Luna Innovations
Annual Report 2018

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, 2018OR¨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 every Interactive Data File required to be submitted pursuant to Rule 405 ofRegulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit 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, a smaller reporting company or anemerging growth company. See the definitions of “large accelerated filer”, “accelerated filer,” “smaller reporting company,” and "emerging growth company"in Rule 12b-2 of the Exchange Act.Large accelerated filer ¨ Accelerated filer ¨Non-accelerated filer x Smaller reporting company xIf an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with anynew or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. oIndicate 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 29, 2018 based upon theclosing price of Common Stock on such date as reported by the Nasdaq Capital Market, was approximately $71.9 million.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 12, 2019 therewere 28,125,598 shares of the registrant’s common stock outstanding.DOCUMENTS INCORPORATED BY REFERENCESpecified portions of the registrant’s Proxy Statement with respect to its 2019 Annual Meeting of stockholders, anticipated to be filed within 120 daysafter the end of its fiscal year ended December 31, 2018, 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, 2018TABLE OF CONTENTS PART I Item 1.Business1Item 1A.Risk Factors9Item 1B.Unresolved Staff Comments24Item 2.Properties24Item 3.Legal Proceedings24Item 4.Mine Safety Disclosure25PART II Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities26Item 6.Selected Financial Data28Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations29Item 7A.Quantitative and Qualitative Disclosures About Market Risk40Item 8.Financial Statements and Supplementary Data41Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure76Item 9A.Controls and Procedures77Item 9B.Other Information78PART III Item 10.Directors, Executive Officers and Corporate Governance79Item 11.Executive Compensation79Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters79Item 13.Certain Relationships and Related Transactions, and Director Independence79Item 14.Principal Accounting Fees and Services79PART IV Item 15.Exhibits, Financial Statement Schedules80Item 16.Form 10-K Summary86SIGNATURES86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 products for industries utilizing composite and other advanced materials,such as the automotive, aerospace, energy and infrastructure industries. Our distributed fiber optic sensing products help designers and manufacturers moreefficiently develop new and innovative products by providing valuable information such as highly detailed stress, strain, and temperature measurements of anew design or manufacturing process. In addition, our distributed fiber optic sensing products are used to monitor the structural integrity or operationalhealth of critical assets, including large civil structures such as bridges. Our communications test products accelerate the development of advanced fiber opticcomponents and networks by providing fast and highly accurate characterization of components and networks. We also provide applied research services,typically under research programs funded by the U.S. government, in areas of advanced materials, sensing, and healthcare applications. Our business model isdesigned to accelerate the process of bringing new and innovative products to market. We use our in-house technical expertise across a range of technologiesto perform applied research services for companies and for government funded projects. We continue to invest in product development andcommercialization, 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 distributed fiber optic1Table of Contentssensing products, as well as communications test products. We are continuing to develop and commercialize our fiber optic technology for sensingapplications for aerospace, automotive, energy, and infrastructure as well as for test and measurement applications in the telecommunications and datacommunications industries. Our Products and Licensing segment revenues represented approximately 51% and 44% of our total revenues for the years endedDecember 31, 2018 and 2017, respectively.Our Technology Development segment performs applied research principally in the areas of sensing & instrumentation, advanced materials, opticaltechnologies, and health sciences. Our Technology Development segment comprised approximately 49% and 56% of our total revenues for the years endedDecember 31, 2018 and 2017, respectively. Most of the government funding for our Technology Development segment is derived from the Small BusinessInnovation 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, 2018, approximately 44% of our total revenues were generated under the SBIR program, compared to 37% for the yearended December 31, 2017.For the years ended December 31, 2018 and 2017, 53% and 48%, respectively, of our total revenues were derived from the U.S. government.Acquisition of General Photonics CorporationOn March 1, 2019, we acquired all of the outstanding stock of General Photonics Corporation ("GP"), a leading provider of innovative components,modules and test equipment focused on the generation, measurement and control of polarized light critical in fiber optic-based applications for aggregateconsideration of $19.0 million. Of the purchase price, $17.1 million was paid at closing and $1.9 million was placed into escrow for possible working capitaladjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations. Additionally, we can become obligated topay additional cash consideration of up to $1.0 million if certain revenue targets for the GP historical business are met for the twelve months following theclosing.Acquisition of Micron Optics, Inc.On October 15, 2018, we acquired the assets of Micron Optics, Inc. ("MOI"), a leading provider of innovative optical components and laser-basedequipment that advance the quality of optical measurements, allowing the sensing, imaging, and telecommunications industries to make criticalmeasurements for total cash consideration of $5 million, including $4.0 million paid at closing and $1.0 million placed in escrow until the later of October 1,2019, or the date that specified matters are resolved as agreed by us and MOI. The purchase price was subject to adjustment after closing based upon ananalysis of final working capital compared to a target amount specified in the purchase agreement. In 2019, we expect to pay an additional $0.5 million toMOI in connection with the working capital adjustment. With the acquisition of MOI, we expanded our technology and product portfolio to include opticalsensors and sensing interrogators capable of a broader range of measurement capabilities, including higher speed measurements such as vibration, and theability to instrument larger structures over longer distances. In addition, the MOI acquisition added a product suite of tunable optical filters, optical sensors,and swept lasers.Products and LicensingOur Products and Licensing segment includes the sale of fiber optic test & measurement instruments. We provide fiber optic test & measurementproducts which provide solutions primarily for the telecommunications industry marketed under the Luna Technologies brand. We also market our ODiSIplatform of products for distributed and very high resolution sensing of strain and temperature utilizing optical fiber. Following the acquisition of MOI, wealso market our Hyperion platform of products for distributed fiber optic sensing that offer dynamic measurement capabilities and the ability to operate overlonger distances. Following our acquisition of GP, we also market solutions for the measurement, management and control of polarization and delay in fiberoptic networks. We refer to the groups within our company who develop, manufacture, support, and sell these products as our Lightwave division.Our key initiative for long term growth is to become a leading provider of fiber optic test and measurement equipment, including products for physicalsensing systems and standard test methods based upon the ODiSI and Hyperion product platforms 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-Assemblies2Table of ContentsOur product lines in the optical test & measurement domain include our Optical Vector Analyzer, our Optical Backscatter Reflectometer, and thePhoenix family of tunable lasers.Historically, our optical test & measurement products have primarily served the telecommunications industry, as well as valuable applications in otherfields. 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. Our products are particularly useful for characterizing and testing photonic integrated circuits, such as silicon photonicscomponents, which are a critical technology enabling the growing worldwide demand for internet connectivity. Most manufacturers and suppliers of opticalcomponents and modules currently use a combination of different types of optical test equipment to measure performance and identify failures in opticalnetworks, such as bad splices, bends, crimps and other reflective and non-reflective events that can cause defects and negatively impact product performance.Our optical test equipment products replace the need to employ multiple test products by addressing all stages of the end user’s product developmentlifecycle, including design verification, component qualification, assembly process verification and failure analysis.ODiSI Sensing SolutionOur 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 and can be integrated into locations andenvironments not accessible with traditional sensors. We believe the technology can provide exceptional value to the aerospace and automotive industries asthey adopt electrification and lighter weight systems and transition from steel and aluminum to composite structures.We have significant expertise in distributed sensing systems, such as ODiSI, which are products that incorporate multiple channels of fiber optic sensorswhose inputs are integrated through an advanced measurement system and software. These products use fiber optic sensing technology with an innovativemonitoring system that allows several thousand sensors to be networked along a single optical fiber.Hyperion Sensing SolutionOur Hyperion sensing products expand our capabilities in fiber optic sensing by providing distributed sensing using hundreds of Fiber-Bragg Grating("FBG") or Extrinsic Fabry-Perot ("FP") sensors measured at sampling rates up to 5KHz. Hyperion enables rapid full-spectrum data acquisition and flexiblepeak detect algorithms of FBGs, Long Period FBGs and FP sensors with low-latency access to data for closed loop feedback applications. Our Hyperionproducts target fiber optic sensing applications that require more dynamic measurement capabilities or longer distances than provided by our ODiSI platform.General PhotonicsOur GP products include components, modules, and instruments to measure, manage and control polarization and group delay in fiber optic networks.Our proprietary fiber optic squeezing technology ensures high performance polarization control. In addition, we manufacture and sell fiber optic coils for usein gyroscopes.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.TeraMetrixOur TeraMetrix products are used to measure and verify physical properties on-line and in real-time to reduce raw materials and rework costs inmanufacturing processes as well as to conduct quality control monitoring utilizing terahertz ("THz") measurement technologies. THz is a region of theelectromagnetic spectrum that lies between microwave and infrared3Table of Contentswaves and is in the early stages of adoption. While microwaves and infrared waves have been explored and commercialized for decades, THz waves are in theearly stages of being explored and commercialized due to the fact that they have historically been very difficult to generate and detect. Advances infemtosecond lasers and ultra-fast semiconductor and electro-optic devices combined with fiber-optic packaging technologies have enabled the developmentof practical THz instrumentation for the research market with increasing adoption in the industrial, military and aerospace markets. THz can be used to "look"through and beneath materials with high two-dimensional and three-dimensional spatial resolution. It can also uniquely identify the chemical composition ofmany hidden or subsurface objects using non-ionizing radiation, which is not harmful to humans at the power levels commonly used today. We market ourTHz based products instruments and sensors primarily 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 primarily to original equipment manufacturers through a mix of technical sales engineers, value added resellers, andindependent sales representatives. We market 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 coatings, adhesives, composites andbio-engineered materials. We generally compete to win contracts in these areas on a fee-for-service basis. Our Technology Development segment has asuccessful 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 $21.0 million and $18.6 millionfor the years ended December 31, 2018 and 2017, 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.4Table of ContentsWe 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 to our proprietary technology and enter into confidentiality and invention assignment agreementswith our employees and consultants and confidentiality agreements with other third parties.Our success depends in part on our ability to develop patentable products and obtain, maintain and enforce patent and trade secret protection for ourproducts, as well as to successfully defend these patents against third-party challenges both in the United States and in other countries. We will only be ableto protect our technologies from unauthorized use by third parties to the extent that we own or have licensed valid and enforceable patents or trade secretsthat cover them. Furthermore, the degree of future protection of our proprietary rights is uncertain because we may not be able to obtain patent protection onsome or all of our technology and because legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keepour competitive advantage.Currently, we own or license approximately 262 U.S. and international patents and approximately 255 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 2019 and 2037. The patents scheduled to expire in 2019 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 Patents5Table of ContentsAs 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. Our executive offices are located at 301 1st St SW, Suite 200, Roanoke, Virginia 24011 and our main telephone number is(540) 769-8400.Material AgreementsSale 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. InDecember 2018, we received $1.5 million of the escrow amount. The remaining $2.5 million remains in escrow and is pending the resolution of certainindemnification claims which the buyer has made and which are disputed by us. The HSOR business was a component of the operations of AdvancedPhotonix, Inc., which we acquired in May 2015.Sale of Luna OptoelectronicsIn July 2018 we sold substantially all of the assets associated with our custom optoelectronic components and sub-assemblies business for total cashconsideration of $17.5 million, paid at closing, in addition to contingent consideration of up to $1.0 million. The contingent consideration is subject to theoptoelectronic business achieving specified revenue targets for the 18 month period following the closing date. The optoelectronic business was acomponent of the operations of Advanced Photonix, Inc. 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.The Phoenix laser is a miniaturized, external-cavity laser offering high performance in a compact footprint and is applicable to a range of fiber optictest and measurement, instrumentation, and sensing applications. These products employ frequency-tuned lasers to measure various aspects of thetransmission properties of telecommunications fiber optic components and systems. Lasers are also used in fiber optic sensing applications such asdistributed strain and temperature mapping, and distributed measurement of shape. We currently use these lasers within our ODiSI platform of products, ourfiber optic shape6Table of Contentssensing products and certain of our backscatter reflectometer products, and we also sell variations of the Phoenix laser as standalone products. Under ouragreements related to our sale of assets to Intuitive, we have certain obligations to supply Intuitive with these lasers and Intuitive has certain rights to requireus to transfer and assign this Coherent 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 asoutstanding equity for purposes of meeting the more than 50% equity ownership requirement. We believe that we are in compliance with the SBA ownershiprequirements.7Table of ContentsIn 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, 2018, we, including all of our divisions, had 196 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, 2018, we had approximately 196 total employees, including approximately 141 in research, development and engineeringpositions, approximately 20 in operations, approximately 12 in sales and marketing, and approximately 23 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 $26.0 million and $23.5 million at December 31,2018 and 2017, 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$4.5 million and $5.5 million as of December 31, 2018 and 2017, respectively. Indefinite delivery and quantity contracts and unexercised options are notreported in total backlog. Our backlog is subject to delays or program cancellations that may be beyond our control.Our backlog of purchase orders received for which the related goods have not been shipped or recognized as revenue within our Products and Licensingsegment was $5.8 million and $6.9 million at December 31, 2018 and 2017, respectively.8Table of ContentsWebsite 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. The SEC maintains an internet site that contains reports, proxy and information statements, and other information regarding our filings atwww.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 Surgical, Inc., which is revocable in certain circumstances. Without this license, we cannot continue tomarket, manufacture or sell our fiber-optic products.As a part of the sale of certain assets to Intuitive Surgical, Inc. ("Intuitive") in 2014, we entered into a license agreement with Intuitive pursuant towhich we received rights to use all of our transferred technology outside the field of medicine and in respect of our existing non-shape sensing products incertain non-robotic medical fields. This license back to us is revocable if after notice and certain time periods, we were to (i) challenge the validity orenforceability of the transferred patents and patent applications, (ii) commercialize our fiber optical shape sensing and localization technology in the field ofmedicine (except to perform on a development and supply project for Hansen Medical, Inc.), (iii) violate our obligations related to our ability to sub-licensein 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 suchviolation. Maintaining this license is necessary for us to conduct our fiber-optic products business, both for our telecom products and our ODiSI sensingproducts. If this license were to be revoked by Intuitive, we would no longer be able to market, manufacture or sell these products which could have amaterial adverse effect on our operations.We depend on third-party vendors for specialized components in our manufacturing operations, making us vulnerable to supply shortages and pricefluctuations that could harm our business.We primarily rely on third-party vendors for the manufacture of the specialized components used in our products. The highly specialized nature of oursupply requirements poses risks that we may not be able to locate additional sources of the specialized components required in our business. For example,there are few manufacturers who produce the special lasers used in our optical test equipment. Our reliance on these vendors subjects us to a number of risksthat could negatively affect our ability to manufacture our products and harm our business, including interruption of supply. Although we are nowmanufacturing tunable lasers in low-rate initial production, we expect our overall reliance on third-party vendors to continue. Any significant delay orinterruption in the supply of components, or our inability to obtain substitute components or materials from alternate sources at acceptable prices and in atimely manner could impair our ability to meet the demand of our customers and could harm our business.9Table of ContentsWe 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 certain lasers. Our reliance on contractmanufacturers for these products makes us vulnerable to possible capacity constraints and reduced control over delivery schedules, manufacturing yields,manufacturing quality control and costs. If the contract manufacturer for our products were unable or unwilling to manufacture our products in requiredvolumes and at high quality levels or to continue our existing supply arrangement, we would have to identify, qualify and select an acceptable alternativecontract manufacturer or move these manufacturing operations to internal manufacturing facilities. An alternative contract manufacturer may not be availableto us when needed or may not be in a position to satisfy our quality or production requirements on commercially reasonable terms, including price. Anysignificant interruption in manufacturing our products would require us to reduce the supply of products to our customers, which in turn would reduce ourrevenue, harm our relationships with the customers of these products and cause us to forego potential revenue opportunities.As a provider of contract research to the U.S. government, we are subject to federal rules, regulations, audits and investigations, the violation or failure 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. We have agreed on final billingrates with the U.S. government through December 31, 2017.In addition to the risk of government audits and investigations, U.S. government contracts and grants impose requirements on contractors and granteesrelating to ethics and business practices, which carry civil and criminal penalties including monetary fines, assessments, loss of the ability to do business withthe U.S. government and certain other criminal penalties.We may also be prohibited from commercially selling certain products that we develop under our Technology Development segment or relatedproducts based on the same core technologies if the U.S. government determines that the commercial availability of those products could pose a risk tonational security. For example, certain of our wireless technologies have been classified as secret by the U.S. government and as a result we cannot sell themcommercially. Any of these determinations would limit our ability to generate product sales and license revenues.We rely and will continue to rely on contracts and grants awarded under the SBIR program for a significant portion of our revenues. A finding by the SBAthat we no longer qualify to receive SBIR awards could adversely affect our business.We compete as a small business for some of our government contracts. Our revenues derived from the SBIR program account for a significant portion ofour consolidated total revenues, and contract research, including SBIR contracts, will remain a significant portion of our consolidated total revenues for theforeseeable future. For the year ended December 31, 2018, 44% of our total revenues were generated under the SBIR program, compared to 37% in for theyear ended December 31, 2017.