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Electro-Sensors Inc.Table of Contents UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549FORM 10-K(MARK ONE)xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934FOR THE FISCAL YEAR ENDED DECEMBER 31, 2016OR¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 000-52008LUNA 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 1st St SW, Suite 200Roanoke, VA 24011(Address of Principal Executive Offices)(540) 769-8400(Registrant’s Telephone Number, Including Area Code)Securities registered pursuant to Section 12(b) of the Act:Title of Each Class Name of Each Exchange on which RegisteredCommon Stock, par value $0.001 per share The NASDAQ Stock Market LLCSecurities registered pursuant to Section 12(g) of the Act: NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No xIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No xIndicate 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 1934during 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 filingrequirements for the past 90 days. Yes x No ¨Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes x No ¨Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to thisForm 10-K. xIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. Seethe definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.Large accelerated filer ¨ Accelerated filer ¨Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company xIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No xThe aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant on June 30, 2016, based upon theclosing price of Common Stock on such date as reported by the NASDAQ Capital Market, was approximately $29.8 million.Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x 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 March 15, 2017 therewere 27,541,277 shares of the registrant’s common stock outstanding.DOCUMENTS INCORPORATED BY REFERENCESpecified portions of the registrant’s Proxy Statement with respect to its 2017 Annual Meeting of stockholders, anticipated to be filed within 120 daysafter the end of its fiscal year ended December 31, 2016, are incorporated by reference into Part III of this annual report on Form 10-K. Table of ContentsLUNA INNOVATIONS INCORPORATEDANNUAL REPORT ON FORM 10-KFOR THE YEAR ENDED DECEMBER 31, 2016TABLE OF CONTENTS PART I Item 1.Business1Item 1A.Risk Factors10Item 1B.Unresolved Staff Comments26Item 2.Properties26Item 3.Legal Proceedings26Item 4.Mine Safety Disclosure26PART II Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities27Item 6.Selected Financial Data29Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations30Item 7A.Quantitative and Qualitative Disclosures About Market Risk40Item 8.Financial Statements and Supplementary Data41Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure66Item 9A.Controls and Procedures66Item 9B.Other Information67PART III Item 10.Directors, Executive Officers and Corporate Governance68Item 11.Executive Compensation68Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters68Item 13.Certain Relationships and Related Transactions, and Director Independence68Item 14.Principal Accounting Fees and Services68PART IV Item 15.Exhibits, Financial Statement Schedules69Item 16.Form 10-K Summary69SIGNATURES76 Table of ContentsCAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTSThis Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operation” sectionin Item 7 of this report, and other materials accompanying this Annual Report on Form 10-K contain forward-looking statements within the meaning ofSection 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. All statements other thanstatements of historical facts are “forward-looking statements” for purposes of these provisions, including those relating to future events or our futurefinancial 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 othercomparable 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, capitalexpenditures, introduction of new products, regulatory compliance, plans for growth and future operations, as well as assumptions relating to theforegoing.These statements are based on current expectations and assumptions regarding future events and business performance and involve known andunknown risks, uncertainties and other factors that may cause actual events or results to be materially different from any future events or results expressedor implied by these statements. These factors include those set forth in the following discussion and within Item 1A “Risk Factors” of this Annual Report onForm 10-K and elsewhere within this report.You should not place undue reliance on these forward-looking statements, which apply only as of the filing date of this Annual Report on Form 10-K.You should carefully review the risk factors described in other documents that we file from time to time with the U.S. Securities and Exchange Commission(“SEC”). Except as required by applicable law, including the rules and regulations of the SEC, we do not plan to publicly update or revise any forward-looking statements, whether as a result of any new information, future events or otherwise, other than through the filing of periodic reports in accordancewith the Securities Exchange Act of 1934, as amended.We have proprietary rights to a number of trademarks used in this Annual Report which are important to our business. Solely for convenience, thetrademarks and trade names in this prospectus are referred to without the ® and TM symbols, but such references should not be construed as any indicatorthat their respective owners will not assert, to the fullest extent under applicable law, their rights thereto. All other trademarks, trade names and servicemarks appearing in this Annual Report are the property of their respective owners.PART I ITEM 1. BUSINESSCompany Overview and Business ModelLuna Innovations Incorporated ("we" or the "Company") is a leader in advanced optical technology, providing unique capabilities in high speedoptoelectronics and high performance fiber optic test products for the telecommunications industry and distributed fiber optic sensing for the aerospace andautomotive industries. Our high-speed optical receiver ("HSOR") transmission products are deployed in the internet infrastructure to enable the high-speedbandwidth necessary to support video and data. Our distributed fiber optic sensing products provide critical stress, strain and temperature information todesigners and manufacturers working with advanced materials. Our custom optoelectronic products are sold to scientific or industrial instrumentationmanufacturers and to defense contractors for various applications such as metrology, missile guidance, flame monitoring, and temperature sensing. Inaddition, we provide applied research services, typically under research programs funded by the U.S. government, in areas of advanced materials, sensing, andhealthcare applications. Our business model is designed to accelerate the process of bringing new and innovative products to market. We use our in-housetechnical expertise across a range of technologies to perform applied research services for companies and for government funded projects. We continue toinvest in product development and commercialization, which we anticipate will lead to increased product sales growth.We are organized into two main business segments, our Products and Licensing segment and our Technology Development segment. Our Products andLicensing segment develops, manufactures and markets fiber optic sensing products, as well as test & measurement products, and also conducts appliedresearch in the fiber optic sensing area for both corporate1 Table of Contentsand government customers. We are continuing to develop and commercialize our fiber optic technology for strain and temperature sensing applications forthe aerospace, automotive, and energy industries. Our Products and Licensing segment revenues represented approximately 72% and 69% of our totalrevenues for the years ended December 31, 2016 and 2015, respectively. For 2016, ZTE Kangxun Telecom, Inc. accounted for approximately 16% of ourProducts and Licensing segment revenues and 11% of our total revenues.Our Technology Development segment performs applied research principally in the areas of sensing & instrumentation, advanced materials, and healthsciences. Our Technology Development segment comprised approximately 28% and 31% of our total revenues for the years ended December 31, 2016 and2015, 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").Our SBIR research is focused on technological areas with commercial potential and we strive to commercialize any resulting scientific advancements.For the year ended December 31, 2016, approximately 24% of our total revenues were generated under the SBIR program, compared to 26% for the yearended December 31, 2015.For the years ended December 31, 2016 and 2015, 28% and 34%, respectively, of our total revenues were derived from the U.S. government.Merger with Advanced Photonix, Inc.On May 8, 2015, we completed a merger with Advanced Photonix, Inc. ("API"), pursuant to the Agreement and Plan of Merger and Reorganization (the"Merger Agreement"), dated as of January 30, 2015, by and among Luna, API and API Merger Sub, Inc., our wholly owned subsidiary ("API Merger Sub"). Inaccordance with the terms of the Merger Agreement, upon the completion of the merger, API Merger Sub merged with and into API, with API surviving as ourwholly-owned subsidiary. In the merger, former API stockholders received 0.31782 shares of our common stock for each share of API common stock theyowned at the effective time of the merger.API was a leading test & measurement company that packaged optoelectronic semiconductors into high-speed optical receivers, custom optoelectronicsub systems and Terahertz instrumentation, serving the test & measurement, telecommunications, military/aerospace and medical markets. API hadmanufacturing facilities located in Camarillo, California and Ann Arbor, Michigan, both of which have remained in operation following the merger.Our results of operations for the year ended December 31, 2015, include the results associated with the operations of API from the closing of our mergeron May 8, 2015 through December 31, 2015.Products and LicensingIn addition to the operations of API acquired in May 2015, our Products and Licensing segment includes the sale of fiber optic test & measurementinstruments. We have been successful in developing and marketing fiber optic test & measurement products which provide solutions primarily for thetelecommunications industry marketed under the Luna Technologies brand. In 2011, we also introduced our ODiSI platform of products for distributedsensing of strain and temperature utilizing optical fiber.Our key initiatives for long term growth are to become a leading provider of fiber optic strain and temperature sensing systems and standard testmethods based upon the ODiSI product platform and to be a leading supplier of HSOR products in the expanding telecommunications markets, principally inAsia. Our primary product lines in our Products and Licensing segment are described in more detail below.Test & Measurement, Sensing, and Instrumentation ProductsTest & Measurement Equipment for Fiber Optic Components and Sub-AssembliesOur product lines in the test & measurement domain include our Optical Vector Analyzer, our Optical Backscatter Reflectometer, and the Phoenixfamily of tunable lasers.Historically, our test & measurement products have primarily served the telecommunications industry, as well as valuable applications in other fields.Our test & measurement products test and monitor the integrity of fiber optic network components and sub-assemblies. These products are designed formanufacturers and suppliers of optical components and sub-assemblies and allow them to reduce development, test and production costs and improve thequality of their products. Most manufacturers and suppliers of optical components and modules currently use a combination of different types of optical testequipment to2 Table of Contentsidentify and measure failures in optical networks, such as bad splices, bends, crimps and other reflective and non-reflective events that can cause defects andnegatively impact product performance. Our optical test equipment products replace the need to employ multiple test products by addressing all stages of theend user’s product development lifecycle, including design verification, component qualification, assembly process verification and failure analysis.ODiSI Sensing Solution; Optical Distributed Sensor InterrogatorOur ODiSI products provide fully distributed strain and temperature measurements and deliver an extraordinary amount of data by using an opticalfiber as a continuous sensor for up to 50 meters in length. Compared to traditional sensing methods, such as electrical strain gages, this technology providesgreater insight into the performance, tolerances and failure mechanisms of composite structures and vehicles. We believe the technology can provideexceptional value to the aerospace and automotive industries as they transition from steel and aluminum to composite structures.We have significant expertise in distributed sensing systems, such as ODiSI, which are products composed of multiple sensors whose inputs areintegrated through a fiber optic network and software. These products use fiber optic sensing technology with an innovative monitoring system that allowsseveral thousand sensors to be networked along a single optical fiber.Tunable LasersWe have acquired the rights to manufacture a line of swept tunable lasers to allow us to compete more effectively in our existing fiber optic test &measurement as well as sensing markets. This technology is being integrated into current and new products to help us provide our customers with faster, moreflexible and cost-effective test & measurement products. The laser has desirable properties in the quality of the laser light produced, the speed at which it canoperate, the small size of the package, and the environmental conditions in which it can operate. We believe that these traits make it possible for us to moveour fiber optic sensing capabilities out of the laboratory, and into more demanding environments such as aircraft structural health monitoring, automotivemanufacturing, green energy, and industrial applications.High Speed Optical ReceiversOur HSOR transmission products include, among other things, 100G optical receivers and 10G avalanche photodiodes. These products are deployed inthe internet communications equipment infrastructure to enable the high-speed bandwidth necessary to support video and data for television, computers,tablets or smart phones anytime and anywhere. Our communication test & measurement products are used to develop, manufacture and test opticalcommunication components and equipment used in the telecom/datacom infrastructure.Optoelectronic SolutionsOur optoelectronics products are sold to a number of scientific instrumentation manufacturers and defense contractors for various applications such asmetrology, missile guidance, flame monitoring, temperature sensing, particle detection, color sensing, infrared detection, and many other applications thatcan only be done through optical sensing.Terahertz SensingOur THz systems are used to measure and verify physical properties on-line and in real-time to reduce raw materials and rework costs in manufacturingprocesses as well as to conduct quality control monitoring. THz is a region of the electromagnetic spectrum that lies between microwave and infrared wavesand is in the early stages of adoption. While microwaves and infrared waves have been explored and commercialized for decades, THz waves are in the earlystages of being explored and commercialized due to the fact that they have historically been very difficult to generate and detect. Advances in femtosecondlasers and ultra-fast semiconductor and electro-optic devices combined with fiber-optic packaging technologies have enabled the development of practicalTHz instrumentation for the research market with increasing adoption in the industrial, military and aerospace markets. THz can be used to "look" throughand beneath materials with high two-dimensional and three-dimensional spatial resolution. It can also uniquely identify the chemical composition of manyhidden or subsurface objects using non-ionizing radiation, which is not harmful to humans at the power levels commonly used today. We market our THzbased products as our T-Ray product platform through value added resellers.Sales and MarketingWe primarily market our fiber optic test & measurement products to telecommunications companies, defense agencies, government system integrators,researchers, original equipment manufacturers, distributors, testing labs and strategic partners3 Table of Contentsworldwide. We have a regional sales force that markets and sells our products through manufacturer representative organizations to customers in NorthAmerica and through partner and distribution channels for other sales around the world. We have a dedicated sales force for direct marketing of ourdistributed sensing products, with an initial focus on customers in the automotive, aerospace, and energy industries.We market our HSOR, optoelectronic, and THz products primarily as components or sub-assemblies to original equipment manufacturers through a mixof technical sales engineers, value added resellers, and independent sales representatives. We market these products and capabilities through industry specificchannels, including the internet, industry trade shows, and in print through trade journals.We believe that we provide a high level of support in developing and maintaining our long-term relationships with our customers. Customer serviceand support are provided through our offices and those of our partners that are located throughout the world.Technology DevelopmentWe provide applied research for customers in our primary areas of focus, including sensing and materials such as nanomaterials, coatings, adhesives,composites and bio-engineered materials. We generally compete to win contracts in these areas on a fee-for-service basis. Our Technology Developmentsegment has a successful track record of evaluating innovative technologies to address the needs of our customers.We seek to maximize the benefits we derive from our contract research business, including revenue generation and identification of promisingtechnologies for further development. We focus primarily on opportunities in which we develop intellectual property rights in areas that we believe havecommercialization potential. We take a disciplined approach to contract research to try to ensure that the costs of any contract we undertake will be fullyreimbursed. We believe that this model is cost-efficient and significantly reduces our development risk in that it enables us to defray the costs of higher risktechnology development with third-party funding.Although we conduct our applied research on a fee-for-service basis for third parties, we seek to retain full or partial rights to the technologies andpatents developed under those contracts and to continuously enlarge and strengthen our intellectual property portfolio. New technology that we developmay complement existing technologies and enable us to develop applications and products that were not previously possible. In addition, the technologieswe develop may also be applicable to commercial markets beyond the scope of the applications originally contemplated in the contract research stage, andwe endeavor to capture the value of those opportunities. Funded research and development within this business segment was $16.8 million and $13.6 millionfor the years ended December 31, 2016 and 2015, respectively.Each year, U.S. government federal agencies and departments are required to set aside a portion of their grant awards for SBIR-qualified organizations.SBIR contracts include Phase I feasibility contracts of up to $150,000 and Phase II proof-of-concept contracts, which can be as high as $1,000,000. We havewon three National Tibbetts Awards from the SBA for outstanding SBIR performance. We have also won research contracts outside the SBIR program fromcorporations and government entities. These contracts typically have a longer duration and higher value than SBIR grants. In the future, we will seek toderive a larger portion of our contract research revenues from contracts outside of the SBIR program.MaterialsWe are actively developing a wide variety of materials. For example, we have developed a range of coatings, including both hydrophobic andsuperoleophobic coatings. These coatings are being evaluated for use in a number of applications. Other coatings under development include anti-corrosionand damage-indicating coatings.We are also working on a variety of bioengineered materials for homeostatic agents and wound healing. These materials must be approved by the FDAor similar foreign regulatory agencies before they can be marketed, which we do not expect to occur for at least several years, if at all.SensingOur Technology Development segment also performs a significant amount of applied research towards developing new sensors. This includes sensorsfor the purpose of corrosion, temperature, strain, pressure, structural health, and chemical detection. Much of the work is directed to harsh environments anduses optics. Examples include measuring temperature and neutron flux in nuclear reactors, pressure and temperature in gas turbines, and temperatures ofcryogenic lines. The effort utilizes both discrete and distributed sensors. Our technology development work in this area is closely aligned with our Productsand Licensing segment and is directed at advancing the technology and the development of new applications.4 Table of ContentsIntellectual PropertyWe seek patent protection on inventions that we consider important to the operations of our business. We rely on a combination of patent, trademark,copyright and trade secret laws in the United States and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect ourproprietary technology and our brand. We control access to our proprietary technology and enter into confidentiality and invention assignment agreementswith our employees and consultants and confidentiality agreements with other third parties.Our success depends in part on our ability to develop patentable products and obtain, maintain and enforce patent and trade secret protection for ourproducts, as well as to successfully defend these patents against third-party challenges both in the United States and in other countries. We will only be ableto protect our technologies from unauthorized use by third parties to the extent that we own or have licensed valid and enforceable patents or trade secretsthat cover them. Furthermore, the degree of future protection of our proprietary rights is uncertain because we may not be able to obtain patent protection onsome or all of our technology and because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keepour competitive advantage.Currently, we own or license approximately 226 U.S. and international patents and approximately 282 U.S. and international patent applications, andwe intend to file, or request that our licensors file, additional patent applications for patents covering our products. Our issued patents generally have termsthat are scheduled to expire between 2017 and 2030. The patents scheduled to expire in 2017 are not expected to have a significant impact on our revenuesor results of operations. However, patents may not be issued for any pending or future pending patent applications owned by or licensed to us. Claimsallowed under any issued patent or future issued patent owned or licensed by us may not be valid or sufficiently broad to protect our technologies. Anyissued patents owned by or licensed to us now or in the future may be challenged, invalidated or circumvented, and, in addition, the rights under such patentsmay 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, which could make it easier for competitors to capture or increasetheir market share with respect to related technologies.A discussion of our material patents and patent applications is set forth below.NASA PatentsWe have licensed, on a non-exclusive basis, four U.S. patents and related patents in Japan, Canada, Germany, France, Great Britain and Belgium fromthe National Aeronautics and Space Administration, an agency of the U.S. government (“NASA”), which patents concern the measurement of strain in opticalfiber using Bragg gratings and Rayleigh scatter and the measurement of the properties of fiber-optic communications devices. These patents expire betweenFebruary 2017 and September 2020.VTIP PatentsWe have licensed, on an exclusive basis, two U.S. patents from Virginia Tech Intellectual Properties, Inc. (“VTIP”) to commercialize fullerenes and tri-metal nitride endohedral fullerene (“Trimetasphere”) nanomaterials for all fields of human endeavor. These patents expire in December 2019 and December2022.Coherent PatentsWe have licensed, on a non-exclusive basis, several U.S. patents and other intellectual property rights owned or controlled by Coherent, Inc., related tothe manufacturing, using, importing, selling and offering for sale of Coherent’s “Iolon” brand of swept tunable lasers, which we market under our “Phoenix”brand. These patents expire between 2020 and 2025.Shape Sensing PatentsAs a part of our sale of assets associated with our fiber optic shape sensing technology in the medical field to Intuitive Surgical, Inc. ("Intuitive"), wetransferred our related patents to Intuitive. Also as a part of this transaction, we entered into a revocable license agreement with Intuitive pursuant to whichwe have the right to use all of our transferred technology outside the field of medicine and in respect of our existing non-shape sensing products in certainnon-robotic medical fields. Two U.S. patents that we now license back from Intuitive cover the use of optical frequency domain reflectometry and multiple,closely5 Table of Contentsspaced Bragg gratings for shape sensing, and the use of the inherent scatter as a strain sensor for shape sensing. These two patents expire in July 2025. Wealso have a license back from Intuitive for a patent application that covers certain refinements to the measurements covered in the first two patents, which arenecessary in order to achieve the necessary accuracies for medical and other applications. This patent application was filed in the United States, the EuropeanPatent Office, China, India, Russia, Brazil, Japan and Indonesia. These patents and patent applications can support other nonmedical applications of our fiberoptic shape sensing technology.Corporate HistoryWe were incorporated in the Commonwealth of Virginia in 1990 and reincorporated in the State of Delaware in April 2003. We completed our initialpublic offering in June 2006. In May 2015, we merged with API. Our executive offices are located at 301 1st St SW, Suite 200, Roanoke, Virginia 24011 andour main telephone number is (540) 769-8400.Material AgreementsSale of Assets to Intuitive SurgicalOn January 17, 2014, we entered into an Asset Purchase Agreement with Intuitive (the “Asset Purchase Agreement”). Under the Asset PurchaseAgreement, effective as of 12:01 a.m. on January 21, 2014, we closed on the sale to Intuitive of substantially all of our assets related to our medical shapesensing business, including all of the patents and patent applications used or useful for our fiber optical shape sensing and localization technology, for $12million, plus up to $8 million upon the accomplishment by Intuitive of certain technical specifications (the “Technical Specifications Payment”) and up to$10 million in potential future royalties (altogether, the “Transaction”). We had been engaged since 2007 in a development project for Intuitive developing afiber optic-based shape sensing and position tracking system to be integrated into Intuitive’s products. Also as a part of the Transaction, Intuitive has hiredcertain of our employees, many of whom were historically engaged in this development project. In December 2015, we and Intuitive agreed to settle allremaining obligations related to the Technical Specifications Payment and royalties for a lump sum payment of $9 million, which we received in December2015.The Asset Purchase Agreement contains representations and warranties, covenants and indemnification provisions common to transactions of thisnature, except that our indemnification obligations are only limited in time until no further payments are due from Intuitive. Any disputes between the partieswill be handled by mediation and arbitration in Chicago, Illinois. All of the transfers of technology contemplated in the Transaction have been made subjectto our existing licenses and related obligations to Hansen Medical Inc. ("Hansen") and Philips Medical Systems.Also, in connection with the Transaction, we and Intuitive entered into a License Agreement of the same date under which we received a license back toall 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.The license back to us outside the medical field is exclusive to us except that Intuitive retained certain non-sublicensable rights for itself. This license backto us is revocable if we were, after notice and certain time periods, (i) to challenge the validity or enforceability of the transferred patents and patentapplications, (ii) to commercialize our fiber optical shape sensing and localization technology in the field of medicine (except to perform on a developmentand supply project for Hansen), (iii) to violate our obligations related to our ability to sublicense in the field of medicine or (iv) to violate our confidentialityobligations in a manner that advantages a competitor in the field of medicine and not cure such violation. As a part of the Transaction, we retained assets andrights necessary to perform on our development and supply project for Hansen if that project is re-started.Also, as a part of the Transaction, for a period of 15 years after closing, we agreed to exit and not develop or commercialize our fiber optical shapesensing and localization technology in the field of medicine (except for Hansen as described above). For a period of 10 years after closing, Intuitive hasagreed not to use any of the assets being acquired in the Transaction, including the key employees being hired, to compete with us outside the field ofmedicine for shape, strain and/or temperature sensing in the aerospace, automotive, and energy markets and for strain sensing in the civil structuralmonitoring and composite material markets.Virginia TechOur nanomaterials activity is focused on Trimetasphere materials. The Trimetasphere nanomaterial is a carbon sphere with three metal atoms and anitrogen atom enclosed. We have obtained an exclusive license from VTIP to commercialize Trimetasphere nanomaterials under two U.S. patents for all fieldsof human endeavor. The term of this license ends upon the6 Table of Contentslast expiration date of the underlying patents, which is December 2022. The license provides for certain royalties to be paid as a percentage of our net sales,certain percentages of amounts received from any of our sublicensees and certain milestone payments based on product development phases. We reimburseVTIP for patent costs incurred under the license. VTIP may terminate the license for cause. We may terminate the license at any time for any reason on 60days' notice.We primarily utilize the VTIP license in our ongoing research into the potential use of Trimetaspheres to improve the safety of contrast agentscommonly utilized in magnetic resonance imaging (“MRI”) procedures. We believe that contrast agents utilizing our Trimetasphere nanomaterials may beable to provide a higher image contrast than existing contrast agents but with a lower risk of toxicity. Medical contrast agents for human use, such as ourTrimetasphere nanomaterials, must be approved by the FDA or similar foreign regulatory agencies before they can be marketed, which we do not expect tooccur for at least several years, if at all. As described below under “Government Regulation,” this approval process can involve significant time and expenseand may delay or prevent our products from reaching the market.CoherentIn December 2006, we entered into an asset transfer and license agreement with Coherent. Under the agreement, we acquired the rights to manufactureCoherent’s “Iolon” brand of swept tunable lasers as well as certain manufacturing equipment and inventory previously used by Coherent to manufacture thelasers. We continue to enhance, produce, and market these lasers under our “Phoenix” brand. Under this agreement, Coherent granted non-exclusive licensesto us for certain U.S. patents and other intellectual property rights owned or controlled by Coherent for making, having made, using, importing, selling andoffering for sale the lasers. This agreement expired in 2016. However, the patent licenses became fully paid and perpetual, as we fulfilled our royaltyobligations during the 10-year period and the license to the other intellectual property rights is perpetual. These