Luna Innovations
Annual Report 2017

Plain-text annual report

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, 2017OR¨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, 2017, based upon theclosing price of Common Stock on such date as reported by the NASDAQ Capital Market, was approximately $40.1 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, 2018 therewere 28,356,322 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, 2017, 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, 2017TABLE OF CONTENTS PART I Item 1.Business1Item 1A.Risk Factors9Item 1B.Unresolved Staff Comments25Item 2.Properties25Item 3.Legal Proceedings25Item 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 Risk39Item 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 Summary74SIGNATURES74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 high performance fiber optic testproducts for the telecommunications industry and distributed fiber optic sensing for the aerospace and automotive industries. Our distributed fiber opticsensing products provide critical stress, strain and temperature information to designers and manufacturers working with composite and other advancedmaterials. Our communications test products accelerate the development of advanced fiber optic components and networks by providing fast and highlyaccurate characterization of components and networks. In addition, we develop and manufacture custom optoelectronic products that are sold to scientific orindustrial instrumentation manufacturers and to defense contractors for various applications such as metrology, missile guidance, flame monitoring, andtemperature sensing. We also provide applied research services, typically under research programs funded by the U.S. government, in areas of advancedmaterials, sensing, and healthcare applications. Our business model is designed to accelerate the process of bringing new and innovative products to market.We use our in-house technical expertise across a range of technologies to perform applied research services for companies and for government fundedprojects. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth.We are organized into two main business segments, 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 60% and 61% of our totalrevenues for the years ended December 31, 2017 and 2016, 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 40% and 39% of our total revenues for the years ended December 31, 2017 and2016, 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, 2017, approximately 37% of our total revenues were generated under the SBIR program, compared to 34% for the yearended December 31, 2016.For the years ended December 31, 2017 and 2016, 48% and 41%, respectively, of our total revenues were derived from the U.S. government.Merger with Advanced Photonix, Inc. and Subsequent Sale of HSOR BusinessOn 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 ("HSOR"), customoptoelectronic sub systems and Terahertz instrumentation, serving the test & measurement, telecommunications, military/aerospace and medical markets. APIhad manufacturing facilities located in Camarillo, California and Ann Arbor, Michigan, both of which have remained in operation following the merger.On August 9, 2017, we completed the sale of the HSOR business, which we had acquired as part of the merger with API, to an unaffiliated third partyfor an initial purchase price of $33.5 million, of which $29.5 million in cash has been received, and $4.0 million was placed into escrow until December 15,2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations.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 provide fiber optic test & measurement products which provide solutions primarily for the telecommunications industry marketed under theLuna Technologies brand. We also market our ODiSI platform of products for distributed sensing of strain and temperature utilizing optical fiber.Our key initiative for long term growth is to become a leading provider of fiber optic test and measurement equipment, including products for strainand temperature sensing systems and standard test methods based upon the ODiSI product platform and products for the characterization of high speed fiberoptic components and networks, including the growing silicon photonics market. Our primary product lines in our Products and Licensing segment aredescribed 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.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 partners worldwide. We have a regional sales force that markets and sellsour products through manufacturer representative organizations to customers in North America and through partner and distribution channels for other salesaround the world. We have a dedicated sales force for direct marketing of our distributed sensing products, with an initial focus on customers in theautomotive, aerospace, and energy industries.We market our THz instruments and our optoelectronic components or sub-assemblies primarily to original equipment manufacturers through a mix oftechnical sales engineers, value added resellers, and independent sales representatives. We3Table of Contentsmarket these products and capabilities through industry specific channels, 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 $18.6 million and $16.3 millionfor the years ended December 31, 2017 and 2016, 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 $225,000 and Phase II proof-of-concept contracts, which can be as high as $1,500,000. 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.Intellectual 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 to4Table of Contentsour proprietary technology and enter into confidentiality and invention assignment agreements with our employees and consultants and confidentialityagreements 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 247 U.S. and international patents and approximately 268 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 2018 and 2037. The patents scheduled to expire in 2018 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 betweenMarch 2020 and September 2020.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") in2014, we transferred our related patents to Intuitive. Also as a part of this transaction, we entered into a revocable license agreement with Intuitive pursuant towhich we 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 incertain non-robotic medical fields. Two U.S. patents that we now license back from Intuitive cover the use of optical frequency domain reflectometry andmultiple, closely spaced Bragg gratings for shape sensing, and the use of the inherent scatter as a strain sensor for shape sensing. These two patents expire inJuly 2025. We also have a license back from Intuitive for a patent application that covers certain refinements to the measurements covered in the first twopatents, which are necessary in order to achieve the necessary accuracies for medical and other applications. This patent application was filed in the UnitedStates, the European Patent Office, China, India, Russia, Brazil, Japan and Indonesia. These patents and patent applications can support other nonmedicalapplications of our fiber optic 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) 769-8400.5Table of ContentsMaterial AgreementsSale of Assets to Intuitive SurgicalOn January 17, 2014, we sold to Intuitive Surgical substantially all of our assets related to our medical shape sensing business, including all of thepatents and patent applications used or useful for our fiber optical shape sensing and localization technology. We had been engaged since 2007 in adevelopment project for Intuitive developing a fiber optic-based shape sensing and position tracking system to be integrated into Intuitive’s products. Alsoas a part of the Intuitive transaction, Intuitive has hired certain of our employees, many of whom were historically engaged in this development project.In connection with the Intuitive transaction, we and Intuitive entered into a license agreement under which we received a license back to all of ourtransferred technology outside the field of medicine and in respect of our existing non-shape sensing products in certain non-robotic medical fields. Thelicense back to us outside the medical field is exclusive to us except that Intuitive retained certain non-sublicensable rights for itself. This license back to usis revocable if we were, after notice and certain time periods, (i) to challenge the validity or enforceability of the transferred patents and patent applications,(ii) to commercialize our fiber optical shape sensing and localization technology in the field of medicine (except to perform on a development and supplyproject for Hansen Medical, Inc. ("Hansen")), (iii) to violate our obligations related to our ability to sublicense in the field of medicine or (iv) to violate ourconfidentiality obligations in a manner that advantages a competitor in the field of medicine and not cure such violation. As a part of the Intuitivetransaction, we retained assets and rights necessary to perform on our development and supply project for Hansen if that project is re-started.Also, as a part of the Intuitive transaction, for a period of 15 years after closing, we agreed to exit and not develop or commercialize our fiber opticalshape sensing 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 Intuitive transaction, including the key employees being hired, to compete with us outside the fieldof medicine 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.Sale of High Speed Optical Receiver ("HSOR") BusinessOn August 9, 2017, we completed the sale of our HSOR business, which was part of our Products and Licensing segment, to an unaffiliated third partyfor an initial purchase price of $33.5 million, of which $29.5 million in cash has been received, and $4.0 million was placed into escrow until December 15,2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations (the"Transaction"). The HSOR business was a component of the operations of Advanced Photonix, Inc., which we acquired in May 2015. As part of theTransaction, the buyer also hired approximately 49 of our employees who were engaged in the development, manufacture, and sale of HSOR products inaddition to certain corporate administrative functions. We and the buyer entered into a transition services agreement under which each party agreed toprovide certain transition services to the other with respect to infrastructure and administration. In connection with the transition services agreement, we paid$0.3 million per month for a period of five months, for a total of $1.5 million, ending in December 2017. We have recorded these payments as a reduction ofthe value of the purchase price. CoherentIn December 2006, we entered into an asset transfer and license agreement with Coherent, Inc. Under the agreement, we acquired the rights tomanufacture Coherent’s “Iolon” brand of swept tunable lasers as well as certain manufacturing equipment and inventory previously used by Coherent tomanufacture the lasers. We continue to enhance, produce, and market these lasers under our “Phoenix” brand. Under this agreement, Coherent granted non-exclusive licenses to us for certain U.S. patents and other intellectual property rights owned or controlled by Coherent for making, having made, using,importing, selling and offering for sale the lasers. This agreement expired in 2016. However, the patent licenses became fully paid and perpetual, as wefulfilled our royalty obligations during the 10-year period and the license to the other intellectual property rights is perpetual. These U.S. patents expirebetween 2020 and 2025. As consideration, we paid Coherent a total of $1.3 million in addition to paying royalties 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$78,000 for 2016 product sales. 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, and6Table of Contentsdistributed measurement of shape. We currently use these lasers within our ODiSI platform of products, our fiber optic shape sensing products and certain ofour backscatter reflectometer products, and we also sell variations of the Phoenix laser as standalone products. Under our agreements related to our sale ofassets to Intuitive, we have certain obligations to supply Intuitive with these lasers and Intuitive has certain rights to require us to transfer and assign thisCoherent license to Intuitive, in which case Intuitive would be similarly required to supply us with lasers.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.We 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 as7Table of Contentsoutstanding 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, 2017, we, including all of our divisions, had 198 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 our ability to expand facilities and pursue certain technologies, as well as require us toacquire costly equipment or to incur potentially significant costs to comply 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, 2017, we had approximately 198 total employees, including approximately 109 in research, development and engineeringpositions, approximately 48 in operations, approximately 16 in sales and marketing, and approximately 25 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 $23.5 million and $17.6 million at December 31,2017 and 2016, 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$5.5 million and $2.1 million as of December 31, 2017 and 2016, 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.8Table of ContentsOur backlog of purchase orders received for which the related goods have not been shipped or recognized as revenue within our Products and Licensingsegment was $6.9 million and $7.2 million at December 31, 2017 and 2016, respectively.Research, Development and EngineeringWe incur research, development and engineering expenses that are not related to our contract performance. These expenses were $3.5 million for theyears ended December 31, 2017 and 2016. In addition, during these years, we spent $14.0 million and $12.5 million, respectively, on customer-sponsoredresearch 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 14 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.ITEM 1A. RISK FACTORSYou 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 sub-license 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.9Table of ContentsWe 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.As a provider of contract research to the U.S. government, we are subject to federal rules, regulations, audits and investigations, the violation or failure 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. On November 29, 2017, ASBCA ruled that theclaimed costs were unallowable for reimbursement but were not considered to be expressly unallowable under the FAR, and accordingly were not subject tothe penalties assessed by the DCMA. The ruling is subject to appeal by DCMA. If DCMA were to successfully appeal the ruling, the assessment of penaltiescould have a material adverse effect on our operating results and cash 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 penalties10Table of Contentsincluding monetary fines, assessments, loss of the ability to do business with the U.S. government and certain other criminal penalties.We may also be prohibited from commercially selling certain products that we develop under our Technology Development segment or 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, 2017, 37% of our total revenues were generated under the SBIR program, compared to 34% in for theyear ended December 31, 2016.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, 2017, we had approximately 198 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 we do not believe that Carilion has or had the power to control our company, we cannot assure you that the SBA will interpret itsregulations in our favor on this question. If the SBA were to make a determination that we are or were affiliated with Carilion, we would exceed the sizelimitations, as Carilion has over 500 employees. In that case, we would lose eligibility for new SBIR contracts and grants and other awards that are set asidefor small businesses based on the criterion of number of employees, and the relevant government agency would have the discretion to suspend performanceon existing SBIR grants. The loss of our eligibility to receive SBIR awards would have a material adverse impact on our revenues, cash flows and our abilityto 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 40% and 39% of our total revenuesfor the years ended December 31, 2017 and 2016, 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.11Table of ContentsIn 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 adverse effect on our business. Any loss of key personnel could have a material adverse effect on our ability to meet keyoperational objectives, such as timely and effective project milestones and product introductions, which in turn could adversely affect our business, results ofoperations 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 the12Table of Contentsglobal economy or a future downturn in the telecommunications industry may cause our results of operations to fluctuate from quarter-to-quarter and year-to-year, harm our business, and may increase the volatility of the price of our common stock.Customer acceptance of our products is dependent on our ability to meet changing requirements, and any decrease in acceptance could adversely 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.Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and results of operations to suffer.We design products to conform to our customers’ requirements and our customers’ systems may be subject to regulations established by governments 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. 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 our optoelectronicproducts 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 optoelectronic business is dependent upon our success infinding new customers and receiving new orders from existing customers.13Table of ContentsIn 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 optoelectronics products prior to qualification of the products and satisfactory completion of factory auditsand vendor evaluation. Our existing products, as well as each new product, must pass through varying levels of qualification with our customers. In addition,because of the rapid technological changes in some markets, a customer may cancel or modify a design project before we begin large-scale manufacturingand receiving revenues from the customer. It is difficult to predict with any certainty whether our customers will delay or terminate product qualification orthe frequency with which customers will cancel or modify their projects. Any such delay, cancellation or modification could have a negative effect on ourresults of operations.In addition, once a customer qualifies a particular supplier’s product or component, these potential customers design the product into their system,which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least theadoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as doing socould involve significant additional redesign efforts and increased costs. If we fail to achieve design-in wins in potential customers’ qualification processes,we will likely lose the opportunity for significant sales to those customers for a lengthy period of time.If the end user customers that purchase systems from our customers fail to qualify or delay qualifications of any products sold by our customers 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 may be responsible for all finished goods, all costs, direct and indirect, incurred by us, aswell as a reasonable allowance for anticipated profits. No assurance can be given that we will receive these amounts after cancellation. Furthermore,uncertainty in customer forecasts of their demands and other factors may lead to delays and disruptions in manufacturing, which could result in delays inproduct shipments to customers and could adversely affect our business.Fluctuations and changes in customer demand are common in our business. Such fluctuations, as well as quality control problems experienced 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 schedules14Table of Contentsrequested by our customers or could be canceled, which would negatively affect our sales, operating income, strategic position at customers, market share andreputation. In addition, disruptions, delays or cancellations could cause inefficient production which in turn could result in higher manufacturing costs, loweryields 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.We 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 less than $0.1 million and a net loss from continuing operations of $2.7 million for the years endedDecember 31, 2017 and 2016, respectively. We expect to continue to incur significant expenses as we pursue our strategic initiatives, including increasedexpenses for research and development, sales and marketing and manufacturing. We may also grow our business in part through acquisitions of additionalcompanies and complementary technologies which could cause us to incur greater than anticipated transaction expenses, amortization or write-offs ofintangible assets and other acquisition-related expenses. As a result, we may incur net losses for the foreseeable future, and these losses could be substantial.At a certain level, continued net losses could impair our ability to comply with NASDAQ continued listing standards, as described further below.