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 eligibility10Table of Contentscriteria are applied as of the time of the award of a contract or grant. A company can be declared ineligible for a contract award as a result of a size challengefiled 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, 2018, we had approximately 196 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 49% and 56% of our total revenuesfor the years ended December 31, 2018 and 2017, 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 or may change its requirements, programs or contract budget, any ofwhich could reduce our revenues and cash flows from U.S. government research contracts. Our revenues and cash flows from U.S. government researchcontracts and subcontracts could also be reduced by declines or other changes in U.S. defense, homeland security and other federal agency budgets. Inaddition, we compete as a small business for some of these contracts, and in order to maintain our eligibility to compete as a small business, we, together withany affiliates, must continue to meet size and revenue limitations established by the U.S. government.Our contract research customer base includes government agencies, corporations and academic institutions. Our customers are not obligated to extendtheir agreements with us and may elect not to do so. Also, our customers’ priorities regarding funding for certain projects may change and funding resourcesmay no longer be available at previous levels.In addition 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 a11Table of Contentsresult of the tight labor market in certain fields. Any difficulty in hiring or retaining qualified employees, combined with our growth strategy and future needsfor additional experienced personnel, particularly in highly specialized areas such as nanomaterial manufacturing and fiber optic sensing technologies, maymake it more difficult to meet all of our needs for these employees in a timely manner. Although we intend to continue to devote significant resources torecruit, train and retain qualified employees, we may not be able to attract and retain these employees, especially in technical fields in which the supply ofexperienced 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 ofkey personnel could have a material adverse effect on our ability to meet key operational objectives, such as timely and effective project milestones andproduct introductions, which in turn could adversely affect our business, results of operations and financial condition.We provide certain services to the U.S. government that require us to maintain a facility security clearance and for certain of our employees and ourboard chairman to hold security clearances. In general, the failure for necessary persons to obtain or retain sufficient security clearances, any loss by us of afacility security clearance or any public reprimand related to security matters could result in a U.S. government customer terminating an existing contract orchoosing not to renew a contract or prevent us from bidding on or winning certain new government contracts.In addition, our future success depends in a large part upon the continued service of key members of our senior management team. We do not maintainany key-person life insurance policies on our officers. The loss of any members of our management team or other key personnel could seriously harm ourbusiness.Our business is subject to the cyclical nature of the markets in which we compete and any future downturn may reduce demand for our products andrevenue.Many factors beyond our control affect our business, including consumer confidence in the economy, interest rates, fuel prices and the generalavailability of credit. The overall economic climate and changes in Gross National Product growth have a direct impact on some of our customers and thedemand for our products. We cannot be sure that our business will not be adversely affected as a result of an industry or general economic downturn.Our customers may reduce capital expenditures and have difficulty satisfying liquidity needs because of continued turbulence in the U.S. and globaleconomies, resulting in reduced sales of our products and harm to our financial condition and results of operations.In particular, our historical results of operations have been subject to substantial fluctuations, and we may experience substantial period-to-periodfluctuations in future results of operations. Any future downturn in the markets in which we compete could significantly reduce the demand for our productsand therefore may result in a significant reduction in revenue or increase the volatility of the price of our common stock. Our revenue and results ofoperations may be adversely affected in the future due to changes in demand from customers or cyclical changes in the markets utilizing our products.In addition, the telecommunications industry has, from time to time, experienced, and may again experience, a pronounced downturn. To respond to adownturn, many service providers may slow their capital expenditures, cancel or delay new developments, reduce their workforces and inventories and take acautious approach to acquiring new equipment and technologies from original equipment manufacturers, which would have a negative impact on ourbusiness. Weakness in the global economy or a future downturn in the telecommunications industry may cause our results of operations to fluctuate fromquarter-to-quarter and year-to-year, harm our business, and may increase the volatility of the price of our common stock.Customer acceptance of our products is dependent on our ability to meet changing requirements, and any decrease in acceptance could adversely affectour revenue.Customer acceptance of our products is significantly dependent on our ability to offer products that meet the changing requirements of our customers,including telecommunication, military, medical and industrial corporations, as well as government agencies. Any decrease in the level of customeracceptance of our products could harm our business.Our products must meet exacting specifications, and defects and failures may occur, which may cause customers to return or stop buying our products.Our customers generally establish demanding specifications for quality, performance and reliability that our products must meet. However, our productsare highly complex and may contain defects and failures when they are first introduced or as new versions are released. Our products are also subject to roughenvironments as they are integrated into our customer products for use by the end customers. If defects and failures occur in our products, we couldexperience lost revenue, increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or reschedulingof orders or shipments, product returns or discounts, diversion of management resources or damage to our12Table of Contentsreputation and brand equity, and in some cases consequential damages, any of which would harm our operating results. In addition, delays in our ability tofill product orders as a result of quality control issues may negatively impact our relationship with our customers. We cannot assure you that we will havesufficient resources, including any available insurance, to satisfy any asserted claims.Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and results of operations to suffer.We design products to conform to our customers’ requirements and our customers’ systems may be subject to regulations established by governments 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 certain of ourproducts 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 our future performance is dependent upon our success in finding new customers andreceiving new orders from existing customers.In several markets, the quality and reliability of our products are a major concern for our customers, not only upon the initial manufacture of theproduct, but for the life of the product. Many of our products are used in remote locations for higher value assembly, making servicing of our productsunfeasible. Any failure of the quality or reliability of our products could harm our business.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 delay13Table of Contentsthe amount of products ordered or to cancel existing orders, leading to lower utilization of our facilities. Because many of our costs and operating expensesare relatively fixed, reduction in customer demand due to market downturns or other reasons would have a negative effect on our gross margin, operatingincome and cash flow.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 losses and may not maintainprofitability or positive cash flow.We have a history of net losses from operations and only recently generated positive net income from continuing operations of $1.2 million for the yearended December 31, 2018. We expect to continue to incur significant expenses as we pursue our strategic initiatives, including increased expenses forresearch and development, sales and marketing and manufacturing. We may also grow our business in part through acquisitions of additional companies andcomplementary technologies which could cause us to incur greater than anticipated transaction expenses, amortization or write-offs of intangible assets andother acquisition-related expenses. As a result, we may incur net losses in the future, and these losses could be substantial. At a certain level, continued netlosses 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 may not be able to sustain or increase our profitability on a quarterly or annual basis.We may require additional capital to support and expand our business.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 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.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.We face and will face substantial competition in several different markets that may adversely affect our results of operations.We face and will face substantial competition from a variety of companies in several different markets. As we focus on developing marketing andselling fiber optic sensing products, we may also face substantial and entrenched competition in that market.Many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, sales andmarketing, manufacturing, distribution, technical and other resources than we do. These competitors may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements.14Table of ContentsIn addition, current and potential competitors have established or may establish financial or strategic relationships among themselves or with existing orpotential customers or other third parties. Accordingly, new competitors or alliances among competitors could emerge and rapidly acquire significant marketshare. We cannot assure you that we will be able to compete successfully against current or new competitors, in which case our revenues may fail to increaseor 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.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 are unable to successfully integrate acquired businesses, it could have an adverse effect on our future results and the market price of our commonstock.In October 2018 we acquired the assets of Micron Optics, Inc., a leading provider of provider of innovative optical components and laser-basedequipment that advance the quality of optical measurements. In March 2019 we acquired General Photonics Corporation, a leading provider of innovativecomponents, modules and test equipment focused on the generation, measurement and control of polarized light critical in fiber optic-based applications. Inthe future, we may continue to seek acquisition targets supporting our growth strategy. The success of an acquisition will depend, in large part, on sales of theacquired company's products and the realization of operating synergies. To realize these anticipated benefits, we must successfully integrate the acquiredcompany's business into our existing business. Such integrations may be complex and time-consuming. The failure to successfully integrate and manage thechallenges presented by the integration process may result in our failure to achieve some or all of the anticipated benefits of the acquisition. Potentialdifficulties that may be encountered in the integration process include the following:•lost sales and customers as a result of customers deciding not to do business with us;•complexities associated with managing the larger combined company with distant business locations;•integrating personnel while maintaining focus on providing consistent, high quality products;•loss of key employees;•potential unknown liabilities associated with the acquisition;•performance shortfalls as a result of the diversion of management's attention caused by completing the acquisition and integrating operations.If any of these events were to occur, our ability to maintain relationships with the customers, suppliers and employees or our ability to achieve theanticipated benefits of the acquisition could be adversely affected, or could reduce our future earnings or otherwise adversely affect our business andfinancial results and, as a result, adversely affect the market price of our common stock.If 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.15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;16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.Recent developments relating to the United Kingdom's referendum vote in favor of withdrawal from the European Union could adversely affect us.The UK held a referendum on June 23, 2016, in which a majority voted for the UK’s withdrawal from the EU, commonly known as ‘Brexit’. As a resultof this vote, on March 29, 2017, the UK officially started the separation process and commenced negotiations to determine the terms of the UK's withdrawalfrom the EU. The UK is currently scheduled to leave the EU at 11:00p.m. GMT on March 29, 2019. If the UK and the EU are unable to negotiate acceptablewithdrawal terms, barrier-free access between the UK and other European Member States or among the EEA overall could be diminished or eliminated. Theeffects of Brexit are expected to be far-reaching and will depend on any agreements (or lack thereof) between the UK and the EU and, in particular, anyarrangements for the UK to retain access to EU markets either during a transitional period or more permanently. Given the level of uncertainty, Brexit, and theperceptions as to its impact, may adversely affect business activity and economic conditions in the UK, Europe and globally and could continue tocontribute to instability in global financial and foreign exchange markets, asset valuations and credit ratings. Brexit could also have the effect of disruptingand potentially ending the free movement of goods, services and people between the UK and the EU, which may negatively affect our operations togetherwith those of our customers and suppliers.For example, it is unclear at this time what Brexit's impact will have on our intellectual property rights and the process for obtaining, maintaining,defending and enforcing such rights. For example, while current guidance provided by the UK’s government suggests that trademarks granted by the EU,known as EU registered trademarks or EUTMs, will be continue to be protected in the UK after Brexit, it is unclear whether we will be required to refile ourtrademarks and other intellectual property applications domestically in the UK and whether any other steps will be required for us to protect our trade marksin the UK in the future. As a result of Brexit, other European countries may seek to conduct referenda with respect to their continuing membership in the EU.Given these possibilities and others we may not anticipate, as well as the lack of comparable precedent, we cannot be certain of the full extent to which Brexitcould adversely affect our business, results of operations and financial condition.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 could be negatively affected by a security breach, either through cyber-attack, cyber-intrusion or other significant disruption of our IT networks andrelated systems.We face the risk, as does any company, of a security breach, whether through cyber-attack or cyber-intrusion over the internet, malware, computerviruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization, or other significant disruption ofour IT networks and related systems. The risk of a security breach or17Table of Contentsdisruption, particularly through cyber-attack or cyber-intrusion, including by computer hackers, foreign governments and cyber terrorists, has increased asthe number, intensity and sophistication of attempted attacks and intrusions from around the world have increased.As a technology company, and particularly as a government contractor, we may face a heightened risk of a security breach or disruption from threats 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. We have not identified any significant security breaches or experienced other significant disruptions of thesetypes to date. Any of these developments in the future could have a negative impact on our results of operations, financial condition and cash 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 systems regulations. We are also required to comply with InternationalOrganization for Standardization ("ISO"), quality system standards in order to produce certain of our products for sale in Europe. If we fail to continue tocomply with Good18Table of ContentsManufacturing Practice requirements or ISO standards, we may be required to cease all or part of our operations until we comply with these regulations.Obtaining and maintaining such compliance is difficult and costly. We cannot be certain that our facilities will be found to comply with GoodManufacturing Practice requirements or ISO standards in future inspections and audits by regulatory authorities. In addition, if we cannot maintain orestablish manufacturing facilities or operations that comply with such standards or do not meet the expectations of our customers, we may not be able torealize certain economic opportunities in our current or future supply arrangements.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.Our patent position is highly uncertain and involves complex legal and factual questions. Accordingly, we cannot predict the breadth of claims thatmay be allowed or enforced in our patents or in third-party patents. For example:•we or our licensors might not have been the first to make the inventions covered by each of our pending patent applications and issued patents;•we or our licensors might not have been the first to file patent applications for these inventions;•others may independently develop similar or alternative technologies or duplicate any of our technologies;•it is possible that none of our pending patent applications or the pending patent applications of our licensors will result in issued patents;•patents may issue to third parties that cover how we might practice our technology;•our issued patents and issued patents of our licensors may not provide a basis for commercially viable technologies, may not provide us with anycompetitive advantages, or may be challenged and invalidated by third parties; and•we may not develop additional proprietary technologies that are patentable.19Table of ContentsPatents 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 assert these claims against us, we could incur extremely substantial costs and diversion ofmanagement resources in defending these claims, and the defense of these claims could have a material adverse effect on our business, financial conditionand results of operations. Even if we believe we have not infringed on a third party’s patent rights, we may have to settle a claim on unfavorable termsbecause we cannot afford to litigate the claim. In addition, if third parties assert claims against us and we are unsuccessful in defending against these claims,these third parties may be awarded substantial damages as well as injunctive or other equitable relief against us, which could effectively block our ability tomake, use, sell, distribute or market our products and services in the United States or abroad.Commercial application of nanotechnologies in particular, or technologies involving nanomaterials, is new and the scope and breadth of patentprotection is uncertain. Consequently, the patent positions of companies involved in nanotechnologies have not been tested, and there are complex legal andfactual questions for which important legal principles will be developed or may remain unresolved. In addition, it is not clear whether such patents will besubject to interpretations or legal doctrines that differ from conventional patent law principles. Changes in either the patent laws or in interpretations ofpatent laws in the United States and other countries may diminish the value of our nanotechnology-related intellectual property. Accordingly, we cannotpredict the breadth of claims that may be allowed or enforced in our nanotechnology-related patents or in third party20Table of Contentspatents. In the event that a claim relating to intellectual property is asserted against us, or third parties not affiliated with us hold pending or issued patentsthat relate to our products or technology, we may seek licenses to such intellectual property or challenge those patents. However, we may be unable to obtainthese licenses on commercially reasonable terms, if at all, and our challenge of the patents may be unsuccessful. Our failure to obtain the necessary licenses orother rights could prevent the sale, manufacture or distribution of our products and, therefore, could have a material adverse effect on our business, financialcondition and results of operations.A substantial portion of our technology is subject to retained rights of our licensors, and we may not be able to prevent the loss of those rights or the 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 cannot assure you that third-party licenses will be availableon commercially reasonable terms, if at all. Our competitors may be able to obtain licenses, or cross-license their technology, on better terms than we can,which could put us at a competitive disadvantage. Also, we often enter into confidentiality agreements with such third parties in which we agree to protectand maintain their proprietary and confidential information, including at times requiring our employees to enter into agreements protecting such information.There can be no assurance that the confidentiality agreements will not be breached by any of our employees or that such third parties will not make claimsthat their proprietary information has been disclosed.RISKS RELATING TO OUR COMMON 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 interest21Table of Contentsexpense to 30% of adjusted earnings (except for certain small businesses), limitation of the deduction for net operating losses to 80% of current year taxableincome and elimination of net operating loss carrybacks, immediate deductions for certain new investments instead of deductions for depreciation expenseover time, and modifying or repealing many business deductions and credits. Federal net operating losses arising in taxable year ending after December 31,2017, will be carried forward indefinitely pursuant to the TCJA. We continue to examine the impact this tax reform legislation may have on our business.Notwithstanding the reduction in the corporate income tax rate, the overall impact of the TCJA is uncertain and our business and financial condition couldbe adversely affected. The impact of this tax reform on holders of our common stock is also uncertain and could be adverse. We urge our stockholders toconsult with their legal and tax advisors with respect to such legislation and the potential tax consequences 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 4.1 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 sale 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.