MicroVision, Inc. Annual Report 2005

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FY2005 Annual Report · MicroVision, Inc.

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> M I C R O V I S I O N , I N C . 2 0 0 5 A N N U A L R E P O RT

RE : INVENTION

RE : DEFINE

With focus on improved operations and sustainable

business opportunities, we have five core initiatives

in 2006. These are as follows:

2006 Priorities

Grow product revenue and margins.

Focus and deliver on a vital few OEM product development
growth opportunities.

Reduce operating loss.

Improve quality and customer centricity.

Improve organizational effectiveness: Restructure business, nurture
a culture of growth and accountability and reward top talent.

M I C R O V I S I O N 2 0 0 5 A N N U A L R E P O RT P 1

> We announced a bold
new vision for the
Company: “To become an
indispensable source for
illuminating information,”
which entails our desire
to be at the heart of every
high-definition display and
imaging product sold.

Dear Fellow Shareholders:

In the fourth quarter of 2005, we assessed our business and organization and
subsequently developed a new operating blueprint for Microvision. We are
fundamentally reinventing the Company through the implementation of a new
direction, new growth strategy, new leadership team, new operating mecha-
nisms, new organizational structure, new culture and a new sense of urgency
and accountability. As 2006 is the commencement year for institutionalizing our
new blueprint, significant progress is underway.

Key Decision-shaping Factors

To provide context for the decisions we made to reinvent Microvision, let me
share some observations and assessments from my first few months after join-
ing Microvision in the third quarter of 2005, prior to being named CEO. During
this time period I met with many stakeholders to solicit their feedback and
input. These stakeholders included investors, customers, partners, employees,
industry leaders and financial analysts. From these discussions, and my own
observations, it became clear that significant changes were necessary. Despite
the strength and uniqueness of our technology, Microvision’s business portfo-
lio has yet to prove its full value due to its strategy and execution.

2005 was a year of mixed results. We had several important accomplish-
ments, which included top-line performance for the full fiscal year of $14.7M,
solid execution on government programs, and enhancement of our intellectual
property portfolio centered around the disruptive Micro Electro-Mechanical
Systems (MEMS) technology. It is a tribute to Microvision employees who, even
amid all the rapid and monumental changes that were introduced in the latter
portion of the year, delivered largely on their reformulated goals. On the
other hand we did not establish a revenue funnel consistent with sustainable
long-term growth. Our lack of market-driven decision making and desire to be
“everything to everybody” took a toll on our ability and agility to pursue the
extraordinary market opportunities that are in front of us. Our cost structure was
not competitive and sustainable for long-term profitability and product margins
suffered due to lack of sufficient product and transactional quality. Employee
morale was another area identified for improvement. Consequently, after assess-
ing our strengths and improvement areas, we initiated several business and
organizational changes targeted at establishing a strong focus on our renewed
mission of transforming the Company.

Vision in Action

In October of 2005 we developed, and in February of 2006 announced, a bold
new vision for the Company: “To become an indispensable source for illumi-
nating information,” which entails our desire to be at the heart of every high-
definition display and imaging product sold. Our exciting new core-growth

RE : FOCUS

We have a clear vision for the Company—

Microvision Inside—and we are implementing

the 2006 turnaround activities to become an

indispensable source for illuminating information
and a profitable enterprise with sustainable

double-digit growth.

M I C R O V I S I O N 2 0 0 5 A N N U A L R E P O RT P 3

> Our goal is ambitious,
yet crystal clear—to
have the same profound
impact on the high-
resolution display and
imaging industry as Intel
microprocessors had on
the computing industry.

strategy and focus for 2006 and beyond, is centered around an embedded
architecture we call Integrated Photonics Module (IPM™). The IPM will contain
all the necessary features and functionality to become an image generator for
many high-definition consumer, automotive, medical and military display and
imaging devices developed and distributed by world-leading OEMs. This strat-
egy will leverage our past and present MEMS technology developments and
will include innovations in the areas of optics, light sources and electronics
developed by Microvision and our partners. Our goal is ambitious, yet crystal
clear—to have the same profound impact on the high-resolution display and
imaging industry as Intel® microprocessors had on the computing industry. Key
to this strategy is partnering with world-leading OEMs to design, develop and
commercialize modular configurations of IPM that are targeted at different high-
volume products and applications.

Defining Primary Focus

In 2006, we are focusing on three primary applications: Automotive head-up
display (MicroHUD™), personal projection display (PicoP™) and personal color
eyewear.

MicroHUD: The MicroHUD is anticipated to be a high-performance automotive
product that will offer several important advantages to the driver, automotive
OEMs and Tier 1 integrators, including performance, cost and form factor. The
driver will benefit from viewing an image of significantly higher contrast and
brightness than current displays that is crisp and distinctive under the full range
of ambient light conditions. We expect to provide the OEMs and Tier 1 integra-
tors a device that offers significantly smaller form factor, generates less heat and
has the ability to be electronically configured to accommodate many different
vehicles and windshields.

PicoP and Personal Color Eyewear: Consumer electronics represents our great-
est market opportunity. Hundreds of millions of portable consumer handsets
are sold each year. Increased bandwidth, cheaper storage and higher process-
ing speed have driven a migration of new applications, previously only available
on desktop or laptop computers, to mobile electronic devices. One impetus,
however, remains the bottleneck: A small, quarter-VGA resolution display screen
that limits device utility and consumer experience as well as revenue opportu-
nities for handset manufacturers and content providers.

Two of our development initiatives defined in late 2005 are expected to focus
on addressing this problem: PicoP (a tiny embedded projector) and personal
color eyewear. The essential attributes required for such consumer products to
be successful in the marketplace are size, cost, power and imaging perfor-
mance. Microvision’s technology offers inherent advantages that could yield
superior solutions by providing a miniature, cost-effective, optically efficient
scanning engine that can produce large, high-resolution and contrast images—
what we like to call, “a large viewing experience in a small package”.

P 4 A N N U A L R E P O RT M I C R O V I S I O N 2 0 0 5

2006 is our rebuilding year.
We’ve added clarity, business
priorities, laser focus on
execution and quality, and
put in place mechanisms
to continually motivate
and energize employees.

Alexander Y. Tokman

President and Chief Executive Officer

July 2006

Leveraging Product Growth

Flic ® Laser Bar Code Scanner: On the product side, we see positive growth in
2006 for the Flic Laser Bar Code Scanner. We have developed a solid sales
pipeline in mobility, household and traditional Automated Identification and
Data Capture (AIDC) markets while focusing on improving product quality,
functionality and manufacturing capacity to maximize our opportunities in the
handheld bar code scanner market.

Nomad® Display System: The Nomad Display System, our head-worn see-
through monochrome display, is an application that could offer powerful capa-
bilities. In 2005, however, our success was limited. The original go-to-market
strategy and current product’s functionality and cost have been prohibitive to
segment growth. Our goal is to complete an assessment of the market viability
of the existing product and to decide on the future of this product line.

Government Contracts

The U.S. Government has been a strong supporter of our technology over the
years and in 2006 we will continue to pursue exciting, mutually rewarding oppor-
tunities together that further expand our technology foundation and translate
it into military and commercial product offerings.

What to Expect from Microvision

> Market- and customer-driven decisions and agile response to market changes;

> Clear direction and focus on IPM and high-volume opportunities;

> More active control of our future by making decisions and taking actions that

mitigate external dependencies;

> New business operating processes and mechanisms focused on lean enterprise;

> Quality at the center of everything we do; and

> A culture of growth and accountability where each employee will have direct

ownership and a stake in Microvision’s future.

Though the challenges ahead of us are real, 2006 is our rebuilding year.
We’ve added clarity, business priorities, laser focus on execution and quality,
and put in place mechanisms to continually motivate and energize employees.
We are building something special at Microvision and we are committed to
utilizing our energy, talents and resources to accelerate the exciting journey of
discovery and growth.

I want to thank you for your continuous support and for being a part of this

very dynamic company.

Sincerely,

M I C R O V I S I O N 2 0 0 5 S E L E C T E D F I N A N C I A L D ATA P 1

Selected Financial Data—2005

A summary of selected financial data as of and for the five years ended December 31, 2005 is set forth below:

Years ended December 31,

(in thousands, except per share data)

Statement of Operations Data

Revenue

Net loss available for common shareholders

Basic and diluted net loss per share

Weighted average shares outstanding, basic and diluted

Balance Sheet Data

Cash and cash equivalents

Investments available-for-sale

Working capital

Total assets

Long-term liabilities

Mandatorily redeemable preferred stock

Total shareholders’ equity

Lumera was deconsolidated in July 2004.

2005

2004

2003

2002

2001

$ 14,746

$ 11,418

$ 14,652

$ 15,917

$ 10,762

(30,284)

(1.35)

22,498

(33,543)

(26,163)

(27,176)

(34,794)

(1.56)

21,493

(1.46)

17,946

(1.93)

(2.85)

14,067

12,200

$ 6,860

$ 1,268

$ 10,700

$ 9,872

$ 15,587

—

(4,723)

23,363

4,412

4,166

(3,509)

—

903

25,538

7,647

7,190

11,078

19,781

33,918

2,204

—

5,304

14,511

32,267

1,480

—

18,065

33,098

54,055

552

—

23,295

17,416

32,326

TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF MICROVISION, INC.

We have completed integrated audits of Microvision’s 2005 and 2004 consolidated financial statements and
of its internal control over financial reporting as of December 31, 2005and an audit of its 2003 consolidated
financial statements in accordance with the standards of the Public Company Accounting Oversight Board
(United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule In our opinion, the consolidated
financial statements listed in the accompanying index, present fairly, in all material respects, the financial
position of Microvision Inc. and its subsidiary at December 31, 2005 and
December 31, 2004, and the results of their operations and their cash flows for each of the three years in the
period ended December 31, 2005 in conformity with accounting principles generally accepted in the United
States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying
index presents fairly, in all material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements. These financial statements and financial statement
schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion
on these financial statements and financial statement schedule based on our audits. We conducted our
audits of these statements in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit of financial
statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

The accompanying consolidated financial statements have been prepared assuming that
Microvision, Inc. will continue as a going concern. As more fully described in Note 1, the Company has
incurred losses since inception, including a net loss of $30.3 million for the year ended December 31, 2005
and its accumulated deficit was $215.7 million at December 31, 2005. Additionally, the Company
anticipates requiring additional financial resources to fund its operations at least through December
31, 2006. These conditions raise substantial doubt about the Company’s ability to continue as a going
concern. Management’s plans as to these matters are also described in Note 1. The financial statements do
not include any adjustments to reflect the possible future effects on the recoverability and classification of
assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

Internal control over financial reporting Also, in our opinion, management’s assessment, included in
Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A (b) that the
Company maintained effective internal control over financial reporting as of December 31, 2005 based on
criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) is fairly stated, in all material respects, based on
those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2005, based on criteria established in Internal
Control - Integrated Framework issued by the COSO. The Company’s management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting. Our responsibility is to express opinions on management’s
assessment and on the effectiveness of the Company’s internal control over financial reporting based on
our audit. We conducted our audit of internal control over financial reporting in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether effective internal control
over financial reporting was maintained in all material respects. An audit of internal control over financial
reporting includes obtaining an understanding of internal control over financial reporting, evaluating
management’s assessment, testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we consider necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A company’s internal
control over financial reporting includes those policies and procedures that (i) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the
assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with authorizations
of management and directors of the company; and (iii) provide reasonable assurance regarding prevention
or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have
a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or

detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to
the risk that controls may become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.

Seattle, Washington
March 15, 2006

Consolidated Balance Sheets

Asse ts

Current asset s

Cash and cash equivalent s

Account s receivable, net of allowances of $264 and $193

Cost s and est imat ed earnings in excess of billings on uncomplet ed cont ract s

Invent ory

Current resrict ed cash and invest ment s

Ot her current asset s

T ot al current asset s

Invest ment in Lumera

P ropert y and equipment , net

Rest rict ed invest ment s

Rest rict ed invest ment in Lumera

Ot her asset s

T ot al asset s

De ce m be r 31,

2005

2004

6,860

1,380

1,204

759

1,856

1,512

13,571

3,582

2,902

1,000

2,184

124

1,268

5,227

597

3,167

1,293

11,552

10,201

2,318

1,238

229

23,363

25,538

Li abi l i ti e s, Man datori l y Re de e m abl e C on ve rti bl e Pre fe rre d S tock an d S h are h ol de rs' (De fi ci t) Equ i ty

Current liabilit ies

Account s payable

Accrued liabilit ies

Allowance for est imat ed cont ract losses

Billings in excess of cost s and est imat ed earnings on uncomplet ed cont ract s

Liabilit y associat ed wit h common st ock warrant s

Current port ion of not es payable

Current port ion of capit al lease obligat ions

Current port ion of long-t erm debt

T ot al current liabilit ies

Not es payable, net of current port ion

Liabilit y associat ed wit h embedded derivat ive feat ure

Capit al lease obligat ions, net of current port ion

Long-t erm debt , net of current port ion

Deferred rent , net of current port ion

T ot al liabilit ies

Commit ment s and cont ingencies (not e 14)

Mandat orily redeemable convert ible preferred st ock, par value $.001; 25,000

shares aut horized; 5 and 10 shares issued and out st anding
(liquidat ion preference of $5,000 and $10,000)

Shareholders' (Deficit ) Equit y

Common st ock, par value $.001; 73,000 shares aut horized; 25,138 and

21,509 shares issued and out st anding

Addit onal paid-in capit al

Deferred compensat ion

Subscript ions receivable from relat ed part ies

Receivables from relat ed part ies, net

Accumulat ed deficit

T ot al shareholders' (deficit ) equit y

2,328

4,513

3,452

7,896

18,294

1,447

1,368

105

1,492

2,624

4,538

3,318

10,649

22,706

10,701

4,166

7,647

212,993

(85)

(792)

(215,650)

(3,509)

196,929

(305)

(166)

(1,823)

(187,467)

7,190

T ot al liabilit ies, mandat orily redeemable convert ible preferred st ock

and shareholders' equit y

23,363

25,538

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

Consolidated Statements of Operations

Contract revenue

Product revenue

T otal revenue

Cost of contract revenue

Cost of product revenue

T otal cost of revenue

Gross margin

Ye ars Ende d De ce mbe r 31,

2005

2004

2003

11,386

8,821

3,360

14,746

6,456

8,636

15,092

2,597

11,418

5,539

3,868

9,407

13,517

1,135

14,652

5,988

1,058

7,046

(346)

2,011

7,606

Research and development expense (exclusive of non-cash compentsation expense

of $0, $548, and $1,006 for 2005, 2004 and 2003, respectively)

6,587

14,709

23,316

Sales, marketing, general and administrative expense (exclusive of non-cash compensation

expense of $429, $1,570 and $1,150 for 2005, 2004 and 2003 respectively)

Non-cash compensation expense

T otal operating expenses

Loss from operations

Interest income

Interest expense

Gain on derivative features of notes payable, net

Loss on debt extinguishment

Other income(expense)

19,923

429

26,939

19,228

2,118

36,055

15,827

2,156

41,299

(27,285)

(34,044)

(33,693)

263

(3,253)

5,975

(3,313)

(28)

272

(151)

(1)

381

(51)

Loss before minority interests and equity in losses of Lumera

(27,641)

(33,924)

(33,288)

Minority interests in loss of consolidated subsidiary

Equity in losses of Lumera

Gain on sale of securities of equity subsidiary

(3,242)

2,700

2,438

(1,711)

7,125

Net loss

(28,183)

(33,197)

(26,163)

Less: Stated dividend on mandatorily redeemable convertible preferred stock

Accretion to par value of preferred stock

Inducement for conversion of preferred stock

Net loss available for common shareholders

Net loss per share basic and diluted

(280)

(637)

(1,184)

(108)

(238)

(30,284) $

(33,543) $

(26,163)

(1.35) $

(1.56) $

(1.46)

Weighted-average shares outstanding basic and diluted

22,498

21,493

17,946

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

Consolidated Statements of Mandatory Redeemable Convertible Preferred Stock and Shareholders’ Equity

Balance at December 31, 2004

Issuance of stock, options and warrants to

non-employ ees for services

Deferred compensation on stock options

Am ortization of deferred com pensation

Exercise of warrants and options

Sales of comm on stock

Conversion of preferred stock

Conversion of senior secured exchageable covertible notes

Stock received for subscriptions receivable

Inducement to preferred shareholders

Issuance of comm on stock and change in warrant value to

preferred shareholders

Beneficial conversion feature of mandatorily redeemable

convertible preferred stock

Issuance of comm on stock for pay ment on senior

exchangeable convertible notes

Issuance of comm on stock for pay ment of interest

on senior secured exchangeable convertible notes

Issuance of comm on stock on preferred dividend

Dividend on preferred stock

Non-cash accretion on mandatorily redeemable

convertible preferred stock

Allowance for doubtful accounts on receivables from related parties

Net loss

Balance at December 31, 2005

Mandatorily

redeemable

convertible

preferred stock

Par Value

Value

(5)

7,647

21,509

(4,539)

421

637

2,171

855

310

(28)

258

4,166

25,138

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

nonemploy ees for services

Deferred compensation on stock options

Amortization of deferred compensation

Exercise of warrants and options

Sales of common stock

Conversion of preferred stock

Stock received for subscriptions receivable

Inducement to preferred shareholders

preferred shareholders

convertible preferred stock

exchangeable convertible notes

on senior secured exchangeable convertible notes

Issuance of common stock on preferred dividend

Dividend on preferred stock

convertible preferred stock

Par Value

Value

(5)

7,647

21,509

(4,539)

421

637

2,171

855

310

(28)

258

4,166

25,138

Additional

paidin

capital

196,929

144

9,908

4,538

1,837

(169)

(763)

763

(421)

867

130

(280)

(637)

(305)

(144)

364

212,993

(85) $

Shareholders' Equity

Subscriptions

Receivables

Accumulated

receivable

Deferred

from related

Compensation

parties

from

parties

other

comprehensive

Accumulated

Shareholders'

(loss) income

defecit

Equity

(187,467)

7,190

(28,183)

(215,650) $

364

9,910

4,539

1,837

(3)

(763)

763

(421)

867

130

(280)

(637)

1,031

(28,183)

(3,509)

(166)

(1,823)

166

1,031

(792) $

Consolidated Statements of Comprehensive Loss

Net loss

Other comprehensive loss

Unrealized loss on investment securities, available-for-sale:

Unrealized holding loss arising during period

Less: reclassification adjustment for gains realized in net loss

Net unrealized loss

Comprehensive loss

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

Consolidated Statements of Cash Flows

Cash flows from ope rating activitie s

Net loss

Adjustments to reconcile net loss to net cash used in operations

Depreciation

Loss (gain) on disposal of fixed assets

Non-cash expenses related to issuance of stock, warrants, and options,

and amortization of deferred compensation

Non-cash interest expense, net

Derivative features of notes payable

Inventory write-downs

Allowance for receivables from related parties

Realized gain on sale of investment securities

Minority interests in loss of consolidated subsidiary

Equity in losses of Lumera

Gain on sale of securities of equity subsidiary

Loss on debt extinguishment

Non-cash deferred rent

Interest on notes payable

Allowance for estimated contract losses

Change in

Accounts receivable

Intercompany receivable

Costs and estimated earnings in excess of billings on uncompleted contracts

Inventory

Other current assets

Other assets

Accounts payable

Accrued liabilities

Billings in excess of costs and estimated earnings on uncompleted contracts

Research liability, current and long-term

Net cash used in operating activities

Cash flows from inve sting activitie s

Sales of investment securities

Purchases of investment securities

Sales of restricted investment securities

Purchases of restricted investment securities

Increase in restricted cash

Collections of receivables from related parties

Sale of long term investment - Lumera

Purchases of property and equipment

Net cash provided by used in investing activities

Ye ars Ende d Dece mbe r 31,

2005

2004

2003

(28,183) $

(33,197) $

(26,163)

(25)

(57)

(39)

(96)

(28,183) $

(33,222) $

(26,259)

Ye ars Ende d De ce mbe r 31,

2005

2004

2003

(28,183) $

(33,197) $

(26,163)

1,602

429

2,730

(2,659)

3,732

1,031

3,242

(2,700)

3,313

(21)

(53)

3,847

(607)

(1,324)

340

(1,050)

(190)

(3,267)

(19,727)

1,248

(1,248)

1,238

(2,101)

(755)

3,893

(1,239)

1,036

2,406

2,118

2,084

(2,438)

1,711

(86)

125

(3,420)

(4,920)

(427)

2,631

865

3,265

(1,762)

(30,831)

12,053

(1,000)

1,269

(1,238)

(1,040)

10,044

3,113

(36)

2,156

500

200

(39)

(7,125)

(85)

(581)

409

(84)

(93)

(68)

705

(177)

923

(26,405)

3,249

(9,080)

1,356

(1,269)

(1,549)

(7,273)

Consolidated Statements of Cash Flows (continued)

Years Ended Decembe r 31,

2005

2004

2003

Cash flows from financing activitie s

Principal payments under capital leases

Proceeds from issuance of short term notes

Principal payments under long-term debt

Proceeds from inssuance of notes and warrants

Payments on notes payable

Increase in deferred rent

Payment of preferred dividend

Net proceeds from inssuance of common stock

Net proceeds from issuance of preferred stock and warrants

Net proceeds from sale of subsidiary's equity to minority interests

Net cash provided by financing activities

Net increase (decrease) in cash and cash equivalents

Cash and cash equivalents at beginning of period

Change in cash due to Lumera deconsolidation

Cash and cash equivalents at end of period

Supple me ntal disclosure of cash flow information

Cash paid for interest

Supple me ntal schedule of non-cash investing and financing activities

Property and equipment acquired under capital leases

Other non-cash additions to property and equipment

Conversion of preferred stock into common stock

Deferred compensation - warrants, options and stock grants

Issuance of common stock for payment of principal and interest on senior

secured exchangeable convertible notes

Issuance of common stock and warrants for services

(46)

(77)

14,148

(1,000)

1,492

(173)

9,939

24,283

5,592

1,268

(63)

2,300

(70)

(108)

360

9,886

500

12,805

(7,982)

10,700

(1,450)

(90)

(63)

32,924

1,735

34,506

828

9,872

6,860

1,268

10,700

348

151

135

812

4,117

209

997

159

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

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

The Company – Note 1

The consolidated financial statements include the accounts of Microvision, Inc. (“Microvision”), a
Delaware corporation, and Lumera Corporation (“Lumera”), a Delaware corporation, (collectively
the “Company”). Prior to July 2004, Lumera was a subsidiary and was consolidated into
Microvision. In July 2004, Lumera completed an initial public offering of its common stock and
as a result of the change in ownership, ceased to be consolidated and became an equity method
investment on Microvision.