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 sensing products, develop and commercialize innovative technologies, expand our contract research capabilities and sellthe products that result from those development initiatives. We are unable to predict when or if we will be able to achieve profitability. If our revenues do notincrease, or if our expenses increase at a greater rate than our revenues, we will continue to experience losses. Even if we do achieve profitability, we may notbe 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 $4.0 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.15Table of ContentsWe 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 licensingto 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.16Table of ContentsFailure 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;•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;17Table of Contents•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.We could be negatively affected by a security breach, either through cyber-attack, cyber-intrusion or other significant disruption of our IT networks andrelated systems.18Table of ContentsWe 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. To date, we have not experienced a significant cyber-intrusion or cyber-attack. There can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not besuccessful 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.Our 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 systems19Table of Contentsregulations. We are also required to comply with International Organization for Standardization ("ISO"), quality system standards in order to produce certainof our products for sale in Europe. If we fail to continue to comply with Good Manufacturing Practice requirements or ISO standards, we may be required tocease all or part of our operations until we comply with these regulations. Obtaining and maintaining such compliance is difficult and costly. We cannot becertain that our facilities will be found to comply with Good Manufacturing Practice requirements or ISO standards in future inspections and audits byregulatory authorities. In addition, if we cannot maintain or establish manufacturing facilities or operations that comply with such standards or do not meetthe expectations of our customers, we may not be able to realize certain economic opportunities in our current or future supply arrangements.Medical products are subject to various international regulatory processes and approval requirements. If we do not obtain and maintain the 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 currently in the early stages of development because we cannot predict which ofthese products will ultimately reach the commercial market or whether the commercial versions of these products will incorporate proprietary technologies.20Table of ContentsOur 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 time been, and may in the futurebe, contacted by third parties, including patent assertion entities or intellectual property advisors, about licensing opportunities that also contain claims thatwe are infringing on third party patent rights. If third parties assert21Table of Contentsthese claims against us, we could incur extremely substantial costs and diversion of management resources in defending these claims, and the defense of theseclaims 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 thirdparty’s patent rights, we may have to settle a claim on unfavorable terms because we cannot afford to litigate the claim. In addition, if third parties assertclaims against us and we are unsuccessful in defending against these claims, these third parties may be awarded substantial damages as well as injunctive orother equitable relief against us, which could effectively block our ability to make, use, sell, distribute or market our products and services in the UnitedStates 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.In the past, we have licensed certain technologies for use in our products. In the future, we may choose, or be required, to license technology orintellectual property from third parties in connection with the development of our products. We cannot22Table of Contentsassure you that third-party licenses will be available on commercially reasonable terms, if at all. Our competitors may be able to obtain licenses, or cross-license their technology, on better terms than we can, which could put us at a competitive disadvantage. Also, we often enter into confidentiality agreementswith such third parties in which we agree to protect and maintain their proprietary and confidential information, including at times requiring our employeesto enter into agreements protecting such information. There can be no assurance that the confidentiality agreements will not be breached by any of ouremployees or that such third parties will not make claims that their proprietary information has been disclosed.RISKS RELATING TO OUR COMMON STOCKThe United States Tax Cuts and Jobs Act of 2017 could adversely affect our business and financial condition.The U.S. Tax Cuts and Jobs Act (the "TCJA") significantly reforms the US Internal Revenue Code. The TCJA, among other things, contains significantchanges to U.S. federal corporate income taxation, including reduction of the U.S. federal corporate income tax rate from a top marginal rate of 35% to a flatrate of 21%, limitation of the tax deduction for interest expense to 30% of adjusted earnings (except for certain small businesses), limitation of the deductionfor net operating losses to 80% of current year taxable income and elimination of net operating loss carrybacks, immediate deductions for certain newinvestments instead of deductions for depreciation expense over time, and modifying or repealing many business deductions and credits. Federal netoperating losses arising in taxable year ending after December 31, 2017, will be carried forward indefinitely pursuant to the TCJA. We continue to examinethe impact this tax reform legislation may have on our business. Notwithstanding the reduction in the corporate income tax rate, the overall impact of theTCJA is uncertain and our business and financial condition could be adversely affected. The impact of this tax reform on holders of our common stock is alsouncertain and could be adverse. We urge our stockholders to consult with their legal and tax advisors with respect to such legislation and the potential taxconsequences of investing in our common stock.If there are substantial sales of our common stock, or the perception that such sales may occur, our stock price could decline.If any of our stockholders were to sell substantial amounts of our common stock, the market price of our common stock may decline, which might 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 us23Table of Contentsthat we have 180 days to regain compliance by maintaining a minimum bid price of at least $1.00 for a minimum of ten consecutive business days. Undercertain circumstances, NASDAQ could require that the minimum bid price exceed $1.00 for more than ten consecutive days before determining that acompany complies.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.The 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.24Table of ContentsAnti-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;and•the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.We are also subject to provisions of the Delaware General Corporation law that, in general, prohibit any business combination with a beneficial 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 11,000 square feet of space in Ann Arbor, Michigan, for research, development and manufacturing of our THz productplatform. This lease expires December 31, 2018.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 900 square feet of space in Quebec, Canada for sales related functions. This lease expires in April 30, 2020.We own a 24,000 square foot facility in Danville, Virginia for use by certain groups in our Technology Development segment.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 Defense Contract Management Agency ("DCMA") regarding the allowability ofcertain costs we included in our billings under cost-plus type research contracts during 2007. In25Table of Contentsconjunction with DCMA's determination of those costs as expressly unallowable under the provisions of the Federal Acquisition Regulations ("FAR"),DCMA assessed penalties and interest to us totaling $1.1 million. In July 2015, we filed an appeal of the assessed penalties and interest with the ArmedServices Board of Contract Appeals ("ASBCA"). A hearing was held with respect to this appeal in January 2017. On November 29, 2017, ASBCA ruled thatthe claimed costs were unallowable for reimbursement but were not considered to be expressly unallowable under the FAR, and accordingly were not subjectto the penalties assessed by DCMA. The ruling is subject to appeal by DCMA.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. 2017 2016Fiscal Period High Low High LowFirst Quarter $2.33 $1.38 $1.25 $0.74Second Quarter $1.79 $1.31 $1.32 $0.97Third Quarter $1.75 $1.16 $1.69 $1.08Fourth Quarter $2.60 $1.47 $1.55 $1.22We have a single class of common stock outstanding. As of March 15, 2018 there were approximately 97 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, 2013, 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, 2017, the Series A Preferred Stock issued to Carilion has accrued $1,160,331 individends. The accrued dividend as of December 31, 2017 will be paid by the issuance of 631,693 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, 2017.PeriodTotal Number of SharesPurchasedAverage Price Paid perShareTotal Number of SharesPurchased as Part of a PubliclyAnnounced Program (1)Approximate Dollar Value ofShares that May Yet bePurchased Under the Program10/1/2017-10/31/2017193,323$1.62193,323$1,601,05911/1/2017-11/30/2017130,120$1.68130,120$1,382,15012/1/2017-12/31/2017159,634$2.3559,636$1,239,174Total483,077$1.88383,079$1,239,174(1) On September 20, 2017, we announced that our board of directors authorized a stock repurchase program for the repurchase of up to $2.0 millionof our common stock. Unless extended, the stock repurchase authorization expires on September 19, 2018 and may be terminated, increased or decreased byour board of directors at any time.ITEM 6. SELECTED FINANCIAL DATAThe consolidated statement of operations data for each of the years ended December 31, 2017 and 2016 and the consolidated balance sheet data as ofDecember 31, 2017 and 2016 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, 2015, 2014 and 2013 and the consolidated balance sheet data as of December 31, 2015, 2014and 2013 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 data2017 2016 2015 2014 2013Consolidated Statement of Operations Data: Revenues: Technology development$18,576 $16,281 $13,599 $12,206 $11,422Products and licensing27,661 25,587 20,851 9,054 6,912Total revenues46,237 41,868 34,450 21,260 18,334Cost of revenues: Technology development13,988 12,473 10,379 9,376 8,882Products and licensing14,120 13,590 10,616 4,047 3,403Total cost of revenues28,108 26,063 20,995 13,423 12,285Gross profit18,129 15,805 13,456 7,837 6,049Operating expense18,240 18,304 19,041 12,342 14,084Operating loss(111) (2,499) (5,586) (4,505) (8,035)Other (expense)/income, net(4) 13 (10) 111 347Interest expense, net(219) (319) (220) (96) (208)Loss from continuing operations before income taxes(334) (2,805) (5,816) (4,490) (7,896)Income tax benefit(296) (136) (602) (1,137) (2,387)Net loss from continuing operations(39) (2,669) (5,214) (3,353) (5,509)Income from discontinued operations, net of income taxes14,654 300 7,531 9,347 4,705Net income/(loss)14,615 (2,369) 2,317 5,994 (804)Preferred stock dividend147 105 86 112 102Net income/(loss) attributable to common stockholders$14,468 $(2,474) $2,231 $5,882 $(906)Net loss per share from continuing operations: Basic and diluted$— $(0.10) $(0.23) $(0.23) $(0.38)Net income per share from discontinued operations: Basic and diluted$0.53 $0.01 $0.33 $0.63 $0.33Net income/(loss) per share attributable to common stockholders: Basic and diluted$0.52 $(0.09) $0.10 $0.40 $(0.06)Weighted-average shares: Basic and diluted27,579,988 27,547,217 23,026,494 14,880,697 14,336,135 As of December 31,In thousands2017 2016 2015 2014 2013Consolidated Balance Sheet Data: Cash and cash equivalents$36,982 $12,802 $17,464 $14,117 $7,779Working capital44,185 21,129 23,417 15,413 10,106Total assets66,223 54,997 58,132 27,584 19,704Total current liabilities14,826 15,968 15,334 8,473 7,206Total debt2,436 4,253 6,125 625 2,125ITEM 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 ContentsSale of High Speed Optical Receiver BusinessOn August 9, 2017, we completed the sale of our high speed optical receivers ("HSOR") business, which was part of our Products and Licensingsegment, to an unaffiliated third party for an initial purchase price of $33.5 million, of which $29.5 million in cash has been received, and $4.0 million wasplaced into escrow until December 15, 2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closingindemnification obligations (the "Transaction"). As part of the Transaction, the buyer also hired approximately 49 of our employees who were engaged in thedevelopment, manufacture, and sale of HSOR products in addition to certain corporate administrative functions. The buyer provided certain transitionservices to us with respect to infrastructure and administration for which we paid $0.3 million per month for a period of five months, for a total of $1.5million, following the closing of the Transaction. We recorded this obligation as a reduction of the value of the purchase price. In assessing the fair value ofthe services expected to be received by us versus those we expect to deliver to the buyer, we concluded that the transition service payments were moreclosely aligned with the fair value of the assets sold versus the services received and thus should be part of the consideration reconciliation versus operatingactivities.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 distributed fiber opticsensing products provide critical stress, strain and temperature information to designers and manufacturers working with advanced materials. Our customoptoelectronic products are sold to scientific instrumentation manufacturers for various applications such as metrology, missile guidance, flame monitoring,and temperature sensing. In addition, we provide applied research services, typically under research programs funded by the U.S. government, in areas ofadvanced materials, sensing, and healthcare applications. Our business model is designed to accelerate the process of bringing new and innovative productsto market. We use our in-house technical expertise across a range of technologies to perform applied research services for companies and for governmentfunded projects. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth.We are organized into two main business segments, 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 60% and 61% of our total revenues for the years ended December 31, 2017 and 2016, 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 40% and 39% of our total revenues for the years ended December 31, 2017 and2016, 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 $23.5 million and $17.6 million at December 31, 2017 and 2016, respectively. The approximatevalue of our Products and Licensing segment backlog was $6.9 million and $7.2 million at December 31, 2017 and 2016, respectively.Revenues from product sales are mostly derived from the sales of our optoelectronics, sensing and test & measurement products that make use of light-transmitting optical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead to increasedproduct sales growth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues to represent asignificant portion of future revenues. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenues fromproduct sales to continue to be primarily in areas associated with our optoelectronics, fiber optic test & measurement and sensing platforms. In the long term,we expect that revenues from product sales will represent a larger portion of our total31Table of Contentsrevenues and that as we develop and commercialize new products, these revenues will reflect a broader and more diversified mix of products.We realized net income attributable to common stockholders of approximately $14.5 million for the year ended December 31, 2017 and net lossattributable to common stockholders of approximately $2.5 million for the year ended December 31, 2016. Excluding the effects of our HSOR business,which we sold in 2017, we incurred a net loss from continuing operations of less than $0.1 million and $2.7 million for the years ended December 31, 2017and 2016, 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.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 40% and 39% of our total revenues for the years ended December 31, 2017 and2016, 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 60% and 61% of our total revenues for the years ended December 31, 2017 and 2016, 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 expenses from equity awards, facilities costs, professional fees, salaries, commissions, travel expenseand related benefits of personnel engaged in sales, marketing, and administrative activities; costs of marketing programs and promotional materials; salaries,bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Technology Developmentsegment; product development activities not provided under contracts with third parties; and overhead costs related to these activities.Interest Expense, NetWe have two term loans with Silicon Valley Bank ("SVB") with scheduled maturities in 2018 and 2019. The term loans carry interest at a variable rateof prime plus 2%. At December 31, 2017, we had $2.5 million in the aggregate outstanding on these term loans.During the years ended December 31, 2017 and 2016, interest expense primarily included interest accrued on our outstanding SVB loans and interestincurred with respect to our capital lease obligations.32Table of ContentsCritical 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.The 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.33Table of ContentsProducts 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 existsonly when we sell the deliverable separately and is the price actually charged by us for that deliverable. Our product sales often include bundled products,options, and services and therefore VSOE is not readily determinable. In addition, we believe that because of unique features of our products, TPE also is notavailable. ESP, which is used when VSOE and TPE does not exist, reflects our best estimates of what the selling prices of elements would be if they were soldregularly on a stand-alone basis. We also sell extended warranties from time to time. In this case, we accrue warranty costs based on our estimate of futureexpense and defer revenue associated with the 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.Income TaxesWe 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.On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act tax reform legislation. This legislation makessignificant changes in U.S. tax law including a reduction in the corporate tax rates, changes34Table of Contentsto net operating loss carryforwards and carrybacks, and a repeal of the corporate alternative minimum tax. The legislation reduced the U.S. corporate tax ratefrom the current rate of 35% to 21%. As a result of the enacted law, the Company was required to revalue deferred tax assets and liabilities at the enacted rate.This revaluation resulted in a $1.9 million reduction in the deferred tax asset and a corresponding reduction in the valuation allowance. The other provisionsof the Tax Cuts and Jobs Act did not have a material impact on the 2017 financial statements.