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;•challenges integrating our recent or future acquisitions, including the inability to realize any expected synergies;•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;22Table of Contents•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.If our estimates relating to our critical accounting policies are based on assumptions or judgments that change or prove to be incorrect, our operatingresults could fall below expectations of financial analysts and investors, resulting in a decline in our stock price.The preparation of financial statements in conformity with U.S. GAAP requires our management to make estimates, assumptions and judgments thataffect the amounts reported in the consolidated financial statements and accompanying notes. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carryingvalues of assets, liabilities, equity, revenue and expenses that are not readily apparent from other sources. Our operating results may be adversely affected ifour assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectationsof financial analysts and investors, resulting in a decline in our stock price. Significant assumptions and estimates used in preparing our consolidatedfinancial statements include those related to revenue recognition, stock-based compensation and income taxes. Moreover, the new revenue recognitionguidance, ASC Topic 606, Revenue from Contracts with Customers, requires more judgment than did the prior guidance.Our financial results may be adversely affected by changes in accounting principles applicable to us.U.S. GAAP are subject to interpretation by the FASB, the SEC, and other bodies formed to promulgate and interpret appropriate accounting principles.For example, in May 2014, the FASB issued ASC Topic 606, Revenue from Contracts with Customers, which supersedes nearly all existing revenuerecognition guidance under U.S. GAAP. We adopted this guidance as of January 1, 2018. The most significant impact relates to changing the revenuerecognition for custom optoelectronics to an over time method. Before the adoption of this standard, we deferred the recognition of revenue until productswere shipped to the customer. Any difficulties in implementing these pronouncements or adequately accounting after adoption could cause us to fail to meetour financial reporting obligations, which could result in regulatory discipline and harm investors’ confidence in us.Anti-takeover provisions in our amended and restated certificate of incorporation and bylaws and Delaware law could discourage or prevent a change incontrol, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by ourstockholders to replace or remove our current management.Our amended and restated certificate of incorporation and bylaws and Delaware law contain provisions that might delay or prevent a change in control,discourage bids at a premium over the market price of our common stock and adversely affect23Table of Contentsthe market price of our common stock and the voting and other rights of the holders of our common stock. These provisions include:•a classified board of directors serving staggered terms;•advance notice requirements to stockholders for matters to be brought at stockholder meetings;•a supermajority stockholder vote requirement for amending certain provisions of our amended and restated certificate of incorporation and bylaws;and•the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer.We are also subject to provisions of the Delaware General Corporation law that, in general, prohibit any business combination with a beneficial 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, 2021.We lease approximately 19,600 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 21,000 square feet of space in Atlanta, Georgia, for use by our Products and Licensing segment. This lease expires October 31,2020.We own a 24,000 square foot facility in Danville, Virginia for use by certain groups in our Technology Development segment.We lease approximately 28,000 square feet of space in Chino, California, for manufacture and support of our GP products.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 December 2018, we received a notice of claim (the "Claim") from Macom Technology Solutions, Inc. ("Macom"), who acquired our HSOR businessin August 2017 pursuant to an asset purchase agreement. Under the asset purchase agreement, we agreed to indemnify Macom for certain matters, including,among other things, the collection of accounts receivable from certain major customers, and placed $4.0 million of the purchase price into an escrow accountfor the potential settlement of any valid indemnity claims. The Claim received from Macom totaled $2.1 million under various indemnity provisions. Wehave disputed Macom's assertion of right to payment for the matters described in the Claim. It is uncertain what amount, if any, will be owed in settlement ofthe Claim. As of December 31, 2018, $1.5 million of the escrow balance had been received with the remaining $2.5 million in the escrow account pendingresolution of the dispute.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.24Table of Contents ITEM 4. MINE SAFETY DISCLOSURESNot applicable.25Table of ContentsPART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIESSTOCKHOLDERSOur common stock is listed on the Nasdaq Capital Market under the symbol "LUNA." As of March 12, 2019, we had 28,125,598 shares of commonstock outstanding held by 100 holders of record. The actual number of stockholders is greater than this number of record holders and includes stockholderswho are beneficial owners but whose shares are held in street name by brokers and other nominees. This number of holders of record also does not includestockholders whose shares may be held in trust by other entities.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 Index overthe same period. This graph assumes the investment of $100,000 in our common stock at the closing price on January 1, 2014, and an equivalent amount inthe Nasdaq Composite Index and the Russell 2000 Index on that date, and assumes the reinvestment of dividends, if any. We have never paid dividends onour 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.26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, 2018, the Series A Preferred Stock issued to Carilion has accrued $1,417,633 individends. The accrued dividend as of December 31, 2018 will be paid by the issuance of 710,985 shares of our common stock, which we will issue atCarilion’s written request. As the Series A27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 Parties-Not applicable.ITEM 6. SELECTED FINANCIAL DATAThe consolidated statement of operations data for each of the years ended December 31, 2018 and 2017 and the consolidated balance sheet data as ofDecember 31, 2018 and 2017 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, 2016, 2015 and 2014 and the consolidated balance sheet data as of December 31, 2016, 2015and 2014 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.28Table of Contents Years ended December 31,In thousands, except share and per share data2018 2017 2016 2015 2014Consolidated Statement of Operations Data: Revenues: Technology development$20,968 $18,576 $16,281 $13,599 $12,206Products and licensing21,950 14,505 13,323 12,975 9,054Total revenues42,917 33,082 29,604 26,574 21,260Cost of revenues: Technology development15,400 13,988 12,473 10,379 9,376Products and licensing8,079 5,724 5,417 5,652 4,047Total cost of revenues23,479 19,713 17,890 16,031 13,423Gross profit19,438 13,369 11,714 10,543 7,837Operating expense18,560 15,577 15,840 17,359 12,342Operating income/(loss)878 (2,208) (4,126) (6,816) (4,505)Other (expense)/income, net(17) 26 28 (53) 111Interest income550 — — — —Interest expense, net(124) (217) (317) (218) (96)Income/(loss) from continuing operations before income taxes1,286 (2,399) (4,414) (7,087) (4,490)Income tax expense/(benefit)48 (1,149) (136) (602) (1,137)Net income/(loss) from continuing operations1,238 (1,250) (4,279) (6,484) (3,353)Income from discontinued operations, net of income taxes9,766 15,866 1,909 8,801 9,347Net income/(loss)11,004 14,616 (2,369) 2,317 5,994Preferred stock dividend257 147 105 86 112Net income/(loss) attributable to common stockholders$10,747 $14,469 $(2,475) $2,231 $5,882Net income/(loss) per share from continuing operations: Basic$0.04 $(0.05) $(0.16) $(0.28) $(0.23) Diluted$0.04 $(0.05) $(0.16) $(0.28) $(0.23)Net income per share from discontinued operations: Basic$0.35 $0.58 $0.07 $0.38 $0.63 Diluted$0.30 $0.58 $0.07 $0.38 $0.63Net income/(loss) per share attributable to common stockholders: Basic$0.39 $0.52 $(0.09) $0.10 $0.40 Diluted$0.33 $0.52 $(0.09) $0.10 $0.40Weighted-average shares: Basic27,596,401 27,579,988 27,547,217 23,026,494 14,880,697Diluted32,452,228 27,579,988 27,547,217 23,026,494 14,880,697 As of December 31,In thousands2018 2017 2016 2015 2014Consolidated Balance Sheet Data: Cash and cash equivalents$42,460 $36,982 $17,464 $14,117 $7,779Working capital56,089 43,975 23,417 15,413 10,106Total assets75,599 66,223 58,132 27,584 19,704Total current liabilities12,139 14,826 15,334 8,473 7,206Total debt619 2,436 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 those29Table of Contentsanticipated in these forward-looking statements as a result of many factors, including those discussed under “Risk Factors” and elsewhere in this report.Business OverviewWe are a leader in advanced optical technology, providing high performance fiber optic test products for the telecommunications industry anddistributed fiber optic sensing products for industries utilizing composite and other advanced materials, such as the automotive, aerospace, energy andinfrastructure industries. Our distributed fiber optic sensing products help designers and manufacturers more efficiently develop new and innovative productsby providing valuable information such as highly detailed stress, strain, and temperature measurements of a new design or manufacturing process. Inaddition, our distributed fiber optic sensing products are used to monitor the structural integrity or operational health of critical assets, including large civilstructures such as bridges. Our communications test products accelerate the development of advanced fiber optic components and networks by providing fastand highly accurate characterization of components and networks. We also provide applied research services, typically under research programs funded bythe U.S. government, in areas of advanced materials, sensing, and healthcare applications. Our business model is designed to accelerate the process ofbringing new and innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research servicesfor companies and for government funded projects. We continue to invest in product development and commercialization, which we anticipate will lead toincreased product sales growth.We are organized into two main operating segments, our Products and Licensing segment and our Technology Development segment. Our Products andLicensing segment develops, manufactures and markets distributed fiber optic sensing products, as well as communications test products. We are continuingto develop and commercialize our fiber optic technology for sensing applications for aerospace, automotive, energy, and infrastructure as well as for test andmeasurement applications in the telecommunications and data communications industries. Our Products and Licensing segment revenues representedapproximately 51% and 44% of our total revenues for the years ended December 31, 2018 and 2017, 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 49% and 56% of our total revenues for the years ended December 31, 2018 and2017, 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. Our Technology Development segment revenues have historically accounted for alarge portion of our total revenues, and we expect that they will continue to represent a significant portion of our total revenues for the foreseeable future.Within the Technology Development segment, we have historically had a backlog of contracts for which work has been scheduled, but for which a specifiedportion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts uponcompletion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed underthese contracts, if any. Total backlog includes funded backlog, which is the amount for which money has been directly authorized by the U.S. governmentand for which a purchase order has been received by a commercial customer, and unfunded backlog, representing firm orders for which funding has not yetbeen appropriated. Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. The approximate value of ourTechnology Development segment backlog was $26.0 million and $23.5 million at December 31, 2018 and 2017, respectively. The approximate value of ourProducts and Licensing segment backlog was $5.8 million and $6.9 million at December 31, 2018 and 2017, respectively.Revenues from product sales are mostly derived from the sales of our sensing and test & measurement products that make use of light-transmittingoptical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead to increased product salesgrowth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues to represent a significant portionof future revenues. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenues from product sales to continueto be primarily in areas associated with our fiber optic test & measurement and sensing platforms. In the long term, we expect that revenues from product saleswill represent a larger portion of our total revenues and that as we develop and commercialize new products, these revenues will reflect a broader and morediversified mix of products.We realized net income attributable to common stockholders of approximately $10.7 million for the year ended December 31, 2018 and net incomeattributable to common stockholders of approximately $14.5 million for the year ended December 31, 2017. Excluding the effects of our HSOR business andour optoelectronics business, which we sold in 2017 and 2018, respectively, we realized a net income from continuing operations of $1.2 million for the yearended December 31, 2018 and a net loss from continuing operations of $1.3 million for the year ended December 31, 2017.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 continue to grow our business in part through acquisitions of additional companies and complementary technologies,which could cause us to incur transaction expenses, amortization or30Table of Contentswrite-offs of intangible assets and goodwill and other acquisition-related expenses. As a result, we may incur net losses in future periods, and these lossescould be substantial.Acquisition of General Photonics Corporation.On March 1, 2019, we acquired all of the outstanding stock of General Photonics Corporation ("GP"), a leading provider of innovative components,modules and test equipment focused on the generation, measurement and control of polarized light critical in fiber optic-based applications for aggregateconsideration of $19.0 million. Of the purchase price, $17.1 million was paid at closing and $1.9 million was placed into escrow for possible working capitaladjustments to the purchase price and potential satisfaction of certain post-closing indemnification obligations. Additionally, we can become obligated topay additional cash consideration of up to $1.0 million if certain revenue targets for the GP historical business are met for the twelve months following theclosing.Acquisition of Micron Optics, Inc.On October 15, 2018, we acquired the assets of the United States operations of Micron Optics, Inc. ("MOI"), a leading provider of innovative opticalcomponents and laser-based equipment that advance the quality of optical measurements, allowing the sensing, imaging, and telecommunications industriesto make critical measurements for total cash consideration of $5 million, including $4.0 million paid at closing and $1.0 million placed in escrow until thelater of October 1, 2019, or the date that specified matters are resolved as agreed by us and MOI. The purchase price was subject to adjustment after closingbased upon an analysis of final working capital compared to a target amount specified in the purchase agreement. In 2019, we expect to pay an additional$0.5 million to MOI in connection with the working capital adjustment. With the acquisition of MOI, we expanded our technology and product portfolio toinclude optical sensors and sensing interrogators capable of a broader range of measurement capabilities, including higher speed measurements such asvibration, and the ability to instrument larger structures over longer distances. In addition, the MOI acquisition adds a product suite of tunable optical filters,optical sensors, and swept lasers.Sale of Luna Optoelectronics BusinessIn July 2018, we sold substantially all of the assets associated with our custom optoelectronic components and sub-assemblies business for total cashconsideration of $17.5 million, paid at closing, in addition to contingent consideration of up to $1.0 million. The contingent consideration is subject to theoptoelectronic business achieving specified revenue targets for the 18 month period following the closing date. In addition, the purchase price was subject toadjustment based upon an analysis of final working capital as of the acquisition date compared to a target amount specified in the purchase agreement.Following closing, we received and additional $0.7 million in connection with the working capital adjustment. We have been engaged since 2015 in theoptoelectronic business as part of our acquisition of Advanced Photonix, Inc.Sale 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. As of December 31, 2018, $1.5 million of the escrow balance had been received. The remaining $2.5 million remains in theescrow account pending resolution of a dispute over certain indemnity claims by the buyer.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. In general, we complete contracted research over periodsranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred. Our Technology Development segmentrevenues represented approximately 49% and 56% of our total revenues for the years ended December 31, 2018 and 2017, 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 patents31Table of Contentsand other intellectual property. Products and licensing revenues represented approximately 51% and 44% of our total revenues for the years endedDecember 31, 2018 and 2017, 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 a term loan with Silicon Valley Bank ("SVB") which is scheduled to mature in May 2019. The term loan carries interest at a variable rate ofprime plus 2%. At December 31, 2018, we had $0.6 million in the aggregate outstanding on this term loan.During the years ended December 31, 2018 and 2017, interest expense primarily included interest accrued on our outstanding SVB debt and interestincurred with respect to our capital lease obligations.Critical Accounting Policies and EstimatesTechnology Development RevenuesWe perform research and development for U.S. Federal government agencies, educational institutions and commercial organizations. We account for aresearch contract when a contract has been executed, the rights of the parties are identified, payment terms are identified, the contract has commercialsubstance, and collectability of the contract price is considered probable. Revenue is earned under cost reimbursable, time and materials and fixed pricecontracts. Direct contract costs are expensed as incurred.Our contracts with agencies of the U.S. government are subject to periodic funding by the respective contracting agency. Funding for a contract may 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.Under the typical payment terms of our U.S. government contracts, the customer pays us either performance-based payments ("PBPs") or progresspayments. PBPs, which are typically used in the firm fixed price contracts, are interim payments based on quantifiable measures of performance or on theachievement of specified events or milestones. Progress payments, which are typically used in our cost type contracts, are interim payments based on costsincurred as the work progresses. For our U.S. government cost-type contracts, the customer generally pays us during the performance period for 80%-90% ofour actual costs incurred. Because the customer retains a small portion of the contract price until completion of the contract and audit of allowable costs, costtype contracts generally result in revenue recognized in excess of billings which32Table of Contentswe present as contract assets on the balance sheet. Amounts billed and due from our customers are classified as receivables on the balance sheet. For non-U.S.government contracts, we typically receive interim payments as work progresses, although for some contracts, we may be entitled to receive an advancepayment. We recognize a liability for these advance payments and PBPs paid in advance which are in excess of the revenue recognized and present theseamounts as contract liabilities on the balance sheet.To determine the proper revenue recognition method for research and development contracts, we evaluate whether two or more contracts should becombined and accounted for as one single modified contract and whether the combined or single contract should be accounted for as more than oneperformance obligation. For instances where a contract has options that were bid with the initial contract and awarded at a later date, we combine the optionswith the original contract when options are awarded. For most of our contracts, the customer contracts for research with multiple milestones that areinterdependent. Consequently, the entire contract is accounted for as one performance obligation. The effect of the combined or modified contract on thetransaction price and measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase inor a reduction of revenue) on a cumulative catch-up basis.Contract revenue recognition is measured over time as we perform because of continuous transfer of control to the customer. For U.S. governmentcontracts which are typically subject to the Federal Acquisition Regulation, this continuous transfer of control to the customer is supported by clauses in thecontract that allow the customer to unilaterally terminate the contract for convenience, pay us for cost incurred plus a reasonable profit and take control ofany work in process. From time to time, as part of normal management processes, facts may change, causing revisions to estimated total costs or revenuesexpected. The cumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period inwhich they become known.Because of control transferring over time, revenue is recognized over time based on the extent of progress towards completion of the performanceobligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the services to be provided.We generally use the input method, more specifically the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control tothe customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion ismeasured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. The underlying bases forestimating our contract research revenues are measurable expenses, such as labor, subcontractor costs and materials, and data that are updated on a regularbasis for purposes of preparing our cost estimates. Our research contracts generally have a period of performance of six months to three years, and ourestimates of contract costs have historically been consistent with actual results. Revisions in these estimates between accounting periods to reflect changingfacts and circumstances have not had a material impact on our operating results, and we do not expect future changes in these estimates to be material. Thecumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period in which theybecome known.