontinued operations of $0.7 million for the six months ended June 30, 2017.

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The table below presents assets for reportable segments:
 
 
June 30,
2018
 
December 31,
2017
 
(unaudited)
 
 
Total segment assets:
 
 
 
Technology development
$
30,704,165

 
$
32,011,084

Products and licensing
34,458,941

 
34,211,552

Total assets
$
65,163,106

 
$
66,222,636

Property plant and equipment, and intangible assets, technology development
$
2,204,428

 
$
2,361,663

Property plant and equipment, and intangible assets, products and licensing
$
4,758,404

 
$
4,831,671



The U.S. government accounted for 46% and 45% of total consolidated revenues for the three months ended June 30, 2018 and 2017, respectively and for 44% and 45% of total consolidated revenues for the six months ended June 30, 2018 and 2017, respectively.
International revenues (customers outside the United States) accounted for 24% and 23% of total consolidated revenues for the three months ended June 30, 2018 and 2017, respectively, and 23% and 21% of the total consolidated revenues for the six months ended June 30, 2018 and 2017, respectively. No single country, outside of the United States, represented more than 10% of total revenues in the three and six months ended June 30, 2018 and 2017.




10.
Subsequent Event - Sale of Luna Optoelectronics



On July 31, 2018 , we sold the assets and operations related to our optoelectronic components and subassemblies ("Opto") business, which was part of our Products and Licensing segment, to an unaffiliated third party for an initial purchase price of $18.5 million, of which $17.5 million was received at closing and up to $1.0 million is contingent upon the attainment of specified revenue targets during the eighteen months following the closing of the sale. 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 Opto business was a component of the operations of Advanced Photonix, Inc., which we acquired in May 2015, and represented all of our operations in our Camarillo, California and Montreal, Quebec facilities.

As the Opto assets did not meet the criteria for classification as held for sale in accordance with ASC 360-10-45 as of June 30, 2018, such assets were included within the assets held and used in our consolidated balance sheets as of June 30, 2018 or December 31, 2017. The following schedule sets forth the carrying amounts of major classes of assets and liabilities associated with the transaction as of June 30, 2018 and December 31, 2017.


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June 30, 2018
 
December 31, 2017
Current assets
 
(unaudited)
 
Accounts receivable
 
$
2,159,843

 
$
1,940,126

 
Contract assets
 
1,249,551

 

 
Inventory
 
1,736,107

 
2,316,329

 
Prepaid expenses and other current assets
 
89,592

 
125,821

 
 
Total current assets
 
5,235,093

 
4,382,276

Property and equipment, net
 
607,468

 
599,102

Intangible assets, net
 
1,423,546

 
1,510,203

Goodwill
 
502,000

 
502,000

Other assets
 
16,029

 
16,029

Total assets of the disposal group
 
$
7,784,136

 
$
7,009,610

 
 
 
 
 
 
 
Current liabilities
 
 
 
 
 
Accounts payable
 
$
1,018,950

 
$
960,116

 
Accrued compensation
 
444,860

 
458,342

 
Contract Liabilities
 
158,758

 

 
Other accrued liabilities
 

 
17,920

 
Total current liabilities
 
1,622,568

 
1,436,378

Deferred rent
 

 
2,271

Total liabilities of the disposal group
 
$
1,622,568

 
$
1,438,649

 
 
 
 
 
 
 


The following schedule sets forth the revenues and expenses associated with the Opto 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, 2018 and 2017.
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(unaudited)
 
(unaudited)
Revenues
 
$
3,849,283

 
$
3,010,465

 
$
7,273,925

 
$
6,462,998

Cost of revenues
 
2,407,467

 
1,953,967

 
4,645,616

 
4,059,829

Gross profit
 
1,441,816

 
1,056,498

 
2,628,309

 
2,403,169

Operating expense
 
 
 
 
 
 
 
 
  Selling, general and administrative
 
502,047

 
420,270

 
978,174

 
938,367

  Research, development and engineering
 
243,588

 
219,291

 
465,484

 
448,035

     Total operating expense
 
745,635

 
639,561

 
1,443,658

 
1,386,402

Operating income
 
696,181

 
416,937

 
1,184,651

 
1,016,767

Other (expense)/income
 
(12,055
)
 
(3,329
)
 
22,703

 
(14,151
)
Income tax expense
 
(59,864
)
 
(140,626
)
 
18,499

 
(340,889
)
Income attributable to disposal group
 
$
624,262

 
$
272,982

 
$
1,225,853

 
$
661,727




11.
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.

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In March 2018, we received a notice of claim (the "Claim") from Macom Technology Solutions, Inc. ("Macom"), who acquired our HSOR business in August 2017 pursuant to an asset purchase agreement. Under the asset purchase agreement, we agreed to indemnify Macom for certain matters, including, among other things, the collection of accounts receivable from certain major customers, and placed $4.0 million of the purchase price into an escrow account for the potential settlement of any valid indemnity claims. The notice of claim received from Macom totaled $2.0 million under various indemnity provisions. We have disputed Macom's assertion of right to payment for the matters described in the Claim. It is uncertain what amount, if any, will be owed in settlement of the Claim.
We executed a non-cancelable purchase order totaling $0.5 million in the fourth quarter of 2017 and a non-cancelable purchase order totaling $1.1 million in the first quarter of 2018 for multiple shipments of tunable lasers to be delivered over an 18-month period. At June 30, 2018, approximately $0.8 million of these commitments remained and is expected to be delivered by July 30, 2019.
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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Table of Contents

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 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. Prior to the sale of our optoelectronics business in July 2018, we also developed and manufactured custom optoelectronic products 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 and measurement products, and also conducts applied research in the fiber optic sensing area for both corporate and government customers. Our Products and Licensing segment revenues represented 60% and 59% of our total revenues for the three months ended June 30, 2018 and 2017, respectively, and 61% and 59% of our total revenues for the six months ended June 30, 2018 and 2017, respectively. The approximate value of our Products and Licensing segment backlog was $5.5 million at June 30, 2018 and $6.9 million at December 31, 2017. The backlog at June 30, 2018 is expected to be recognized as revenue in the future as follows:

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2018
2019
2020
2021
2022 and beyond
Total
Products and Licensing
$
3,775,446

$
1,559,621

$
131,614