Annual Report 2014 About the pictures on the front cover (left to right): Modular LED line Light, Multi-Wavelength, Highly Uniform, Long Working Distance The modular LED line light produces a highly uniform line utilizing dual-axis collimation. The light can be configured to maintain a specific line thickness across a wide working distance range. Highly uniform line lights have applications within the machine vision industry for various types of inspection such as rail, container, and optical sorting applications. UV COBRA™ Cure Line Light UV COBRA™ Cure is a compact LED line light illuminator with a modular form factor. It produces a uniform line and offers field adjustable optics to allow users to select the optimum lens position for their application in the field. The light has applications in machine vision systems, adhesive curing assembly lines and industrial scale printing applications. Green 3D PRO Laser Modules The 3D PRO™ Laser Green series includes the 3D PRO Green, the Adjustable Focus 3D PRO Laser Green and the 3D PRO Laser Mini Green. These direct emission green structured light lasers deliver excellent uniformity making them an ideal solution for a wide range of applications such as 3D Printing and 3D imaging. Compact LED Light Sources for Endoscopic applications ProPhotonix has developed LED light sources for endoscopic applications in several different form factors. The pictured light engine placement at the tip of the endoscope is unique. ProPhotonix utilized innovative technologies to overcome thermal issues while staying within size and performance constraints of the product. A 3D ceramic substrate containing laser patterning of interconnects forms the platform on which the LEDs are precisely placed and bonded allowing for a precise placement into the scope. Solutions for LEDs ProPhotonix Limited (IRE) 3020 Euro Business Park Little Island Cork, Ireland +353-21-5001300 Solutions for Lasers ProPhotonix Limited Sparrow Lane, Hatfield Broad Oak Hertfordshire, CM22 7BA UK +44-1279-717170 Corporate ProPhotonix Limited 32 Hampshire Road Salem, NH 03079 +1-603-893-8778 Page 2 Business Activities: ProPhotonix consists of two business units: an LED systems manufacturing business based in Ireland (Cork), and a laser modules production and laser diode distribution business located in the United Kingdom (Hatfield Broad Oak). Corporate headquarters and the North American sales activities are based in Salem, New Hampshire, USA. The fundamental strategy of the Company is growth in revenue through its existing customers, new customer activity, and new product and market expansion. ProPhotonix Limited sells its products principally into three markets: industrial, (primarily machine vision illumination), medical, and homeland security and defense. The Company foresees growth opportunities in all three markets it serves which are briefly described below: Industrial (Machine Vision) Within the industrial market, machine vision is the term used to describe computerized analysis for controlling manufacturing processes, for example automated inspection. In terms of quality and speed, lighting is often a critical component in machine vision and the Company manufactures both LED systems and lasers designed specifically for this market. The recently enhanced 3D Pro Laser line generators and improved LED line light family specifically address this market. Medical The Company has experienced successes in the medical (including dental) market and has gained a foothold in the market, supplying a variety of applications, with current customers including the world leader in stationary imaging equipment, a portable x-ray equipment manufacturer, a dental imaging manufacturer and also a pioneer in the manufacturing of devices offering eye tracking capability utilizing ProPhotonix’s custom infrared LED arrays. The Company intends to broaden its product marketing effort in the medical field since it offers significant long-term revenue growth opportunities. Homeland Security & Defense LED systems, laser modules and laser diodes are used in a wide variety of applications in the security and defense fields. The Company currently supplies several defense sighting manufacturers in the US and Europe, as well as leading manufacturers of Auto Number Plate Recognition systems. This market offers significant growth opportunities for ProPhotonix over the next several years and the Company is currently marketing its laser and LED capabilities to additional security and Optical Character Recognition systems companies in this market space. Page 3 To the Shareholders of ProPhotonix Limited: 2014 Annual Report to Shareholders 2014 has been a landmark year in a number of respects – our first full year of positive operating income in nearly two decades, our first full year of positive EBITDA in fourteen years, and we have achieved three consecutive half-yearly periods of positive EBITDA. In addition to a continuation of improving financial results, Team ProPhotonix has been diligently pursuing new customer engagement and new product and market initiatives which help set the stage for 2015 and beyond. Financial Progress: Our financial performance has dramatically improved during 2014. Revenue grew a modest 5% while operating income improved by $1.3 million ($0.7 million adjusted for 2013 one-time charges) and EBITDA improved similarly by $1.3 million ($0.7 million adjusted for the 2013 one-time charges of $0.6 million). The growth in revenue, improvement in the gross margin rate, and continuing costs reductions, all factors into the continued financial improvement of ProPhotonix. I am pleased with the revenue growth in 2014, but more importantly, the improvement in operating income and EBITDA. The balance sheet also continued to improve in 2014. Term debt was reduced by $293,000 in accordance with the various loan facilities and total available credit from the Company’s various loan facilities was $1.9 million as of December 31, 2014. During 2014, order bookings declined 9% to $16.1 million from 2013 and the book-to-bill ratio ended at 0.98 (2013: 1.13). Our order backlog at December 31, 2014 was down 20% from 2013 to $5.6 million. Several factors contributed to the decline in bookings and backlog including: customers’ reluctance to place large blanket orders opting instead for smaller short-cycle orders, business softness or delays in several industrial customers, the decline in foreign currency translation rates from year-end 2013 to year-end 2014 and, as compared to 2013, several large non-recurring engineering (NRE) orders received in 2013 and completed in 2014. Since May 2014, the exchange rates of the Euro and British Pound (GBP) to the dollar (USD) have been weakening. The Euro to USD and GBP to USD exchange rates, as of March 18, 2015, have eroded 20% and 10% respectively from the 2014 average and 13% and 5% respectively since the beginning of the year. The effect of a strengthening dollar may negatively impact 2015 revenue growth on a comparative basis when Euro and GBP denominated revenue is translated into USD. EBITDA will likely be less impacted due to the translation of costs at lower exchange rates, our natural operating hedges in the locations we operate in and the supply chain we utilize. Recent booking trends, the macroeconomic environment, and foreign exchange rate impacts cause us to be cautious for the first half of 2015, but we remain very positive about our growing business pipeline and confident in our ability to achieve continued positive momentum toward our profitability objectives. Customer development initiatives: New customer activity is a cornerstone for our growth and I am pleased that we are continuously partnering with new customers. New customer orders received, in 2014, accounted for $0.8 million of the total growth across several market sectors, including: Glass Inspection, Medical Devices, Metrology, Entertainment Industry, Aeronautics, and Industrial Automation and Inspection. In addition, several large non-recurring engineering (NRE) orders received in 2013 were completed in 2014 for which we now await production orders from these customers based on their go-forward schedules. We continue to add new customer opportunities through customer sponsored development. Such development has resulted in the release of two new products in 2014. I expect the custom/OEM versions of these products will deploy commercially beginning in the second half 2015 with the announced new products lines gaining commercial acceptance late in 2015. Page 4 Product development and market development: During the year, ProPhotonix completed the development of a multi-channel compact fiber-coupled high power UV laser light source (32 channels). This new capability is now being marketed to the computer-to- plate (Ctp) and maskless lithography industries. Our technology roadmap in this area includes: single-mode fiber coupled lasers, multi-spectral beam combiners, multi-channel beam combiners, and expansion of the multi-mode fiber laser product. Target markets for future systems include sensing, such as optical sorting, medical, and microscopy applications. Product development initiatives in 2014 also included the release of one new laser module and three new LED products. All in, the ProPhotonix development team announced four new products during 2014. The New Year will be even more interesting with the release of six new products early in the first quarter alone; obviously the team has been very busy developing new products for our addressable markets during 2014 which should positively impact 2015 and beyond. We also continue to pursue our existing market activities. In 2014, we added eight new diodes to the distribution product line-up. We also improved our distribution network coverage with the addition of Alava Ingenieros S.A. group, representing us in Spain and Portugal. Last year, I mentioned the UV LED market as a high potential target market. One of the new products released during 2014 is the COBRA Cure, one of the several ProPhotonix UV LED products. We are currently working with several potential customers to provide robust UV LED illuminators in markets including: 3D printing, pinning in the printing market, and UV curing. We are very excited about the LED UV market and believe the additional markets for these products include: disinfection, DNA sequencing, protein analysis, and drug discovery. Growth, Prosperity, the Future I am happy with our financial performance, but not nearly satisfied. Whilst the macroeconomic and notably foreign exchange issues are beyond our control, we are confident that the work we have done on new product and customer development will bear fruit. We remain committed to revenue growth through our existing customer base, but also by securing new customers. We must build on the 2014 success, furthering new customer revenue, while growing within our existing customer base by helping all customers prosper with ever evolving products for their applications. ProPhotonix’ near-term perspective has not changed, seeking sustained positive: EBITDA, cash flow, and net income. We will accomplish these goals through a relentless focus on cost management and most importantly through revenue growth. ProPhotonix’s growth in the medium-term will be accomplished with not only new customer wins in our currently served markets, but also through expansion into new markets and with new products. In addition to the few important areas where we are focused, we will continuously evaluate additional high growth opportunities. In conclusion, I remain deeply grateful for the continued support of you my co-workers, and our customers, suppliers, service providers, and investors! Respectfully submitted, Tim Losik President and Chief Executive Officer Page 5 Director Remuneration Report For the year ended December 31, 2014 Executive Director Compensation - Executive Director Compensation is reviewed by the Independent Non-Executive Directors. Executive Director ($) Bonus ($) Salary Pension ($) Other (1) ($) Total Cash Compensation ($) Options ($) Total ($) Total All Compensation 2014 ($) Total All Compensation 2013 ($) Tim Losik 300,750 - 5,750 - 306,500 29,271 29,271 335,771 270,957 Total Executive Compensation Non-Executive Director 300,750 - 5,750 - 306,500 29,271 29,271 335,771 270,957 Ray Oglethorpe Timothy Steel - - - - - - 25,000 25,000 3,507 3,507 28,507 28,731 25,000 25,000 3,507 3,507 28,507 28,731 Vincent Thompson - - - 25,000 25,000 3,507 3,507 28,507 28,731 Mark Weidman - - - 25,000 25,000 3,507 3,507 28,507 16,231 Total Non-Executive Compensation Director Share Options: - - - 100,000 100,000 14,028 14,028 114,028 102,424 Director Options @ 12/31/13 Options Granted Options Forfeited Options @ 12/31/14 Tim Losik 1,400,000 3,500,000 - 4,900,000 Ray Oglethorpe 1,684,006 150,000 (25,000) 1,809,006 Timothy Steel 1,145,433 150,000 - 1,295,433 Vincent Thompson 1,145,433 150,000 - 1,295,433 Mark Weidman 700,000 150,000 - 850,000 Total All Directors 6,074,872 4,100,000 (25,000) 10,149,872 (1) Other compensation for non-executive directors represents cash payments expensed in the current year. 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Page 7 ProPhotonix Limited Consolidated Financial Statements Years Ended December 31, 2014 and 2013 Page 8 FINANCIAL STATEMENTS INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Item Page Independent Auditor’s Report ....................................................................................................................... 10 Consolidated Balance Sheets as of December 31, 2014 and 2013 ............................................................... 12 Consolidated Statements of Operations and Comprehensive Loss for the Years Ended December 31, 2014 and 2013 ........................................................................................................................................... 13 Consolidated Statements of Stockholders’ (Deficit) for the Years Ended December 31, 2014 and 2013 ... 14 Consolidated Statements of Cash Flows for the Years Ended December 31, 2014 and 2013 ..................... 15 Notes to Consolidated Financial Statements………………………………………………………………. 16 Page 9 Independent Auditors’ Report The Board of Directors ProPhotonix Limited 32 Hampshire Road Salem New Hampshire United States of America Report on the Financial Statements We have audited the accompanying consolidated financial statements of ProPhotonix Limited and its subsidiaries, which comprise the consolidated balance sheets as of December 31, 2014 and 2013, and the related consolidated statements of operations and comprehensive loss, stockholders’ (deficit), and cash flows for the years then ended, and the related notes to the consolidated financial statements. This report is made solely to the company’s stockholders, as a body, in accordance with the terms of our engagement. Our audit work has been undertaken so that we might state to the company’s stockholders those matters we have been engaged to state to them in this report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s stockholders, as a body, for our audit work, for this report, or for the opinions we have formed. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Page 10 Opinion In our opinion, the consolidated financial statements referred to above present fairly in all material respects, the financial position of ProPhotonix Limited and its subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for the years then ended in accordance with U.S. generally accepted accounting principles. Cambridge United Kingdom (cid:48)(cid:68)(cid:85)(cid:70)(cid:75)(cid:3)(cid:21)(cid:23)(cid:15)(cid:3)(cid:21)(cid:19)(cid:20)(cid:24) Page 11 FINANCIAL STATEMENTS PROPHOTONIX LIMITED CONSOLIDATED BALANCE SHEETS ($ in thousands except share and per share data) December 31 2014 2013 Assets Current assets: Cash and cash equivalents Accounts receivable, less allowances of $20 in 2014 and $19 in 2013 Inventories Prepaid expenses and other current assets Total current assets Net property, plant and equipment Goodwill Acquired intangible assets, net Other long-term assets Total assets Liabilities and Stockholders’(Deficit) Current liabilities: Revolving credit facility Current portion of long-term debt Capital lease obligations Accounts payable Accrued expenses Total current liabilities Long-term debt, net of current portion Other long-term liabilities Total liabilities Stockholders’ deficit: Common stock, par value $0.001; shares authorized 250,000,000 at December 31, 2014 and 150,000,000 at December 31, 2013; 83,665,402 shares issued and outstanding at December 31, 2014 and at December 31, 2013 Additional paid-in capital Accumulated deficit Accumulated other comprehensive income / (loss) Total stockholders’ deficit Total liabilities and stockholders’ deficit $ $ 331 2,606 1,686 180 4,803 184 429 - 206 402 2,559 2,003 220 5,184 303 486 102 354 $ 5,622 $ 6,429 $ $ 1,140 770 - 1,463 965 4,338 1,641 178 6,157 1,127 265 10 1,542 1,296 4,240 2,445 178 6,863 84 111,583 (113,014) 812 84 111,302 (111,674) (146) (535) (434) $ 5,622 $ 6,429 See the notes to consolidated financial statements. Page 12 PROPHOTONIX LIMITED Consolidated Statements of Operations and Comprehensive Loss ($ in thousands except share and per share data) Revenue Cost of Revenue Gross Profit Research & Development Expenses Selling, General & Administrative Expenses Amortization of Intangible Assets Operating Income (Loss) Other Income / (Expense), net Foreign Currency Translation (losses) / gains Warrant & Debt Acquisition Expense Interest Expense Loss Before Taxes Tax Benefit Net Loss Other Comprehensive Income / (Loss): Foreign currency translation Total Comprehensive Loss Years Ended December 31, 2014 2013 $ 16,431 (10,006) $ 15,599 (9,628) 6,425 (879) (5,350) (100) 96 93 (1,031) (198) (300) (1,340) - 5,971 (941) (6,091) (120) (1,181) 117 178 (103) (237) (1,226) 73 $ ( 1,340) $ (1,153) 958 (368) $ ( 382) $ ( 1,521) Loss Per Share: Basic and diluted: Net loss per share Basic and diluted weighted average shares outstanding ($0.02) 83,665,402 ($0.01) 80,496,977 See the notes to consolidated financial statements. Page 13 PROPHOTONIX LIMITED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ DEFICIT (in thousands) Common Stock Shares Par $0.001 Additional Paid in Capital Accumulated Deficit Accumulated Other Comprehensive Income Total Stockholders’ Equity (Deficit) Balance December 31, 2012 Share based compensation, net of forfeitures ................ Issuance of common stock to settle liabilities ............ Issuance of warrants for financings .................... Translation adjustment ...... Net loss .............................. 76,059 $ 76 $110,893 $ (110,521) $ 222 $ - 7,606 - - 8 - 169 185 55 - - - - - (1,153) - (368) 670 169 193 55 (368) (1,153) Balance December 31, 2013 83,665 $ 84 $111,302 $ (111,674) $ (146) $ (434) Share based compensation, net of forfeitures ................ Translation adjustment ...... Net loss .............................. - - - - 280 - - (1,340) - 958 - 280 958 (1,340) Balance December 31, 2014 83,665 $ 84 $111,583 $ (113,014) $ 812 $ (535) See the notes to consolidated financial statements. Values may not add due to rounding Page 14 PROPHOTONIX LIMITED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Years Ended December 31 2014 2013 Cash flows from operating activities Net loss Adjustments to reconcile net loss to net cash used in operating activities: $ (1,340) $ (1,153) Stock-based compensation expense Depreciation and amortization Foreign exchange loss / (gain) Amortization of debt discount and financing costs Loss / (gain) on disposal of assets Provision for inventories Provision for bad debts Other changes in assets and liabilities: Accounts receivable Inventories Prepaid expenses and other current assets Accounts payable Accrued expenses Other assets and liabilities Net cash provided by (used in) operating activities Investing Purchase of property, plant and equipment Net cash used in investing activities Financing Borrowings of revolving credit facilities, net Proceeds from issuance of debt Principal repayment of long-term debt Debt issuance costs Net cash provided by financing activities Effect of exchange rate on cash Net change in cash and equivalents Cash and equivalents at beginning of period Cash and equivalents at end of period Supplemental cash flow information: Cash paid for interest Common stock issued in connection with financing Warrants issued in connection with financing 280 258 1,066 186 4 55 5 169 332 (408) 96 (7) 120 (12) (395) 38 23 100 (248) (2) (222) (8) 20 (518) 171 (9) 30 (64) (64) 144 175 (292) - 27 (64) (71) 402 $ $ $ $ 331 