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.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. We have agreed on final billingrates with the government through December 31, 2017.33Table of ContentsProducts and Licensing RevenuesTo determine the proper revenue recognition method for Products and Licensing contracts, we evaluate whether two or more contracts should becombined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performanceobligation. We recognize revenue when the performance obligation has been satisfied by transferring the control of the product or service to the customer.For tangible products that contain software that is essential to the tangible product’s functionality, we consider the product and software to be a singleperformance obligation and recognize revenue accordingly. For contracts with multiple performance obligations, we allocate the contract’s transaction priceto each performance obligation based on their relative stand-alone selling prices. In such circumstances, we use the observable price of goods or serviceswhich are sold separately in similar circumstances to similar customers. If these prices are not observable, then we will estimate the stand-alone selling priceusing information that is reasonably available. For the majority of our standard products and services, price list and discount structures related to customertype are available. For products and services that do not have price list and discount structures, we may use one or more of the following: (i) adjusted marketassessment approach, (ii) expected cost plus a margin approach, and (iii) residual approach. The adjusted market approach requires us to evaluate the marketin which we sell goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. The expected costplus margin approach requires us to forecast our expected costs of satisfying the performance obligation and then add a reasonable margin for that good orservice. The residual approach decreases the total transaction price by the sum of the observable standalone selling prices if either the company sells the samegood or services to different customers for a broad range of amounts or the company has not established a price for the good or service and that good orservice has not been sold on a standalone basis. Shipping and handling activities primarily occur after a customer obtains control and are consideredfulfillment cost rather than separate performance obligations. Similarly, sales and similar taxes assessed by a governmental authority that are both imposed onand concurrent with a specific revenue-producing transaction and collected by the entity from a customer are excluded from the measurement of thetransaction price.For standard products, we recognize revenue at a point in time when control passes to the customer. Absent substantial product acceptance clauses, thisis based on the shipping terms. For custom products that require engineering and development based on customer requirements, we will recognize revenueover time using the output method for any items shipped and any finished goods or work in process that is produced for balances of open sales orders. For anyfinished goods or work in process that has been produced for the balance of open sales orders we recognize revenue by applying the average selling price forsuch open order to the lesser of the on hand balance in finished goods or open sales order quantity which we present as a contract asset on the balance sheet.Cost of sales is recognized based on the standard cost of the finished goods and work in process associated with this revenue and inventory balances arereduced accordingly. For extended warranties and product rentals, revenue is recognized over time using the output method based on the time elapsed for thewarranty or service period. In the case of warranties, we record a contract liability for amounts billed but that are not recognized until subsequent period. Aseparate contract liability is recorded for the cost associated with warranty repairs based on our estimate of future expense. For testing services where we areperforming testing on an asset the customer controls, revenue is recognized over time by the output method using the performance to date. For training wherethe customer is receiving the benefit of training as it is occurring and for repairs to a customer controlled asset, revenue is recognized over time by the outputmethod using the performance to date. For royalty revenue, we apply the practical expedient “royalty exception” recognizing revenue based on the royaltyagreement which specifies an amount based on sales or minimum amount, whichever is greater.In some product rental contracts, a customer may be offered a discount on the purchase of an item that would provide for a material right. When amaterial right has been provided to a customer, a separate performance obligation is established and a portion of the rental revenue will be deferred until thefuture product is purchased or the option expires. This deferred revenue is recognized as a contract liability on the balance sheet. In certain circumstances wemay offer a "right of return" to a distributor of our products, in which case a contract liability is calculated based on the terms of the agreement and recordedas a reduction to revenue. In addition, a contract asset for the rights to recover products from customers and a reduction of cost of sales is also calculated andrecorded.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, management34Table of Contentsconsiders factors such as future reversals of existing taxable temporary differences, taxable income in prior carry back years, whether carry back is permittedunder the tax law, tax planning strategies and estimated future taxable income exclusive of reversing temporary differences and carry forwards. To the extentthat we cannot conclude that it is more likely than not that the benefit of such assets will be realized, we establish a valuation allowance to reduce their netcarrying 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, 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,we were 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 assetand a corresponding reduction in the valuation allowance in 2017. In 2018, we realized a benefit of $0.6 million in recovery of the alternative minimum taxcredit from prior periods. The other provisions of the Tax Cuts and Jobs Act did not have a material impact on our 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.Goodwill35Table of ContentsGoodwill 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.Business CombinationsWe account for business combinations under the acquisition method of accounting. Under this method, the total estimated purchase consideration isallocated to the acquired tangible and intangible assets and assumed liabilities based on their estimated fair values as of the acquisition date. Any excess ofthe fair value of acquisition consideration over the fair value of identifiable assets acquired and liabilities assumed is recorded as goodwill.Results 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, 2018 2017Revenues: Technology development48.9% 56.2 %Products and licensing51.1 43.8Total revenues100.0 100.0Cost of revenues: Technology development35.9 42.3Products and licensing18.8 17.3Total cost of revenues54.7 59.6Gross profit45.3 40.4Operating expense43.2 47.1Operating income/(loss)2.1 (6.7)Total other income/(expense)1.0 (0.6)Income/(loss) from continuing operations before income taxes3.1 (7.3)Income/(loss) from continuing operations, net of income taxes2.9 (3.8)Income from discontinued operations, net of income taxes22.8 48.0Net income25.7% 44.2 %Year Ended December 31, 2018 Compared to Year Ended December 31, 2017Revenues Years ended December 31, 2018 2017 $ Difference % DifferenceTechnology development revenues$20,967,556 $18,576,383 $2,391,173 12.9%Products and licensing revenues21,949,689 14,505,482 7,444,207 51.3%Total revenues$42,917,245 $33,081,865 $9,835,380 29.7%Our Technology Development segment revenues increased $2.4 million to $21.0 million for the year ended December 31, 2018 compared to $18.6million for the year ended December 31, 2017. 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 $7.4 million to $21.9 million for the year ended December 31, 2018 compared to $14.5million for the year ended December 31, 2017. This increase was primarily driven by an increase in our sales of optical backscatter reflectometer instrumentsand ODiSI instruments. In addition, revenues associated with the operations of MOI, which we acquired on October 15, 2018, were $2.6 million for the periodfrom the completion of the acquisition through December 31, 2018.Cost of Revenues36Table of Contents Years ended December 31, 2018 2017 $ Difference % DifferenceTechnology development costs$15,400,475 $13,988,378 $1,412,097 10.1%Products and licensing costs8,078,870 5,724,457 2,354,413 41.1%Total costs of revenues$23,479,345 $19,712,835 $3,766,510 19.1%Our Technology Development segment costs increased $1.4 million, to $15.4 million for the year ended December 31, 2018 compared to $14.0 millionfor the year ended December 31, 2017. The overall increase in Technology Development segment costs was driven by increases in direct labor andsubcontractor costs consistent with the rate of growth in Technology Development segment revenues.Our Products and Licensing segment costs increased $2.4 million to $8.1 million for the year ended December 31, 2018 compared to $5.7 million forthe year ended December 31, 2017. The increase in product and licensing cost is attributable to the component costs associated with increased volume ofoptical backscatter reflectometer and ODiSI instrument sales. In addition, cost of revenues associated with the operations of MOI were $0.7 million for theperiod from the completion of the acquisition through December 31, 2018. Products and Licensing segment costs increased in accordance with the increasein Products and Licensing segment revenues over the same period taking into account the gross margin effect of the product mix.Operating Expense Years ended December 31, 2018 2017 $ Difference % DifferenceSelling, general and administrative expense$14,794,205 $12,923,841 $1,870,364 14.5%Research, development and engineering expense3,766,160 2,653,337 1,112,823 41.9%Total operating expense$18,560,365 $15,577,178 $2,983,187 19.2%Selling, general and administrative expenses increased $1.9 million to $14.8 million for the year ended December 31, 2018 compared to$12.9 millionfor the year ended December 31, 2017. The increase in selling, general and administrative expenses included $0.8 million in transaction-related expensesassociated with the acquisition of MOI and $0.5 million in expenses associated with the operations of MOI for the period from the completion of theacquisition through December 31, 2018.Research, development and engineering expenses increased $1.1 million to $3.8 million for the year ended December 31, 2018 compared to $2.7million for the year ended December 31, 2017. During 2018, we increased our headcount and other expenses in engineering within our Lightwave division inorder to accelerate our product development roadmap to continue our growth in the areas of fiber optic-based sensing and communications testing. Inaddition, the operations of research development and engineering expense associated with the operations of MOI for the period from the completion of theacquisition through December 31, 2018 were $0.3 million.Interest Expense, NetOur net interest expense was $0.1 million for the year ended December 31, 2018 compared to $0.2 million for the year ended December 31, 2017. Theaverage monthly loan balance for the year ended December 31, 2018 was $1.5 million as compared to $3.3 million for the year ended December 31, 2017,resulting in this decrease in interest expense.Investment IncomeInvestment income was $0.5 million for the year ended December 31, 2018. During the year ended December 31, 2018, we invested a portion of ourcash in funds holding U.S. treasury securities. We did not have any investment income for the year ended December 31, 2017.Income Tax Expense/(Benefit) from Continuing OperationsFor the year ended December 31, 2018, we recorded income tax expense of $47,818, or 3.7% of our income from continuing operations, compared to anincome tax benefit of $1.1 million, or 47.9% of our loss from continuing operations for the year ended December 31, 2017. The change resulted from therecognition of income from continuing operations in 2018 compared to a loss from continuing operations in 2017. The income tax benefit recognized in2017 was also driven by the37Table of Contentsdiscrete gain associated with the discontinued operations of our former HSOR and optoelectronic components business and the related intraperiod taxallocation requirements.Net Income/(Loss) From Continuing OperationsFor the year ended December 31, 2018, we recognized income from continuing operations before income taxes of $1.3 million compared to a loss fromcontinuing operations before income taxes of $2.4 million for the year ended December 31, 2017. After tax, our net income from continuing operations was$1.2 million for the year ended December 31, 2018, compared to a net loss from continuing operations of $1.3 million for the year ended December 31, 2017.Income from Discontinued Operations, Net of Income TaxesFor the year ended December 31, 2018, we recognized income from discontinued operations, net of income taxes, of $9.8 million. For the year endedDecember 31, 2017, we recognized income from discontinued operations, net of income taxes, of $15.9 million. Net income from discontinued operations forthe year ended December 31, 2018, included an after tax gain recognized on the sale of our optoelectronics business during 2018 of $8.6 million in additionto $1.2 million of after-tax income associated with the operations of the optoelectronics business prior to its sale. 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 in addition to after-tax incomeof $0.2 million related to the operations of both the HSOR and optoelectronics businesses that were disposed of during 2017 and 2018, respectively.Preferred Stock DividendIn January 2010, we issued 1,321,514 shares of our newly designated Series A Convertible Preferred Stock to Carilion. The Series A ConvertiblePreferred Stock carries an annual cumulative dividend of 6%, or approximately 79,292 shares of common stock per year. During each of 2018 and 2017, weaccrued $0.3 million and $0.1 million, respectively, for the dividends payable to Carilion. The dividends are not payable in cash, but rather in shares of ourcommon stock, until liquidation event occurs. During each of 2018 and 2017, 79,292 shares of common stock became issuable to Carilion as dividends andhave been recorded in the statement of changes in stockholders’ equity.Liquidity and Capital ResourcesAt December 31, 2018, our total cash and cash equivalents were $42.5 million. As described elsewhere in this report, subsequent to year end, we used$19.0 million of cash to purchase GP.We have a term loan with SVB which, at December 31, 2018, had a balance of $0.6 million and matures on May 1, 2019. We may prepay amounts dueunder the term loan at any time, subject to prepayment penalties of up to 2% of the amount of prepayment. Amounts due under the term loan are secured bysubstantially all of our assets, including intellectual property, personal property and bank accounts.The term loan contains 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, 2018, we were in compliance with allcovenants under the credit facility.We maintain a letter-of-credit in the amount of $1.0 million as a condition of our lease on our Blacksburg office.We believe that our cash and cash equivalents as of December 31, 2018 will provide adequate liquidity for us to meet our working capital needs overthe next twelve months. Additionally, we believe that should we have the need for increased capital spending to support our planned growth, we will be ableto fund such growth through either third-party financing on competitive market terms or through our available cash and cash equivalents.38Table of ContentsDiscussion of Cash Flows Years ended December 31, 2018 2017Net cash (used in)/provided by operating activities$(3,308,825) $915,042Net cash provided by investing activities10,037,123 26,181,400Net cash used in financing activities(1,249,564) (2,917,367)Net increase in cash and cash equivalents$5,478,734 $24,179,075During 2018, operations used $3.3 million of net cash, as compared to 2017, when operations provided $0.9 million of net cash. In 2018, our netincome of $11.0 million included a gain on the sale of our optoelectronics business, net of income tax, of $8.6 million, and non-cash expenses which did notimpact cash flow for the period. These non-cash expenses were depreciation and amortization of $1.2 million, and stock-based compensation of $0.6 million.Additionally, changes in working capital resulted in a net cash outflow of $7.6 million, principally driven by an increase in accounts receivable of $6.2million, an increase in inventory of $1.0 million, an increase in contract assets of $0.8 million and decreases in accounts payable and accrued expenses of$0.5 million and contract liabilities of $1.0 million, partially offset by a decrease in prepaid expenses of $1.8 million.In 2017, our net income of $14.6 million included after-tax income from discontinued operations of $15.7 million as well as charges for depreciationand amortization of $2.5 million and stock-based compensation of $0.7 million, each of which were non-cash items that do not impact cash flow for theperiod. 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 millionand an increase in accounts payable and accrued liabilities of $0.9 million partially offset by a decrease in accounts receivable of $1.2 million.Cash provided by investing activities in 2018 consisted primarily of the proceeds from the sale of our optoelectronics business of $15.8 million,partially offset by payment of $5.0 million related to our acquisition of MOI along with $0.4 million of fixed asset additions and $0.4 million of capitalizedintellectual property costs.Cash provided by investing activities in 2017 consisted primarily of the proceeds from the sale of our HSOR business of $28.0 million, partially offsetby a cash outflow of $2.0 million related to the purchase of property and equipment to expand our manufacturing capability as well as capitalized costsassociated with securing intellectual property rights.Cash used in financing activities for the year ended December 31, 2018 was $1.2 million, compared to cash used in financing activities of $2.9 millionin 2017. During 2018, we repaid $1.8 million on our term loans with SVB. We also used $0.5 million to repurchase our common stock under our stockrepurchase program and received $1.1 million from exercises of stock options and warrants. During 2017, we repaid $1.8 million on our outstanding termloan with SVB and also used $1.1 million to repurchase our common stock under our stock repurchase program.Summary of Contractual ObligationsThe following table sets forth information concerning our known contractual obligations as of December 31, 2018 that are fixed and determinable. Total Less than 1year 1 - 3 years 3 - 5 years More than 5yearsLong-term debt obligations (1)$625,000 $625,000 $— $— $—Operating facility leases (2)4,608,720 1,216,124 1,758,484 1,089,408 544,704Other leases (3)147,076 53,052 72,664 21,360 —Purchase order obligation (4)752,448 752,448 — — —MOI working capital adjustment (5)542,983 542,983 — — —Other liabilities (6)440,000 440,000 — — —Total$7,116,227 $3,629,607 $1,831,148 $1,110,768 $544,704_________________________(1) Amounts due under our debt obligations to SVB are payable in monthly installments, plus accrued interest, through May 2019.39Table of Contents(2) We lease our facilities in Blacksburg, Charlottesville and Roanoke, Virginia, Ann Arbor, Michigan, and Atlanta, Georgia under operating leases that asof December 31, 2018, are scheduled to expire between December 2018 and December 2024. Upon expiration of our office leases, we may exercisecertain renewal options as specified in the leases. Rental payments associated with these option periods are not included in the table 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 and 2018, our Luna Technologies subsidiary executed non-cancelable purchase orders for a total amount of $2.3 million for multiple shipments of tunable lasers to be delivered over an 18-month periodbeginning in November 2017.(5) The final working capital associated with the acquisition of MOI is estimated to be higher than the target value specified in the asset purchaseagreement and therefore such excess amount is payable to the stockholders of MOI.