Microvision was established to acquire, develop, manufacture and market scanned beam

technology, which projects images using a single beam of light. Microvision has entered into
contracts with commercial and U.S. government customers to develop applications using the
scanned beam technology. Microvision has introduced two commercial products, Nomad, a see
through head-worn display, and Flic, a hand-held bar code scanner. In addition, Microvision has
produced and delivered various demonstration units using Microvision’s display technology.
Microvision is working to commercialize additional products for potential medical, defense,
industrial, aviation, and consumer applications.

Lumera was established to develop, manufacture and market optical devices using

organic non-linear electro-optical chromophore materials. Lumera is working to commercialize
the devices for potential wireless networking and optical networking applications.

The accompanying consolidated financial statements have been prepared assuming that

the Company continues as a going concern. The financial statements do not include any
adjustments to reflect the possible future effects on the recoverability and classification of assets
or the amounts and classification of liabilities that may result from the matters discussed above.

The Company’s current cash resources are sufficient to fund operations through July 2006. The
Company plans to raise additional cash before July 2006 through the sale of its common stock,
preferred stock or through the issuance of debt. The Company has taken the following actions to
reduce its use of cash and improve the operations of the Company:

• Made significant changes to it senior management team including appointing a new Chief

Executive Officer.

• Announced a restructuring and realignment plan that targets a 30% reduction in operating

loss

• Begun adding members to the Board of Directors with experience that directly supports the

Company's business objectives.

• Engaged an investment bank to assist the Company in pursuing financing alternatives.

The Company’s operating plan calls for the addition of sales, marketing, technical and other staff
and the purchase of additional laboratory and production equipment. The Company’s future
expenditures and capital requirements will depend on numerous factors, including the progress of
its research and development program, the progress in commercialization activities and
arrangements, the cost of filing, prosecuting, defending and enforcing any patent claims and other
intellectual property rights, competing technological and market developments and the ability of
the Company to establish cooperative development, joint venture and licensing arrangements.
There can be no assurance that additional financing will be available to the Company or that, if
available, it will be available on terms acceptable to the Company on a timely basis. If adequate
funds are not available to satisfy either short-term or long-term capital requirements or planned
revenues are not generated, the Company may be required to limit its operations substantially.

This limitation of operations may include reduction in capital expenditures and reductions in staff
and discretionary costs, which may include non-contractual research costs. The Company’s
capital requirements will depend on many factors, including, but not limited to, the rate at which
the Company can, directly or through arrangements with original equipment manufacturers,
introduce products incorporating the scanned beam technology and optical polymer based
products and the market acceptance and competitive position of such products.

Summary of significant accounting policies – Note 2

Use of estimates The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. The Company’s management has identified the
following areas where significant estimates and assumptions have been made in preparing the financial
statements: revenue recognition, allowance for uncollectible receivables, management loans,
inventory valuation and potential losses from litigation.

Principles of consolidation The company has historically included both Microvision and Lumera
Corporation (“Lumera”), a subsidiary that was consolidated through July 2004. In July 2004, Lumera
completed an initial public offering of its common stock.

In connection with the Lumera initial public offering, all Lumera Series A and Series B

Preferred Stock was converted into Lumera common stock. Immediately after the offering,
Microvision owned 5,434,000 shares, or 33%, of the common stock of Lumera. As a result of the
change in ownership percentage, Microvision changed the method of accounting for its investment in
Lumera to the equity method and after July 2004 recorded its share of Lumera income or losses.
Microvision recorded a non-cash change in ownership interest gain of $13.7 million to stockholders
equity as a component of additional paid-in capital during 2004. At December 31, 2004 and 2005,
Microvision owned 33% and 28%, respectively, of Lumera’s common stock.

Cash, cash equivalents and investment securities The Company considers all investments that mature
within 90 days of the date of purchase to be cash equivalents. At December 31, 2005, all short-term
investment securities held by the Company were classified as cash equivalents.

Inventory Inventory consists of raw material; work in process and finished goods for the Company’s
Nomad and Flic products. Inventory is recorded at the lower of cost or market with cost determined on
the weighted-average method. Management periodically assesses the need to provide for obsolescence
of inventory and adjusts the carrying value of inventory to its net realizable value when required. In
addition, Microvision reduces the value of its inventory to its estimated scrap value when management
determines that it is not probable that the inventory will be consumed through normal production
during the next twelve months.

Restricted cash and investments As of December 31, 2005, restricted cash and investments includes:

•

$1.0 million irrevocable letter of credit as security on a lease agreement for the corporate
headquarters building in Redmond, WA. The required letter of credit balance decreases over the
term of the lease, which expires in 2013.
$754,000 cash received in connection with a lease agreement for the corporate headquarters
building in Redmond, WA. The use of the cash is restricted to the terms of the tenant
improvement agreement associated with the lease.
$1.1 million certificates of deposit held as collateral for letters of credit issued in connection with
a lease agreement for the former corporate headquarters building in Bothell, WA. The balance is
required to be maintained for the remaining term of the lease, which expires in April 2006.
$1.0 million, 1,750,000 shares of Lumera common stock pledged as collateral for the Company’s
Notes.

Property and equipment Property and equipment is stated at cost and depreciated over the estimated
useful lives of the assets (two to five years) using the straight-line method. Leasehold improvements
are depreciated over the shorter of estimated useful lives or the lease term.

Revenue recognition Revenue has primarily been generated from contracts for further development of
the scanned beam technology and to produce demonstration units for commercial enterprises and the
United States government. Revenue on such contracts is recorded using the percentage-of-completion
method measured on a cost incurred basis. The percentage of completion method is used because the
Company can make reasonably dependable estimates of the contract cost. Changes in contract
performance, contract conditions, and estimated profitability, including those arising from contract
penalty provisions, and final contract settlements, may result in revisions to costs and revenues and are
recognized in the period in which the revisions are determined. Profit incentives are included in
revenue when realization is assured.

The Company recognizes losses, if any, as soon as identified. Losses occur when the
estimated direct and indirect costs to complete the contract exceed unrecognized revenue. The
Company evaluates the reserve for contract losses on a contract-by-contract basis.

Revenue from product shipments is recognized in accordance with Staff Accounting Bulletin

No. 104 “Revenue Recognition.” Revenue is recognized when there is sufficient evidence of an
arrangement, the selling price is fixed and determinable and collection is reasonably assured. Revenue
for product shipments is recognized upon acceptance of the product by the customer or expiration of
the contractual acceptance period, after which there are no rights of return. Provisions are made for
warranties at the time revenue is recorded. Warranty expense was not material for any periods
presented.

Concentration of credit risk and sales to major customers Financial instruments that potentially
subject the Company to concentrations of credit risk are primarily cash equivalents, investments and
accounts receivable. The Company typically does not require collateral from its customers. The
Company has a cash investment policy that generally restricts investments to ensure preservation of
principal and maintenance of liquidity.

The United States government accounted for approximately 35%, 42%, and 49% of total

revenue during 2005, 2004 and 2003, respectively. Contracts with three commercial customers
represented 38%, 25%, and 35% of total revenues during 2005, 2004, and 2003, respectively. At
December 31, 2004, one commercial customer accounted for 65% of the accounts receivable balance.
The receivable was paid in full in January 2005.

The United States government accounted for approximately 41% and 21% of the accounts

receivable balance at December 31, 2005 and 2004, respectively. In 2005, 61% of consolidated
revenue was earned from development contracts with two customers. In 2004, 11% of consolidated
revenue was earned from a development contract with one customer.

Income taxes Deferred tax assets and liabilities are recorded for differences between the financial
statement and tax bases of the assets and liabilities that will result in taxable or deductible amounts in
the future, based on enacted tax laws and rates applicable to the periods in which the differences are
expected to affect taxable income. Valuation allowances are established when necessary to reduce
deferred tax assets to the amount expected to be realized. Income tax expense is recorded for the
amount of income tax payable for the period increased or decreased by the change in deferred tax
assets and liabilities during the period.

Net loss per share Basic net loss per share is calculated on the basis of the weighted-average number
of common shares outstanding during the periods. Net loss per share assuming dilution is calculated
on the basis of the weighted-average number of common shares outstanding and the dilutive effect of
all potentially dilutive securities, including common stock equivalents and convertible securities. Net
loss per share assuming dilution for 2005, 2004 and 2003 is equal to basic net loss per share because
the effect of dilutive securities outstanding during the periods including options and warrants
computed using the treasury stock method, is anti-dilutive. The dilutive securities and convertible
securities that were not included in earnings per share were 9,440,000, 6,836,000, and 6,295,000, at
December 31, 2005, 2004 and 2003, respectively.

Research and development Research and development costs are expensed as incurred.

Fair value of financial instruments The Company’s financial instruments include cash and cash
equivalents, accounts receivable, accounts payable, accrued liabilities and long-term debt. The
carrying amount of long-term debt at December 31, 2005 and 2004 was not materially different
from the fair value based on rates available for similar types of arrangements. The carrying value
of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities
approximate fair value due to the short maturities. The convertible notes are not publicly traded
and it is no practicable for the Company to estimate the fair value of the convertible notes due to
the absence of comparable publicly traded financial instruments.

Long-lived assets The Company evaluates the recoverability of its long-lived assets when an
impairment is indicated based on expected undiscounted cash flows and recognizes impairment of
the carrying value of long-lived assets, if any, based on the fair value of such assets.

Stock-based compensation The Company and Lumera each have stock-based employee
compensation plans, which are more fully described in Note 13.

The Company accounts for stock-based employee compensation arrangements in
accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25,
“Accounting for Stock Issued to Employees” and related amendments and interpretations,
including FASB Interpretation Number (“FIN”) 44, “Accounting for Certain Transactions
Involving Stock Compensation,” and complies with the disclosure provisions of SFAS No. 123,
“Accounting for Stock-Based Compensation.” The Company accounts for equity instruments
issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues
Task Force Issue No. 96-18.

Total non-cash stock option expense related to employee and director awards was

$94,000, $1,057,000, and $271,000 for the years ended December 31, 2005, 2004 and 2003,
respectively. Had compensation cost for employee and director options been determined using the
fair values at the grant dates consistent with the methodology prescribed under SFAS 123, the
Company’s consolidated net loss available to common shareholders and associated net loss per
share would have increased to the pro forma amounts indicated below (in thousands):

Year Ended December 31,

2005

2004

2003

Net loss available for common shareholders, as reported

(30,284) $

(33,542) $

(26,199)

Add: Stock-based employee compensation expense included in net loss

available for common shareholders, as reported

339

266

Deduct: T otal stock-based employee compensation expense determined

under fair value based method for all awards

Net loss available for common shareholders, pro forma

Net loss per share As reported

Basic and diluted pro forma

(1,931)

(5,886)

(8,915)

(32,121) $

(39,089) $

(34,848)

(1.35) $

(1.43) $

(1.56) $

(1.82) $

(1.46)

(1.94)

The first reporting period where employee share-based compensation will be recognized is March
31, 2006. Share-based compensation expense in 2006 will be affected by our stock price at the
time of grants are awarded, the number and structure of stock-based awards our board of directors
may grant during the year, any other actions taken with respect to outstanding options, as well as a
number of complex and subjective valuation assumptions. These valuation assumptions include,
but are not limited to, the future volatility of our stock price and employee stock option exercise
behaviors. The Company is currently evaluating the alternative methods for implementing SFAS
No. 123(R) and there is sufficient uncertainty surrounding future share-based compensation
actions and valuation estimates that the Company is not in a position to provide a useful estimate
of the financial statement impact of SFAS No. 123(R) in 2006 at this time.

In November 2004 the FASB issued SFAS 151 Inventory Cost - an Amendment of ARP
No. 43, chapter 4 (“SFAS 151”) which provides clarifies accounting for abnormal manufacturing
costs. The Company is required to adopt SFAS 151 for years beginning after June 30, 2005. The
Company does not believe that adoption of SFAS 151 will have a material impact on its financial
statements.

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff
Accounting Bulletin No. 107 (“SAB 107”), “Share Based Payment,” which expresses the SEC’s
views on the interaction between SFAS 123R and certain SEC rules and regulations. The
Company is currently assessing the guidance in SAB 107 as part of its evaluation of the adoption
of SFAS 123R.

Long-term contracts – Note 3

Cost and estimated earnings in excess of billings on uncompleted contracts comprises amounts of
revenue recognized on contracts that the Company has not yet billed to customers because the
amounts were not contractually billable at December 31, 2005 and 2004. The following table
summarizes when the Company will be contractually able to bill the balance as of December 31,
2005 and 2004.

Billable within 30 days

Billable between 31 and 90 days

Billable after 90 days

Year Ended Decembe r 31,

2005

2004

686,000

3,000

515,000

1,204,000

577,000

2,000

18,000

597,000

"Billable after 90 days" includes $496,000 of unbilled costs related to work on a development
contract that are billable upon the completion of a contractual milestone that the Company plans to
complete during the second quarter of 2006.

The Company’s current contracts with the U.S. government are primarily cost plus fixed

fee type contracts. Under the terms of a cost plus fixed fee contract, the U.S. government
reimburses the Company for negotiated actual direct and indirect cost incurred in performing the
contracted services. The Company is under no obligation to spend more than the contract value to
complete the contracted services. The period of performance is generally one year. Each of the
Company’s contracts with the United States government can be terminated for convenience by the
government at any time.

In June 2005, the Company entered into a $4,359,000 contract with General Dynamics

C4 Systems to continue the development of a helmet-mounted display for the Air Warrior Block 3
system. General Dynamics is under contract with the U.S. Army's Product Manager -- Air
Warrior in Huntsville, Ala., to develop and integrate the Air Warrior Block 3 system. The
Microvision helmet-mounted display is being designed as a full-color, see-through, daylight and
night-readable, high-resolution display.

In May 2004, Microvision entered into a $3,900,000 contract modification with the U.S. Army’s
Aviation Applied Technology Directorate to continue work on an advanced helmet mounted
display and imaging system to be used in the Virtual Cockpit Optimization Program.

In December 2004, Microvision entered into a $6,200,000 contract with Ethicon Endo-

Surgery, Inc. a subsidiary of Johnson & Johnson to integrate Microvision’s technology into certain
medical products. The contract includes an exclusive license for Microvision’s technology for
certain human medical applications during the term of the development agreement.

In April 2003, the Company entered into a $2,200,000 contract modification with the

U.S. Army’s Aviation Applied Technology Directorate to continue work on an advanced helmet
mounted display and imaging system to be used in the Virtual Cockpit Optimization Program.
In April 2003, the Company entered into a $1,600,000 contract modification with the

U.S. Army’s Medical Research Acquisition Activities, Telemedicine and Advanced Technology
Research Center to continue development of a mobile wireless personal display system for
medical applications.

The following table summarizes the costs incurred on the Company’s revenue contracts:

Costs and estimated earnings incurred on uncompleted contracts

Billings on uncompleted contracts

Included in accompanying balance sheets under the following captions:

Costs and estimated earnings in excess of billings on uncompleted

contracts

Billings in excess of costs and estimated earnings on uncompleted

contracts

December 31,

2005

17,325,000

(16,172,000)

1,153,000

2004

6,410,000

(9,131,000)

(2,721,000)

1,204,000

597,000

(51,000)

(3,318,000)

1,153,000

(2,721,000)

Inventory – Note 4
Inventory consists of the following:

Raw materials

Work in process

Finished goods

December 31,

2005

2004

267,000

141,000

351,000

759,000

1,607,000

77,000

1,483,000

3,167,000

The inventory at December 31, 2005 and 2004 consisted of raw materials, work in
process and finished goods for Nomad and Flic. Inventory is stated at the lower of cost or market,
with cost determined on a weighted average basis. Management periodically assesses the need to
provide for obsolescence of inventory and adjusts the carrying value of inventory to its net
realizable value when required. In addition, Microvision reduces the value of its inventory to its
estimated scrap value when management determines that it is not probable that the inventory will
be consumed through the normal course of business during the next twelve months. In 2005, 2004
and 2003, Microvision recorded inventory write-downs of $3,732,000, $2,084,000and $500,000
respectively.

Accrued liabilities – Note 5
Accrued liabilities consist of the following:

Bonuses

Payroll and payroll taxes

Compensated absences

T axes other than income taxes

Facility closing cost

Professional Fees

Relocation

Consultants

Other

December 31,

2005

2004

1,000,000

1,600,000

732,000

497,000

12,000

558,000

166,000

525,000

1,023,000

4,513,000

763,000

475,000

43,000

253,000

371,000

90,000

943,000

4,538,000

Property and equipment, net – Note 6

Property and equipment consists of the following:

Lab and production equipment

Leasehold improvements

Computer hardware and software

Office furniture and equipment

Less: Accumulated depreciation

December 31,

2005

2004

2,126,000

3,990,000

6,495,000

1,124,000

13,735,000

(10,833,000)

2,902,000

4,455,000

2,165,000

3,873,000

1,057,000

11,550,000

(9,232,000)

2,318,000

Depreciation expense was $1,602,000, $2,406,000 and $3,113,000 in 2005, 2004 and 2003
respectively.

Receivables from related parties – Note 7

In 2000, the Board of Directors authorized the Company to provide unsecured lines of credit to
each of the Company’s three senior officers. The limit of the line of credit is three times the
executives’ base salary less any amounts outstanding under the Executive Option Exercise Note
Plan. In 2002 and 2001, the Board of Directors authorized a $200,000 and $500,000 addition,
respectively, to the limit for one senior officer. The lines of credit carry interest rates of 5.4% to
6.2%. The lines of credit must be repaid within one year of the senior officer’s termination or
within thirty days of demand by the Company in the event of a plan termination, provided that in
the event of such a demand the senior officer may elect to deliver a promissory note with a one-
year term in lieu of payment. At December 31, 2005 and 2004, a total of $2,723,000 and
$2,723,000, respectively, was outstanding under the lines of credit.

In 2005, the Company determined that certain of its senior officers may have insufficient net
worth and short-term earnings potential to repay loans outstanding under the Company’s lines of
credit. In 2003 and 2002, the Company recorded an allowance for doubtful accounts for
receivables from senior officers of $200,000 and $700,000, respectively. In January 2006, two
senior officers left the Company. Because the lines of credit are unsecured and collection is
uncertain, the Company recorded an additional allowance of $1,031,000 in December 2005. The
balance of the allowance for doubtful accounts for receivables from senior officers was
$1,931,000 and $900,000 at December 31, 2005 and 2004, respectively.

Under current SEC rules, the Company is prohibited from changing the repayment terms

of the lines of credit. No repayments have been made on the outstanding lines of credit. At
December 31, 2003, the Company reclassified the loan balance to shareholder’s equity under the
guidance provided by the SEC for loans to shareholders due to the absence of any repayments of
the loans to date. The Company has no plans to forgive the principal balance outstanding under
the lines of credit.

In 2000, three executive officers of the Company exercised a total of 128,284 stock

options, in exchange for full recourse notes totaling $285,000. These notes bear interest at 4.6%
to 6.2% per annum. Each note is payable in full upon the earliest of (1) a fixed date ranging from
January 31, 2001 to December 31, 2004 depending on the expiration of the options exercised; (2)
the sale of all of the shares acquired with the note; (3) on a pro rata basis upon the partial sale of
shares acquired with the note, or (4) within 90 days of the officer’s termination of employment.
At December 31, 2005 and 2004, a total of $0 and $165,600, respectively, was outstanding under
the full recourse notes. The $165,600 plus accrued interest was paid in full in February 2005. The
notes are included as subscriptions receivable from related parties in shareholders’ equity on the
consolidated balance sheet.