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, 2017 2016Revenues: Technology development40.2 % 38.9 %Products and licensing59.8 61.1Total revenues100.0 100.0Cost of revenues: Technology development30.3 29.8Products and licensing30.5 32.5Total cost of revenues60.8 62.3Gross profit39.2 37.7Operating expense39.4 43.7Operating loss(0.2) (6.0)Total other expense(0.5) (0.7)Loss from continuing operations before income taxes(0.7) (6.7)Income/(loss) from continuing operations, net of income taxes(0.1) (6.4)Income from discontinued operations, net of income taxes31.7 0.7Net income/(loss)31.6 % (5.7)%Year Ended December 31, 2017 Compared to Year Ended December 31, 2016Revenues Years ended December 31, 2017 2016 $ Difference % DifferenceTechnology development revenues$18,576,383 $16,280,582 $2,295,801 14.1%Products and licensing revenues27,660,891 25,587,187 2,073,704 8.1%Total revenues$46,237,274 $41,867,769 $4,369,505 10.4%Our Technology Development segment revenues increased $2.3 million to $18.6 million for the year ended December 31, 2017 compared to $16.3million for the year ended December 31, 2016. This increase was attributable primarily to growth in our intelligent systems and biomedical technologiesgroups. Revenues within these groups increased due to additional contract awards, including higher value Phase II SBIR contracts.Our Products and Licensing segment revenues increased $2.1 million to $27.7 million for the year ended December 31, 2017 compared to $25.6million for the year ended December 31, 2016. This increase was primarily driven by an increase in our sales of optical backscatter reflectometer instrumentsand optoelectronic components.Cost of Revenues Years ended December 31, 2017 2016 $ Difference % DifferenceTechnology development costs$13,988,378 $12,473,211 $1,515,167 12.1%Products and licensing costs14,120,071 13,589,858 530,213 3.9%Total costs of revenues$28,108,449 $26,063,069 $2,045,380 7.8%Our Technology Development segment costs increased $1.5 million, to $14.0 million for the year ended December 31, 2017 compared to $12.5 millionfor the year ended December 31, 2016. The overall increase in Technology Development36Table of Contentssegment costs was driven by increases in direct labor and subcontractor costs consistent with the rate of growth in Technology Development segmentrevenues.Our Products and Licensing segment costs increased $0.5 million to $14.1 million for the year ended December 31, 2017 compared to $13.6 million forthe year ended December 31, 2016. The increase in product and licensing cost is attributable to the component costs associated with increased volume ofoptical backscatter reflectometer instrument sales. Products and Licensing segment costs increased in accordance with the increase in Products and Licensingsegment revenues over the same period taking into account the gross margin effect of the product mix.Operating Expense Years ended December 31, 2017 2016 $ Difference % DifferenceSelling, general and administrative expense$14,770,986 $14,763,709 $7,277 — %Research, development and engineering expense3,469,193 3,540,227 (71,034) (2.0)%Total operating expense$18,240,179 $18,303,936 $(63,757) (0.3)%Selling, general and administrative expenses remained substantially unchanged at $14.8 million for the years ended December 31, 2017 and 2016.Research, development and engineering expenses also remained substantially unchanged at $3.5 million for the years ended December 31, 2017 and2016.Interest Expense, NetOur net interest expense was approximately $0.2 million for the year ended December 31, 2017 compared to approximately $0.3 million for the yearended December 31, 2016. The average monthly loan balance for the year ended December 31, 2017 was $3.3 million as compared to $5.1 million for theyear ended December 31, 2016, resulting in this decrease in interest expense.Income Tax Benefit from Continuing OperationsFor the year ended December 31, 2017, we recorded income tax benefit of $0.3 million, or 88.5% of our loss from continuing operations, compared toan income tax benefit of $0.1 million, or 4.8% of our loss from continuing operations for the year ended December 31, 2016. The change resulted from thedecrease in our loss from continuing operations. The income tax benefit recognized in the current period is primarily driven by the discrete gain associatedwith the discontinued operations of HSOR and related intraperiod tax allocation requirements. Absent this discrete transaction we would expect theCompany to have an immaterial provision related to certain state income taxes.Net Loss From Continuing OperationsFor the year ended December 31, 2017, we recognized a loss from continuing operations before income taxes of $0.3 million compared to a loss fromcontinuing operations before income taxes of $2.8 million for the year ended December 31, 2016. After tax, our net loss from continuing operations was lessthan $0.1 million for the year ended December 31, 2017, compared to a net loss from continuing operations of $2.7 million for the year ended December 31,2016.Income from Discontinued Operations, Net of Income TaxesFor the year ended December 31, 2017, we recognized income from discontinued operations, net of income taxes, of $14.7 million. For the year endedDecember 31, 2016, we recognized net income from discontinued operations, net of income taxes, of $0.3 million. For the year ended December 31, 2017, ournet income from discontinued operations included a $15.7 million after tax gain recognized on the sale of the HSOR business, partially offset by a net loss of$1.0 million associated with the operations of the HSOR business prior to its sale. For the year ended December 31, 2016, our net income from discontinuedoperations consisted of the after tax income associated with the operations of HSOR during the year.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 of37Table of Contentscommon stock per year. During each of 2017 and 2016, we accrued $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 liquidation event occurs. During each of 2017 and 2016, 79,292 shares of common stock became issuable toCarilion as dividends and have been recorded in the statement of stockholders’ equity.Liquidity and Capital ResourcesAt December 31, 2017, our total cash and cash equivalents were $37.0 million.We have two term loans with SVB which, at December 31, 2017, had an aggregate balance of $2.5 million. One term loan, with a balance of $0.3million as of December 31, 2017, matures on December 1, 2018. The other term loan with a balance of $2.1 million as of December 31, 2017, 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 $4.0 million. As of December 31, 2017, 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 and cash equivalents as of December 31, 2017 will provide adequate liquidity for us to meet our working capital needs overthe next twelve months. Additionally, we believe that should we have the need for increased capital spending to support our planned growth, we will be ableto fund such growth through either third-party financing on competitive market terms or through our available cash and cash equivalents.Discussion of Cash Flows Years ended December 31, 2017 2016Net cash provided by/(used in) operating activities$915,042 $(399,837)Net cash provided/(used in) by investing activities26,181,400 (2,000,184)Net cash used in financing activities(2,917,367) (2,261,561)Net increase/(decrease) in cash and cash equivalents$24,179,075 $(4,661,582)During 2017, operations provided $0.9 million of net cash, as compared to 2016, when operations used $0.4 million of net cash. In 2017, our netincome of $14.6 million included a gain on the sale of our HSOR business, net of income tax, of $15.7 million, and non-cash expenses which do not impactcash flow for the period. These non-cash expenses were depreciation and amortization of $2.5 million, stock-based compensation of $0.7 million, and baddebt of $0.1 million. Additionally, changes in working capital resulted in a net cash outflow of $1.4 million, principally driven by an increase in inventory of$1.9 million and a decrease in accounts payable and accrued expenses of $0.9 million partially offset by a decrease in accounts receivable of $1.2 millionand an increase in deferred revenue of $0.2 million.In 2016, our net loss of $2.4 million included charges for depreciation and amortization of $3.7 million and stock-based compensation of $0.9 million,each of which are non-cash items that do not impact cash flow for the period. Additionally, changes in working capital resulted in a net cash outflow of $2.9million, principally driven by an increase in accounts receivable of $3.6 million, partially offset by an increase in accounts payable and accrued liabilities of$0.6 million.Cash provided by investing activities in 2017 included proceeds from the sale of our HSOR business of $28.0 million, partially offset by $1.4 millionof fixed asset additions and $0.5 million of capitalized intellectual property costs.38Table of ContentsCash 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 as well as capitalized costs associated with securing intellectual property rights.Cash used in financing activities for the year ended December 31, 2017 was $2.9 million, compared to cash used in financing activities of $2.3 millionin 2016. During 2017, we repaid $1.8 million on our term loans with SVB. We also used $1.1 million to repurchase our common stock under our stockrepurchase program. During 2016, we repaid $1.9 million on our outstanding term loan with SVB and also used $0.3 million to repurchase our common stockunder our stock repurchase program.Summary of Contractual ObligationsThe following table sets forth information concerning our known contractual obligations as of December 31, 2017 that are fixed and determinable. Total Less than 1year 1 - 3 years 3 - 5 years More than 5yearsLong-term debt obligations (1)$2,458,333 $1,833,333 $625,000 $— $—Operating facility leases (2)5,012,282 1,284,525 1,548,941 1,089,408 1,089,408Other leases (3)125,257 49,257 72,960 3,040 —Purchase order obligation (4)1,006,526 892,456 114,070 — —Other liabilities (5)660,000 220,000 440,000 — —Total$9,262,398 $4,279,571 $2,800,971 $1,092,448 $1,089,408_________________________(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 Quebec, Canada underoperating leases that as of December 31, 2017, are scheduled to expire between December 2018 and December 2024. Upon expiration of our officeleases, we may exercise certain renewal options as specified in the leases. Rental payments associated with these option periods are not included in thetable above.(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) Purchase order obligations included outstanding orders for inventory purchases. In 2017, our Luna Technologies subsidiary executed a non-cancelable purchase order in the amounts of $0.5 million for multiple shipments of tunable lasers to be delivered over an 18-month period beginningin November 2017.(5) Other liabilities include remaining amounts payable for minimum royalty payments for certain licensed technologies payable over the remainingpatent terms of the underlying technology.Off-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.39Table of ContentsInterest 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 $2.5 million outstanding under the term loan as of December 31,2017, 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 $15,000 in our annual interest expense under the SVB debt facility.Foreign Currency Exchange Rate RiskAs of December 31, 2017, 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, 2017 and 201643Consolidated Statements of Operations for the years ended December 31, 2017 and 201644Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 2017 and 201645Consolidated Statements of Cash Flows for the years ended December 31, 2017 and 201646Notes to Consolidated Financial Statements4741Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMBoard of Directors and ShareholdersLuna Innovations IncorporatedOpinion on the financial statementsWe have audited the accompanying consolidated balance sheets of Luna Innovations Incorporated (a Delaware corporation) andsubsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of operations, changes instockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2017, and the related notes andschedule (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all materialrespects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flowsfor each of the two years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in theUnited States of America.Basis for opinionThese financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on theCompany’s financial statements based on our audits. We are a public accounting firm registered with the Public Company AccountingOversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with theU.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. TheCompany is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part ofour audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressingan opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to erroror fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles usedand significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believethat our audits provide a reasonable basis for our opinion./s/ GRANT THORNTON LLPWe have served as the Company’s auditor since 2005.Arlington, VirginiaMarch 21, 201842Table of ContentsCONSOLIDATED BALANCE SHEETS December 31, 2017 December 31, 2016Assets Current assets: Cash and cash equivalents$36,981,533 $12,802,458Accounts receivable, net9,857,009 10,269,012 Receivable from sale of HSOR business4,000,976 —Inventory6,951,110 6,848,835Prepaid expenses and other current assets1,220,650 1,375,659Current assets held for sale— 5,801,629Total current assets59,011,278 37,097,593Property and equipment, net3,453,741 3,482,687Intangible assets, net3,237,593 3,367,217Goodwill502,000 502,000Other assets18,024 38,194Non-current assets held for sale— 10,509,282Total assets$66,222,636 $54,996,973Liabilities and stockholders’ equity Current liabilities: Current portion of long term debt obligations$1,833,333 $1,833,333Current portion of capital lease obligations43,665 52,128Accounts payable2,962,863 2,954,742Accrued liabilities8,959,935 7,913,544Deferred revenue1,026,339 837,906Current liabilities held for sale— 2,376,703Total current liabilities14,826,135 15,968,356Long-term portion of deferred rent1,184,438 1,319,402Long-term debt obligations603,007 2,420,032Long-term capital lease obligations71,275 114,940Non-current liabilities held for sale— 84,555Total liabilities16,684,855 19,907,285Commitments and contingencies Stockholders’ equity: Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at December 31, 2017and 20161,322 1,322Common stock, par value $0.001, 100,000,000 shares authorized, 28,354,822 and 27,988,104 shares issued,27,283,918 and 27,541,277 shares outstanding at December 31, 2017 and 2016, respectively29,186 28,600Treasury stock at cost, 1,070,904 and 446,827 shares at December 31, 2017 and 2016, respectively(1,649,746) (517,987)Additional paid-in capital83,563,208 82,451,958Accumulated deficit(32,406,189) (46,874,205)Total stockholders’ equity49,537,781 35,089,688Total liabilities and stockholders’ equity$66,222,636 $54,996,973The accompanying notes are an integral part of these consolidated financial statements.43Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS Years ended December 31, 2017 2016Revenues: Technology development$18,576,383 $16,280,582Products and licensing27,660,891 25,587,187Total revenues46,237,274 41,867,769Cost of revenues: Technology development13,988,378 12,473,211Products and licensing14,120,071 13,589,858Total cost of revenues28,108,449 26,063,069Gross profit18,128,825 15,804,700Operating expense: Selling, general and administrative14,770,986 14,763,709Research, development and engineering3,469,193 3,540,227Total operating expense18,240,179 18,303,936Operating loss(111,354) (2,499,236)Other income/(expense): Other (expense)/income, net(4,498) 13,071Interest expense, net(218,506) (319,334)Total other expense(223,004) (306,263)Loss from continuing operations before income taxes(334,358) (2,805,499)Income tax benefit295,753 135,567Net loss from continuing operations(38,605) (2,669,932)Operating (loss)/income from discontinued operations, net of income tax expense of $23,762 and $210,933(1,017,518) 300,440Gain on sale, net of $912,298 of related income taxes15,671,028 —Income from discontinued operations, net of income tax expense of $0.9 and $0.2 million14,653,510 300,440Net income/(loss)14,614,905 (2,369,492)Preferred stock dividend146,889 105,258Net income/(loss) attributable to common stockholders$14,468,016 $(2,474,750) Net loss per share from continuing operations: Basic and diluted$— $(0.10)Net income per share from discontinued operations: Basic and diluted$0.53 $0.01Net income/(loss) per share attributable to common stockholders: Basic and diluted$0.52 $(0.09)Weighted average shares: Basic and diluted27,579,988 27,547,217The 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—January1, 20161,321,514 $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 oftreasury stock— — (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) $35,089,688Exercise of stockoption— $— 83,888 $84 — $—$99,769 $— $99,853Stock-basedcompensation— $— 147,333 $287 — $—$714,807 $— $715,094Non-cashcompensation— $— 135,497 $136 — $—$149,864 $— $150,000Stock dividends(1)— $— — $79 — $—$146,810 $(146,889) $—Purchase oftreasury stock— $— (624,077) $— 624,077 $(1,131,759)$— $— $(1,131,759)Net income— $— — $— — $—$— $14,614,905 $14,614,905Balance—December 31,20171,321,514 1,322 27,283,918 29,186 1,070,904 (1,649,746)83,563,208 (32,406,189) 49,537,781 (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, 2017 2016Cash flows provided by/(used in) operating activities: Net income/(loss)$14,614,905 $(2,369,492)Adjustments to reconcile net income/(loss) to net cash provided by/(used in) operating activities: Depreciation and amortization2,526,609 3,713,879Stock-based compensation715,094 860,215Loss on disposal of fixed assets3,640 —Gain on sale of discontinued operations, net of income taxes(15,671,028) —Bad debt99,888 305,593Changes in operating assets and liabilities: Accounts receivable1,152,055 (3,568,761)Inventory(1,902,311) 492,932Other assets83,428 (238,736)Accounts payable and accrued expenses(896,534) 564,689Deferred revenue189,296 (160,156)Net cash provided by/(used in) operating activities915,042 (399,837)Cash flows provided by/(used in) investing activities: Acquisition of property and equipment(1,352,531) (1,509,984)Proceeds from sale of property and equipment3,000 —Intangible property costs(495,597) (490,200)Proceeds from sale of discontinued operations, net28,026,528 —Net cash provided by/(used in) investing activities26,181,400 (2,000,184)Cash flows used in financing activities: Payments on debt obligations(1,833,333) (1,871,635)Payments on capital lease obligations(52,128) (56,873)Purchase of treasury stock(1,131,759) (333,053)Proceeds from the exercise of options99,853 —Net cash used in financing activities(2,917,367) (2,261,561)Net change in cash and cash equivalents24,179,075 (4,661,582)Cash and cash equivalents—beginning of period12,802,458 17,464,040Cash and cash equivalents—end of period$36,981,533 $12,802,458Supplemental disclosure of cash flow information Cash paid for interest$209,497 $308,116Cash paid for income taxes$377,907 $233,732Cash received for income tax refunds$— $67,127Dividend on preferred stock, 79,292 shares of common stock issuable for each of the years ended December 31,2017 and 2016$146,889 $105,258The 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 distributed fiber opticsensing products provide critical stress, strain and temperature information to designers and manufacturers working with advanced materials. Our customoptoelectronic products are sold to scientific instrumentation manufacturers for various applications such as metrology, missile guidance, flame monitoring,and temperature sensing. In addition, we provide applied research services, typically under research programs funded by the U.S. government, in areas ofadvanced materials, sensing, and healthcare applications. Our business model is designed to accelerate the process of bringing new and innovative productsto market. We use our in-house technical expertise to perform applied research services on government funded projects across a range of technologies andalso for corporate customers in the fiber optic sensing area. We are organized into two business segments: our Technology Development segment and ourProducts and Licensing segment. Our Technology Development segment performs applied research principally on government-funded projects. Most of thegovernment funding in our Technology Development segment is derived from the U.S. government’s Small Business Innovation Research ("SBIR") programcoordinated by the U.S. Small Business Administration ("SBA"). Our Products and Licensing segment focuses on fiber optic test & measurement, sensing, andinstrumentation products and also conducts applied research in the fiber optic sensing area to corporate and government customers.We have a history of net losses. We have historically managed our liquidity through cost reduction initiatives, debt financings, capital marketstransactions 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 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.47Table of ContentsProduct 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 exists only when we sell thedeliverable separately and is the price actually charged by us for that deliverable. Our product sales often include bundled products, options, and services andtherefore VSOE is not readily determinable. In addition, we believe that because of unique features of our products, TPE also is not available. Also, due to theuniqueness of our products comparable third party evidence is generally not available. ESP, which is used when VSOE and TPE does not exist, reflects ourbest estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis.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 $0.3 million at December 31, 2017 and $0.2 million at December 31,2016.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. Cash equivalents at December 31, 2017 and 2016 include $25.2 million and $0, respectively, invested in U.S.Treasury obligations through a sweep account with our bank. The full value of amounts invested through the sweep account are convertible to cash on adaily basis. Our cash transactions are processed through reputable commercial banks. We regularly maintain cash balances with financial institutions whichexceed Federal Deposit Insurance Corporation (“FDIC”) insurance limits. At December 31, 2017 and December 31, 2016, we had approximately $11.5million and $12.6 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$4.0 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"). We amortize our identified intangible assets over their estimated useful livesranging between one and eleven years, and analyze the reasonableness of the remaining useful life whenever events or circumstances indicate that thecarrying amount may not be recoverable to 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 $3.5 million of non-contract related research, development and engineering expenses for each of the years ended December 31, 2017 and 2016.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 Income/(Loss) per ShareBasic per share data is computed by dividing net income/(loss) attributable to common stockholders by the weighted average number of sharesoutstanding during the period. Diluted per share data is computed by dividing net income/(loss) 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 4.3 million and $5.5 million common stock equivalents (which include outstanding warrants, preferred stock and stock options) are notincluded for the year ended December 31, 2017 and 2016, as they are anti-dilutive to earnings per share due to us having a net loss from continuingoperations.Stock-Based CompensationWe have two stock-based compensation plans, which are described further in Note 9. We recognize compensation expense based upon the fair value ofthe underlying equity award as of the date of grant. We have elected to use the Black-Scholes option pricing model to value any stock options granted.Restricted stock and restricted stock units awarded are valued at the closing price of our common stock on the date of the award. We recognize stock-basedcompensation for such awards on49Table of Contentsa straight-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 $0.1 million for each of the years ended December 31, 2017 and 2016.