U.S. patents expire between 2020 and 2025.As consideration, we agreed to pay Coherent a total of $1.3 million over a period of two years and royalty payments on net sales of products sold by us thatincorporate the lasers or that are manufactured using the intellectual property covered by the licenses. We paid Coherent royalty fees of approximately$70,000 for both 2016 and 2015. We also agreed to sell Coherent a limited number of lasers each year.The Phoenix laser is a miniaturized, external-cavity laser offering high performance in a compact footprint and is applicable to a range of fiber optictest and measurement, instrumentation, and sensing applications. These products employ frequency-tuned lasers to measure various aspects of thetransmission properties of telecommunications fiber optic components and systems. Lasers are also used in fiber optic sensing applications such asdistributed strain and temperature mapping, and distributed measurement of shape. We currently use these lasers within our ODiSI platform of products, ourfiber optic shape sensing products and certain of our backscatter reflectometer products, and we also sell variations of the Phoenix laser as standaloneproducts. Under our agreements related to our sale of assets to Intuitive, we have certain obligations to supply Intuitive with these lasers and Intuitive hascertain rights to require us to transfer and assign this Coherent license to Intuitive, in which case Intuitive would be similarly required to supply us withlasers.NASAWe have licensed, on a non-exclusive basis, certain patents from NASA under two license agreements. These patents concern the measurement of strainin optical fiber using Bragg gratings and Rayleigh scatter, and also the measurement of the properties of fiber-optic communications devices. Under thelicense agreements, we pay NASA certain royalties based on a percentage of net sales of products covered by the patents. We incur a royalty obligation toNASA based upon a specified percentage of the revenue earned on each product sold utilizing these patents subject to combined minimum royalties of$220,000 per year under the license agreements. The term of the license agreements continues until the expiration of the last licensed patent, which isSeptember 2020. These license agreements may be terminated by us on 90 days' notice. Either party may terminate the license agreements for cause uponcertain conditions.CompetitionWe compete for government, university and corporate research contracts relating to a broad range of technologies. Competition for contract research isintense and the industry has few barriers to entry. We compete against a number of in-house research and development departments of major corporations, aswell as a number of small, limited-service contract research providers and companies backed by large venture capital firms. The contract research industrycontinues to experience consolidation, which has resulted in greater competition for clients. Increased competition might lead to price and other forms ofcompetition that could harm our operating results. We compete for contract research on the basis of a number of factors, including reliability, pastperformance, expertise and experience in specific areas, scope of service offerings, technological capabilities and price.7 Table of ContentsWe also compete, or will compete, with a variety of companies in several different product markets. The products that we have developed or arecurrently developing will compete with other technologically innovative products, as well as products incorporating conventional materials andtechnologies. We expect that we will compete with companies in a wide range of industries, including semiconductors, electronics, biotechnology, textiles,alternative energy, military, defense, healthcare, telecommunications, industrial measurement, security applications and consumer electronics. Althoughthere can be no assurance that we will continue to do so, we believe that we compete favorably in these areas because our products leverage advancedtechnologies to offer superior performance. If we are unable to effectively compete in these areas in the future, we could lose business to our competitors,which could harm our operating results.Government RegulationQualification for Small Business Innovation Research GrantsSBIR is a highly competitive program that encourages small businesses to explore their technological potential and provides them with incentives tocommercialize their technologies by funding research that might otherwise be prohibitively expensive or risky for companies like us. As noted above, wepresently derive a significant portion of our revenue from this program, but we must continue to qualify for the SBIR program in order to be eligible toreceive future SBIR awards. The eligibility requirements are:•Ownership. The company must be more than 50 percent owned and controlled by U.S. citizens or permanent resident aliens, or owned by anentity that is itself more than 50 percent owned and controlled by U.S. citizens or permanent resident aliens; and•Size. The company, including its affiliates, cannot have more than 500 employees.These requirements are set forth in the SBA’s regulations and are interpreted by the SBA’s Office of Hearings and Appeals. In determining whether wesatisfy the more than 50% ownership requirement, agreements to merge, stock options, convertible debt and other similar instruments are given “presenteffect” by the SBA as though the underlying security were actually issued unless the exercisability or conversion of such securities is speculative, remote orbeyond the control of the security holder. We therefore believe our outstanding options and warrants held by eligible individuals may be counted asoutstanding equity for purposes of meeting the more than 50% equity ownership requirement. We believe that we are in compliance with the SBA ownershiprequirements.In addition, to be eligible for SBIR contracts, the number of our employees, including those of any entities that are considered to be affiliated with us,cannot exceed 500. As of December 31, 2016, we, including all of our divisions, had 245 full- and part-time employees. In determining whether we have 500or fewer employees, the SBA may count the number of employees of entities that are large stockholders who are “affiliated” or have the power to control us.In determining whether firms are affiliated, the SBA evaluates factors such as stock ownership and common management, but it ultimately may make itsdetermination based on the totality of the circumstances. Eligibility protests can be raised to the SBA by a competitor or by the awarding contracting agency.If we grow larger, and if our ownership becomes more diversified, we may no longer qualify for the SBIR program, and we may be required to seek alternativesources and partnerships to fund some of our research and development costs. Additional information regarding these risks may be found below in “RiskFactors.”Environmental, Health and Safety RegulationOur facilities and current and proposed activities involve the use of a broad range of materials that are considered hazardous under applicable laws andregulations. Accordingly, we are subject to a number of domestic and foreign laws and regulations and other requirements relating to employee health andsafety, protection of the environment, product labeling and product take back. Regulated activities include the storage, use, transportation and disposal of,and exposure to, hazardous or potentially hazardous materials and wastes. Our current and proposed activities also include potential exposure to physicalhazards associated with work environment and equipment. We could incur costs, fines, civil and criminal penalties, personal injury and third-party propertydamage claims, or we could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental,health and safety laws and regulations or requirements. Liability under environmental, health and safety laws can be joint and several and without regard tofault. There can be no assurance that violations of environmental, health and safety laws will not occur in the future as a result of the inability to obtainpermits in a timely manner, human error, equipment failure or other causes. Environmental, health and safety laws could also become more stringent overtime, imposing greater compliance costs and increasing risks and penalties associated with violations, which could harm our business. Further, violations ofpresent and future environmental, health and safety laws could restrict our8 Table of Contentsability to expand facilities and pursue certain technologies, as well as require us to acquire costly equipment or to incur potentially significant costs tocomply with environmental, health and safety regulations and other requirements.We have made, and will continue to make, expenditures to comply with current and future environmental, health and safety laws. We anticipate that wecould incur additional capital and operating costs in the future to comply with existing environmental, health and safety laws and new requirements arisingfrom new or amended statutes and regulations. In addition, because the applicable regulatory agencies have not yet promulgated final standards for someexisting environmental, health and safety programs, we cannot at this time reasonably estimate the cost for compliance with these additional requirements.The amount of any such compliance costs could be material. We cannot predict the impact that future regulations will impose upon our business.EmployeesAs of December 31, 2016, we had approximately 245 total employees, including approximately 121 in research, development and engineeringpositions, approximately 78 in operations, approximately 14 in sales and marketing, and approximately 32 in administrative positions. None of ouremployees are covered by a collective bargaining agreement, and we consider our relationship with our employees to be good.BacklogWe have historically had a backlog of contracts, primarily within our Technology Development segment, for which work has been scheduled, but forwhich a specified portion of work has not yet been completed. The approximate value of our backlog was $17.6 million and $16.7 million at December 31,2016 and 2015, respectively.We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work thathas not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. Total backlog includesfunded backlog, which is the amount for which money has been directly authorized by the U.S. government or for which a purchase order has been receivedfrom a commercial customer, and unfunded backlog, which represents firm orders for which funding has not yet been appropriated. Unfunded backlog was$2.1 million and $3.3 million as of December 31, 2016 and 2015, respectively. Indefinite delivery and quantity contracts and unexercised options are notreported in total backlog. Our backlog is subject to delays or program cancellations that may be beyond our control.Our backlog of purchase orders received for which the related goods have not been shipped or recognized as revenue within our Products and Licensingsegment was $10.4 million and $10.7 million at December 31, 2016 and 2015, respectively.Research, Development and EngineeringWe incur research, development and engineering expenses that are not related to our contract performance. These expenses were $5.5 million and $4.3million for the years ended December 31, 2016 and 2015, respectively. In addition, during these years, we spent $12.7 million and $10.4 million,respectively, on customer-sponsored research activities, which amounts are reimbursed as part of our performance of customer contracts.Operating Segments and Geographic AreasFor information with respect to our operating segments and geographic markets, see Note 15 to our Consolidated Financial Statements in Part II, Item 8of this Annual Report on Form 10-K.Website Access to ReportsOur website address is www.lunainc.com. We make available, free of charge under “SEC Filings” on the Investor Relations portion of our website,access to our annual report on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K, as well as amendments to those reportsfiled or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such materialis electronically filed with or furnished to the SEC. Information appearing on our website is not incorporated by reference in and is not a part of this annualreport. A copy of this annual report, as well as our other periodic and current reports, may be obtained from the SEC’s public reference room at 100 F Street,N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SECmaintains an internet site that contains reports, proxy and information statements, and other information regarding our filings at www.sec.gov.9 Table of ContentsITEM 1A. You should carefully consider the risks described below before deciding whether to invest in our common stock. The risks described below are not theonly ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations andfinancial results. If any of the following risks actually occurs, our business, financial condition or results of operations could be adversely affected. In suchcase, the trading price of our common stock could decline and you could lose all or part of your investment. Our filings with the Securities and ExchangeCommission also contain forward-looking statements that involve risks or uncertainties. Our actual results could differ materially from those anticipated orcontemplated by these forward-looking statements as a result of a number of factors, including the risks we face described below, as well as other variablesthat could affect our operating results. Past financial performance should not be considered to be a reliable indicator of future performance, and investorsshould not use historical trends to anticipate results or trends in future periods.RISKS RELATING TO OUR BUSINESS GENERALLYOur technology is subject to a license from Intuitive, which is revocable in certain circumstances. Without this license, we cannot continue to market,manufacture or sell certain of our fiber-optic products.As a part of the sale of certain assets to Intuitive, we entered into a license agreement with Intuitive pursuant to which we received rights to use all ofour transferred technology outside the field of medicine and in respect of our existing non-shape sensing products in certain non-robotic medical fields. Thislicense 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 andpatent applications, (ii) commercialize our fiber optical shape sensing and localization technology in the field of medicine (except to perform on adevelopment 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 thislicense 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 tobe revoked by Intuitive, we would no longer be able to market, manufacture or sell these products which could have a material adverse effect on ouroperations.We depend on third-party vendors for specialized components in our manufacturing operations, making us vulnerable to supply shortages and pricefluctuations 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 oursupply 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 risksthat could negatively affect our ability to manufacture our products and harm our business, including interruption of supply. Although we are nowmanufacturing tunable lasers in low-rate initial production, we expect our overall reliance on third-party vendors to continue. Any significant delay orinterruption in the supply of components, or our inability to obtain substitute components or materials from alternate sources at acceptable prices and in atimely 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 relatedto 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 ouroptoelectronic components and certain lasers. Our reliance on contract manufacturers for these products makes us vulnerable to possible capacity constraintsand reduced control over delivery schedules, manufacturing yields, manufacturing quality control and costs. If the contract manufacturer for our productswere unable or unwilling to manufacture our products in required volumes and at high quality levels or to continue our existing supply arrangement, wewould have to identify, qualify and select an acceptable alternative contract manufacturer or move these manufacturing operations to internal manufacturingfacilities. An alternative contract manufacturer may not be available to us when needed or may not be in a position to satisfy our quality or productionrequirements on commercially reasonable terms, including price. Any significant interruption in manufacturing our products would require us to reduce thesupply of products to our customers, which in turn would reduce our revenue, harm our relationships with the customers of these products and cause us toforego potential revenue opportunities.10 Table of ContentsAs a provider of contract research to the U.S. government, we are subject to federal rules, regulations, audits and investigations, the violation or failure ofwhich 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. governmentcontracts. Government contract laws and regulations affect how we do business with our government customers and, in some instances, impose added costson our business. A violation of a specific law or regulation could result in the imposition of fines and penalties, termination of our contracts or debarmentfrom bidding on contracts. In some instances, these laws and regulations impose terms or rights that are more favorable to the government than thosetypically 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 investigategovernment 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 andpolicies, including the contractor’s purchasing, property, estimating, compensation and management information systems. Any costs found to be improperlyallocated to a specific contract will not be reimbursed, while such costs already reimbursed must be refunded. If an audit uncovers the inclusion of certainclaimed costs deemed to be expressly unallowable, or improper or illegal activities, we may be subject to civil and criminal penalties and administrativesanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with theU.S. government. In addition, our reputation could suffer serious harm if allegations of impropriety were made against us. In June 2015, we received adetermination from the Defense Contract Management Agency ("DCMA") of expressly unallowable costs included in our claimed costs for the 2007 contractyear. As a result of that determination, DCMA assessed us penalties, interest and over billings of $1.1 million. We have appealed that assessment, and ourappeal is currently pending. Depending on the outcome of this appeal, we could be required to make payments that have a material adverse effect on ourfinancial position.In addition to the risk of government audits and investigations, U.S. government contracts and grants impose requirements on contractors and granteesrelating to ethics and business practices, which carry civil and criminal penalties including monetary fines, assessments, loss of the ability to do business withthe 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 relatedproducts based on the same core technologies if the U.S. government determines that the commercial availability of those products could pose a risk tonational 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 themcommercially. Any of these determinations would limit our ability to generate product sales and license revenues.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 SBAthat 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 ofour consolidated total revenues, and contract research, including SBIR contracts, will remain a significant portion of our consolidated total revenues for theforeseeable future. For the year ended December 31, 2016, 24% of our total revenues were generated under the SBIR program, compared to 26% in for theyear ended December 31, 2015.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 SBIRcontracts 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 contractor 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 areU.S. citizens or permanent resident aliens, and/or other small business concerns (each of which is more than 50% owned and controlled by individuals whoare 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 beaffiliated with us, cannot exceed 500. As of December 31, 2016, we had approximately 245 full and part-time employees. In determining whether we areaffiliated with any other entity, the SBA may analyze whether another entity controls or has the power to control us. Carilion Clinic is our largestinstitutional stockholder. Since early 2011, a formal size determination by the SBA that focused on whether or not Carilion is or was our affiliate has beenoutstanding. Although we11 Table of Contentsdo 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 thisquestion. 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 500employees. 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 thecriterion of number of employees, and the relevant government agency would have the discretion to suspend performance on existing SBIR grants. The lossof 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 seekalternative 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 28% and 31% of our total revenuesfor the years ended December 31, 2016 and 2015, respectively. As a result, we are vulnerable to adverse changes in our revenues and cash flows if asignificant number of our research contracts and subcontracts were to be simultaneously delayed or canceled for budgetary, performance or other reasons. Forexample, the U.S. government may cancel these contracts at any time without cause and without penalty or may change its requirements, programs or contractbudget, any of which could reduce our revenues and cash flows from U.S. government research contracts. Our revenues and cash flows from U.S. governmentresearch 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, togetherwith 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 extendtheir agreements with us and may elect not to do so. Also, our customers’ priorities regarding funding for certain projects may change and funding resourcesmay 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 ofautomatic, across-the-board spending cuts and caps on discretionary spending. This “sequestration” under the Budget Control Act, which is split equallybetween defense and non-defense programs, went into effect on March 1, 2013. Any spending cuts required by “sequestration” could have a material adverseeffect on our Technology Development segment 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 newcontract awards also could be negatively affected.In addition to contract cancellations and changes in agency budgets, our future financial results may be adversely affected by curtailment of orrestrictions on the U.S. government’s use of contract research providers, including curtailment due to government budget reductions and related fiscal mattersor 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 federalagencies to conduct research internally rather than through commercial research organizations or direct awards to other organizations, to reduce their overallcontract research requirements or to exercise their rights to terminate contracts. Alternatively, the U.S. government may discontinue the SBIR program or itsfunding altogether. Also, SBIR regulations permit increased competition for SBIR awards from companies that may not have previously been eligible, suchas those backed by venture capital operating companies, hedge funds and private equity firms. Any of these developments could limit our ability to obtainnew contract awards and adversely affect our revenues, cash flows and ability to fund our growth.Our failure to attract, train and retain skilled employees or members of our senior management and to obtain necessary security clearances for suchpersons 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 forscientists, engineers, technicians and professional personnel is intense and our competitors aggressively recruit key employees. In the past, we haveexperienced difficulties in recruiting and hiring these personnel as a result of the tight labor market in certain fields. Any difficulty in hiring or retainingqualified employees, combined with our growth strategy and future needs for additional experienced personnel, particularly in highly specialized areas suchas nanomaterial manufacturing and fiber optic sensing technologies, may make it more difficult to meet all of our needs for these employees in a timelymanner. Although we intend to continue to devote significant resources to recruit, train and retain qualified employees, we may not be able to attract andretain 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 adverse12 Table of Contentseffect 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 andeffective 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 ourboard chairman to hold security clearances. In general, the failure for necessary persons to obtain or retain sufficient security clearances, any loss by us of afacility security clearance or any public reprimand related to security matters could result in a U.S. government customer terminating an existing contract orchoosing 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 maintainany key-person life insurance policies on our officers. The loss of any members of our management team or other key personnel could seriously harm ourbusiness.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 andrevenue.Many factors beyond our control affect our business, including consumer confidence in the economy, interest rates, fuel prices and the generalavailability of credit. The overall economic climate and changes in Gross National Product growth have a direct impact on some of our customers and thedemand 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 globaleconomies, 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-periodfluctuations in future results of operations. Any future downturn in the markets in which we compete could significantly reduce the demand for our productsand therefore may result in a significant reduction in revenue or increase the volatility of the price of our common stock. Our revenue and results ofoperations 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 adownturn, many service providers may slow their capital expenditures, cancel or delay new developments, reduce their workforces and inventories and take acautious approach to acquiring new equipment and technologies from original equipment manufacturers, which would have a negative impact on ourbusiness. Weakness in the global economy or a future downturn in the telecommunications industry may cause our results of operations to fluctuate fromquarter-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 affectour 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 customeracceptance 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 productsare 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 roughenvironments as they are integrated into our customer products for use by the end customers. If defects and failures occur in our products, we couldexperience lost revenue, increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or reschedulingof orders or shipments, product returns or discounts, diversion of management resources or damage to our reputation and brand equity, and in some casesconsequential damages, any of which would harm our operating results. In addition, delays in our ability to fill product orders as a result of quality controlissues may negatively impact our relationship with our customers. We cannot assure you that we will have sufficient resources, including any availableinsurance, to satisfy any asserted claims.13 Table of ContentsRapidly 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 orindustry standards bodies worldwide. Because some of our products are designed to conform to current specific industry standards, if competing or newstandards emerge that are preferred by our customers, we would have to make significant expenditures to develop new products. If our customers adopt new orcompeting industry standards with which our products are not compatible, or the industry groups adopt standards or governments issue regulations withwhich our products are not compatible, our existing products would become less desirable to our customers and our revenue and results of operations wouldsuffer.The markets for many of our products are characterized by changing technology which could cause obsolescence of our products, and we may incursubstantial costs in delivering new products.The markets for many of our products are characterized by changing technology, new product introductions and product enhancements, and evolvingindustry standards. The introduction or enhancement of products embodying new technology or the emergence of new industry standards could renderexisting products obsolete, and result in a write down to the value of our inventory, or result in shortened product life cycles. Accordingly, our ability tocompete 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. Some of our products are used by our customers to develop, test and manufacture their products. We therefore must anticipate industry trends anddevelop products in advance of the commercialization of our customers’ products. In developing any new product, we may be required to make a substantialinvestment before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, wemay 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 the legacy APIproducts 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 productshave been dependent upon the success of our customers’ products and the future performance of the legacy API business is dependent upon our success infinding 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 theproduct, but for the life of the product. Many of our products are used in remote locations for higher value assembly, making servicing of our productsunfeasible. 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 HSOR and optoelectronics products prior to qualification of the products and satisfactory completion offactory audits and vendor evaluation. Our existing products, as well as each new product, must pass through varying levels of qualification with ourcustomers. 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 customdesign projects. It is difficult to predict with any certainty whether our customers will delay or terminate product qualification or the frequency with whichcustomers 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 are14 Table of Contentsunlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporateentirely new products into their new systems, as doing so could involve significant additional redesign efforts and increased costs. If we fail to achievedesign-in wins in potential customers’ qualification processes, we will likely lose the opportunity for significant sales to those customers for a lengthy periodof 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 thatcontain our products, our business could be harmed. The qualification and field testing of our customers’ systems by end user customers is long andunpredictable. 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 unanticipateddelay in qualification of one of our customers’ products could result in the delay or cancellation of orders from our customers for products included in theirequipment, 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 customerdemand, 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, inventorylevels, 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 toaccurately estimate future customer requirements. On occasion, customers may require rapid increases in production, which can strain our resources, cause ourmanufacturing to be negatively impacted by materials shortages, necessitate higher or more restrictive procurement commitments, increase our manufacturingyield loss and scrapping of excess materials, and reduce our gross margin. We may not have sufficient capacity at any given time to meet the volumedemands 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, adownturn 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 ofproducts ordered or to cancel existing orders, leading to lower utilization of our facilities. Because many of our costs and operating expenses are relativelyfixed, reduction in customer demand due to market downturns or other reasons would have a negative effect on our gross margin, operating income and cashflow.