The interest on both the lines of credit and the full recourse notes is forgiven if the

executive is an employee of the Company at December 31 of the respective year. Compensation
expense of $156,000, $163,000 and $163,000 was recognized in 2005, 2004 and 2003,
respectively, for interest forgiven.

Lumera Subsidiary Equity Transactions – Note 8

In March 2000, Lumera issued 4,700,000 shares of its Class B common stock to the Company for
services provided by the Company to Lumera valued at $94,000. At the same time, Lumera issued
670,000 shares of its Class B common stock to certain Microvision employees for $12,000 in
cash.

In January 2001, Lumera issued 802,000 shares of Lumera Class A common stock to the

University of Washington ("UW") at a value of $3.75 per share in connection with the research
agreement. The valuation of the shares issued to the UW was more than the per share carrying
amount of the Company’s interest in Lumera. Although the Company’s percentage ownership in
Lumera was reduced as a result of this transaction, the increased value of Lumera stock on the
change in ownership interest resulted in a gain for the Company. The amount of the gain of
$3,001,000 resulting from the revaluation of the Company’s interest in Lumera was credited to
paid-in capital.

In March 2001, Lumera issued 2,400,000 shares of its Series A preferred stock at a price

of $10.00 per share. Included in this total were 264,000 shares issued to the Company in
repayment of intercompany borrowings.

In October 2002, Lumera paid $200,000 and issued a warrant to purchase 164,000 shares

of Lumera Class A Common Stock at an exercise price of $3.65 per share to Arizona
Microsystems, Inc. in exchange for a license of certain Arizona Microsystems, Inc. technology.
The warrant expires 10 years following the date of grant, and vests 25% on the date of grant and
25% annually from the date of grant. The warrant was valued at the date of grant at $133,000.
The total purchase price of $333,000 was recorded as capitalized licensing costs. The fair value of
the warrant was estimated using the Black Scholes option pricing model with a stock price of
$0.98 per share, dividend yield of zero percent; expected volatility of 100%; risk-free interest rate
of 4.0% and expected life of ten years.

In August 2003, Lumera raised $1,900,000, before issuance costs of $34,000, from the sale of
944,000 shares of Series B convertible preferred stock to Microvision and other purchasers.
Microvision purchased 434,000 of these shares for an aggregate purchase price of $868,000. In
October 2003, Lumera raised $782,000 before issuance costs of $32,000, from the sale of 391,000
shares of Series B convertible preferred stock. Microvision did not purchase additional shares of
Series B preferred stock in the October 2003 offering.

In August 2003, Lumera issued options to purchase an aggregate of 164,000 shares of its

Class A Common Stock to two consultants in connection with entering into certain consulting
agreements. Each holder was granted a warrant to purchase up to 82,000 shares of Class A
Common Stock at a price of $3.65 per share with a ten year life. In aggregate, 41,000 of the
options were vested on the grant date. The remaining 123,000 shares vest one-third on each
subsequent annual anniversary of the grant date were subject to remeasurement at each balance
sheet date during the vesting period. The deferred compensation and liability related to these
options was amortized to non-cash compensation expense over the two year period of service
under the agreements. The aggregate value of both options was estimated at $136,000 at the grant
date and December 31, 2003. Total non-cash compensation expense was $315,000 for the period
from January 1, 2004 through July 2004, and $32,000 for the year ended December 31, 2003. The
fair values of the options were estimated at the grant date and December 31, 2003, using the Black
Scholes option pricing model with the following weighted-average assumptions: underlying
security fair market value of $0.98, dividend yield of zero percent; expected volatility of 100% for
both measurement dates; risk-free interest rates of 4.4% and 4.3%; and expected lives of 10 and
9.7 years, respectively.

During 2004, Lumera granted options to purchase 415,000 shares of Class A common

stock to Lumera employees and directors with a weighted-average exercise price of $2.00. Lumera
subsequently determined that the fair market value of its common stock was greater than the
exercise price of the options. Lumera recorded aggregate charges of $216,000 during 2004 related
to these grants.

During 2004, Lumera granted vested options to purchase 40,000 shares of Class A
common stock to Microvision employees with a weighted-average exercise price of $2.00. Lumera
subsequently determined that the fair market value of its common stock was greater than the
exercise price of the options. The Company recorded aggregate charges of $134,000 during 2004
related to these grants.

In July 2004, Lumera completed an initial public offering of its common stock. As a

result of the offering, Microvision’s ownership interest in Lumera was reduced to 33%. As a result
of the reduction in ownership, Microvision changed to the equity method of accounting for its
investment in Lumera. Microvision recorded a non-cash change in interest gain of $13.7 million
during the third quarter. Because of uncertainty surrounding the ultimate realizability of the gain,
the gain was recorded as an increase to stockholders’ equity as a component of additional paid-in
capital. As of December 31, 2005, Microvision owned 4,622,000 shares or 28% of Lumera’s
common stock.

During the period from inception to July 2004, losses in Lumera were first allocated to
the holders of the common stock and then to the holders of the preferred shareholders pro rata in
accordance with their respective ownership interest. Losses were not allocated to the options and
warrants until exercised.

Lumera common stock, Series A preferred stock and Series B preferred stock were

eliminated in consolidation with Microvision interests in Lumera common stock, Series A
preferred stock, Series B preferred stock and options and warrants to purchase equity in Lumera
held by investors other than the Company, and are presented as minority interests on the
Company’s consolidated balance sheet.

A reconciliation of the changes in ownership interests through Lumera’s initial public offering is
as follows (in thousands):

Minority Inte re sts

Common

Pre fe rre d

Total

Microvision

Total

Balance at De ce mbe r 31, 2002

308

6,915

7,223

(440) $

Issuance of preferred stock, net

Options and warrants

Loss allocation for 2003

Balance at De ce mbe r 31, 2003

Issuance of preferred stock, net

Preferred stock reallocation

Options and warrants

Loss allocation for 2004

Balance at July 2004

322

342

1,735

(7,125)

1,525

500

413

1,735

(7,125)

1,847

500

413

342

(2,438)

664

868

(958)

(530)

(413)

6,783

2,603

(8,083)

1,317

500

342

(1,286)

(2,229) $

(3,724)

(1,565)

As a result of the Series B stock issuance, the allocations of Lumera losses changed between
Microvision and other minority interests and resulted in an additional $413,000 of losses being
allocated to minority interest during 2004, with a resultant change in interest loss allocated to
Microvision. In July 2004, Microvision’s ownership interest in Lumera was reduced to 33% as a
result of Lumera completing an initial public offering of its common stock. As a result of the
reduction in ownership, Microvision changed to the equity method of accounting for its
investment in Lumera. Microvision recorded a non-cash change in interest gain of $14,138,000
during the third quarter as a result of the change to the equity method. The net change in interest
gain for 2004 was $13,727,000. Because of uncertainty surrounding the ultimate realizability of
the gain; the gain was recorded as an increase to stockholders’ equity as a component of additional
paid-in capital.

The following table shows the Lumera balances included in the consolidated balance sheet
immediately prior to the change in interest and the reconciliation to the investment account shown
at December 31, 2005.

Cash and cash equivalents

657

Costs and estimated earnings in excess of billings on

uncompleted contracts

Other current assets

Property and equipment, net

Other assets

Accounts payable

Accrued liabilities

Current portion of research liability

Notes payable - current

Other long-term liabilities

Net Assets

Less minority interest options and warrants

Cumulative losses in excess of investment

Gain on change in interest

Investment losses from July 2004 to December 31, 2004

Investment in Lumera at December 31, 2004

Investment losses from January 1, 2005 to December 31, 2005

Sales of Lumera Stock

Investment in Lumera at December 31, 2005

117

1,077

2,369

(434)

(1,315)

(78)

(2,386)

(245)

(205)

(664)

(1,360)

(2,229)

14,138

(1,708)

10,201

(3,242)

(1,193)

5,766

The difference between the amount at which an investment is carried at December 31, 2005 and
the amount of underlying equity in net assets of Lumera is a result of equity transaction of Lumera
for which Microvision does not recognize any change in interest gains or losses.

Long-term Notes – Note 9

The following table summarizes the activity related to the issuance of convertible notes in 2005:

Embedded

Common

Loss on

derivative

stock and

extinguishment

Notes

Warrants

feature

APIC

of debt

Total

March 10, 2005 issuance

5,395

1,650

2,955

Debt restructuring at July 25, 2005

Conversion of debt to common stock at October 11, 2005

December 1, 2005 issuance

Principal pay ments on notes

Discount accretion for the y ear ended December 31, 2005

(1,398)

3,667

(867)

2,546

2,295

2,200

1,018

(439)

1,116

Changes in market value for the y ear ended December 31, 2005

(2,693)

(3,282)

1,837

3,017

867

10,000

(3,313)

10,000

2,546

(5,975)

Balances at December 31, 2005

9,343

3,452

1,368

5,721

(3,313)

December Notes

In December 2005, the Company raised $10,000,000, before issuance costs of $134,000, from the
issuance of notes ("December Notes"), 838,000 shares of common stock and warrants to purchase
an aggregate of 1,089,000 shares of Microvision common stock. The December Notes are
convertible on demand by the holders into Microvision common stock at a conversion price of
$3.94 per share. The note holders may convert all or a portion of their December Notes. In
addition, upon the request of the note holders, the Company is required to redeem the notes for
cash upon a change of control or an event of default at a redemption price equal to 125% of the
then outstanding balance of the December Notes. The Company has pledged 1,750,000 shares of
its Lumera common stock as collateral for the December Notes and the notes issued as of March
2005 ("March Notes") described below. Those shares have been classified as a "Restricted
investment in Lumera" on the Company's consolidated balance sheet.

The terms of the December Notes include interest at LIBOR plus 3.0%, provided that the
interest rate shall not be less than 6% or greater than 8%payable quarterly in cash or Microvision
common stock if the stock price is greater than $4.06 per share, at the election of the Company,
subject to certain additional conditions. Under certain circumstances the interest rate increase to
LIBOR plus 6% but not less than 12% or greater than 15%. If the Company chooses to pay
interest in Microvision common stock as opposed to cash, the price will be based on 90% of the
arithmetic average of the volume weighted average prices for the 20 trading days prior to the
payment date. The December Notes are payable in five equal quarterly installments beginning in
March 2006. The Company can elect to make the principal payments in common stock in lieu of
cash if the stock price is greater than $4.06 per share, subject to certain other conditions. If the
Company elects to pay principal in stock the stock will be issued at a 10% discount to the
arithmetic average of the volume weighted average prices for the 15 trading days prior to the
payment date. Additionally, the Company can elect to convert the December Notes into
Microvision common stock if the stock price exceeds $6.90 per share for 20 out of any 30
consecutive trading days, subject to certain conditions.

The Company concluded that the note holders’ right to convert all or a portion of the

December Notes into Microvision common stock is an embedded derivative instrument as defined
by FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
("FAS 133"). Accordingly, $1.1 million of the cash proceeds were allocated to the embedded
derivative instrument, which represents the fair value of the instrument on the date of issuance.
The value was determined using the Black Scholes option-pricing model with the following
assumptions: expected volatility of 58%; expected dividend yield of 0%; risk free interest rates
ranging from 4.01%to 4.39%; and contractual life of four to sixteen months , which corresponds to
the principal repayment dates. Due to changes in Microvision’s stock price and remaining
contractual life, the fair value of the embedded derivative feature decreased to $1,038,000 at
December 31, 2005. The change in value of $78,000 was recorded as a non-operating gain and
included in Gain on derivative features of note payable in the consolidated statement of
operations. At December 31, 2005 total principal payments of $7.0 million remain under the
December Notes.

The warrants issued with the December Notes vested on the date of grant, have an
exercise price of $3.94 per share of common stock share and expire in December 2010. The
warrants met the definition of a derivative instrument that must be accounted for as a liability
under the provisions of Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, because the
Company cannot engage in certain corporate transactions affecting the common stock unless it
makes a cash payment to the holders of the warrants. Accordingly, $2.2 million of the cash
proceeds were allocated to the warrants, which represents the fair value of the warrants on the date
of issuance and the amount was recorded as a current liability. Subsequent changes in the fair
value of the warrants will be recorded in the statement of operations each period. The warrants
were valued using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 65%; expected dividend yield of 0%; risk free interest rate of 4.35%; and
contractual life of five years.

The Microvision common stock was valued at the closing price on the date of closing of $3.60 per
share. Aggregate proceeds of $3.0 million were allocated to the common stock. The remaining
gross proceeds of $3.7 million were allocated to the notes.

March Notes

In March 2005, the Company raised $10,000,000, before issuance costs of $423,000, from the
issuance of convertible March Notes (“March Notes”) and warrants to purchase an aggregate of
462,000 shares of Microvision common stock. The March Notes are convertible on demand by
the holders into Microvision common stock at a conversion price of $6.84 per share of
Microvision common stock or Lumera common stock held by the Company at a conversion price
of $5.64 per share up to a limit of 1,750,000 shares of Lumera common stock. The right to
convert the March Notes into shares of Lumera common stock was removed pursuant to the
amendment described below. The initial conversion price is subject to adjustment in the event
Microvision issues common stock or common stock equivalents at a price per share of common
stock below the conversion price of the March Notes. Due to below market issuances of
Company’s common stock the conversion price of the March Notes at December 31, 2005 was
$5.54 per share of common stock. In addition, upon the request of the Note holders, the Company
is required to redeem the March Notes for cash upon a change of control or an event of default at a
redemption price equal to 125% of the then outstanding balance of the March Notes. The
Company has pledged 1,750,000 shares of its Lumera common stock as collateral for the March
Notes and the December Notes described above. Those shares have been classified as a
"Restricted investment in Lumera" on the Company's consolidated balance sheet.

The terms of the March Notes include interest at LIBOR plus 3.0% payable quarterly in
cash or Microvision common stock, at the election of the Company, subject to certain conditions.
However, in no case shall the interest rate be less than 6.0% or greater than 8.0%. If the Company
chooses to pay interest in Microvision common stock as opposed to cash, the price will be based
on 92% of the arithmetic average of the volume weighted average prices for the 10 trading days
prior to the payment date. The March Notes are payable in six equal quarterly installments
beginning in December 2005. The Company can subject to certain conditions, elect to make the
principal payments in common stock in lieu of cash. If the Company elects to pay principal in
common stock, the Note holders can elect to receive Microvision or Lumera common stock.
Payment in stock will be issued at a 10% discount to the arithmetic average of the volume
weighted average prices for the 15 trading days prior to the payment date. Additionally, the
Company can elect to convert the March Notes into Microvision common stock if the stock price
exceeds $11.97 per share for 20 out of any 30 consecutive trading days, subject to certain
conditions.

The Company concluded that the note holders’ right to convert all or a portion of the

March Notes into Microvision or Lumera common stock is an embedded derivative instrument as
defined by FASB Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities ("FAS 133"). Accordingly, $2,955,000 of the cash proceeds were allocated to the
embedded derivative instrument, which represents the fair value of the instrument on the date of
issuance. The derivative instrument was valued using the higher of the Microvision or Lumera
conversion feature. The value was determined using the Black Scholes option-pricing model with
the following assumptions: expected volatility of 83%; expected dividend yield of 0%; risk free
interest rate of 4.62%; and contractual life of nine months to two years, which corresponds to the
principal repayment dates. Due to changes in Lumera and Microvision’s stock price and
remaining contractual life, the fair value of the embedded derivative feature decreased to
$2,463,000 at July 25, 2005 the date of the deemed extinguishment described below. The
decrease in the fair value of $492,000 for the period from issuance to extinguishment was recorded
as a non-operating gain and included in "Gain on derivative features of note payable” in the
consolidated statement of operations. At December 31, 2005 total principal payments of $7.3
million remain under the March Notes.

The warrants issued with the March Notes vested on the date of grant, have an exercise price of
$6.84 per common share and expire in March 2010. The initial exercise price is subject to
adjustment in the event Microvision issues common stock or common stock equivalents at a price
per share of common stock below the exercise price of the warrant. Due to below market issuances
of Company’s common stock the exercise price of the warrants issued with the March Notes was
adjusted to $6.29 as of December 31, 2005.

The warrants met the definition of a derivative instrument that must be accounted for as a

liability under the provisions of Emerging Issues Task Force Issue No. 00-19, Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,
because the Company cannot engage in certain corporate transactions affecting the common stock
unless it makes a cash payment to the holders of the warrants. Accordingly, $1,651,000 of the
cash proceeds were allocated to the warrants, which represents the fair value of the warrants on the
date of issuance and the amount was recorded as a current liability. Subsequent changes in the fair
value of the warrants will be recorded in the statement of operations each period. The warrants
were valued using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 75%; expected dividend yield of 0%; risk free interest rate of 4.62%; and
contractual life of five years. The remaining gross proceeds of $5,394,000 were allocated to the
Notes.

In July 2005, the Company entered into an agreement to amend the March Notes. In
connection with the amendment, the Company issued three year warrants to purchase 750,000
shares of Microvision common stock at an exercise price of $6.84 per share. The conversion price
of the amended March Notes and exercise price of the warrants are subject to anti-dilution
adjustments, subject to conditions. In addition, the price at which the note holders can convert the
March Notes to Microvision common stock was reduced to $5.85 per share, and the price at which
the Company can mandatorily convert the March Notes to Microvision common stock was
reduced to $10.24. The note holders may convert all or a portion of their March Notes. As a
result of the amendment, the March Notes are no longer exchangeable into Lumera common stock.

The Company has concluded that the amendment of the Notes met the criteria of a debt

extinguishment. The Company recorded a charge of $3,313,000 for the change in the fair value of
the debt and related consideration between the original and the amended March Notes. The
change in the value was measured as the value of the additional warrants that were issued to the
note holders and the change in the price at which the debt could be converted to Microvision
common stock. The additional warrants were valued using the Black Scholes option-pricing
model with the following assumptions: expected volatility of 75%; expected dividend yield of
0%; risk free interest rate of 3.66%; and contractual life of three years. The additional warrants
were initially valued at $2,295,000. The change in the conversion feature was valued using the
Black Scholes option-pricing model with the following assumptions: expected volatility of 75%;
expected dividend yield of 0%; risk free interest rates ranging from 3.25% to 3.58% and
contractual life equal to the length of the option. The change in the conversion price was valued at
$1,018,000.

The amended conversion feature continued to meet the definition of a derivative in fair
value under FAS 133 and accordingly has been recorded at fair value and included within long-
term liabilities. The carrying amount of the derivative will be adjusted to fair value at each balance
sheet date. An adjustment of $2,712,000 was recorded for the period from July 25, 2005 to
December 31, 2005.

In October 2005, the noteholder converted $1.8 million of the March Notes to 310,000

shares of common stock. The value of the embedded derivative feature associated with the
converted shares of $439,000 was recorded to additional paid in capital.

The liability for both the initial warrant and the additional warrant are adjusted to the fair

market value of $1,273,000 at December 31, 2005. The combined adjustment during the year
ended December 31, 2005 was $2,672,000.

Convertible Preferred Stock – Note 10

In August 2005, the holder of the Company’s preferred stock agreed to convert 5,000 shares of the
Company’s preferred stock into 734,000 shares of common stock. As an inducement to convert
the preferred stock the Company issued 124,000 shares of its common stock to the preferred stock
holder and adjusted the exercise price from $8.16 to $6.84 per share for the existing warrants to
purchase 362,000 shares of common stock issued in connection with the original sale of the
Company’s preferred stock. The value of the common shares issued of $701,000, the change in
the value of the warrants of $62,000 and the amount of unamortized beneficial conversion feature
on the preferred stock of $421,000 was recorded as an inducement to convert the preferred stock
and charged to common shareholders in 2005.

In September 2004, Microvision raised $10,000,000 before issuance costs of $90,000
from the sale of 10,000 shares of convertible preferred stock and a warrant to purchase 362,000
shares of common stock. The preferred stock is convertible on demand by the holder into
common stock at a conversion price of $6.91 per share of common stock. The initial conversion
price is subject to adjustment in the event Microvision issues common stock or derivative
securities at a price per share of common stock below the market price or the conversion price of
the preferred stock. Due to below market issuances of Company’s common stock the conversion
price of the Preferred Stock as of December 31, 2005 was $6.36 per share of common stock.
In addition, upon the request of the preferred stockholder, Microvision is required to redeem the
preferred stock for cash in certain circumstances, including in the event of a material breach of
representations, warranties or covenants under the purchase agreement or a change in control.
Accordingly, Microvision has classified the preferred stock as “mandatorily redeemable
convertible preferred stock” in its consolidated balance sheet.