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 PronouncementsEffective January 1, 2017, we adopted Accounting Standards Update ("ASU") No. 2016-09, Improvements to Employee Share-Based PaymentAccounting. These amendments apply to several aspects of accounting for share-based compensation including the recognition of excess tax benefits anddeficiencies and their related presentation in the statement of cash flows as well as accounting for forfeitures. The adoption of ASU No. 2016-09 did not havea significant impact on our consolidated financial statements.Effective January 1, 2017, we adopted ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes, which simplifies the presentation of deferredtaxes by requiring that deferred tax assets and liabilities be classified as noncurrent in any classified balance sheet rather than being separated into currentand non-current amounts. The adoption of ASU No. 2015-17 did not have a significant impact on our consolidated financial statements.In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires a lessee to recognize in its statement of financial position an asset 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 beginning after December 15, 2018, includinginterim periods within those fiscal years. We are currently evaluating the impact the adoption of this standard will have on our consolidated financialstatements.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 should be applied retrospectively to all periods presented. We do not expect ASU 2016-15 will have a material impact on our financialstatements. 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 doing50Table of Contentsso, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP. The standard, assubsequently updated in July 2015, is effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of thefollowing transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to electcertain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption(which includes additional footnote disclosures).We have completed our assessment of the impact of Topic 606 and have reached the following conclusions regarding its impact on our revenuerecognition policies and procedures. Contracts in our Technology Development segment primarily provide research services. We have concluded thatrevenue specific to this segment will not be materially impacted upon the adoption of Topic 606 as revenue will continue to be recognized over time usingan input model. Contracts in our Products and Licensing segment generally provide for the following revenue sources: standard product sales, customproduct development and sales, product rental, extended warranties, training/service, and certain royalties. We expect revenues for this segment to berecognized using either the “point in time” or “over time” methods of Topic 606, depending upon the revenue source. We expect the pattern of recognitionof custom optoelectronic products to change from “point in time” to “over time” upon the adoption of Topic 606. Our revenue recognized specific to customproducts approximates $10 million annually. This change will result in the acceleration of revenue when compared to existing standards with thecumulative adjustment relating to contracts that are not complete as of December 31, 2017 recognized as an adjustment to opening retained earnings onJanuary 1, 2018. Our revenue for our standard products will be recognized using the "point in time" criteria of Topic 606, and the timing of such revenuerecognition is not expected to differ materially from our historical revenue recognition. Other immaterial adjustments related to the products segment that aresometimes offered to customers include discounts on future purchases related to rental agreements, customer rights of return, and volume discounts. We areadopting the standard using the modified retrospective transition method. Under the modified retrospective approach, the new standard will, for the periodbeginning January 1, 2018, apply to new contracts and those that were not completed as of January 1, 2018. For those contracts not completed as of January1, 2018, this method will result in a cumulative adjustment to increase retained earnings in the amount of $0.4 million. Prior periods will not beretrospectively adjusted, but we will maintain dual reporting for the year of initial application in order to disclose the effect on revenue of adopting the newguidance. In 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. 2. 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.Components of inventory are as follows: December 31, 2017 2016Finished goods$2,143,953 $1,952,885Work-in-process578,195 714,867Raw materials4,228,962 4,181,083 $6,951,110 $6,848,83551Table of Contents3. 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 Advanced Photonics, Inc. ("API"), we entered into the Joinder, Consent and Sixth LoanModification Agreement (the "2015 Term Loan") under which we borrowed $6.0 million and used the proceeds principally to repay the then outstandingdebt 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 arrearsand 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 toprime rate then in effect, as published in the Wall Street Journal, plus 2%. We may prepay amounts due under the 2015 Term Loan at any time, subject to anearly termination fee of up to 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 $4.0 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, 2017,we were in compliance with all covenants under the Term Loans.The balance under the Term Loans at December 31, 2017 was $2.5 million, of which $1.8 million was classified as short-term. The effective rate of ourTerm Loans at December 31, 2017 was 6.5%.The following table presents a summary of debt outstanding as of December 31, 2017 and 2016: December 31, 2017 2016Silicon Valley Bank Term Loans$2,458,333 $4,291,667Less: unamortized debt issuance costs21,993 38,302Less: current portion1,833,333 1,833,333Total long-term debt obligations$603,007 $2,420,032Debt 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 endedDecember 31, 2017. 52Table of ContentsMaturities on long-term debt are as follows:YearAmount2018$1,833,3332019625,000Total$2,458,333Interest expense for the years ended December 31, 2017 and 2016 consisted of the following: Years ended December 31, 2017 2016Interest expense on Term Loans $202,850 $287,491Amortization of debt issuance costs 16,308 16,308Other interest (income)/expense (652) 15,535Total interest expense $218,506 $319,3344. Accounts Receivable—TradeAccounts receivable consist of the following: December 31, 2017 2016Billed$8,186,961 $8,519,581Unbilled1,921,256 1,977,191Other35,509 19,479 10,143,726 10,516,251Less: allowance for doubtful accounts(286,717) (247,239) $9,857,009 $10,269,012Unbilled 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.5. Property and EquipmentProperty and equipment, net, consists of the following: December 31, 2017 2016Building$69,556 $69,556Equipment9,246,094 8,649,886Furniture and fixtures592,258 591,569Software1,139,715 1,137,043Leasehold improvements4,984,010 4,973,556 16,031,633 15,421,610Less—accumulated depreciation(12,577,892) (11,938,923) $3,453,741 $3,482,687Depreciation for the years ended December 31, 2017 and 2016 was approximately $0.7 million and $0.8 million, respectively.53Table of Contents6. Intangible AssetsThe following is a summary of intangible assets, net: December 31, 2017 2016Patent costs$4,668,577 $4,263,386Developed technology2,200,000 2,200,000Customer base1,200,000 1,200,000Backlog200,000 200,000 8,268,577 7,863,386Accumulated amortization(5,030,984) (4,496,169) $3,237,593 $3,367,217Amortization for the years ended December 31, 2017 and 2016 was approximately $0.5 million and $0.6 million, respectively. Estimated aggregateamortization, based on the net value of intangible assets at December 31, 2017, for each of the next five years and beyond is as follows:Year Ending December 31, 2018466,1932019397,1322020373,0322021362,0382022354,7332023 and beyond1,284,465$3,237,593 7. Accrued LiabilitiesAccrued liabilities consist of the following: December 31, 2017 2016 Accrued compensation$5,274,005 $4,742,760 Claims reserve1,637,118 1,577,123 Accrued sub-contracts544,342 483,477 Accrued professional fees117,445 67,719 Accrued income tax403,548 — Deferred rent144,741 155,138 Royalties290,235 345,895 Warranty reserve210,599 185,125 Accrued liabilities-other337,902 356,307Total accrued liabilities$8,959,935 $7,913,54454Table of Contents8. Income TaxesIncome tax expense/(benefit) from continuing operations consisted of the following for the periods indicated: Years ended December 31, 2017 2016Current: Federal$(320,560) $—State24,807 (135,567)Deferred federal— —Deferred state— —Income tax benefit$(295,753) $(135,567)Deferred tax assets and liabilities consist of the following components: December 31, 2017 December 31, 2016 Current Long-Term Current Long-TermBad debt and inventory reserve$— $226,358 $382,075 $—Inventory adjustment— 405,242 — 940,885UNICAP— 32,579 — 46,593Deferred revenue 84,669 — 154,608Deferred rent— 340,199 — 550,419Depreciation and amortization— (1,238,458) — (3,490,869)Charitable contributions— 3,385 — 5,741Net operating loss carryforwards- Luna— 349,421 — 4,779,976Net operating loss carryforwards- API— 1,436,568 — 9,783,512Net operating loss carryforwards - state— 534,194 — 281,799Net operating loss carryforwards- Canada— 10,503 — 10,503Research and development credits— 235,613 — 4,250,803California manufacturing credit— 15,554 — 15,554Accrued liabilities— 504,472 1,067,019 —Deferred compensation— 223,607 — 267,897Stock-based compensation— 1,275,371 — 1,867,947AMT credit— 581,467 — 395,083Total— 5,020,744 1,449,094 19,860,451Valuation allowance— (5,020,744) (1,449,094) (19,860,451)Net deferred tax asset$— $— $— $—55Table of ContentsThe benefit from income taxes from continuing operations differs from the amount computed by applying the federal statutory income tax rate to ourloss from continuing operations before income taxes as follows for the periods indicated: Years ended December 31, 2017 2016Income tax expense at federal statutory rate 34.00 % 34.00 %State taxes, net of federal tax effects (102.48)% (0.93)%Change in tax rate from Tax Cuts and Jobs Act (568.11)% — %Change in valuation allowance 796.72 % (18.17)%Incentive stock options (69.26)% (9.00)%Provision to return adjustments 27.75 % (0.82)%Meals and entertainment (4.69)% (0.64)%Capitalized merger costs — % — %Windfall deduction — % — %Other permanent differences (25.48)% 0.35 %Income tax benefit 88.45 % 4.79 %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 taxable income and tax planning strategies that we can implement in making our assessment. We haveU.S. federal income tax net operating loss carryforwards at December 31, 2017 of approximately $1.7 million for Luna and net operating loss carryforwards ofapproximately $6.8 million for API expiring at varying dates through 2025. We have research and development tax credit carryforwards at December 31,2017 of approximately $0.2 million, which expire at varying 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 was prepared in 2017, and it was determined that there was no ownership changes in2017 resulting in a limitation on NOLs, but a portion of the net operating losses will expire unutilized. As there is a full valuation allowance against all ofthe API deferred tax assets, there will not be a statement of operations impact to any expiration of the net operating losses or research and developmentcredits.The U.S. federal statute of limitations remains open for the year 2014 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, 2017 or December 31, 2016 will not be realized, and as a result a valuation allowance was established against all suchdeferred tax assets.Effective January 1, 2017, we adopted Accounting Standards Update ("ASU") No. 2016-09, Improvements to Employee Share-Based PaymentAccounting. These amendments apply to several aspects of accounting for share-based compensation including the recognition of excess tax benefits anddeficiencies and their related presentation in the statement of cash flows as well as accounting for forfeitures. The adoption of ASU No. 2016-09 did not havea significant impact on our financial condition, results of operations or cash flows.Effective January 1, 2017, we adopted ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes, which simplifies the presentation of deferredtaxes by requiring that deferred tax assets and liabilities be classified as noncurrent in56Table of Contentsany classified balance sheet rather than being separated into current and non-current amounts. The adoption of ASU No. 2015-17 did not have a significantimpact on our consolidated financial statements.On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act tax reform legislation. This legislation makessignificant changes in U.S. tax law including a reduction in the corporate tax rates, changes to net operating loss carryforwards and carrybacks, and a repeal ofthe corporate alternative minimum tax. The legislation reduced the U.S. corporate tax rate from the current rate of 35% to 21%. As a result of the enacted law,the Company was required to revalue deferred tax assets and liabilities at the enacted rate. This revaluation resulted in a $1.9 million reduction in thedeferred tax asset and a corresponding reduction in the valuation allowance. The other provisions of the Tax Cuts and Jobs Act did not have a materialimpact on the 2017 financial statements.9. 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, 2017, 631,693 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 per share and expireon December 31, 2020.Equity Incentive PlansIn 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 of 3,500,000 shares plus any amounts forfeited from grants under the 2006 Plan after theexpiration date of the 2006 Plan. Options generally have a life of 10 years and exercise price equal to or greater than the fair market value of the CommonStock as determined by the Board of Directors.Vesting for employees typically occurs over a four-year period.57Table of ContentsThe 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, 20163,800,728 $0.61 - 8.43 $2.17 $111,314 3,045,150 $2.39 $103,603Forfeited(963,614) $1.18 - 8.43 $2.99 Exercised— 0 $— 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 $101,071Forfeited(178,665) $1.27 - 6.83 $2.24 Exercised(83,888) $0.82 - 1.40 $1.19 Granted120,000 $1.51 - 2.40 $1.82 Balance at December 31, 20172,714,561 $0.61 - 6.55 $1.88 $2,098,195 2,590,030 $1.89 $2,013,034 (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, 2017 2016Risk-free interest rate range 2.1% 1.5%Expected life of option-years 6.5 7.5Expected stock price volatility 69% 73%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.58Table of Contents Options Outstanding Options Exercisable Range ofExercise Prices OptionsOutstanding WeightedAverageRemainingLife inYears WeightedAverageExercisePrice OptionsExercisable WeightedAverageExercisePrice ofOptionsExercisableYear ended December 31, 2016$0.61 - 6.83 2,857,114 5.09 $1.89 2,637,630 $1.93Year ended December 31, 2017$0.61 - 6.55 2,714,561 4.23 $1.88 2,590,030 $1.89 Total Intrinsic Value ofOptions Exercised Total Fair Value ofOptions VestedYear ended December 31, 2016$— $370,654Year ended December 31, 2017$62,549 $3,962,746For the years ended December 31, 2017 and 2016, the weighted average grant date fair value of options granted was $1.18 and $1.15, respectively, pershare. We estimate the fair value of options at the grant date using the Black-Scholes model. For all stock options granted through December 31, 2017, theweighted average remaining service period is 3.2 years.Restricted Stock and Restricted Stock UnitsIn 2017 and 2016, we issued 349,000 and 319,000, respectively, shares of restricted stock to certain employees. Shares issued to employees vest inthree equal annual installments on the anniversary dates of their grant. In 2017 and 2016, 530,542 and 245,583 shares, respectively, of restricted stockvested.In addition, in 2017 and 2016, we issued 129,865 and 86,956, respectively, restricted stock units to members of our Board of Directors. Restricted stockunits issued to our Board of Directors vest at the earlier of the one year anniversary of their grant or the next annual stockholders' meeting. In 2017 and 2016,86,956 and 48,542 restricted stock units, respectively, vested.The following table summarizes our aggregate restricted stock awards and restricted stock unit activity in 2016 and 2017: Number of UnvestedShares Weighted Average GrantDate Fair Value Aggregate Value ofUnvested SharesBalance at January 1, 2016718,167 $1.22 $874,186Granted405,956 $1.15 $466,849Vested(294,125) $1.20 $(352,272)Forfeitures— $0.00 $—Balance at December 31, 2016829,998 $1.19 $988,763Granted478,865 $1.63 $780,252Vested(617,498) $1.23 $(758,653)Forfeitures(201,667) $1.35 $(272,017)Balance at December 31, 2017489,698 $1.51 $738,345We recognized $0.7 million and $0.9 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, 2017 and 2016, respectively, and we will recognize $0.5 million over theremaining requisite service period.59Table of ContentsNon-employee Director Deferred Compensation PlanWe maintain a non-employee director deferred compensation plan (the “Deferred Compensation Plan”) that permits our non-employee directors to deferreceipt of certain of the compensation that they receive for serving on our board and board committees. During the years ended December 31, 2017 and 2016,the Deferred Compensation Plan permitted the participants to elect to defer cash fees to which they were entitled for board and committee service. Forparticipating directors, in lieu of payment of cash fees, we credit their accounts under the Deferred Compensation Plan with a number of stock units based onthe trading price of our common stock as of the date of the deferral. These stock units are vested immediately, although the participating directors do notreceive the shares represented by such units until a future qualifying event. A summary of stock unit activity under the Deferred Compensation Plan for 2016and 2017 is as follows. Number of StockUnits WeightedAverage GrantDate Fair Valueper Share Intrinsic ValueOutstandingJanuary 1, 2016315,382 $1.38 Granted101,901 $1.21 Vested— $1.01 Converted(24,271) $1.01 December 31, 2016393,012 $1.37 $577,728Granted73,690 $1.54 Vested— $1.15 Converted— $0.00 December 31, 2017466,702 $1.40 $1,134,086In December 2017, we amended and restated our Deferred Compensation Plan to also permit participating non-employee directors to elect, beginning in2018, to defer the receipt of some or all of the equity compensation that they receive for board and committee service.Stock Repurchase ProgramIn May 2016, our board of directors authorized us to repurchase up to $2.0 million of our common stock through May 31, 2017. As of May 31, 2017,we had repurchased a total of 205,500 shares for an aggregate purchase price of $0.2 million under this stock repurchase program, after which this stockrepurchase program expired.In September 2017, our board of directors authorized a new stock repurchase program and providing for the repurchase of up to $2.0 million of ourcommon stock through September 19, 2018. Our stock repurchase program does not obligate us to acquire any specific number of shares. Under the program,shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the SecuritiesExchange Act of 1934, as amended. As of December 31, 2017, we had repurchased a total of 433,179 shares for an aggregate purchase price of $0.8 millionunder this stock repurchase program. In addition, in December 2017 we repurchased 100,000 shares directly from a member of our Board of Directors outsideof the repurchase program. We currently maintain all repurchased shares under these stock repurchase programs as treasury stock. The following chart detailsour share repurchases during the year ended December 31, 2017:60Table of Contents Total Number of Shares Repurchased Average Price Paid per ShareJanuary 1 - September 30, 2017141,000 $1.62October 2017193,323 $1.62November 2017130,120 $1.68December 2017159,634 $2.35We currently maintain these repurchased shares as treasury stock.10. Commitments and ContingenciesObligation under Operating LeasesWe lease facilities in Virginia, Michigan, California, and Canada under operating leases that as of December 31, 2017 were scheduled to expirebetween March 2019 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 $1.1 million and $1.5 million, respectively, for the years endedDecember 31, 2017 and 2016.Minimum future payments, as of December 31, 2017, under the aforementioned operating leases for each of the next five years and thereafter are:20181,284,5242019833,0942020715,8482021544,7042022544,704Thereafter1,089,408 $5,012,282Purchase CommitmentIn 2016 we executed two non-cancelable purchase orders totaling $1.5 million for multiple shipments of tunable lasers to be delivered over an 18-month period beginning in the third quarter of 2016. At December 31, 2017, approximately $0.1 million of this commitment remained under these purchaseagreements. In the third quarter of 2017 we executed a non-cancelable purchase order totaling $0.5 million for multiple shipments of tunable lasers to bedelivered over an 18-month period beginning the third quarter of 2017. At December 31, 2017, approximately $0.5 million of this commitment remainedunder this purchase order.Royalty AgreementWe have licensed certain third-party technologies from vendors for which we owe minimum royalties aggregating $0.7 million payable over theremaining patent terms of the underlying technology. 11. 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 $0.3 million to the plan for each of the years ended December 31, 2017 and 2016.61Table of Contents 12. 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"). On November 29, 2017, ASBCA ruled that the claimed costs were unallowable for reimbursement but were notconsidered to be expressly unallowable under the FAR, and accordingly were not subject to the penalties assessed by the DCMA. The ruling is subject toappeal by the DCMA.We 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. 