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 canceledor 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 asa reasonable allowance for anticipated profits. No assurance can be given that we will receive these amounts after cancellation. Furthermore, uncertainty incustomer forecasts of their demands and other factors may lead to delays and disruptions in manufacturing, which could result in delays in product shipmentsto 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 inmanufacturing 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 oursales, operating income, strategic position at customers, market share and reputation. In addition, disruptions, delays or cancellations could cause inefficientproduction 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 anegative or uncertain political climate could adversely affect our customers’ financial conditions and the timing or levels of business activity of ourcustomers 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 onour results of operations. Changes in global economic conditions could also shift demand to products or services for which we do not have competitiveadvantages, and this could negatively affect the amount of business we are able to obtain. In addition, if we are unable to successfully anticipate changingeconomic and political conditions, we may be unable to effectively plan for and respond to those changes, and our business could be negatively affected as aresult.15 Table of ContentsWe have a history of losses, and because our strategy for expansion may be costly to implement, we may experience continuing losses and may neverachieve or maintain profitability or positive cash flow.We realized a net loss from continuing operations of $2.4 million and $6.0 million for the years ended December 31, 2016 and 2015, respectively. Weexpect to continue to incur significant expenses as we pursue our strategic initiatives, including increased expenses for research and development, sales andmarketing and manufacturing. We may also grow our business in part through acquisitions of additional companies and complementary technologies whichcould 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 ourability to comply with NASDAQ continued listing standards, as described further below.Our ability to generate additional revenues and to become profitable will depend on our ability to execute our key growth initiative regarding thedevelopment, marketing and sale of HSOR and sensing products, develop and commercialize innovative technologies, expand our contract researchcapabilities and sell the products that result from those development initiatives. We are unable to predict when or if we will be able to achieve profitability. Ifour revenues do not increase, or if our expenses increase at a greater rate than our revenues, we will continue to experience losses. Even if we do achieveprofitability, we may not be able to sustain or increase our profitability on a quarterly or annual basis.We have obtained capital by borrowing money under a term loan and we might require additional capital to support and expand our business; our termloan 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 scalemanufacturing facilities. To the extent that we are unable to become or remain profitable and to finance our activities from our continuing operations, we mayrequire 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 suffersignificant dilution, including as the result of the issuance of warrants in connection with the financing, and any new equity securities we issue could haverights, preferences and privileges superior to those of our existing common stock. Furthermore, such financings may jeopardize our ability to apply for SBIRgrants or qualify for SBIR contracts or grants, and our dependence on SBIR grants may restrict our ability to raise additional outside capital. If we raiseadditional funds through debt financings, these financings may involve significant cash payment obligations and covenants that restrict our ability tooperate our business and make distributions to our stockholders.We have a term loan with Silicon Valley Bank ("SVB"), which requires us to observe certain financial and operational covenants, includingmaintenance of a minimum cash balance of $5.0 million, protection and registration of intellectual property rights, and certain customary negativecovenants, as well as other customary events of default. If any event of default occurs SVB may declare due immediately all borrowings under our term loanand 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 businessgrowth 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 ispossible that our current or future products, particularly carbon-based nanomaterials, may become subject to environmental or other regulation. We intend todevelop and sell carbon-based nanomaterials as well as nanotechnology-enabled products, which are products that include nanomaterials as a component toenhance those products’ performance. Nanomaterials and nanotechnology-enabled products have a limited historical safety record. Because of their size orshape 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 orthe environment. These characteristics may also cause countries to adopt regulations in the future prohibiting or limiting the manufacture, distribution or useof nanomaterials or nanotechnology-enabled products. Such regulations may inhibit our ability to sell some products containing those materials and therebyharm 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 otherpurposes, prohibit or regulate the use of nanotechnology. Ethical and other concerns about16 Table of Contentsnanotechnology 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 andselling 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 andmarketing, manufacturing, distribution, technical and other resources than we do. These competitors may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements. In addition, current and potential competitors have established or may establish financial or strategicrelationships among themselves or with existing or potential customers or other third parties. Accordingly, new competitors or alliances among competitorscould emerge and rapidly acquire significant market share. We cannot assure you that we will be able to compete successfully against current or newcompetitors, 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 orselling older inventory at a discount. If our current or future competitors utilize aggressive business tactics, including those described above, demand for ourproducts 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 expensescommensurately.The market for optical components and subsystems continues to be characterized by declining average selling prices resulting from factors such asincreased price competition among optical component and subsystem manufacturers, excess capacity, the introduction of new products and increased unitvolumes 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 productintroductions by competitors or by us, or in response to other factors, including price pressures from significant customers. In order to sustain profitableoperations, we must, therefore, reduce the cost of our current designs or continue to develop and introduce new products on a timely basis that incorporatefeatures that can be sold at higher average selling prices. Failure to do so could cause our sales to decline and operating losses to increase.Our cost reduction efforts may not keep pace with competitive pricing pressures. To remain competitive, we must continually reduce the cost ofmanufacturing our products through design and engineering changes. We may not be successful in redesigning our products or delivering our products tomarket 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 toremain 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 profitmay 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 inaverage 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 highgross profit margins, our total gross profits could be harmed.Risks Relating to our Operations and Business StrategyIf we cannot successfully transition our revenue mix from contract research revenues to product sales and license revenues, we may not be able to fullyexecute 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 revenuesfrom the provision of services or from licensing. Product sales and these revenues potentially offer greater scalability than contract research revenues. Ourcurrent plan is to increase our sales of commercial products, our licensing revenues and our provision of non-research services to customers so as to representa 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 licensing17 Table of Contentsto augment our contract research revenues, however, our ability to execute our business model or grow our business could suffer. There can be no assurancethat 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 tendto be increasingly complex, incorporating more functions and operating at faster speeds than old products. If we fail to introduce new product designs ortechnologies in a timely manner or if customers do not successfully introduce new systems or products incorporating our products, our business, financialcondition 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 strainon 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 staffand 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, butwe may not always have success in doing so in part because our contract research largely centers on identification and development of unproventechnologies, often for new or emerging markets. Furthermore, we must identify the most promising technologies from a sizable pool of projects. If ourcommercialization strategy process fails to identify projects with commercial potential or if management does not ensure that such projects advance to thecommercialization 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 developingsuccessful new products. Many of our existing products and those currently under development are technologically innovative and require significant andlengthy 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 resourceconstraints require us to focus on specific products and to forgo other opportunities. We expect that one or more of the potential products we choose todevelop will not be technologically feasible or will not achieve commercial acceptance, and we cannot predict which, if any, of our products we willsuccessfully develop or commercialize. The technologies we research and develop are new and steadily changing and advancing. The products that arederived from these technologies may not be applicable or compatible with the state of technology or demands in existing markets. Our existing products andtechnologies 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 givenproduct may not be readily determinable, and we cannot reasonably estimate the size of any markets that may develop. If we are not able to successfullydevelop 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 businessoperations 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 supplyforeign 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 theUnited 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;18 Table of Contents•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 bediscontinued or, to the extent possible, divested. In addition, if we are unable to generate the amount of cash needed to fund the future operations of ourbusiness, 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 technologydevelopments to dispose or discontinue or that our decision to dispose of or discontinue various investments, products lines and technology developments isprudent if market conditions change. In addition, there are no assurances that the discontinuance of various product lines will reduce operating expenses orwill 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 ofthe net assets for the product line. Other risks include managing the expectations of, and maintaining good relations with, our historical customers whopreviously purchased products from a disposed or discontinued product line, which could prevent us from selling other products to them in the future. Wemay also incur other significant liabilities and costs associated with disposal or discontinuance of product lines, including employee severance costs andexcess 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 againstour 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 occurfrom time to time. Our customers’ testing procedures may be limited to evaluating our products under likely and foreseeable failure scenarios and overvarying amounts of time. For various reasons, such as the occurrence of performance problems that are unforeseeable in testing or that are detected only whenproducts age or are operated under peak stress conditions, our products may fail to perform as expected long after customer acceptance. Failures could resultfrom faulty components or design, problems in manufacturing or other unforeseen reasons. As a result, we could incur significant costs to repair or replacedefective products under warranty, particularly when such failures occur in installed systems. In addition, we may in certain circumstances honor warrantyclaims after the warranty has expired or for problems not covered by warranty in order to maintain customer relationships. Any significant product failurecould 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 ofcomponents, modules and subsystems and may be expected to interoperate with modules produced by third parties. As a result, not all defects areimmediately detectable, and, when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significantdamages or warranty and repair costs, divert the attention of our engineering personnel from internal product development efforts and cause significantcustomer 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 couldpotentially 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. Ifa 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 aproduct 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.19 Table of ContentsWe could be negatively affected by a security breach, either through cyber-attack, cyber-intrusion or other significant disruption of our IT networks andrelated systems.We face the risk, as does any company, of a security breach, whether through cyber-attack or cyber-intrusion over the internet, malware, computerviruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization, or other significant disruption ofour IT networks and related systems. The risk of a security breach or disruption, particularly through cyber-attack or cyber-intrusion, including by computerhackers, foreign governments and cyber terrorists, has increased as the number, intensity and sophistication of attempted attacks and intrusions from aroundthe 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 togain unauthorized access to our proprietary, confidential or classified information on our IT networks and related systems. These types of information and ITnetworks 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, arecritical to the operations of certain of our customers. In addition, as certain of our technological capabilities become widely known, it is possible that we maybe subjected to cyber-attack or cyber-intrusion as third parties seek to gain improper access to information regarding these capabilities and cyber-attacks orcyber-intrusion could compromise our confidential information or our IT networks and systems generally, as it is not practical as a business matter to isolateall of our confidential information and trade secrets from email and internet access. There can be no assurance that our security efforts and measures will beeffective 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 properfunctioning of these networks and systems and therefore our operations, compromise our confidential information and trade secrets, or damage our reputationamong our customers and the public generally. Any of these developments could have a negative impact on our results of operations, financial condition andcash flows.Risks Relating to our Regulatory EnvironmentOur operations are subject to domestic and foreign laws, regulations and restrictions, and noncompliance with these laws, regulations and restrictionscould 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), technologytransfer restrictions, anti-boycott provisions, economic sanctions and the FCPA. The number of our various emerging technologies, the development of manyof which has been funded by the Department of Defense, presents us with many regulatory challenges. Failure by us or our sales representatives or consultantsto 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 inforeign 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, includingthose relating to air and water quality, solid and hazardous waste handling, and the promotion of occupational safety. Various federal, state and local lawsand regulations require that we maintain certain environmental permits. While we believe that we have obtained all necessary environmental permits requiredto 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 damagesresulting 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 andadditional 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 partof our manufacturing operations, which would result in product delivery delays and negatively impact revenues.20 Table of ContentsOur manufacturing facilities are subject to periodic inspection by regulatory authorities and our operations will continue to be regulated by the FDA forcompliance with Good Manufacturing Practice requirements contained in the quality systems regulations. We are also required to comply with InternationalOrganization for Standardization ("ISO"), quality system standards in order to produce certain of our products for sale in Europe. If we fail to continue tocomply with Good Manufacturing Practice requirements or ISO standards, we may be required to cease all or part of our operations until we comply withthese regulations. Obtaining and maintaining such compliance is difficult and costly. We cannot be certain that our facilities will be found to comply withGood Manufacturing Practice requirements or ISO standards in future inspections and audits by regulatory authorities. In addition, if we cannot maintain orestablish manufacturing facilities or operations that comply with such standards or do not meet the expectations of our customers, we may not be able torealize 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 necessaryinternational 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 thosecountries. These regulations, including the requirements for approvals and the time required for regulatory review, vary from country to country. Obtainingand maintaining foreign regulatory approvals are expensive, and we cannot be certain that we will have the resources to be able to pursue such approvals orwhether we would receive regulatory approvals in any foreign country in which we plan to market our products. For example, the European Union requiresthat 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 ourproducts, 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, andfailure 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 andregulations. Accordingly, we are subject to a number of foreign, federal, state and local laws and regulations relating to health and safety, protection of theenvironment 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 orbecome liable under environmental, health and safety laws. Moreover, a failure to comply with environmental laws could result in fines and the revocation ofenvironmental permits, which could prevent us from conducting our business. Liability under environmental laws can be joint and several and without regardto fault. There can be no assurance that violations of environmental and health and safety laws will not occur in the future as a result of the inability to obtainpermits, human error, equipment failure or other causes. Environmental laws could become more stringent over time, imposing greater compliance costs andincreasing risks and penalties associated with violations, which could harm our business. Accordingly, violations of present and future environmental lawscould restrict our ability to expand facilities, pursue certain technologies, and could require us to acquire costly equipment or incur potentially significantcosts 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 complywith 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 suchfine or expenditure may adversely affect our development. We cannot predict the extent to which future legislation and regulation could cause us to incuradditional operating expenses, capital expenditures or restrictions and delays in the development of our products and properties.Risks Relating to our Intellectual PropertyOur 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 ourtechnologies in the United States and other jurisdictions as well as successfully enforcing this intellectual property and defending it against third-partychallenges. We will only be able to protect our technologies from unauthorized use by third parties to the extent that valid and enforceable intellectualproperty protections, such as patents or trade secrets, cover them. In particular, we place considerable emphasis on obtaining patent and trade secretprotection for significant new technologies, products and processes. The degree of future protection of our proprietary rights is uncertain because legal meansafford only limited protection and may not adequately protect our rights or permit us to gain or keep our competitive advantage. The degree of futureprotection of our proprietary rights is also uncertain for products that are currently21 Table of Contentsin the early stages of development because we cannot predict which of these products will ultimately reach the commercial market or whether the commercialversions 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 thatmay 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 anycompetitive 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 issuedpatent or future issued patent owned or licensed by us may not be valid or sufficiently broad to protect our technologies. Moreover, protection of certain ofour intellectual property may be unavailable or limited in the United States or in foreign countries, and we have not sought to obtain foreign patentprotection for certain of our products or technologies due to cost, concerns about enforceability or other reasons. Any issued patents owned by or licensed tous 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 orlimited 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 tocapture or increase their market share with respect to related technologies. We could incur substantial costs to bring suits in which we may assert our patentrights against others or defend ourselves in suits brought against us. An unfavorable outcome of any litigation could have a material adverse effect on ourbusiness 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, tradesecrets are difficult to protect. We regularly attempt to obtain confidentiality agreements and contractual provisions with our collaborators, employees andconsultants 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 strategicpartners, may unintentionally or willfully disclose our information to competitors. If we were to enforce a claim that a third party had illegally obtained andwas using our trade secrets, our enforcement efforts would be expensive and time consuming, and the outcome would be unpredictable. In addition, courtsoutside 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 fromdeveloping or marketing competing technologies and we may not generate enough revenues from product sales to justify the cost of developing ourtechnologies 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 tofile 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 trademarkapplications from challenge by third parties. Enforcing or defending our registered and unregistered trademarks might result in significant litigation costs anddamages, 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 thirdparties may claim that we infringe their patents. Because patent applications can take several years to result in a patent issuance, there may be currentlypending applications, unknown to us, which may later result in issued patents that our technologies may infringe. For example, we are aware of competitorswith patents in technology areas applicable to our optical test equipment products. Such competitors may allege that we infringe these patents. There couldalso be existing patents of which we are not aware that our technologies may inadvertently infringe. We have from time to time22 Table of Contentsbeen, and may in the future be, contacted by third parties, including patent assertion entities or intellectual property advisors, about licensing opportunitiesthat also contain claims that we are infringing on third party patent rights. If third parties assert these claims against us, we could incur extremely substantialcosts 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 onunfavorable terms because we cannot afford to litigate the claim. In addition, if third parties assert claims against us and we are unsuccessful in defendingagainst these claims, these third parties may be awarded substantial damages as well as injunctive or other equitable relief against us, which could effectivelyblock 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 patentprotection is uncertain. Consequently, the patent positions of companies involved in nanotechnologies have not been tested, and there are complex legal andfactual questions for which important legal principles will be developed or may remain unresolved. In addition, it is not clear whether such patents will besubject to interpretations or legal doctrines that differ from conventional patent law principles. Changes in either the patent laws or in interpretations ofpatent laws in the United States and other countries may diminish the value of our nanotechnology-related intellectual property. Accordingly, we cannotpredict 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 claimrelating to intellectual property is asserted against us, or third parties not affiliated with us hold pending or issued patents that relate to our products ortechnology, we may seek licenses to such intellectual property or challenge those patents. However, we may be unable to obtain these licenses oncommercially reasonable terms, if at all, and our challenge of the patents may be unsuccessful. Our failure to obtain the necessary licenses or other rightscould prevent the sale, manufacture or distribution of our products and, therefore, could have a material adverse effect on our business, financial conditionand 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 grantof similar rights to third parties.A substantial portion of our technology is licensed from academic institutions, corporations and government agencies. Under these licensingarrangements, 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 thelicensor or that we provide licensed technology or material to third parties for non-commercial research. The grant of a license for any of our coretechnologies to a third party could have a material and adverse effect on our business. In addition, some of our licensors retain certain rights under thelicenses, including the right to grant additional licenses to a substantial portion of our core technology to third parties for non-commercial academic andresearch use. It is difficult to monitor and enforce such non-commercial academic and research uses, and we cannot predict whether the third-party licenseeswould comply with the use restrictions of such licenses. We have incurred and could incur substantial expenses to enforce our rights against them. We alsomay 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 havelicensed 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 theseinstitutions. In certain cases we also have the right to practice improvements on the licensed technology to the extent they are encompassed by the licensedpatents and are within our field of use. Our licensors may currently own and may in the future obtain additional patents and patent applications that arenecessary for the development, manufacture and commercial sale of our anticipated products. We may be unable to agree with one or more academicinstitutions from which we have obtained licenses whether certain intellectual property developed by researchers at these academic institutions is covered byour 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 licenseagreement. 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 usto 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 orother federal funding agreements. With respect to inventions conceived or first reduced to practice under a federal funding agreement, the U.S. governmentmay retain a non-exclusive, non-transferable, irrevocable, paid-up license to practice or have practiced for or on behalf of the United States the inventionthroughout 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 inthe 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 intellectualproperty, our business and results of operations will be adversely affected.23 Table of ContentsIn the past, we have licensed certain technologies for use in our products. In the future, we may choose, or be required, to license technology orintellectual property from third parties in connection with the development of our products. We cannot assure you that third-party licenses will be availableon 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 protectand 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 claimsthat their proprietary information has been disclosed.RISKS RELATING TO OUR COMMON STOCKIf 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 makeit 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 commonstock, 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 uponconversion of shares of Series A Convertible Preferred Stock that Carilion holds). All of these shares have been registered for resale on a Form S-3 registrationstatement 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 mayoccur by Carilion or any of our other significant stockholders, may have a material adverse effect on the market price of our stock. Any such continuingmaterial adverse effect on the market price of our stock could impair our ability to comply with NASDAQ’s continuing listing standards in respect of ourminimum 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 coveragemay 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 commonstock of technology companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, following periods ofvolatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. Securitiesclass litigation also often follows certain significant business transactions, such as the sale of a business division or a change in control transaction. We maybecome involved in this type of litigation in the future. Litigation often is expensive and diverts management’s attention and resources, which couldadversely 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 ourcommon stock.Our common stock is listed on The NASDAQ Capital Market. In order to maintain that listing, we must satisfy minimum financial and other continuedlisting 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. Althoughwe 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 soin 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 thatwe 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 certaincircumstances, NASDAQ could require that the minimum bid price exceed $1.00 for more than ten consecutive days before determining that a companycomplies.In the event that our common stock is not eligible for continued listing on NASDAQ or another national securities exchange, trading of our commonstock 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 theOTC Bulletin Board. In such event, it could become more difficult to dispose of, or obtain accurate price quotations for, our common stock, and there wouldlikely 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 causeyou to lose all or a substantial part of your investment.24 Table of ContentsThe public trading price for our common stock is volatile and may fluctuate significantly. Since January 1, 2009, our common stock has traded betweena 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 themarket 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 operatingperformance 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 thosecontrols, investors could lose confidence in our financial reports, and our stock price may be adversely affected.