The preferred stock terms include a dividend of 3.5% per annum, payable quarterly in
cash or registered common stock, at the election of the Company, subject to certain conditions.
The preferred stock matures on September 10, 2007, at which time it is payable in cash or
registered common stock, at the election of the Company, subject to certain conditions. Some of
the conditions which would preclude the Company from paying in common stock are not within
the Company’s immediate control. The Company can elect to convert the preferred stock into
common stock if the stock price exceeds $12.09 per share, subject to certain conditions. The
warrant was vested on the date of grant, has an exercise price of $8.16 per share and expires on
September 10, 2009. The initial exercise price is subject to adjustment in the event Microvision
issues common stock or derivative securities at a price per share of common stock below the
market price or the exercise price of the warrant. Due to below market issuances of Company’s
common stock the exercise price of the warrants issued with the Preferred Stock was adjusted to
$6.40 as of December 31, 2005.

The net cash proceeds of $9,910,000 were allocated to the preferred stock and the warrant

based on the relative fair values of the securities. The warrants were valued using the Black
Scholes option-pricing model with the following assumptions: expected volatility of 75%, risk
free interest rate of 3.4%, and contractual life of five years. Proceeds of $1.3 million were
allocated to the warrant and were recorded as an increase to additional paid-in capital.

Subsequent to the relative fair value allocation, the effective conversion price of the

convertible preferred stock was less than the closing price of Microvision’s common stock on the
date of commitment to purchase the preferred stock resulting in the recognition of a beneficial
conversion feature in accordance with Emerging Issues Task Force No 00-27 “Application of
Issue No. 98-5 to Certain Convertible Instruments.”. This beneficial conversion feature was
measured as $1,181,000 which represents the difference between the fair value of the common
stock and the effective conversion price. This beneficial conversion feature was recorded to
additional paid-in capital and will be recorded as a deemed dividend to preferred stockholders
(accretion) over the stated life of the preferred stock which is three years. During 2005, the
Company recorded $280,000 in dividends on the preferred stock and $303,000 in accretion of the
beneficial conversion feature of the preferred stock.

Common stock – Note 11

In August and September 2005, the Company raised $7,000,000, before issuance costs, through
the sale of 1,333,000 shares of common stock at a price of $5.25 per share and five-year fully
exercisable warrants to purchase 301,000 shares of common stock at an exercise price of $6.50 per
share to a holder of the Company’s preferred stock and other investors. The holder of the
Company’s preferred stock also agreed to convert 5,000 shares of the Company’s preferred stock
into 734,000 shares of common stock. (See Note 10).

In November 2003, the Company raised $22,250,000, before issuance costs of
$1,454,000, from the sale of 3,560,000 shares of common stock to a group of private investors.

In August 2003, the Company issued 8,600 fully vested shares of Microvision common

stock to a professional services firm in connection with consulting services provided to the
Company. The shares were valued at $7.28, the closing price on the date of issuance, and the full
value of the shares, $63,000, was charged to non-cash compensation at the time of issuance.
In March 2003, the Company raised $12,560,000, before issuance costs of $970,000,
from the sale of 2,644,000 shares of common stock and warrants to purchase 529,000 shares of
common stock at an exercise price of $6.50 per share. Each share of common stock and
accompanying partial warrant was sold for $4.75. The warrants are first exercisable in September
2003 and expire in March 2008. The exercise price of the warrants was greater than the fair
market value of the common stock on the date of issue.

Warrants – Note 12

In September 2003, the Company issued two warrants to purchase an aggregate of 70,000 shares
of common stock to a third party in exchange for services provided to the Company. One warrant
grants the holder the right to purchase up to 60,000 shares of common stock at a price of $7.50 per
share. The warrant vests in three equal tranches on the date of grant, in December 2003, and
March 2004. The other warrant grants the holder the right to purchase up to 10,000 shares at a
price of $12.00 per share and vests in March 2004. The unvested warrants were subject to
remeasurement at each balance sheet date until vested. The deferred compensation related to these
warrants was being amortized to non-cash compensation expense over the fourteen month service
period of the agreement. Non-cash amortization expense related to these warrants was $140,000
and $192,000 for 2004 and 2003 respectively. The total value of the warrants was estimated on
December 31, 2003 and the grant date at $318,000 and $328,000, respectively. The fair values of
the warrants were estimated on the date of grant and December 31, 2003, using the Black Scholes
option-pricing model with the following weighted-average assumptions: expected volatilities of
83%, risk-free interest rates of 2.7% and dividend yields of zero percent. The contractual lives
used at the measurement dates above were 4 years and 3.9 years, respectively.

In August 2000, the Company issued warrants to purchase an aggregate of 200,000

shares of common stock to two consultants in connection with entering into certain consulting
agreements with the Company. One of the consultants subsequently became a director. The
warrants grant each of the holders the right to purchase up to 100,000 shares of common stock at a
price of $34.00 per share. The warrants to purchase an aggregate of 150,000 shares vested over
three years and were subject to remeasurement at each balance sheet date during the vesting
period. The remaining warrants to purchase an aggregate of 50,000 shares had a measurement
date at the time of grant. The deferred compensation related to these warrants is being amortized
to non-cash compensation expense over the five-year period of service under the agreements. The
total original value of both warrants were estimated at $5,476,000.

On June 7, 2003, the warrants became fully vested and the value of both warrants was

fixed. Total non-cash amortization expense was $270,000, $447,000, and $595,000 for the years
ended December 31, 2005, 2004 and 2003, respectively. The fair values of the warrants were
estimated at June 7, 2003 and December 31, 2002 using the Black Scholes option-pricing model
with the following weighted-average assumptions: dividend yield of zero percent, and expected
volatility of 83% for all measurement dates; risk-free interest rates of 4.0%, and 5.0% and
expected lives of 7.4 and 8.1 years.

The following summarizes activity with respect to Microvision common stock warrants during the
three years ended December 31, 2005:

O utstanding at De ce mbe r 31, 2002

975,000

18.10

Warrants to

purchase

common

We ighte d

ave rage

e xce rcise

price

Granted:

Exercise price greater than fair value

Exercise price less than fair value

Exercised

Canceled/expired

O utstanding at De ce mbe r 31, 2003

Granted:

Exercise price greater than fair value

Exercised

Canceled/expired

O utstanding at De ce mbe r 31, 2004

Granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercised

Canceled/expired

O utstanding at De ce mbe r 31, 2005

539,000

60,000

1,574,000

362,000

(22,000)

(196,000)

1,718,000

2,602,000

7,000

(207,000)

4,120,000

6.60

7.50

13.76

8.16

6.50

18.41

12.14

5.59

5.32

25.14

6.99

Exe rcisable at De ce mbe r 31, 2005

4,120,000

6.99

The following table summarizes information about the weighted-average fair value of Microvision
common stock warrants granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercise price less than fair value

Year Ended December 31,

2005

2004

2003

2.74

3.24

4.07

1.69

4.10

The following table summarizes information about Microvision common stock warrants
outstanding and exercisable at December 31, 2005:

Warrants outstanding and exercisable
Weighte d
average
remaining
contractual
life
(years)

We ighted
average
excercise
price

Number
outstanding at
December 31,
2005

1,090,000
241,000
1,513,000
1,006,000
70,000
200,000

4,120,000

4.92
1.64
3.47
2.65
1.70
4.61

3.94
4.81
6.25
6.47
8.14
34.00

Range of exe rcise prices

$3.94
$4.80-$5.32
$6.10-$6.29
$6.40-$6.56
$7.50-$12.00
$34.00

$3.94-$34.00

The fair value of the Microvision common stock warrants granted was estimated on the date of
grant using the Black Scholes option-pricing model with the following weighted-average
assumptions used for grants in 2005, 2004 and 2003, respectively: dividend yield of zero percent
for all years; expected volatility of 70%, 75% and 83%; risk-free interest rates of 4.2%, 3.4%, and
2.1% and expected lives of 4, 5 and 3 years, respectively.

Options – Note 13

The Company has several stock option plans (“Option Plans”) that provide for granting incentive
stock options (“ISOs”) and nonqualified stock options (“NSOs”) to employees, directors, officers
and certain non-employees of the Company as determined by the Board of Directors, or its
designated committee (“Plan Administrator”). The Company deems the fair market value of its
stock on any given trading day to be the closing price of its stock on the NASDAQ National
Market on that date.

In June 2005, shareholders approved an amendment to the Director Option Plan,

increasing the number of shares reserved for the plan by 400,000, to 900,000 shares.

In June 2004, the Company granted its independent directors options to purchase an

aggregate of 90,000 shares of common stock at an exercise price of $8.35. The exercise price of
the options was less than the fair market value of the shares at the date of grant. The Company
recorded $81,000 of deferred compensation expense related to these options in June 2004. The
deferred compensation was amortized to non cash compensation expense over the one-year
vesting period of the grants. Deferred compensation expense of $35,000 and $46,000 was
recorded in 2005 and 2004, respectively.

In December 2003, the Board of Directors authorized extending the original expiration

date for all outstanding employee options with original expiration terms of less than 10 years.
Under terms of the offer, employees could extend the life of options that had original lives less
than ten years by five years from the original expiration date. No other terms of the options were
amended. All options were fully vested on the offer date. The extensions were voluntary and, in
total, holders elected to extend 263,000 of the 264,000 eligible shares. At the time of the
extensions the Company recorded $145,000 in non-cash compensation expense for the excess of
the fair market value of the common stock over the relevant exercise prices of the options on the
modification date.

In November 2002, the Company offered to exchange most of its outstanding options to purchase
common stock for new options scheduled to be granted on or after June 11, 2003. All eligible
options that were properly submitted for exchange were accepted and cancelled effective
December 10, 2002. Employees tendered options to purchase an aggregate of 2,521,714 shares of
the Company’s common stock. Under the terms of the exchange program, the Company granted
new options to purchase an aggregate of 1,731,825 shares of the Company’s common stock on
June 13, 2003. The exercise price of the new options was $7.00 per share.

In May 2002, shareholders approved an amendment to the 1996 Stock Option Plan,

increasing the number of shares reserved for the Plan by 2,500,000 to 8,000,000. The
shareholders also approved amendments to the Independent Director Stock Option Plan (“Director
Option Plan”) that increased the total shares reserved for the Plan by 350,000 to 500,000 shares;
established a fully vested option grant to purchase 15,000 shares to each independent director
upon initial election or appointment to the Board of Directors; increased the number of shares
granted in the annual initial and reelection grants from 5,000 to 15,000; granted a one-time option
to each independent director to purchase 10,000 shares; and, authorized the Board of Directors to
make discretionary grants.

For Option Plan grants, other than non-discretionary grants to directors, the date of grant,
option price, vesting period and other terms specific to options granted are determined by the Plan
Administrator. The specific terms of Mandatory Director Grants are specified by the plan
document.

Stock options issued under the Option Plans, other than the Director Option Plan,
generally have vesting ranges from three years to four years; expirations of 10 years; and exercise
prices greater than or equal to the fair market value of the Company’s stock on the date of grant.

The Director Option Plan provides for two types of Mandatory Grants: a fully vested

option to purchase 15,000 shares of common stock to each independent director upon initial
election or appointment to the Board of Directors, and an additional initial or annual reelection
option to purchase 15,000 shares of common stock, which the earlier of one year or no later than
the Company’s subsequent regularly scheduled annual shareholders’ meeting. For both types of
Mandatory Grants, the exercise prices are set equal to the closing price of the Company’s common
stock as reported on the NASDAQ National Market on the date of grant and have ten year terms.
Upon leaving the Board, the director’s grants remain exercisable until their expiration dates.

The following table summarizes activity with respect to Microvision common stock options for
the three years ended December 31, 2005:

O utstanding at De ce mbe r 31, 2002

3,076,000

16.03

Weighted

ave rage

e xce rcise

price

Granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercise price less than fair value

Exercised

Forfeited

O utstanding at De ce mbe r 31, 2003

Granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercise price less than fair value

Exercised

Forfeited

O utstanding at De ce mbe r 31, 2004

Granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercise price less than fair value

Exercised

Forfeited

O utstanding at De ce mbe r 31, 2005

1,935,000

378,000

197,000

(82,000)

(783,000)

4,721,000

177,000

487,000

90,000

(38,000)

(319,000)

5,118,000

274,000

300,000

(5,000)

(367,000)

5,320,000

7.15

6.76

6.93

6.60

10.06

12.43

7.55

6.76

8.35

6.25

12.03

11.72

5.34

5.32

4.03

10.99

11.09

Exe rcisable at De ce mbe r 31, 2005

4,515,000

11.90

The following table summarizes information about the weighted-average fair value of Microvision
common stock options granted:

Exercise price greater than fair value

Exercise price equal to fair value

Exercise price less than fair value

3.21

3.66

3.19

3.33

4.58

3.19

4.26

2.69

Year Ended December 31,

2005

2004

2003

The following table summarizes information about Microvision common stock options
outstanding and exercisable at December 31, 2005:

O ptions outstanding

O ptions exercisable

Weighted

Number

average

Weighted

Number

Weighted

outstanding at

remaining

average

excercisable at

average

De cember 31,

contractual

e xcercise

December 31,

excercise

Range of exercise prices

2005

$3.25-$5.32

$5.33-6.99

$7.00-7.07

$7.19-10.00

$10.20-14.94

$15.00-15.16

$15.63-60.75

$3.25-$60.75

558,000

549,000

1,582,000

561,000

565,000

874,000

631,000

5,320,000

life

(years)

9.05

7.70

7.46

7.14

5.69

5.81

4.72

price

2005

price

5.09

6.13

7.00

7.82

11.58

15.00

27.99

4.89

6.18

7.00

7.91

11.66

15.00

27.99

133,000

474,000

1,574,000

354,000

475,000

874,000

631,000

4,515,000

Fair Value Disclosures The fair values of Microvision common stock options granted were
estimated on the date of each grant using the Black Scholes option pricing model with the
following weighted average assumptions used for grants in 2005, 2004 and 2003, respectively:
dividend yield of zero percent for all years; expected volatility of 70%, 76% and 83%; risk free
interest rates of 4.0%, 3.0%, and 2.2%; and expected lives of 5, 3 and 3 years. Actual forfeitures
of 7.2%, 6.8% and 25.4% were used for the years ended December 31, 2005, 2004, and 2003
respectively. Excluding shares cancelled under the voluntary extension for grants with terms less
than ten years, the actual forfeiture rate for 2003 was 16.3%.

Commitments and contingencies – Note 14

Agreements with the University of Washington

In October 1993, the Company entered into a Research Agreement and an exclusive license
agreement (“License Agreement”) with the UW. The License Agreement grants the Company the
rights to certain intellectual property, including the technology being subsequently developed
under the Microvision research agreement (“Research Agreement”), whereby the Company has an
exclusive, royalty-bearing license to make, use and sell or sublicense the licensed technology. In
consideration for the license, the Company agreed to pay a one-time nonrefundable license issue
fee of $5,134,000. Payments under the Research Agreement were credited to the license fee. In
addition to the nonrefundable fee, which has been paid in full, the Company is required to pay
certain ongoing royalties. Beginning in 2001, the Company is required to pay the UW a
nonrefundable license maintenance fee of $10,000 per quarter, to be credited against royalties due.

Litigation

The Company is subject to various claims and pending or threatened lawsuits in the normal course
of business. The Company is not currently party to any legal proceedings that management
believes the adverse outcome of which would have a material adverse effect on the Company’s
financial position, results of operations or cash flows.

Lease commitments

The Company leases its office space and certain equipment under noncancelable capital and
operating leases with initial or remaining terms in excess of one year. The Company entered into
a facility lease that commenced in April 1999, which includes extension and rent escalation
provisions over the seven-year term of the lease. Rent expense is recognized on a straight-line
basis over the lease term.

The Company entered into a 90 month facility lease that commenced in February 2006. The lease
includes extension and rent escalation provisions over the 90 month term of the lease. Rent
expense will be recognized on a straight-line basis over the lease term.

Future minimum rental commitments under capital and operating leases for years ending
December 31 are as follows:

Capital

leases

O perating

leases

41,000

2006

2007

2008

2009

2010

T hereafter

T otal minimum lease payments

Less: Amount representing interest

Present value of capital lease obligations

Less: Current portion

Long-term obligation at December 31, 2005

741,000

850,000

834,000

837,000

867,000

2,400,000

6,529,000

39,000

33,000

27,000

20,000

160,000

(23,000)

137,000

(32,000)

105,000

Operating lease commitments amounts do not include the impact of contractual sublease receipts
of $79,000 for the year ended December 31, 2006.

The capital leases are collateralized by the related assets financed and by security deposits held by
the lessors under the lease agreements. The cost and accumulated depreciation of equipment
under capital leases was $1,309,000, and $1,140,000, respectively at December 31, 2005 and
$1,175,000 and $1,053,000, respectively, at December 31, 2004.

Net rent expense was $1,435,000, $1,689,000, and $2,302,000 for 2005, 2004 and 2003,
respectively. Rent expense in 2003 includes $540,000 for the closure of the Company’s facility in
San Mateo, California. Sub- lease income of $575,000, $363,000 and $226,000 for 2005, 2004,
and 2003 respectively was included as a reduction in rent expense.

Long-term debt

During 1999, the Company entered into a loan agreement with the lessor of the Company’s
corporate headquarters to finance $420,000 in tenant improvements. The loan carries a fixed
interest rate of 10% per annum, is repayable over the initial term of the lease, which expires in
2006, and is secured by a letter of credit. The balance of the loan was $22,000 and $99,000 at
December 31, 2005 and 2004 respectively.

Income taxes – Note 15

A provision for income taxes has not been recorded for 2005, 2004 or 2003 due to valuation
allowances placed against the net operating losses and deferred tax assets arising during such
periods. A valuation allowance has been recorded for all deferred tax assets because based on the
Company's history of losses since inception, the available objective evidence creates sufficient
uncertainty regarding the realizability of the deferred tax assets.

At December 31, 2005, Microvision has net operating loss carry forwards of approximately $191
million, for federal income tax reporting purposes. In addition, Microvision has research and
development tax credits of $2,559,000. The net operating loss carry forwards and research and
development credits available to offset future taxable income, if any, will expire in varying
amounts from 2008 to 2025 if not previously utilized. In certain circumstances, as specified in the
Internal Revenue Code, a 50% or more ownership change by certain combinations of the
Company’s stockholders during any three-year period would result in limitations on the
Company’s ability to utilize its net operating loss carry-forwards. The Company has determined
that such a change occurred during 1995 and the annual utilization of loss carry-forwards
generated through the period of that change will be limited to approximately $761,000. An
additional change occurred in 1996; and the limitation for losses generated in 1996 is
approximately $1,600,000.
Deferred tax assets are summarized as follows:

Decembe r 31,

2005

2004

Net operating loss carry forwards Microvision

65,006,000

57,112,000

R&D credit carry forwards Microvision

Other

Less: Valuation allowance

Deferred tax assets

2,559,000

3,463,000

2,218,000

4,642,000

71,028,000

63,972,000

(71,028,000)

(63,972,000)

The valuation allowance and the research and development credit carry forwards account for
substantially all of the difference between the Company’s effective income tax rate and the
Federal statutory tax rate of 34%.

Certain net operating losses arise from the deductibility for tax purposes of compensation under
nonqualified stock options equal to the difference between the fair value of the stock on the date of
exercise and the exercise price of the options. For financial reporting purposes, the tax effect of
this deduction when recognized is accounted for as a credit to shareholders’ equity.

Retirement savings plan – Note 16

The Company has a retirement savings plan (“the Plan”) that qualifies under Internal Revenue
Code Section 401(k). The Plan covers all qualified employees. Contributions to the Plan by the
Company are made at the discretion of the Board of Directors.

In February 2000, the Board of Directors approved a plan amendment to match 50% of employee
contributions to the Plan up to 6% of the employee’s per pay period compensation, starting on
April 1, 2000. During 2005, 2004 and 2003, the Company contributed $321,000, $337,000 and
$392,000 respectively, to the Plan under the matching program.

Segment Information – Note 17

Prior to Lumera’s initial public offering in July 2004, the Company was organized into two
segments – Microvision, which is engaged in scanned beam displays and related technologies, and
Lumera, which is engaged in optical systems components technology. The segments were
determined based on how management views and evaluates the Company’s operations.

The accounting policies used to derive reportable segment results are described in Note 2,
“Summary of Significant Accounting Policies.”

A portion of each segments’ administration expenses arise from shared services and infrastructure
that Microvision has provided to both segments in order to realize economies of scale and to
efficiently use resources. These efficiencies include costs of certain legal, accounting, human
resources and other Microvision corporate and infrastructure costs. These expenses are allocated
to the segments and the allocation has been determined on a basis that the Company considered to
be a reasonable reflection of the utilization of services provided to, or benefits received by, the
segments.

Since 2000, Microvision has held an investment in Lumera. From inception to July 2004, Lumera
was a consolidated subsidiary and treated as a separate segment within Microvision. Subsequent
to July 2004, Lumera became an equity method investment. Since July 2004, Microvision has
operated as one segment.