13. Relationship with Major CustomersDuring the years ended December 31, 2017 and 2016, approximately 48% and 41%, respectively, of our consolidated revenues were attributable tocontracts with the U.S. government.At December 31, 2017 and 2016, receivables with respect to contracts with the U.S. government represented 20% and 14% of total trade receivables,respectively. 14. 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, 2017 and 2016.During the years ended December 31, 2017 and 2016, 20% and 19%, respectively, of our total sales took place outside the United States. No singlecountry, outside of the United States, represented more than 10% of total revenues during the years ended December 31, 2017 or 2016.62Table of Contents Years ended December 31, 2017 2016Technology Development revenue $18,576,383 $16,280,582Products and Licensing revenue 27,660,891 25,587,187Total revenue 46,237,274 41,867,769Technology Development operating loss (120,417) (499,583)Products and Licensing operating loss 9,063 (1,999,653)Total operating loss $(111,354) $(2,499,236)Depreciation, Technology Development $359,626 $352,435Depreciation, Products and Licensing $747,216 $1,148,195Amortization, Technology Development $139,067 $195,619Amortization, Products and Licensing $1,280,699 $2,017,629Products and licensing depreciation includes amounts from discontinued operations of $0.4 million and $0.7 million for the years ended December 31,2017 and 2016, respectively. Products and licensing amortization includes amounts from discontinued operations of $0.9 million and $1.6 million for theyears ended December 31, 2017 and 2016, respectively.Additional segment information is as follows: December 31, 2017 2016Total segment assets: Technology Development$32,011,084 $16,923,090Products and Licensing34,211,552 38,073,883Total$66,222,636 $54,996,973Property plant and equipment and intangible assets, Technology Development$2,361,663 $2,602,803Property plant and equipment and intangible assets, Products and Licensing$4,831,671 $4,749,101For December 31, 2016, the products and licensing segment assets include assets held for sale in the amount of $16.3 million. Property plant andequipment, and intangible assets excludes HSOR amounts for December 31, 2017 and December 31, 2016.63Table of Contents15. Quarterly Results (unaudited)The following table sets forth our unaudited historical revenues, operating loss and net (loss)/income by quarter during 2017 and 2016. Quarter Ended(Dollars in thousands,except per share amounts)March 31, 2017 June 30, 2017 September 30, 2017 December 31, 2017 March 31, 2016 June 30, 2016 September 30, 2016 December 31, 2016Revenues: Technology development$4,235 $4,602 $4,591 $5,148 $3,607 $4,047 $4,118 $4,509Products and licensing5,851 6,691 7,052 8,067 5,381 5,854 7,067 7,285Total revenues10,086 11,293 11,643 13,215 8,988 9,901 11,185 11,794Gross margin3,876 4,368 4,533 5,352 3,148 3,628 4,358 4,671Operating (loss)/income(774) 180 446 37 (1,760) (922) (271) 454Net (loss)/income fromcontinuing operations(865) 78 514 234 (1,711) (919) (388) 348(Loss)/income fromdiscontinued operations netof income taxes(491) (299) 15,243 201 250 149 (57) (42)Net (loss)/income(1,356) (221) 15,757 435 (1,461) (770) (445) 306Net (loss)/income attributableto common stockholders$(1,390) $(251) $15,723 $386 $(1,481) $(796) $(474) $276Net (loss)/income per sharefrom continuing operations: Basic$(0.03) $— $0.02 $0.01 $(0.06) $(0.03) $(0.01) $0.01Diluted$(0.03) $— $0.02 $0.01 $(0.06) $(0.03) $(0.01) $0.01Net (loss)/income per sharefrom discontinued operations: Basic$(0.02) $(0.01) $0.55 $0.01 $0.01 $0.01 $— $—Diluted$(0.02) $(0.01) $0.47 $0.01 $0.01 $0.01 $— $—Net (loss)/income attributableto common stockholders: Basic$(0.05) $(0.01) $0.57 $0.01 $(0.05) $(0.03) $(0.02) $0.01Diluted$(0.05) $(0.01) $0.48 $0.01 $(0.05) $(0.03) $(0.02) $0.01Weighted average shares: Basic27,541,356 27,600,147 27,692,539 27,485,278 27,477,181 27,557,960 27,605,028 27,543,882Diluted27,541,356 32,579,379 32,714,389 31,790,418 27,477,181 27,557,960 27,605,028 32,568,289 16. Discontinued OperationsOn August 9, 2017, we completed the sale of our high speed optical receivers ("HSOR") business, which was part of our Products and Licensingsegment, to an unaffiliated third party for an initial purchase price of $33.5 million, of which $29.5 million in cash has been received, and $4.0 million wasplaced into escrow until December 15, 2018 for possible working capital adjustments to the purchase price and potential satisfaction of certain post-closingindemnification obligations (the "Transaction"). The purchase price is subject to adjustment in the future based upon a determination of final workingcapital, as defined in the asset purchase agreement. The HSOR business was a component of the operations of Advanced Photonix, Inc., which we acquired inMay 2015. As part of the Transaction, the buyer also hired approximately 49 of our employees who were engaged in the development, manufacture, and saleof HSOR products in addition to certain corporate administrative functions. The buyer provided certain transition services to us with respect to infrastructureand administration for which we paid $0.3 million per month for a period of five months, for a total of $1.5 million. We recorded this obligation as areduction of the value of the purchase price. In assessing the fair value of the services expected to be received by us in relation to those we expected todeliver to the buyer, we concluded that the transition service payments were more closely aligned with the fair value of the assets sold than the servicesreceived and, thus, should be accounted for as part of the consideration reconciliation rather than operating activities. Our HSOR business accounted for16.1% of revenues and 18.5% of our costs of revenues for the twelve months ended December 31, 2017.64Table of ContentsWe have reported the results of operations of our HSOR business as discontinued operations in our consolidated financial statements. We allocated aportion of the consolidated tax (benefit)/expense to discontinued operations based on the ratio of the discontinued business's loss/(income) beforeallocations.The following table presents a summary of the transactions related to the sale. December 31, 2017Sale price$33,500,000Less: transition services payments(1,500,000)Adjusted purchase price32,000,000 Assets held for sale(16,851,540)Liabilities held for sale2,330,052Transaction costs(895,186)Income tax expense(912,298)Gain on sale of discontinued operations$15,671,028Assets and liabilities held for sale as of December 31, 2016 were as follows: December 31, 2016 Assets Current assets: Accounts receivable, net $4,028,713Inventory 1,521,400Prepaid expenses and other current assets 251,516Total current assets 5,801,629Property and equipment, net 3,298,151Intangible assets, net 5,314,046Goodwill 1,846,331Other assets 50,754 Total non-current assets 10,509,282Total assets held for sale $16,310,911Liabilities Current liabilities: Accounts payable $1,511,450Accrued liabilities 753,556Deferred revenue 111,697Total current liabilities 2,376,703Long-term deferred rent 84,555 Total non-current liabilities 84,555Total liabilities held for sale $2,461,25865Table of ContentsThe key components of income from discontinued operations were as follows: Twelve Months Ended December 31, 2017 2016Net revenues$6,356,237 $17,343,227Cost of revenues4,599,042 11,413,166Operating expenses2,750,951 5,368,160Other expenses— 50,528(Loss)/income before income taxes(993,756) 511,373Allocated tax expense23,762 210,933Operating (loss)/income from discontinued operations(1,017,518) 300,440Gain on sale, net of related income taxes15,671,028 —Net income from discontinued operations$14,653,510 $300,440For the years ended December 31, 2017 and 2016, depreciation and amortization from discontinued operations were $1.3 million and $2.3 million,respectively. For the years ended December 31, 2017 and 2016, the acquisition of property plant and equipment for discontinued operations was $0.1 millionand $1.4 million, respectively. For the years ended December 31, 2017 and 2016, intangible property costs associated with discontinued operations were$0.1 million in each period. Proceeds from the sale of the HSOR business which are included in cash flows from investing activities for 2017 were $28.0million. The gain on sale of discontinued operations included in non-cash adjustments to cash flows from operating activities for 2017 was $15.7 million.ITEM 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, 2017, 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) ofSecurities Exchange Act Rule 13a-15(e) and Rule 15d-15(e) that occurred in the quarter ended December 31, 2017 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, 2017. 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, 2017 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 2018 Annual Meeting of Stockholders, (the"2018 Proxy Statement"), anticipated to be filed with the SEC within 120 days after December 31, 2017, 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 2018 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 2018 Proxy Statement.EQUITY COMPENSATION PLANSThe following table summarizes our equity compensation plans as of December 31, 2017: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 holders2,813,089 $1.73 3,593,712Total2,813,089 $1.73 3,593,712Our 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 2018 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 2018 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, 2016 Reserves deducted from assets to which they apply: Deferred tax valuation allowance$20,759,102 $550,444 $— $21,309,546Allowances for doubtful accounts129,411 305,593 (187,765) 247,239 $20,888,513 $856,037 $(187,765) $21,556,785Year Ended December 31, 2017 Reserves deducted from assets to which they apply: Deferred tax valuation allowance$21,309,546 $(16,288,802) $5,020,744Allowances for doubtful accounts247,239 99,888 (60,410) 286,717 $21,556,785 $99,888 $(16,349,212) $5,307,461All 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 Document2.6(2)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(3)Amended and Restated Certificate of Incorporation of the Registrant (Exhibit 3.2)3.2(4)Certificate of Designations of the Series A Convertible Preferred Stock (Exhibit 3.1)3.3(5)Amended and Restated Bylaws of the Registrant (Exhibit 3.4)3.4(6)Amendment to Amended and Restated Bylaws (Exhibit 3.1)3.4(2)Amendment to Amended and Restated Bylaws (Exhibit 3.1)4.1(7)Specimen Common Stock certificate of the Registrant (Exhibit 4.1)4.2(8)2006 Equity Incentive Plan (Exhibit 10.9)4.3(5)Form of Stock Option Agreement under 2006 Equity Incentive Plan (Exhibit 4.7)4.4(30)2016 Equity Incentive Plan (Exhibit 4.7)4.5(30)Form of Stock Option Grant Notice and Stock Option Agreement under 2016 Equity Incentive Plan (Exhibit 4.8)4.6(30)Form of Restricted Stock Unit Grant Notice and Restricted Stock Unit Award Agreement under 2016 Equity Incentive Plan (Exhibit 4.9)4.7(31)Form of Restricted Stock Award Grant Notice and Restricted Stock Award Agreement under 2016 Equity Incentive Plan (Exhibit 10.1)10.1(9)Form of Indemnification Agreement for directors and executive officers (Exhibit 10.1)10.2(7)**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)10.3(7)**License Agreement No. DN-951, dated December 20, 2000, by and between NASA and Luna Technologies, Inc. (Exhibit 10.23)10.4(7)**Amended and Restated License Agreement, dated March 19, 2004, by and between Virginia Tech Intellectual Properties, Inc. and LunaInnovations Incorporated (Exhibit 10.26)10.5(10)Asset Transfer and License Agreement by and between Luna Innovations Incorporated and Coherent, Inc. (Exhibit 10.21)10.6(11)**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(12)Amendment to Commercial Lease, by and between Luna Innovations Incorporated and Canvasback Real Estate & Investments LLC datedMarch 18, 2008 (Exhibit 10.5)10.9(4)Securities Purchase and Exchange Agreement, dated January 12, 2010, by and between Luna Innovations Incorporated and Carilion Clinic(Exhibit 10.1)10.10(4)Warrant No. 1 to Purchase Common Stock, dated January 13, 2010, issued to Carilion Clinic (Exhibit 10.2)10.11(4)Warrant No. 2 to Purchase Common Stock, dated January 13, 2010, issued to Carilion Clinic (Exhibit 10.3)10.12(4)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)10.13Non-Employee Directors’ Deferred Compensation Plan10.14(13)**License Agreement, effective January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc. and HansenMedical, Inc. (Exhibit 10.6)10.15(13)**License Agreement, effective January 12, 2010, by and among Luna Innovations Incorporated, Luna Technologies, Inc. and IntuitiveSurgical, Inc. (Exhibit 10.8)10.16(13)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)10.17(13)Loan and Security Agreement, dated February 18, 2010, by and between Luna Innovations Incorporated, Luna Technologies, Inc. andSilicon Valley Bank (Exhibit 10.5)10.18(14)Third Amendment to Commercial Lease dated June 21, 2010, by and between Canvasback Real Estate & Investments, LLC and LunaInnovations, Incorporated (Exhibit 10.5)70Table of Contents10.19(15)First Loan Modification Agreement, dated as of March 7, 2011, by and between Luna Innovations Incorporated and Silicon Valley Bank(Exhibit 10.1)10.20(16)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)10.21(17)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)10.22(18)Fifth Amendment to Industrial Lease Agreement, dated as of November 1, 2011, by and between The Economic Development Authority ofMontgomery County and Luna Innovations Incorporated (Exhibit 10.39)10.23(18)Employment Agreement dated March 28, 2012, by and between My E. Chung and Luna Innovations Incorporated (Exhibit 10.40)10.24(18)Employment Agreement dated March 28, 2012, by and between Dale E. Messick and Luna Innovations Incorporated (Exhibit 10.41)10.25Employment Agreement dated December 5, 2017, by and between Scott A. Graeff and Luna Innovations Incorporated10.26(19)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)10.27(20)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)10.28(21)Fourth Loan Modification Agreement, dated March 21, 2013, by and between Luna Innovations Incorporated, Luna Technologies, Inc. andSilicon Valley Bank (Exhibit 10.1)10.29(1)**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)10.30(1)**Consent, Release and Fifth Loan Modification Agreement between Luna Innovations incorporated and Silicon Valley Bank dated as ofJanuary 21, 2014 (Exhibit 10.3)10.31(22)Sixth Amendment to Industrial lease Agreement by and between the Economic Development Authority of Montgomery County, Virginiaand Luna Innovations Incorporated dated October 1, 2014 (Exhibit 10.47)10.32(22)Industrial Lease Agreement by and between The Economic Development Authority of Montgomery County, Virginia and LunaInnovations Incorporated dated October 1, 2014 (Exhibit 10.48)10.33(22)Lease Agreement by and between SBA Tenant, LLC and Luna Innovations Incorporated dated November 2014 (Exhibit 10.49)10.34(23)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)10.35(24)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)10.36(25)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)10.37(26)Amended and Restated Non-Employee Director Compensation Policy, dated June 30, 2015 (Exhibit 10.1)10.38(27)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)10.39(28)Eighth Loan Modification Agreement, dated December 15, 2016, by and between Luna Innovations Incorporated, Luna Technologies, Inc.,Advanced Photonix, LLC and Silicon Valley Bank (Exhibit 10.54)21.1List 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 2002.71Table of Contents101The following materials from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2017, are formatted in XBRL(eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at December 31, 2017 and 2016, (ii) Consolidated Statementsof Operations for the years ended December 31, 2017 and 2016, (iii) Consolidated Statements of Changes in Stockholder’s Equity for theyears ended December 31, 2017 and 2016 (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2017 and 2016,and (v) Notes to Audited Consolidated Financial Statements.(1)Incorporated by reference to the exhibit to the Registrant's Quarterly Report on Form 10-A, Commision File No. 000-52008, filed on May 13, 2014.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(2)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.(3)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.(4)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.(5)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.(6)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.(7)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 May 19, 2006. The number given in parentheses indicates the corresponding exhibit number in such Form S-1.(8)Incorporated by reference to the exhibit to Amendment No. 3 of the Registrant's Registration Statement on Form S-1, Commission File No. 333-131764, filed on April 28, 2006. The number given in parentheses indicates the corresponding exhibit number in such Form S-1.(9)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.(10)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.(11)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.(12)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.(13)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.(14)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.(15)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.(16)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.(17)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.72Table of Contents(18)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.(19)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.(20)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.(21)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.(22)Incorporated by reference to the exhibit to the Registrant's Quarterly 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.(23)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.(24)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.(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 14, 2015.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 Current Report on Form 10-Q, Commission File No. 000-52008, filed on August 14,2015. 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 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.(28)Incorporated by reference to the exhibit to the Registrant's Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 20, 2017.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.(29)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.(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 10,2016. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.