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 mustinclude 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 theTreadway Commission. During the course of our ongoing evaluation of the internal controls, we may identify areas requiring improvement, and may have todesign enhanced processes and controls to address issues identified through this review. Remedying any deficiencies, significant deficiencies or materialweaknesses that we identify may require us to incur significant costs and expend significant time and management resources. We cannot assure you that anyof the measures we implement to remedy any such deficiencies will effectively mitigate or remedy such deficiencies. Investors could lose confidence in ourfinancial reports, and our stock price may be adversely affected, if our internal controls over financial reporting are found not to be effective by managementor 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 incontrol, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by ourstockholders 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 otherrights 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;and25 Table of Contents•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 ownerof 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 certainother 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 bewilling to pay in the future for shares of our common stock. ITEM 1B. UNRESOLVED STAFF COMMENTSNot applicable. ITEM 2. PROPERTIESWe lease approximately 4,400 square feet of office space in Roanoke, Virginia, which serves as our corporate headquarters and is used for general andadministrative functions. This lease expires March 31, 2020.We lease approximately 42,000 square feet of space in Blacksburg, Virginia, near Virginia Tech, which is used by both our Technology Developmentsegment and our Products and Licensing segment. This lease expires December 31, 2024.We lease approximately 50,000 square feet of space in Ann Arbor, Michigan, for research, development and manufacturing of our HSOR and THzproduct platforms. This lease expires May 31, 2021.We lease approximately 29,000 square feet of space in Camarillo, California, for development and manufacturing of our custom optoelectronicsolutions operations. This lease expires March 31, 2019.We lease approximately 16,000 square feet of space in Charlottesville, Virginia, near the University of Virginia, for use by certain groups in ourTechnology Development segment. This lease expires December 31, 2020.We lease approximately 4,000 square feet of space in Montreal, Canada for research and development of optoelectronic solutions. This lease expires inApril 2017. We are currently evaluating whether to renew this lease or relocate these operations to another location.We own a 24,000 square foot facility in Danville, Virginia. Our Technology Development segment primarily uses this facility for biomedical researchand development and manufacturing.We believe that our existing facilities are adequate for our current needs and suitable additional or substitute space will be available as needed toaccommodate expansion of our operations.ITEM 3. LEGAL PROCEEDINGSIn June 2015, we received a letter of final determination from the DCMA regarding the allowability of certain costs we included in our billings undercost-plus type research contracts during 2007. In conjunction with the DCMA's determination of those costs as expressly unallowable under the provisions ofthe Federal Acquisition Regulations, the DCMA assessed penalties and interest to us totaling $1.1 million. In July 2015, we filed an appeal of the assessedpenalties and interest with the Armed Services Board of Contract Appeals ("ASBCA"). A hearing was held with respect to this appeal in January 2017, and adecision has not yet been reached by ASBCA. Accordingly, the appeal remains outstanding.Additionally, from time to time, we may become involved in litigation or claims arising out of our operations in the normal course of business.Management currently believes the amount of ultimate liability, if any, with respect to these actions will not materially affect our financial position, results ofoperations, or liquidity. ITEM 4. MINE SAFETY DISCLOSURESNot applicable.26 Table of ContentsPART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIESPRICE RANGE OF COMMON STOCKOur common stock trades on The NASDAQ Capital Market. The following table sets forth the high and low sales prices of our common stock for eachperiod indicated as reported by NASDAQ. 2016 2015Fiscal Period High Low High LowFirst Quarter $1.25 $0.74 $1.85 $1.27Second Quarter $1.32 $0.97 $1.47 $0.96Third Quarter $1.69 $1.08 $1.30 $0.88Fourth Quarter $1.55 $1.22 $1.23 $0.88We have a single class of common stock outstanding. As of March 15, 2017 there were approximately 99 stockholders of record of our common stock.The number of holders of record of our common stock does not reflect the number of beneficial holders whose shares are held by depositories, brokers or othernominees.STOCK PERFORMANCE GRAPHThe graph set forth below compares the cumulative total stockholder return on our common stock for the previous five years, during which our commonstock was traded on the NASDAQ Capital Market, as compared to the cumulative total return of the NASDAQ Composite Index and the Russell 2000 Indexover the same period. This graph assumes the investment of $100,000 in our common stock at the closing price on January 1, 2012, and an equivalentamount in the NASDAQ Composite Index and the Russell 2000 Index on that date, and assumes the reinvestment of dividends, if any. We have never paiddividends on our common stock and have no present plans to do so.Since there is no published industry or line-of-business index for our business reflective of our performance, nor do we believe we can reasonablyidentify a peer group, we measure our performance against issuers with similar market capitalizations. We selected the Russell 2000 Index because itmeasures the performance of a broad range of companies with lower market capitalizations than those companies included in the S&P 500 Index.The comparisons shown in the graph below are based upon historical data. We caution that the stock price performance shown in the graph below is notnecessarily indicative of, nor is it intended to forecast, the potential future performance of our common stock.27 Table of ContentsThe preceding Stock Performance Graph is not deemed filed with the Securities and Exchange Commission and shall not be incorporated by referencein any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the datehereof and irrespective of any general incorporation language in any such filing.DIVIDEND POLICYSince our inception, we have never declared or paid any cash dividends on our common stock. We currently expect to retain any future earnings for usein the operation and expansion of our business, and therefore do not anticipate paying any cash dividends in the foreseeable future. In addition, our debtfacility with Silicon Valley Bank restricts us from paying cash dividends on our capital stock without the bank’s prior written consent.Unregistered Sales of Equity SecuritiesCommon Stock Dividend Payable to CarilionWe 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 inreliance 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 accruesdividends 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 thenumber of shares being equal to the quotient of (i) the cumulative aggregate balance of accrued but unpaid dividends on each share of Series A PreferredStock 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, theoriginal issue date of the Series A Preferred Stock, through December 31, 2016, the Series A Preferred Stock issued to Carilion has accrued $1,013,442 individends. The accrued dividend as of December 31, 2016 will be paid by the issuance of 552,401 shares of our common stock, which we will issue atCarilion’s written request. As the Series A28 Table of ContentsPreferred 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 exemptfrom registration in reliance on Section 3(a)(9) of the Securities Act.Purchases of Equity Securities by the Issuer and Affiliated PartiesThe following table summarizes repurchases of our common stock during the three months ended December 31, 2016.PeriodTotal Number of SharesPurchasedAverage Price Paid per ShareTotal Number of SharesPurchased as Part of aPublicly Announced Program(1)Approximate Dollar Value ofShares that May Yet to bePurchased Under the Program10/1/2016-10/31/2016———$1,759,18411/1/2016-11/30/20166,400$1.256,400$1,751,19112/1/2016-12/31/2016—$——$1,751,191Total6,4001.256,4001,751,191(1) 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 ourcommon stock. Unless extended, the stock repurchase program expires on May 31, 2017.ITEM 6. SELECTED FINANCIAL DATAThe consolidated statement of operations data for each of the years ended December 31, 2016 and 2015 and the consolidated balance sheet data as ofDecember 31, 2016 and 2015 have been derived from our audited consolidated financial statements appearing elsewhere in this report. The consolidatedstatement of operations data for the years ended December 31, 2014, 2013 and 2012 and the consolidated balance sheet data as of December 31, 2014, 2013and 2012 have been derived from our audited consolidated financial statements that do not appear in this report. The following selected consolidatedfinancial data should be read in conjunction with our consolidated financial statements and the accompanying notes and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included at Part II, Item 7 in this Annual Report on Form 10-K. The selected data in this section isnot intended to replace the consolidated financial statements, and the historical results are not necessarily indicative of the results to be expected in anyfuture period.29 Table of Contents Years ended December 31,In thousands, except share and per share data2016 2015 2014 2013 2012Consolidated Statement of Operations Data: Revenues: Technology development$16,825 $13,599 $12,206 $11,422 $15,127Products and licensing42,386 30,421 9,054 6,912 8,339Total revenues59,211 44,020 21,260 18,334 23,466Cost of revenues: Technology development12,711 10,379 9,376 8,882 10,749Products and licensing24,765 17,141 4,047 3,403 3,825Total cost of revenues37,476 27,520 13,423 12,285 14,574Gross profit21,735 16,501 7,837 6,049 8,892Operating expense23,672 22,750 12,342 14,084 13,022Operating loss(1,937) (6,250) (4,505) (8,035) (4,130)Other (expense)/income, net(36) (10) 111 347 108Interest expense, net(321) (220) (96) (208) (312)Loss from continuing operations before income tax(2,294) (6,480) (4,490) (7,896) (4,334)Income tax expense/(benefit)75 (471) (1,137) (2,387) (1,107)Net loss from continuing operations(2,369) (6,009) (3,353) (5,508) (3,227)Income from discontinued operations, net of income taxes— 8,326 9,347 4,705 1,843Net (loss)/income(2,369) 2,317 5,995 (803) (1,384)Preferred stock dividend105 86 112 102 120Net (loss)/income attributable to common stockholders$(2,475) $2,231 $5,883 $(905) $(1,504)Net loss per share from continuing operations: Basic and diluted$(0.09) $(0.26) $(0.23) (0.38) (0.23)Net income per share from discontinued operations: Basic and diluted$— $0.36 $0.63 0.33 0.13Net (loss)/income per share attributable to common stockholders: Basic and diluted$(0.09) $0.10 $0.40 (0.06) (0.11)Weighted-average shares: Basic and diluted27,547,217 23,026,494 14,880,697 14,336,135 13,930,267 As of December 31, 2016 2015 2014 2013 2012Consolidated Balance Sheet Data: Cash and cash equivalents$12,802 $17,464 $14,117 $7,779 $6,340Working capital21,129 23,417 15,413 10,106 10,509Total assets54,997 58,132 27,584 19,704 20,458Total current liabilities15,968 15,334 8,473 7,206 9,186Total debt4,253 6,125 625 2,125 3,625ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidatedfinancial statements and the related notes to those statements included elsewhere in this report. In addition to historical financial information, thefollowing discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing ofselected 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.30 Table of ContentsMerger with Advanced Photonix, Inc.On May 8, 2015, we completed a merger with Advanced Photonix, Inc. ("API"), pursuant to the Agreement and Plan of Merger and Reorganization (the"Merger Agreement"), dated as of January 30, 2015, by and among Luna, API and API Merger Sub, Inc., our wholly owned subsidiary ("API Merger Sub"). Inaccordance with the terms of the Merger Agreement, upon the completion of the merger, API Merger Sub merged with and into API, with API surviving as ourwholly-owned subsidiary. In the merger, former API stockholders received 0.31782 shares of our common stock for each share of API common stock theyowned at the effective time of the merger. The merger is being accounted for under the acquisition method of accounting in accordance with FinancialAccounting Standards Board Accounting Standard Topic 805, Business Combinations ("ASC 805") with Luna treated as the accounting acquirer.Business OverviewWe are a leader in advanced optical technology, providing unique capabilities in high speed optoelectronics and high performance fiber optic testproducts for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. Our high-speed optical receiver("HSOR") transmission products are deployed in the internet infrastructure to enable the high-speed bandwidth necessary to support video and data. Ourdistributed fiber optic sensing products provide critical stress, strain and temperature information to designers and manufacturers working with advancedmaterials. Our custom optoelectronic products are sold to scientific instrumentation manufacturers for various applications such as metrology, missileguidance, 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 newand innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research services for companiesand for government funded projects. We continue to invest in product development and commercialization, which we anticipate will lead to increasedproduct sales growth.We are organized into two main business segments, our Products and Licensing segment and our Technology Development segment. Our Products andLicensing segment develops, manufactures and markets fiber optic sensing products, as well as test & measurement products, and also conducts appliedresearch in the fiber optic sensing area for both corporate and government customers. We are continuing to develop and commercialize our fiber optictechnology for strain and temperature sensing applications for the aerospace, automotive, and energy industries. Our Products and Licensing segmentrevenues represented approximately 72% and 69% of our total revenues for the years ended December 31, 2016 and 2015, respectively.Our Technology Development segment performs applied research principally in the areas of sensing & instrumentation, advanced materials, and healthsciences. Our Technology Development segment comprised approximately 28% and 31% of our total revenues for the years ended December 31, 2016 and2015, 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"). Our Technology Development segment revenues have historicallyaccounted for a large portion of our total revenues, and we expect that they will continue to represent a significant portion of our total revenues for theforeseeable future. Within the Technology Development segment, we have historically had a backlog of contracts for which work has been scheduled, but forwhich a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiatedcontracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work alreadyperformed under these contracts, if any. Total backlog includes funded backlog, which is the amount for which money has been directly authorized by theU.S. government and for which a purchase order has been received by a commercial customer, and unfunded backlog, representing firm orders for whichfunding has not yet been appropriated. Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. The approximatevalue of our Technology Development segment backlog was $17.6 million and $16.7 million at December 31, 2016 and 2015, respectively. The approximatevalue of our Products and Licensing segment backlog was $10.4 million and $10.7 million at December 31, 2016 and 2015, respectively.Revenues from product sales are mostly derived from the sales of our HSOR, optoelectronics, sensing and test & measurement products that make use oflight-transmitting optical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead toincreased product sales growth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues torepresent a significant portion of future revenues. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenuesfrom product sales to continue to be primarily in areas associated with our HSOR, optoelectronics, fiber optic test & measurement and sensing platforms. Inthe long term, we expect that revenues from product sales will represent a larger portion of our total revenues and that as we develop and commercialize newproducts, these revenues will reflect a broader and more diversified mix of products.31 Table of ContentsWe realized net loss attributable to common stockholders of approximately $2.5 million for the year ended December 31, 2016 and net incomeattributable to common stockholders of approximately $2.2 million for the year ended December 31, 2015. Excluding the effects of our medical shapesensing business, which we sold in 2014, we incurred net losses from continuing operations of approximately $2.4 million and $6.0 million for the yearsended December 31, 2016 and 2015, respectively.We may incur increasing expenses as we seek to expand our business, including expenses for research and development, sales and marketing andmanufacturing capabilities. We may also grow our business in part through acquisitions of additional companies and complementary technologies, whichcould cause us to incur transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we may incurnet losses for the foreseeable future, and these losses could be substantial.Reductions in government spending may impact the availability of new program awards in the future. For example, the Budget Control Act commitsthe 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 capson discretionary spending, or sequestration. Automatic across-the-board cuts required by sequestration could have a material adverse effect on ourTechnology Development segment revenues and, consequently, our results of operations. While the exact manner in which sequestration will impact ourbusiness is unclear, funding for programs in which we participate could be reduced, delayed or canceled. Our ability to obtain new contract awards also couldbe negatively affected.Sale of Medical Shape Sensing Business in 2014In January 2014, we sold our assets associated with the development of fiber optic shape sensing and localization for the medical field to affiliates ofIntuitive Surgical, Inc. ("Intuitive") for total cash consideration of up to $30 million, including $6 million received at closing, $6 million received in April2014 and up to $18 million in the future based on the achievement of certain technical milestones and royalties on system sales, if any. In December 2015,although the specified technical milestones had not yet been achieved, we and Intuitive agreed to settle all remaining potential amounts payable under theagreement for a single payment of $9 million, which we received in December 2015.Description of Our Revenues, Costs and ExpensesRevenuesWe generate revenues from technology development, product sales and commercial product development and licensing activities. We deriveTechnology Development segment revenues from providing research and development services to third parties, including government entities, academicinstitutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we completecontracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred. OurTechnology Development segment revenues represented approximately 28% and 31% of our total revenues for the years ended December 31, 2016 and2015, respectively.Our Products and Licensing segment revenues reflect amounts that we receive from sales of our products or development of products for third partiesand, to a lesser extent, fees paid to us in connection with licenses or sub-licenses of certain patents and other intellectual property. Products and licensingrevenues represented approximately 72% and 69% of our total revenues for the years ended December 31, 2016 and 2015, respectively.Cost of RevenuesCost of revenues associated with Technology Development segment revenues consists of costs associated with performing the related researchactivities including direct labor, amounts paid to subcontractors and overhead allocated to Technology Development segment activities.Cost of revenues associated with Products and Licensing segment revenues consists of license fees for use of certain technologies, productmanufacturing 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 ExpenseOperating 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 operationalfunctions including certain non-cash charges related to expenses32 Table of Contentsfrom option grants, facilities costs, professional fees, salaries, commissions, travel expense and related benefits of personnel engaged in sales, marketing, andadministrative activities; costs of marketing programs and promotional materials; salaries, bonuses and related benefits of personnel engaged in our ownresearch and development beyond the scope and activities of our Technology Development segment; product development activities not provided undercontracts with third parties; and overhead costs related to these activities.Interest Expense, NetIn February 2010, we entered into a line of credit facility with Silicon Valley Bank ("SVB") with a borrowing capacity of $5.0 million. In May 2011, weentered into a loan modification agreement with SVB under which we repaid the outstanding balance under the prior line of credit and obtained a term loanin the amount of $6.0 million, along with a new $1.0 million line of credit. In May 2012, we entered into another loan modification agreement with SVBunder which we extended the maturity date of the line of credit to May 2014 and adjusted certain covenants. On May 8, 2015, we entered into a loanmodification agreement with SVB to borrow an additional $6 million, which we primarily used to repay the previously outstanding loans of API that existedat the time of our merger. On September 29, 2015, we entered into another loan modification with SVB under which we borrowed an additional $1 million tofinance specified planned capital expenditures. On December 15, 2016, we entered into another loan modification with SVB, under which we and SVBadjusted specified covenants. At December 31, 2016, we had $4.3 million outstanding on the term loan.During the years ended December 31, 2016 and 2015, interest expense primarily included interest accrued on our outstanding bank credit facilities andinterest incurred with respect to our capital lease obligations.Critical Accounting Policies and EstimatesTechnology Development RevenuesWe perform research and development for U.S. Federal government agencies, educational institutions and commercial organizations. We recognizerevenue under research contracts when a contract has been executed, the contract price is fixed and determinable, delivery of services or products hasoccurred, and collectability of the contract price is considered reasonably assured and can be reasonably estimated. Revenue is earned under costreimbursable, time and materials and fixed price contracts. Direct contract costs are expensed as incurred.Under cost reimbursable contracts, we are reimbursed for costs that are determined to be reasonable, allowable and allocable to the contract and paid afixed fee representing the profit negotiated between us and the contracting agency. Revenue from cost reimbursable contracts is recognized as costs areincurred plus an estimate of applicable fees earned. We consider fixed fees under cost reimbursable contracts to be earned in proportion to the allowable costsincurred 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 basedon the proportional performance method and involve a specified number of deliverables, we recognize revenue based on the proportion of the cost of thedeliverables 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 percentageof completion method.Our contracts with agencies of the U.S. government are subject to periodic funding by the respective contracting agency. Funding for a contract may beprovided in full at inception of the contract or ratably throughout the contract as the services are provided. In evaluating the probability of funding forpurposes of assessing collectability of the contract price, we consider our previous experience with our customers, communication with our customersregarding funding status and our knowledge of available funding for the contract or program. If funding is not assessed as probable, revenue recognition isdeferred until realization is reasonably assured.Contract revenue recognition inherently involves estimation, including the contemplated level of effort to accomplish the tasks under the contract, thecost of the effort and an ongoing assessment of progress toward completing the contract. From time to time, as part of normal management processes, factsmay change, causing revisions to estimated total costs or revenues expected. The cumulative impact of any revisions to estimates and the full impact ofanticipated losses on any type of contract are recognized in the period in which they become known.33 Table of ContentsThe underlying bases for estimating our contract research revenues are measurable expenses, such as labor, subcontractor costs and materials, and datathat 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 tothree years, and our estimates of contract costs have historically been consistent with actual results. Revisions in these estimates between accounting periodsto 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 tobe material.Whether certain costs under government contracts are allowable is subject to audit by the government. Certain indirect costs are charged to contractsusing provisional or estimated indirect rates, which are subject to later revision based on government audits of those costs. Management is of the opinion thatcosts subsequently disallowed, if any, would not likely have a significant impact on revenues recognized for those contracts.Products and Licensing RevenuesWe recognize revenue relating to our product sales when persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixedor determinable and collectability of the resulting receivable is reasonably assured. For tangible products that contain software that is essential to thetangible product’s functionality, we consider the product and software to be a single unit of accounting and recognize revenue accordingly. We evaluateproduct sales that are a part of multiple-element revenue arrangements to determine whether separate units of accounting exist, and we follow appropriaterevenue recognition policies for each separate unit. For multi-element arrangements we allocate revenue to all significant deliverables based on their relativeselling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specificobjective evidence of fair value ("VSOE"), (ii) third-party evidence of selling price ("TPE"), and (iii) best estimate of the selling price ("ESP"). VSOE generallyexists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. Our product sales often include bundledproducts, options and services and therefore VSOE is not readily determinable. In addition, we believe that because of unique features of our products, TPEalso is not available. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. We alsosell extended warranties from time to time. In this case, we accrue warranty costs based on our estimate of future expense and defer revenue associated withthe warranty. The deferred warranty revenue is recognized over the period of the warranty.Our process for determining ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts andcircumstances related to each deliverable. Key factors considered in developing the ESPs include prices charged by us for similar offerings, our historicalpricing practices, the nature of the deliverables, and the relative ESP of all of the deliverables as compared to the total selling price of the product. We mayalso consider, when appropriate, the impact of other products and services, on selling price assumptions when developing and reviewing our ESPs.Business CombinationsWe apply the provisions of ASC 805 in the accounting for acquisitions. ASC 805 requires us to recognize separately from goodwill the assets acquiredand the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred overthe net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accuratelyapply preliminary value to assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, theseestimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisitiondate, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurementperiod or final determination of the values of the assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded in ourConsolidated Statements of Operations. Accounting for business combinations requires management to make significant estimates and assumptions,especially at the acquisition date, including estimates for intangible assets, contractual obligations assumed, restructuring liabilities, pre-acquisitioncontingencies, and contingent consideration, where applicable. Although we believe the assumptions and estimates we have made have been reasonable andappropriate, they are based in part on historical experience and information obtained from management of the acquired companies and are inherentlyuncertain. Critical estimates in valuing certain of the intangible assets we have acquired include: future expected cash flows from product sales; customercontracts and acquired technologies; expected costs to develop in-process research and development into commercially viable products and estimated cashflows from the projects when completed; and discount rates. Unanticipated events and circumstances may occur that may affect the accuracy or validity ofsuch assumptions, estimates, or actual results.Income Taxes34 Table of ContentsWe estimate our tax liability through calculating our current tax liability, together with assessing temporary differences resulting from the differenttreatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we record on our balance sheet.Management then assesses the likelihood that deferred tax assets will be recovered in future periods. In assessing the need for a valuation allowance againstthe net deferred tax asset, management considers factors such as future reversals of existing taxable temporary differences, taxable income in prior carry backyears, whether carry back is permitted under the tax law, tax planning strategies and estimated future taxable income exclusive of reversing temporarydifferences and carry forwards. To the extent that we cannot conclude that it is more likely than not that the benefit of such assets will be realized, weestablish a valuation allowance to reduce their net carrying value.As we assess our projections of future taxable income or other factors that may impact our ability to generate taxable income in future periods, ourestimate of the required valuation allowance may change, which could have a material impact on future earnings or losses.We recognize tax benefits from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination bytaxing authorities. While it is often difficult to predict the final outcome of timing of the resolution of any particular tax matter, we establish a liability at thetime we determine it is probable we will be required to pay additional taxes related to certain matters. These liabilities are recorded in accrued liabilities inour consolidated balance sheets. We adjust this provision, including any impact on the related interest and penalties, in light of changing facts andcircumstances, such as the progress of a tax audit. A number of years may elapse before a particular matter for which we have established a liability is auditedand finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. Settlement of any particular issue would usuallyrequire the use of cash. We recognize favorable resolutions of tax matters for which we have previously established liabilities as a reduction to our income taxexpense when the amounts involved become known.Due to differences between federal and state tax law, and accounting principles generally accepted in the United States of America ("GAAP") certainitems are included in the tax return at different times than when those items are reflected in the consolidated financial statements. Therefore, the annual taxrate reflected in our consolidated financial statements is different than that reported in our tax return. Some of these differences are permanent, such asexpenses that are not deductible in our tax return. Some differences, such as depreciation expense, reverse over time and create deferred tax assets andliabilities. The tax rates used to determine deferred tax assets or liabilities are the enacted tax rates in effect for the year in which the differences are expectedto reverse. Based on the evaluation of all available information, we recognize future tax benefits, such as net operating loss carry forwards, to the extent thatrealizing these benefits is considered more likely than not.Stock-Based CompensationWe recognize stock-based compensation expense based upon the fair value of the underlying equity award on the date of the grant. The calculation ofthe fair value of our awards requires certain inputs that are subjective and changes to the estimates used will cause the fair values of our stock awards andrelated stock-based