At December 31, 2005 and 2004, Lumera was a significant unconsolidated equity investment of
Microvision. For 2005 Lumera revenue was $1,509,000, Gross profit was $587,000, Loss from
operations was $11,108,000 and Net loss was $10,453,000 For the period that Lumera was an
unconsolidated investment in 2004 (July 2004 through December 31, 2004) Lumera revenue was
$303,000, Gross profit was $85,000, Loss from operations was $5,205,000 and Net loss was
$5,199,000. At December 31, 2005 Lumera had Current assets of $22,384,000, Noncurrent assets
of $1,322,000, Current liabilities of $1,552,000 and Shareholders equity of $22,154,000 At
December 31, 2004 Lumera had Current assets of $19,623,000, Noncurrent assets of $13,263,000,
Current liabilities of $1,493,000 and Shareholders equity of $31,393,000.

The following tables reflect the results of the Company’s reportable segments under the
Company’s management system. The performance of each segment is measured based on several
metrics. These results are used, in part, by management, in evaluating the performance of, and in
allocation of resources to, each of the segments (in thousands):

Contract Revenue

Product Revenue

Cost of Contract Revenue

Cost of Product Revenue

Research and development expense

Marketing, general and administrative expense

Non-cash compensation expense

Interest income

Interest expense

Segment loss

Depreciation

Expenditures for capital assets

Segment assets

Contract Revenue

Product Revenue

Cost of Contract Revenue

Cost of Product Revenue

Research and development expense

Marketing, general and administrative expense

Non-cash compensation expense

Interest income

Interest expense

Segment loss

Depreciation

Expenditures for capital assets

Segment assets

Year Ended December 31, 2004

Microvision

Lumera

Elimination

Total

8,135

686

2,597

5,106

3,868

13,581

17,795

821

270

32,257

1,711

970

25,538

433

1,129

1,433

1,297

120

3,724

695

(2,438)

8,821

2,597

5,539

3,868

14,710

19,228

2,118

272

151

33,543

2,406

1,040

25,538

Year Ended December 31, 2003

Microvision

Lumera

Elimination

Total

11,792

1,725

1,135

5,015

1,017

16,755

14,557

1,115

342

25,205

1,924

1,094

37,224

1,014

6,561

1,270

1,041

8,083

1,185

455

4,058

(7,125)

(7,364)

13,517

1,135

6,029

1,017

23,316

15,827

2,156

381

26,163

3,109

1,549

33,918

Quarterly Financial Information (Unaudited) – Note 18

The following table presents the Company’s unaudited quarterly financial information for the
years ending December 31, 2005 and 2004:

Year Ende d De cember 31, 2005

December 31,

September 30,

June 30,

March 31,

Revenue

Gross Margin

Net loss available for common shareholders

Net loss per share basic and diluted

2,709,000

3,330,000

4,725,000

(1,756,000)

(5,566,000)

(0.23)

(434,000)

840,000

(12,571,000)

(4,968,000)

(7,179,000)

(0.56)

(0.23)

(0.33)

3,982,000

1,004,000

Revenue

Gross Margin

Net loss

Year Ende d De cember 31, 2004

December 31,

September 30,

June 30,

March 31,

3,317,000

2,729,000

2,398,000

76,000

263,000

568,000

2,974,000

1,104,000

(8,247,000)

(10,094,000)

(8,512,000)

(6,690,000)

Net loss per share basic and diluted

(0.38)

(0.47)

(0.40)

(0.31)

Subsequent Event – Note 19

In January 2006, the Company raised $10,324,000 from the sale of 2,550,000 shares of Lumera
common stock. As a result of the sale, the Company will record a “gain on sale of equity
subsidiary” of approximately $7.3 million. Subsequent to the sale, the Company owned 2,072,000
shares, or 12%, of the outstanding shares of Lumera common stock. After January 31, 2006, due
to the change in ownership percentage, Microvision will account for its investment in Lumera
using the cost method.

In January 2006 the Chief Executive Officer's employment was terminated and the Chief Financial
Officer resigned. The Company appointed Alexander Y. Tokman to Chief Executive Officer in
January 2006.

CONTROLS AND PROCEDURES - Item 9A

(a) Evaluation of disclosure controls and procedures. The Chief Executive Officer and the Principal Financial
Officer evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities and Exchange Act of 1934 (the “Exchange Act”) prior to the filing of this annual report. Based on that
evaluation, they concluded that, as of the end of the period covered by this annual report, our disclosure controls and
procedures were, in design and operation is effective and such information is accumulated and communicated to
management as appropriate to allow timely decisions regarding required disclosure.
(b) Management’s Report on Internal Control Over Financial Reporting. Our management is responsible for
establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange
Act Rule 13a-15(f). Our management conducted an evaluation of the effectiveness of our internal control over
financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Based on its evaluation under the framework in Internal
Control — Integrated Framework, our management concluded that our internal control over financial reporting was
effective as of December 31, 2005.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December
31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which is included in Item 8 of this Annual Report on Form 10-K.
(c) Changes in internal controls over financial reporting. There have not been any changes in the Company’s
internal control over financial reporting during the quarter ended December 31, 2005 which have materially
affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION

Overview The Company commenced operations in May 1993 to develop and commercialize technology for
displaying images and information onto the retina of the eye. In 1993, the Company acquired an exclusive
license to the Virtual Retinal Display technology from the University of Washington and entered into a
research agreement with the University of Washington to further develop the Virtual Retinal Display
technology. The Company has continued to develop the Virtual Retinal Display technology as part of its
broader research and development efforts relating to the scanned beam technology.

In February 2004, Microvision introduced a new version of its see-through monochrome head-

worn display called Nomad Expert Technician System. The Company also produces and sells Flic, a hand-
held bar code scanner. The Company has also developed demonstration scanned beam displays, including
hand-held and head-worn color versions and is currently refining and developing its scanned beam display
technology for potential medical, defense, industrial, aerospace and consumer applications. The Company
expects to continue funding prototype and demonstration versions of products incorporating the scanned
beam technology at least through 2006. Future revenues, profits and cash flow and the Company’s ability
to achieve its strategic objectives as described herein will depend on a number of factors, including
acceptance of the scanned beam technology by various industries and original equipment manufacturers,
market acceptance of products incorporating the scanned beam technology and the technical performance
of such products.

The Company has incurred substantial losses since its inception and expects to incur a substantial

loss during the year ended December 31, 2006.

Key Accounting Policies and Estimates The Company’s discussions and analysis of its financial condition
and results of operations are based upon the Company’s consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the United States. The preparation
of these financial statements requires the Company to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent
liabilities. On an on-going basis, the Company evaluates its estimates, including those related to revenue
recognition, contract losses, bad debts, investments and contingencies and litigation. The Company bases
its estimates on historical experience, terms of existing contracts, its evaluation of trends in the display and
image capture industries, information provided by its current and prospective customers and strategic
partners, information available from other outside sources, and on various other assumptions management
believes to be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following key accounting policies require its more significant

judgments and estimates used in the preparation of its consolidated financial statements:

Revenue Recognition The Company recognizes contract revenue as work progresses on long-term, cost
plus fixed fee and fixed price contracts using the percentage-of-completion method, which relies on
estimates of total expected contract revenue and costs. The Company uses this revenue recognition
methodology because it can make reasonably dependable estimates of the revenue and costs. Recognized
revenues are subject to revisions as the contract progresses to completion and actual revenue and cost
become certain. Revisions in revenue estimates are reflected in the period in which the facts that give rise
to the revision become known.

Revenue from product shipments is recognized in accordance with Staff Accounting Bulletin No.
104 “Revenue Recognition.” Revenue is recognized when there is sufficient evidence of an arrangement,
the selling price is fixed and determinable and collection is reasonably assured. Revenue for product
shipments is recognized upon acceptance of the product by the customer or expiration of the contractual
acceptance period, after which there are no rights of return. Provisions are made for warranties at the time
revenue is recorded. Warranty expense was not material for any periods presented.

Losses on Uncompleted Contracts The Company maintains an allowance for estimated losses if a
contract has an estimated cost to complete that is in excess of the remaining contract value. The entire
estimated loss is recorded in the period in which the loss is first determined. The Company determines the
estimated cost to complete a contract through a detail review of the work to be completed, the resources
available to complete the work and the technical difficulty of the remaining work. If the actual cost to
complete the contract is higher than the estimated cost, the entire loss is recognized. The actual cost to
complete a contract can vary significantly from the estimated cost, due to a variety of factors including
availability of technical staff, availability of materials and technical difficulties that arise during a project.
Most of the Company’s development contracts are cost plus fixed fee type contracts. Under these types of
contracts, the Company is not required to spend more than the contract value to complete the contracted
work.

Allowance for uncollectible receivables The Company maintains allowances for uncollectible receivables,
including accounts receivable, cost and estimated earnings in excess of billings on uncompleted contracts
and receivables from related parties. The Company reviews several factors in determining the allowances
including the customer’s past payment history and financial condition. If the financial condition of our
customers or the related parties with whom the Company has receivables were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances could be required.

Inventory. The Company values inventory at the lower of cost or market with cost determined on a
weighted average cost basis. The Company reviews several factors in determining the market value of its
inventory including evaluating the replacement cost of the raw materials and the net realizable value of the
finished goods. If we do not achieve our targeted sales prices, if market conditions for our components or
products were to decline or if we do not achieve our sales forecast, additional reductions in the carrying
value of the inventory would be required.

Warrants and Derivatives The Company has issued convertible notes that include rights to convert the
notes into Microvision common stock. The Company also issued warrants to purchase common stock in
connection with the notes. The Company accounts for these derivatives and warrants under the guidance
provided by FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities and
Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to,
and Potentially Settled in, a Company’s Own Stock. The Company uses the Black Scholes option pricing
model to estimate the value of these instruments. The Company uses the Black Scholes model because it is
widely accepted and provides comparability across a wide range of similar companies. The use of the
Black Scholes model requires management to evaluate a range of estimates and determine the reasonable
estimate of future stock volatility and interest rates. Changes in these estimates could result in a materially
different valuation of the instruments. Other models for valuing these instruments exist and the use of an
alternative model could result in a materially different valuation of the instruments.

Litigation The Company believes that the probability of an unfavorable outcome to any potential pending
or threatened litigation is low and therefore has not recorded an accrual for any potential loss. The
Company’s current estimated range of liability related to any potential pending litigation is based on claims
for which our management can estimate the amount and range of potential loss. As additional information
becomes available, the Company will assess the potential liability related to any pending litigation and, if
appropriate, revise its estimates. Such revisions in the Company’s estimates of the potential liability could
materially impact our results of operation and financial position.

The key accounting policies described above are not intended to be a comprehensive list of all of
our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically
dictated by generally accepted accounting principles, with no need for management to apply its judgment
or make estimates. There are also areas in which management’s judgment in selecting any available
alternative would not produce a materially different result to the Company’s consolidated financial
statements. Additional information about Microvision’s accounting policies, and other disclosures required
by generally accepted accounting principles, are set forth in the notes to the Company’s consolidated
financial statements.

Inflation has not had a material impact on the Company’s net sales, revenues, or income from

continuing operations over the Company’s three most recent fiscal years.

Results of Operations Since 2000, Microvision has held an investment in Lumera. From inception to July
2004, Lumera was a consolidated subsidiary and treated as a separate segment within the Company.
Subsequent to July 2004, Lumera became an equity method investment and the Company now operates
under one segment.

Prior to Lumera’s initial public offering in July 2004, the Company was organized into two
segments - Microvision, which is engaged in scanned beam displays and related technologies, and Lumera,
which is engaged in optical systems components technology. Up to the date of Lumera's initial public
offering, the segments were determined based on how management viewed and evaluated the Company’s
operations.

A portion of each segments’ administration expenses arose from shared services and infrastructure
that Microvision had provided to both segments in order to realize economies of scale and to efficiently use
resources. These efficiencies include costs of certain legal, accounting, human resources and other
Microvision corporate and infrastructure costs. These expenses were allocated to the segments and the
allocation was determined on a basis that the Company considered to be a reasonable reflection of the
utilization of services provided to, or benefits received by, the segments.

After Lumera's initial public offering, Lumera became a significant unconsolidated equity

investment of Microvision.

The following tables reflect the results of the Company’s reportable segments for the years ended
December 31, 2004 and 2003 under the Company’s management system. The performance of each
segment was measured based on several metrics. Since July 2004 Microvision has operated as one
segment. These results were used, in part, by management, in evaluating the performance of, and in
allocation of resources to, each of the segments (in thousands):

Contract Revenue

Product Revenue

Cost of Contract Revenue

Cost of Product Revenue

Research and development expense

Marketing, general and administrative expense

Non-cash compensation expense

Interest income

Interest expense

Segment loss

Depreciation

Expenditures for capital assets

Segment assets

Contract Revenue

Product Revenue

Cost of Contract Revenue

Cost of Product Revenue

Research and development expense

Marketing, general and administrative expense

Non-cash compensation expense

Interest income

Interest expense

Segment loss

Depreciation

Expenditures for capital assets

Segment assets

Year Ended December 31, 2004

Microvision

Lumera

Elimination

Total

8,135

686

2,597

5,106

3,868

13,581

17,795

821

270

32,257

1,711

970

25,538

433

1,129

1,433

1,297

120

3,724

695

(2,438)

8,821

2,597

5,539

3,868

14,710

19,228

2,118

272

151

33,543

2,406

1,040

25,538

Year Ended December 31, 2003

Microvision

Lumera

Elimination

Total

11,792

1,725

1,135

5,015

1,017

16,755

14,557

1,115

342

25,205

1,924

1,094

37,224

1,014

6,561

1,270

1,041

8,083

1,185

455

4,058

(7,125)

(7,364)

13,517

1,135

6,029

1,017

23,316

15,827

2,156

381

26,163

3,109

1,549

33,918

YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004

Contract Revenue Contract revenue increased by $2.6 million, or 29%, to $11.4 million from $8.8 million
in 2004. The increase resulted from a higher level of development contract business performed in 2005 than
that performed in 2004 on contracts entered into in both 2005 and 2004. In 2005, 43% and 35% of contract
revenue was earned from development contracts with a single commercial customer and a single U. S.
government customer, respectively.

Contract revenue is earned from the Company’s work on development contracts with the United

States government and commercial enterprises. In 2005, 46% of contract revenue was derived from
performance on development contracts with the United States government and 54% from performance on
development contracts with commercial customers. In comparison, 55% of contract revenue was derived
from performance on development contracts with the United States government and 45% from performance
on development contracts with commercial customers in 2004. The Company expects contract revenue to
fluctuate significantly from year to year.

In June 2005, the Company entered into a $4.4 million contract with General Dynamics C4

Systems to continue the development of a helmet-mounted display for the Air Warrior Block 3 system.
General Dynamics is under contract with the U.S. Army's Product Manager -- Air Warrior in Huntsville,
Ala., to develop and integrate the Air Warrior Block 3 system. The Microvision helmet-mounted display
is being designed as a full-color, see-through, daylight and night-readable, high-resolution display.

The Company had a contract revenue backlog of $2.8 million at December 31, 2005. The backlog

is composed of development contracts, including amendments, entered through December 31, 2005. The
Company plans to complete all of the contract backlog during 2006.

Product Revenue Microvision earns product revenue from the sale of Nomad and Flic. Microvision
recognizes revenue on product sales upon customer acceptance or when the right to return has expired.
Product revenue increased $800,000 or 29% to $3.4 million from $2.6 million in 2004. Revenue from
Nomad sales increased by approximately $900,000 in 2005 from 2004, while revenue from Flic sales
decreased by approximately $100,000 over the same period.

During 2005, Microvision earned $1.8 million from the sale of approximately 300 Nomads
compared to $864,000 from the sale of approximately 200 Nomads in 2004. Microvision introduced a new
version of the Nomad in March 2004. The new version is 40% smaller than the previous version and cost
less to produce. Microvision is targeting truck and automotive repair and military applications for the
Nomad.

The Nomad has not gained the commercial acceptance the company had planned when the product

was introduced. In January 2006 the Company took steps to reduce its cost in manufacturing, sales and
marketing of Nomad until it develops a go to market strategy that will be more successful. The Company
is working with a small number of potential customers to define applications and business cases for the
Nomad. Defining the business case consists of studying the potential customers work environment,
identifying operations that could be performed more economically using Nomad, conducting trials to
demonstrate the cost savings, collecting customer feedback, making modifications or improvements to the
applications or the Nomad, and then developing sales tools to take advantage of the proven benefits. The
company expects to take at least the first half of 2006 to develop a go to market strategy for Nomad. Until
the go to market strategy is complete the Company expects limited sales of Nomad.

During 2005 and 2004, Microvision recorded $1.6 million and $1.7 million respectively, in
revenue from sales of Flic barcode scanners. Revenue from Flic was negatively impacted in 2005 by
delays in product shipments from the Company’s contract manufacturer. The Company is working closely
with its contract manufacturer to improve deliveries of Flic.

The Company had a product revenue backlog of $579,000 at December 31, 2005. The backlog is
composed primarily of orders for Flic received through December 31, 2005. The Company plans to deliver
all products in backlog during 2006.

Cost of Contract Revenue. Cost of contract revenue includes both the direct and allocated indirect costs of
performing on development contracts. Direct costs include labor, materials and other costs incurred
directly in performing specific projects. Indirect costs include labor and other costs associated with
operating the Company’s research and product development department and building the technical
capabilities of the Company. Cost of contract revenue is determined both by the level of direct costs
incurred on development contracts and by the level of indirect costs incurred in managing and building the
technical capabilities and capacity of the Company. The cost of contract revenue can fluctuate
substantially from period to period depending on the level of both the direct costs incurred in the
performance of projects and the level of indirect costs incurred.

Cost of contract revenue increased by $917,000, or 17%, to $6.5 million from $5.5 million. On a

percentage of contract revenue basis, cost of contract revenue decreased to 57% from 63% in 2004. The
change in cost of contract revenue as a percentage of contract revenue is primarily attributable to changes
in the contract costs mix. Total direct costs in 2005 increased approximately 23% from 2004. The direct
labor cost portion of direct cost increased by approximately 8% from 2004. The increase in direct labor
cost resulted from a higher volume of contract work performed during 2005 compared to 2004.

Research and development overhead is allocated to both cost of contract revenue and research and

development expense based on the proportion of direct labor cost incurred in cost of contract revenue and
research and development, respectively.

The Company expects that cost of contract revenue on an absolute dollar basis will increase in the

future. This increase will likely result from planned additional development contract work that the
Company expects to perform, and commensurate growth in the Company’s personnel and technical
capacity required to perform on such contracts. The cost of contract revenue, as a percentage of contract
revenue, can fluctuate significantly from period to period depending on the contract mix and the level of
direct and indirect cost incurred.

Cost of Product Revenue Cost of product revenue includes both the direct and allocated indirect costs of
manufacturing Nomads and Flics sold to customers. Direct costs include labor, materials and other costs
incurred directly in the manufacture of Flic and Nomad. Indirect costs include labor and other costs
associated with maintaining Microvision manufacturing capabilities and capacity. Cost of product revenue
increased $4.7 million or 123% to $8.6 million from $3.9 million in 2004.

Microvision’s costs to produce Nomad units during 2005 were substantially higher than product

revenue. Until October 2004, Microvision classified production cost in excess of product revenue as
research and development expense. In October 2004, management determined that Nomad production and
manufacturing processes were sufficiently mature to support “commercial production” as described in
SFAS No. 2 “Accounting for Research and Development Costs”. As a result of this determination
Microvision began full absorption of manufacturing overhead cost.

Cost of product revenue in 2005 includes the write off of $3.0 million of Nomad inventory and

$700,000 of Flic inventory. The writeoff’s were due to changes in product design and customer demand
that caused components and accessories to become obsolete or excess to forecasted demand. Microvision
values inventory at the lower of cost or market. Microvision also reduces the value of its raw material
inventory to its estimated scrap value when management determines that it is not probable that the
inventory will be utilized through normal production during the next 12 months.

Manufacturing overhead is allocated to inventory, cost of product revenue, cost of contract

revenue, and research and development expense based on the proportion of direct material purchased for
the respective activity. During 2005, the Company expensed approximately $1.5 million of manufacturing
overhead associated with production capacity in excess of production requirements

In January 2006, the Company implemented a plan that included steps to reduce production costs.
These steps included ongoing activities to improve product quality and reductions in overhead costs. The
Company expects gross margins on product sales to improve in 2006.

The Company expects that cost of product revenue on an absolute dollar basis will increase in the

future. This increase will likely result from increased shipments of commercial products. The Company
expects that cost of product revenue will be higher than product revenue until the Company achieves sales
volumes that match its production capability.

Research and Development Expense Research and development expense consists of:

•

•
•
•
•

compensation related costs of employees and contractors engaged in internal research and product
development activities,
research fees paid to the University of Washington under the Lumera Sponsored Research
Agreement (prior to July 2004),
laboratory operations, outsourced development and processing work,
fees and expenses related to patent applications, prosecution and protection,
related operating expenses and
costs relating to acquiring and maintaining licenses.