303 - - (1,429) (17) (17) 438 800 (339) (398) 501 69 (876) 1,278 $ $ $ $ 402 263 193 55 See the notes to consolidated financial statements. Page 15 PROPHOTONIX LIMITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND BASIS OF PRESENTATION ProPhotonix Limited (also referred to in this document as “ProPhotonix”, “we”, or the “Company”) operates in two segments: as an independent designer and manufacturer of LED systems through ProPhotonix (IRL) Limited; and as a manufacturer of laser modules and a distributor of laser diodes through ProPhotonix Limited, a U.K. subsidiary. The operating units are ProPhotonix (IRL) Limited based in Cork, Ireland, ProPhotonix Limited, a U.K. subsidiary based near Stansted, United Kingdom and ProPhotonix Limited, based in Salem, New Hampshire, U.S.A. The Company’s products serve a wide range of applications and industries including machine vision and industrial inspection, biomedical, defense and security, and other commercial applications. ProPhotonix Limited was incorporated on March 27, 1951 in the Commonwealth of Massachusetts and is currently incorporated in the state of Delaware. The common stock of the Company now trades on the OTC Market in the U.S. under the trading symbol “STKR” and is also traded on the London Stock Exchange, plc (AIM listing), under the trading symbols “PPIR” and “PPIX”. The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements, during the years ended December 31, 2014 and 2013, the Company recorded net losses of $1,340,000 and $1,153,000, respectively. Net cash flow from operating activities for the same time periods were $30,000 and $(1,429,000), respectively. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company believes that it has adequate available working capital to continue to trade for at least the next twelve months from the issuance of these financial statements. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements are prepared in conformity with Generally Accepted Accounting Principles (“U.S. GAAP”) and reflect the application of the Company’s most significant accounting policies as described in this note and elsewhere in the accompanying consolidated financial statements and notes. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, ProPhotonix (IRL) Limited, StockerYale (UK) Ltd., which owns 100% of ProPhotonix Limited, a U.K. subsidiary, and ProPhotonix Holdings, Inc., which holds all of the outstanding shares of StockerYale Canada. All intercompany balances and transactions have been eliminated. CASH AND CASH EQUIVALENTS The Company considers cash equivalents to consist of highly liquid investments with original maturities of three months or less when purchased. Page 16 ACCOUNTS RECEIVABLE The Company reviews the financial condition of new customers prior to granting credit. After completing the credit review, the Company establishes a credit line for each customer. Periodically, the Company reviews the credit line for major customers and adjusts the credit limit based upon an updated financial condition of the customer, historical sales and payment information and expected future sales. The Company has a large number of customers; therefore, material credit risk is limited. The Company periodically reviews the collectability of its accounts receivable. Provisions are established for accounts that are potentially uncollectible. The Company also has accounts receivables insurance at ProPhotonix Limited, a U.K. subsidiary, which also covers most of the larger customers at the ProPhotonix (IRL) Limited subsidiary, and allows the Company to submit a claim on overdue receivables in excess of 60 days past invoice due date. Determining adequate reserves for accounts receivable requires management’s judgment. Conditions impacting the collectability of the Company’s receivables could change causing actual write-offs to be materially different than the reserved balances. Changes in the allowance for doubtful accounts were as follows: Years Ended December 31 Balance at beginning of period .................................................................. Charges (recoveries) to costs and expenses .............................................. Account write-offs and other deductions .................................................. Balance at end of period ............................................................................ 2014 2013 In thousands $ 19 $ 3 (2) 31 (10) (2) $ 20 $ 19 INVENTORY The Company values inventories at the lower of cost or market using the first in, first-out (“FIFO”) method. The Company periodically reviews the quantities of inventory on hand and compares these amounts to the expected usage for each particular product or product line. The Company records as a charge to cost of sales any amounts required to reduce the carrying value amount of the inventory to market. Actual results could be different from management’s estimates and assumptions. INTANGIBLE ASSETS The Company’s intangible assets consist of goodwill, trademarks, acquired patents and patented technologies, distributor and customer relationships and related contracts, technology design and programs, non-compete agreements and other intangible assets which, except for goodwill, are being amortized over their useful lives. Goodwill is tested for impairment on an annual basis, and between annual tests when indicators of impairment are present, and written down when and if impaired. The Company has elected the end of the fourth quarter to complete its annual goodwill impairment test. LONG-LIVED ASSETS The Company reviews the recoverability of its long-lived assets including property, plant and equipment and amortizing intangible assets when events or changes in circumstances occur that indicate that the carrying value of the assets may not be recoverable. This review is based on the Company’s ability to recover the carrying value of the assets from expected undiscounted future cash flows. If impairment is indicated, the Page 17 Company measures the loss based on the difference between the carrying value and fair value of the asset using various valuation techniques including discounted cash flows. If the asset is determined not to be recoverable,, the amount of the loss will be recorded in the consolidated statements of operations. It is possible that future events or circumstances could cause these estimates to change. LOSS PER SHARE The Company calculates basic and diluted net loss per common share by dividing the net loss applicable to common stockholders by the weighted average number of common shares outstanding. As of December 31, 2014, 22,365,040 shares underlying options and 8,577,567 shares underlying warrants were excluded from the calculation of diluted shares, as their effects were anti-dilutive. As of December 31, 2013, 12,615,690 shares underlying options and 8,582,567 shares underlying warrants were excluded from the calculation of diluted shares, as their effects were anti-dilutive. REVENUE RECOGNITION The Company recognizes revenue from product sales at the time of shipment and when persuasive evidence of an arrangement exists, performance of our obligation is complete, the price to the buyer is fixed or determinable, and collectability is reasonably assured. Custom products are designed and supplied to original equipment manufacturers and produced in accordance with a customer-approved design. Custom product revenue is recognized when the criteria for acceptance has been met. Title to the product generally passes upon shipment, as products are generally shipped free on board at shipping point. In certain limited situations, distributors may have the right to return products. Such rights of return may preclude the Company from recognizing revenue until the return period has ended. Revenues from funded research and development and product development are recognized based on contractual arrangements, which may be based on cost reimbursement or fixed fee-for-service models. Revenue from reimbursement contracts is recognized as services are performed. On fixed-price contracts, revenue is generally recognized on a percentage of completion basis based on proportion of costs incurred to the total estimated costs of the contract. Over the course of a fixed-price contract, the Company routinely evaluates whether revenue and profitability should be recognized in the current period. The Company estimates the proportional performance on their fixed-price contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If the Company does not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance, subject to any project management assessments as to the status of work performed. When the current estimates of total contract revenue and contract costs indicate a loss, a provision for the entire loss on the contract is recorded. For those arrangements that include multiple deliverables, the Company first determines whether each service or deliverable meets the separation criteria of FASB ASC 605-25, Revenue Recognition—Multiple- Element Arrangements. In general, a deliverable (or a group of deliverables) meets the separation criteria if the deliverable has stand-alone value to the customer and, if the arrangement includes a general right of return related to the delivered item, that delivery or performance of the undelivered item(s) is considered probable and is substantially in control of the Company. Each deliverable that meets the separation criteria is considered a separate ‘‘unit of accounting”. After the arrangement consideration has been allocated to each unit of accounting, the Company applies the appropriate revenue recognition method for each unit of accounting based on the nature of the arrangement and the services included in each unit of accounting. All deliverables that do not meet the separation criteria of FASB ASC 605-25 are combined into one unit of accounting, and the most appropriate revenue recognition method is applied. Page 18 WARRANTY The Company provides standard warranties for most products for periods up to one year. The warranty is limited to the cost of the product and the Company will repair or replace the product as required. The Company monitors the actual warranty repair costs and trends in relation to the reserve as a percent of sales. The Company adjusts annually the warranty provision based on actual experience and for any particular known instances. Warranty Reserves: Balance at beginning of period .................................................... Charges (recoveries) to costs and expenses ................................. Account write-offs and other deductions ..................................... $ $ In thousands 146 36 (36) Balance at end of period ...................................................... $ 146 $ 164 (4) (14) 146 Years Ended December 31, 2014 2013 The Company expenses advertising costs as incurred. Advertising expenses for the years ended 2014 and 2013 were approximately $82,000 and $181,000, respectively. ADVERTISING EXPENSE PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are valued at the lower of cost or estimated carrying values. The Company provides for depreciation on a straight-line basis over the assets estimated useful lives or capital lease terms, if shorter. The following table summarizes the estimated useful lives by asset classification: Asset Classification Building and building improvements ................................... Term of the lease or 10-40 years Computer equipment ............................................................ Machinery and equipment .................................................... Furniture and fixtures ........................................................... 3 to 5 years 5 to 10 years 3 to 10 years Estimated Useful Life Maintenance and repairs are expensed as incurred. INCOME TAXES The Company accounts for income taxes under the asset and liability method. Under this method the Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax basis of the assets and liabilities using tax rates expected to be in place when the differences reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company recognizes the tax benefit of tax positions to the extent that the benefit will more likely than not be realized. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical Page 19 merits of the tax position as well as consideration of the available facts and circumstances. With respect to any uncertain tax positions, the Company records interest and penalties, if any, as a component of income tax expense. It did not have any interest and penalties related to uncertain tax positions during the years ended December 31, 2014 or 2013. STOCK-BASED COMPENSATION the grant of a variety of awards with various The Company has stock-based compensation plans for its employees, officers, and directors. The plans permit the Remuneration Committee of the Company’s Board of Directors. Generally the grants vest over terms of one to four years and are priced at fair market value, or in certain circumstances 110% of the fair market value, of the common stock on the date of the grant. The options are generally exercisable after the period or periods specified in the option agreement, but no option may be exercised after 10 years from the date of grant. terms and prices as determined by Additionally, in the case of incentive stock options, the exercise price may not be less than 100% of the fair market value of the Company’s common stock on the date of grant, except in the case of a grant to an employee who owns or controls more than 10% of the combined voting power of all classes of the Company’s stock or the stock of any parent or subsidiary. In that case, the exercise price shall not be less than 110% of the fair market value on the date of grant. In the case of non-qualified stock options, the exercise price shall not be less than 85% of the fair market value of the Company’s common stock on the date of grant, except in the case of a grant to an independent director; in which case the exercise price shall be equal to fair market value determined by reference to market quotations on the date of grant. During 2014, the Company recognized approximately $280,000 of stock-based compensation related to options, all of which was charged to general and administrative expense. During 2013, the Company recognized approximately $169,000 of stock-based compensation related to options, all of which was charged to general and administrative expense. Stock Option Awards—The fair value of each option grant is estimated using the Black-Scholes option pricing model. The fair value is then expensed ratably over the requisite service periods of the awards, which is generally the vesting period. Use of a valuation model requires management to make certain assumptions with respect to selected model inputs. Expected volatility is calculated based on the historical volatility of the Company’s stock at the time of the award. The average expected option term is based on historical trends. The risk-free interest rate is based on U.S. Treasury zero-coupon issues assumed at the date of grant and generally no dividends are assumed in the calculation. The compensation expense recognized for all equity-based awards is net of estimated forfeitures. Forfeitures are estimated based on the historical trends. During 2014, the Company implemented the 2014 stock incentive plan, which is described in Note 11. TRANSLATION OF FOREIGN CURRENCIES The Company’s operating results are affected by fluctuations in the value of the U.S. dollar as compared to currencies in foreign countries, as a result of our transactions in these foreign markets. For foreign subsidiaries, whose functional currency is not the U.S. dollar, assets and liabilities are translated using the foreign exchange rates prevailing at the balance sheet date, and income and expense accounts using average exchange rates for the period. Cumulative transaction gains or losses from the translation into the Company’s reporting currency are included as a separate component of stockholder’s deficit (accumulated other comprehensive income) in the accompanying consolidated balance sheets. Page 20 Management determined the functional currency of ProPhotonix Limited, a U.K. subsidiary, and ProPhotonix (IRL) Limited is the euro, while the functional currency of ProPhotonix Limited U.S.A. is the U.S. dollar. FAIR VALUES OF FINANCIAL INSTRUMENTS The Company’s financial instruments consist mainly of cash and cash equivalents, accounts receivable, revolving credit facility, accounts payable and long-term debt. The estimated fair value of these financial instruments, with the exception of fixed rate long-term debt, approximates their carrying value due to the short- term maturity of certain instruments and the variable interest rates associated with certain instruments, which have the effect of re-pricing such instruments regularly. At December 31, 2014, the Company estimated the fair value of long term fixed rate debt to be approximately $3,300,000 compared to its carrying value of $3,100,000. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of trade receivables. The risk is limited due to the relatively large number of customers composing the Company’s customer base and their dispersion across many industries and geographic areas within the United States, Canada, United Kingdom, Europe and Asia. The Company performs ongoing credit evaluations of existing customers’ financial condition. The Company believes that its concentrated credit risk is limited to only a small number of customers. The Company had no customer accounting for 10% or more of consolidated revenues in either 2014 or 2013. The Company had one customer that accounted for 10% of the outstanding accounts receivable balance at December 31, 2014 and 2013. The Company maintains its cash and cash equivalents in bank deposit accounts, which at times may exceed insured limits. At December 31, 2014, the amount in excess of governmental insurance protection was approximately $0.2 million, measured across all entities and jurisdictions. At December 31, 2013, the amount in excess of governmental insurance protection was approximately $0.3 million. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents. 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 as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Actual results in the future could vary from the amounts derived from management’s estimates and assumptions. Page 21 (3) RECENT ACCOUNTING PRONOUNCEMENTS The Company has reviewed recently issued accounting pronouncements to determine the impact that these pronouncements are expected to have on the financial statements when adopted in future periods. In August 2014, the FASB updated the Accounting Standards Codification and amended Subtopic 205- 40, Presentation of Financial Statement – Going Concern. This amended guidance requires that in connection with preparing financial statements for each annual and interim reporting period, an entity’s management should evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued (or at the date that the financial statements are available to be issued when applicable). Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or available to be issued). The term probable is used consistently with its use in Topic 450, Contingencies. When management identifies conditions or events that raise substantial doubt about an entity’s ability to continue as a going concern, management should consider whether its plans that are intended to mitigate those relevant conditions or events will alleviate the substantial doubt. The mitigating effect of the management’s plans should be considered only to the extent that (1) it is probable that the plans will be effectively implemented and, if so (2) it is probable that the plans will mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern. If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, but the substantial doubt is alleviated as a result of consideration of management’s plans, the entity should disclose information that enables users of the financial statements to understand all of the following: a. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans) b. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations c. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern. If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, and substantial doubt is not alleviated after consideration of management’s plans, an entity should include a statement in the footnotes indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or available to be issued). Additionally, the entity should disclose information that enables users of the financial statements to understand all of the following: a. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern b. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations Page 22 c. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern. The amendments are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company will evaluate this reporting requirement and adopt with the year beginning January 1, 2016. However the adoption of these requirements is not expected to have a significant impact on the Company’s financial statements. In June, 2014, the FASB updated the Accounting Standards Codification and amended Topic 718, Compensation – Stock Compensation. This amended guidance requires that a performance based target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The reporting entity should apply existing guidance, in Topic 718, as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the target should not be reflected in the estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. The adoption of this guidance did not have an impact on our consolidated financial position, results of operation or cash flows. In May 2014, the FASB amended the Accounting Standards Codification and created a new Topic 606, Revenue from Contracts with Customers. The new guidance establishes a single comprehensive contract-based model for entities to use in accounting for revenue arising from contracts with customers. The new model significantly changes existing GAAP, requires substantial judgment in its application, and will generally require companies to make more disclosures about revenue. The core principle of the amendment is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the new guidance, an entity will (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the contract’s performance obligations; and (5) recognize revenue when (or as) the entity satisfies a performance obligation. The new standard provides for two alternative implementation methods. The first is to apply the new standard retrospectively to each prior reporting period presented. This method does allow the use of certain practical expedients. The second method is to apply the new standard retrospectively in the year of initial adoption and record a cumulative effect adjustment for the impact of adjusting contracts open at the date of adoption. Under this transition method, we would apply this guidance retrospectively only to contracts that are not completed contracts at the date of initial application. We would then recognize the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings. This method also requires us to disclose comparative information for the year of adoption. We will adopt the FASB’s amended guidance for our year beginning January 1, 2016; early adoption is not permitted. We are currently evaluating the new guidance and have not determined the impact this standard may have on our financial statements nor have we decided upon the method of adoption. Page 23 (4) INVENTORIES Inventories are stated at the lower of cost (first-in, first-out basis) or market when applicable and include materials, labor and overhead. Inventories are as follows: Years Ended December 31 Finished goods...................................................................................... Work in-process ................................................................................... Raw materials ....................................................................................... Net inventories ............................................................................. 2014 2013 In thousands $ 327 226 1,133 $ 1,686 $ 403 218 1,382 $ 2,003 Management performs quarterly reviews of inventory and disposes of items not required by their manufacturing plan and reduces the carrying cost of inventory to the lower of cost or market. (5) PROPERTY, PLANT AND EQUIPMENT Major classes of property, plant and equipment were as follows: Years Ended December 31 2014 2013 Buildings and building improvements ........................................... Computer equipment ...................................................................... Machinery and equipment .............................................................. Furniture and fixtures ..................................................................... Property, plant and equipment................................................ Less accumulated depreciation ....................................................... Net property, plant and equipment ......................................... $ In thousands $ 276 413 1,668 410 301 437 1,843 523 $ 2,767 (2,583) $ 3,104 (2,801) $ 184 $ 303 Depreciation expense from operations was approximately $158,000 and $212,000 in the years ended December 31, 2014 and 2013, respectively. (6) GOODWILL The Company uses a three-step approach to a goodwill impairment test. First, ASU 2011-08 allows entities with the option to first use an assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If a conclusion is reached that reporting unit fair value is not more likely than not below carrying value, no further impairment testing is necessary. If further testing is necessary, the second step is to estimate the fair value of its reporting units by using forecasts of discounted cash flows and compare that value to the carrying value which requires that certain assumptions and estimates be made regarding industry economic factors and future profitability of reporting units to assess the need for an impairment charge. The methodology the Company uses to allocate certain corporate expenses is based on each segment’s use of services and/or direct benefit to its employees. While the Company believes it has made reasonable estimates and assumptions to calculate the fair value of the reporting segments and implied fair value of goodwill, the impairment analysis is highly sensitive to actual versus forecast results. Finally, if the Page 24 estimated value is less than the carrying value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. In connection with the annual fair value test of goodwill, performed at the end of the fourth quarter 2014, and at the end of the fourth quarter 2013, the Company concluded that no impairment existed. The changes in the carrying amount of goodwill for the years ended December 31, 2014 and 2013 were as follows: Beginning of the year .................................................. Effect of exchange rate ............................................... $ 486 (57) $ 467 19 End of year .................................................................. $ 429 $ 486 December 31, 2014 December 31, 2013 ( In thousands) Goodwill as of December 31, 2014 and 2013 relates to the LED reporting unit. (7) INTANGIBLE ASSETS Intangible assets consist of distributor and customer relationships and related contracts, technology design and programs, and other intangible assets. There are no intangible assets with indefinite lives. There were no intangible assets acquired in 2014. Intangible assets and their respective useful lives are as follows: Acquired customer contracts and relationships Acquired technology design and programs Other Useful Life 5 – 8 Years 8 Years 3 – 7 Years Gross carrying amounts and accumulated amortization of intangible assets were as follows as of December 31, 2014 for each intangible asset class. Gross Carrying Amount Accumulated Amortization (in thousands) Net Balances Acquired customer contracts and relationships ......................... Acquired technology design and programs................................ Other .......................................................................................... Total ................................................................................... 1,942 329 107 $ 2,378 $ (1,942) (329) (107) (2,378) $ - - - - Gross carrying amounts and accumulated amortization of intangible assets were as follows as of December 31, 2013 for each intangible asset class. Page 25 Gross Carrying Amount Accumulated Amortization (in thousands) Net Balances Acquired customer contracts and relationships ......................... Acquired technology design and programs ............................... Other .......................................................................................... Total ................................................................................... 2,062 349 114 $ 2,525 $ (2,011) (298) (114) (2,423) $ 51 51 - 102 Actual Expense 2013 2014 In thousands Amortization expense of intangible assets ................... $ 118 $ 100 (8) DEBT Years Ended December 31 Senior Fixed Rate Secured Bond (“PPI Bond”) to a private investor, maturing on June 30, 2017 with an interest rate of 8%, net of unamortized debt discount of $26,000 at December 31, 2014 and $45,000 at December 31, 2013, with an interest rate of 8%. Senior Fixed Rate Secured Bond to a private investor, maturing on June 20, 2017, with an interest rate of 12.25%, at December 31, 2014 and at December 31, 2013. Senior Fixed Rate Secured Bond to a private investor, maturing on June 20, 2017, with an interest rate of 12.25%, at December 31, 2014 and at December 31, 2013 2014(1) 2013 In thousands $ 1,408 $ 1,750 334 320 669 640 Borrowings under Revolving Credit facility with Barclays Bank Sales Financing with an interest rate of 2.50% above Barclay’s base rate at December 31, 2014 and at December 31, 2013 (3.0% as of December 31, 2014 and at December 31, 2013). Sub-total debt Less – revolving credit facility Less—Current portion of long-term debt Total long-term debt 1,140 3,551 (1,140) (770) 1,127 3,837 (1,127) (265) $ 1,641 $ 2,445 (1) As of December 31, 2014, the Company had approximately $ 1,872,000 available under the various borrowing facilities. Page 26 Photonic Products Ltd. BORROWING AGREEMENTS StockerYale (UK) Ltd., a wholly owned subsidiary of the Company, issued bonds to each of the former stockholders of Photonic Products Ltd. with an aggregate initial principal amount equal to $2,400,000 (Photonic Bonds). During the term of the Photonic Bonds, the Company and the bond holders entered into various amendments and Deeds of Variation. The bonds were paid in full on April 30, 2013. Private Investor Notes and Bond ProPhotonix (IRL) Limited Senior Fixed Rate Secured Bond On July 24, 2008, ProPhotonix (IRL) Limited issued a three-year 12% Senior Fixed