compensation expense to vary. We have elected to use the Black-Scholes-Merton ("Black-Scholes") option pricing model to determinethe fair value of stock options. The fair value of a stock option award is affected by our stock price on the date of the grant as well as other assumptions usedas inputs in the valuation model including the estimated volatility of our stock price over the term of the awards, the estimate period of time that we expectemployees to hold their stock options and the risk-free interest rate assumption. In addition, we are required to reduce stock-based compensation expense forthe effects of estimated forfeitures of awards over the expense recognition period. Although we estimate the rate of future forfeitures based on historicalexperience, actual forfeitures may differ.Long-lived and Intangible AssetsLong-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that thecarrying amount of an asset might not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of anasset to future un-discounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported atthe lower of the carrying amount or fair value, less cost to sell.GoodwillGoodwill is reviewed for impairment at least annually, or more frequently if events or circumstances indicate that goodwill might be impaired. We haveestablished October 1 as our specified annual date for impairment testing.35 Table of ContentsResults of OperationsThe following table shows information derived from our consolidated statements of operations expressed as a percentage of total revenues for theperiods presented. Years ended December 31, 2016 2015Revenues: Technology development28.4 % 30.9 %Products and licensing71.6 69.1Total revenues100.0 100.0Cost of revenues: Technology development21.5 23.6Products and licensing41.8 38.9Total cost of revenues63.3 62.5Gross profit36.7 37.5Operating expense40.0 51.7Operating loss(3.3) (14.2)Total other expense(0.6) (0.5)Loss from continuing operations before income taxes(3.9) (14.7)Loss from continuing operations, net of income taxes(4.0) (13.7)Income from discontinued operations, net of income taxes— 18.9Net (loss)/income(4.0)% 5.2 %Year Ended December 31, 2016 Compared to Year Ended December 31, 2015Revenues Years ended December 31, 2016 2015 $ Difference % DifferenceTechnology development revenues$16,825,157 $13,599,048 $3,226,109 23.7%Products and licensing revenues42,385,839 30,421,310 11,964,529 39.3%Total revenues$59,210,996 $44,020,358 $15,190,638 34.5%Our Technology Development segment revenues increased $3.2 million to $16.8 million for the year ended December 31, 2016 compared to $13.6million for the year ended December 31, 2015. This increase was attributable primarily to growth in our biomedical and intelligent systems groups. Thesegroups saw a significant increase in the number of active contracts along with an increase in the average revenue per contract.Our Products and Licensing segment revenues increased $12.0 million to $42.4 million for the year ended December 31, 2016 compared to $30.4million for the year ended December 31, 2015. This increase was due primarily to inclusion of product sales associated with API's legacy operations for thefull year of 2016 compared to the period from the closing of our merger on May 8, 2015 through December 31, 2015 for 2015. The increase in productrevenue from API's legacy operations due to inclusion of the full year for 2016 was approximately $10.0 million. Sales of HSOR products for the telecommarket and instrumentation for measuring strain in composite materials contributed to the additional increase in product revenues.36 Table of ContentsCost of Revenues Years ended December 31, 2016 2015 $ Difference % DifferenceTechnology development costs$12,711,447 $10,378,616 $2,332,831 22.5%Products and licensing costs24,764,788 17,141,079 7,623,709 44.5%Total costs of revenues$37,476,235 $27,519,695 $9,956,540 36.2%Our Technology Development segment costs increased $2.3 million, to $12.7 million for the year ended December 31, 2016 compared to $10.4 millionfor the year ended December 31, 2015. The overall increase in Technology Development segment costs was consistent with the rate of growth in TechnologyDevelopment segment revenues.Our Products and Licensing segment costs increased $7.6 million to $24.8 million for the year ended December 31, 2016 compared to $17.1 million forthe year ended December 31, 2015. The overall increase in Products and Licensing segment costs was consistent with the rate of growth in the Products andLicensing segment revenues, when taking into account our revenue growth was driven by legacy API products. This product mix contributes to an overalllower margin for our product sales.Operating Expense Years ended December 31, 2016 2015 $ Difference % DifferenceSelling, general and administrative expense$18,139,966 $18,481,270 $(341,304) (1.8)%Research, development and engineering expense5,532,130 4,268,988 1,263,142 29.6 %Total operating expense$23,672,096 $22,750,258 $921,838 4.1 %Selling, general and administrative expenses decreased $0.3 million to $18.1 million for the year ended December 31, 2016 compared to $18.5 millionfor the year ended December 31, 2015. This decrease was due to $3.7 million in merger related expenses for the year ended December 31, 2015 not recurringin the year ended December 31, 2016. This decrease was partially offset by an increase of selling, general and administrative expenses of approximately $2.6million due to the inclusion of expenses of API's legacy operations for the entire year ended December 31, 2016 compared to the period from the closing ofour merger on May 8, 2015 through December 31, 2015. We also experienced an increase in costs related to annual employee salary increases andprofessional fees of approximately $0.8 million.Research, development and engineering expenses increased $1.3 million to $5.5 million for the year ended December 31, 2016 compared to $4.3million for the year ended December 31, 2015, primarily due to a $1.2 million increase resulting from the inclusion of expenses from API's legacy operationsfor the entire year ended December 31, 2016 compared to the period from the closing of our merger on May 8, 2015 through December 31, 2015.Interest Expense, NetOur net interest expense was approximately $0.3 million for the year ended December 31, 2016 compared to approximately $0.2 million for the yearended December 31, 2015. The average monthly loan balance for the year ended December 31, 2016 was $5.1 million as compared to $3.8 million for theyear ended December 31, 2015, resulting in this increase in interest expense.Income TaxFor the year ended December 31, 2016, we recorded income tax expense of $0.1 million, or 3.6% of our loss from continuing operations, compared to anincome tax benefit of $0.5 million, or 7.3% of our loss from continuing operations for the year ended December 31, 2015. The change from an income taxbenefit in 2015 to income tax expense in 2016 resulted from the decrease in our loss from continuing operations. Certain expenses included in our loss fromcontinuing operations are not deductible for determination of the federal alternative minimum taxable income or state income taxes, and the recognition ofthose book-tax differences, which in the aggregate exceeded our loss from continuing operations, resulted in a current tax expense for the year endedDecember 31, 2016.37 Table of ContentsIncome from Discontinued Operations, Net of Income TaxesFor the year ended December 31, 2016, we did not recognize income from discontinued operations. For the year ended December 31, 2015, werecognized a net income from discontinued operations, net of income taxes, of $8.3 million. This income consisted of $9.0 million received from Intuitive inDecember 2015 in satisfaction of all remaining potential amounts payable, including future technological milestone payments and future royalty payments,associated with the sale of our medical shape sensing business for medical applications in 2014, offset by income tax expense of $0.7 million associated withthe gain.Preferred Stock DividendIn January 2010, we issued 1,321,514 shares of our newly designated Series A Convertible Preferred Stock to Carilion. The Series A ConvertiblePreferred Stock carries an annual cumulative dividend of 6%, or approximately 79,292 shares of common stock per year. During each of 2016 and 2015, weaccrued $0.1 million for the dividends payable to Carilion. The dividends are not payable in cash, but rather in shares of our common stock, until liquidationevent occurs. During each of 2016 and 2015, 79,292 shares of common stock became issuable to Carilion as dividends and have been recorded in thestatement of stockholders’ equity.Liquidity and Capital ResourcesAt December 31, 2016, our total cash and cash equivalents were $12.8 million.We have two term loans with SVB which, at December 31, 2016, had an aggregate balance of $4.3 million. One term loan, with a balance of $0.7million as of December 31, 2016, matures on December 1, 2018. The other term loan with a balance of $3.6 million as of December 31, 2016, matures on May1, 2019.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, materialadverse 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 occursSVB may declare due immediately all borrowings under the credit facility and foreclose on the collateral. Furthermore, an event of default under the creditfacility would result in an increase in the interest rate on any amounts outstanding. The credit facility requires us to comply with certain operational andfinancial covenants, including maintaining a minimum cash balance of at least $5.0 million. As of December 31, 2016, we were in compliance with allcovenants under the credit facility.We maintain a letter-of-credit in the amount of $1.0 million as a condition of our lease on our Blacksburg office.We believe that our cash balance as of December 31, 2016 will provide adequate liquidity for us to meet our working capital needs over the next twelvemonths. Additionally, we believe that should we have the need for increased capital spending to support our planned growth, we will be able to fund suchgrowth through either third-party financing on competitive market terms or through our available cash.Discussion of Cash Flows Years ended December 31, 2016 2015Net cash used in operating activities$(399,837) $(5,087,907)Net cash (used in)/provided by investing activities(2,000,184) 8,294,714Net cash (used in)/provided by financing activities(2,261,561) 140,264Net (decrease)/increase in cash and cash equivalents$(4,661,582) $3,347,071During 2016, operations used $0.4 million of net cash, as compared to 2015, when operations used $5.1 million of net cash. In 2016, our net loss of$2.4 million included charges for depreciation and amortization of $3.7 million and stock-based38 Table of Contentscompensation of $0.9 million and bad debt of $0.3 million, which are non-cash expenses and do not impact cash flow for the period. Additionally, changes inworking capital resulted in a net cash outflow of $2.9 million, principally driven by an increase in accounts receivable of $3.6 million, partially offset by anincrease in accounts payable and accrued liabilities of $0.6 million.In 2015, our net income of $2.3 million included a benefit of an $8.3 million after-tax gain associated with contingent consideration received in 2015from the sale of our medical shape sensing business in 2014 and a tax benefit of $0.5 million. Absent the effects of that gain and the tax benefit, our pre-taxloss from continuing operations was $6.5 million. The pre-tax loss from continuing operations included charges for depreciation and amortization of $2.5million and stock-based compensation of $1.1 million, each of which are non-cash items that do not impact cash flow for the period. In 2015, our cash used inoperating activities also included $3.7 million of expenses associated with completing our merger with API.Cash used in investing activities in 2016 consisted of a cash outflow of $2.0 million related to the purchase of property and equipment to expand ourmanufacturing capability for HSOR products as well as capitalized costs associated with securing intellectual property rights.Cash provided by investing activities in 2015 consisted of a cash inflow of $9.0 million related to a payment arising from the sale of our medical shapesensing business in 2014, cash of $0.4 million acquired in our merger with API, and cash outflows of $0.7 million for the purchase of equipment and $0.4million in patent costs associated with certain intangible assets, primarily associated with our fiber optic platform and our THz sensing platform.Cash used in financing activities for the year ended December 31, 2016 was $2.3 million, compared to cash provided by financing activities of $0.1million in 2015. During 2016, we repaid $1.9 million on our term loans with SVB. We also used $0.3 million to repurchase our common stock under ourstock repurchase program. During 2015, we repaid $6.7 million on our outstanding term loan with SVB and borrowed $7.0 million under a new term loanwith SVB.Summary of Contractual ObligationsThe following table sets forth information concerning our known contractual obligations as of December 31, 2016 that are fixed and determinable. Total Less than 1year 1 - 3 years 3 - 5 years More than 5yearsLong-term debt obligations (1)$4,291,666 $1,833,333 $2,458,333 $— $—Operating facility leases (2)8,244,602 1,601,292 3,054,013 2,148,120 1,441,177Other leases (3)186,501 61,244 85,737 39,520 —Purchase order obligation (4)1,522,642 1,522,642 — — —Other liabilities (5)880,000 220,000 440,000 220,000 —Total$15,125,411 $5,238,511 $6,038,083 $2,407,640 $1,441,177_________________________(1) Amounts due under our debt obligations to SVB are payable in monthly installments, plus accrued interest, through May 2019.(2) We lease our facilities in Blacksburg, Charlottesville and Roanoke, Virginia, Ann Arbor, Michigan, Camarillo California, and Montreal, Canada underoperating leases that as of December 31, 2016, are scheduled to expire between April 2017 and December 2024. Upon expiration of our office leases,we may exercise certain renewal options as specified in the leases. Rental payments associated with these option periods are not included in the tableabove.(3) In August 2013 and January 2016, we executed leases in the amounts of $51,000, and $207,000, respectively, for office equipment. These equipmentleases expire in 2018 and 2021, respectively.(4) In 2016, our Luna Technologies subsidiary executed two non-cancelable purchase orders in the amounts of $0.5 million and $1.0 million for multipleshipments of tunable lasers to be delivered over an 18-month period beginning in July 2016. In addition, in 2016 we issued two purchase orders forcomponent parts and capital equipment for our HSOR products with an aggregate value of $0.8 million for delivery through the second quarter of2017, of which $0.5 million was outstanding as of December 31, 2016.(5) Other liabilities include remaining amounts payable for minimum royalty payments for certain licensed technologies payable over the remainingpatent terms of the underlying technology.39 Table of ContentsOff-Balance Sheet ArrangementsWe have no off-balance sheet arrangements as defined in Regulation S-K, Item 303(a)(4)(ii).InflationWe do not believe that inflation has had a material effect on our business, financial condition or results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. We do nothold or issue financial instruments for trading purposes or have any derivative financial instruments. Our exposure to market risk is limited to interest ratefluctuations due to changes in the general level of U.S. interest rates.Interest Rate RiskWe do not use derivative financial instruments as a hedge against interest rate fluctuations, and, as a result, interest income earned on our cash and cashequivalents and short-term investments is subject to changes in interest rates. However, we believe that the impact of these fluctuations does not have amaterial effect on our financial position due to the immediate available liquidity or short-term nature of these financial instruments.We are exposed to interest rate fluctuations as a result of our SVB debt facility having a variable interest rate. We do not currently use derivativeinstruments to alter the interest rate characteristics of our debt. The principal amount of $4.3 million outstanding under the term loan as of December 31,2016, is scheduled to amortize in monthly installments through May 2019. A change of 1% in the applicable interest rate during 2017 would have an impactof approximately $33,000 in our annual interest expense under the SVB debt facility.Foreign Currency Exchange Rate RiskAs of December 31, 2016, all payments made under our research contracts have been denominated in U.S. dollars. Our product sales to foreigncustomers are also generally denominated in U.S. dollars, and we do not receive payments in foreign currency. As such, we are not directly exposed tosignificant currency gains or losses resulting from fluctuations in foreign exchange rates.40 Table of ContentsITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAIndex to Consolidated Financial StatementsReport of Independent Registered Public Accounting Firm42Consolidated Balance Sheets at December 31, 2016 and 201543Consolidated Statements of Operations for the years ended December 31, 2016 and 201544Consolidated Statements of Changes in Stockholder's Equity for the years ended December 31, 2016 and 201545Consolidated Statements of Cash Flows for the years ended December 31, 2016 and 201546Notes to Consolidated Financial Statements4741 Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMBoard of Directors and StockholdersLuna Innovations IncorporatedWe have audited the accompanying consolidated balance sheets of Luna Innovations Incorporated (a Delaware corporation) and subsidiaries (the“Company”) as of December 31, 2016 and 2015, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows foreach of the two years in the period ended December 31, 2016. Our audits of the basic consolidated financial statements included the financial statementschedule listed in the index appearing under Item 15(a)(2). These consolidated financial statements and financial statement schedule are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule basedon our audits.We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. We werenot engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control overfinancial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide areasonable basis for our opinion.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Luna InnovationsIncorporated and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the two years in theperiod ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, therelated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein./s/ GRANT THORNTON LLPArlington, VirginiaMarch 20, 201742 Table of ContentsCONSOLIDATED BALANCE SHEETS December 31, 2016 December 31, 2015Assets Current assets: Cash and cash equivalents$12,802,458 $17,464,040Accounts receivable, net14,297,725 11,034,557Inventory, net8,370,235 8,863,167Prepaid expenses and other current assets1,627,175 1,388,439Total current assets37,097,593 38,750,203Property and equipment, net6,780,838 6,614,238Intangible assets, net8,681,263 10,404,312Goodwill2,348,331 2,274,112Other assets88,948 88,948Total assets$54,996,973 $58,131,813Liabilities and stockholders’ equity Current liabilities: Current portion of long term debt obligations$1,833,333 $1,833,333Current portion of capital lease obligations52,128 31,459Accounts payable4,466,192 4,054,425Accrued liabilities8,667,100 8,304,686Deferred revenue949,603 1,109,759Total current liabilities15,968,356 15,333,662Long-term portion of deferred rent1,403,957 1,564,229Long-term debt obligations2,420,032 4,291,667Long-term capital lease obligations114,940 35,237Total liabilities19,907,285 21,224,795Commitments and contingencies Stockholders’ equity: Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at December 31, 2016and 20151,322 1,322Common stock, par value $0.001, 100,000,000 shares authorized, 27,988,104 and 27,644,833 shares issued,27,541,277 and 27,477,181 shares outstanding at December 31, 2016 and 2015, respectively28,600 28,178Treasury stock at cost, 446,827 and 167,652 shares at December 31, 2016 and 2015, respectively(517,987) (184,934)Additional paid-in capital82,451,958 81,461,907Accumulated deficit(46,874,205) (44,399,455)Total stockholders’ equity35,089,688 36,907,018Total liabilities and stockholders’ equity$54,996,973 $58,131,813The accompanying notes are an integral part of these consolidated financial statements.43 Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS Years ended December 31, 2016 2015Revenues: Technology development$16,825,157 $13,599,048Products and licensing42,385,839 30,421,310Total revenues59,210,996 44,020,358Cost of revenues: Technology development12,711,447 10,378,616Products and licensing24,764,788 17,141,079Total cost of revenues37,476,235 27,519,695Gross profit21,734,761 16,500,663Operating expense: Selling, general and administrative18,139,966 18,481,270Research, development and engineering5,532,130 4,268,988Total operating expense23,672,096 22,750,258Operating loss(1,937,335) (6,249,595)Other expense: Other expense, net(35,849) (9,967)Interest expense, net(320,942) (220,403)Total other expense(356,791) (230,370)Loss from continuing operations before income taxes(2,294,126) (6,479,965)Income tax expense/(benefit)75,366 (470,605)Net (loss)/income from continuing operations(2,369,492) (6,009,360)Income from discontinued operations, net of income taxes of $0 and $0.7 million— 8,326,386Net (loss)/income(2,369,492) 2,317,026Preferred stock dividend105,258 85,830Net (loss)/income attributable to common stockholders$(2,474,750) $2,231,196Net loss per share from continuing operations: Basic and diluted$(0.09) $(0.26)Net income per share from discontinued operations: Basic and diluted$— $0.36Net (loss)/income per share attributable to common stockholders: Basic and diluted$(0.09) $0.10Weighted average shares: Basic and diluted27,547,217 23,026,494The accompanying notes are an integral part of these consolidated financial statements.44 Table of ContentsCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Preferred Stock Common Stock Treasury StockAdditionalPaid inCapital AccumulatedDeficit Total Shares $ Shares $ Shares $$ $ $Balance—January 1,20151,321,514 1,322 15,088,199 15,541 22,727 (32,221)64,147,666 (46,630,651) 17,501,657Exercise of stockoptions— — 233,704 233 — —82,283 — 82,516Stock-basedcompensation— — 453,522 453 — —1,018,224 — 1,018,677Non-cashcompensation— — — — — —280,202 — 280,202Issuance of stock toformer APIstockholders— — 11,872,557 11,872 — —15,659,902 — 15,671,774Options issued inexchange for APIoptions— — — — — —187,879 — 187,879Stock dividends (1)— — — 79 — —85,751 (85,830) —Forfeitures ofrestricted stockgrants— — (25,876) — — —— — —Purchase of treasurystock— — (144,925) — 144,925 (152,713)— — (152,713)Net Income— — — — — —— 2,317,026 2,317,026Balance—December31, 20151,321,514 $1,322 27,477,181 $28,178 167,652 $(184,934)$81,461,907 $(44,399,455) $36,907,018Stock-basedcompensation— — 319,000 319 — —859,896 — 860,215Non-cashcompensation— — 24,271 24 — —24,976 — 25,000Stock dividends (1)— — — 79 — —105,179 (105,258) —Purchase of treasurystock— — (279,175) — 279,175 (333,053)— — (333,053)Net loss— — — — — —— (2,369,492) (2,369,492)Balance—December 31, 20161,321,514 $1,322 27,541,277 $28,600 446,827 $(517,987)$82,451,958 $(46,874,205) $35,089,688 (1)The stock dividends payable in connection with the Series A Convertible Preferred Stock are issuable upon the request of Carilion.The accompanying notes are an integral part of these consolidated financial statements.45 Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2016 2015Cash flows used in operating activities: Net (loss)/income$(2,369,492) $2,317,026Adjustments to reconcile net income to net cash used in by operating activities: Depreciation and amortization3,713,879 2,457,032Stock-based compensation860,215 1,124,379Gain on sale of discontinued operations, net of income taxes— (8,326,386)Bad debt305,593 10,375Tax benefit from utilization of loss from current year operations— (510,772)Changes in operating assets and liabilities: Accounts receivable(3,568,761) (2,040,323)Inventory492,932 (252,934)Other assets(238,736) (131,411)Accounts payable and accrued liabilities564,689 16,429Deferred revenue(160,156) 248,678Net cash used in operating activities(399,837) (5,087,907)Cash flows (used in)/provided by investing activities: Acquisition of property and equipment(1,509,984) (710,348)Intangible property costs(490,200) (367,050)Cash acquired in business combination— 374,517Proceeds from sale of discontinued operations, net— 8,997,595Net cash (used in)/provided by investing activities(2,000,184) 8,294,714Cash flows (used in)/provided by financing activities: Payments on debt obligations(1,871,635) (6,712,355)Payments on capital lease obligations(56,873) (77,184)Purchase of treasury stock(333,053) (152,713)Borrowings under term loans— 7,000,000Proceeds from the exercise of options and warrants— 82,516Net cash (used in)/provided by financing activities(2,261,561) 140,264Net change in cash and cash equivalents(4,661,582) 3,347,071Cash and cash equivalents—beginning of period17,464,040 14,116,969Cash and cash equivalents—end of period$12,802,458 $17,464,040Supplemental disclosure of cash flow information Cash paid for interest$308,116 $187,017Cash paid for income taxes$233,732 $40,167Cash received for income tax refunds$67,127 Value of common stock issued for business combination$— $15,485,187Dividend on preferred stock, 79,292 shares of common stock issuable for each of the years ended December 31,2016 and 2015$105,258 $85,830The accompanying notes are an integral part of these consolidated financial statements.46 Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting PoliciesLuna Innovations Incorporated (“we” or the "Company”), headquartered in Roanoke, Virginia, was incorporated in the Commonwealth of Virginia in1990 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 testproducts for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. Our high-speed optical receiver("HSOR") transmission products are deployed in the internet infrastructure to enable the high-speed bandwidth necessary to support video and data. Ourdistributed fiber optic sensing products provide critical stress, strain and temperature information to designers and manufacturers working with advancedmaterials. Our custom optoelectronic products are sold to scientific instrumentation manufacturers for various applications such as metrology, missileguidance, 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 newand innovative products to market. We use our in-house technical expertise to perform applied research services on government funded projects across arange of technologies and also for corporate customers in the fiber optic sensing area. We are organized into two business segments: our TechnologyDevelopment segment and our Products and Licensing segment. Our Technology Development segment performs applied research principally ongovernment-funded projects. Most of the government funding in our Technology Development segment is derived from the U.S. government’s SmallBusiness Innovation Research ("SBIR") program coordinated by the U.S. Small Business Administration ("SBA"). Our Products and Licensing segmentfocuses on fiber optic test & measurement, sensing, and instrumentation products and also conducts applied research in the fiber optic sensing area tocorporate and government customers.We have a history of net losses and negative cash flow from operations. We have historically managed our liquidity through cost reduction initiatives,debt financings, capital markets transactions and the sale of assets.Although there can be no guarantees, we believe that our current cash and cash equivalents balance, provides adequate liquidity for us to meet ourworking capital needs for the foreseeable future.Consolidation PolicyOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP") andinclude the accounts of the Company and its wholly owned subsidiaries. We eliminate from our financial results intercompany transactions.Use of EstimatesThe preparation of our consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect thereported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statementsand accompanying notes.Although these estimates are based on our knowledge of current events and actions we may undertake in the future, actual results may differ from suchestimates and assumptions.Technology Development RevenuesWe perform research and development for U.S. government agencies, educational institutions and commercial organizations. We recognize revenuesunder research contracts when a contract has been executed, the contract price is fixed and determinable, delivery of services or products has occurred andcollection of the contract price is considered reasonably assured. Revenue is earned under cost reimbursable, time and materials and fixed price contracts.Direct contract costs are expensed as incurred.Under cost reimbursable contracts, we are reimbursed for costs that are determined to be reasonable, allowable and allocable to the contract and are paida fixed fee representing the profit negotiated between us and the contracting agency. Revenue from cost reimbursable contracts is recognized as costs areincurred plus a portion of the fee earned. Revenue from time and materials contracts is recognized based on direct labor hours expended at contract billingrates plus other billable direct costs.Revenue from fixed price research contracts that involve the delivery of services and a prototype model is recognized under the percentage ofcompletion method. Revenue from fixed price arrangements are recognized under the percentage of47 Table of Contentscompletion method by determining proportional performance based upon the ratio of costs incurred to achieve contract milestones to total estimated cost asthis method more accurately measures performance under these arrangements. Losses on contracts, if any, are recognized in the period in which they becomeknown and estimable.Product Sales RevenuesRevenues from product sales are generated by the sale of commercial products and services under various sales programs to the end user and throughdistribution channels. We sell fiber optic sensing systems to end users for use in numerous fiber optic based measurement applications. Revenues are recordednet of applicable sales taxes collected from customers and payable to state or local governmental entities.We recognize revenue relating to our products when persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed ordeterminable and collectability of the resulting receivable is reasonably assured.For multi-element arrangements that include tangible products that contain software that is essential to the tangible product’s functionality, we allocaterevenue to all deliverables based on their relative selling prices. Other deliverables include extended warranty, training and various add-on products. In suchcircumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence offair value ("VSOE"), (ii) third-party evidence of selling price ("TPE"), and (iii) best estimate of the selling price ("ESP"). VSOE generally exists only when wesell the deliverable separately and is the price actually charged by us for that deliverable. Due to the uniqueness of our products comparable third partyevidence is generally not available. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alonebasis.Our process for determining our ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique factsand circumstances related to each deliverable. Key factors considered in developing the ESPs include prices charged by us for similar offerings, our historicalpricing practices, the nature of the deliverables, and the relative ESP of all of the deliverables as compared to the total selling price of the product. We mayalso consider, when appropriate, the impact of other products and services on selling price assumptions when developing and reviewing our ESPs.Revenues from product sales that require no ongoing obligations are recognized as revenues when shipped to the customer, title has passed andcollection is reasonably assured.Allowance for Uncollectible ReceivablesAccounts receivable are recorded at their face amount, less an allowance for doubtful accounts. We review the status of our uncollected receivables on aregular basis. In determining the need for an allowance for uncollectible receivables, we consider our customers’ financial stability, past payment history andother factors that bear on the ultimate collection of such amounts. The allowance was $252,639 at December 31, 2016 and $134,811 at December 31, 2015.Cash EquivalentsWe consider all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. To date, we have not incurredlosses related to cash and cash equivalents. Our cash transactions are processed through reputable commercial banks. We regularly maintain cash balanceswith financial institutions which exceed Federal Deposit Insurance Corporation (“FDIC”) insurance limits. At December 31, 2016 and December 31, 2015, wehad approximately $12.6 million and $17.2 million, respectively, in excess of FDIC insured limits.We have outstanding term loans that require us to comply with certain financial covenants, including maintaining a minimum cash balance of at least$5.0 million.Fair Value MeasurementsOur financial assets and liabilities are measured at fair value, which is defined as the price that would be received to sell an asset, or paid to transfer aliability, in an orderly transaction between market participants. Valuation techniques are based on observable or unobservable inputs. Observable inputsreflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs have created thefollowing fair value hierarchy:•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; andmodel-derived valuations in which significant value drivers are observable.