Research and development expense decreased by $8.1 million, or 55%, to $6.6 million from $14.7 million
in 2004.

Research and development expense in 2004 included approximately $4.3 million in manufacturing

overhead associated with Nomad production. The Company classified Nomad manufacturing expense in
excess of Nomad product revenue as research and development expense until the Nomad design and
production capabilities were sufficiently mature to support commercial production in the fourth quarter of
2004.

Research and Development expense attributable to Lumera was $1.1 million in 2004. The
decrease in Research and Development expense attributable to Lumera accounts for 14% of the decrease in
consolidated Research and Development expense.

The Company allocates research and development resources to customer funded projects and

internally funded projects based on management's determination of customer requirements, product
development requirement, and the availability of research and development resources to meet project
objectives. During 2005 the Company allocated $917,000 more resources to customer funded projects than
in 2004.

The Company believes that a substantial level of continuing research and development expense
will be required to develop commercial products using the scanned beam technology. Accordingly, the
Company anticipates that its research and development expenditures will continue to be significant. These
expenses could be incurred as a result of:

•
•
•
•
•

subcontracting work to development partners,
expanding and equipping in-house laboratories,
acquiring rights to additional technologies,
incurring related operating expenses, and
hiring additional technical and support personnel.

The Company expects that the amount of spending on research and product development will remain

high in future quarters as we:

•
•

•

continue development and commercialization of the Company’s scanned beam technology,
accelerate development of the integrated photonics module to meet emerging market
opportunities, and
pursue other potential business opportunities.

Sales, Marketing, General and Administrative Expense Sales, marketing, general and administrative
expenses include compensation and support costs for sales, marketing, management and administrative
staff, and for other general and administrative costs, including legal and accounting, consulting and other
operating expenses.

The Company’s marketing activities include corporate awareness campaigns, such as web site
development and participation at trade shows, corporate communications initiatives, and working with
potential customers and joint venture partners to identify and evaluate product applications in which the
Company’s technology could be integrated or otherwise used.

Sales, marketing, general and administrative expenses increased by $695,000, or 4%, to

$19.9million from $19.2 million in 2004. The increase in sales, marketing, general and administrative
expenses are due to the increase in sales and marketing activity related to Nomad and Flic sales. The
Company has added sales staff, demonstration equipment and promotion materials to support increased
sales of Nomad and Flic.

In 2000, the Board of Directors authorized Microvision to provide unsecured lines of credit to each of its
three senior officers. No loans have been made under either Microvision’s Executive Option Exercise Note
Plan or the Executive Loan Plan since July 2002, and Microvision does not intend to make any additional
loans under these plans. A total of $2,723,000 was issued and remains outstanding under the Executive
Loan Plan. There are currently no outstanding loans under the Executive Option Exercise Note Plan.

In 2005, Microvision determined that certain of its senior officers may have had insufficient net

worth and short-term earnings potential to repay their outstanding loans. As a result, Microvision recorded
additional allowances for doubtful accounts for the receivables from senior officers of $1,031,000. The
balance of the allowance for doubtful accounts for receivables from senior officers was $1.9 million at
December 31, 2005. Two of the officers left the Company in January 2006. In accordance with the terms,
the loans will be due in January 2007. Microvision has no plans to forgive any portion of the principal of
the outstanding receivable balance.

In January 2006, the Company took the following steps to reduce sales, marketing, general and

administrative expense:

• Reduced the number of executive officers and vice presidents by 50%.
• Reduced the sales and marketing costs for Nomad until the Company completes a new go to

market strategy.

After the expected decline in 2006 compared to 2005, the Company anticipates sales, marketing, general
and administrative expenses will increase as product revenue increases in future periods and as the
Company:
•
• makes additional investments in sales and marketing activities, and
•

increases the level of corporate and administrative activity.

adds to its sales and marketing staff,

Non-Cash Compensation Expense Non-cash compensation expense includes the amortization of the value
of stock options granted to individuals who are not employees or directors of the Company for services
provided to the Company as well as employee stock based compensation expenses. Non-cash
compensation expense decreased by $1.7 million or 80% to $429,000 from $2.1 million in 2004.

The following table shows the components of non-cash compensation expense for 2005 and 2004,
respectively.

Microvision stock, options and warrants issued to third parties

335,000

587,000

2005

2004

Microvision stock options issued to employees

Microvision stock and options issued to Independent Directors

Lumera options issued to Microvision employees

Lumera non-cash compensation expense

59,000

35,000

54,000

46,000

134,000

1,297,000

429,000

2,118,000

At December 31, 2005, the Company had $85,000 of unamortized non-cash compensation expense that will
be amortized over the next two years.

Interest Income and Expense Interest expense increased in 2005 by $3.1 million to $3.3 million from
$151,000 in 2004. In March 2005, the Company raised $10 million before issuance costs of $423,000 from
the issuance of convertible notes (“March Notes”) and warrants to purchase an aggregate of 462,000 shares
of Microvision common stock. In December 2005, the Company raised $10 million before issuance costs of
$134,000 from the issuance of convertible notes (“December Notes”), 838,000 shares of Microvision
common stock and warrants to purchase 1,089,000 shares of Microvision common stock. This increase in
interest expense relates to the stated interest on the March Notes and December Notes, (together "the
Notes") as well as the amortization of the discount recorded on the Notes due to the warrants and embedded
derivative feature of the Notes. The Company expects interest expense will be substantially higher than in
previous periods as a result of these transactions.

Loss on debt extinguishment In July 2005, the Company entered into an agreement to amend the
Company’s March Notes. In connection with the amendment, the Company issued three year warrants to
purchase 750,000 shares of Microvision common stock with an exercise price of $6.84 per share. The
conversion price of the amended notes and exercise price of the warrants are subject to anti-dilution
adjustments. In addition, the price at which the note holder can convert the March Notes to Microvision
common stock was reduced to $5.85 per share, and the price at which the Company can mandatorily
convert the March Notes to Microvision common stock was reduced to $10.24. The Company has
pledged 1,750,000 shares of its Lumera common stock as collateral for the March Notes. As a result of the
amendment, the amended notes are no longer exchangeable into Lumera common stock.

The Company has concluded that the amendment of the March Notes met the criteria of a debt
extinguishment and recorded a charge of $3,313,000 for the change in the fair value of the debt in July
2005. The charge was measured as the value of the additional warrants that were issued to the note holders
and the fair value of the reduced price at which the debt could be converted to Microvision common stock.
The additional warrants were valued using the Black Scholes option-pricing model with the following
assumptions: expected volatility of 75%; expected dividend yield of 0%; risk free interest rate of 4.62%;
and contractual life of three years. The warrants were initially valued at $2,295,000. The change in the
conversion price was valued using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 75%; expected dividend yield of 0%; risk free interest rate of 4.62%; and contractual
life equal to the length of the option. The change in the conversion price was valued at $1,018,000.

Gain on derivative feature of notes payable The following table summarizes the accounting for the
Company's Notes:

Embedded

Common

Loss on

derivative

stock and

extinguishment

Notes

Warrants

feature

APIC

of debt

Total

March 10, 2005 issuance

5,395

1,650

2,955

Debt restructuring at July 25, 2005

Conversion of debt to common stock at October 11, 2005

December 1, 2005 issuance

Principal pay ments on notes

Discount accretion for the y ear ended December 31, 2005

(1,398)

3,667

(867)

2,546

2,295

2,200

1,018

(439)

1,116

Changes in market value for the y ear ended December 31, 2005

(2,693)

(3,282)

1,837

3,017

867

10,000

(3,313)

10,000

2,546

(5,975)

Balances at December 31, 2005

9,343

3,452

1,368

5,721

(3,313)

In connection with the issuance of the Company’s March Notes, the Company concluded that the note
holders' right to convert all or a portion of the notes into Microvision or Lumera common stock is an
embedded derivative instrument as defined by FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities. Accordingly, $2,955,000 of the cash proceeds were allocated to the
embedded derivative instrument, which represents the fair value of the instrument on the date of issuance.
The derivative instrument was valued using the higher of the Microvision or Lumera conversion feature.
The value was determined using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 83%; expected dividend yield of 0%; risk free interest rate of 4.62%; and contractual
life of six months to two years, which corresponds to the principal repayment dates. Due to change in the
stock price and remaining life, the fair value of the embedded derivative instrument decreased to
$2,463,000 at July 25, 2005 the date of the extinguishment. The change in value of $492,000 for the period
from issuance to July 25, 2005, was recorded as a non-operating gain and is included in "Gain on derivative
features of note payable, net" in the consolidated statement of operations.

The Company issued warrants to purchase 462,000 shares of common stock in connection with the
issuance of the March Notes. The warrants vested on the date of grant, have an exercise price of $6.84 per
share and expire in March 2010. The initial exercise price is subject to adjustment in the event Microvision
issues common stock or common stock equivalents at a price per share of common stock below the exercise
price of the warrant. Under the terms of the restructuring of the notes in July 2005, the Company issued
three year warrants to purchase 750,000 shares of Microvision common stock at a price of $6.84. The
warrants met the definition of a derivative instrument that must be accounted for as a liability under the
provisions of Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, because the Company cannot
engage in certain corporate transactions affecting the common stock unless it makes a cash payment to the
holders of the warrants. Accordingly, $1,651,000 of the cash proceeds were allocated to the original
warrants and an additional $2,295,000 was allocated to the warrant issued in July 2005. These amounts
which represent the fair value of the warrants on the date of issuance have been included in current
liabilities. Subsequent changes in the fair value of the warrants will be recorded in the statement of
operations each period. As of December 31, 2005, the warrants were valued using the Black Scholes
option-pricing model with the following assumptions: expected volatilities of 65%and 58%; expected
dividend yield of 0%; risk free interest rates ranging from 4.36% to 4.39%; and contractual lives of 4.2
years and 2.6 years. The change in value of the warrants of$2,671,000 for the year ended December 31,
2005 was recorded as a non-operating gain and is included in "Gain on Derivative Features of Note Payable
Net" in the consolidated statement of operations.

The amended conversion feature described above continued to meet the definition of a derivative

under FAS 133 and accordingly was recorded at fair value at issuance and included within long term
liabilities. The carrying amount of the derivative will be adjusted to fair value at each balance sheet date.
The derivative feature was valued at $331,000 at December 31, 2005 and the change in value from July 25,
21005 to December 31, 2005 of $2,712, was recorded as a now operating gain and is included in "Gain on
derivative features of note payable, net" in the consolidated statement of operations.

In October 2005, the noteholder converted $1.8 million of the March Notes to 310,000 shares of

common stock. The value of the embedded derivative feature associated with the converted shares of
$439,000 was recorded to additional paid in capital.

In connection with the issuance of the December Notes, the Company concluded that the note

holders' right to convert all or a portion of the notes into Microvision common stock is an embedded
derivative instrument as defined by FASB Statement No. 133, accordingly $1.1 million of the cash
proceeds were allocated to the embedded derivative instrument, which represents the fair value of the
instrument on the date of issuance. The value of the derivative feature was determined using the Black
Scholes option-pricing model with the following assumptions: expected volatility of 58%; expected
dividend yield of 0%; risk free interest rates ranging from 4.01% to 4.39%; and contractual life of four to
sixteen months, which corresponds to the principal repayment dates. Due to change in the stock price and
remaining life, the fair value of the embedded derivative instrument decreased to $1,038,000 at December
31, 2005. The change in value of $78,000 was recorded as a non-operating gain and is included in "Gain on
derivative features of note payable, net" in the consolidated statement of operations.

The Company issued warrants to purchase 1,089,000 shares of common stock in connection with

the issuance of the December Notes. The warrants vested on the date of grant, have an exercise price of
$3.94 per share and expire in December 2010. The warrants met the definition of a derivative instrument
that must be accounted for as a liability under the provisions of Emerging Issues Task Force Issue No. 00-
19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s
Own Stock, because the Company cannot engage in certain corporate transactions affecting the common
stock unless it makes a cash payment to the holders of the warrants. Accordingly, $2.2 million of the cash
proceeds were allocated to the original warrants which represent the fair value of the warrants on the date
of issuance, and the amount was recorded as a current liability. Subsequent changes in the fair value of the
warrants will be recorded in the statement of operations each period. As of December 31, 2005, the
warrants were valued using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 65%; expected dividend yield of 0%; risk free interest rate of 4.35%; and contractual
life of five years. The change in value of $22,000 was recorded as a non-operating gain and is included in
"Gain on Derivative Features of Note Payable, Net" in the consolidated statement of operations.

Loss on equity in investment subsidiary In July 2004, Lumera completed an initial public offering of its common
stock. In connection with the offering, all Lumera Series A and Series B Preferred Stock was converted to Lumera
common stock. Immediately after the offering, Microvision owned 5,434,000 shares, or 33%, of the common stock
of Lumera. As a result of the change in ownership percentage, Microvision has changed the method of accounting
for its investment in Lumera to the equity method. Under the equity method, Microvision recorded its ownership
interest in the net book value of Lumera immediately following the initial public offering as an investment in equity
method subsidiary of $11.9 million. Microvision records its pro rata share of Lumera’s income or loss as an
adjustment in the value of its investment in Lumera. Microvision’s share in Lumera’s losses was $3.2 million for
the year ended December 31, 2005 and $1.7 million for the period from July 2004 to December 31, 2004.

Gain on Sale of Securities of Equity Subsidiary During 2005 Microvision sold 812,000 shares of its Lumera
common stock at prices between $4.04 and $5.00 per share. The total proceeds from the sales were $3,893,000.
The sales price was higher than the average carrying value of the shares and the Company recognized a gain of $2.7
million in 2005.

Income Taxes No provision for income taxes has been recorded because the Company has experienced net losses
from inception through December 31, 2005. At December 31, 2005, Microvision had net operating loss carry-
forwards of approximately $191.0 million for federal income tax reporting purposes. In addition, Microvision has
research and development tax credits of $2.6 million. The net operating losses begin expiring in 2008 if not
previously utilized. In certain circumstances, as specified in the Internal Revenue Code, a 50% or more ownership
change by certain combinations of Microvision’s shareholders during any three-year period would result in a
limitation on Microvision’s ability to utilize a portion of its net operating loss carry-forwards. Microvision has
determined that such a change of ownership occurred during 1995 and that the annual utilization of loss carry-
forwards generated through the period of that change will be limited to approximately $761,000. An additional
change of ownership occurred in 1996 and the annual limitation for losses generated in 1996 is approximately $1.6
million.

Inducement for Conversion of Preferred Stock In September 2004, Microvision raised $10.0 million before
issuance costs of $90,000 from the sale of 10,000 shares of convertible preferred stock and a warrant to purchase
362,000 shares of common stock. The preferred stock terms include a dividend of 3.5% per annum, payable
quarterly in cash or registered common stock, at the election of the Company, subject to certain conditions.

The net cash proceeds of $9,910,000 were allocated to the preferred stock and the warrant based on the

relative fair values of the securities. The warrants were valued using the Black Scholes option-pricing model with
the following assumptions: expected volatility, 75%; risk free interest rate, 3.4%, and contractual life five years.
$1.3 million of the proceeds were allocated to the warrant and was recorded as an increase to additional paid-in
capital.

Subsequent to the relative fair value allocation, the effective conversion price of the convertible preferred

stock was less than the closing price of Microvision’s common stock on the date of commitment to purchase the
preferred stock, resulting in the recognition of a beneficial conversion feature in accordance with Emerging Issues
Task Force No 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” This beneficial
conversion feature was measured as $1.2 million, which represents the difference between the fair value of the
common stock and the effective conversion price. This beneficial conversion feature was recorded to additional
paid-in capital and will be recorded as a deemed dividend to preferred stockholders (accretion) using the effective
interest method, over the stated life of the preferred stock, which is three years. During 2005, the Company
recorded $280,000 in dividends on the preferred stock and $303,000 in accretion of the beneficial conversion feature
of the preferred stock.

In August 2005, the holder of the Company’s preferred stock agreed to convert 5,000 shares of the
Company’s preferred stock into 734,000 shares of common stock. As an inducement to convert the preferred stock
the Company issued 124,000 shares of its common stock to the preferred stock holder and adjusted the exercise
price from $8.16 to $6.84 per share for the existing warrants to purchase 362,000 shares of common stock issued in
connection with the original sale of the Company’s preferred stock. The total value of the 124,000 common shares
issued of $701,000, the change in the value of the warrants of $62,000 and the amount of unamortized beneficial
conversion feature on the preferred stock of $421,000 was recorded as an inducement to convert the preferred stock
and charged to common shareholders in 2005. The warrants were valued using the Black Scholes option pricing
model with the following assumption: expected volatility 65%, risk free interest rate 4.25% and contractual life 4.1
years.

YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003

Contract Revenue Contract revenue decreased by $4.7 million, or 35%, to $8.8 million from $13.5 million
in 2003. The decrease resulted from a lower level of development contract business performed in 2004 than
that performed in 2003 on contracts entered into in both 2004 and 2003.

In 2004, 55% of contract revenue was derived from performance on development contracts with

the United States government and 45% from performance on development contracts with commercial
customers. In comparison to 53% of contract revenue was derived from performance on development
contracts with the United States government and 47% from performance on development contracts with
commercial customers in 2003. In 2003, 29% of consolidated contract revenue was earned from
development contracts with a single commercial customer.

In May 2004, Microvision entered into a $3.9 million contract modification with the U.S. Army’s

Aviation Applied Technology Directorate to continue work on an advanced helmet mounted display and
imaging system to be used in the Virtual Cockpit Optimization Program.

In December 2004, Microvision entered into a $6.2 million contract with Ethicon Endo-Surgery,

Inc., a subsidiary of Johnson & Johnson, to integrate Microvision’s technology into certain medical
products. The contract includes an exclusive license for Microvision’s technology for certain human
medical applications during the term of the development agreement.

The Company had a contract revenue backlog of $7.0 million at December 31, 2004. The backlog

was composed of development contracts, including amendments, entered through December 31, 2004.

Product Revenue Product revenue increased $1.5 million or 129% to $2.6 million from $1.1 million in
2003. The increase resulted from increased sales of both Flic and Nomad in 2004.

During 2004, Microvision earned $864,000 from the sale of 208 Nomads compared to $855,000

from the sale of 133 Nomads in 2003. Microvision introduced a new version of the Nomad in March 2004.

During 2004 and 2003, Microvision recorded $1,732,000 and $280,000, respectively, in revenue

from sales of Flic barcode scanners.

The Company had a product revenue backlog of $157,000 at December 31, 2004. The backlog

was composed of orders for Nomad and Flic received through December 31, 2004.

Cost of Contract Revenue Cost of contract revenue decreased by $449,000, or 8%, to $5.5 million from
$6.0 million. On a percentage of contract revenue basis, cost of contract revenue increased to 63% from
44% in 2003. The change in cost of contract revenue as a percentage of contract revenue is primarily
attributable to changes in the contract costs mix. Total direct costs in 2004 decreased approximately 6%
from 2003. The direct labor cost portion of direct cost decreased by approximately 6% from 2003. The
decrease in direct labor cost resulted from a lower volume of contract work performed during 2004
compared to 2003.

During 2004, the Company experienced unplanned technical difficulties on one significant project.

As a result of the difficulties, more direct costs than planned were incurred in completing the project
resulting in a lower gross margin during 2004 than in 2003.

Cost of Product Revenue Cost of product revenue increased $2.8 million or 266% to $3.9 million from
$1.1 million in 2003. Microvision’s costs to produce Nomad units during 2004 were substantially higher
than product revenue. Until October 2004, Microvision classified production cost in excess of product
revenue as research and development expense. In October 2004, management determined that Nomad
production and manufacturing processes were sufficiently mature to support “commercial production” as
described in SFAS No. 2 “Accounting for Research and Development Costs”. As a result of this
determination Microvision began full absorption of manufacturing overhead cost. During the fourth quarter
of 2004, the cost of product revenue exceeded product revenue for both the Flic and Nomad products.

Cost of product revenue in 2004 includes the write off of $764,000 of Flic inventory and $479,000

of Nomad inventory. The write off’s were due to changes in product design and customer demand that
caused components and accessories to become obsolete or slow moving

Research and Development Expense Research and development expense decreased by $8.6 million, or
37%, to $14.7 million from $23.3 million in 2003.

Research and development expense attributable to Lumera decreased $5.5 million, or 83%, to $1.1

million from $6.6 million in 2003. The decrease in research and development expense attributable to
Lumera accounts for 64% of the decrease in consolidated research and development expense.