(6) 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.Interest Rate RiskWe do not use derivative financial instruments as a hedge against interest rate fluctuations, and, as a result, interest income earned on our cash and cashequivalents and short-term investments is subject to changes in interest rates. However, we believe that the impact of these fluctuations does not have amaterial effect on our financial position due to the immediate available liquidity or short-term nature of these financial instruments.We are exposed to interest rate fluctuations as a result of our SVB debt facility having a variable interest rate. We do not currently use derivativeinstruments to alter the interest rate characteristics of our debt. The principal amount of $0.6 million outstanding under the term loan as of December 31,2018, is scheduled to amortize in monthly installments through May 2019. A change of 1% in the applicable interest rate during 2018 would have had aninsignificant impact in our annual interest expense.Foreign Currency Exchange Rate RiskAs of December 31, 2018, 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, 2018 and 201743Consolidated Statements of Operations for the years ended December 31, 2018 and 201744Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 2018 and 201746Consolidated Statements of Cash Flows for the years ended December 31, 2018 and 201747Notes to Consolidated Financial Statements4841Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMBoard of Directors and StockholdersLuna 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, 2018 and 2017, the related consolidated statements of operations, changes instockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2018, and the related notes andfinancial statement schedule included under Item 15(a) (collectively referred to as the “financial statements”). In our opinion, thefinancial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017,and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2018, in conformity withaccounting principles generally accepted in the United 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 14, 201942Table of ContentsCONSOLIDATED BALANCE SHEETS December 31, 2018 December 31, 2017Assets Current assets: Cash and cash equivalents$42,460,267 $36,981,533Accounts receivable, net13,037,068 5,929,042 Receivable from sale of HSOR business2,500,000 4,000,976Contract assets2,422,495 1,778,142Inventory6,873,742 4,634,781Prepaid expenses and other current assets935,185 1,140,999Current assets held for sale— 4,336,105Total current assets68,228,757 58,801,578Property and equipment, net3,627,886 2,854,641Intangible assets, net3,302,270 1,727,390Goodwill101,008 —Long term contract assets336,820 209,699Other assets1,995 1,995Non-current assets held for sale— 2,627,333Total assets$75,598,736 $66,222,636Liabilities and stockholders’ equity Current liabilities: Current portion of long term debt obligations$619,315 $1,833,333Current portion of capital lease obligations40,586 43,665Accounts payable2,395,984 2,111,077Accrued liabilities6,597,458 6,547,230Contract liabilities2,486,111 3,318,379Current liabilities held for sale— 972,451Total current liabilities12,139,454 14,826,135Long-term portion of deferred rent1,035,974 1,184,438Long-term debt obligations— 603,007Long-term capital lease obligations68,978 71,275Total liabilities13,244,406 16,684,855Commitments and contingencies Stockholders’ equity: Preferred stock, par value $0.001, 1,321,514 shares authorized, issued and outstanding at December 31, 2018and 20171,322 1,322Common stock, par value $0.001, 100,000,000 shares authorized, 29,209,506 and 28,354,822 shares issued,27,956,401 and 27,283,918 shares outstanding at December 31, 2018 and 2017, respectively30,120 29,186Treasury stock at cost, 1,253,105 and 1,070,904 shares at December 31, 2018 and 2017, respectively(2,116,640) (1,649,746)Additional paid-in capital85,744,750 83,563,208Accumulated deficit(21,305,222) (32,406,189)Total stockholders’ equity62,354,330 49,537,781Total liabilities and stockholders’ equity$75,598,736 $66,222,636The accompanying notes are an integral part of these consolidated financial statements.43Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS Years ended December 31, 2018 2017Revenues: Technology development$20,967,556 $18,576,383Products and licensing21,949,689 14,505,482Total revenues42,917,245 33,081,865Cost of revenues: Technology development15,400,475 13,988,378Products and licensing8,078,870 5,724,457Total cost of revenues23,479,345 19,712,835Gross profit19,437,900 13,369,030Operating expense: Selling, general and administrative14,794,205 12,923,841Research, development and engineering3,766,160 2,653,337Total operating expense18,560,365 15,577,178Operating income/(loss)877,535 (2,208,148)Other income/(expense): Other (expense)/income, net(17,143) 26,106Investment income549,580 —Interest expense, net(124,344) (217,352)Total other income/(expense)408,093 (191,246)Income/(loss) from continuing operations before income taxes1,285,628 (2,399,394)Income tax (expense)/benefit(47,818) 1,148,579Net income/(loss) from continuing operations1,237,810 (1,250,815)Operating income from discontinued operations, net of income tax expense of $183,921 and $876,5881,170,634 194,692Gain on sale, net of $1,572,244 and $912,298 of related income taxes8,595,797 15,671,028Income from discontinued operations, net of income taxes9,766,431 15,865,720Net income11,004,241 14,614,905Preferred stock dividend257,302 146,889Net income attributable to common stockholders$10,746,939 $14,468,016 Net income/(loss) per share from continuing operations: Basic$0.04 $(0.05) Diluted$0.04 $(0.05)Net income per share from discontinued operations: Basic$0.35 $0.58 Diluted$0.30 $0.58Net income per share attributable to common stockholders: Basic$0.39 $0.52 Diluted$0.33 $0.52Weighted average shares: Basic27,596,401 27,579,988Diluted32,452,228 27,579,98844Table of ContentsThe accompanying notes are an integral part of these consolidated financial statements.45Table of ContentsCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Preferred Stock Common Stock Treasury StockAdditionalPaid inCapital AccumulatedDeficit Total Shares $ Shares $ Shares $$ $ $Balance—January1, 20171,321,514 $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) $49,537,781Impact of changein accountingpolicy— — — — — —— 354,028 354,028Adjusted balanceas of January 1,20181,321,514 1,322 27,283,918 29,186 1,070,904 (1,649,746)83,563,208 (32,052,161) 49,891,809Exercise of stockoptions andwarrants— — 442,425 441 — —1,096,592 — 1,097,033Stock-basedcompensation— — 282,394 282 — —627,857 — 628,139Non-cashcompensation— — 129,865 131 — —199,871 — 200,002Stock dividends(1)— — — 80 — —257,222 (257,302) —Purchase oftreasury stock— — (182,201) — 182,201 (466,894)— — (466,894)Net income— — — — — —— 11,004,241 11,004,241Balance—December 31,20181,321,514 $1,32227,956,401$30,1201,253,105$(2,116,640)$85,744,750$(21,305,222)$62,354,330 (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.46Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2018 2017Cash flows (used in)/provided by operating activities: Net income$11,004,241 $14,614,905Adjustments to reconcile net income to net cash (used in)/provided by operating activities: Depreciation and amortization1,218,559 2,526,609Stock-based compensation627,856 715,094Loss on disposal of fixed assets(1,000) 3,640Gain on sale of discontinued operations, net of income taxes(8,595,797) (15,671,028)Bad debt6,000 99,888Changes in operating assets and liabilities: Accounts receivable(6,240,377) 1,152,055Contract assets(761,714) —Inventory(967,797) (1,902,311)Other assets1,849,630 83,428Accounts payable and accrued expenses(461,928) (896,534)Contract liabilities(986,498) —Deferred revenue— 189,296Net cash (used in)/provided by operating activities(3,308,825) 915,042Cash flows provided by investing activities: Acquisition of property and equipment(386,890) (1,352,531)Proceeds from sale of property and equipment1,000 3,000Intangible property costs(374,766) (495,597)Acquisition of Micron Optics(5,001,750) —Proceeds from sale of discontinued operations, net15,799,529 28,026,528Net cash provided by investing activities10,037,123 26,181,400Cash flows used in financing activities: Payments on debt obligations(1,833,333) (1,833,333)Payments on capital lease obligations(46,653) (52,128)Purchase of treasury stock(466,894) (1,131,759)Proceeds from the exercise of options and warrants1,097,316 99,853Net cash used in financing activities(1,249,564) (2,917,367)Net change in cash and cash equivalents5,478,734 24,179,075Cash and cash equivalents—beginning of period36,981,533 12,802,458Cash and cash equivalents—end of period$42,460,267 $36,981,533Supplemental disclosure of cash flow information Cash paid for interest$117,616 $209,497Cash paid for income taxes$1,846,037 $377,907Cash received for income tax refunds$17,834 $—Common stock issued pursuant to restricted stock vesting$200,202 $150,000Dividend on preferred stock$257,302 $146,889The accompanying notes are an integral part of these consolidated financial statements.47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 high performance fiber optic test products for the telecommunications industry anddistributed fiber optic sensing products for industries utilizing composite and other advanced materials, such as the automotive, aerospace, energy andinfrastructure industries. Our distributed fiber optic sensing products help designers and manufacturers more efficiently develop new and innovative productsby providing valuable information such as highly detailed stress, strain, and temperature measurements of a new design or manufacturing process. Inaddition, our distributed fiber optic sensing products are used to monitor the structural integrity or operational health of critical assets, including large civilstructures such as bridges. Our communications test products accelerate the development of advanced fiber optic components and networks by providing fastand highly accurate characterization of components and networks. We also provide applied research services, typically under research programs funded bythe U.S. government, in areas of advanced materials, sensing, and healthcare applications. Our business model is designed to accelerate the process ofbringing new and innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research servicesfor companies and for government funded projects. We continue to invest in product development and commercialization, which we anticipate will lead toincreased product sales growth.Consolidation PolicyOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP") andinclude our accounts and the accounts of our wholly owned subsidiaries. We eliminate from our financial results all intercompany transactions.ReclassificationsCertain amounts in the prior period have been reclassified to conform to current presentation. As a result of the adoption of Accounting StandardsCodification ("ASC") 2014-09, Revenue from Contracts with Customers (Topic 606), we presented balances entitled contract assets and contract liabilitieswithin the consolidated balance sheet as well as the impact of the changes in these balances within the consolidated statement of cash flows. We reclassifiedcomparable balances within the December 31, 2017 consolidated balance sheet as well as the impact of changes in those balances within the consolidatedstatement of cash flows in order to enhance comparability. These reclassifications had no effect on our reported financial condition, results of operations, orcash flows. Any other reclassifications were immaterial to the consolidated interim financial statements taken as a whole.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. Federal government agencies, educational institutions and commercial organizations. We account for aresearch contract when a contract has been executed, the rights of the parties are identified, payment terms are identified, the contract has commercialsubstance, and collectability of the contract price is considered probable. Revenue is earned under cost reimbursable, time and materials and fixed pricecontracts. Direct contract costs are expensed as incurred.Our contracts with agencies of the U.S. government are subject to periodic funding by the respective contracting agency. Funding for a contract may 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 of48Table of Contentsavailable funding for the contract or program. If funding is not assessed as probable, revenue recognition is deferred until realization is reasonably assured.Under the typical payment terms of our U.S. government contracts, the customer pays us either performance-based payments ("PBPs") or progresspayments. PBPs, which are typically used in the firm fixed price contracts, are interim payments based on quantifiable measures of performance or on theachievement of specified events or milestones. Progress payments, which are typically used in our cost type contracts, are interim payments based on costsincurred as the work progresses. For our U.S. government cost-type contracts, the customer generally pays us during the performance period for 80% to 90%of our actual costs incurred. Because the customer retains a small portion of the contract price until completion of the contract and audit of allowable costs,cost type contracts generally result in revenue recognized in excess of billings which we present as contract assets on the balance sheet. Amounts billed anddue from our customers are classified as receivables on the balance sheet. For non-U.S. government contracts, we typically receive interim payments as workprogresses, although for some contracts, we may be entitled to receive an advance payment. We recognize a liability for these advance payments and PBPspaid in advance which are in excess of the revenue recognized and present these amounts as contract liabilities on the balance sheet.To determine the proper revenue recognition method for research and development contracts, we evaluate whether two or more contracts should becombined and accounted for as one single modified contract and whether the combined or single contract should be accounted for as more than oneperformance obligation. For instances where a contract has options that were bid with the initial contract and awarded at a later date, we combine the optionswith the original contract when options are awarded. For most of our contracts, the customer contracts for research with multiple milestones that areinterdependent. Consequently, the entire contract is accounted for as one performance obligation. The effect of the combined or modified contract on thetransaction price and measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase inor a reduction of revenue) on a cumulative catch-up basis.Contract revenue recognition is measured over time as we perform because of continuous transfer of control to the customer. For U.S. governmentcontracts which are typically subject to the Federal Acquisition Regulation, this continuous transfer of control to the customer is supported by clauses in thecontract that allow the customer to unilaterally terminate the contract for convenience, pay us for cost incurred plus a reasonable profit and take control ofany work in process. From time to time, as part of normal management processes, facts may change, causing revisions to estimated total costs or revenuesexpected. The cumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period inwhich they become known.Because of control transferring over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. Theselection of the method to measure progress towards completion requires judgment and is based on the nature of the services to be provided. We generallyuse the input method, more specifically the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control to the customerwhich occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based onthe ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. The underlying bases for estimating our contractresearch revenues are measurable expenses, such as labor, subcontractor costs and materials, and data that are updated on a regular basis for purposes ofpreparing our cost estimates. Our research contracts generally have a period of performance of six months to three years, and our estimates of contract costshave historically been consistent with actual results. Revisions in these estimates between accounting periods to reflect changing facts and circumstanceshave not had a material impact on our operating results, and we do not expect future changes in these estimates to be material. The cumulative impact of anyrevisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period in which they become known.Under cost reimbursable contracts, we are reimbursed for costs that are determined to be reasonable, allowable and allocable to the contract and paid 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 in49Table of Contentsthe contract as this method more accurately measures performance under these arrangements. For fixed price contracts that provide for the development anddelivery of a specific prototype or product, revenue is recognized based upon the percentage of completion method.Whether certain costs under government contracts are allowable is subject to audit by the government. Certain indirect costs are charged to 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.Product Sales RevenuesRevenues from product sales are generated by the sale of commercial products and services under various sales programs to the end user and throughdistribution channels. We sell fiber optic sensing systems to end users for use in numerous fiber optic based measurement applications. Revenues are recordednet of applicable sales taxes collected from customers and payable to state or local governmental entities.To determine the proper revenue recognition method for Products and Licensing contracts, we evaluate whether two or more contracts should becombined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performanceobligation. We recognize revenue when the performance obligation has been satisfied by transferring the control of the product or service to the customer.For tangible products that contain software that is essential to the tangible product’s functionality, we consider the product and software to be a singleperformance obligation and recognize revenue accordingly. For contracts with multiple performance obligations, we allocate the contract’s transaction priceto each performance obligation based on their relative stand-alone selling prices. In such circumstances, we use the observable price of goods or serviceswhich are sold separately in similar circumstances to similar customers. If these prices are not observable, then we will estimate the stand-alone selling priceusing information that is reasonably available. For the majority of our standard products and services, price list and discount structures related to customertype are available. For products and services that do not have price list and discount structures, we may use one or more of the following: (i) adjusted marketassessment approach, (ii) expected cost plus a margin approach, and (iii) residual approach. The adjusted market approach requires us to evaluate the marketin which we sell goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. The expected costplus margin approach requires us to forecast our expected costs of satisfying the performance obligation and then add a reasonable margin for that good orservice. The residual approach decreases the total transaction price by the sum of the observable standalone selling prices if either the company sells the samegood or services to different customers for a broad range of amounts or the company has not established a price for the good or service and that good orservice has not been sold on a standalone basis. Shipping and handling activities primarily occur after a customer obtains control and are consideredfulfillment cost rather than separate performance obligations. Similarly, sales and similar taxes assessed by a governmental authority that are both imposed onand concurrent with a specific revenue-producing transaction and collected by the entity from a customer are excluded from the measurement of thetransaction price.For standard products, we recognize revenue at a point in time when control passes to the customer. Absent substantial product acceptance clauses, thisis based on the shipping terms. For custom products that require engineering and development based on customer requirements, we will recognize revenueover time using the output method for any items shipped and any finished goods or work in process that is produced for balances of open sales orders. For anyfinished goods or work in process that has been produced for the balance of open sales orders we recognize revenue by applying the average selling price forsuch open order to the lesser of the on hand balance in finished goods or open sales order quantity which we present as a contract asset on the balance sheet.Cost of sales is recognized based on the standard cost of the finished goods and work in process associated with this revenue and inventory balances arereduced accordingly. For extended warranties and product rentals, revenue is recognized over time using the output method based on the time elapsed for thewarranty or service period. In the case of warranties, we record a contract liability for amounts billed but that are not recognized until subsequent period. Aseparate contract liability is recorded for the cost associated with warranty repairs based on our estimate of future expense. For testing services where we areperforming testing on an asset the customer controls, revenue is recognized over time by the output method using the performance to date. For training wherethe customer is receiving the benefit of training as it is occurring and for repairs to a customer controlled asset, revenue is recognized over time by the outputmethod using the performance to date. For royalty revenue, we apply the practical expedient “royalty exception” recognizing revenue based on the royaltyagreement which specifies an amount based on sales or minimum amount, whichever is greater.In some product rental contracts, a customer may be offered a discount on the purchase of an item that would provide for a material right. When amaterial right has been provided to a customer, a separate performance obligation is established and a portion of the rental revenue will be deferred until thefuture product is purchased or the option expires. This deferred revenue50Table of Contentsis recognized as a contract liability on the balance sheet. In certain circumstances we may offer a "right of return" to a distributor of our products, in whichcase a contract liability is calculated based on the terms of the agreement and recorded as a reduction to revenue. In addition, a contract asset for the rights torecover products from customers and a reduction of cost of sales is also calculated and recorded.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 each of December 31, 2018 and 2017.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, 2018 and 2017 included $38.3 million and $25.2 million, 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 convertibleto cash on a daily basis. Our cash transactions are processed through reputable commercial banks. We regularly maintain cash balances with financialinstitutions which exceed Federal Deposit Insurance Corporation (“FDIC”) insurance limits. At December 31, 2018 and 2017, we had approximately $4.0million and $11.5 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.The 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") and Micron Optics, Inc. ("MOI"). We amortize our identified intangibleassets over their estimated useful lives ranging between one and eleven years, and analyze the reasonableness of the remaining useful life whenever events orcircumstances indicate that the carrying amount may not be recoverable to determine whether their carrying value has been impaired.51Table of ContentsGoodwillGoodwill 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.Research, Development and EngineeringResearch, development and engineering expenses not related to contract performance are expensed as incurred. We expensed $3.8 million and $2.7million of non-contract related research, development and engineering expenses for the year ended December 31, 2018 and 2017, respectively.Valuation of Long-Lived AssetsWe review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to begenerated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amountof the assets exceeds their fair value. Assets to be disposed of by sale are reflected at the lower of their carrying amount or fair value less cost to sell.InventoryInventory consists of finished goods, work in process and raw materials valued at the lower of cost (determined on the first-in, first-out basis) or netrealizable value.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 4.9 million common stock equivalents (which include outstanding warrants, preferred stock, accrued stock dividends, and stock options)are included for the diluted per share data for the year ended December 31, 2018. The effect of 4.3 million common stock equivalents (which includeoutstanding warrants, preferred stock and stock options) are not included for the year ended December 31, 2017, as they are anti-dilutive to earnings per sharedue to us having a net loss from continuing operations.Stock-Based CompensationWe have two stock-based compensation plans, which are described further in Note 10. We recognize compensation expense based upon the fair valueof the underlying equity award as of the date of grant. We have elected to use the Black-Scholes option pricing model to value any 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 on a straight-line method over the requisite service period of the awards taking into account the effects of the employees’expected exercise. We reduce stock-based compensation expense for the value of any forfeitures of vested awards as such forfeitures occur.