•Level 3—Valuations derived from valuation techniques in which significant value drivers are unobservable.48 Table of ContentsThe carrying values of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term nature ofthese instruments. We consider the terms of the Silicon Valley Bank ("SVB") debt facility including its interest rate of prime plus 2%, to be at market basedupon similar instruments that would be available to us.Property and EquipmentProperty and equipment are stated at cost less accumulated depreciation. We record depreciation using the straight-line method over the followingestimated useful lives:Equipment3 – 7 yearsFurniture and fixtures7 yearsSoftware3 yearsLeasehold improvementsLesser of lease term or life of improvementsIntangible AssetsIntangible assets consist of patents related to certain intellectual property that we have developed or acquired and identifiable intangible assetsrecognized in connection with our merger with Advanced Photonix, Inc. ("API"). (See Note 2) We amortize our patents over their estimated useful life of fiveyears, and analyze the reasonableness of the remaining useful life whenever events or circumstances indicate that the carrying amount may not be recoverableto determine whether their carrying value has been impaired.Research, Development and EngineeringResearch, development and engineering expenses not related to contract performance are expensed as incurred. We expensed $5.5 million and $4.3million of non-contract related research, development and engineering expenses for the years ended December 31, 2016 and 2015, respectively.Valuation of Long-Lived AssetsWe review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to begenerated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amountof the assets exceeds their fair value. Assets to be disposed of by sale are reflected at the lower of their carrying amount or fair value less cost to sell.InventoryInventory 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.Net (Loss)/Income per ShareBasic per share data is computed by dividing net (loss)/income attributable to common stockholders by the weighted average number of sharesoutstanding during the period. Diluted per share data is computed by dividing net (loss)/income attributable to common stockholders by the weightedaverage shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have beenoutstanding if potential common shares had been issued using the treasury stock method. Diluted per share data would also include the potential commonshare equivalents relating to convertible securities by application of the if-converted method.The effect of 5.5 million and 6.0 million common stock equivalents (which include outstanding warrants, preferred stock and stock options) are notincluded for the years ended December 31, 2016 and 2015, respectively, as they are anti-dilutive to earnings per share due to us having a net loss fromcontinuing operations.Stock-Based CompensationWe have two stock-based compensation plans, which are described further in Note 10. We recognize compensation expense based upon the fair valueof the underlying equity award as of the date of grant. We have elected to use the Black-Scholes option pricing model to value any awards granted. Werecognize stock-based compensation for such awards on a49 Table of Contentsstraight-line method over the requisite service period of the awards taking into account the effects of the employees’ expected exercise and post-vestingemployment termination behavior.We recognize expense for equity instruments issued to non-employees based upon the fair value of the equity instruments issued.AdvertisingWe expense the cost of advertising as incurred. Advertising expenses were $111,181 and $57,000 for the years ended December 31, 2016 and 2015,respectively.Income TaxesWe recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statementcarrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates ineffect for the year in which those temporary differences are expected to be recovered or settled. We evaluate our ability to benefit from all deferred tax assetsand establish valuation allowances for amounts we believe are not more-likely-than-not to be realizable. For uncertain tax positions, we use a more-likely-than-not threshold, 51% or greater, based on the technical merits of the income tax position taken. Income tax positions that meet the more-likely-than-notrecognition threshold are measured in order to determine the tax benefit recognized in the financial statements. Penalties, if probable and reasonablyestimable, and interest expense related to uncertain tax positions are recognized as a component of the tax provision.We account for income taxes using the liability method. Deferred tax assets or liabilities are determined based on the difference between the financialstatement and tax basis of assets and liabilities as measured by the enacted tax rates which will be in effect when the differences reverse. A valuationallowance against net deferred tax assets is provided unless we conclude it is more likely than not that the deferred tax assets will be realized.Recent Accounting PronouncementsIn January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This update simplifies the subsequent measurement of goodwill. Theguidance removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be theamount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. The accounting standard will beeffective 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 December 2016, the FASB issued ASU No. 2016-20, Technical corrections and improvements to Topic 606, Revenue from Contracts withCustomers. This update provides additional clarification and implementation guidance on the previously issued ASU 2014-09, Revenue from Contracts withCustomers (Topic 606). ASU No. 2014-09 supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is torecognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to beentitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimatesmay be required within the revenue recognition process than are required under existing GAAP. The standard, as subsequently updated in July 2015, iseffective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a fullretrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) aretrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnotedisclosures). We are currently identifying our various revenue streams which may be subject to new recognition criteria under ASU 2014-09 and assessing the potential impacts on our financial statements. We plan to utilize a modified retrospective approach with the cumulative effectof initial adoption recognized at the date of adoption.In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230), which addresses eight specific cash flow issues with theobjective 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 iseffective for public entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted.The amendments should50 Table of Contentsbe applied retrospectively to all periods presented. We do not expect ASU 2016-15 will have a material impact on our financial statements. In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting. The amendments apply to severalaspects of accounting for share-based compensation including the recognition of excess tax benefits and deficiencies and their related presentation in thestatement of cash flows as well as accounting for forfeitures. ASU No. 2016-09 is effective for fiscal years beginning after December 15, 2016, includinginterim periods and allows for prospective, retrospective or modified retrospective adoption, depending on the area covered in the update, with earlyadoption permitted. We adopted ASU 2016-09 on January 1, 2017, and we do not expect the adoption to have a material impact on our 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 andliability 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 representingthe 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 interimperiods within those fiscal years. We are currently evaluating the impact the adoption of this standard will have on our consolidated financial statements.In September 2015, the FASB issued ASU No. 2015-16, Simplifying the Accounting for Measurement Period Adjustments, which requires that anacquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustmentamounts are determined. The amendment is effective for fiscal years beginning after December 15, 2015 and requires acquirer to record, in the same period’sfinancial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to theprovisional amounts, calculated as if the accounting had been completed at the acquisition date. Additionally, an entity is to present separately on the face ofthe income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded inprevious reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. We adopted ASU 2015-16 on January1, 2016.2. Merger with Advanced Photonix, Inc.On May 8, 2015, we completed our merger with API (the "Merger") pursuant to the Agreement and Plan of Merger (the "Merger Agreement") for a totalpurchase consideration of $15.9 million. In accordance with the terms of the Merger Agreement, API shareholders received 0.31782 shares of our commonstock for each share of API common stock they owned. The Merger has been accounted for under the acquisition method of accounting in accordance withASC 805, with Luna treated as the accounting acquirer. We incurred approximately $3.7 million in Merger-related costs for the year ended December 31,2015, which are included within selling, general and administrative expenses in the consolidated statement of operations. For the period from the closing ofthe Merger on May 8, 2015, through December 31, 2015, we recognized revenues of $20.6 million and income of $0.5 million associated with the operationsof API.The total purchase consideration of $15.9 million consisted of the following: Purchase ConsiderationFair value of Luna common stock Issued to API shareholders$15,671,775Fair value of vested API options assumed by Luna187,879Total purchase consideration$15,859,654 Under the acquisition method of accounting, the total estimated purchase consideration is allocated to the acquired tangible and intangible assets andassumed liabilities based on their estimated fair values as of the acquisition date. Any excess of the fair value of assets acquired and liabilities assumed overthe fair value of the acquisition consideration is recognized as a gain by the acquirer. We have completed the following allocation of the purchaseconsideration with the assistance of a third-party valuation expert.51 Table of Contents Allocation of Purchase ConsiderationCash$374,517Accounts receivable3,314,994Inventory5,246,000Other current assets541,726Property and equipment3,601,850Identifiable intangible assets11,100,000Goodwill2,348,331Other assets86,953Accounts payable and accrued expenses(5,508,789)Debt(5,212,355)Other liabilities(33,573)Total purchase consideration$15,859,654 The preliminary identifiable intangible assets acquired and their estimated lives were as follows:Estimated Fair ValueEstimated Useful LifeDeveloped technology$4,500,0002 - 10 yearsIn-process research and development3,900,000IndefiniteCustomer base1,300,0009 - 11 yearsTrade names1,000,00010 yearsBacklog400,0001 year$11,100,000Developed technologies acquired primarily consist of API's existing technologies related to HSOR products, optoelectronic systems, modules andcomponents, and Terahertz solutions. The developed technologies of API were valued using both the "relief-from-royalty" method and the "multi-periodexcess earnings" method, under the income approach. This multi-period excess earnings method reflects the present value of the projected cash flows that areexpected to be generated by the developed technologies less charges representing the contribution of other assets to those cash flows. A discount rate of32.5% was used to discount the cash flows to the present value.In-process research and development represents the estimated fair values of incomplete API research and development projects that had not reachedtechnological feasibility as of the closing date of the Merger. As of December 31, 2016, all of the technologies associated with $3.9 million of in-processresearch and development were placed into service. The fair value of in-process research and development was determined using the multi-period excessearnings method. A discount rate of 37.5% was used to discount the cash flows to the present value.Customer base represents the fair value of projected cash flows that will be derived from the sale of products to API's existing customers as of theclosing date of the Merger. Customer relationships were valued utilizing both a multi-period excess earnings method and the "distributor" method, under theincome approach. Under this premise, the margin of a distributor within the industry is deemed to be the margin attributable to customer relationships. Thisisolates the cash flows attributable to the customer relationships that a market participant would be willing to pay for. A discount rate of 32.5% was used todiscount the cash flows to the present value.Trade names and trademarks are considered a type of guarantee of a certain level of quality or performance represented by the API brand. Trade namesand trademarks were valued using the "relief-from-royalty" method of income approach. This52 Table of Contentsmethod is based on the assumption that in lieu of ownership, a market participant would be willing to pay a royalty in order to exploit the related benefits ofthis asset. A discount rate of 24.5% was used to discount the cash flows to the present value.Backlog represents the fair value of projected cash flows that will be derived from the sale of products under existing contracts and customer orders asof the closing date of the Merger. The fair value of the customer backlog was determined using the multi-period excess earnings method. A discount rate of21.5% was used to discount the cash flows to the present value.GoodwillGoodwill represents the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilitiesassumed in connection with the Merger. During 2015, we recognized various measurement period adjustments to the value of assets acquired and liabilitiesassumed in the Merger. These adjustments primarily related to the estimated value of trade names acquired and certain deferred compensation liabilitiesassumed, with an offsetting increase to the recorded value of goodwill. During 2016, we recognized measurement period adjustments to the value of assetsacquired and liabilities assumed in the Merger. These adjustments primarily related to the estimated value of accrued liabilities assumed, with an offsettingincrease to the recorded value of goodwill. We performed a qualitative analysis of the goodwill balance as of October 1, 2016, and determined no impairmentof goodwill is necessary.Goodwill as of January 1, 2015$—Goodwill recorded at acquisition date of API614,184Measurement period adjustments1,659,928Goodwill as of December 31, 20152,274,112Measurement period adjustments74,219Goodwill as of December 31, 2016$2,348,331 Pro Forma Consolidated Results of OperationsThe following unaudited pro forma financial information presents combined results of operations for each of the periods presented as if the Merger hadbeen completed on January 1, 2015. The pro forma information includes adjustments to depreciation expense for property and equipment acquired, toamortization expense for the intangible assets acquired, to interest expense for the new debt facility, and to eliminate the Merger transaction expensesrecognized in each period. Transaction related expenses associated with the merger and excluded from the pro forma loss from continuing operations for theyear ended December 31, 2015 were $4.7 million. The pro forma data are for informational purposes only and are not necessarily indicative of theconsolidated results of operations of the combined business had the Merger actually occurred on January 1, 2015, or the results of future operations of thecombined business. For instance, planned or expected operational synergies following the Merger are not reflected in the pro forma information.Consequently, actual results will differ from the unaudited pro forma information presented below. Years ended December 31, 2016 2015 (unaudited) Revenue $59,210,996 $52,887,000 Loss from continuing operations $(2,369,492) $(4,641,000)3. Inventory53 Table of ContentsInventory 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.Components of inventory are as follows: December 31, 2016 2015Finished goods$1,993,543 $1,938,466Work-in-process1,098,173 1,227,270Raw materials5,278,519 5,697,431 $8,370,235 $8,863,1674. DebtSilicon Valley Bank FacilityWe currently have a Loan and Security Agreement with SVB under which we have a term loan with an original borrowing amount of $6.0 million (the“Term Loan”). The Term Loan was to be repaid by us in 48 monthly installments, plus accrued interest payable monthly in arrears and matured on May 1,2015. On May 8, 2015, in connection with the Merger with API, we entered into the Joinder, Consent and Sixth Loan Modification Agreement (the "2015Term Loan") under which we borrowed $6.0 million and used the proceeds principally to repay the then outstanding debt of API at the time of the Merger.The 2015 Term Loan is to be repaid by us in 48 monthly installments, plus accrued interest payable monthly in arrears and matures at the earlier of May 1,2019, or upon an event of a default under the loan agreement. The term loan carries a floating annual interest rate equal to prime rate then in effect, aspublished in the Wall Street Journal, plus 2%. We may prepay amounts due under the 2015 Term Loan at any time, subject to an early termination fee of upto 2% of the amount of prepayment.On September 29, 2015, we entered into the Waiver and Seventh Loan Modification Agreement with SVB, under which we borrowed an additional $1.0million in December 2015 to fund certain anticipated capital expenditures (the "2015 Equipment Term Loan"). The principal amount plus accrued interest ofthe 2015 Equipment Term Loan is to be repaid by us in 36 monthly installments. The 2015 Equipment Term Loan carries a floating annual interest rate equalto the prime rate then in effect, as published in the Wall Street Journal, plus 2%. We may prepay amounts due under the 2015 Equipment Term Loan at anytime, subject to an early termination fee of up to 2% of the amount of prepayment.In December 2016, we entered into the Eighth Loan Modification Agreement with SVB, under which the financial covenants were modified.Amounts due under the 2015 Term Loan and the 2015 Equipment Term Loan (collectively, the "Term Loans") are secured by substantially all of ourassets, including intellectual property, personal property and bank accounts.In addition, 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. The Term Loans require that wemeet certain financial covenants, including a minimum cash balance of $5.0 million, and a minimum liquidity coverage ratio, each as defined in the 2015Equipment Term Loan. If any event of default occurs, SVB may declare due immediately all borrowings under the Term Loans and foreclose on the collateral.Furthermore, an event of default under the Term Loans would result in an increase in the interest rate on any amounts outstanding. As of December 31, 2016,we were in compliance with all covenants under the Term Loans.The balance under the Term Loans at December 31, 2016 was $4.3 million, of which $1.8 million was classified as short-term. The effective rate of ourTerm Loans at December 31, 2016 was 5.75%.The following table presents a summary of debt outstanding as of December 31, 2016 and 2015:54 Table of Contents December 31, 2016 2015Silicon Valley Bank Term Loans$4,291,666 $6,125,000Less: unamortized debt issuance costs38,301 —Less: current portion1,833,333 1,833,333Total long-term debt obligations$2,420,032 $4,291,667Debt issuance costs associated with the issuance of the SVB Term Loans totaled $55 thousand. Amortization of debt issuance costs is computedusing the straight line method and is included in interest expense. Amortization of the debt issuance costs totaled $16 thousand for the year ended December31, 2016. Maturities on long-term debt are as follows:YearAmount2017$1,833,33320181,833,3332019625,000Total$4,291,666Interest expense for the years ended December 31, 2016 and 2015 consisted of the following: Years ended December 31, 2016 2015Interest expense on Term Loans $287,491 $202,994Amortization of debt issuance costs 16,308 9,072Other interest expense 17,143 8,337Total interest expense $320,942 $220,4035. Accounts Receivable—TradeAccounts receivable consist of the following: December 31, 2016 2015Billed$12,299,453 $9,661,387Unbilled2,231,432 1,412,381Other19,479 95,600 14,550,364 11,169,368Less: allowance for doubtful accounts(252,639) (134,811) $14,297,725 $11,034,557Unbilled receivables result from contract retainages and revenues that have been earned in advance of billing and can be invoiced at contractuallydefined intervals, milestones, or at completion of the contract. Unbilled amounts are expected to be billed in future periods and are classified as current assetsin accordance with industry practice.55 Table of Contents6. Property and EquipmentProperty and equipment, net, consists of the following: December 31, 2016 2015Building$69,556 $69,556Equipment12,589,998 11,055,886Furniture and fixtures656,769 666,654Software1,225,992 1,092,484Leasehold improvements5,267,349 5,257,703 19,809,664 18,142,283Less—accumulated depreciation(13,028,826) (11,528,045) $6,780,838 $6,614,238Depreciation for the years ended December 31, 2016 and 2015 was approximately $1.5 million and $1.2 million, respectively. 7. Intangible AssetsThe following is a summary of intangible assets, net: December 31, 2016 2015Patent costs$3,169,920 $2,723,971Developed technology8,400,000 6,100,000In-process research and development— 2,300,000Customer base1,300,000 1,300,000Trade names1,000,000 1,000,000Backlog400,000 400,000 14,269,920 13,823,971Accumulated amortization(5,588,657) (3,419,659) $8,681,263 $10,404,312During 2016, the development was completed for certain products that were in process at the time of the Merger, and those products began beingmarketed. Accordingly $2.3 million of in-process research and development recorded in the initial purchase price allocation has been reclassified todeveloped technology as of December 31, 2016. Amortization for the years ended December 31, 2016 and 2015 was approximately $2.2 million and $1.2million, respectively. Estimated aggregate amortization, based on the net value of intangible assets at December 31, 2016, for each of the next five years andbeyond is as follows:Year Ending December 31, 20171,754,96720181,405,2282019894,3252020814,9562021807,0432022 and beyond3,004,744$8,681,263 8. Accrued Liabilities56 Table of ContentsAccrued liabilities consist of the following: December 31, 2016 2015 Accrued compensation$5,442,723 $4,719,533 Accrued sub-contracts483,477 351,847 Accrued professional fees67,719 133,847 Accrued income tax— 160,438 Deferred rent155,138 137,889 Royalties345,895 351,003 Warranty reserve185,125 173,687 Claims reserve1,577,123 1,752,904 Accrued liabilities - other409,900 523,538Total accrued liabilities$8,667,100 $8,304,6869. Income TaxesIncome tax expense/(benefit) from continuing operations consisted of the following for the periods indicated: Years ended December 31, 2016 2015Current: Federal$— $(510,772)State75,366 40,167Deferred Federal— —Deferred State— —Income tax expense/(benefit)$75,366 $(470,605)57 Table of ContentsDeferred tax assets and liabilities consist of the following components: December 31, 2016 December 31, 2015 Current Long-Term Current Long-TermBad debt and inventory reserve$382,075 $— $157,847 $—Inventory adjustment— 940,885 — 939,793UNICAP— 46,593 — 40,752Deferred revenue— 154,608 — 131,489Deferred rent— 550,419 — 599,094Depreciation and amortization— (3,490,869) — (4,231,265)Charitable contributions— 5,741 — 4,954Net operating loss carryforwards- Luna— 4,779,976 — 5,106,166Net operating loss carryforwards- API— 9,783,512 — 9,783,512Net operating loss carryforwards - state— 281,799 — 323,557Net operating loss carryforwards- Canada— 10,503 — 39,867Research and development credits— 4,250,803 — 4,250,803California manufacturing credit— 15,554 — 15,554Accrued liabilities1,067,019 1,211,752 —Deferred compensation— 267,897 — 192,547Stock-based compensation— 1,867,947 — 1,804,338AMT credit— 395,083 — 388,342Total1,449,094 19,860,451 1,369,599 19,389,503Valuation allowance(1,449,094) (19,860,451) (1,369,599) (19,389,503)Net deferred tax asset$— $— $— $—The expense/(benefit) from income taxes from continuing operations differs from the amount computed by applying the federal statutory income taxrate to our loss from continuing operations before income taxes as follows for the periods indicated: Years ended December 31, 2016 2015Income tax expense at federal statutory rate 34.00 % 34.00 %State taxes, net of federal tax effects (1.15)% 3.34 %Change in valuation allowance (23.99)% (10.50)%Incentive stock options (11.08)% (4.84)%Provision to return adjustments (1.01)% 0.18 %Meals and entertainment (0.78)% (0.25)%Capitalized merger costs — % (14.95)%Windfall deduction — % 0.26 %Other permanent differences 0.44 % 0.01 %Income tax (expense)/benefit (3.57)% 7.25 %The realization of our deferred income tax assets is dependent upon sufficient taxable income in future periods. In assessing whether deferred tax assetsmay be realized, we consider whether it is more likely than not that some portion, or all, of the deferred tax asset will be realized. We consider scheduledreversals of deferred tax liabilities, projected future taxable58 Table of Contentsincome and tax planning strategies that we can implement in making our assessment. We have U.S. federal income tax net operating loss carryforwards atDecember 31, 2016 of approximately $12.6 million for Luna and net operating loss carryforwards of approximately $28.8 million for API expiring at varyingdates through 2025. We have research and development tax credit carryforwards at December 31, 2016 of approximately $4.3 million, which expire atvarying dates through 2024.In 2015, we performed a formal section 382 study and determined that we do not have a limitation on our net operating loss available to offset futureincome for the Luna net operating losses. As a result of the acquisition of API, the API net operating loss carryover and research and development credits willbe subject to the Section 382 limitation. A formal Section 382 study has not been prepared, however, based on our estimated calculations it is likely that thata portion of the net operating losses and research and development credits will expire unutilized. As there is a valuation allowance against the API deferredtax assets, there will not be a statement of operations impact to any expiration of the net operating losses or research and development credits.The U.S. federal statute of limitations remains open for the year 2007 and onward. We currently have no federal income tax returns under examination.U.S. state jurisdictions have statutes of limitation generally ranging from three to seven years. We currently have no state income or franchise tax returnsunder examination. We currently do not file tax returns in any foreign tax jurisdiction other than Canada.We currently have no positions for which we expect that the amount of unrecognized tax benefit will increase or decrease significantly within twelvemonths of the reporting date or for which we believe there is significant risk of disallowance upon audit. We have no tax interest or penalties reported ineither our statement of operations or statement of financial position for any year reported herein. Management believes it is not more likely than not that thedeferred tax assets at December 31, 2016 or December 31, 2015 will not be realized, and as a result a valuation allowance was established against all suchdeferred tax assets.Windfall equity-based compensation deductions are tracked, but will not be recorded to the balance sheet until management determines it is morelikely than not that such amounts will be utilized. As of December 31, 2016, we had no windfall stock compensation deductions. If and when realized, the taxbenefit associated with these deductions will be credited to additional paid-in capital. These excess benefit deductions are included in the total federal netoperating losses disclosed above.10. Stockholders’ EquitySeries A Convertible Preferred StockIn January 2010, we entered into a transaction with Carilion, in which Carilion agreed to exchange all of its Senior Convertible Promissory Notes withan original principal amount of $5.0 million plus all accrued but unpaid interest, totaling $1.2 million, for 1,321,514 shares of our newly designated Series AConvertible Preferred Stock. The Series A Convertible Preferred Stock is non-voting, carries a dividend of 6% payable in shares of common stock andmaintains a liquidation preference up to $6.2 million. As of December 31, 2016, 552,401 shares of common stock were issuable to Carilion as dividends andhave been recorded in the statement of stockholders’ equity. These dividends are issuable on demand. Each share of Series A Convertible Preferred Stock maybe converted into one share of our common stock at the option of the holder. We recorded the fair value of the Series A Convertible Preferred Stock,determined based upon the conversion value immediately prior to the exchange, the fair value of the new warrant issued to Carilion, determined using theBlack-Scholes valuation model, and the incremental fair value of the prior warrant due to the re-pricing and extension of maturity to stockholders’ equity.WarrantsCarilion Clinic holds unexercised warrants for 366,000 shares of our common stock. The warrants have an exercise price of $2.50 and expire onDecember 31, 2020.Equity Incentive PlansIn January 2006, we adopted our 2006 Equity Incentive Plan (the "2006 Plan"). Under the 2006 Plan, our Board of Directors was authorized to grantboth incentive and non-statutory stock options to purchase common stock and restricted stock awards to our employees, directors, and consultants. The 2006Plan expired in January 2016.In April 2016, we adopted our 2016 Equity Incentive Plan (the "2016 Plan") as a successor to the 2006 Plan. Under the 2016 Plan, our Board ofDirectors is authorized to grant both incentive and non-statutory stock options to purchase common stock and restricted stock awards to our employees,directors, and consultants. The 2016 Plan provides for the issuance of59 Table of Contents3,500,000 shares plus any amounts forfeited from grants under the 2006 Plan after the expiration date of the 2006 Plan. Options generally have a life of 10years and exercise price equal to or greater than the fair market value of the Common Stock as determined by the Board of Directors.Vesting for employees typically occurs over a four-year period.The following table sets forth the activity of the options to purchase common stock under the 2006 Plan and the 2016 Plan. The prices represent theclosing price of our Common Stock on the NASDAQ Capital Market on the respective dates. Options Outstanding Options Exercisable Number ofShares Price perShare Range WeightedAverageExercisePrice AggregateIntrinsicValue (1) Number ofShares WeightedAverageExercisePrice AggregateIntrinsicValue (1)Balance at January 1, 20154,289,631 $0.35 - 6.55 $1.93 $512,901 3,111,199 $2.11 $453,032Forfeited(789,412) $0.35 - 9.03 $2.86 Exercised(230,672) $0.35 - 1.77 $0.37 Granted65,500 $0.94 - 1.45 $1.21 Issued in exchange for APIoptions465,681 $1.38 - 9.03 $4.83 Balance at December 31, 20153,800,728 $0.61 - 8.43 $2.17 $111,314 3,045,150 $2.39 $103,603Forfeited(963,614) $1.18 - 8.43 $2.99 Exercised— — $— Granted20,000 $1.15 $1.15 Balance at December 31, 20162,857,114 $0.61 - 6.83 $1.89 $107,063 2,367,630 $1.93 $101,071 (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-moneyoptions only.The fair value of each option granted is estimated as of the grant date using the Black-Scholes option pricing model with the following assumptions: Years ended December 