*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.73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 21, 2018KNOW 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/ Scott A. Graeff President, Chief Executive Officer and Director (Principal ExecutiveOfficer) March 21, 2018Scott A. Graeff /s/ Dale E. Messick Chief Financial Officer (Principal Financial Officer and PrincipalAccounting Officer) March 21, 2018Dale E. Messick /s/ Michael W. Wise Director March 21, 2018Michael W. Wise /s/ Donald Pastor Director March 21, 2018Donald Pastor /s/ John B. Williamson III Director March 21, 2018John B. Williamson III /s/ N. Leigh Anderson Director March 21, 2018N. Leigh Anderson /s/ Warren B. Phelps, III Director March 21, 2018Warren B. Phelps, III /s/ Gary Spiegel Director March 21, 2018Gary Spiegel /s/ Richard W. Roedel Chairman of the Board of Directors March 21, 2018Richard W. Roedel 74EXHIBIT 10.13LUNA INNOVATIONS INCORPORATEDNON-EMPLOYEE DIRECTORS’ DEFERRED COMPENSATION PLANAs Amended and Restated Through December 2017TABLE OF CONTENTS PageARTICLE 1INTRODUCTION1ARTICLE 2ELIGIBILITY1ARTICLE 3DEFERRAL ELECTIONS1ARTICLE 4DEFERRED COMPENSATION ACCOUNTS2ARTICLE 5DISTRIBUTION OF DEFERRED COMPENSATION2ARTICLE 6UNFUDED STATUS3ARTICLE 7DESIGNATION OF BENEFICIARY4ARTICLE 8ADMINISTRATION4ARTICLE 9TAXES4ARTICLE 10SECURITIES LAWS COMPLIANCE5ARTICLE 11GENERAL PROVISIONS5ARTICLE 12DEFINITIONS6 ARTICLE 1INTRODUCTION1.1Establishment. Luna Innovations Incorporated (the “Company”) established this Non-Employee Directors’ DeferredCompensation Plan (the “Plan”) for those members of the Company’s Board of Directors who are not employees of the Company orany of its subsidiaries or affiliates. The Plan allows such Eligible Directors to defer the receipt of their Director Fees and to receivesettlement of the right to receive payment of such amounts in the form of an issuance of Company Shares. Capitalized terms used in thePlan have the definitions set forth in Article 12.1.2Purpose. This Plan is intended to advance the interests of the Company and its stockholders by providing a means toattract and retain qualified persons to serve as Eligible Directors and to promote Company equity ownership by Eligible Directors,thereby aligning such Eligible Directors’ interests more closely with the interests of the stockholders of the Company.1.3Effective Date. This Plan originally became effective as of August 9, 2007 (the “Effective Date”). This amendmentand restatement of the Plan is effective December 28, 2017.ARTICLE 2ELIGIBILITY2.1Effective Date Eligibility. Each person who was an Eligible Director on the Effective Date became eligible toparticipate in the Plan on the Effective Date.2.2Initial Board Appointment Eligibility. Each person who becomes an Eligible Director following the Effective Dateshall become eligible on the date of his or her initial appointment to the Board.2.3Change in Employment Status. If any Participant subsequently becomes an employee of the Company or any of itssubsidiaries or affiliates such Participant shall not be eligible to defer any Director Fees earned during any calendar year thatcommences following such change in status, if applicable. Such change in status shall not otherwise impact the Participant’s Stock UnitAccount, which will continue to be administered in accordance with the terms of the Plan and the Participant’s Deferral Election.ARTICLE 3DEFERRAL ELECTIONS3.1Deferral Elections. Each Eligible Director may elect to defer a whole percentage (in increments of 1%) of up to 100%of his or her Cash Director Fees and/or Stock Director Fees by submitting a completed Deferral Election form to the Administrator inaccordance with the procedures set forth in this Article 3.3.2Timing of Deferral Election. An Eligible Director may make a Deferral Election within thirty (30) days after the dateon which he or she initially becomes eligible to participate in the Plan (the “Initial Election Period”). An Eligible Director who does notmake a Deferral Election within the Initial Election Period may make a Deferral Election in accordance with administrative proceduresestablished by the Administrator.3.3Effect and Duration of Deferral Election. A Deferral Election shall apply only to Director Fees earned after the datesuch election is made and is irrevocable consistent with the requirements of Section 409A. Any Deferral Election made within the InitialElection Period will be irrevocable upon expiration of the Initial Election Period and will apply to any Director Fees earned duringcalendar quarters that commence following expiration of such Initial Election Period, including calendar quarters in any subsequentcalendar year. Any Deferral Election made after expiration of the Initial Election Period will be irrevocable as of December 31st of thecalendar year in which it was made and will apply to any Director Fees earned in any subsequent calendar year. Deferral Elections shallevergreen so that they will continue in effect and will be applicable to Director Fees earned in all subsequent calendar years, unless anduntil such Deferral Election is modified as provided in Section 3.4.13.4Modifications to Deferral Elections. A Participant may revoke or modify a prior Deferral Election by submitting anew Deferral Election to the Administrator at such time before the first day of any subsequent calendar year in accordance withprocedures established by the Administrator. Any modified Deferral Election will commence effectiveness with respect to suchsubsequent calendar year and will evergreen and remain effective for calendar years commencing thereafter.3.5Form of Deferral Election. A Deferral Election shall be made in a form approved by the Administrator (including inthe form attached to the Plan as Appendix I).ARTICLE 4DEFERRED COMPENSATION ACCOUNTS4.1Establishment of Stock Unit Account. The Company shall establish a Stock Unit Account for each Participant. AllDirector Fees deferred pursuant to Article 3 shall be converted to Stock Units which are credited to the Participant’s Stock Unit Accounton the Deferral Date. Stock Director Fees deferred under the Plan will have the number of Shares subject to such deferral electionconverted into an equivalent number of Stock Units credited to the Participant’s Stock Unit Account. With respect to any Cash DirectorFees deferred under the Plan, the number of Stock Units credited to a Participant’s Stock Unit Account as of a Deferral Date shall equalthe amount of the deferred Director Fees divided by the Fair Market Value of a Share on such Deferral Date, with fractional Stock Unitscalculated to three decimal places. Fractional Stock Units shall be credited cumulatively, but any fractional Stock Unit credited to aParticipant’s Stock Unit Account at the time of a distribution under Article 5 shall be converted into the right to receive a cash amountequal to the Fair Market Value of a corresponding fractional Share on the date of distribution.4.2Crediting of Dividend Equivalents. As of each dividend payment date with respect to Shares, if any, each Participantshall have credited to his or her Stock Unit Account a dollar amount equal to the amount of cash dividends that would have been paidon the number of Shares equal to the number of Stock Units credited to the Participant’s Stock Unit Account as of the close of businesson the record date for such dividend. Such dollar amount shall then be converted into a number of Stock Units equal to the number ofwhole and fractional Shares that could have been purchased with such dollar amount at Fair Market Value on the dividend paymentdate.4.3Adjustment Provisions. In the event of a reorganization, recapitalization, stock split, stock dividend, spin off,combination, corporate exchange, merger, consolidation or other change in the Shares that does not qualify as a Change in Control, orany distribution to holders of Shares other than cash dividends or any transaction determined in good faith by the Administrator to besimilar to the foregoing but, the Administrator shall make appropriate equitable changes in the number of Stock Units credited to theParticipant’s Stock Unit Account.ARTICLE 5DISTRIBUTION OF DEFERRED COMPENSATION5.1Share Settlement and Source of Shares. Settlement of a Participant’s Stock Unit Account will be effected bydelivering to the Participant a number of Shares equal to the number of whole Stock Units credited to the Participant’s Stock UnitAccount. The source of Shares distributed pursuant to this Plan shall be the Company’s 2016 Equity Incentive Plan or any successorequity incentive plan adopted by the Company. Any fractional Stock Units credited to a Participant’s Stock Unit Account at the time ofa distribution shall be paid in cash at the time of such distribution.5.2Timing and Form of Distribution. The Participant shall specify on the Deferral Election form the timing of distributionin settlement of the Participant’s Stock Unit Account as specified on the Deferral Election form, which may commence on any of thefollowing permissible distribution events, with such distribution to be made in either (i) a lump sum, or (ii) substantially equal annualinstallments over a period not to exceed five (5) years:(a)The Participant’s Separation from Service;(b)Change in Control; or2(c)A Specified Date.5.3Default Form of Distribution. If a Participant submits a Deferral Election form but fails to specify a distribution eventor form of distribution on the Deferral Election form, the Participant’s Stock Unit Account will be distributed in a single lump sum uponSeparation from Service.5.4Specified Employee Delay in Distribution Upon Separation from Service. The provisions of this Section 5.4 shallapply to the extent necessary to avoid adverse tax consequences to a Participant under Section 409A of the Code. If a Participant is aSpecified Employee no distribution to such Participant which is triggered by a Separation from Service will be made any earlier than sixmonths and one day following the date of the Separation from Service. If a Participant is a Specified Employee and is scheduled toreceive payments in the form of annual installments upon a Separation from Service, the first annual installment payment will be madesix months and one day following the date of the Separation from Service, and the remaining annual installment payments shall bemade as originally scheduled.5.5Distribution upon Death. In the event of a Participant’s death at any time prior to distribution of the Participant’sentire Stock Unit Account, whether before or after such distribution had commenced, as soon as administratively feasible after theParticipant’s death the entire balance of the Participant’s Stock Unit Account shall be immediately settled in an issuance of Shares with acash payment for any fractional Stock Unit to the beneficiary designated by the Participant under Article 7.5.6Unforeseeable Emergency. In the event the Participant experiences an unforeseeable emergency as defined in Treas.Reg. § 1.409A-3(i)(3), the Administrator may, at the request of the Participant, make a distribution from the Participant’s Stock UnitAccount equivalent to the amount reasonably necessary to satisfy the emergency need. The balance of the Stock Unit Account will notbe distributed until the occurrence of the earliest distribution event as provided in the Participant’s Deferral Election. Unforeseeableemergency distributions will be administered in manner compliant with the requirements of Section 409A.5.7Specified Date Distribution Downstream Election Changes. A Participant who had elected to receive distribution insettlement of his or her Stock Unit Account on a Specified Date is permitted to elect to delay a distribution or change the form of adistribution in accordance with procedures established by the Administrator so long as the following conditions are met:(a)Such election does not take effect until at least twelve (12) months after the date on which the election is made;(b)Such election must defer the distribution for a period of at least five (5) years from the date such distribution wouldotherwise have been made; and(c)If the distribution is scheduled to begin at specified time or pursuant to a fixed schedule, then such election must bemade no less than twelve (12) months before the date the distribution is scheduled to be made.Any subsequent deferral election shall become irrevocable as of the last permissible date for making such subsequent deferral election.ARTICLE 6UNFUNDED STATUS6.1General. The interest of each Participant in any Director Fees deferred under the Plan (and any Stock Units or StockUnit Account relating thereto) shall be that of a general creditor of the Company. Stock Unit Accounts, and Stock Units credited thereto,shall at all times be maintained by the Company as bookkeeping entries evidencing unfunded and unsecured general obligations of theCompany. Except as provided in Section 6.2, no money or other assets shall be set aside for any Participant.6.2Trust. To the extent determined by the Board, the Company may, but shall not be required to, transfer fundsnecessary to fund all or part of the payments under the Plan to a trust; provided, the assets held in such trust shall remain at all timessubject to the claims of the general creditors of the Company. No participant or beneficiary shall have any interest in the assets held insuch trust or in the general assets of the Company other than as a general,3unsecured creditor. Accordingly, the Company shall not grant a security interest in the assets held by the trust in favor of anyParticipant, beneficiary or creditor.ARTICLE 7DESIGNATION OF BENEFICIARY7.1Beneficiary Designation. Each Participant may designate one or more beneficiaries to receive settlement of theParticipant’s Stock Unit Account in the event of such Participant’s death. The Company may rely upon the beneficiary designation filedwith the Administrator, provided that such form was executed by the Participant or his or her legal representative and filed with theAdministrator prior to the Participant’s death. If a Participant has not designated a beneficiary, or if the designated beneficiary is notsurviving when a payment is to be made to such person under the Plan, the beneficiary with respect to such payment shall be theParticipant’s surviving spouse, or if there is no surviving spouse, the Participant’s estate.ARTICLE 8ADMINISTRATION8.1Administrator. The Plan shall be administered by the Administrator appointed by the Board. Unless the Boarddetermines otherwise, the Administrator shall be a committee of Company employees consisting of the Company’s Chief FinancialOfficer, Corporate Secretary and one or more Company employees selected by the Chief Financial Officer. The Administrator shallhave the authority to make all determinations it deems necessary or advisable for administering the Plan, subject to the expressprovisions of the Plan, and to delegate its authority to one or more Company employees.8.2Binding Effect of Decisions. The decision or action of the Administrator with respect to any question arising out of orin connection with the administration, interpretation and application of the Plan and the rules and regulations promulgated hereundershall be final and conclusive and binding upon the Participants and any other persons having any interest in the Plan.8.3Indemnification of Administrator. The Company shall indemnify and hold harmless the members of the committeecomprising the Administrator, and any Company employee to whom the duties of the Administrator are delegated, against any and allclaims, losses, damages, expenses or liabilities arising from any action or failure to act with respect to this Plan, except in the case ofwillful misconduct.ARTICLE 9TAXES9.1Withholding Taxes. By electing to make a deferral under this Plan, each Participant authorizes any requiredwithholding from, at the Company’s election, distributions and any other amounts payable to the Participant, and the Participantotherwise agrees to make adequate provision for any sums required to satisfy the federal, state, local and foreign tax withholdingobligations of the Company if any, which arise in connection with payments or distributions from this Plan. Unless the tax withholdingobligations of the Company are satisfied, the Company shall have no obligation to make distributions under this Plan. Any taxwithholding obligation triggered by a distribution of Shares will be satisfied by an automatic reduction in the number of Shares issued tothe Participant or the Participant’s beneficiary.9.2409A Savings. This Plan is intended to comply with the requirements of Section 409A of the Code. The Administratorshall interpret the Plan provisions in a manner consistent with the requirements of Section 409A of the Code. To the extent one or moreprovisions of this Plan do not comply with Section 409A of the Code, such provision shall be automatically and immediately voided,and shall be amended as soon as administratively feasible and shall be administered to so comply. Notwithstanding the foregoing oranything else to the contrary in the Plan, the Company4shall have no liability to any Participant should any provision of the Plan fail to satisfy the requirements of Section 409A.ARTICLE 10SECURITIES LAWS COMPLIANCE10.1Action by Administrator. With respect to any Participant who is then subject to Section 16 of the Exchange Act,notwithstanding anything to the contrary set forth herein, any function of the Administrator under the Plan relating to such Participantshall be performed solely by the Board or its Compensation Committee, if and to the extent required to ensure the availability of anexemption under Section 16 of the Exchange Act for any transaction relating to such Participant under the Plan.10.2Compliance with Section 16. Notwithstanding any other provision of the Plan or any rule, instruction, election formor other form, the Plan and any such rule, instruction or form shall be subject to any additional conditions or limitations set forth in anyapplicable exemptive rule under Section 16 of the Exchange Act (including any amendment to Rule 16b-3) that are requirements for theapplication of such exemptive rule. To the extent permitted by applicable law, such provision, rule, instruction or form shall be deemedamended to the extent necessary to conform to such applicable exemptive rule.ARTICLE 11GENERAL PROVISIONS11.1No Stockholder Rights Conferred. Nothing contained in the Plan will confer upon any Participant or beneficiary anyrights of a stockholder of the Company, unless and until Shares are in fact issued or transferred to such Participant or beneficiary inaccordance with Article 5.11.2Changes to The Plan. The Administrator may amend, alter, suspend, discontinue, extend, or terminate the Planwithout the consent of Participants; provided, no action taken without the consent of an affected Participant may materially impair therights of such Participant with respect to any Stock Units credited to his or her Stock Unit Account at the time of such change ortermination except that the Administrator may without the consent of any Participant terminate the Plan and distribute Shares insettlement of Stock Units then credited to Participant’s Stock Unit Account upon a Change in Control.11.3Compliance With Laws and Obligations. The Company will not be obligated to issue or deliver Shares in connectionwith the Plan in a transaction subject to the registration requirements of the Securities Act of 1933, as amended, or any other federal orstate securities law, any requirement under any listing agreement between the Company and any national securities exchange orautomated quotation system or any other laws, regulations, or contractual obligations of the Company, until the Company is satisfiedthat such laws, regulations and other obligations of the Company have been complied with in full. Certificates representing Sharesdelivered under the Plan will be subject to such restrictions as may be applicable under such laws, regulations and other obligations ofthe Company.11.4Limitations on Transferability. Stock Units and other rights under the Plan may not be pledged, mortgaged,hypothecated or otherwise encumbered, and shall not be subject to the claims of creditors of any Participant.11.5Governing Law. The validity, construction and effect of the Plan and any agreement hereunder will be determined inaccordance with laws of the State of Delaware.11.6Plan Termination. The Administrator reserves the right to terminate the Plan at any time to the extent suchtermination is in compliance with the requirements of Section 409A. Unless earlier terminated by action of the Board, the Plan willremain in effect until such time as the Company and the Participants have no further rights or obligations under the Plan.511.7Acceleration of Plan Distributions. The Administrator reserves the right to accelerate the distribution of Shares insettlement of Stock Unit Accounts to the extent compliant with the requirements of Section 409A, including any accelerated distributionpermitted by Treas. Reg. § 1.409A-3(j)(4).ARTICLE 12DEFINITIONSWherever used herein, the following terms shall have the meanings set forth below:“Administrator” means the committee appointed to administer the Plan under Article 8.“Board” means the Board of Directors of the Company.“Cash Director Fees” means all or part of any annual or quarterly retainer or meeting fees payable in cash to a Non-EmployeeDirector as consideration for services provided as a Director in the form of cash.“Change in Control” means a change in the ownership or effective control of the Company, or in the ownership of a substantialportion of the assets of the Company, as defined in Section 409A(a)(2)(A)(v) of the Code. Whether a Change in Control has occurredwill be determined in manner consistent with the requirements of Section 409A.“Code” means the Internal Revenue Code of 1986, as amended.“Company” means Luna Innovations Incorporated, a Delaware corporation, or any successor thereto.“Deferral Date” means the date Director Fees would otherwise have been paid to the Participant in the absence of a DeferralElection.“Deferral Election” means a written election by a Participant to defer Director Fees under the Plan.“Director” means any individual who is a member of the Board.“Director Fees” means Cash Director Fees and/or Stock Director Fees. Director Fees shall not include any expenses paiddirectly or through reimbursement.“Eligible Director” means a Director who is not an employee of the Company or any of its subsidiaries or affiliates.“Exchange Act” means the Securities Exchange Act of 1934, as amended.“Fair Market Value” of a Share means on a given date (a) if the principal market for the Shares is the Nasdaq stock market, anational securities exchange or other recognized national market or service reporting sales, the closing price of a Share on the date ofthe determination on the principal market on which the Shares are then listed or admitted to trading, (b) if the Shares are not listed onthe Nasdaq stock market, a national securities exchange or other recognized national market or service reporting sales, the closing priceof a Share on the date of the determination as reported by the system then regarded as the most reliable source of such quotations, (c) ifShares are listed on a domestic stock exchange or market or quoted in a domestic market or service, but there are not reported sales orquotations, as the case may be, on the given date, the value determined pursuant to (a) or (b) above using the reported sale prices orquotations on the last previous day on which so reported, or (d) if none of the foregoing clauses apply, the fair market value of a Shareas determined in good faith by the Administrator.“Specified Employee” means a “specified employee” as defined in Treas. Reg. § 1.409A-1(i).“Participant” means an Eligible Director who elects to defer Director Fees under the Plan.6“Section 409A” shall mean Section 409A of the Code and the regulations and other guidance thereunder.“Separation from Service” means the termination of an individual’s service as a Director for any reason within the meaning ofTreas. Reg. § 1.409A-1(h). Whether a Separation from Service has occurred will be determined in manner consistent with therequirements of Section 409A.“Shares” means shares of the Company’s common stock, par value $0.001 per share, or, in the event that the outstandingshares of the Company’s common stock are recapitalized, converted into or exchanged for different stock or securities of the Company,such other stock or securities..“Specified Date” means the date elected by the Participant on the Deferral Form for commencement of distribution of Shares insettlement of the Participant’s Stock Unit Account.“Stock Units” means the credits made to a Participant’s Stock Unit Account under Article 4 of the Plan. Each Stock Unitrepresents the right to receive one Share upon settlement of the Stock Unit Account.“Stock Unit Account” means the bookkeeping account established by the Company pursuant to Section 4.1.