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, 2018 and 2017.Income TaxesWe 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.52Table of ContentsWe 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, 2018, we adopted Revenue from Contracts with Customers (Topic 606), using the modified retrospective transition method. Underthe modified retrospective approach, we apply the standards to new contracts and those that were not completed as of January 1, 2018. For those contracts notcompleted as of January 1, 2018, this method resulted in a cumulative adjustment to decrease the accumulated deficit in the net amount of $0.4 million. Priorperiods will not be retrospectively adjusted, but we will maintain dual reporting for the year of initial application in order to maintain comparability of theperiods presented. The cumulative effect of the changes made to our January 1, 2018 consolidated balance sheet for the adoption of Topic 606 was asfollows: Balance at Adjustment for Adjusted balance at December 31, 2017 Topic 606 January 1, 2018Assets: Current assets held for sale$4,336,105 $379,891 $4,715,996 Liabilities: Contract liabilities$3,318,379 $2,250 $3,320,629Current liabilities held for sale$862,205 $23,613 $885,818 Stockholders' equity: Accumulated deficit$(32,406,189) $354,028 $(32,052,161)Contract assets were formerly reported as unbilled accounts receivable. Contract liabilities were formerly reported as accrued liabilities or deferredrevenue. Inventory was also impacted by the adoption of the new guidance. The titles have been changed in the table below to be consistent with accountscurrently used under the new standard. December 31, 2017 As Reported As AdoptedAccounts receivables, net$9,857,009 $5,929,042Contract assets— 1,778,142Current assets held for sale— 1,940,126Long-term contract assets— 209,699Accrued liabilities8,959,935 6,547,230Contract liabilities— 3,318,379Current liabilities held for sale— 120,665Deferred revenue1,026,339 —53Table of ContentsUnder the new standard, contracts in our Technology Development segment, which primarily provide research services, are not materially impactedupon the adoption of Topic 606 as revenue will continue to be recognized over time using an input model. Contracts in our Products and Licensing segmentgenerally provide for the following revenue sources: standard product sales, custom product development and sales, product rental, extended warranties,training/service, and certain royalties. Revenues for this segment are recognized using either the “point in time” or “over time” methods of Topic 606,depending upon the revenue source. The major change in revenue recognition for the Products and Licensing segment related to custom optoelectronicproducts which changed from “point in time” to “over time” upon the adoption of Topic 606. This change results in the acceleration of revenue whencompared to existing standards with the cumulative adjustment relating to contracts that are not complete as of December 31, 2017 recognized as anadjustment to opening accumulated deficit on January 1, 2018. The revenue received from our custom optoelectronic products segment is included as partof our discontinued operations (Note 17) and shown above in the current assets and liabilities held for sale as of December 31, 2017. Our revenue for ourstandard products will continue to be recognized using the "point in time" model of Topic 606, and the timing of such revenue recognition is not expected todiffer materially from our historical revenue recognition. Other immaterial adjustments related to the Products and Licensing segment that are sometimesoffered to customers include discounts on future purchases related to rental agreements, customer rights of return, and volume discounts.Technology Development RevenuesWe perform research and development for U.S. Federal government agencies, educational institutions and commercial organizations. We account for aresearch contract when a contract has been executed, the rights of the parties are identified, payment terms are identified, the contract has commercialsubstance, and collectability of the contract price is considered probable. Revenue is earned under cost reimbursable, time and materials and fixed pricecontracts. Direct contract costs are expensed as incurred.Our contracts with agencies of the U.S. government are subject to periodic funding by the respective contracting agency. Funding for a contract may 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.Under the typical payment terms of our U.S. government contracts, the customer pays us either performance-based payments ("PBPs") or progresspayments. PBPs, which are typically used in the firm fixed price contracts, are interim payments based on quantifiable measures of performance or on theachievement of specified events or milestones. Progress payments, which are typically used in our cost type contracts, are interim payments based on costsincurred as the work progresses. For our U.S. government cost-type contracts, the customer generally pays us during the performance period for 80% to 90%of our actual costs incurred. Because the customer retains a small portion of the contract price until completion of the contract and audit of allowable costs,cost type contracts generally result in revenue recognized in excess of billings which we present as contract assets on the balance sheet. Amounts billed anddue from our customers are classified as receivables on the balance sheet. For non-U.S. government contracts, we typically receive interim payments as workprogresses, although for some contracts, we may be entitled to receive an advance payment. We recognize a liability for these advance payments and PBPspaid in advance which are in excess of the revenue recognized and present these amounts as contract liabilities on the balance sheet.To determine the proper revenue recognition method for research and development contracts, we evaluate whether two or more contracts should becombined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performanceobligation. For instances where a contract has options that were bid with the initial contract and awarded at a later date, we combine the options with theoriginal contract when options are awarded. For most of our contracts, the customer contracts for research with multiple milestones that are interdependent.Consequently, the entire contract is accounted for as one performance obligation. The effect of the combined or modified contract on the transaction priceand measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase in or a reduction ofrevenue) on a cumulative catch-up basis.Contract revenue recognition is measured over time as we perform because of continuous transfer of control to the customer. For U.S. governmentcontracts which are typically subject to the Federal Acquisition Regulation, this continuous transfer of control to the customer is supported by clauses in thecontract that allow the customer to unilaterally terminate the contract for convenience, pay us for cost incurred plus a reasonable profit and take control ofany work in process. From time to time, as part of normal management processes, facts may change, causing revisions to estimated total costs or revenues54Table of Contentsexpected. The cumulative impact of any revisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period inwhich they become known.Because of control transferring over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. Theselection of the method to measure progress towards completion requires judgment and is based on the nature of the services to be provided. We generallyuse the input method, more specifically the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control to the customerwhich occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based onthe ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. The underlying bases for estimating our contractresearch revenues are measurable expenses, such as labor, subcontractor costs and materials, and data that are updated on a regular basis for purposes ofpreparing our cost estimates. Our research contracts generally have a period of performance of six months to three years, and our estimates of contract costshave historically been consistent with actual results. Revisions in these estimates between accounting periods to reflect changing facts and circumstanceshave not had a material impact on our operating results, and we do not expect future changes in these estimates to be material. The cumulative impact of anyrevisions to estimates and the full impact of anticipated losses on any type of contract are recognized in the period in which they become known.Under cost reimbursable contracts, we are reimbursed for costs that are determined to be reasonable, allowable and allocable to the contract and paid 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.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. We have agreed on final billingrates with the government through December 31, 2017.Products and Licensing RevenuesWe produce standard and customized products for commercial organizations, educational institutions, and U.S. Federal government agencies. Inaddition we will also offer extended warranties, product rentals, and services which include testing, training, or repairs for specific products. Customers alsopay royalties as agreed based on sales or usage. We account for product and related items when a contract has been executed, the rights of the parties areidentified, payment terms are identified, the contract has commercial substance, and collectability of the contract price is considered probable.To determine the proper revenue recognition method for Products and Licensing contracts, we evaluate whether two or more contracts should becombined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performanceobligation. We recognize revenue when the performance obligation has been satisfied by transferring the control of the product or service to the customer.For tangible products that contain software that is essential to the tangible product’s functionality, we consider the product and software to be a singleperformance obligation and recognize revenue accordingly. For contracts with multiple performance obligations, we allocate the contract’s transaction priceto each performance obligation based on their relative stand-alone selling prices. In such circumstances, we use the observable price of goods or serviceswhich are sold separately in similar circumstances to similar customers. If these prices are not observable, then we will estimate the stand-alone selling priceusing information that is reasonably available. For the majority of our standard products and services, price list and discount structures related to customertype are available. For products and services that do not have price list and discount structures, we may use one or more of the following: (i) adjusted marketassessment approach, (ii) expected cost plus a margin approach, and (iii) residual approach. The adjusted market55Table of Contentsapproach requires us to evaluate the market in which we sell goods or services and estimate the price that a customer in that market would be willing to payfor those goods or services. The expected cost plus margin approach requires us to forecast our expected costs of satisfying the performance obligation andthen add a reasonable margin for that good or service. The residual approach decreases the total transaction price by the sum of the observable standaloneselling prices if either the company sells the same good or services to different customers for a broad range of amounts or the company has not established aprice for the good or service and that good or service has not been sold on a standalone basis. Shipping and handling activities primarily occur after acustomer obtains control and are considered fulfillment cost rather than separate performance obligations. Similarly, sales and similar taxes assessed by agovernmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customerare excluded from the measurement of the transaction price.For standard products, we recognize revenue at a point in time when control passes to the customer. Absent substantial product acceptance clauses, thisis based on the shipping terms. For custom products that require engineering and development based on customer requirements, we will recognize revenueover time using the output method for any items shipped and any finished goods or work in process that is produced for balances of open sales orders. For anyfinished goods or work in process that has been produced for the balance of open sales orders we recognize revenue by applying the average selling price forsuch open order to the lesser of the on hand balance in finished goods or open sales order quantity which we present as a contract asset on the balance sheet.Cost of sales is recognized based on the standard cost of the finished goods and work in process associated with this revenue and inventory balances arereduced accordingly. For extended warranties and product rentals, revenue is recognized over time using the output method based on the time elapsed for thewarranty or service period. In the case of warranties, we record a contract liability for amounts billed but that are not recognized until subsequent period. Aseparate contract liability is recorded for the cost associated with warranty repairs based on our estimate of future expense. For testing services where we areperforming testing on an asset the customer controls, revenue is recognized over time by the output method using the performance to date. For training wherethe customer is receiving the benefit of training as it is occurring and for repairs to a customer controlled asset, revenue is recognized over time by the outputmethod using the performance to date. For royalty revenue, we apply the practical expedient “royalty exception” recognizing revenue based on the royaltyagreement which specifies an amount based on sales or minimum amount, whichever is greater.In some product rental contracts, a customer may be offered a discount on the purchase of an item that would provide for a material right. When amaterial right has been provided to a customer, a separate performance obligation is established and a portion of the rental revenue will be deferred until thefuture product is purchased or the option expires. This deferred revenue is recognized as a contract liability on the balance sheet. In certain circumstances wemay offer a "right of return" to a distributor of our products, in which case a contract liability is calculated based on the terms of the agreement and recordedas a reduction to revenue. In addition, a contract asset for the rights to recover products from customers and a reduction of cost of sales is also calculated andrecorded.Unfulfilled performance obligations represent amounts expected to be earned on executed contracts. Indefinite delivery and quantity contracts andunexercised options are not reported in total unfulfilled performance obligations. Unfulfilled performance obligations include funded obligations, which isthe amount for which money has been directly authorized by the U.S. government and for which a purchase order has been received by a commercialcustomer, and unfunded obligations, representing firm orders for which funding has not yet been appropriated. The approximate value of our TechnologyDevelopment segment unfulfilled performance obligations was $26.0 million at December 31, 2018. We expect to satisfy 87% of the performance obligationsin 2019, 9% in 2020 and the remaining by 2022. The approximate value of our Products and Licensing segment unfulfilled performance obligations was $5.8million at December 31, 2018. We expect to satisfy 95% of the performance obligations in 2019, 4% in 2020 and the remaining by 2023.We disaggregate our revenue from contracts with customers by geographic locations, customer-type, contract type, timing of recognition, and majorcategories for each of our segments, as we believe it best depicts how the nature, amount, timing and uncertainty of our revenue and cash flows are affected byeconomic factors. See details in the tables below.56Table of Contents Three Months Ended December 31, 2018 Year Ended December 31, 2018 (unaudited) TechnologyDevelopmentProducts andLicensingTotal TechnologyDevelopmentProducts andLicensingTotalTotal Revenue by Geographic Location United States$5,548,639$3,624,247$9,172,886 $20,967,556$11,585,296$32,552,852 Asia—2,697,2152,697,215 —5,977,5635,977,563 Europe—1,331,1451,331,145 —3,873,1613,873,161 Canada, Central and South America—282,990282,990 —382,797382,797 All Others—54,08954,089 —130,872130,872 Total$5,548,639$7,989,686$13,538,325 $20,967,556$21,949,689$42,917,245 Total Revenue by Major Customer Type Sales to the U.S. government$5,418,679$469,534$5,888,213 $20,703,338$1,834,289$22,537,627 U.S. direct commercial sales and other129,9603,154,7143,284,674 264,2189,737,72010,001,938 Foreign commercial sales & other—4,365,4384,365,438 —10,377,68010,377,680 Total$5,548,639$7,989,686$13,538,325 $20,967,556$21,949,689$42,917,245 Total Revenue by Contract Type Fixed-price contracts$2,777,012$7,989,686$10,766,698 $9,388,770$21,949,689$31,338,459 Cost-type contracts2,771,627—2,771,627 11,578,786—11,578,786 Total$5,548,639$7,989,686$13,538,325 $20,967,556$21,949,689$42,917,245 Total Revenue by Timing of Recognition Goods transferred at a point in time$—$7,824,102$7,824,102 $—$21,329,999$21,329,999 Goods/services transferred over time5,548,639165,5845,714,223 20,967,556619,69021,587,246 Total$5,548,639$7,989,686$13,538,325 $20,967,556$21,949,689$42,917,245 Total Revenue by Major Products/Services Technology development$5,548,639$—$5,548,639 $20,967,556$—$20,967,556 Optical test and measurement systems—7,625,3257,625,325 —19,641,43419,641,434 Optical components and sub-assemblies——— ——— Other—364,361364,361 —2,308,2552,308,255 Total$5,548,639$7,989,686$13,538,325 $20,967,556$21,949,689$42,917,245The following tables summarize the impacts of adopting Topic 606 on our consolidated financial statements as of and for the three months and yearended December 31, 2018.57Table of Contents Impact of changes in accounting policies December 31, 2018 As Reported Adjustments Balances without adoptionof Topic 606 Assets Current assets: Cash and cash equivalents$42,460,267 $— $42,460,267Accounts receivable, net13,037,068 — 13,037,068Receivable from sale of HSOR business2,500,000 — 2,500,000Contract assets2,422,495 — 2,422,495Inventory6,873,742 — 6,873,742Prepaid expenses and other current assets935,185 — 935,185Total current assets68,228,757 — 68,228,757Long-term contract assets336,820 — 336,820Property and equipment, net3,627,886 — 3,627,886Intangible assets, net3,302,270 — 3,302,270Goodwill101,008 — 101,008Other assets1,995 — 1,995Total assets$75,598,736 $— $75,598,736Liabilities and stockholders’ equity Current liabilities: Current portion of long-term debt obligations$619,315 $— $619,315Current portion of capital lease obligations40,586 — 40,586Accounts payable2,395,984 — 2,395,984Accrued liabilities6,597,458 — 6,597,458Contract liabilities2,486,111 (3,880) 2,482,231Total current liabilities12,139,454 (3,880) 12,135,574Long-term deferred rent1,035,974 — 1,035,974Long-term capital lease obligations68,978 — 68,978Total liabilities13,244,406 (3,880) 13,240,526Commitments and contingencies Stockholders’ equity: Preferred stock, par value $0.001, 1,321,514 shares authorized, issued andoutstanding at December 31, 2018 and December 31, 2017, respectively1,322 — 1,322Common stock, par value $0.001, 100,000,000 shares authorized, 29,209,506 and28,354,822 shares issued, 27,956,401 and 27,283,918 shares outstanding atDecember 31, 2018 and 2017, respectively30,120 — 30,120Treasury stock at cost, 1,253,105 and 1,070,904 shares at December 31, 2018 andDecember 31, 2017, respectively(2,116,640) — (2,116,640)Additional paid-in capital85,744,750 — 85,744,750Accumulated deficit(21,305,222) 3,880 (21,301,342)Total stockholders’ equity62,354,330 3,880 62,358,210Total liabilities and stockholders’ equity$75,598,736 $— $75,598,73658Table of Contents Impact of changes in accounting policies Three Months Ended December 31, 2018 Year Ended December 31, 2018 As reported Adjustments Balances withoutadoption ofTopic 606 As reported Adjustments Balances withoutadoption of Topic606 Revenues: Technology development$5,548,639 $— $5,548,639 $20,967,556 $— $20,967,556Products and licensing7,989,686 — 7,989,686 21,949,689 1,630 21,951,319 Total revenues13,538,325 — 13,538,325 42,917,245 1,630 42,918,875Cost of revenues: Technology development4,268,509 — 4,268,509 15,400,475 — 15,400,475Products and licensing2,697,538 — 2,697,538 8,078,870 — 8,078,870 Total cost of revenues6,966,047 — 6,966,047 23,479,345 — 23,479,345Gross profit6,572,278 — 6,572,278 19,437,900 1,630 19,439,530Operating expense: Selling, general and administrative4,896,136 — 4,896,136 14,794,205 — 14,794,205Research, development andengineering1,252,663 — 1,252,663 3,766,160 — 3,766,160 Total operating expense6,148,799 — 6,148,799 18,560,365 — 18,560,365Operating income423,479 — 423,479 877,535 1,630 879,165Other income: Other expense(1,070) — (1,070) (17,143) — (17,143)Investment income198,525 — 198,525 549,580 — 549,580Interest expense(21,136) — (21,136) (124,344) — (124,344)Total other income176,319 — 176,319 408,093 — 408,093Income from continuing operationsbefore income taxes599,798 — 599,798 1,285,628 1,630 1,287,258Income tax expense722,148 — 722,148 47,818 — 47,818Net (loss)/income from continuingoperations$(122,350) $— $(122,350) $1,237,810 $1,630 $1,239,440Effective January 1, 2018, we adopted Accounting Standards Update ("ASU") No. 2016-15, Statement of Cash Flows (Topic 230), which addresseseight specific cash flow issues with the objective of reducing the existing diversity in practice in how cash receipts and cash payments are presented in thestatement of cash flows. The adoption of ASU No. 2016-15 did not have a significant impact on our consolidated financial statements.In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This standard revises the accounting for leases and requires lessees torecognize, for all leases with terms greater than one year, a right-of-use asset and liability which depicts the rights and obligations arising from a lease. Thisstandard also requires qualitative and quantitative disclosures designed to provide information regarding the nature, amount and timing of lease expense.The new guidance is not expected to significantly change the recognition and measurement of lease expense. It is effective for the first interim and annualperiods beginning after December 15, 2018, with early adoption permitted. In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): TargetedImprovements, permitting the recognition of a cumulative-effect adjustment to retained earnings on the date of adoption. We adopted the standard beginningJanuary 1, 2019 using the alternative transition method. We are finalizing the value as of the adoption date of the right-of-use asset and lease liabilities andestimate that the right-of-use asset will be between $4 million and $5 million and that the lease liability will be reasonably consistent with the right-of-useasset amounts. We do not expect a material impact from adopting the new standard on our results of operations or cash flows.59Table of ContentsIn January 2017, the Financial Accounting Standards Board ("FASB") issued ASU No. 2017-04, Intangibles—Goodwill and Other (Topic 350):Simplifying the Test for Goodwill Impairment. This update simplifies the subsequent measurement of goodwill. The guidance removes Step 2 of the goodwillimpairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit's carryingvalue exceeds its fair value, not to exceed the carrying amount of goodwill. The accounting standard will be effective for reporting periods beginning afterDecember 15, 2019. We do not expect ASU 2017-04 will have a material impact on our financial statements. In February 2018, the FASB issued ASU 2018-02: Income Statement – Reporting Comprehensive Income (Topic 220). Under current accountingguidance, the income tax effects for changes in income tax rates and certain other transactions are recognized in income from continuing operations resultingin income tax effects recognized in AOCI that do not reflect the current tax rate of the entity (“stranded tax effects”). The new guidance allows us the optionto reclassify these stranded tax effects to accumulated deficit that relate to the change in the federal tax rate resulting from the passage of the Tax Cuts andJobs Act. This update is effective for fiscal years beginning after December 15, 2018, including interim periods therein, and early adoption is permitted. Wedo not expect the adoption of this standard will have a significant impact on our