31, 2016 2015Risk-free interest rate range 1.5% 1.88% – 1.95%Expected life of option-years 7.5 7.5Expected stock price volatility 73% 75% - 103%Executive turnover rates —% —%Non-executive turnover rates 14.0% 40.0%Expected dividend yield —% —%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. Expectedvolatility is based upon the average historical volatility of our common stock over the period commensurate with the expected term of the related instrument.The expected life and estimated post-employment termination behavior is based upon historical experience of homogeneous groups, executives and non-executes, within our company. We do not currently pay dividends on our common stock nor do we expect to in the foreseeable future.60 Table of Contents Options Outstanding Options Exercisable Range ofExercise Prices OptionsOutstanding WeightedAverageRemainingLife inYears WeightedAverageExercisePrice OptionsExercisable WeightedAverageExercisePrice ofOptionsExercisableYear ended December 31, 2015$0.61 - $8.43 3,800,728 5.55 $2.17 3,045,150 $2.39Year ended December 31, 2016$0.61- $6.83 2,857,114 5.09 $1.89 2,637,630 $1.93 Total Intrinsic Value ofOptions Exercised Total Fair Value ofOptions VestedYear ended December 31, 2015198,013 741,619Year ended December 31, 2016— 370,654For the years ended December 31, 2016 and 2015, the weighted average grant date fair value of options granted was $1.15 and $0.97, respectively, pershare. We estimate the fair value of options at the grant date using the Black-Scholes model.Restricted Stock IssuancesIn 2016 and 2015, we issued 319,000 and 334,000, respectively, shares of restricted stock to certain employees. These shares vest in four equal annualinstallments on the anniversary dates of their grant. In 2016 and 2015, 245,583 and 168,750 shares vested, respectively.The following table summarizes our restricted stock awards: Number of UnvestedShares Weighted Average GrantDate Fair Value Aggregate Value ofUnvested SharesBalance at January 1, 2015530,250 $1.34 $710,535Granted334,000 $1.12 $374,080Vested(168,750) $1.33 $(224,438)Forfeitures(25,875) $1.35 $(35,018)Balance at December 31, 2015669,625 $1.23 $825,159Granted319,000 $1.15 $366,850Vested(245,583) $1.23 $(303,245)Forfeitures— $— $—Balance at December 31, 2016743,042 $1.20 $888,764We recognized $0.9 million and $1.1 million in stock-based compensation expense, which is recorded in selling, general and administrative expenseson the consolidated statement of operations for the years ended December 31, 2016 and 2015, respectively, and we will recognize $0.9 million over theremaining requisite service period. For all stock options granted through December 31, 2016, the weighted average remaining service period is 0.8 years.Restricted Stock UnitsWe issue restricted stock units, ("RSUs"), to our non-employee directors for service provided. Under our non-employee director compensation planRSUs issued for annual retainer fees vest on the earlier of the one year anniversary of the61 Table of Contentsgrant or the following shareholder meeting. Amounts issued for quarterly fees vest immediately upon their issuance. A summary of our RSU activity for 2015and 2016 is as follows. Number of RSUs Intrinsic Value Issued Unvested WeightedAverage GrantDate Fair Valueper Share OutstandingUnvestedBalance at January 1, 2015329,524 — $1.53 Granted152,697 72,813 $1.01 Vested— — $0.00 Forfeitures— — $0.00 Converted(118,297) — $1.46 Balance at December 31, 2015363,924 72,813 $1.33 Granted188,857 86,956 $1.18 Vested— (72,813) $1.01 Forfeitures— — $0.00 Converted(24,271) — $1.01 Balance at December 31, 2016528,510 86,956 $1.29 $776,910$127,825Stock Repurchase ProgramIn May 2016, our board of directors authorized us to repurchase up to $2,000,000 of our common stock through May 31, 2017. Our stock repurchaseprogram does not obligate us to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open markettransactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. As of December 31, 2016, we hadrepurchased a total of 205,500 shares for an aggregate purchase price of $0.2 million. The following chart details our share repurchases during each month ofthe quarter ended December 31, 2016: Total Number of Shares Repurchased Average Price Paid per ShareOctober 2016— $—November 20166,400 $1.25December 2016— $—We currently maintain these repurchased shares as treasury stock.11. Commitments and ContingenciesObligation under Operating Leases62 Table of ContentsWe lease facilities in Virginia, Michigan, California, and Canada under operating leases that as of December 31, 2016 were scheduled to expirebetween April 2017 and December 2024. Certain of the leases are subject to fixed escalations and provide for possible termination prior to their expirationdates. We recognize rent expense on such leases on a straight-line basis over the lease term. The difference between the straight line method and cash paid isreflected in changes to the deferred rent balance in our consolidated balance sheets. Deferred rent primarily resulted from recognition of the value of certainleasehold improvements associated with our Blacksburg, Virginia facility at the inception of the lease. Rent expense under these leases recorded in selling,general and administrative expense on our statements of operations totaled approximately $1.5 million and $1.1 million, respectively, for the years endedDecember 31, 2016 and 2015.Minimum future payments, as of December 31, 2016, under the aforementioned operating leases for each of the next five years and thereafter are:2017$1,601,29220181,602,93220191,451,08120201,341,2552021806,865Thereafter1,441,177 $8,244,602Purchase CommitmentIn the third quarter of 2016 we executed two non-cancelable purchase orders totaling $1.5 million for multiple shipments of tunable lasers to bedelivered over an 18-month period beginning in the third quarter of 2016. At December 31, 2016, approximately $1.0 million of this commitment remainedunder these purchase agreements. In 2016, we also executed two purchase orders for component parts and capital equipment related to our HSOR products inthe aggregate amount of $0.7 million for delivery through the second quarter of 2017. As of December 31, 2016, approximately $0.5 million remainedoutstanding under these purchase orders.Royalty AgreementWe have licensed certain third-party technologies from vendors for which we owe minimum royalties aggregating $0.9 million payable over theremaining patent terms of the underlying technology. 12. Employee Profit Sharing PlanWe maintain a salary reduction/profit-sharing plan under provisions of Section 401(k) of the Internal Revenue Code. The plan is offered to allpermanent employees of Luna Innovations Incorporated and its wholly-owned subsidiaries. We contribute 25% of the salary deferral elected by eachemployee up to a maximum deferral of 10% of annual salary.We contributed approximately $305,000 and $180,000 to the plan for the years ended December 31, 2016 and 2015, respectively. 13. Litigation and Other ContingenciesFrom time to time, we may become involved in litigation in relation to claims arising out of our operations in the normal course of business. Whilemanagement currently believes it is not reasonably possible the amount of ultimate liability, if any, with respect to these actions will have a material adverseeffect on our financial position, results of operations or liquidity, the ultimate outcome of any litigation is uncertain.In September 2014, we received a preliminary audit report from the Defense Contract Audit Agency ("DCAA"), with respect to our 2007 incurred costsubmission 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 (the "DCMA") a final determination anddemand 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 ServicesBoard of Contract Appeals ("ASBCA"). In January 2017, a hearing was held before ASBCA. No ruling has yet been issued with respect to our appeal. Theappeals process remains ongoing, and we are unable to estimate the amount of loss, if any, that may be realized.63 Table of ContentsWe have made, and will continue to make, efforts to comply with current and future environmental laws. We anticipate that we could incur additionalcapital and operating costs in the future to comply with existing environmental laws and new requirements arising from new or amended statutes andregulations. In addition, because the applicable regulatory agencies have not yet promulgated final standards for some existing environmental programs, wecannot at this time reasonably estimate the cost for compliance with these additional requirements. The amount of any such compliance costs could bematerial. We cannot predict the impact that future regulations will impose upon our business. 14. Relationship with Major CustomersDuring the years ended December 31, 2016 and 2015, approximately 28% and 34%, respectively, of our consolidated revenues were attributable tocontracts with the U.S. government. In addition, we had one commercial customer whose revenues accounted for 11% of our consolidated revenues for 2016.At December 31, 2016 and 2015, receivables with respect to contracts with the U.S. government represented 10% and 17% of total billed tradereceivables, respectively. At December 31, 2016, receivables from the above noted commercial customer represented 19% of our billed trade receivables. 15. Financial Information About SegmentsOur operations are divided into two operating segments: Technology Development and Products and Licensing. Our engineers and scientistscollaborate with our network of government, academic and industry experts to identify technologies and ideas with promising market potential. We thencompete to win fee-for-service contracts from government agencies and industrial customers who seek innovative solutions to practical problems that requirenew technology. The Technology Development segment derives its revenue primarily from services. The Technology Development segment providesapplied research to customers in our areas of focus.The Products and Licensing segment develops and sells products or licenses technologies based on commercially viable concepts developed by theTechnology Development segment. The Products and Licensing segment derives its revenue from product sales, funded product development andtechnology licenses.Our President and Chief Executive Officer and his direct reports collectively represent our chief operating decision makers, and they evaluate segmentperformance based primarily on revenue and operating income or loss.Information about the results of operations for each segment is set forth in the table below. There were no significant inter-segment sales during theyears ended December 31, 2016 and 2015.During the years ended December 31, 2016 and 2015, 29% and 30%, respectively, of our total sales took place outside the United States. Revenuesfrom customers in China represented approximately 16% and 9% of total revenues for the years ended December 31, 2016 and 2015, respectively. No othersingle country, outside of the United States, represented more than 10% of total revenues during the years ended December 31, 2016 or 2015. Years ended December 31, 2016 2015Technology Development revenue $16,825,157 $13,599,048Products and Licensing revenue 42,385,839 30,421,310Total revenue 59,210,996 44,020,358Technology Development operating loss (193,244) (3,708,710)Products and Licensing operating loss (1,744,091) (2,540,885)Total operating loss $(1,937,335) $(6,249,595)Depreciation, Technology Development $352,435 $399,857Depreciation, Products and Licensing $1,148,195 $920,932Amortization, Technology Development $195,619 $88,423Amortization, Products and Licensing $2,017,629 $1,152,072Additional segment information is as follows:64 Table of Contents December 31, 2016 2015Total segment assets: Technology Development$16,923,090 $21,203,211Products and Licensing38,073,883 36,928,602Total$54,996,973 $58,131,813Property plant and equipment and intangible assets, Technology Development$2,602,803 $2,917,448Property plant and equipment and intangible assets, Products and Licensing$15,207,630 $16,375,21516. Quarterly Results (unaudited)The following table sets forth our unaudited historical revenues, operating loss and net (loss)/income by quarter during 2016 and 2015. Quarter Ended(Dollars in thousands,except per share amounts)March 31, 2016 June 30, 2016 September 30, 2016 December 31, 2016 March 31, 2015 June 30, 2015 September 30, 2015 December 31, 2015Revenues: Technology development$3,723 $4,137 $4,312 $4,653 $2,876 $3,728 $3,277 $3,718Products and licensing10,264 10,510 10,307 11,305 2,463 6,298 9,928 11,732Total revenues13,987 14,647 14,619 15,958 5,339 10,026 13,205 15,450Gross margin4,844 5,171 5,609 6,111 2,289 4,197 4,979 5,036Operating (loss)/income(1,352) (652) (362) 427 (2,615) (2,123) (723) (815)Net (loss)/income fromcontinuing operations(1,460) (771) (445) 306 (2,627) (2,168) (802) (414)Income from discontinuedoperations net of income taxes— — — — — — — 8,329Net (loss)/income(1,460) (771) (445) 306 (2,627) (2,168) (802) 7,914Net (loss)/income attributableto common stockholders$(1,481) $(796) $(474) $276 $(2,654) $(2,189) $(820) $7,893Net (loss)/income per sharefrom continuing operations: Basic and diluted$(0.05) $(0.03) $(0.02) $0.01 $(0.17) $(0.10) $(0.03) $(0.02)Net income per share fromdiscontinued operations: Basic and diluted$— $— $— $— $— $— $— $0.30Net (loss)/income attributableto common stockholders: Basic and diluted$(0.05) $(0.03) $(0.02) $0.01 $(0.18) $(0.10) $(0.03) $0.29Weighted average shares: Basic and diluted27,477,181 27,557,960 27,605,028 27,538,606 15,117,679 21,997,768 27,393,392 27,464,993 17. Discontinued OperationsOn January 21, 2014, we sold our assets associated with the development of fiber optic shape sensing and localization for the medical field to affiliatesof Intuitive Surgical, Inc. ("Intuitive"), for total cash consideration of up to $30 million, including $6 million received at closing, and $6 million to bereceived within 90 days of closing, and up to $18 million that may be received in the future based on the achievement of certain technical milestones androyalties on system sales, if any. In the transaction, we sold equipment and intellectual property associated with our shape sensing technology. Tenemployees were65 Table of Contentstransferred to Intuitive. Included in the transaction were current assets of totaling approximately $0.2 million and long term assets with a net book value ofapproximately $0.2 million.In December 2015, although the required technical milestones specified in our agreement with Intuitive had not yet been achieved by Intuitive, we andIntuitive agreed to settle all remaining future payment obligations related to the technical milestones and royalties on system sales for a lump-sum paymentof $9 million, which we received in December 2015.We have reported the payment received from Intuitive in 2015 as discontinued operations in our consolidated financial statements. We allocated aportion of the consolidated tax expense to discontinued operations based on the ratio of the discontinued groups’ income or loss before allocations.The key components of income from discontinued operations were as follows: Year endedDecember 31, 2015Net revenues $—Cost of revenues —Operating expenses —Loss before income taxes —Allocated tax benefit —Operating loss from discontinued operations —Gain on sale, net of $0.7 million of related income taxes 8,326,386Income from discontinued operations, net of income taxes $8,326,386ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.None.ITEM 9A. CONTROLS AND PROCEDURES.Evaluation of Disclosure Controls and ProceduresWe 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 bya company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified inthe SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that informationrequired 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’smanagement, 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 achievingtheir 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 thatany design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes inconditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatementsdue to error or fraud may occur and not be detected.Under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Chief FinancialOfficer, 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 report.Based on this evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that, as of December 31, 2016, ourdisclosure controls and procedures were effective at the reasonable assurance level.66 Table of ContentsChanges in Internal Control over Financial Reporting There have been no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d)of Securities Exchange Act Rule 13a-15(e) and Rule 15d-15(e) that occurred in the quarter ended December 31, 2016 that have materially affected, or arereasonably likely to materially affect, our internal control over financial reporting.Management’s Report on Internal Control over Financial ReportingOur management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act. Our internal control over financial reporting is designed, under the supervision of our principal executive and principalfinancial officers, and effected by our board of directors, management and other personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in theUnited States of America ("GAAP"). Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures arebeing made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.There are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and thecircumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance withrespect to financial statement preparation and may not prevent or detect all misstatements. Further, because of changes in conditions, effectiveness of internalcontrol over financial reporting may vary over time. Our internal control system was designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for external purposes in accordance with GAAP.Under the supervision and with the participation of our management, including our President and Chief Executive Officer, and our Chief FinancialOfficer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2016. This evaluation was basedon the criteria established in the 2013 Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the TreadwayCommission.Based on our evaluation under the framework established in the 2013 Internal Control—Integrated Framework, our President and Chief Executiveofficer, and our Chief Financial Officer concluded that our internal control over financial reporting was effective as of December 31, 2016 to providereasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance withGAAP.ITEM 9B. OTHER INFORMATION.None67 Table of ContentsPART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCEThe information required by Item 10 of Form 10-K will be included in the proxy statement related to our 2017 Annual Meeting of Stockholders, (the"2017 Proxy Statement"), anticipated to be filed with the SEC within 120 days after December 31, 2016, and is incorporated into this report by reference. ITEM 11. EXECUTIVE COMPENSATION.The information required by Item 11 of Form 10-K is incorporated into this report by reference to the information to be provided in our 2017 ProxyStatement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERSOther than the information below relating to securities authorized for issuance under our equity compensation plans, the information required byItem 12 of Form 10-K is incorporated into this report by reference to the information to be provided in our 2017 Proxy Statement.EQUITY COMPENSATION PLANSThe following table summarizes our equity compensation plans as of December 31, 2016:Plan categoryNumber ofsecurities to beissued uponexercise ofoutstandingoptions, warrantsand rights(a) Weighted-average exerciseprice ofoutstandingoptions,warrants andrights(b) Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column (a))(c)Equity compensation plans approved by security holders3,223,114 $1.96 3,749,619Total3,223,114 $1.96 3,749,619Our 2016 Equity Incentive Plan allows for forfeited awards to be added back to our pool of available awards, including awards forfeited from the 2006Plan after the expiration date of our 2006 Plan. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCEThe information required by Item 13 of Form 10-K is incorporated into this report by reference to the information to be provided in our 2017 ProxyStatement. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICESThe information required by Item 14 of Form 10-K is incorporated into this report by reference to the information to be provided in our 2017 ProxyStatement.68 Table of ContentsPART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE(a)The following documents are filed as part of this Annual Report on Form 10-K:(1)Financial Statements. See Index to Consolidated Financial Statements at Item 8 of this Report on Form 10-K.(2)Schedules.Schedule IILuna Innovations IncorporatedValuation and Qualifying AccountsColumn AColumn B Column C Column D Column E Balanceat beginningof Period Additions Deductions Balance atendof periodYear Ended December 31, 2015 Reserves deducted from assets to which they apply: Deferred tax valuation allowance$12,690,449 $8,068,653 $— $20,759,102Allowances for doubtful accounts134,811 10,375 (10,375) 134,811 $12,825,260 $8,079,028 $(10,375) $20,893,913Year Ended December 31, 2016 Reserves deducted from assets to which they apply: Deferred tax valuation allowance$20,759,102 $550,444 $— $21,309,546Allowances for doubtful accounts134,811 305,593 (187,765) 252,639 $20,893,913 $856,037 $(187,765) $21,562,185All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements andnotes thereto in Item 8 of Part II of this Annual Report on Form 10-K.(3)Exhibits. The exhibits filed as part of this report are listed under “Exhibits” at subsection (b) of this Item 15.(b)Exhibits69 Table of ContentsEXHIBIT INDEXExhibit No.Exhibit Document2.1(1)Findings of Fact, Conclusions of Law, and Order under 11 U.S.C. §§ 1129(a) and (b) and Fed. R. Bankr. P. 3020 Confirming First AmendedJoint Plan of Reorganization of Luna Innovations Incorporated and Luna Innovations, Inc., debtors and debtors-in-possession, datedJanuary 12, 2010 (Exhibit 2.1)2.2(1)First Amended Joint Plan of Reorganization of Luna Innovations Incorporated and Luna Technologies, Inc., dated December 18, 2009(Exhibit 2.2)2.3(1)First Amended Disclosure Statement in support of First Amended Joint Plan of Reorganization of Luna Innovations Incorporated, et al.,under Chapter 11 of the Bankruptcy Code, dated December 18, 2009 (Exhibit 2.3)2.4(2)*Asset Purchase Agreement, dated March 1, 2013, by and between Luna Innovations Incorporated and MacAulay-Brown, Inc. (Exhibit 2.4)2.5(3)*Asset Purchase Agreement by and between Luna innovations Incorporated and Luna Technologies, Inc. and Intuitive Surgical Operations,Inc., and Intuitive Surgical International, Ltd., dated as of January 17, 2014 (Exhibit) 2.1)2.6(4)Agreement and Plan of Merger and Reorganization dated as of January 30, 2015, by and among Luna Innovations Incorporated, APIMerger Sub, Inc. and Advanced Photonix, Inc. (Exhibit 2.1)3.1(5)Amended and Restated Certificate of Incorporation of the Registrant (Exhibit 3.2)3.2(6)Certificate of Designations of the Series A Convertible Preferred Stock (Exhibit 3.1)3.3(7)Amended and Restated Bylaws of the Registrant (Exhibit 3.4)3.4(8)Amendment to Amended and Restated Bylaws (Exhibit 3.1)3.4(4)Amendment to Amended and Restated Bylaws (Exhibit 3.1)4.1(9)Specimen Common Stock certificate of the Registrant (Exhibit 4.1)4.2(9)2006 Equity Incentive Plan (Exhibit 10.9)4.3(7)Form of Stock Option Agreement under 2006 Equity Incentive Plan (Exhibit 4.7)4.4(10)Form of Performance Unit Award Agreement (Exhibit 4.5)4.5(39)2016 Equity Incentive Plan (Exhibit 4.7)4.6(39)Form of Stock Option Grant Notice and Stock Option Agreement under 2016 Equity Incentive Plan (Exhibit 4.8)4.7(39)Form of Restricted Stock Unit Grant Notice and Restricted Stock Unit Award Agreement under 2016 Equity Incentive Plan (Exhibit 4.9)4.8(40)Form of Restricted Stock Award Grant Notice and Restricted Stock Award Agreement under 2016 Equity Incentive Plan (Exhibit 10.1)10.1(11)Form of Indemnification Agreement for directors and executive officers (Exhibit 10.1)10.2(12)Commercial Lease, dated March 15, 2007, between Canvasback Real Estate & Investments LLC and Luna Innovations Incorporated (705Dale Avenue, Charlottesville, Virginia) (Exhibit 10.1)10.3(9)**License Agreement No. DN-982, dated June 10, 2002, by and between the National Aeronautics and Space Administration (NASA) andLuna Innovations Incorporated; Modification No. 1 to License Agreement No. DN-982, dated January 23, 2006, by and between NASA andLuna Innovations Incorporated (Exhibit 10.22)10.4(9)**License Agreement No. DN-951, dated December 20, 2000, by and between NASA and Luna Technologies, Inc. (Exhibit 10.23)10.5(9)**Amended and Restated License Agreement, dated March 19, 2004, by and between Virginia Tech Intellectual Properties, Inc. and LunaInnovations Incorporated (Exhibit 10.26)10.6(13)Asset Transfer and License Agreement by and between Luna Innovations Incorporated and Coherent, Inc. (Exhibit 10.21)10.7(14)**Development and Supply Agreement, dated December 12, 2006, by and between Luna Innovations Incorporated and Intuitive Surgical,Inc. dated June 11, 2007 (Exhibit 10.1)10.8(15)Amendment to Commercial Lease, by and between Luna Innovations Incorporated and Canvasback Real Estate & Investments LLC datedMarch 18, 2008 (Exhibit 10.5)10.9(16)Confidential Settlement Agreement, dated as of December 11, 2009, by and between Luna Innovations, Inc. and Luna Technologies, Inc.and Hansen Medical, Inc. (Exhibit 10.26)10.10(6)Securities Purchase and Exchange Agreement, dated January 12, 2010, by and between Luna Innovations Incorporated and Carilion Clinic(Exhibit 10.1)70 Table of Contents10.11(6)Warrant No. 1 to Purchase Common Stock, dated January 13, 2010, issued to Carilion Clinic (Exhibit 10.2)10.12(6)Warrant No. 2 to Purchase Common Stock, dated January 13, 2010, issued to Carilion Clinic (Exhibit 10.3)10.13(6)Amended and Restated Investor Rights Agreement, dated January 13, 2010, by and among Luna Innovations Incorporated, Carilion Clinic,and certain stockholders of Luna Innovations Incorporated (Exhibit 10.4)10.14(17)Non-Employee Directors’ Deferred Compensation Plan (Exhibit 10.37)10.15(18)**License Agreement, effective January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc. and HansenMedical, Inc. (Exhibit 10.6)10.16(18)**Development and Supply Agreement, effective January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc.and Hansen Medical, Inc., as amended on February 17, 2010 and April 2, 2010 (Exhibit 10.7)10.17(18)**License Agreement, effective January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc. and IntuitiveSurgical, Inc. (Exhibit 10.8)10.18(18)**Amendments to Development and Supply Agreement, effective January 12, 2010 and April 27, 2010, by and between Luna InnovationsIncorporated and Intuitive Surgical, Inc. (Exhibit 10.9)10.19(18)Confidential Mutual Release, effective as of January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc. andHansen Medical, Inc. (Exhibit 10.13)10.20(18)Industrial Lease Agreement, dated as of March 21, 2006, by and between Luna Innovations Incorporated and the Economic DevelopmentAuthority of Montgomery County, Virginia, as amended by a First Amendment effective as of May 11, 2006, a Second Amendmenteffective as of July 15, 2009 and a Third Amendment effective as of March 23, 2010 (Exhibit 10.14)10.21(18)Lease for Riverside Center, dated December 30, 2005, by and between Carilion Medical Center and Luna Innovations Incorporated, asamended by an Amended Lease dated July 20, 2006, a Second Amendment dated on or about October 5, 2007 and a Third Amendmenteffective as of April 1, 2010 (Exhibit 10.15)10.22(18)Loan and Security Agreement, dated February 18, 2010, by and between Luna Innovations Incorporated, Luna Technologies, Inc. andSilicon Valley Bank (Exhibit 10.5)10.23(19)Third Amendment to Commercial Lease dated June 21, 2010, by and between Canvasback Real Estate & Investments, LLC and LunaInnovations, Incorporated (Exhibit 10.5)10.24(20)**Amendment No.3 to the Development Supply Agreement, dated as of September 2, 2010, by and between Luna Innovations Incorporatedand Intuitive Surgical, Inc. (Exhibit 10.5)10.25(21)First Loan Modification Agreement, dated as of March 7, 2011, by and between Luna Innovations Incorporated and Silicon Valley Bank(Exhibit 10.1)10.26(22)**Amendment No. 4 to the Development and Supply Agreement, dated as of March 23, 2011, by and between Luna Innovations Incorporatedand Intuitive Surgical, Inc. (Exhibit 10.2)10.27(22)Fourth Amendment to Industrial Lease Agreement, dated as of March 1, 2011, by and between The Economic Development Authority ofMontgomery County and Luna Innovations Incorporated (Exhibit 10.3)10.28(23)Second Loan Modification Agreement, dated as of May 18, 2011, by and between Luna Innovations Incorporated, Luna Technologies, Inc.and Silicon Valley Bank (Exhibit 10.1)10.29(24)Fifth Amendment to Industrial Lease Agreement, dated as of November 1, 2011, by and between The Economic Development Authority ofMontgomery County and Luna Innovations Incorporated10.30(24)Employment Agreement dated March 28, 2012, by and between My E. Chung and Luna Innovations Incorporated10.31(24)Employment Agreement dated March 28, 2012, by and between Dale E. Messick and Luna Innovations Incorporated10.32(24)Employment Agreement dated March 28, 2012, by and between Scott A. Graeff and Luna Innovations Incorporated10.33(25)**Amendment No. 5 to Development and Supply Agreement, dated as of March 22, 2012, by and between Luna Innovations Incorporatedand Intuitive Surgical, Inc. (Exhibit 10.1)10.34(26)Fourth Amendment to Commercial Lease, dated as of April 15, 2012, by and between Canvasback Real Estate & Investments, LLC andLuna Innovations Incorporated (Exhibit 10.3)10.35(27)Development Agreement, dated as of April 25, 2012, by and between Luna Innovations Incorporated and Philips Medical SystemsNederland BV (Exhibit 10.1)10.36(28)Third Loan Modification Agreement, dated as of May 17, 2012, by and between Luna Innovations Incorporated, Luna Technologies, Inc.and Silicon Valley Bank (Exhibit 10.1)10.37(29)Fourth Loan Modification Agreement, dated March 21, 2013, by and between Luna Innovations Incorporated, Luna Technologies, Inc. andSilicon Valley Bank (Exhibit 10.1)71 Table of Contents10.38(29)Fourth Amendment to Luna Innovations Lease of Riverside Center, dated March 21, 2013, by and between Carilion Clinic Properties, LLCand Luna Innovations Incorporated (Exhibit 10.2)10.39(30)**Amendment No. 6 to the Intuitive-Luna Development and Supply Agreement, dated December 15, 2012, by and between Luna InnovationsIncorporated and Intuitive Surgical Operations, Inc., a successor in interest to Intuitive Surgical, Inc. (Exhibit 10.2)10.40(30)**Amendment No. 7 to the Intuitive-Luna Development and Supply Agreement, entered into on June 28, 2013, by and between LunaInnovations Incorporated and Intuitive Surgical Operations, Inc., a successor in interest to Intuitive Surgical, Inc. (Exhibit 10.3)10.41(31)Fifth Amendment to Luna Innovations Lease of Riverside Center, dated December 13, 2013, by and between Carilion Clinic Properties,LLC and Luna Innovations Incorporated (Exhibit 10.44)10.42(3)**Cross-License Agreement by and among Luna Innovations Incorporated and Luna Technologies, Inc., and Intuitive Surgical Operations,Inc., and Intuitive Surgical international, Ltd., dated as of January 17, 2014 (Exhibit 10.2)10.43(3)**Consent, Release and Fifth Loan Modification Agreement between Luna Innovations incorporated and Silicon Valley Bank dated as ofJanuary 21, 2014 (Exhibit 10.3)10.44(32)Sixth Amendment to Industrial lease Agreement by and between the Economic Development Authority of Montgomery County, Virginiaand Luna Innovations Incorporated dated October 1, 201410.45(32)Industrial Lease Agreement by and between The Economic Development Authority of Montgomery County, Virginia and LunaInnovations Incorporated dated October 1, 201410.46(32)Lease Agreement by and between SBA Tenant, LLC and Luna Innovations Incorporated dated November 201410.47(33)Joinder, Consent, and Sixth Loan Modification Agreement between Luna Innovations Incorporated, Luna Technologies, Inc., AdvancedPhotonix, LLC and Silicon Valley Bank, dated as of May 8, 2015 (Exhibit 10.1)10.48(34)Joinder, Consent, and Seventh Loan Modification Agreement between Luna Innovations Incorporated, Luna Technologies, Inc., AdvancedPhotonix, LLC and Silicon Valley Bank, dated as of September 29, 2015 (Exhibit 10.1)10.49(35)First Amendment to Industrial Lease Agreement by and between the Economic Development Authority of Montgomery County, Virginiaand Luna Innovation Incorporated, dated January 20, 2015 (Exhibit 10.3)10.50(35)Sixth Amendment to Luna Innovations Lease of Riverside Center, dated January 20, 2015, by and between Carilion Clinic Properties, LLCand Luna Innovations Incorporated (Exhibit 10.4)10.51(36)Amended and Restated Non-Employee Director Compensation Policy, dated June 30, 2015 (Exhibit 10.1)10.52(37)Fifth Amendment to Commercial Lease by and between Canvasback Real Estate and Investments, LLC and the Registrant, dated as ofAugust 5, 2015 (Exhibit 10.2)10.53(38)Addendum to Asset Purchase Agreement, by and among Luna Innovations Incorporated, Intuitive Surgical Operations, Inc. and IntuitiveSurgical International, Ltd., dated as of December 22, 2015 (Exhibit 10.1)10.54Eighth Loan Modification Agreement, dated December 15, 2016, by and between Luna Innovations Incorporated, Luna Technologies, Inc.,Advanced Photonix, LLC and Silicon Valley Bank21.1(10)List of Subsidiaries (Exhibit 21.1)23.1Consent of Grant Thornton LLP, Independent Registered Public Accounting Firm24.1Power of Attorney (see signature page)31.1Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, asadopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, asadopted 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-OxleyAct 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-OxleyAct of 2002.101The following materials from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2016, are formatted in XBRL(eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at December 31, 2016 and 2015, (ii) Consolidated Statementsof Operations for the years ended December 31, 2016 and 2015, (iii) Consolidated Statements of Changes in Stockholder’s Equity for theyears ended December 31, 2016 and 2015 (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2016 and 2015,and (v) Notes to Audited Consolidated Financial Statements.72 Table of Contents(1)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on January 15, 2010(reporting under Items 1.03, 5.02 and 9.01). The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(2)Incorporated by reference to the Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 29, 2013. The numberin parentheses indicates the corresponding exhibit number in such Form 10-K.