“Stock Director Fees” means all or part of any award providing for an issuance of Shares granted to a Non-Employee Director asconsideration for services provided as a Director, but excluding any stock option.7APPENDIX IFORM OF NOTICE OF ELECTION TO DEFER DIRECTOR FEES[Date]Corporate SecretaryLuna Innovations Incorporated301 1st Street, SW Suite 200Roanoke, VA 24011RE: Notice of Election to Defer Board of Director CompensationDear Mr. Graeff:Pursuant to the Luna Innovations Incorporated Non-Employee Directors' Deferred Compensation Plan, as amended (the "Plan"), I hereby elect todefer receipt of my Director fees that I earn in future periods, whether otherwise payable to me in cash (“Cash Director Fees”) or in an issuance ofshares of common stock or restricted stock units (“Stock Director Fees” and, collectively with the Cash Director Fees, the “Director Fees”),commencing with the Director Fees that I earn on or after January 1, 2018 in accordance with my elections below. I understand that this electionwill remain in effect with respect to any Director Fees that I earn in future taxable years unless and until changed by me in a manner permitted bySection 409A of the Internal Revenue Code.I elect to have my Director Fees credited as follows (fill in appropriate percentages for options a, b, c and d below):Cash Director Fees (percentages should total to 100%):(a)_____% of my aggregate Cash Director Fees shall be credited to my Stock Unit Account as provided for in the Plan;(b)_____% of my aggregate Cash Director Fees shall not be deferred;Stock Director Fees (percentages should total to 100%):(c)_____% of my aggregate Stock Director Fees shall be credited to my Stock Unit Account as provided for in the Plan; and(d)_____% of my aggregate Stock Director Fees shall not be deferred.I understand that application of any elected deferral percentage to Stock Director Fees will be rounded up the nearest whole share to avoid anyfractional share deferral.Further, I elect to receive any future payments to be made from my Stock Unit Account under the Plan in the following method (check one desiredmethod below): in one lump sum; or in ______ (insert number) of equal annual installments.8I elect to receive (in the case of a lump sum) or begin to receive (in the case of installments) payment from my Stock Unit Account on the first dayof the month next following the earlier of the following to occur:(a)My Separation of Service (as defined by the Plan);(b)My _______ birthday, which is ____________, 20___ (indicate the age you would like to trigger the distribution and the date uponwhich you will be that age);(c)____________ (indicate date that you would like to trigger distribution); or(d)A Change in Control (as defined by the Plan).I understand an election to defer my Director Fees is irrevocable as of each December 31 with respect to fees earned for services performed in theimmediately following calendar year.In the event of my death prior to the receipt of all or any amount of the balance of my Stock Unit Account so accumulated. I designate thefollowing one or more individuals; _________________________________________________________; as my beneficiary or beneficiaries toreceive any accumulated but unpaid funds from my Stock Unit Account.Sincerely,____________________________________Signature of Director____________________________________Printed Name of Director____________________________________Date9EXHIBIT 10.25AMENDED AND RESTATED EMPLOYMENT AGREEMENTThis AMENDED AND RESTATED EMPLOYMENT AGREEMENT (the “Agreement”) is entered into effective as ofDecember 5, 2017 (the “Effective Date”), by and between Scott A. Graeff (the “Employee”) and Luna Innovations Incorporated (the“Company”) and amends and restates in its entirety the Employment Agreement between the Company and Employee that waseffective as of March 28, 2012.The Company desires to continue to employ the Employee and, in connection therewith, to compensate the Employee forEmployee’s personal services to the Company; andThe Employee wishes to continue to be employed by the Company and provide personal services to the Company in return forcertain compensation.This Agreement supersedes any and all prior and contemporaneous oral or written employment agreements or arrangementsbetween Employee and the Company or any predecessor thereof.Accordingly, in consideration of the mutual promises and covenants contained herein, the parties agree to the following:1.EMPLOYMENT BY THE COMPANY.1.1 At-Will Employment. Employee shall continue to be employed by the Company on an “at-will” basis, meaningeither the Company or Employee may terminate Employee’s employment at any time, with or without cause or advanced notice. Anycontrary representations that may have been made to Employee shall be superseded by this Agreement. This Agreement shallconstitute the full and complete agreement between Employee and the Company on the “at-will” nature of Employee’s employmentwith the Company, which may be changed only in an express written agreement signed by Employee and a duly authorized officer ofthe Company. Employee’s rights to any compensation following a termination shall be only as set forth in Section 6.1.2 Position; Board Role. Subject to the terms set forth herein, the Company agrees to continue to employ Employee,in the position of President and Chief Executive Officer, and Employee hereby accepts such continued employment. During the termof Employee’s employment with the Company, and excluding periods of vacation and sick leave to which Employee is entitled,Employee shall devote all business time and attention to the affairs of the Company necessary to discharge the responsibilities assignedhereunder, and shall use commercially reasonable efforts to perform faithfully and efficiently such responsibilities. Employee shallfurther serve as a Director of the Company’s Board of Directors (the “Board”) during the term of his employment1.3 Duties. Employee will report to Board will render such business and professional services in the performance ofhis duties, consistent with Employee’s position as President and Chief Executive Officer, as shall reasonably be assigned to him by theBoard, subject to the oversight and direction of the Board. Employee shall perform his duties under this Agreement principally out ofthe Company’s corporate headquarters, or such other location as assigned. In addition, the Employee shall make such business trips tosuch places as may be reasonably necessary or advisable for the efficient operations of the Company.1.4 Company Policies and Benefits. The employment relationship between the parties shall also be subject to theCompany’s personnel policies and procedures as they may be adopted, revised or deleted from time to time in the Company’s solediscretion. The Employee will continue to be eligible to participate on the same basis as similarly situated employees in the Company’sbenefit plans in effect from time to time during his employment. All matters of eligibility for coverage or benefits under any benefitplan shall be determined in accordance with the provisions of such plan. The Company reserves the right to change, alter, or terminateany benefit plan in its sole discretion. Notwithstanding the foregoing, in the event that the terms of this Agreement differ from or are inconflict with the Company’s general employment policies or practices, this Agreement shall control.2.COMPENSATION.2.1 Salary. Effective as of October 1, 2017, Employee shall receive for Employee’s services to be rendered hereunderan initial annualized base salary of $325,000, subject to review and adjustment from time to time by the Company in its sole discretion,payable subject to standard federal and state payroll withholding requirements in accordance with Company’s standard payrollpractices (“Base Salary”). This increase will be reflected in the Company’s first regularly scheduled payroll date after the EffectiveDate.2.2 Bonus.(a) During Employment. Employee shall continue to be eligible to earn an annual performance bonus with atarget of 50%, with a maximum potential of 75% of the actual salary received in the year in which the bonus is being measured (an“Annual Bonus” and the target amount of an Annual Bonus, the “Target Bonus” and the maximum amount of an Annual Bonus, the“Maximum Target Bonus). The Annual Bonus will be based upon the Board’s assessment of the Employee’s performance and theCompany’s attainment of targeted goals as set by the Board in its reasonable good faith discretion. The Annual Bonus, if any, will besubject to applicable payroll deductions and withholdings. Following the close of each calendar year, the Board will determine whetherthe Employee has earned the Annual Bonus, and the amount of any Annual Bonus, based on the set criteria. No amount of the AnnualBonus is guaranteed, and the Employee must be an employee in good standing through December 31 of the year in which the AnnualBonus is being measured to be eligible to receive an Annual Bonus. No partial or prorated bonuses will be provided. The AnnualBonus, if earned, will be paid no later than March 15 of the calendar year immediately following the applicable calendar year forwhich the Annual Bonus is being measured. The Employee’s eligibility for an Annual Bonus is subject to change in the discretion ofthe Board (or any authorized committee thereof). Employee acknowledges that if the Company adopts an incentive compensation planthe terms of any such plan may supersede and replace the provisions of this Section 2.2, as determined by the Company in its solediscretion(b) Upon Termination. Subject to the provisions of Section 6.1(a)(iii), in the event Employee leaves theemploy of the Company for any reason prior to December 31 of the year in which the Annual Bonus is being measured, he is noteligible for such Annual Bonus, prorated or otherwise.2.3 Equity Incentive Awards.(a) Prior Equity Incentive Awards. The parties acknowledge that Exhibit A is a complete and accurate listof Employee’s options to purchase shares of the Company’s common stock (the “Prior Options”) and restricted shares of theCompany’s common stock (“Prior Restricted Stock Awards”) granted by the Company to Employee prior to the Effective Date of thisAgreement. The Prior Options and Prior Restricted Stock Awards are subject to the Company’s 2006 Equity Incentive Plan (the “2006Plan”) or the Company’s 2016 Equity Incentive Plan (the “2016 Plan”) and individual stock option and restricted stock grant noticesand agreements (“Award Agreements”), as applicable, including but not limited to the vesting schedules set forth therein.(b) Restricted Stock Award. Subject to approval by the Board at its next regularly scheduled meetingfollowing the Effective Date, the Company will grant Employee fifty thousand (50,000) restricted shares of the Company’s CommonStock (the “Restricted Stock Award”). The Restricted Stock Award will be subject to the terms of the 2016 Plan and a restricted stockgrant notice and agreement. The Restricted Stock Award will vest subject to Employee’s continued employment in annual installmentsover a three-year period, whereby one third of the shares will vest on each of the first, second and third anniversaries of October 1,2017, in each case subject to Employee’s continued employment through the applicable vesting dates.(c) Acceleration. The Prior Options, Prior Restricted Stock Awards and Restricted Stock Award may besubject to accelerated vesting in accordance with Section 6 of this Agreement.2.4 Expense Reimbursement. The Company will reimburse Employee for reasonable business expenses inaccordance with the Company’s standard expense reimbursement policy. For the avoidance of doubt, to the extent that anyreimbursements payable to Employee are subject to the provisions of Section 409A of the Internal Revenue Code of 1986, as amended(the “Code”): (a) any such reimbursements will be paid no later than December 31 of the year following the year in which the expensewas incurred, (b) the amount of expenses reimbursed in one year will not affect the amount eligible for reimbursement in anysubsequent year, and (c) the right to reimbursement under this Agreement will not be subject to liquidation or exchange for anotherbenefit.3.PROPRIETARY INFORMATION, INVENTIONS, AND NON-SOLICITATION OBLIGATIONS.Contemporaneously with this Agreement and as a condition of continued employment, the parties hereto have entered into aConfidential Information, Inventions, Non-Competition and Non-Solicitation Agreement (the “Confidential InformationAgreement”), which may be amended by the parties from time to time without regard to this Agreement. The Confidential InformationAgreement contains provisions that are intended by the parties to survive and do survive termination or expiration of this Agreement. 4.OUTSIDE ACTIVITIES. Except with the prior written consent of the Board, , Employee will not, while employed by theCompany, undertake or engage in any other employment, occupation or business enterprise that would interfere with Employee’sresponsibilities and the performance of Employee’s duties hereunder except for (i) reasonable time devoted to volunteer services for oron behalf of such religious, educational, non-profit and/or other charitable organization as Employee may wish to serve, (ii) reasonabletime devoted to activities in the non-profit and business communities consistent with Employee position with the Company; or (iii)reasonable time serving as trustee, director or advisor to any family companies or trusts. This restriction shall not, however, precludethe Employee (x) from owning (A) less than one percent (1%) of the total outstanding shares of a publicly traded company or (B)equity in real estate holding or management companies, or (y) from employment or service in any capacity with Affiliates of theCompany. As used in this Agreement, “Affiliates” means an entity under common management or control with the Company.5.NO CONFLICT WITH EXISTING OBLIGATIONS. Employee represents that Employee’s performance of all the termsof this Agreement and as an employee of the Company do not and will not breach any agreement or obligation of any kind made priorto Employee’s employment by the Company, including agreements or obligations Employee may have with prior employers or entitiesfor which Employee has provided services. Employee has not entered into, and Employee agrees that Employee will not enter into,any agreement or obligation, either written or oral, in conflict herewith.6.TERMINATION OF EMPLOYMENT. The parties acknowledge that Employee’s employment relationship with theCompany is at-will. Either Employee or the Company may terminate the employment relationship at any time, with or without cause.The provisions in this Section govern the amount of compensation, if any, to be provided to Employee upon termination ofemployment and do not alter this at-will status.6.1 Termination by the Company or Resignation by Employee.(a) The Company shall have the right to terminate Employee’s employment with the Company pursuant to thisSection 6.1 at any time with or without Cause (as defined below), by giving notice as described in Section 7.1 of this Agreement.Likewise, Employee can resign from employment with the Company with or without Good Reason (as defined below), by givingnotice as described in Section 7.1 of this Agreement. If Employee is terminated by the Company (with or without Cause) or resignsfrom employment with the Company (with or without Good Reason), then Employee shall be entitled to the Accrued Obligations (asdefined below), and in addition, if Employee is terminated without Cause or resigns for Good Reason, and provided that suchtermination constitutes a “separation from service” (as defined under Treasury Regulation Section 1.409A-1(h), without regard to anyalternative definition thereunder, a “Separation from Service”), and further provided that the Employee executes and allows to becomeeffective a separation agreement that includes, among other terms, a general release of claims in favor of the Company and its affiliatesand representatives, in a reasonable form presented by the Company (the “Release”), and subject to Section 6.1(b) (the date that theRelease becomes effective and may no longer be revoked by the Employee is referred to as the “Release Date”), then the Employeeshall be eligible to receive the following severance benefits (collectively the “Severance Benefits”):(i) An amount equal to twelve (12) months of Employee’s then current Base Salary, lessstandard payroll deductions and withholdings, paid in installments on the Company’s regular payroll dates;(ii) provided Employee timely elects continued coverage under COBRA under the Company’sgroup health plans following such termination, the portion of the COBRA premiums that the Company was previously paying,to continue Employee’s health insurance coverage in effect on the termination date until the earliest of: (1) twelve (12) monthsfollowing the termination date (the “COBRA Severance Period”); (2) the date when Employee becomes eligible forsubstantially equivalent health insurance coverage in connection with new employment or self-employment; or (3) the dateEmployee ceases to be eligible for COBRA continuation coverage for any reason, including plan termination (such period fromthe termination date through the earlier of (1)-(3), (the “COBRA Payment Period”). Notwithstanding the foregoing, if at anytime the Company determines that its payment of COBRA premiums on Employee’s behalf would result in a violation ofapplicable law (including, but not limited to, the 2010 Patient Protection and Affordable Care Act, as amended by the 2010Health Care and Education Reconciliation Act), then in lieu of paying COBRA premiums pursuant to this Section, theCompany shall pay Employee on the last day of each remaining month of the COBRA Payment Period, a fully taxable cashpayment equal to the COBRA premium for such month, subject to applicable tax withholding (such amount, the “SpecialSeverance Payment”), for the remainder of the COBRA Payment Period. Nothing in this Agreement shall deprive Employee ofhis rights under COBRA or ERISA for benefits under plans and policies arising under his employment by the Company;(iii) A lump sum cash payment in an amount equal to the Target Bonus for the year in whichthe termination occurs (the “Bonus Severance Payment”), subject to standard payroll deductions and withholdings, which will be paidwhen annual bonuses are otherwise paid, which in no event will be later than March 15 of the year following the year in which thetermination date occurs; and(iv) A lump cash payment equal to the value of any unvested 401(k) Company match amount.(b) Employee shall not receive the Severance Benefits pursuant to Section 6.1(a) unless he executes theRelease within the consideration period specified therein, which shall in no event be more than 45 days, and until the Release becomeseffective and can no longer be revoked by Employee under its terms. Employee’s ability to receive benefits pursuant to Section 6.1(a)is further conditioned upon his: returning all Company property; complying with his post-termination obligations under this Agreementand the Confidential Information Agreement; complying with the Release including without limitation any non-disparagement andconfidentiality provisions contained therein; and resignation from any other positions he holds with the Company, effective no laterthan his Employee’s date of termination (or such other date as requested by the Board).(c) The Company will not make any payments to Employee with respect to any of the benefits pursuant toSection 6.1(a) prior to the 60th day following Employee’s date of termination. On the 60th day following Employee’s date oftermination, and provided that Employee has delivered an effective Release, the Company will make the first payments to Employeeunder Section 6.1(a)(i) in a lump sum equal to the aggregate amount of payments that the Company would have paid Employeethrough such date had the payments commenced on the Employee’s date of termination through such 60th day, with the balance of thepayments paid thereafter on the schedule described above, subject to any delay in payment required by Section 6.7.(d) For purposes of this Agreement, “Accrued Obligations” are (i) Employee’s accrued but unpaid salary andaccrued but unused vacation through the date of termination (which, for purpose of clarity, shall be paid in cash), (ii) any unreimbursedbusiness expenses incurred by Employee payable in accordance with the Company’s standard expense reimbursement policies, (iii)benefits owed to Employee under any qualified retirement plan or health and welfare benefit plan in which Employee was a participantin accordance with applicable law and the provisions of such plan; and (iv) any Annual Bonus earned but unpaid for the prior fiscalyear.(e) For purposes of this Agreement, “Good Reason” means any of the following actions taken by theCompany without Employee’s consent: (i) a reduction of Employee’s Base Salary (unless such reduction is made in connection withan across the board reduction in base salaries of the Company’s senior executives); (ii) material reduction in Employee’s authority,duties or responsibilities as President and Chief Executive Officer, provided, however, that the acquisition of the Company andsubsequent conversion of the Company to a division or unit of the acquiring company will not by itself result in a diminution ofEmployee’s position; (iii) a material change in the geographic location of Employee’s primary work facility or location; provided, that arelocation of fifty (50) or more miles from downtown Roanoke, Virginia, will be considered a material change in geographic location;(iv) any material breach by the Company of any of its obligations hereunder; or (v) a change so that Employee is no longer eligible toreceive an Annual Bonus as described in the first two sentences of Section 2.2(a). In order to resign for Good Reason, Employee mustprovide written notice of the event giving rise to Good Reason to the Board within thirty (30) days after the condition first arises, allowthe Company thirty (30) days to cure such condition, and if the Company fails to cure the condition within such period, Employee’sresignation from all positions Employee then holds with the Company must be effective not later than sixty (60) days after the end ofthe Company’s cure period.