consolidated financial statements.In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Changes to the Disclosure Requirements for Fair ValueMeasurement. which amends the disclosure requirements in ASC 820 by adding, changing, or removing certain disclosures. The ASU applies to all entitiesthat are required under this guidance to provide disclosures about recurring or nonrecurring fair value measurements. These amendments are effective for allentities for fiscal years beginning after December 15, 2019 including interim periods within those fiscal years. We do not expect ASU 2018-13 will have amaterial 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 netrealizable value.Components of inventory are as follows: December 31, 2018 2017Finished goods$1,339,832 $762,394Work-in-process643,420 288,165Raw materials4,890,490 3,584,222 $6,873,742 $4,634,7813.Contract BalancesOur contract assets consist of unbilled amounts for technology development contracts, custom product contracts, royalty revenue receivable and thecarrying amounts of right of returned inventory. Long-term contract assets include the fee withholding on cost reimbursable contracts that will not be billedwithin a year. Contract liabilities include excess billings, subcontractor accruals, warranty expense, extended warranty revenue, right of return refund, andcustomer deposits.The following table shows the significant changes in contract balances for the year ended December 31, 2018:60Table of Contents Contract Assets Contract LiabilitiesOpening Balance as of January 1, 2018$1,987,841 $3,320,629Revenue recognized that was included in the contract liabilities balance at the beginning ofthe period— (878,402)Transferred to payables from contract liabilities recognized at the beginning of the period— (2,078,640)Increases due to cash received or adjustment of estimates, excluding amounts recognized asrevenue during the period— 2,122,524Transferred to receivables from contract assets recognized at the beginning of the period(1,679,363) —Increases as a result of cumulative catch-up adjustment arising from changes in the estimate ofthe stage of completion2,450,837 —Balance as of December 31, 2018$2,759,315 $2,486,111 4. DebtSilicon Valley Bank FacilityWe currently have a Loan and Security Agreement with SVB (the "Credit Facility") under which, as amended on May 8, 2015, we have a term loan withan original borrowing amount of $6.0 million (the “Original Term Loan”). The Original Term Loan is repayable in 48 monthly installments of $125,000, plusaccrued interest payable monthly in arrears, and unless earlier terminated, is scheduled to mature in May 2019. The Original Term Loan carries a floatingannual interest rate equal to SVB’s prime rate then in effect plus 2%. We may prepay amounts due under the Original Term Loan at any time, subject to anearly termination fee of up to 2% of the amount of prepayment.In September 2015, we entered into the Waiver and Seventh Loan Modification Agreement, which provided an additional $1.0 million of availablefinancing for purchases of equipment through December 31, 2015, which we fully borrowed in December 2015 (the "Second Term Loan" and, together withthe Original Term Loan, the "Term Loans"). The Second Term Loan was repaid in December 2018.The Credit Facility requires us to maintain a minimum cash balance of $4.0 million and to maintain at each month end a ratio of cash plus 60% ofaccounts receivable greater than or equal to 1.5 times the outstanding principal of the Term Loans. The Credit Facility also requires us to observe a number ofadditional operational covenants, including protection and registration of intellectual property rights, and certain customary negative covenants. As ofDecember 31, 2018, we were in compliance with all covenants under the Credit Facility.Amounts due under the Credit Facility are secured by substantially all of our assets, including intellectual property, personal property and bankaccounts. In addition, the Credit Facility contains customary events of default, including nonpayment of principal, interest or other amounts, violation ofcovenants, material adverse change, an event of default under any subordinated debt documents, incorrectness of representations and warranties in anymaterial respect, bankruptcy, judgments in excess of a threshold amount, and violations of other agreements in excess of a threshold amount. If any event ofdefault occurs SVB may declare due immediately all borrowings under the Credit Facility and foreclose on the collateral. Furthermore, an event of defaultunder the Credit Facility would result in an increase in the interest rate on any amounts outstanding. As of December 31, 2018 there were no events of defaulton the Credit Facility.The aggregate balance under the Term Loans at December 31, 2018 and December 31, 2017 was $0.6 million and $2.5 million, respectively. Theremaining term loan, with a balance of $0.6 million as of December 31, 2018, matures on May 1, 2019. The effective rate of our Term Loan at December 31,2018 was 7%.The following table presents a summary of debt outstanding:61Table of Contents December 31, 2018 2017Silicon Valley Bank Term Loans$625,000 $2,458,333Less: unamortized debt issuance costs5,685 21,993Less: current portion619,315 1,833,333Total long-term debt obligations$— $603,007Debt issuance costs associated with the issuance of the SVB Term Loans totaled $55 thousand. Amortization of debt issuance costs is computedusing the effective interest method and is included in interest expense. Amortization of the debt issuance costs totaled $16 thousand for the year endedDecember 31, 2018. Maturities on outstanding debt are as follows:YearAmount2019$625,000Total$625,000Interest expense for the years ended December 31, 2018 and 2017 consisted of the following: Years ended December 31, 2018 2017Interest expense on Term Loans $108,062 $201,696Amortization of debt issuance costs 16,308 16,308Other interest income (26) (652)Total interest expense $124,344 $217,3525. Accounts Receivable, NetAccounts receivable, net consist of the following: December 31, 2018 2017Billed$13,289,790 $6,189,625Other31,361 20,000 13,321,151 6,209,625Less: allowance for doubtful accounts(284,083) (280,583) $13,037,068 $5,929,04262Table of Contents6. Property and EquipmentProperty and equipment, net, consists of the following: December 31, 2018 2017Building$69,556 $69,556Equipment9,341,007 8,213,626Furniture and fixtures640,890 565,885Software1,122,231 1,122,231Leasehold improvements4,950,510 4,840,510 16,124,194 14,811,808Less—accumulated depreciation(12,496,308) (11,957,167) $3,627,886 $2,854,641Depreciation for the years ended December 31, 2018 and 2017 was approximately $0.5 million and $0.7 million, respectively.7. Intangible AssetsIntangible assets, net consist of the following: December 31, Estimated Life 2018 2017Patent costs1 - 18 years $4,991,460 $4,658,198Developed technology5 years 2,600,000 1,400,000In-process research and developmentN/A 200,000 —Customer base7 years 100,000 —Trade names3 years 150,000 — 8,041,460 6,058,198Accumulated amortization (4,739,190) (4,330,808) $3,302,270 $1,727,390Amortization for the years ended December 31, 2018 and 2017 was approximately $0.4 million and $0.5 million, respectively. Estimated aggregateamortization, based on the net value of intangible assets at December 31, 2018, for each of the next five years and beyond is as follows:Year Ending December 31, 2019$591,1202020558,1562021535,2882022480,2192023279,6312023 and beyond857,856$3,302,270 8. Accrued LiabilitiesAccrued liabilities consist of the following:63Table of Contents December 31, 2018 2017 Accrued compensation$4,467,587 $5,274,005 Accrued professional fees198,062 117,445 Accrued income tax236,636 403,547 Deferred rent146,542 144,740 Royalties302,428 290,235 Accrued liabilities-other404,752 317,258 Working capital payable542,983 — Liability to related party298,468 —Total accrued liabilities$6,597,458 $6,547,23064Table of Contents9. Income TaxesIncome tax expense/(benefit) from continuing operations consisted of the following for the periods indicated: Years ended December 31, 2018 2017Current: Federal$(44,727) $(1,154,105)State92,545 5,526Deferred federal— —Deferred state— —Income tax expense/(benefit)$47,818 $(1,148,579)Deferred tax assets consist of the following components: December 31, 2018 December 31, 2017 Long-Term Long-TermBad debt and inventory reserve $332,721 $226,358Inventory adjustment (21,785) 405,242UNICAP 2,804 32,579Deferred revenue 115,676 84,669Deferred rent 288,017 340,199Depreciation and amortization (838,540) (1,238,458)Charitable contributions — 3,385Net operating loss carryforwards- Luna 349,421 349,421Net operating loss carryforwards- API 1,265,538 1,436,568Net operating loss carryforwards - state 179,149 534,194Net operating loss carryforwards- Canada 10,503 10,503Research and development credits — 235,613California manufacturing credit — 15,554Accrued liabilities 394,118 504,472Deferred compensation 216,944 223,607Stock-based compensation 803,757 1,275,372Restricted stock 60,681 —State bonus 44,861 —AMT credit — 581,467Transaction costs 63,668 —Total 3,267,533 5,020,745Valuation allowance (3,267,533) (5,020,745)Net deferred tax asset $— $—65Table of ContentsThe expense/(benefit) from income taxes from continuing operations differs from the amount computed by applying the federal statutory income taxrate to our loss from continuing operations before income taxes as follows for the periods indicated: Years ended December 31, 2018 2017Income tax expense at federal statutory rate 21.00 % 34.00 %State taxes, net of federal tax effects — % (10.84)%Change in tax rate from Tax Cuts and Jobs Act — % (79.17)%Change in valuation allowance (27.65)% 113.86 %Incentive stock options (1.05)% (9.65)%Provision to return adjustments 21.16 % 3.87 %Meals and entertainment 0.97 % (0.65)%Capitalized merger costs — % — %AMT Carryover (9.83)% — %Other permanent differences (0.88)% (3.55)%Income tax expense/(benefit) 3.72 % 47.87 %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 have noU.S. federal income tax net operating loss carryforwards at December 31, 2018 for Luna and net operating loss carryforwards of approximately $6.0 millionfor API expiring at varying dates through 2025.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 2015 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, 2018 or December 31, 2017 will not be realized, and as a result a valuation allowance was established against all suchdeferred tax assets.Effective January 1, 2018, we adopted ASC Topic 606, Revenue from Contracts with Customers, which changes the timing of contract revenuerecognition from recognizing at customer delivery to recognizing over a period of time. The adoption of ASC Topic 606 did not have a significant impact onour 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 legislation66Table of Contentsreduced the U.S. corporate tax rate from the current rate of 35% to 21%. As a result of the enacted law, we were required to revalue deferred tax assets andliabilities at the enacted rate. This revaluation resulted in a $1.9 million reduction in the deferred tax asset and a corresponding reduction in the valuationallowance. In 2018, we realized a benefit of $0.7 million in recovery of the alternative minimum tax credit from prior periods. The other provisions of the TaxCuts and Jobs Act did not have a material impact on our consolidated financial statements.10. Stockholders’ EquitySeries A Convertible Preferred StockIn January 2010, we entered into a transaction with Carilion, in which Carilion agreed to exchange all of its Senior Convertible Promissory Notes withan original principal amount of $5.0 million plus all accrued but unpaid interest, totaling $1.2 million, for 1,321,514 shares of our newly designated Series AConvertible Preferred Stock. The Series A Convertible Preferred Stock is non-voting, carries a dividend of 6% payable in shares of common stock andmaintains a liquidation preference up to $6.2 million. As of December 31, 2018, 710,985 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.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.The following table sets forth the activity of the options to purchase common stock under the 2006 Plan and the 2016 Plan. The prices represent theclosing price of our Common Stock on the Nasdaq Capital Market on the respective dates.67Table of Contents Options Outstanding Options Exercisable Number ofShares Price perShare Range WeightedAverageExercisePrice AggregateIntrinsicValue (1) Number ofShares WeightedAverageExercisePrice AggregateIntrinsicValue (1)Balance at January 1, 20172,857,114 $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 $2,013,034Forfeited(675,607) $1.15 - 6.55 $1.90 Exercised(96,425) $0.65 - 2.46 $2.07 Granted1,166,339 $2.67 - 3.53 $3.09 Balance at December 31, 20183,108,868 $0.61 - 6.55 $2.26 $3,669,794 1,986,740 $1.81 $3,314,494 (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, 2018 2017Risk-free interest rate range 3.0% 2.05%Expected life of option-years 7 6.5Expected stock price volatility 67% 69%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. Options Outstanding Options Exercisable Range ofExercise Prices OptionsOutstanding WeightedAverageRemainingLife inYears WeightedAverageExercisePrice OptionsExercisable WeightedAverageExercisePrice ofOptionsExercisableYear ended December 31, 2017$0.61 - 6.55 2,714,561 4.23 $1.88 2,590,030 $1.89Year ended December 31, 2018$0.61 - 6.55 3,108,868 5.72 $2.26 1,986,740 $1.81 Total Intrinsic Value ofOptions Exercised Total Fair Value ofOptions VestedYear ended December 31, 2017$62,549 $3,962,746Year ended December 31, 2018$112,213 $2,980,11068Table of ContentsFor the years ended December 31, 2018 and 2017, the weighted average grant date fair value of options granted was $2.07 and $1.18 per share,respectively. We estimate the fair value of options at the grant date using the Black-Scholes model. For all stock options granted through December 31, 2018,the weighted average remaining service period is 3.6 years.Unamortized stock option expense at December 31, 2018 that will be amortized over the weighted-average remaining service period of 3.6 yearstotaled $2.2 million.Restricted Stock and Restricted Stock UnitsIn 2018 and 2017, we issued 280,000 and 349,000 shares of restricted stock, respectively, to certain employees. Shares issued to employees vest inthree equal annual installments on the anniversary dates of their grant. In 2018 and 2017, 182,500 and 530,542 shares of restricted stock vested, respectively.In addition, in 2018 and 2017, we issued 16,286 and 129,865, respectively, restricted stock units to members of our Board of Directors in respect of theannual equity compensation under our non-employee director compensation policy. Restricted stock units issued to our Board of Directors vest at the earlierof the one year anniversary of their grant or the next annual stockholders' meeting. In 2018 and 2017, 129,865 and 86,956 restricted stock units, respectively,vested.The following table summarizes our aggregate restricted stock awards and restricted stock unit activity in 2018 and 2017: Number of UnvestedShares Weighted Average GrantDate Fair Value Aggregate Value ofUnvested SharesBalance at January 1, 2017829,998 $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 $738,345Granted296,287 $3.07 $909,600Vested(312,365) $1.45 $(454,339)Forfeitures(15,000) $1.41 $(21,150)Balance at December 31, 2018458,620 $2.56 $1,172,456We recognized $0.6 million and $0.7 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, 2018 and 2017, respectively, and we will recognize $0.9 million over theremaining requisite service period.Unamortized restricted stock and restricted stock units expense at December 31, 2018 that will be amortized over the weighted-average remainingservice period of 2 years totaled $1.0 million.Non-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, 2018 and 2017,the Deferred Compensation Plan permitted the participants to elect to defer cash fees to which they were entitled for board and committee service. For 2018,the Deferred Compensation Plan also permitted participants to defer the annual equity compensation for board service (which would otherwise be issued inthe form of restricted stock units) under our non-employee director compensation policy. For participating directors, we credit their accounts under theDeferred Compensation Plan with a number of stock units based on the trading price of our common69Table of Contentsstock as of the date of the deferral. These stock units are vested immediately, in the case of stock units in lieu of cash fees, and upon the earlier of the one yearanniversary date of the grant or next annual meeting of stockholders, in the case of annual equity compensation, 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 2018and 2017 is as follows. Number of StockUnits WeightedAverage GrantDate Fair Valueper Share Intrinsic ValueOutstandingJanuary 1, 2017393,012 $1.37 Granted73,690 $1.54 Vested— $1.15 Converted— $0.00 December 31, 2017466,702 $1.40 $1,134,086Granted40,588 $2.99 Vested— $1.15 Converted— $0.00 December 31, 2018507,290 $1.40 $1,699,422Stock 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 did 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, 2018 and 2017, we had repurchased a total of 565,629 and 433,179 shares, respectively, for anaggregate purchase price of $1.1 million under this stock repurchase program. We currently maintain all repurchased shares under these stock repurchaseprograms as treasury stock.11. Commitments and ContingenciesObligation under Operating LeasesWe lease facilities in Virginia, Michigan, and Georgia under operating leases that as of December 31, 2018 were scheduled to expire between March2020 and December 2024. Certain of the leases are subject to fixed escalations and provide for possible termination prior to their expiration dates. Werecognize rent expense on such leases on a straight-line basis over the lease term. The difference between the straight line method and cash paid is reflected inchanges to the deferred rent balance in our consolidated balance sheets. Deferred rent primarily resulted from recognition of the value of certain leaseholdimprovements associated with our Blacksburg, Virginia facility at the inception of the lease. Rent expense under these leases recorded in selling, general andadministrative expense on our statements of operations totaled approximately $1.0 million and $1.1 million, respectively, for the years ended December 31,2018 and 2017.Minimum future payments, as of December 31, 2018, under the aforementioned operating leases for each of the next five years and thereafter are:20191,216,12420201,117,6842021640,8002022544,7042023544,704Thereafter544,704 $4,608,720Purchase CommitmentWe executed a non-cancelable purchase order totaling $0.5 million in the fourth quarter of 2017, a non-cancelable purchase order totaling $1.1 millionin the first quarter of 2018, and a non-cancelable purchase order totaling $0.7 million in the second quarter of 2018 for multiple shipments of tunable lasersto be delivered over an 18-month period. At December 31, 2018, approximately $0.8 million of these commitments remained and is expected to be deliveredby July 30, 2019.Royalty AgreementWe have licensed certain third-party technologies from vendors for which we owe minimum royalties aggregating $0.4 million payable over theremaining patent terms of the underlying technology. 12. Employee Profit Sharing PlanWe maintain a salary reduction/profit-sharing plan under provisions of Section 401(k) of the Internal Revenue Code. The plan is offered to all of ourpermanent employees. We contribute 25% of the salary deferral elected by each employee 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, 2018 and 2017. 13. Litigation and Other ContingenciesFrom time to time, we may become involved in litigation in relation to claims arising out of our operations in the normal course of business. Whilemanagement currently believes it is not reasonably possible the amount of ultimate liability, if any, with respect to these actions will have a material adverseeffect on our financial position, results of operations or liquidity, the ultimate outcome of any litigation is uncertain.In December 2018, we received a notice of claim (the "Claim") from Macom Technology Solutions, Inc. ("Macom"), who acquired our HSOR businessin August 2017 pursuant to an asset purchase agreement. Under the asset purchase agreement, we agreed to indemnify Macom for certain matters, including,among other things, the collection of accounts receivable from certain major customers, and placed $4.0 million of the purchase price into an escrow accountfor the potential settlement of any valid indemnity claims. The Claim received from Macom totaled $2.1 million under various indemnity provisions. Wehave disputed Macom's assertion of right to payment for the matters described in the Claim. It is uncertain what amount, if any, will be owed in settlement ofthe Claim. As of December 31, 2018, $1.5 million of the escrow balance had been received with the remaining $2.5 million in the escrow account pendingresolution of the dispute.On July 31, 2018, we sold the assets associated with our optoelectronic components and sub-assemblies ("Opto") business to an unaffiliated third party.The asset purchase agreement provides for additional consideration of up to $1.0 million contingent upon the achievement of a specified revenue level bythe sold business during the 18 months following the sale. There have been no amounts recorded in reference to the above matter in the financial statementsas of December 31, 2018. It is uncertain what amount, if any, will be received with respect to this potential adjustment.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 estimate70Table of Contentsthe cost for compliance with these additional requirements. The amount of any such compliance costs could be material. We cannot predict the impact thatfuture regulations will impose upon our business. 14. Relationship with Major CustomersDuring the years ended December 31, 2018 and 2017, approximately 53% and 48%, respectively, of our consolidated revenues were attributable tocontracts with the U.S. government.At December 31, 2018 and 2017, receivables with respect to contracts with the U.S. government represented 23% and 20% of total trade receivables,respectively. 