(3)Incorporated by reference to the exhibit to the Registrant's Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 13, 2014.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(4)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on February 2, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(5)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on June 8, 2006. Thenumber given in parentheses indicates the corresponding exhibit number in such Form 8-K.(6)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on January 15, 2010(reporting under Items 1.01, 3.02, 3.03, 5.03 and 9.01). The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(7)Incorporated by reference to the exhibit to the Registrant’s Registration Statement on Form S-1, Commission File No. 333-131764, filed onFebruary 10, 2006. The number given in parentheses indicates the corresponding exhibit number in such Form S-1.(8)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed with the Securitiesand Exchange Commission on May 10, 2010. The number in parentheses indicates the corresponding exhibit number in such Form 8-K.(9)Incorporated by reference to the exhibit to Amendment No. 5 of the Registrant’s Registration Statement on Form S-1, Commission File No. 333-131764, filed on April 19, 2006. The number given in parentheses indicates the corresponding exhibit number in such Form S-1.(10)Incorporated by reference to the exhibit to the Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 29, 2016.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(11)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on July 17, 2009(reporting under Items 1.01, 5.02 and 9.01). The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(12)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 15, 2007.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(13)Incorporated by reference to the exhibit to Amendment No. 1 to Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filedon April 6, 2007. The number given in parentheses indicates the corresponding exhibit number in such Form 10-K/A.(14)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on June 14, 2007.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(15)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 9, 2008. Thenumber given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(16)Incorporated by reference to the exhibit to Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 26, 2010.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(17)Incorporated by reference to the exhibit to Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 16, 2009.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(18)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 17, 2010.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(19)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 16, 2010.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(20)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on November 15,2010. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.73 Table of Contents(21)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on March 9, 2011.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(22)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 16, 2011.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(23)Incorporated by reference to the exhibit to Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 12, 2011.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(24)Incorporated by reference to the exhibit to the Registrant’s Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 29, 2012.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(25)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 10, 2012.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(26)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 9,2012. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(27)Incorporated by reference to the exhibit to the Registrant’s Amendment No. 1 to Quarterly Report on Form 10-Q, Commission File No. 000-52008,filed on August 10, 2012. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(28)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on July 11, 2012.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(29)Incorporated by reference to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on March 27, 2013. The numbergiven in parentheses indicates the corresponding exhibit number in such Form 8-K.(30)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 8,2013. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(31)Incorporated by reference to the exhibit to the Registrant's Annual Report on Form 10-K, Commission File No. 000-52008, filed on April 10, 2014.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(32)Incorporated by reference to the exhibit to the Registrant's Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 16, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(33)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on May 11, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(34)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on October 5, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(35)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on May 14, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(36)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on August 14, 2015.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(37)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on November 13,2015. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(38)Incorporated by reference to the exhibit to the Registrant’s Current Report on Form 8-K, Commission File No. 000-52008, filed on December 29,2015. The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(39)Incorporated by reference to the exhibit to the Registrant’s Registration Statement on Form S-8, Commission File No. 333-211802, filed on June 3,2016. The number given in parentheses indicates the corresponding exhibit number in such Form S-8.(40)Incorporated by reference to the exhibit to the Registrant’s Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 10,2016. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.74 Table of Contents*Confidential treatment has been granted with respect to portions of this exhibit, indicated by asterisks, which has been filed separately with theSecurities and Exchange Commission. Pursuant to Item 601(b)(2) of Regulation S-K, the schedules and exhibits to this agreement are omitted, butwill be furnished to the Securities and Exchange Commission upon request.**Confidential treatment has been granted with respect to portions of this exhibit, indicated by asterisks, which has been filed separately with theSecurities and Exchange Commission.***These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. Section 1350, and are not being filed forpurposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of the registrant, whethermade before or after the date hereof, regardless of any general incorporation language in such filing.75 Table of ContentsITEM 16.FORM 10-K SUMMARYNot applicable.SIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized. LUNA INNOVATIONS INCORPORATED By: /s/ Dale E. Messick Dale E. MessickChief Financial OfficerMarch 20, 2017KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Scott A. Graeff andDale E. Messick, and each of them acting individually, as his true and lawful attorneys-in-fact and agents, with full power of each to act alone, with fullpowers of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this AnnualReport on Form 10-K with all exhibits thereto and all documents in connection therewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, with full power of each to act alone, full power and authority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully for all intents and purposes as he might or could do in person, hereby ratifying and confirming all thatsaid attorneys-in-fact and agents, or his or their substitutes, may lawfully do or cause to be done by virtue hereof.Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.Signature Title Date /s/ My E. Chung President, Chief Executive Officer and Director (Principal ExecutiveOfficer) March 20, 2017My E. Chung /s/ Dale E. Messick Chief Financial Officer (Principal Financial Officer and PrincipalAccounting Officer) March 20, 2017Dale E. Messick /s/ Michael W. Wise Director March 20, 2017Michael W. Wise /s/ Donald Pastor Director March 20, 2017Donald Pastor /s/ John B. Williamson III Director March 20, 2017John B. Williamson III /s/ Gary Spiegel Director March 20, 2017Gary Spiegel /s/ Richard W. Roedel Chairman of the Board of Directors March 20, 2017Richard W. Roedel 76 EXHIBIT 10.54EIGHTH LOAN MODIFICATION AGREEMENTThis Eighth Loan Modification Agreement (this “Loan Modification Agreement”) is entered into as of December 15, 2016, by and between (i)SILICON VALLEY BANK, a California corporation with a loan production office located at 8020 Towers Crescent Drive, Suite 475, Vienna, Virginia22182 (“Bank”), (ii) LUNA INNOVATIONS INCORPORATED, a Delaware corporation (“Innovations”), LUNA TECHNOLOGIES, INC., a Delawarecorporation (“Technologies”), ADVANCED PHOTONIX, INC., a Delaware corporation (“API”), and PICOMETRIX, LLC, a Delaware limited liabilitycompany (“Picometrix”; Innovations, Technologies, API and Picometrix are referred to herein, individually and collectively, jointly and severally, as“Borrower”), each with offices located at 301 1st Street SW, Suite 200, Roanoke, Virginia 24011.1.DESCRIPTION OF EXISTING INDEBTEDNESS AND OBLIGATIONS. Among other indebtedness and obligations which may be owing by Borrower toBank, Borrower is indebted to Bank pursuant to a loan arrangement dated as of February 18, 2010, evidenced by, among other documents, a certain Loan andSecurity Agreement dated as of February 18, 2010, between Borrower and Bank, as amended by a certain First Loan Modification Agreement, dated as ofMarch 7, 2011, as further amended by a certain Second Loan Modification Agreement, dated as of May 18, 2011, as further amended by a certain Third LoanModification Agreement, dated as of June 1, 2012, as further amended by a certain Fourth Loan Modification Agreement, dated as of March 1, 2013, asfurther amended by a certain Consent, Release and Fifth Loan Modification Agreement, dated as of January 21, 2014, as further amended by a certain Joinder,Consent and Sixth Loan Modification Agreement, dated as of May 8, 2015, and as further amended by a certain Waiver and Seventh Loan ModificationAgreement, dated as of September 29, 2015 (as amended, the “Loan Agreement”). Capitalized terms used but not otherwise defined herein shall have thesame meaning as in the Loan Agreement.2. DESCRIPTION OF COLLATERAL. Repayment of the Obligations is secured by the Collateral as described in the Loan Agreement and in certainIntellectual Property Security Agreements executed by each Borrower in favor of Bank (collectively, the “IP Agreements”, and together with any othercollateral security granted to Bank, the “Security Documents”).Hereinafter, the Security Documents, together with all other documents evidencing or securing the Obligations shall be referred to as the “Existing LoanDocuments”.3. DESCRIPTION OF CHANGE IN TERMS.A.Modifications to Loan Agreement.1The Loan Agreement shall be amended by deleting the following text appearing as Section 6.9 thereof:“6.9 Financial Covenants.(a) Minimum Cash. Borrower shall maintain at all times, to be certified as of the last day of each month, unrestrictedcash at Bank of not less than Three Million Dollars ($3,000,000).(b) Liquidity Coverage Ratio. Borrower shall maintain at all times, to be certified as of the last day of each monthcommencing with the month ending on September 30, 2015, a Liquidity Coverage Ratio of greater than 1.50 to 1.00.(c) Minimum Adjusted EBITDA. Borrower shall achieve, measured as of the last day of each fiscal quarter during thefollowing periods, Adjusted EBITDA of at least (loss not worse than) the following:PeriodMinimum Adjusted EBITDATrailing three (3) month period endingSeptember 30, 2015($600,000)Trailing six (6) month period endingDecember 31, 2015($250,000)Trailing nine (9) month period ending March31, 2016($550,000)Trailing twelve (12) month period ending June30, 2016, and the last day of each fiscalquarter thereafter on a trailing twelve (12)month basis$1.00”and inserting in lieu thereof the following: “6.9 Financial Covenants.(a) Minimum Cash. Borrower shall maintain at all times, to be certified as of the last day of each month, unrestrictedcash at Bank of not less than (i) Five Million Dollars ($5,000,000) through and including June 30, 2017, (ii) Four Million Dollars($4,000,000) from July 1, 2017 through and including June 30, 2018, and (iii) Three Million Dollars ($3,000,000) at all timesthereafter.(b) Liquidity Coverage Ratio. Borrower shall maintain at all times, to be certified as of the last day of each month, aLiquidity Coverage Ratio of greater than 1.50 to 1.00.”2The Loan Agreement shall be amended by deleting the following definitions appearing in Section 13.1 thereof:“Adjusted EBITDA” shall mean (a) Net Income, plus (b) Interest Expense, plus (c) to the extent deducted in the calculation of NetIncome, depreciation expense and amortization expense, plus (d) income tax expense, plus (e) to the extent deducted in thecalculation of Net Income, non-cash stock compensation expense, plus (f) to the extent paid by Borrower, up to $2,700,000 paidby Borrower to the Defense Contract Management Agency (“DCMA”) as refunds for overpayments by the DCMA, minus (g)Unfinanced Capital Expenditures, including, without limitation, capitalized Intellectual Property.“Capital Expenditures” means, with respect to any person for any period, the sum of (a) the aggregate of all expenditures by suchPerson and its Subsidiaries during such period that are capital expenditures as determined in accordance with GAAP, whether suchexpenditures are paid in cash or financed, plus (b) to the extent not covered by clause (a), the aggregate of all expenditures by suchPerson and its Subsidiaries during such period to acquire by purchase or otherwise the business or capitalized assets or the capitalstock of any other Person.“Interest Expense” means for any fiscal period, interest expense (whether cash or non-cash) determined in accordance with GAAPfor the relevant period ending on such date, including, in any event, interest expense with respect to any Credit Extension andother Indebtedness of Borrower and its Subsidiaries, if any, including, without limitation or duplication, all commissions,discounts, or related amortization and other fees and charges with respect to letters of credit and bankers’ acceptance financing andthe net costs associated with interest rate swap, cap, and similar arrangements, and the interest portion of any deferred paymentobligation (including leases of all types).“Net Income” means, as calculated on a consolidated basis for Borrower and its Subsidiaries, if any, for any period as at any date ofdetermination, the net profit (or loss), exclusive of any extraordinary gains, after provision for taxes, of Borrower and itsSubsidiaries for such period taken as a single accounting period.“Unfinanced Capital Expenditures” means, with respect to any Person for any period, the aggregate of all Capital Expendituresby such Person and its Subsidiaries during such period that are paid in cash and are not financed or funded using proceeds from (a)the issuance of additional equity interests of Borrower, (b) Credit Extensions, (c) Subordinated Debt, (d) specific equipmentfinancing, (e) asset sales, (f) insurance proceeds, or (g) government grants or other incentives, and in each instance determined inaccordance with GAAP.3The Compliance Certificate appearing as Exhibit B to the Loan Agreement is hereby replaced with the Compliance Certificate inthe form of Exhibit B attached hereto.4. FEES. Borrower shall reimburse Bank for all legal fees and expenses incurred in connection with this amendment to the Existing Loan Documents.5. RATIFICATION OF IP AGREEMENTS. Borrower hereby ratifies, confirms and reaffirms, all and singular, the terms and conditions of the IP Agreements,and acknowledges, confirms and agrees that said IP Agreements contain an accurate and complete listing of all Intellectual Property Collateral as defined ineach respective IP Agreement, and each remains in full force and effect. Notwithstanding the terms and conditions of any of the IP Agreements, Borrower shallnot register any Copyrights or Mask Works in the United States Copyright Office unless it: (i) has given at least fifteen (15) days’ prior written notice to Bankof its intent to register such Copyrights or Mask Works and has provided Bank with a copy of the application it intends to file with the United StatesCopyright Office (excluding exhibits thereto); (ii) executes a security agreement or such other documents as Bank may reasonably request in order tomaintain the perfection and priority of Bank’s security interest in the Copyrights proposed to be registered with the United States Copyright Office; and (iii)records such security documents with the United States Copyright Office contemporaneously with filing the Copyright application(s) with the United StatesCopyright Office. Borrower shall promptly provide to Bank a copy of the Copyright application(s) filed with the United States Copyright Office, togetherwith evidence of the recording of the security documents necessary for Bank to maintain the perfection and priority of its security interest in such Copyrightsor Mask Works. Borrower shall provide written notice to Bank of any application filed by Borrower in the United States Patent Trademark Office for a patentor to register a trademark or service mark within thirty (30) days of any such filing.6. RATIFICATION OF PERFECTION CERTIFICATE. Borrower hereby ratifies, confirms and reaffirms, all and singular, the terms and disclosures containedin that certain Perfection Certificate dated as of May 8, 2015, and acknowledges, confirms and agrees the disclosures and information provided to Bank in such Perfection Certificate remains true and correct in all material respects as of the date hereof.7. AUTHORIZATION TO FILE. Borrower hereby authorizes Bank to file UCC financing statements without notice to Borrower, with all appropriatejurisdictions, as Bank deems appropriate, in order to further perfect or protect Bank’s interest in the Collateral, including a notice that any disposition of theCollateral, by either the Borrower or any other Person, shall be deemed to violate the rights of the Bank under the Code.8. CONSISTENT CHANGES. The Existing Loan Documents are hereby amended wherever necessary to reflect the changes described above.9. RATIFICATION OF LOAN DOCUMENTS. Borrower hereby ratifies, confirms, and reaffirms all terms and conditions of the Loan Agreement (as modifiedby this Loan Modification Agreement), and all security or other collateral granted to the Bank, and confirms that the indebtedness secured thereby includes,without limitation, the Obligations.10. NO DEFENSES OF BORROWER. Borrower hereby acknowledges and agrees that Borrower has no offsets, defenses, claims, or counterclaims againstBank with respect to the Obligations, or otherwise, and that if Borrower now has, or ever did have, any offsets, defenses, claims, or counterclaims againstBank, whether known or unknown, at law or in equity, all of them are hereby expressly WAIVED and Borrower hereby RELEASES Bank from any liabilitythereunder.11. CONTINUING VALIDITY. Borrower understands and agrees that in modifying the existing Obligations, Bank is relying upon Borrower’srepresentations, warranties, and agreements, as set forth in the Existing Loan Documents. Except as expressly modified pursuant to this Loan ModificationAgreement, the terms of the Existing Loan Documents remain unchanged and in full force and effect. Bank’s agreement to modifications to the existingObligations pursuant to this Loan Modification Agreement in no way shall obligate Bank to make any future modifications to the Obligations. Nothing inthis Loan Modification Agreement shall constitute a satisfaction of the Obligations. It is the intention of Bank and Borrower to retain as liable parties allmakers of Existing Loan Documents, unless the party is expressly released by Bank in writing. No maker will be released by virtue of this Loan ModificationAgreement.12. JURISDICTION/VENUE. Section 11 of the Loan Agreement is hereby incorporated by reference in its entirety.13. COUNTERSIGNATURE. This Loan Modification Agreement shall become effective only when it shall have been executed by Borrower and Bank.14. EFFECTIVENESS. As a condition precedent to the effectiveness of this Loan Modification Agreement and Bank’s obligation to make the Term Loan,Bank shall have received the following prior to or concurrently with this Loan Modification Agreement, each in form and substance satisfactory to Bank:A.this Loan Modification Agreement duly executed on behalf of Borrower;B.certified copies, dated as of a recent date, of financing statement and other lien searches of each Borrower, as Bank may request and whichshall be obtained by Bank, accompanied by written evidence (including any UCC termination statements) that the Liens revealed in anysuch searched either (i) will be terminated prior to or in connection with the Agreement, or (ii) in the sole discretion of Bank, will constitutePermitted Liens;C.Borrower’s payment of the fees set forth in Section 5 above; andD.such other documents as Bank may reasonably request.[Signatures included on the following page]IN WITNESS WHEREOF, the parties hereto have caused this Loan Modification Agreement to be executed as a sealed instrument under the lawsof the Commonwealth of Massachusetts as of the date first above written.BORROWER:LUNA INNOVATIONS INCORPORATEDBy /s/ Scott A. Graeff Name: Scott A. Graeff Title: CSO & Treasurer LUNA TECHNOLOGIES, INC.By /s/ Scott A. GraeffName: Scott A. Graeff Title: PresidentADVANCED PHOTONIX, INC.By /s/ Dale E. Messick Name: Dale E. Messick Title: President PICOMETRIX, LLCBy /s/ Dale E. Messick Name: Dale E. Messick Title: PresidentBANK:SILICON VALLEY BANKBy: /s/ Alicia Fuller Name: Alicia Fuller Title: Director EXHIBIT BCOMPLIANCE CERTIFICATETO: SILICON VALLEY BANK Date: FROM: LUNA INNOVATIONS INCORPORATED, et alThe undersigned authorized officer of Luna Innovations Incorporated, Luna Technologies, Inc., Advance Photonix, Inc., and Picometrix, LLC (individuallyand collectively, jointly and severally, the “Borrower”) certifies that under the terms and conditions of the Loan and Security Agreement between Borrowerand Bank (the “Agreement”), (1) Borrower is in complete compliance for the period ending _______________ with all required covenants except as notedbelow, (2) there are no Events of Default, (3) all representations and warranties in the Agreement are true and correct in all material respects on this dateexcept as noted below; provided, however, that such materiality qualifier shall not be applicable to any representations and warranties that already arequalified or modified by materiality in the text thereof; and provided, further that those representations and warranties expressly referring to a specific dateshall be true, accurate and complete in all material respects as of such date, (4) Borrower, and each of its Subsidiaries, has timely filed all required tax returnsand reports, and Borrower has timely paid all foreign, federal, state and local taxes, assessments, deposits and contributions owed by Borrower except asotherwise permitted pursuant to the terms of Section 5.9 of the Agreement, and (5) no Liens have been levied or claims made against Borrower or any of itsSubsidiaries, if any, relating to unpaid employee payroll or benefits of which Borrower has not previously provided written notification to Bank. Attached arethe required documents supporting the certification. The undersigned certifies that these are prepared in accordance with GAAP consistently applied fromone period to the next except as explained in an accompanying letter or footnotes. The undersigned acknowledges that no borrowings may be requested atany time or date of determination that Borrower is not in compliance with any of the terms of the Agreement, and that compliance is determined not just atthe date this certificate is delivered. Capitalized terms used but not otherwise defined herein shall have the meanings given them in the Agreement.Please indicate compliance status by circling Yes/No under “Complies” column. Reporting CovenantRequiredComplies Monthly financial statements with Compliance CertificateMonthly within 30 daysYes No10‑Q, 10‑K and 8-KWithin 5 days after filing with SECYes NoProjectionsFYE within 30 days, and as amendedYes NoA/R & A/P AgingsMonthly within 30 daysYes No The following Intellectual Property was registered after the Effective Date (if no registrations, state “None”)____________________________________________________________________________Financial CovenantRequiredActualComplies Maintain as indicated: Minimum Cash**$_______Yes NoLiquidity Coverage Ratio>1.50:1.00:1.00Yes No**See Section 6.9(a)The following financial covenant analyses and information set forth in Schedule 1 attached hereto are true and accurate as of the date ofthis Certificate.The following are the exceptions with respect to the certification above: (If no exceptions exist, state “No exceptions to note.”)---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------LUNA INNOVATIONS INCORPORATEDLUNA TECHNOLOGIES, INC.ADVANCED PHOTONIX, INC.PICOMETRIX, LLCBy: Name: Title: BANK USE ONLYReceived by: _____________________AUTHORIZED SIGNERDate: _________________________Verified: ________________________AUTHORIZED SIGNERDate: _________________________Compliance Status: Yes NoSchedule 1 to Compliance CertificateFinancial Covenants of BorrowerI. Minimum Cash (Section 6.9(a))Required:Borrower shall maintain at all times, to be certified as of the last day of each month, unrestricted cash at Bank of not less than (i) FiveMillion Dollars ($5,000,000) through and including June 30, 2017, (ii) Four Million Dollars ($4,000,000) from July 1, 2017 through andincluding June 30, 2018, and (iii) Three Million Dollars ($3,000,000) at all times thereafter.Actual:A.Aggregate value of Borrower’s unrestricted cash at Bank$ Is line A equal to or greater than $_________________? No, not in compliance Yes, in complianceII. Liquidity Coverage Ratio (Section 6.9(b))Required:Borrower shall maintain at all times, to be certified as of the last day of each month, a Liquidity Coverage Ratio of greater than 1.50 to 1.00.Actual:A.Aggregate value of Borrower’s unrestricted cash at Bank$ B.Net accounts receivable of Borrower$ C.Line B multiplied fifty percent (60%)$ D.Line A. plus Line C$ E.Aggregate of all Obligations owing to Bank, including, without limitation, all issued and outstanding letters of credit$ F.Line D divided by Line E$ Is Line F greater than 1.50? No, not in compliance Yes, in compliance EXHIBIT 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated March 20, 2017, with respect to the consolidated financial statements and schedule included in theAnnual Report of Luna Innovations Incorporated on Form 10-K for the year ended December 31, 2016. We consent to theincorporation by reference of said report in the Registration Statements of Luna Innovations Incorporated on Form S-3 (File No. 333-191809), Form S-4 (File NO. 333-2001956) and on Forms S-8 (File No. 333-211802, File No. 333-204435 and File No. 333-138745)./s/ GRANT THORNTON LLPArlington, VirginiaMarch 20, 2017 Exhibit 31.1CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, My E. Chung, certify that:1.I have reviewed this annual report on Form 10-K of Luna Innovations Incorporated;2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in ExchangeAct Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for theregistrant and have:a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared;b.designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles;c.evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; andd.disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely tomaterially affect, the registrant’s internal control over financial reporting; and5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; andb.any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 20, 2017 /S/ MY E. CHUNG My E. Chung President and Chief Executive Officer(principal executive officer) Exhibit 31.2CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Dale E. Messick, certify that:1.I have reviewed this annual report on Form 10-K of Luna Innovations Incorporated;2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in ExchangeAct Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for theregistrant and have:a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, toensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within thoseentities, particularly during the period in which this report is being prepared;b.designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principles;c.evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; andd.disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recentfiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely tomaterially affect, the registrant’s internal control over financial reporting; and5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonablylikely to adversely affect the registrant’s ability to record, process, summarize and report financial information; andb.any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controlover financial reporting.Date: March 20, 2017 /S/ DALE E. MESSICK Dale E. Messick Chief Financial Officer(principal financial officer) Exhibit 32.1CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002In connection with the annual report of Luna Innovations Incorporated (the “Company”) on Form 10-K for the year ended December 31, 2016 as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), I, My E. Chung, President and Chief Executive Officer of the Company, certify,pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.This certification accompanies this Report to which it relates, shall not be deemed “filed” with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended(whether made before or after the date of the Report), irrespective of any general incorporation language contained in such filing. /S/ MY E. CHUNG My E. Chung President and Chief Executive Officer(principal executive officer) March 20, 2017 Exhibit 32.2CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002In connection with to the annual report of Luna Innovations Incorporated (the “Company”) on Form 10-K for the year ended December 31, 2016 as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), I, Dale E. Messick, Chief Financial Officer of the Company, certify, pursuant to18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.This certification accompanies this Report to which it relates, shall not be deemed “filed” with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended(whether made before or after the date of the Report), irrespective of any general incorporation language contained in such filing. /S/ DALE E. MESSICK Dale E. Messick Chief Financial Officer(principal financial officer) March 20, 2017
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