(f) For purposes of this Agreement, “Cause” means first, the Employee’s conviction of any felony or anycrime involving fraud, dishonesty or moral turpitude under the laws of the United States or any state thereof (which, for purpose ofclarity, would exclude traffic offenses). Second, “Cause” means, as reasonably determined in good faith by the Board, Employee’swillful and material acts or omissions that constitute the following conduct: (i) commission or attempted commission of, or participationin, a fraud or act of dishonesty against the Company; (ii) material violation of any contract or agreement between the Employee and theCompany or of any statutory duty owed to the Company after Employee is provided with a reasonable opportunity of not less thanthirty (30) days to cure from the date written notice (in reasonable detail) thereof is given to Employee by the Company; (iii)unauthorized use or disclosure of the Company’s confidential information or trade secrets; (iv) gross misconduct or gross negligencecausing material injury to the Company; (v) breach of fiduciary duty, including without limitation concealing information relevant tothe Company from the Board of a nature that senior executives should disclose to boards of directors in fulfilling such duty; or (vii)refusal to comply with a lawful directive of the Board after Employee is provided with a reasonable opportunity of not less than ten(10) days to cure from the date notice thereof is given to Employee by the Company.(g) The benefits provided to Employee pursuant to this Section 6.1 are in lieu of, and not in addition to, anybenefits to which Employee may otherwise be entitled under any Company severance plan, policy or program.(h) Any damages caused by the termination of Employee’s employment without Cause or for Good Reasonwould be difficult to ascertain; therefore, the Severance Benefits for which Employee is eligible pursuant to Section 6.1(a) above inexchange for the Release is agreed to by the parties as liquidated damages, to serve as full compensation, and not a penalty.(i) If the Company terminates the Employee’s employment for Cause or Employee resigns from employmentwith the Company without Good Reason, regardless of whether or not such termination is in connection with a Change in Control (asdefined below), then Employee shall be entitled to the Accrued Obligations, but Employee will not receive the Severance Benefits orany other severance compensation or benefit.6.2 Resignation by the Employee for Good Reason or Termination by the Company without Cause (inconnection with a Change in Control).(a) In the event that the Company terminates Employee’s employment without Cause or Employee resigns forGood Reason within three months prior to or twelve (12) months following the effective date of a Change in Control (“Change inControl Termination Date”), then Employee shall be entitled to the Accrued Obligations and, subject to Employee’s compliance withSection 6.1(b) above, including but not limited to the Release requirement and Employee’s continued compliance with his obligationsto the Company under his Confidential Information Agreement, then:(i) Employee shall be eligible to receive the Severance Benefits under the terms and conditionsdescribed in Section 6.1; provided that (A) the amounts set forth in clauses (i) and (iv) of Section 6.1(a) shall be paid in lumpsums in accordance with the timing set forth in Section 6.1(a) and not deferred per such clauses (i) and (iv) and (B) the BonusSeverance Payment shall be equal to the Maximum Target Bonus as opposed to the Target Bonus; and(ii) Effective as of the later of Employee’s Change in Control Termination Date or the effectivedate of the Change in Control, the vesting and exercisability of all outstanding stock options and other stock awards covering theCompany’s Common Stock that are held by Employee as of immediately prior to the Change in Control Termination Date shallbe accelerated (and lapse, in the case of reacquisition or repurchase rights) in full. Employee’s stock options and stock awardsshall remain outstanding following Employee’s Change in Control Termination Date if and to the extent necessary to give effectto this Section 6.2(a)(ii) subject to earlier termination under the terms of the equity plan under which such awards were grantedand the original maximum term of the award (without regard to Employee’s termination).(b) As used in this Agreement, “Change in Control” means “Change in Control” as defined in the Company’s2016 Equity Incentive Plan.6.3 Termination by Virtue of Death or Disability of the Employee.(a) In the event of Employee’s death while employed pursuant to this Agreement, all obligations of the partieshereunder and Employee’s employment shall terminate immediately, and the Company shall, pursuant to the Company’s standardpayroll policies, pay to the Employee’s legal representatives the Accrued Obligations due to Employee, but the Company will notprovide the Severance Benefits, or any other severance compensation or benefit.(b) Subject to applicable state and federal law, the Company shall at all times have the right, upon writtennotice to the Employee, to terminate this Agreement based on the Employee’s Disability (as defined below). Termination by theCompany of the Employee’s employment based on “Disability” shall mean termination because the Employee is unable due to aphysical or mental condition to perform the essential functions of his position with or without reasonable accommodation for six (6)months in the aggregate during any twelve (12) month period or based on the written certification by two licensed physicians of thelikely continuation of such condition for such period. This definition shall be interpreted and applied consistent with the Americanswith Disabilities Act, the Family and Medical Leave Act, and other applicable law. In the event Employee’s employment is terminatedbased on the Employee’s Disability, Employee will be entitled to the Accrued Obligations, but will not receive the Severance Benefits,or any other severance compensation or benefit.6.4 Termination Due to Discontinuance of Business. Anything in this Agreement to the contrary notwithstanding,in the event the Company’s business is discontinued because rendered impracticable by substantial financial losses, lack of funding,legal decisions, administrative rulings, declaration of war, dissolution, national or local economic depression or crisis or any reasonsbeyond the control of the Company, then this Agreement shall terminate as of the day the Company determines to cease operation withthe same force and effect as if such day of the month were originally set as the termination date hereof. In the event this Agreement isterminated pursuant to this Section 6.4, Employee will be entitled to the Accrued Obligations, but will not receive the SeveranceBenefits, or any other severance compensation or benefit.6.5 Cooperation With Company After Termination of Employment. Following termination of Employee’semployment for any reason, Employee shall reasonably cooperate with the Company in all matters relating to the winding up ofEmployee’s pending work including, but not limited to, any litigation in which the Company is involved, and the orderly transfer ofany such pending work to such other Employees as may be designated by the Company; provided, however, that the obligationshereunder shall not interfere with Employee’s efforts to obtain subsequent employment and/or his obligations to and responsibilities fora subsequent employer and the obligations hereunder shall end six months after the termination of the Employee’s employment; andprovided further that the Employee will be paid for his efforts hereunder at an hourly rate determined by dividing his last AnnualSalary by 1,800 hours and that Employee shall be reimbursed his reasonable expenses.6.6 Effect of Termination. Employee agrees that should his employment be terminated for any reason, he shall bedeemed to have resigned from any and all positions with the Company, including, but not limited, to a position on the Board and allpositions with any and all subsidiaries and Affiliates of the Company.6.7 Application of Section 409A. It is intended that all of the severance payments payable under this Agreementsatisfy, to the greatest extent possible, the exemptions from the application of Section 409A of the Code and the regulations and otherguidance thereunder and any state law of similar effect (collectively, “Section 409A”) provided under Treasury Regulations Sections1.409A-1(b)(4) and 1.409A-1(b)(9), and this Agreement will be construed in a manner that complies with Section 409A. If not soexempt, this Agreement (and any definitions hereunder) will be construed in a manner that complies with Section 409A, andincorporates by reference all required definitions and payment terms. No severance payments will be made under this Agreementunless Employee’s termination of employment constitutes a Separation from Service. For purposes of Section 409A (including,without limitation, for purposes of Treasury Regulations Section 1.409A-2(b)(2)(iii)), Employee’s right to receive any installmentpayments under this Agreement (whether severance payments or otherwise) shall be treated as a right to receive a series of separatepayments and, accordingly, each installment payment hereunder shall at all times be considered a separate and distinct payment. To theextent that any severance payments are deferred compensation under Section 409A, and are not otherwise exempt from the applicationof Section 409A, then, if the period during which Employee may consider and sign the Release spans two calendar years, theseverance payments will not begin until the second calendar year. If the Company determines that the severance benefits providedunder this Agreement constitutes “deferred compensation” under Section 409A and if Employee is a “specified employee” of theCompany, as such term is defined in Section 409A(a)(2)(B)(i) of the Code at the time of Employee’s Separation from Service, then,solely to the extent necessary to avoid the incurrence of the adverse personal tax consequences under Section 409A, the timing of theSeverance will be delayed as follows: on the earlier to occur of (a) the date that is six months and one day after Employee’s Separationfrom Service, and (b) the date of Employee’s death (such earlier date, the “Delayed Initial Payment Date”), the Company will pay toEmployee a lump sum amount equal to the sum of the severance benefits that Employee would otherwise have received through theDelayed Initial Payment Date if the commencement of the payment of the severance benefits had not been delayed pursuant to thisSection 6.7 and (ii) commence paying the balance of the severance benefits in accordance with the applicable payment schedule setforth in Section 6.1. No interest shall be due on any amounts deferred pursuant to this Section 6.7.6.8 Excise Tax Adjustment. Notwithstanding any of the foregoing to the contrary in the event that the severance andother benefits provided for in this Agreement or otherwise payable to Employee (i) constitute “parachute payments” within themeaning of Section 280G of the Internal Revenue Code of 1986, as amended (the “Code”) and (ii) but for this Section, would besubject to the excise tax imposed by Section 4999 of the Code (“Excise Tax”), then Employee’s severance benefits under thisAgreement shall be payable either (A) in full, or (B) as to such lesser amount which would result in no portion of such severancebenefits being subject to excise tax under Section 4999 of the Code, whichever of the foregoing amounts, taking into account theapplicable federal, state and local income taxes and the excise tax imposed by Section 4999, results in the receipt by Employee on anafter-tax basis, of the greatest amount of severance benefits under this Agreement, notwithstanding that all or some portion of suchseverance benefits may be taxable under Section 4999 of the Code. Unless the Company and Employee otherwise agree in writing,any determination required under this Section shall be made in writing by the Company’s independent public accountants (the“Accountants”), whose determination shall be conclusive and binding upon Employee and the Company for all purposes. Forpurposes of making the calculations required by this Section, the Accountants may make reasonable assumptions and approximationsconcerning applicable taxes and may rely on reasonable, good faith interpretations concerning the application of Sections 280G and4999 of the Code. The Company and Employee shall furnish to the Accountants such information and documents as the Accountantsmay reasonably request in order to make a determination under this Section. The Company shall bear all costs the Accountants mayreasonably incur in connection with any calculations contemplated by this Section. Any reduction in payments and/or benefits requiredby this Section shall occur in the following order: (1) reduction of cash payments; (2) reduction in vesting acceleration of equityawards; and (3) reduction of other benefits paid or provided to Employee. In the event that acceleration of vesting of equity awards isto be reduced, such acceleration of vesting shall be cancelled in the reverse order of the date of grant for Employee’s equity awards. Iftwo or more equity awards are granted on the same date, each award will be reduced on a pro-rata basis.7.GENERAL PROVISIONS.7.1 Notices. Any notices required hereunder to be in writing shall be deemed effectively given: (a) upon personaldelivery to the party to be notified, (b) when sent by electronic mail or confirmed facsimile if sent during normal business hours of therecipient, and if not, then on the next business day, (c) five (5) days after having been sent by registered or certified mail, return receiptrequested, postage prepaid, or (d) one (1) day after deposit with a nationally recognized overnight courier, specifying next daydelivery, with written verification of receipt. All communications shall be sent to the Company at its primary office location and toEmployee at Employee’s address as listed on the Company payroll or to Employee’s Company-issued email address, or at such otheraddress as the Company or Employee may designate by ten (10) days advance written notice to the other.7.2 Severability. Whenever possible, each provision of this Agreement will be interpreted in such manner as to beeffective and valid under applicable law, but if any provision of this Agreement is held to be invalid, illegal or unenforceable in anyrespect under any applicable law or rule in any jurisdiction, such invalidity, illegality or unenforceability will not affect any otherprovision or any other jurisdiction, but this Agreement will be reformed, construed and enforced in such jurisdiction as if such invalid,illegal or unenforceable provisions had never been contained herein.7.3 Waiver. If either party should waive any breach of any provisions of this Agreement, Employee or it shall notthereby be deemed to have waived any preceding or succeeding breach of the same or any other provision of this Agreement.7.4 Complete Agreement. This Agreement constitutes the entire agreement between Employee and the Companywith regard to the subject matter hereof. This Agreement is the complete, final, and exclusive embodiment of their agreement withregard to this subject matter and supersedes any prior oral discussions or written communications and agreements. This Agreement isentered into without reliance on any promise or representation other than those expressly contained herein, and it cannot be modified oramended except in writing signed by Employee and an authorized officer of the Company. The parties have entered into a separateConfidential Information Agreement and have or may enter into separate agreement related to stock awards. These separate agreementsgovern other aspects of the relationship between the parties, have or may have provisions that survive termination of the Employee’semployment under this Agreement, may be amended or superseded by the parties without regard to this Agreement and areenforceable according to their terms without regard to the enforcement provision of this Agreement.7.5 Counterparts. This Agreement may be executed by electronic transmission and in separate counterparts, any oneof which need not contain signatures of more than one party, but all of which taken together will constitute one and the sameAgreement.7.6 Headings. The headings of the sections hereof are inserted for convenience only and shall not be deemed toconstitute a part hereof nor to affect the meaning thereof.7.7 Successors and Assigns. The Company shall assign this Agreement and its rights and obligations hereunder inwhole, but not in part, to any company or other entity with or into which the Company may hereafter merge or consolidate or to whichthe Company may transfer all or substantially all of its assets, if in any such case said company or other entity shall by operation of lawor expressly in writing assume all obligations of the Company hereunder as fully as if it had been originally made a party hereto, butmay not otherwise assign this Agreement or its rights and obligations hereunder. The Employee may not assign or transfer thisAgreement or any rights or obligations hereunder, other than to his estate upon his death.7.8 Choice of Law. All questions concerning the construction, validity and interpretation of this Agreement will begoverned by the law of the Commonwealth of Virginia.7.9 Resolution of Disputes. The parties recognize that litigation in federal or state courts or before federal or stateadministrative agencies of disputes arising out of the Employee’s employment with the Company or out of this Agreement, or theEmployee’s termination of employment or termination of this Agreement, may not be in the best interests of either the Employee or theCompany, and may result in unnecessary costs, delays, complexities, and uncertainty. The parties agree that any dispute between theparties arising out of or relating to the negotiation, execution, performance or termination of this Agreement or the Employee’semployment, including, but not limited to, any claim arising out of this Agreement, claims under Title VII of the Civil Rights Act of1964, as amended, the Civil Rights Act of 1991, the Age Discrimination in Employment Act of 1967, the Americans with DisabilitiesAct of 1990, Section 1981 of the Civil Rights Act of 1966, as amended, the Family Medical Leave Act, the Employee RetirementIncome Security Act, and any similar federal, state or local law, statute, regulation, or any common law doctrine, whether that disputearises during or after employment, shall be settled by binding arbitration in accordance with the National Rules for the Resolution ofEmployment Disputes of the American Arbitration Association; provided however, that this dispute resolution provision shall not applyto any separate agreements between the parties that do not themselves specify arbitration as an exclusive remedy. The location for thearbitration shall be the Roanoke, Virginia area. Any award made by such panel shall be final, binding and conclusive on the partiesfor all purposes and shall be kept confidential, and judgment upon the award rendered by the arbitrators may be entered in any courthaving jurisdiction thereof. The arbitrators’ fees and expenses and all administrative fees and expenses associated with the filing of thearbitration shall be borne by the Company; provided however, that at the Employee’s option, Employee may voluntarily pay up to one-half the costs and fees. The parties acknowledge and agree that their obligations to arbitrate under this Section survive the terminationof this Agreement and continue after the termination of the employment relationship between Employee and the Company. The partieseach further agree that the arbitration provisions of this Agreement shall provide each party with its exclusive remedy, and each partyexpressly waives any right it might have to seek redress in any other forum, except as otherwise expressly provided in this Agreement.By election arbitration as the means for final settlement of all claims, the parties hereby waive their respective rights to, and agreenot to, sue each other in any action in a Federal, State or local court with respect to such claims, but may seek to enforce incourt an arbitration award rendered pursuant to this Agreement. The parties specifically agree to waive their respectiverights to a trial by jury, and further agree that no demand, request or motion will be made for trial by jury. IN WITNESS WHEREOF, the parties have executed this Employment Agreement on the day and year first written above.Luna Innovations IncorporatedBy: /s/ Richard W. Roedel Richard W. RoedelChairman of the Board of DirectorsEmployee:/s/ Scott A. Graeff Scott A. Graeff Prior Option and Prior Restricted Stock Awards(see attached)1EXHIBIT 21.1SUBSIDIARIESLuna Technologies, Inc.Advanced Photonix, Inc.TeraMetrix, LLCAdvanced Photonix Inc. CanadaEXHIBIT 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated March 21, 2018, 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, 2017. 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. 333-201956) and on Forms S-8 (File No. 333-211802, File No. 333-204435 and File No. 333-138745)./s/ Grant Thornton LLPArlington, VirginiaMarch 21, 2018Exhibit 31.1CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002I, Scott A. Graeff, 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 21, 2018 /S/ Scott A. Graeff Scott A. Graeff 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 21, 2018 /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, 2017 as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), I, Scott A. Graeff, 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/ Scott A. Graeff Scott A. Graeff President and Chief Executive Officer(principal executive officer) March 21, 2018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, 2017 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 21, 2018

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