In April 2004, Lumera and the University of Washington entered into a fourth amendment to the
Sponsored Research Agreement that required payments of $125,000 for quarters ending March 31, 2004
and June 30, 2004 and eliminates the contingent payment of $2.0 million. For each of the quarters ending
September 30, 2004 and December 31, 2004, Lumera was required to pay $250,000. The agreement
terminated in 2005 after payments of $375,000 were made in quarters ending March 31, 2005 and June 30,
2005. Total payments under the Sponsored Research Agreement were $5.8 million instead of the original
$9.0 million. Lumera recognizes research and development expense under the Sponsored Research
Agreement on a straight line basis over the term of the agreement. At the time of the fourth amendment to
the Sponsored Research Agreement, Lumera had recognized $6.5 million in expense related to the
Sponsored Research Agreement. In April 2004, Lumera recorded a reduction in its liability and an
offsetting reduction in expense of $2.4 million to reduce the cumulative expense recognized under the
Sponsored Research Agreement to the expense incurred under the fourth amendment on a straight line
basis.

Research and development expense in 2003 included $645,000 for the closure of Microvision’s

research and development facility in San Mateo, California. Microvision consolidated its research and
development activities in Bothell, Washington in May 2003.

Sales, Marketing, General and Administrative Expense Sales, marketing, general and administrative
expenses increased by $3.4 million, or 22%, to $19.2 million from $15.8 million in 2003. The increase in
sales, marketing, general and administrative expenses was due to the increase in sales and marketing
activity related to Nomad and Flic sales. The Company added sales staff, demonstration equipment and
promotion materials to support increased sales of Nomad and Flic

Non-Cash Compensation Expense Non-cash compensation expense decreased by $38,000 or 2% to $2.1
million from $2.2 million in 2003.

In September 2003, the Company issued two warrants to purchase an aggregate of 70,000 shares
of common stock to a third party in exchange for services provided to the Company. One warrant grants
the holder the right to purchase up to 60,000 shares of common stock at a price of $7.50 per share. The
warrant vests in three equal tranches on the date of grant, in December 2003, and March 2004. The other
warrant grants the holder the right to purchase up to 10,000 shares at a price of $12.00 per share and vests
in March 2004. The unvested warrants were subject to remeasurement at each balance sheet date until
vested. The deferred compensation related to these warrants was being amortized to non-cash
compensation expense over the fourteen month service period of the agreement. Non-cash amortization
expense related to these warrants was $140,000 and $192,000 for 2004 and 2003 respectively. The total
value of the warrants was estimated on December 31, 2003 and the grant date at $318,000 and $328,000,
respectively. The fair values of the warrants were estimated on the date of grant and December 31, 2003,
using the Black Scholes option-pricing model with the following weighted-average assumptions: expected
volatilities of 83%, risk-free interest rates of 2.7% and dividend yields of zero percent. The contractual
lives used at the measurement dates above were 4 years and 3.9 years, respectively.

In August 2000, the Company issued warrants to purchase an aggregate of 200,000 shares of

common stock to two consultants in connection with entering into certain consulting agreements with the
Company. One of the consultants subsequently became a director. The warrants grant each of the holders
the right to purchase up to 100,000 shares of common stock at a price of $34.00 per share. The warrants to
purchase an aggregate of 150,000 shares vested over three years and were subject to remeasurement at each
balance sheet date during the vesting period. The remaining warrants to purchase an aggregate of 50,000
shares had a measurement date at the time of grant. The deferred compensation related to these warrants is
being amortized to non-cash compensation expense over the five-year period of service under the
agreements. The total original value of both warrants were estimated at $5,476,000.

During 2004, Lumera granted options to purchase 415,000 shares of Class A common stock to Lumera
employees and directors with a weighted-average exercise price of $2.00. Lumera subsequently determined
that the fair market value of its common stock was greater than the exercise price of the options. Lumera
recorded aggregate charges of $216,000 during 2004 related to these grants.
During 2004, Lumera granted vested options to purchase 40,000 shares of Class A common stock to
Microvision employees with a weighted-average exercise price of $2.00. Lumera subsequently determined
that the fair market value of its common stock was greater than the exercise price of the options. The
Company recorded aggregate charges of $134,000 during 2004 related to these grants.

The following table shows the components of non-cash compensation expense for 2004 and 2003,
respectively.

Microvision stock, options and warrants issued to third parties

587,000

Microvision stock options issued to employees

Microvision stock and options issued to Independent Directors

Lumera options issued to Microvision employees

Lumera non-cash compensation expense

54,000

46,000

134,000

1,297,000

849,000

265,000

1,000

1,041,000

2,118,000

2,156,000

2004

2003

At December 31, 2004, the Company had $305,000 of unamortized non-cash compensation expense that
will be amortized over the next year.

Interest Income and Expense Interest income in 2004 decreased by $109,000, or 29%, to $272,000 from
$381,000 in 2003. This decrease resulted primarily from lower average cash and investment securities
balances in 2004 than the average cash and investment securities balances in the prior year.

Interest expense was consistent with 2004 because the amount of borrowings did not change

significantly.

Loss on equity in investment subsidiary In July 2004, Lumera completed an initial public offering of its
common stock. In connection with the offering, all Lumera Series A and Series B Preferred Stock was
converted to Lumera common stock. Immediately after the offering, Microvision owned 5,434,000 shares,
or 33%, of the common stock of Lumera. As a result of the change in ownership percentage, Microvision
has changed the method of accounting for its investment in Lumera to the equity method. Under the equity
method, Microvision recorded its ownership interest in the net book value of Lumera immediately
following the initial public offering as an investment in equity method subsidiary of $11.9 million.
Microvision records its pro rata share of Lumera’s income or loss as an adjustment in the value of its
investment in Lumera. For the period from July 2004 to December 31, 2004 Microvision’s share in
Lumera’s losses was $1.7 million.

Income Taxes No provision for income taxes has been recorded because the Company has experienced net
losses from inception through December 31, 2004. At December 31, 2004, Microvision had net operating
loss carry-forwards of approximately $168.0 million for federal income tax reporting purposes. In addition,
Microvision had research and development tax credits of $2.2 million.

Non-cash Beneficial Conversion Feature of Preferred Stock. In September 2004, Microvision raised
$10.0 million before issuance costs of $90,000 from the sale of 10,000 shares of convertible preferred stock
and a warrant to purchase 362,000 shares of common stock. The preferred stock is convertible on demand
by the holder into common stock at a conversion price of $6.91 per share of common stock.

The warrant vested on the date of grant, has an exercise price of $8.16 per share and expires on
September 10, 2009. The initial exercise price is subject to adjustment in the event the Company issues
common stock or derivative securities at a price per share of common stock below the market price or the
exercise price of the warrant.

The net cash proceeds of $9,910,000 were allocated to the preferred stock and the warrant based on the
relative fair values of the securities. The warrants were valued using the Black Scholes option-pricing
model with the following assumptions: expected volatility, 75%, risk free interest rate of 3.4%, and a
contractual life 5 years. $1.3 million of the proceeds were allocated to the warrant and were recorded as an
increase to additional paid-in capital.

Subsequent to the relative fair value allocation, the effective accounting conversion price of the
convertible preferred stock was less than the closing price of Microvision’s common stock on the date of
commitment to purchase the preferred stock. This beneficial conversion feature was measured as $1.2
million, which represents the difference between the fair value of the common stock and the effective
accounting conversion price. This beneficial conversion feature was recorded to additional paid-in capital
and will be recorded as a deemed dividend to preferred stockholders (accretion) over the stated life of the
preferred stock which is three years.

Liquidity and Capital Resources Microvision has incurred significant losses since inception. The
Company has funded operations to date primarily through the sale of common stock, convertible preferred
stock, warrants, the issuance of convertible debt and, to a lesser extent, from development contract
revenues and product sales. At December 31, 2005, Microvision had $6.9 million in cash and cash
equivalents. In January 2006 the Company raised $10.3 million through the sale of 2.6 million shares of its
Lumera common stock equity method investment to a small group of private investors. The Company has
sufficient cash to fund its operations through July 2006.

As discussed elsewhere in this report, the Company has received a report from our independent

registered public accounting firm regarding the consolidated financial statements for the year ended
December 31, 2005 that includes an explanatory paragraph stating that the financial statements have been
prepared assuming Microvision will continue as a going concern. The explanatory paragraph states the
following conditions, which raise substantial doubt about our ability to continue as a going concern: (i) the
Company has incurred operating losses since inception, including a net loss available for common
shareholders of $30.3 million for the fiscal year ended December 31, 2005, and the Company has an
accumulated deficit of $215.7 million at December 31, 2005 and (ii) the Company anticipates requiring
additional financial resources to enable it to fund its operations at least through December 31, 2006.

The Company plans to raise additional cash before July 2006 to fund its operations through the

sale of its common stock, preferred stock or through the issuance of debt. The Company has taken the
following actions to reduce its use of cash and improve the operations of the Company:

• Made significant changes to it senior management team including appointing a new Chief

Executive Officer

• Announced a restructuring and realignment plan that targets a 30% reduction in operating loss

• Begun adding members to the Board of Directors with experience that directly supports the

Company's business objectives

• Engaged an investment bank to assist the Company in pursuing financing alternatives

Cash used in operating activities totaled $19.7 million during 2005, compared to $30.8 million during 2004.

The Company had the following material gains and charges and changes in assets and liabilities

during the year ended December 31, 2005.

• “Non cash interest expense, net” In connection with the issuance of the Company’s notes in

March 2005 and December 2005 the Company allocated proceeds to the embedded derivative
features and the warrants. The aggregate discount to the notes of $7.9 million is amortized to
noncash interest expense using the imputed interest method over the life of the notes. At
December 31, 2005 the Company has $5.0 million in unamortized discount associated with the
notes remaining.

•

"Derivative feature of notes payable” In connection with the issuance of the Notes, the Company
allocated a portion of the proceeds to the embedded derivative features of the Notes. Due to
changes in the stock price and remaining life, the fair value of the embedded derivative instrument
decreased to $1.4 million at December 31, 2005. The aggregate change in value of $3.3 million for
the year ended December 31, 2005 was recorded as a non-operating gain and is included in "Gain
on derivative features of note payable, net" in the consolidated statement of operations.

• “Allowance for receivables from related parties” In 2000, the Board of Directors authorized

Microvision to provide unsecured lines of credit to each of its three senior officers. No loans have
been made under either Microvision’s Executive Option Exercise Note Plan or the Executive Loan
Plan since July 2002, and Microvision does not intend to make any additional loans under these plans.
A total of $2,723,000 was issued and remains outstanding under the Executive Loan Plan. There are
currently no outstanding loans under the Executive Option Exercise Note Plan.

In 2005, Microvision determined that certain of its senior officers may have had insufficient
net worth and short-term earnings potential to repay their outstanding loans. As a result, Microvision
recorded additional allowances for doubtful accounts for the receivables from senior officers of $1.0
million. The balance of the allowance for doubtful accounts for receivables from senior officers was
$1.9 million at December 31, 2005. Two of the officers left the Company in January 2006, in
accordance with the terms, the loans issued to these officers will be due in January 2007. Microvision
has no plans to forgive any portion of the principal of the outstanding receivable balance.

•

“Equity losses in Lumera”, “Investment in Lumera”and “Gain on sale of securities of equity
subsidiary” Microvision accounts for its investment in Lumera using the equity method. Microvision
records its pro rata share of Lumera’s income or loss as an adjustment in the value of its investment in
Lumera. Microvision’s share in Lumera’s losses was $3.2 million for the year ended December 31,
2005 and $1.7 million for the period from July 2004 to December 31, 2004. During 2005, Microvision
sold 812,000 shares of its Lumera common stock at prices between $4.04 and $5.00 per share. The
total proceeds from the sales were $3,893,000. The aggregate carrying value of the shares sold was
$1,192,000. The sales price was higher than the average carrying value of the shares and the Company
recognized a gain of $2,700,000 in 2005. In March 2005 and December 2005, the Company issued
convertible notes that are secured by 1,750,000 shares Lumera common stock with a book value of
$2.2 million at December 31, 2005. The value of the restricted Lumera common stock has been
recorded as “Restricted investment in Lumera.”

• “Loss on debt extinguishment” In July 2005, the Company entered into an agreement to amend the

March Notes. In connection with the amendment, the Company issued three year warrants to purchase
750,000 shares of Microvision common stock with an exercise price of $6.84 per share. The
conversion price of the amended notes and exercise price of the warrants are subject to anti-dilution
adjustments. In addition, the price at which the note holder can convert the March Notes to
Microvision common stock was reduced to $5.85 per share, and the price at which the Company can
mandatorily convert the March Notes to Microvision common stock was reduced to $10.24. The
Company has pledged 1,750,000 shares of its Lumera common stock as collateral for the March Notes.
As a result of the amendment, the March Notes are not currently exchangeable into Lumera common
stock.

• The Company has concluded that the amendment of March Notes met the criteria of a debt

extinguishment and recorded a charge of $3,313,000 for the change in the fair value of the debt in July
2005. The change in the value of the debt was measured as the value of the additional warrants that
were issued to the note holders and the change in the price at which the debt could be converted to
Microvision common stock. The additional warrants were valued using the Black Scholes option-
pricing model with the following assumptions: expected volatility of 75%; expected dividend yield of
0%; risk free interest rate of 3.66%; and contractual life of three years. The warrants were initially
valued at $2,295,000. The change in the conversion price was valued using the Black Scholes option-
pricing model with the following assumptions: expected volatility of 75%; expected dividend yield of
0%; risk free interest rates ranging from 3.25% to 3.58%; and contractual life equal to the length of the
option. The change in the conversion price was valued at $1,018,000.

• “Accounts receivable” and “Billings in excess of costs and estimated earnings on uncompleted

contracts” In December 2004 the Company recorded a receivable of $3.5 million from a customer for
an advance payment in accordance with the terms of the development contract. The Company
received the payment in January 2005 and the Company performed work on the contract during 2005.

• “Inventory” Inventory decreased by $2.4 million to $759,000 at December 31, 2005 from $ 3.2 million
at December 31, 2004. The decrease was primarily attributable to the write off of excess and obsolete
inventory. The Company had previously made commitments to purchase certain minimum quantities
based on the economic order quantities, sales forecast and the availability of raw materials. The
Company values inventory at the lower of cost or market with cost determined on a weighted average
cost basis. The following table shows the composition of the inventory at December 31, 2005 and
December 31, 2004, respectively:

Raw materials

Work in process

Finished goods

Decembe r 31,

December 31,

2005

2004

267,000

141,000

351,000

759,000

1,607,000

77,000

1,483,000

3,167,000

Cash provided by investing activities totaled $1.0 million in 2005 compared to $10.0 million in 2004.

During 2005, the Company had net purchases of investment securities of $863,000 compared net sales of
investment securities of $11.1 million during 2004. The proceeds from the sales of investment securities were
used to fund the Company’s operations.

The Company used cash of $1.2 million for capital expenditures in 2005, compared to $1.0 million in
2004. Capital expenditures include leasehold improvements to leased office space and computer hardware and
software, laboratory equipment and furniture and fixtures to support operations.

Cash provided by financing activities totaled $24.3 million in 2005, compared to $12.8 million in

2004. The following is a list of stock issuances during 2005 and 2004.

•

In December 2005, the Company raised $10.0 million, before issuance costs of $134,000, from the
issuance of convertible notes ("December Notes"), 838,000 shares of common stock and warrants to
purchase 1,089,000 shares of Microvision common stock. The December Notes are convertible on
demand by the holders into Microvision common stock at a conversion price of $3.94 per share. The
note holders may convert all or a portion of their notes. In addition, upon the request of the note
holders, the Company is required to redeem the December Notes for cash upon a change of control or
an event of default at a redemption price equal to 125% of the then outstanding balance of the notes.
The Company has pledged 1,750,000 shares of its Lumera common stock as collateral for the
December Notes and the shares have been classified as a "Restricted investment in Lumera" on the
Company's consolidated balance sheet.

The terms of the December Notes include interest at LIBOR plus 3.0% provided that the
interest rate shall not be less than 6% or greater than 8% payable quarterly in cash or Microvision
common stock if the stock price is greater than $4.06 per share, at the election of the Company, subject
to certain additional conditions. Under certain circumstances the interest rate increases to LIBOR plus
6% but not less than 12% or greater than 15%. If the Company chooses to pay interest in Microvision
common stock as opposed to cash, the price will be based on 90% of the arithmetic average of the
volume weighted average prices for the 20 trading days prior to the payment date. The December
Notes are payable in five equal quarterly installments beginning in March 2006. The Company can
elect to make the principal payments in common stock in lieu of cash if the stock price is greater than
$4.06 per share, subject to certain other conditions. If the Company elects to pay principal in stock the
stock will be issued at a 10% discount to the arithmetic average of the volume weighted average prices
for the 15 trading days prior to the payment date. Additionally, the Company can elect to convert the
December Notes into Microvision common stock if the stock price exceeds $6.90 per share for 20 out
of any 30 consecutive trading days, subject to certain conditions.

The Company concluded that the note holders’ right to convert all or a portion of the December
Notes into Microvision common stock is an embedded derivative instrument as defined by FASB
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133").
Accordingly, $1.1 million of the cash proceeds were allocated to the embedded derivative
instrument, which represents the fair value of the instrument on the date of issuance. The value
was determined using the Black Scholes option-pricing model with the following assumptions:
expected volatility of 58%; expected dividend yield of 0%; risk free interest rate of 4.01% to
4.39%; and contractual life of four to sixteen months, which corresponds to the principal
repayment dates. Due to changes in Microvision’s stock price and remaining contractual life, the
fair value of the embedded derivative feature decreased to $1,038,000 at December 31, 2005. The
change in value of $78,000 was recorded as a non-operating gain and included in Gain on
derivative features of note payable in the consolidated statement of operations. As of December
31, 2005 total principal payments of $7.0 million remain under the December Notes.

The warrants vested on the date of grant, have an exercise price of $3.94 per share of

common stock and expire in December 2010. The warrants met the definition of a derivative
instrument that must be accounted for as a liability under the provisions of Emerging Issues Task
Force Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock, because the Company cannot engage in certain
corporate transactions affecting the common stock unless it makes a cash payment to the holders
of the warrants. Accordingly, $2.2 million of the cash proceeds were allocated to the warrants,
which represents the fair value of the warrants on the date of issuance and the amount was
recorded as a current liability. Subsequent changes in the fair value of the warrants will be
recorded in the statement of operations each period. The warrants were valued using the Black
Scholes option-pricing model with the following assumptions: expected volatility of 65%;
expected dividend yield of 0%; risk free interest rate of 4.35%; and contractual life of five years.

The Microvision common stock was valued at the closing price on the date of closing of

$3.60 per share. Aggregate proceeds of $3.0 million were allocated to the common stock. The
remaining gross proceeds of $3.7 million were allocated to the December Notes.

•

In August and September 2005 the Company raised $7.0 million before issuance costs through the
sale of 1,333,000 shares of common stock at a price of $5.25 per share and five-year warrants to
purchase 310,000 shares of common stock at a price of $6.50 to a holder of the Company’s
preferred stock and other investors.

In March 2005, the Company raised $10.0 million, before issuance costs of $423,000,

from the issuance of convertible notes (“March Notes”) and warrants to purchase an aggregate of
462,000 shares of Microvision common stock. The March Notes are convertible on demand by
the holders into Microvision common stock at a conversion price of $6.84 per share of
Microvision common stock or Lumera common stock held by the Company at a conversion price
of $5.64 per share up to a limit of 1,750,000 shares of Lumera common stock.

The right to convert the March Notes into shares of Lumera common stock was removed

pursuant to the amendment described below. The note holders may convert all or a portion of
their notes. The initial conversion price is subject to adjustment in the event Microvision issues
common stock or common stock equivalents at a price per share of common stock below the
conversion price of the March Notes. Due to below market issuances of Company’s common
stock the conversion price of the March Notes at December 31, 2005 was $5.54 per share of
common stock. In addition, upon the request of the note holders, the Company is required to
redeem the March Notes for cash upon a change of control or an event of default at a redemption
price equal to 125% of the then outstanding balance of the March Notes. The Company has
pledged 1,750,000 shares of its Lumera common stock as collateral for the March Notes and the
December Notes, described above. Those shares have been classified as a "Restricted investment
in Lumera" on the Company's consolidated balance sheet.

The terms of the March Notes include interest at LIBOR plus 3.0% payable quarterly in cash or
Microvision common stock, at the election of the Company, subject to certain conditions.
However, in no case shall the interest rate be less than 6.0% or greater than 8.0%. If the Company
chooses to pay interest in Microvision common stock instead of cash, the price will be based on
92% of the arithmetic average of the volume weighted average prices for the 10 trading days prior
to the payment date. The March Notes are payable in six equal quarterly installments beginning in
December 2005. The Company can subject to certain conditions, elect to make the principal
payments in common stock in lieu of cash. Payment in stock will be issued at a 10% discount to
the arithmetic average of the volume weighted average prices for the 15 trading days prior to the
payment date. Additionally, the Company can elect to convert the March Notes into Microvision
common stock if the stock price exceeds $11.97 per share for 20 out of any 30 consecutive trading
days, subject to certain conditions.