15. Financial Information About SegmentsOur operations are divided into two operating segments: Technology Development and Products and Licensing. Our engineers and scientistscollaborate with our network of government, academic and industry experts to identify technologies and ideas with promising market potential. We thencompete to win fee-for-service contracts from government agencies and industrial customers who seek innovative solutions to practical problems that requirenew technology. The Technology Development segment derives its revenue primarily from services. The Technology Development segment providesapplied research to customers in our areas of focus.The Products and Licensing segment develops and sells products or licenses technologies based on commercially viable concepts developed by theTechnology Development segment. The Products and Licensing segment derives its revenue from product sales, funded product development andtechnology licenses.Our President and Chief Executive Officer and his direct reports collectively represent our chief operating decision makers, and they evaluate segmentperformance based primarily on revenue and operating income or loss.Information about the results of operations for each segment is set forth in the table below. There were no significant inter-segment sales during theyears ended December 31, 2018 and 2017.During the years ended December 31, 2018 and 2017, 24% 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, 2018 or 2017. Years ended December 31, 2018 2017Technology Development revenue $20,967,556 $18,576,383Products and Licensing revenue 21,949,689 14,505,482Total revenue 42,917,245 33,081,865Technology Development operating income/(loss) 378,212 (120,417)Products and Licensing operating income/(loss) 499,323 (2,087,731)Total operating income/(loss) $877,535 $(2,208,148)Depreciation, Technology Development $379,952 $359,626Depreciation, Products and Licensing $273,185 $747,216Amortization, Technology Development $130,765 $139,067Amortization, Products and Licensing $418,349 $1,280,699Products and licensing depreciation includes amounts from discontinued operations of $0.1 million and $0.4 million for the years ended December 31,2018 and 2017, respectively. Products and licensing amortization includes amounts from discontinued operations of $0.1 million and $0.9 million for theyears ended December 31, 2018 and 2017, respectively.Additional segment information is as follows:71Table of Contents December 31, 2018 2017Total segment assets: Technology Development$34,823,525 $32,011,084Products and Licensing40,775,211 34,211,552Total$75,598,736 $66,222,636Property plant and equipment and intangible assets, Technology Development$2,103,711 $2,361,663Property plant and equipment and intangible assets, Products and Licensing$4,927,453 $4,831,671For December 31, 2017, the products and licensing segment assets include assets held for sale in the amount of $7.0 million. Property plant andequipment, and intangible assets as of December 31, 2017 excludes assets associated with the optoelectronic components business sold during 2018.16. Quarterly Results (unaudited)The following table sets forth our unaudited historical revenues, operating loss and net (loss)/income by quarter during 2018 and 2017. Quarter Ended(Dollars in thousands,except per share amounts)March 31, 2018 June 30, 2018 September 30, 2018 December 31, 2018 March 31, 2017 June 30, 2017 September 30, 2017 December 31, 2017Revenues: Technology development$4,637 $5,466 $5,316 $5,549 $4,235 $4,602 $4,591 $5,549Products and licensing4,131 4,457 5,371 7,990 2,398 3,681 3,713 4,637Total revenues8,768 9,923 10,687 13,538 6,633 8,283 8,304 10,186Gross margin4,929 5,693 5,998 6,572 1,770 2,414 2,385 4,384Operating income/(loss)(373) 205 581 423 (1,374) (237) (150) (61)Net income/(loss) fromcontinuing operations(272) 299 1,293 (122) (1,254) (195) 194 257Income/(loss) fromdiscontinued operations net ofincome taxes421 768 7,556 1,062 (102) (26) 15,563 749Net (loss)/income149 1,067 8,849 940 (1,356) (221) 15,757 1,006Net (loss)/income attributableto common stockholders$84 $1,004 $8,785 $873 $(1,390) $(251) $15,723 $939Net income/(loss) per sharefrom continuing operations: Basic$(0.01) $0.01 $0.05 $— $(0.05) $(0.01) $0.01 $0.01Diluted$(0.01) $0.01 $0.04 $— $(0.05) $(0.01) $0.01 $0.01Net income/(loss) per sharefrom discontinued operations: Basic$0.02 $0.03 $0.27 $0.04 $— $— $0.56 $0.03Diluted$0.02 $0.02 $0.23 $0.04 $— $— $0.48 $0.02Net income/(loss) attributableto common stockholders: Basic$— $0.04 $0.31 $0.03 $(0.05) $(0.01) $0.57 $0.03Diluted$— $0.03 $0.27 $0.03 $(0.05) $(0.01) $0.48 $0.03Weighted average shares: Basic27,204,989 27,531,361 27,901,631 28,067,348 27,541,356 27,600,147 27,692,539 27,485,278Diluted27,204,989 31,506,745 33,055,881 28,067,348 27,541,356 27,600,147 32,714,389 31,790,418 72Table of Contents17. 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 year ended December 31, 2017.On July 31, 2018, we sold the assets and operations related to our Opto business, which was part of our Products and Licensing segment, to anunaffiliated third party for an initial purchase price up to $18.5 million, of which $17.5 million was received at closing and has been properly recorded in thefinancial statements in accordance with GAAP with the remaining purchase price adjustment up to $1.0 million which is contingent upon the attainment ofspecified revenue targets during the eighteen months following the closing of the sale. The purchase price is subject to adjustment in the future based upon adetermination of final working capital, as defined in the asset purchase agreement. The Opto business was a component of the operations of API, which weacquired in May 2015, and represented all of our operations in our Camarillo, California and Montreal, Quebec facilities. We have reported the results of operations of both our HSOR and Opto businesses as discontinued operations in our consolidated financialstatements. We allocated a portion of the consolidated tax expense to discontinued operations based on the ratio of the discontinued business's loss beforeallocations. We allocated a portion of the consolidated tax (benefit)/expense to discontinued operations based on the ratio of the discontinued business'sloss/(income) before allocations.The following table presents a summary of the transactions related to the sales of Opto in the year ended December 31, 2018 and HSOR in the year endedDecember 31, 2017: Year Ended December 31, 2018 2017 Sale price$17,500,000 $33,500,000Less: transition services payments— (1,500,000)Adjusted purchase price17,500,000 32,000,000 Assets held for sale(8,193,184) (16,851,540)Liabilities held for sale989,453 2,330,052Transaction costs(858,227) (895,186)Return of working capital730,000 —Income tax expense(1,572,245) (912,298)Gain on sale of discontinued operations$8,595,797 $15,671,028Assets and liabilities held for sale as of December 31, 2017 were as follows:73Table of Contents December 31, 2017 Assets Current assets: Accounts receivable, net $1,940,125Inventory 2,316,329Prepaid expenses and other current assets 79,651Total current assets 4,336,105Property and equipment, net 599,102Intangible assets, net 1,510,203Goodwill 502,000Other assets 16,028 Total non-current assets 2,627,333Total assets held for sale $6,963,438Liabilities Current liabilities: Accounts payable $851,785Accrued liabilities 120,666Deferred revenue —Total current liabilities 972,451Long-term deferred rent — Total non-current liabilities —Total liabilities held for sale $972,451The key components of income from discontinued operations were as follows: Year Ended December 31, 2018 2017Net revenues$8,363,606 $19,511,646Cost of revenues5,294,268 12,994,656Operating expenses1,728,113 5,413,952Other (income)/expenses(13,330) 31,758Income before income taxes1,354,555 1,071,280Allocated tax expense183,921 876,588Operating income from discontinued operations1,170,634 194,692Gain on sale, net of related income taxes8,595,797 15,671,028Net income from discontinued operations$9,766,431 $15,865,720For the years ended December 31, 2018 and 2017, depreciation and amortization from discontinued operations were $0.2 million and $1.3 million,respectively. For the years ended December 31, 2018 and 2017, the acquisition of property plant and equipment for discontinued operations were $0.1million in each period. For the years ended December 31, 2018 and 2017, intangible property costs associated with discontinued operations were $0.01million and $0.1 million, respectively. Proceeds from the sale of the Opto business which were included in cash flows from investing activities in 2018 were$16.0 million and proceeds from the sale of the HSOR business which are included in cash flows from investing activities for 2017 were $28.0 million. Thegain on sale of discontinued operations included in non-cash adjustments to cash flows from operating activities for 2018 and 2017 was $8.6 million and$15.7 million, respectively.74Table of Contents18. Business AcquisitionsOn October 15, 2018, we acquired substantially all of the assets, other than cash, the United States operations of Micron Optics, Inc. ("MOI") for cashconsideration of $5.5 million, of which $5.0 million was paid during 2018, with the remaining $0.5 million reflected in accrued liabilities. The transactionhas been accounted for under the acquisition method of accounting in accordance with ASC 805. We incurred approximately $0.8 million of costs associatedwith the acquisition during 2018, which are included in selling, general and administrative expenses in our consolidated statement of operations. For theperiod from the closing of the acquisition through December 31, 2018, we recognized revenues of $2.6 million and income of $1.1 million associated withthe operations of MOI.Under the acquisition method of accounting, the total estimated purchase consideration is allocated to the acquired tangible and intangible assets andassumed liabilities based on their estimated fair values as of the acquisition date. Any excess of the fair value of the acquisition consideration over theidentifiable assets acquired and liabilities assumed is recognized as goodwill. We have completed a preliminary allocation of the purchase consideration withthe assistance of a third-party valuation expert. The following allocation of the purchase consideration is subject to revision as additional informationbecomes known in the future. Preliminary Allocation Accounts receivable $1,742,693Inventory 1,435,606Other current assets 69,951Property and equipment 996,460Identifiable intangible assets 1,650,000Goodwill 101,008Accounts payable and accrued expenses (450,985)Total purchase consideration $5,544,733The preliminary identifiable intangible assets and their estimated useful lives were as follows: Estimated Estimated Fair Value Useful Life Developed technology $1,200,000 5.0 yearsIn process research and development 200,000 7.0 yearsTrade names 150,000 3.0 yearsCustomer base 100,000 7.0 years $1,650,000 Developed technologies acquired primarily consists of MOI's existing technologies related to fiber optic sensing instruments, modules, andcomponents. The developed technologies were valued using the "multi-period excess earnings" method, under the income approach. The multi-period excessearnings method reflects the present value of the projected cash flows that are expected by the developed technologies less charges representing thecontribution of other assets to those cash flows. A discount rate of 24.5% was used to discount the cash flows to present value.In process research and development represents the fair value of incomplete MOI research and development projects that had not reached technologicalfeasibility as of the closing date of the acquisition. In the future, the fair value of such project at75Table of Contentsthe closing date of the acquisition will be either amortized or impaired depending on whether the project is completed or abandoned. The fair value of inprocess research and development was determined using the multi-period excess earnings method. A discount rate of 29.5% was used to discount the cashflows to the present value.Customer base represents the fair value of projected cash flows that will be derived from the sale of products to MOI's existing customers as of theclosing date of the acquisition. Customer relationships were valued using the "distributor" method, under the income approach. Under this premise, themargin of a distributor within the industry is deemed to be the margin attributable to customer relationships. This isolates the cash flows attributable to thecustomer relationships for which a market participant would be willing to pay. A discount rate of 24.5% was used to discount cash flows to present value.Trade names and trademarks are considered a type of guarantee of a certain level of quality or performance represented by the MOI brand. Trade namesand trademarks were valued using the "relief from royalty" method of the income approach. This method is based on the assumption that in lieu of ownership,a market participant would be willing to pay a royalty in order to exploit the related benefits of this asset. A discount rate of 17% was used to discount thecash flows to the present value.Goodwill represents the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilitiesassumed in connection with the acquisition.Pro forma consolidated results of operationsThe following unaudited pro forma financial information presents combined results of operations for each of the periods presented as if the acquisitionof MOI had been completed on January 1, 2017. The pro forma information includes adjustments to depreciation expense for property and equipmentacquired, to amortize expense for the intangible assets acquired, and to eliminate the acquisition transaction expenses recognized in each period.Transaction-related expenses associated with the acquisition and excluded from the pro forma income/(loss) from continuing operations were $0.8 million.The pro forma data are for informational purposes only and are not necessarily indicative of the consolidated results of operations or the combined businesshad the acquisition of MOI actually occurred on January 1, 2017, or the results of future operations of the combined business. For instance, planned orexpected operational synergies following the acquisition are not reflected in the pro forma information. Consequently, actual results will differ from theunaudited pro forma information presented below. Year ended December 31, 2018 2017 (unaudited) (unaudited) Revenue $49,494,358 $40,954,093 Income/(loss) from continuing operations $1,579,318 $(2,778,487)On March 1, 2019, we acquired the outstanding stock of General Photonics Corporation for cash consideration of $19.0 million. Of the purchase price,$17.1 million was paid at closing and $1.9 million was placed into escrow for possible working capital adjustments to the purchase price and potentialsatisfaction of certain post-closing indemnification obligations. Additionally, we can become obligated to pay additional cash consideration of up to $1.0million if certain revenue targets for the General Photonics Corporation historical business are met for the twelve month period following the closing. Thepurchase price is also subject to adjustment based upon the determination of final working capital as of the closing date compared to a target working capitalvalued specified in the stock purchase agreement. We have not yet completed its analysis of the fair market value of the assets acquired and liabilitiesassumed as of the closing date and the associated allocation of the purchase price.ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.None.76Table of ContentsITEM 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, 2018, ourdisclosure controls and procedures were effective at the reasonable assurance level.Changes 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, 2018 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 financial77Table of Contentsreporting as of December 31, 2018. This evaluation was based on the criteria established in the 2013 Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission. This evaluation excluded the internal control over financial reporting of the UnitedStates operations of Micron Optics, Inc. ("MOI"), which were acquired on October 15, 2018. The total acquired assets, based on the preliminary purchaseallocation is approximately 8% of our consolidated assets. Revenues and income from continuing operations from MOI for the period from October 16, 2018through December 31, 2018, were approximately 6% and 83%, respectively, of our consolidated operations.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, 2018 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.None78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 2019 Annual Meeting of Stockholders, (the"2019 Proxy Statement"), anticipated to be filed with the SEC within 120 days after December 31, 2018, 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 2019 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 2019 Proxy Statement.EQUITY COMPENSATION PLANSThe following table summarizes our equity compensation plans as of December 31, 2018:Plan categoryNumber ofsecurities to beissued uponexercise ofoutstandingoptions, warrantsand rights(a) Weighted-average exerciseprice ofoutstandingoptions,warrants andrights(b) Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column (a))(c)Equity compensation plans approved by security holders3,316,888 (1) 2.16 (2) 2,702,667Total3,316,888 (1) 2.16 (2) 2,702,667(1) Consists of 3,035,238 shares underlying stock options and 281,650 shares underlying restricted stock units.(2) Does not take into account restricted stock units, which have no exercise price.Our 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 2019 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 2019 ProxyStatement.79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, 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) $5,307,461Year Ended December 31, 2018 Reserves deducted from assets to which they apply: Deferred tax valuation allowance$5,020,744 $— $(1,753,211) $3,267,533Allowances for doubtful accounts286,717 3,500 (6,134) 284,083 $5,307,461 $3,500 $(1,759,345) $3,551,616All 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)Exhibits80Table of ContentsEXHIBIT INDEXExhibit No.Exhibit Document2.1(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)2.2(32)#Asset Purchase Agreement, dated July 31, 2018 by and among Luna Innovations Incorporated, Advanced Photonix, Inc., AdvancedPhotonix Canada, Inc. and OSI Optoelectronics, Inc. (Exhibit 2.1)2.3(33)#Asset Purchase Agreement, dated October 15, 2018 by and among Luna Innovations Incorporated, Luna Technologies, Inc. and MicronOptics, Inc. (Exhibit 2.1)2.4(34)+#Stock Purchase Agreement, dated March 1, 2019 by and among Luna Innovations Incorporated, Luna Technologies, Inc., Steve Yao andGeneral Photonics Corporation (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(29)2016 Equity Incentive Plan (Exhibit 4.7)4.5(29)Form of Stock Option Grant Notice and Stock Option Agreement under 2016 Equity Incentive Plan (Exhibit 4.8)4.6(35)Form of Restricted Stock Unit Grant Notice and Restricted Stock Unit Award Agreement under 2016 Equity Incentive Plan (Exhibit 4.1)4.7(30)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)10.13(36)Non-Employee Directors’ Deferred Compensation Plan (Exhibit 10.13)10.14(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)81Table of Contents10.18(14)Third Amendment to Commercial Lease dated June 21, 2010, by and between Canvasback Real Estate & Investments, LLC and LunaInnovations, Incorporated (Exhibit 10.5)10.19(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(36)Employment Agreement dated December 5, 2017, by and between Scott A. Graeff and Luna Innovations Incorporated (Exhibit 10.25)10.24(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)10.25(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)10.27(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)10.28(1)**Consent, Release and Fifth Loan Modification Agreement between Luna Innovations incorporated and Silicon Valley Bank dated as ofJanuary 21, 2014 (Exhibit 10.3)10.29(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)10.30(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)10.31(22)Lease Agreement by and between SBA Tenant, LLC and Luna Innovations Incorporated dated November 2014 (Exhibit 10.49)10.32(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)10.33(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)10.34(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)10.35(26)Amended and Restated Non-Employee Director Compensation Policy, dated June 30, 2015 (Exhibit 10.1)10.36(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)10.37(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)10.38(31)Employment Agreement, dated May 1, 2018 by and between the Registrant and Dale E. Messick (Exhibit 10.1)21.1List of Subsidiaries 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 2002.82Table of Contents101The following materials from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2018, are formatted in XBRL(eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at December 31, 2018 and 2017, (ii) Consolidated Statementsof Operations for the years ended December 31, 2018 and 2017, (iii) Consolidated Statements of Changes in Stockholder’s Equity for theyears ended December 31, 2018 and 2017 (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2018 and 2017,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, Commission File No. 000-52008, filed on May 13, 2014.The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(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.83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.(31)Incorporated by reference to the exhibit to the Registrant's Current Report on Form 8-K, Commission File No. 000-52008, filed on August 1, 2018.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(32)Incorporated by reference to the exhibit to the Registrant's Quarterly Report on Form 10-Q, Commission File No. 000-52008, filed on August 1,2018. The number given in parentheses indicates the corresponding exhibit number in such Form 10-Q.(33)Incorporated by reference to the exhibit to the Registrant's Current Report on Form 8-K, Commission File No. 000-52008, filed on October 16, 2018.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(34)Incorporated by reference to the exhibit to the Registrant's Current Report on Form 8-K, Commission File No. 000-52008, filed on March 4, 2018.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(35)Incorporated by reference to the exhibit to the Registrant's Current Report on Form 8-K, Commission File No. 000-52008, filed on January 14, 2019.The number given in parentheses indicates the corresponding exhibit number in such Form 8-K.(36)Incorporated by reference to the exhibit to the Registrant's Annual Report on Form 10-K, Commission File No. 000-52008, filed on March 21, 2018.The number given in parentheses indicates the corresponding exhibit number in such Form 10-K.+ Confidential treatment has been requested with respect to portions of this exhibit, indicated by asterisks, which hasbeen filed separately with the Securities and Exchange Commission.84Table of Contents#Pursuant to Item 601(b)(2) of Regulation S-K, the schedules and exhibits to this agreement are omitted, but will be furnished to the Securities andExchange 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.85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 14, 2019KNOW 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 14, 2019Scott A. Graeff /s/ Dale E. Messick Chief Financial Officer (Principal Financial Officer and PrincipalAccounting Officer) March 14, 2019Dale E. Messick /s/ Michael W. Wise Director March 14, 2019Michael W. Wise /s/ Donald Pastor Director March 14, 2019Donald Pastor /s/ John B. Williamson III Director March 14, 2019John B. Williamson III /s/ N. Leigh Anderson Director March 14, 2019N. Leigh Anderson /s/ Warren B. Phelps, III Director March 14, 2019Warren B. Phelps, III /s/ Gary Spiegel Director March 14, 2019Gary Spiegel /s/ Richard W. Roedel Chairman of the Board of Directors March 14, 2019Richard W. Roedel 86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 21.1SUBSIDIARIESLuna Technologies, Inc.Former Luna Subsidiary, Inc. (previously Advanced Photonix, Inc.)TeraMetrix, LLCAdvanced Photonix Inc. CanadaGeneral Photonics CorporationEXHIBIT 23.1CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMWe have issued our report dated March 14, 2019, with respect to the consolidated financial statements included in the Annual Reportof Luna Innovations Incorporated on Form 10-K for the year ended December 31, 2018. We consent to the incorporation by referenceof said report in the Registration Statements of Luna Innovations Incorporated on Form S-3 (File No. 333-191809), on Form S-4 (FileNo. 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 14, 2019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 14, 2019 /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 14, 2019 /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, 2018 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 14, 2019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, 2018 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 14, 2019

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