Rate Secured Bond (“PPI Bond”), as amended at various times, to a bondholder in the original principal amount of €935,000 ($1,472,905 at July 24, 2008) secured by all of the assets of ProPhotonix (IRL) Limited. On June 20, 2013 the bondholder entered into an amendment and waiver agreement with the Company waiving all events of default from inception of the bond through the date of the amendment. In addition, the bondholder also agreed to amend the terms of the bond as follows: (a) Convert € 144,324 ($193,132) of the balance of the bond into common stock of the Company with a subsequent transfer of such common stock to the Term Loan holder, described below as part of the Term Loan provided to the Company (b) Issue 1,900,000 warrants over common stock of the Company exercisable at a price of $0.03 per share through June 20, 2023 as described in Note 10. The fair value of these warrants of $55,185 was deducted from the carrying value of the bond and is being amortized over the remaining term of the PPI Bond (c) Principal as of June 20, 2013: € 1,426,540 ($1,909,281) (d) Interest Rate: 8% per annum (e) Interest payments only: June 30, 2013 through June 30, 2014 (f) Principal Repayment: €15,000 per month plus interest July 1, 2014 through June 30, 2015, thereafter principal and interest monthly €56,378 ($75,456) from July 1, 2015 through June 30, 2017* (g) One-time fee of €31,413 ($42,043) payable on June 30, 2017. This fee is being accrued ratably over the life of the loan, payable in June, 2017. In addition, the Company recorded debt acquisition costs of $134,484 which is being amortized over the life of the amended term note. (cid:13) In addition to the terms above, the bondholder will be entitled to accelerated principal payments, on a quarterly basis, equal to 30% of Free Cash Flow (defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) minus debt repaid and interest paid, minus capital expenditures not financed, and minus taxes paid, each during such calendar quarter). Such payments have been made within 45 days of the end of such calendar quarter, or as agreed to by the lender. At December 31, 2014, $1,433,877 remained outstanding under the note, which has been classified as $420,992 current portion of long term debt and $1,012,885 long term debt and reported net of $25,648 of unamortized debt discount, which has been reported as $16,190 as short-term and $9,458 as long-term. Page 27 At December 31, 2013, $1,794,702 remained outstanding under the note, which has been classified as $123,912 current portion of long term debt and $1,670,790 long term debt and reported net of $44,857 of unamortized debt discount, which has been reported as $19,209 as short-term and $25,648 as long-term. Term Notes: PPI Bond Holder On June 20, 2013, the Company entered into a Term Loan agreement with the PPI Bond holder to provide up to $1.0 million of loan availability subject to certain terms as follows: (a) Available Loan (subject to (b) below): (b) 50% of each advance shall be used to repay amounts owed under the PPI Bond $1.0 million (c) Interest Rate: (d) Interest payments only: (e) Principal Repayment term: 12.25% per annum June 30, 2013 through June 30, 2014 36 months (July 1, 2014 through June 20, 2017) The Company recorded debt acquisition costs of $70,437 which is being amortized over the life of the term note. In addition, the Company is accruing a back-end fee of $15,000 ratably over the life of the loan, payable in June, 2017. At December 31, 2014, $334,486 remained outstanding under the note, which has been classified as $121,711 current portion of long-term debt and $212,775 as long term debt. As of December 31, 2014, the Company had net available funding of $305,000. At December 31, 2013, $320,000 remained outstanding under the note, which has been classified as $53,415 current portion of long-term debt and $266,585 as long term debt. As of December 31, 2013, the Company had net available funding of $340,000. Tiger Investments 1 LLC On June 20, 2013, the Company entered into a Term Loan agreement with a Lender, which is owned and controlled by the wife of Tim Losik, Patricia Losik. As Mr. Losik is a director and the Chief Executive of the Company, the entry into the Loan Facility constitutes a “related party transaction” for the purposes of AIM Rule 13. The Term Loan provides availability to the Company of up to $2.0 million during the term of the Loan, as follows, subject to certain restrictions: (a) Available Loan: (b) Interest Rate: $2.0 million 12.25% per annum (c) Interest payments only: (d) Principal Repayment term: June 30, 2013 through June 30, 2014 36 months (July 1, 2014 through June 20, 2017) The Company recorded debt acquisition costs of $165,817 which is being amortized over the life of the term note. In addition, the Company is accruing a back-end fee of $60,000 over the life of the loan, payable in June, 2017. Page 28 At December 31, 2014, $668,973 remained outstanding under the note, which has been classified as $243,422 current portion of long-term debt and $425,551 as long term debt. As of December 31, 2014, the Company had $1,220,000 available under this borrowing facility. At December 31, 2013, $640,000 remained outstanding under the note, which has been classified as $106,830 current portion of long-term debt and $533,170 as long term debt. As of December 31, 2013, the Company had $1,360,000 available under this borrowing facility. Barclays Bank, PLC On February 6, 2008, ProPhotonix Limited, a U.K. subsidiary, entered into a Confidential Invoice Discounting Agreement, as amended at various times, with Barclays Bank Sales Financing (“Barclays”). Under the Discounting Agreement, a three-year revolving line of credit was established. The Discounting Agreement originally provided for a revolving line of credit not to exceed an aggregate principal amount of £700,000 ($1,087,000), later reduced to £650,000 ($1,010,000), and grants a security interest in and lien upon all of ProPhotonix Limited, a U.K. subsidiary, trade receivables in favor of Barclays. The Company originally could borrow a total amount at any given time up to ₤700,000, limited to qualifying receivables as defined. The facility requires the maintenance of certain financial covenants including a minimum tangible net worth. On November 29, 2013, the Company entered into an amendment to the revolving credit facility to (i) increase the line from £650,000 to £1,400,000; (ii) to reduce the discount rate from 2.65% plus Barclays base rate to 2.50% plus Barclays base rate and service charges and extended the minimum period of this amendment to 24 months through November 29, 2015. The Company recorded debt acquisition costs of $27,172 which is being amortized over the two year amendment period. The amount outstanding under the facility was $1,140,000 as of December 31, 2014 and $1,127,000 as of December 31, 2013, all of which was classified as a short term debt under revolving credit facility. As of December 31, 2014, the Company had approximately $347,000 available under this facility. (9) TAXES The Company had deferred tax assets, before considering the full valuation allowance, totaling approximately $27.1 million as of December 31, 2014 and approximately $27.3 million as of December 31, 2013. Realization of the deferred tax assets is dependent upon the Company’s ability to generate sufficient future taxable income and, if necessary, execution of tax planning strategies. The Company’s historical operating losses raise considerable doubt as to when, if ever, any of the deferred tax assets will be realized. As a result, management has provided a valuation allowance for the net deferred tax assets. In the event management determines that sufficient future taxable income may be generated in subsequent periods and the previously recorded valuation allowance is no longer needed, the Company will decrease the valuation allowance by providing an income tax benefit in the period that such a determination is made. Because of its historical operating losses, the Company has not been subject to income taxes since 1996. The Company is subject to taxation in the U.S., Canada, the United Kingdom, Ireland and various states and local jurisdictions. As a result of the Company’s tax loss position, the tax years 2000 through 2013 remain open to examination by the federal and most state tax authorities. In addition, the tax years 2007 through 2013 are open to examination in foreign jurisdictions. During 2014, the Company’s 2012 tax return was audited by the Internal Revenue Service. As of December 31, 2014, this audit is complete, with no effective change in our ‘as filed’ 2012 return. Page 29 The following is a reconciliation of the federal income tax provision calculated at the statutory rate of 34% to the recorded amount: Years Ended December 31, Loss before taxes ............................................................................... Reconciliation Applicable statutory federal income tax benefit ................................ Foreign tax rate differential ............................................................... Non deductible items ......................................................................... Valuation allowance .......................................................................... 2014 2013 In thousands $ (1,340) $ (1,226) (456) 292 38 126 (417) 230 84 30 Net income tax provision ........................................................... $ - $ (73) The significant items comprising the deferred tax asset and liability at December 31, 2014 and 2013 are as follows: Years Ended December 31, 2014 2013 In Thousands Net operating loss carry forwards ............................................... Foreign net operating loss carry forwards ................................... R&D tax credit ............................................................................ Other ............................................................................................ Valuation allowance .................................................................... Total ....................................................................................... $ 25,160 1,602 525 278 (27,565) $ - $ 25,010 1,611 525 124 (27,270) $ - As of December 31, 2014, the Company had United States federal net operating loss carry forwards (NOLs) of approximately $62.2 million (2013: $62.5 million) available to offset future taxable income, if any. These carry forwards expire through 2034 and are subject to review and possible adjustment by the Internal Revenue Service. The Company may be subject to limitations under Section 382 of the Internal Revenue Service Code as a result of changes in ownership. The Company’s historical operating losses raise considerable doubt as to when, if ever, any of the deferred tax assets will be realized. As a result, management has provided a full valuation allowance for the net deferred tax assets. At December 31, 2014, the Company also has Canadian federal NOLs of approximately $1.5 million (2013: $1.5 million) available to offset future taxable income, if any. These carry forwards expire through 2031 and are subject to review and possible adjustment by the Canadian Revenue Agency. The Company may be subject to limitations of the use of the Canadian NOLs as a result of changes in ownership. At December 31, 2014, the Company also has a United Kingdom NOL of approximately $4.6 million (2013: $4.6 million) for which management has provided a full valuation allowance against. At December 31, 2014, the Company also has an Ireland NOL of approximately $2.6 million (2013: $2.3 million) for which management has provided a full valuation allowance against. The total valuation allowance against deferred tax assets increased by $0.3 million (2013: decreased by $0.4 million). Page 30 The Company must determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. A tax position that meets the more-likely-than-not threshold is then measured to determine the amount of benefit to recognize in the financial statements. As of December 31, 2014 and 2013, the Company has cumulatively recorded long-term liabilities of $178,000 and $178,000 respectively, relative to the sale of its North American operations to Coherent, Inc. This represents the only significant uncertain tax position of the Company. (10) UNREGISTERED SALES OF EQUITY SECURITIES AND WARRANTS On June 20, 2013, €144,324 ($193,132) of the PPI Bond (Note 8) was converted in exchange for 7,605,946 shares of common stock of the Company; such shares were issued to the Term Loan holder in partial consideration relating to securing the Term Loan. Also on June 20, 2013, the Company issued a Warrant in partial consideration for the Term Loan issued by the PPI Bond holder, described in Note 8. The Warrant for 1,900,000 shares of common stock of the Company is exercisable at a price of $0.03 per share through June 20, 2023. Warrants As of December 31, 2014, there were 8,577,567 common shares outstanding warrants with the following exercise prices and expiration dates: Number of Common Shares Warrants 551,500 3,570,000 1,150,000 906,067 500,000 1,900,000 8,577,567 Exercise Price Expiration Date $0.32 –$1.44 $1.15 –$3.12 $0.80 –$1.72 $0.45 –$0.60 $0.10 –$0.10 $0.03 2015 2016 2017 2018 2019 2023 On June 9, 2014, the Company implemented the creation of a 2014 stock incentive plan. (11) STOCK OPTION PLANS New remuneration policy for senior management Summary In order to incentivize the achievement of its objectives, the Company has implemented a new remuneration policy for its senior management with the following elements: (cid:120) A one-off substantial performance based option grant to key senior management at market value (cid:120) No further grants intended to said senior management through the end of the three-year measurement period (cid:120) Cliff vesting on December 31, 2016 at different levels dependent on achievement against the performance target (zero below 50% up to 100% vesting at 90% attainment) (cid:120) 10 year option term Page 31 Performance measure - The performance measure is the driving factor behind the new policy. Broadly, the target is EBITDA equal to 90% of the term debt and lease principal payments, and all interest payments, which are due during the performance period. Such payments would, on the basis of current obligations, amount to approximately $3.0 million in total. Achievement of this objective will result in full vesting. The committee and board believe that achievement of the objective will result in the creation of significant stockholder value. Under the Company’s 2014 Stock Incentive Plan (the 2014 Plan), the Company may issue options, restricted stock, restricted stock units and other stock-based awards to its employees, officers, directors, consultants and advisors. An aggregate of 10,200,000 shares of the Company’s common stock were initially reserved for issuance under the 2014 Plan. In addition, there is an annual increase to the number of shares reserved for issuance under the 2014 Plan equal to the lesser of (i) 2,000,000 shares of common stock, (ii) 5% of the outstanding shares of common stock of the Company, or (iii) an amount determined by the Board of Directors of the Company. As of December 31, 2014, there were 2,000,000 shares available to be issued from this plan. In May, 2014, the Board of Directors approved the Seventh Amended and Restated Policy Regarding Compensation of Independent Directors, (i) cash compensation is $25,000 per annum paid in arrears each quarter in installments of $6,250; and (ii) options to purchase 150,000 shares of the Company’s common stock, $.001 par value per share (the “Common Stock”), such that each Independent Director who is serving as director of the Company on the date of each annual meeting of stockholders (or special meeting in lieu thereof) beginning with the 2014 annual meeting, shall automatically be granted on such day an option (the “Option Award”) entitling the recipient to acquire 150,000 shares of Common Stock, pursuant to the Company’s 2007 Stock Incentive Plan (the “Plan”). In May 2007, the Company adopted the 2007 Stock Option and Incentive Plan (the 2007 Option Plan) for the purpose of issuing both Incentive Options and Nonqualified Options to officers, employees and directors of the company. No further grants are allowed under this plan. In May 2004, the Company adopted the 2004 Stock Option and Incentive Plan (the 2004 Option Plan) for the purpose of issuing both Incentive Options and Nonqualified Options to officers, employees and directors of the company. No further grants are allowed under this plan. In May 2000, the Company adopted the 2000 Stock Option and Incentive Plan for the purpose of issuing both Incentive Options and Nonqualified Options to officers, employees and directors of the Company. No further grants are allowed under this plan. The following table summarizes information about the stock options outstanding as of December 31, 2014. The intrinsic value on the options outstanding, and exercisable, at December 31, 2014 is approximately $8,000. There is no intrinsic value on the options outstanding, and exercisable, at December 31, 2013. Page 32 During 2014 and 2013, the Remuneration Committee approved various qualified and non-qualified stock option awards to purchase shares of the Company’s common stock to various officers, directors and employees. There were 10,500,000 options granted during the year ended December 31, 2014 and 3,500,000 options were granted during the year ended December 31, 2013. These options vest over a one year, two year or a four year anniversary of the grant date, provided that the recipient continues to serve the Company in that capacity until each such vesting. The weighted average assumptions for grants during the years ended December 31, 2014 and December 31, 2013 used in the Black-Scholes option pricing model were as follows: Twelve months Ended December 31, 2014 Twelve months Ended December 31, 2013 Volatility……………………………………….. Expected option life…………………………… Interest rate (risk free)…………………………. Dividends………………………………………. Weighted average grant date fair value………... 237.58% 5.1 years 1.71% $0 $0.0366 224.1% 4.5 years 1.19% $0 $0.02 Balance at December 31, 2012 ......................... Granted ..................................................... Exercised .................................................. Cancelled .................................................. Balance at December 31, 2013 ......................... Weighted Average Remaining Contractual Term (in Years) 6.70 Weighted Average Exercise Price per Share ($) 0.19 0.02 - 0.92 0.13 7.63 Options Outstanding 9,355,890 3,500,000 - ( 240,200) 12,615,690 Vested and Exercisable at December 31, 2013 5,519,840 0.20 6.24 Balance at December 31, 2013 ......................... Granted ..................................................... Exercised .................................................. Cancelled .................................................. Balance at December 31, 2014 ......................... Vested and Exercisable at December 31, 2014 12,615,690 10,500,000 - ( 750,650) 22,365,040 8,175,238 0.13 0.04 - 0.56 0.07 0.11 7.63 7.97 6.32 Vested and Expected to Vest at December 31, 2014 .................................................. 