The Company concluded that the note holders’ right to convert all or a portion of the

March Notes into Microvision or Lumera common stock is an embedded derivative instrument as
defined by FASB Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities ("FAS 133"). Accordingly, $2,955,000 of the cash proceeds were allocated to the
embedded derivative instrument, which represents the fair value of the instrument on the date of
issuance. The derivative instrument was valued using the higher of the Microvision or Lumera
conversion feature. The value was determined using the Black Scholes option-pricing model with
the following assumptions: expected volatility of 83%; expected dividend yield of 0%; risk free
interest rate of 4.62%; and contractual life of nine months to two years, which corresponds to the
principal repayment dates. Due to changes in Lumera and Microvision’s stock price and
remaining contractual life, the fair value of the embedded derivative feature decreased to
$2,463,000 at July 25, 2005 the date of the extinguishment. The changes in value of a decrease of
$492,000 for the year ended December 31, 2005 was recorded as a non-operating gain and
included in "Gain on derivative features of note payable” in the consolidated statement of
operations. As of December 31, 2005 total principal payments of $7.3 million remain under the
March Notes.

The warrants vested on the date of grant, have an exercise price of $6.84 per common
share and expire in March 2010. The initial exercise price is subject to adjustment in the event
Microvision issues common stock or common stock equivalents at a price per share of common
stock below the exercise price of the warrant. Due to below market issuances of Company’s
common stock the exercise price of the warrants issued with the March Notes was adjusted to
$6.29 as of December 31, 2005. The warrants met the definition of a derivative instrument that
must be accounted for as a liability under the provisions of Emerging Issues Task Force Issue No.
00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock, because the Company cannot engage in certain corporate transactions
affecting the common stock unless it makes a cash payment to the holders of the warrants.
Accordingly, $1,651,000 of the cash proceeds were allocated to the warrants, which represents the
fair value of the warrants on the date of issuance and the amount was recorded as a current
liability. Subsequent changes in the fair value of the warrants will be recorded in the statement of
operations each period. The warrants were valued using the Black Scholes option-pricing model
with the following assumptions: expected volatility of 75%; expected dividend yield of 0%; risk
free interest rate of 4.62%; and contractual life of five years. The remaining gross proceeds of
$5,394,000 were allocated to the Notes.

In July 2005, the Company entered into an agreement to amend the March Notes. In
connection with the amendment, the Company issued three year warrants to purchase 750,000
shares of Microvision common stock at an exercise price of $6.84 per share. The conversion
price of the amended March Notes and exercise price of the warrants are subject to anti-dilution
adjustments, subject to conditions. In addition, the price at which the Note holders can convert the
March Notes to Microvision common stock was reduced to $5.85 per share, and the price at which
the Company can mandatorily convert the March Notes to Microvision common stock was
reduced to $10.24. As a result of the amendment, the March Notes are no longer exchangeable
into Lumera common stock.

The Company has concluded that the amendment of the March Notes met the criteria of a debt
extinguishment. The Company recorded a non cash charge of $3,313,000 for the change in the fair value of
the debt and related consideration. The change in the value was measured as the value of the additional
warrants that were issued to the note holders and the change in the price at which the debt could be
converted to Microvision common stock. The additional warrants were valued using the Black Scholes
option-pricing model with the following assumptions: expected volatility of 75%; expected dividend yield
of 0%; risk free interest rate of 3.66%; and contractual life of three years. The additional warrants were
initially valued at $2,295,000. The change in the conversion feature was valued using the Black Scholes
option-pricing model with the following assumptions: expected volatility of 75%; expected dividend yield
of 0%; risk free interest rates ranging from 3.25% to 3.58% and contractual life equal to the length of the
option. The change in the conversion price was valued at $1,018,000.

The amended conversion feature continued to meet the definition of a derivative under FAS 133

and accordingly has been recorded at fair value and included within long-term liabilities. The carrying
amount of the derivative will be adjusted to fair value at each balance sheet date. An adjustment of
$2,712,000 was recorded for the period from July 25, 2005 to December 31, 2005.

In October 2005, the noteholder converted $1.8 million of the March Notes to 310,000 shares of

common stock. The value of the embedded derivative feature associated with the converted shares of
$439,000 was recorded to additional paid in capital.

The liability for both the initial warrant and the additional warrant are adjusted to the fair market

value of $1,273,000 at December 31, 2005. The combined adjustment during the year ended December 31,
2005 was $2,672,000.

In September 2004, Microvision raised $10.0 million before issuance costs of $90,000 from the
sale of 10,000 shares of convertible preferred stock and a warrant to purchase 361,795 shares of common
stock. The preferred stock is convertible on demand by the holder into common stock at a conversion price
of $6.91 per share of common stock. The initial conversion price is subject to adjustment in the event
Microvision issues common stock or derivative securities at a price per share of common stock below the
market price or the conversion price of the preferred stock. Due to below market issuances of Company’s
common stock the conversion price of the Preferred Stock as of December 31, 2005 was $6.36 per share of
common stock. In addition, upon the request of the preferred stockholder, Microvision is required to
redeem the preferred stock for cash in certain circumstances, including in the event of a material breach of
representations, warranties or covenants under the purchase agreement or a change in control.
Accordingly, Microvision has classified the preferred stock as “mandatorily redeemable convertible
preferred stock” in its consolidated balance sheet. The preferred stock terms include a dividend of 3.5% per
annum, payable quarterly in cash or registered common stock, at the election of the Company, subject to
certain conditions. The preferred stock matures on September 10, 2007, at which time it is payable in cash
or registered common stock, at the election of the Company, subject to certain conditions. Some of the
conditions which would preclude the Company from paying in common stock are not within the
Company’s immediate control. The Company can elect to convert the preferred stock into common stock if
the stock price exceeds $12.09 per share, subject to certain conditions. The warrant vested on the date of
grant, has an exercise price of $8.16 per share and expires on September 10, 2009. The initial exercise price
is subject to adjustment in the event Microvision issues common stock or derivative securities at a price per
share of common stock below the market price or the exercise price of the warrant. Due to below market
issuances of Company’s common stock the exercise price of the warrants issued with the Preferred Stock
was adjusted to $6.40 as of December 31, 2005.

The net cash proceeds of $9.9 million were allocated to the preferred stock and the warrant based

on the relative fair values of the securities. The warrants were valued using the Black Scholes option-
pricing model with the following assumptions: expected volatility, 75%, risk free interest rate, 3.4%, and
contractual life five years. $1.3 million of the proceeds were allocated to the warrant and were recorded as
an increase to additional paid-in capital.

Subsequent to the relative fair value allocation, the effective conversion price of the convertible

preferred stock was less than the closing price of Microvision’s common stock on the date of commitment
to purchase the preferred stock. This beneficial conversion feature was measured as $1.2 million which
represents the difference between the fair value of the common stock and the effective conversion price.
This beneficial conversion feature was recorded to additional paid-in capital and will be recorded as a
deemed dividend to preferred stockholders (accretion) over the stated life of the preferred stock which is
three years.

•

In April 2004, Lumera raised $2.3 million from the issuance of convertible promissory notes. The
notes accrue interest at a rate of 6.5% per annum and are payable on demand upon the closing of
an underwritten public offering of Lumera’s common stock. Lumera completed an initial public
offering in July 2004. The principal amount and any accrued but unpaid interest in respect of each
note is convertible at any time, at the option of the holder, into shares of Lumera’s Class A
common stock. The conversion price is $6.00 per share of common stock. In connection with the
sale of these convertible notes, Lumera also issued warrants to purchase shares of common stock.
The number of shares is based on a formula based on the exercise price of the warrant and the face
amount of the holder’s convertible note. The exercise price of the warrants is equal to $7.20 per
share. All of the warrants are exercisable on the date of grant and expire in April 2009. The value
of the warrants granted was estimated to be approximately $344,000 using the Black Scholes
option pricing model. The relative fair value of the warrants of $299,000 was treated as a debt
issuance cost and amortized to interest expense over the one year term of the convertible notes.

•

In March 2004 Lumera raised $500,000, before issuance costs, from the sale of 250,000 shares of
Series B convertible preferred stock to a group of private investors. Microvision did not
participate in the offering.

The Company’s investment policy restricts investments to ensure principal preservation and liquidity.

Generally, the Company invests cash that it expects to use within approximately sixty days in U.S.
treasury-backed instruments. The Company invests the balance of its cash in high quality investment
securities. The investment securities portfolio is limited to U.S. government and U.S. government agency
debt securities and other high-grade securities generally with maturities of three years or less.

Future operating expenditures and capital requirements will depend on numerous factors, including the

following:

•
•
•

the progress of research and development programs,
the progress in commercialization activities and arrangements,
the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual
property rights,
competing technological and market developments, and

•
• Microvision’s ability to establish cooperative development, joint venture and licensing

arrangements.

In order to maintain its exclusive rights under the Company’s license agreement with the University of

Washington, the Company is obligated to make royalty payments to the University of Washington with
respect to the Virtual Retinal Display technology. If the Company is successful in establishing original
equipment manufacturer co-development and joint venture arrangements, the Company expects its partners
to fund certain non-recurring engineering costs for technology development and/or for product
development. Nevertheless, the Company expects its cash requirements to increase at a rate consistent with
revenue growth as it expands its activities and operations with the objective of commercializing the
scanned beam technology.

The following table lists the Company’s contractual obligations (in thousands):

Contractual O bligations:

Open purchase orders *

Minimum payments under senior secured

2006

2007

2008

2009

2010

After 2010

Total

December 31,

2,875

convertable notes including interest

12,202

2,812

Minimum payments under capital leases

Minimum payments under operating leases
Minimum payments under research, royalty

and licensing agreements†

T otal

741

390

850

390

834

215

837

215

867

175

2,400

15,014

160

6,529

1,385

16,249

4,091

1,082

1,079

1,062

2,400

25,963

*
and other goods used in the normal course of the Company’s business.

Open purchase orders represent commitments to purchase inventory, materials, capital equipment

†
currently at least 2017.

License and royalty obligations continue through the lives of the underlying patents, which is

Microvision’s cash balance at December 31, 2005 was $6.9 million. In addition, Microvision raised

$10.3 million in January 2006 through the sale of 2.6 million shares of its Lumera common stock to a small group
of investors. To the extent required to implement the Microvision’s operating plan, Microvision may sell or
pledge as collateral, its unpledged shares of Lumera common stock. As of March 1, 2006, Microvision owns
approximately 322,000 shares of Lumera common stock that have not been pledged as collateral for the
Company’s convertible notes issued as of March 11, 2005 and the notes issued in December 2005. Based on the
March 1, 2006 closing price of $4.10, the Lumera shares that have not been pledged as collateral have a market
value of approximately $1.2 million. Based on our current operating plan and budgeted cash requirements, we
expect to need additional cash to fund our operations in July 2006. Since we hold a large percentage of Lumera’s
common stock, if an active market is not sustained, it may be difficult for us to sell our shares of Lumera’s
common stock at a value sufficient to fund our operating plans.

Microvision may also raise financing through future sales of Microvision preferred or common

stock, issuance of debt securities or other borrowings. There can be no assurance that other additional
financing will be available to Microvision or that, if available, it will be available on terms acceptable to
Microvision on a timely basis. If adequate funds are not available to satisfy either short-term or long-term
capital requirements, Microvision may be required to limit its operations substantially. This limitation of
operations may include reductions in staff and operating costs as well as reductions in capital expenditures
and investment in research and development.

Should expenses exceed the amounts budgeted, the Company may require additional capital

earlier than July 2006 to further the development of its technology, for expenses associated with product
development, and to respond to competitive pressures or to meet unanticipated development difficulties
The operating plan also provides for the development of strategic relationships with systems and equipment
manufacturers that may require additional investments by the Company. The Company’s capital
requirements will depend on many factors, including, but not limited to, the rate at which the Company can,
directly or through arrangements with original equipment manufacturers, introduce products incorporating
the scanned beam technology and the market acceptance and competitive position of such products.

New accounting pronouncements In December 2004, the Financial Accounting Standards Board
(''FASB'') issued SFAS No. 123(R), ''Share-Based Payment'', which is a revision of SFAS No. 123 and
supersedes APB Opinion No. 25. SFAS No. 123(R) requires all employee share-based awards granted after
the effective date to be valued at fair value, and to be expensed over the applicable vesting period. Pro
forma disclosure of the income statement effects of share-based payments is no longer an alternative. SFAS
No. 123(R) is effective for all share-based awards granted on or after January 1, 2006. In addition,
companies must recognize compensation expense related to any awards that are not fully vested as of the
effective date. Compensation expense for the unvested employee awards will be measured based on the fair
value of the awards previously calculated in developing the pro forma disclosures in accordance with the
provisions of SFAS No. 123. The first reporting period where employee share-based compensation will be
recognized is March 31, 2006. Share-based compensation expense in 2006 will be affected by our stock
price at the time of grants are awarded, the number and structure of stock-based awards our board of
directors may grant during the year, any other actions taken with respect to outstanding options, as well as a
number of complex and subjective valuation assumptions. These valuation assumptions include, but are not
limited to, the future volatility of our stock price and employee stock option exercise behaviors. The
Company is currently evaluating the alternative methods for implementing SFAS No. 123(R) and there is
sufficient uncertainty surrounding future share-based compensation actions and valuation estimates that the
Company is not in a position to provide a useful estimate of the financial statement impact of SFAS No.
123(R) in 2006 at this time.

In November 2004 the FASB issued SFAS 151 Inventory Cost - an Amendment of ARP No. 43,

chapter 4 (“SFAS 151”) which provides clarifies accounting for abnormal manufacturing costs. The
Company is required to adopt SFAS 151 for years beginning after June 30, 2005. The Company does not
believe that adoption of SFAS 151 will have a material impact on its financial statements.

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting

Bulletin No. 107 (“SAB 107”), “Share Based Payment,” which expresses the SEC’s views on the
interaction between SFAS 123R and certain SEC rules and regulations. The Company is currently assessing
the guidance in SAB 107 as part of its evaluation of the adoption of SFAS 123R.

Subsequent Events In January 2006, the Company raised $10,324,000 from the sale of 2,550,000 shares of
Lumera common stock. As a result of the sale, the Company will record a “gain on sale of equity
subsidiary” of approximately $7.3 million. Subsequent to the sale, the Company owned 2,072,000 shares,
or 12%, of the outstanding shares of Lumera common stock. After January 31, 2006, due to the change in
ownership percentage, Microvision will account for its investment in Lumera using the cost method.

In January 2006 the Chief Executive Officer's employment was terminated and the Chief Financial

Officer resigned. The Company appointed Alexander Y. Tokman to Chief Executive Officer in January
2006.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Substantially all of the Company’s cash equivalents and investment securities are at fixed interest rates and,
as such, the fair value of these instruments is affected by changes in market interest rates. Due to the
generally short-term maturities of these investment securities, the Company believes that the market risk
arising from its holdings of these financial instruments is not significant. The Company’s investment
policy restricts investments to ensure principal preservation and liquidity. The Company invests cash that
it expects to use within approximately sixty days in U.S. treasury-backed instruments. The Company
invests cash in excess of sixty days of its requirements in high quality investment securities. The
investment securities portfolio is limited to U.S. government and U.S. government agency debt securities
and other high-grade securities generally with maturities of three years or less.

The maturities of cash equivalents and investment securities, available-for-sale, as of December

31, 2005, are as follows:

Cash

Less than one year

Amount

Percent

1,778,000

5,082,000

6,860,000

25.9 %

74.1

100.0 %

All of the Company’s development contract payments are made in U.S. dollars. However, in the

future the Company may enter into additional development contracts in foreign currencies that may subject
the Company to additional foreign exchange rate risk. The Company intends to enter into foreign
currency hedges to offset the exposure to currency fluctuations when it can determine the timing and
amounts of the foreign currency exposure.

The Company owns 2.1 million shares of Lumera common stock with a market value of $8.5

million based on the closing price of $4.10 per share on March 1, 2006. Lumera’s stock price is subject to
fluctuation and may decrease, lowering the value of our investment. The Company owns approximately
12% of Lumera’s common stock. Since the Company holds a large percentage of Lumera’s common stock,
if an active market does not develop or is not sustained, it may be difficult to sell the shares of Lumera’s
common stock at an attractive price or at all. The likelihood of Lumera’s success, and the value of the
Company’s common stock, must be considered in light of the risks frequently encountered by early stage
companies, especially those formed to develop and market new technologies. These risks include Lumera’s
potential inability to establish product sales and marketing capabilities; to establish and maintain markets
for their potential products; and to continue to develop and upgrade their technologies to keep pace with
changes in technology and the growth of markets using polymer materials. If Lumera is unsuccessful in
meeting these challenges, its stock price, and the value of the Company’s investment, could decrease.

CORPORATE INFORMATION

FORM 10-K

A copy of the Company's Annual Report on Form 10-K as filed with the Securities and Exchange

Commission may be obtained upon request without charge from the Company's headquarters, attention:
Investor Relations

MARKET FOR REGISTRANT'S COMMON EQUITY RELATED SHAREHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITES.

The Company’s common stock trades on The NASDAQ National Market under the symbol

“MVIS.” As of March 1, 2006, there were 377 holders of record of 25,243,000 shares of common stock
outstanding. The Company has never declared or paid cash dividends on the common stock. The
Company currently anticipates that it will retain all future earnings to fund the operation of its business and
does not anticipate paying dividends on the common stock in the foreseeable future.

The Company's common stock began trading publicly on August 27, 1996. The quarterly high
and low sales prices of the Company’s common stock for each full quarterly period in the last two fiscal
years and the year to date as reported by The NASDAQ National Market are as follows:

Q uarter Ended

2004

March 31, 2004

June 30, 2004

September 30, 2004

December 31, 2004

2005

March 31, 2005

June 30, 2005

September 30, 2005

December 31, 2005

2006

January 1, 2006 to March 1, 2006

Common Stock

HIGH

LO W

10.93

10.00

8.95

8.00

7.70

6.77

6.49

6.53

7.34

5.06

3.75

5.04

5.03

4.15

5.04

3.02

4.25

3.05

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Officers and Directors

> Board of Directors
Richard A. Cowell
Principal
Booz Allen Hamilton, Inc.

> Executive Officers

Alexander Y. Tokman
President and
Chief Executive Officer

Slade Gorton
Of Counsel
Preston Gates & Ellis, LLP;
Former U.S. Senator

Jeanette Horan
Vice President, Business Process
and Architecture Integration
IBM

Marc Onetto

Richard F. Rutkowski

Alexander Y. Tokman
President and
Chief Executive Officer
Microvision, Inc.

Brian Turner
Chief Financial Officer
Coinstar, Inc.

Ian D. Brown
Vice President
Sales and Marketing

Sridhar Madhavan
Vice President
Engineering

Todd R. McIntyre
Senior Vice President
Global Strategic Marketing and
Business Development

Thomas M. Walker
Vice President
General Counsel and Secretary

Stephen R. Willey
President
Sales and Marketing for Asia

Jeff T. Wilson
Chief Financial Officer

> Independent Accountants
PricewaterhouseCoopers LLP

> Transfer Agent

American Stock Transfer
and Trust Company
59 Maiden Lane
New York, NY 10038
Shareholder Services
800 937-5449

> Stock Listing

Microvision, Inc. common stock
is traded on The Nasdaq Stock
Market under the symbol MVIS.

> Investor Inquiries
Microvision, Inc.
Attn: Investor Relations
6222 185th Ave NE
Redmond, WA 98052
425 936-6847
ir@microvision.com

> Corporate Counsel
Ropes & Gray LLP
One International Place
Boston, MA 02110

> Forward-looking Statements

Statements contained in this annual report that relate to future plans, potential applications of our technology, plans for product development, future
product size and cost, sales and sales growth, customers and partners, signing of contracts, future operations and shipping of products, as well as
statements containing words like “expect,” “believe,” “could,” “anticipate,” “estimate,” “will,” and other similar expressions, are forward-looking
statements that involve a number of risks and uncertainties. Factors that could cause actual results to differ materially from those projected in the
Company’s forward-looking statements include the following: Capital market risks, our ability to raise additional capital when needed; market accept-
ance of our technologies and products; our financial and technical resources relative to those of our competitors; our ability to keep up with rapid
technological change; our dependence on the defense industry and a limited number of government development contracts; government regulation
of our technologies; our ability to enforce our intellectual property rights and protect our proprietary technologies; the ability to obtain additional
contract awards; the timing of commercial product launches and delays in product development; the ability to achieve key technical milestones in
key products; dependence on third parties to develop, manufacture, sell and market our products; potential product liability claims, risks related
to Lumera’s business and the market for its equity and other risk factors identified from time to time in the company’s SEC reports and other filings,
including the Company’s Annual Report on Form 10-K filed with the SEC. Except as expressly required by the federal securities laws, we undertake no
obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changes in circumstances
or any other reason.

The Microvision logo, Flic, IPM, Nomad, MicroHUD and PicoP are trademarks of Microvision, Inc. All other trademarks are the property of their respective owners.
©2006, Microvision, Inc. All rights reserved.

www.microvision.com

6222 185th Ave NE

Redmond, WA 98052

425 936-6847 TEL

425 936-6600 FAX

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