21,827,405 0.07 7.91 Page 33 Range of Exercise Prices $ 0.02 – 0.99 Options Outstanding 22,365,040 Weighted Average Contractual Life (years) 8.0 Weighted Average Exercise Price Options Exercisable Weighted Average Exercise Price $ 0.07 8,175,238 $ 0.11 At December 31, 2014, there was approximately $419,000 of total unrecognized compensation cost related to stock options granted. The cost is expected to be recognized over the next 1.38 years. Total stock option expense recorded in 2014 and 2013 was approximately $280,000 and $169,000, respectively. There were no options exercised during 2014 and 2013. (12) EMPLOYEE STOCK PURCHASE PLAN In May 2000, the Company adopted the 2000 Employee Stock Purchase Plan (the Stock Purchase Plan), which permits the eligible employees of the Company and its subsidiaries to purchase shares of the Company’s common stock, at a discount, through regular monthly payroll deductions of up to 10% of their pre-tax gross salary. Subject to adjustment for stock splits, stock dividends and similar events, a maximum of 300,000 shares of common stock may be issued under the Stock Purchase Plan. During the years ended December 31, 2014 and 2013, there were no shares issued under the Stock Purchase Plan. (13) EMPLOYEE DEFINED CONTRIBUTION PLANS On January 17, 1994, the Company established the ProPhotonix Limited (formerly StockerYale, Inc.) 401(k) Plan (the Plan). Under the Plan, employees are allowed to make pre-tax retirement contributions. In addition, the Company may make matching contributions, not to exceed 100% of the employee contributions, and profit sharing contributions at its discretion. The Company made matching contributions of $27,000 in the year ended December 31, 2014 and $33,000 in the year ended December 31, 2013. The Company incurred costs of approximately $1,200 in 2014 and approximately $1,100 in 2013 to administer the Plan. The Company also has voluntary contribution pension schemes in Ireland and in the United Kingdom. In the United Kingdom, the Company contributes a maximum of 3% of the participating employee salaries, with one exception, where the maximum contribution is 10%. The plan is voluntary, with plan administration costs coming out of the plan itself. The Company made contributions of approximately $46,000 and $44,000 in the years ended December 31, 2014 and 2013, respectively. In Ireland, the Company also has a voluntary plan that matches contributions for those participating employees with minimum of 6 months of service. After two years of service, the Company will match up to a maximum of 5% of salary. The Company made contributions of approximately $32,000 and $20,000 in the years ended December 31, 2014 and 2013, respectively. Plan administration costs come out of the plan itself. Other obligations and contingent liabilities (14) COMMITMENTS AND CONTINGENCIES The Company leases approximately 3,600 square feet for its corporate headquarters and sales office in Salem, New Hampshire. The term of the lease requires monthly tenant at-will payments with a 90 day termination notice. Base rent is $2,550 per month plus the tenant’s share of expenses. Page 34 ProPhotonix (IRL) Limited leases approximately 10,000 square feet for its operations in Cork, Ireland. The original five year lease term ended on August 22, 2013 with rent and service charges of €102,000 per year. The lease is still under re-negotiation, however, the rent and service charges are now €72,000 per year. ProPhotonix Limited, a U.K. subsidiary, leases approximately 13,000 square feet of space in Hatfield Broad Oak, Hertfordshire, U.K. The original lease had a term of nine years ending September 29, 2013 at £87,000 per year, at which time the Company renegotiated the lease for an additional 3 years. Rent charges are £70,000 per year under the renegotiated terms of the lease. The Company utilizes, or has assumed, capital leases to finance purchases of equipment or vehicles. At December 31, 2014, these capital leases were paid in full. There was approximately $10,000 payable in principal and interest under these leases at December 31, 2013. The Company records depreciation expense on assets acquired under a capital lease in the consolidated statement of operations. The net book value of assets acquired under capital leases at December 31, 2014 and December 31, 2013, is as follows: 2014 Assets under capital lease ............................................... $ 594,000 Less—accumulated depreciation .................................... (582,000) 2013 $ 631,000 (606,000) Assets under capital lease, net ........................................ $ 12,000 $ 25,000 Scheduled future maturities of debt, and operating lease obligations for the next five years: Due by period 2015 2016 2017 2019 2018 in thousands Total Debt obligations ..................... $ 770 $ 1,066 $ 576 $ Operating lease obligations .... - 116 82 - - $ 886 $ 1,148 $ 576 $ - - $ - $ - $2,412 198 $2,610 The Company expensed approximately $241,000 and $269,000 in rent for the years ended December 31, 2014 and 2013, respectively. (15) LEGAL PROCEEDINGS The Company is party to various legal proceedings generally incidental to its business. Although the disposition of any legal proceedings cannot be determined with certainty, it is the Company’s opinion that any pending or threatened litigation will not have a material adverse effect on the Company’s results of operations, cash flow or financial condition. Page 35 (16) SEGMENT INFORMATION Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief decision-making group, in making decisions how to allocate resources and assess performance. The Company’s chief decision-maker is the Chief Executive Officer. The Company’s accounting policies and method of presentation for segments is consistent with that used throughout the consolidated financial statements. The Company operates in two segments: LED’s (light emitting diode systems) and Laser & Diodes. In the LED segment, the Company designs and manufactures LED systems for the inspection, machine vision, medical and military markets. The Laser & Diodes segment distributes laser diodes and designs and manufactures custom laser diodes modules for industrial, commercial, defense and medical applications. The policies relating to segments are the same as the Company’s corporate policies. The Company evaluates performance and allocates resources based on revenues and operating income (loss). The operating profit / (loss) for each segment includes selling, research and development and expenses directly attributable to the segment. In addition, the operating profit / (loss) includes amortization of acquired intangible assets, including any impairment of these assets and of goodwill. Certain of the Company’s indirect overhead costs, which include corporate general and administrative expenses, are allocated between the segments based upon an estimate of costs associated with each segment. Segment assets include accounts receivable, inventory, machinery and equipment, goodwill and intangible assets directly associated with the product line segment. 2014 2013 (In thousands) Years Ended December 31 Revenues: LEDs ........................................................................................................... Laser & diodes ............................................................................................ $ 7,111 9,320 $ 6,599 9,000 Total revenues ............................................................................................. $ 16,431 $ 15,599 Gross profit: LEDs ........................................................................................................... Laser & diodes ............................................................................................ $ 3,288 3,137 $ 2,947 3,024 Total gross profit ......................................................................................... $ 6,425 $ 5,971 Operating profit (loss) LEDs ........................................................................................................... Laser & diodes ............................................................................................ $ 126 (30) $ (806) (375) Total operating profit / (loss) ....................................................................... $ 96 $ (1,181) Page 36 Years Ended December 31 Current assets: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total current assets ...................................................................................... Property, plant & equipment: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total property, plant & equipment .............................................................. Intangible assets: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total intangible assets ................................................................................. Goodwill: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total goodwill ............................................................................................. Other assets: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total other assets ......................................................................................... Years Ended December 31 Total assets: LEDs ........................................................................................................... Laser & diodes ............................................................................................ Corporate ..................................................................................................... Total assets .................................................................................................. Revenues by geographic area: United States ............................................................................................... Canada, Mexico & So. America .................................................................. Europe ......................................................................................................... Asia & the rest of the world ........................................................................ 2014 2013 (In thousands) 2,201 2,222 380 4,803 64 116 4 184 — — — — 429 — — 429 30 — 176 206 $ $ $ $ $ $ $ $ $ $ 1,984 2,737 463 5,184 179 120 4 303 — 102 — 102 486 — — 486 28 — 326 354 2014 2013 (In thousands) 2,797 2,265 560 5,622 4,724 419 8,531 2,757 $ $ 2,677 2,959 793 6,429 4,585 274 8,148 2,592 $ $ $ $ $ $ $ $ $ $ $ $ Total ...................................................................................................................... $ 16,431 $ 15,599 Page 37 The Company’s long-lived assets consist of property, plant and equipment, goodwill and intangible assets located in the following geographic locations: Years Ended December 31 Long-lived assets by geographic area: United States and North America ................................................................ Europe .......................................................................................................... UK ............................................................................................................... Total ...................................................................................................................... $ $ 4 546 64 614 $ $ 4 666 222 892 2014 2013 (In thousands) (17) SUBSEQUENT EVENTS The Company has evaluated subsequent events through March 24, 2015, the date which the financial statements were available to be issued, and there were no additional events that impacted these financial statements or required additional disclosure to the financial statements. Page 38 (This page left intentionally blank.) Page 39 BR743465-0315-AR
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