Stock Option Plans

     In June 2007, the shareholders of RAE Systems approved the Company’s 2007 Equity Incentive Plan (the “2007 Plan”) at the annual meeting of shareholders. The 2007 Plan replaced the Company’s 2002 Stock Option Plan (the “2002 Plan”). A total of 4,000,000 shares of the Company’s common stock are authorized for issuance under the 2007 Plan. The maximum number of shares that may be issued under the 2007 plan will be increased from time to time by shares subject to options granted under the 2002 Plan that expire or are terminated and by shares acquired under the 2002 Plan that are forfeited or repurchased by the Company for the option holder’s purchase price. However, no more than 1,500,000 additional shares may be authorized for issuance under the 2007 Plan as a result of these adjustments.

     As of JuneSeptember 30, 2010, the Company has reserved 120,87793,442 shares of common stock for issuance under its 1993 Stock Option Plan, 2,078,8772,025,126 shares under the 2002 Plan and 3,309,1673,199,479 shares under the 2007 Plan. As of JuneSeptember 30, 2010, 1,254,5411,264,541 shares have been added to the balance available for grant under the 2007 Plan as a result of grants cancelled under the 2002 Plan and 1,795,3741,908,812 shares of common stock remain available for future grants under the 2007 Plan.

     Non-Plan Stock Options

     In 2002, the Company granted certain of its director’s non-plan options to purchase 400,000 shares of common stock at a weighted-average exercise price of $0.99 per share. The options vested 25% after one year with the remainder vesting pro-rata monthly over the following three years. From 2002 to 2006, the Company issued 300,000 shares of common stock due to the exercise of such options. There have been no further grants, exercises or cancellations through JuneSeptember 30, 2010. As such, total outstanding non-plan stock options at JuneSeptember 30, 2010 were 100,000 at a weighted-average exercise price of $1.06. The vested options are

     Basic earnings per common share includes no dilution and is computed by dividing net income (loss)or loss attributable to RAE Systems by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution of common stock equivalents, such as options and warrants, to the extent the impact is dilutive. As the Company incurred a net loss for the three months ended September 30, 2010 and net losses for the three and sixnine months ended JuneSeptember 30, 2009, the effect of potentially dilutive securities on diluted net loss per share computations was anti-dilutive.anti-dilutive for these periods.

     The weighted-average number of shares attributable to anti-dilutive stock options excluded from the diluted net incomeloss per common share calculation for the three and sixnine months ended JuneSeptember 30, 2010 was 5,355,9214,790,334 and 5,321,400,4,801,147, respectively. The weighted-average number of anti-dilutive shares excluded from the diluted net loss per common share calculation for the three and sixnine months ended JuneSeptember 30, 2009 was 4,679,7644,880,232 and 4,724,024,4,926,143, respectively.

     FASB Accounting Standards Codification (“ASC”) Topic 280,“Segment Reporting,”establishes standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are

     There were no restrictions or other special conditions on the assets or liabilities of RAE France.

     In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance became effective for the Company on January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as certain enhanced disclosures. The Company evaluated its investments and concluded it does not have any additional variable interests which give it controlling financial interest in a VIE; therefore, the adoption of this new standard did not have a material impact on its financial statements.

     In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue

     Amortization expense associated with intangible assets was $226,000$228,000 and $242,000$219,000 for the three months ended JuneSeptember 30, 2010 and 2009, respectively, and $452,000$680,000 and $495,000$714,000 for the sixnine months ended JuneSeptember 30, 2010 and 2009, respectively.

     Based on the carrying amount of intangible assets as of JuneSeptember 30, 2010, and assuming no future impairment of the underlying assets, the estimated future amortization is as follows(in thousands):

     The Company estimates its annual effective tax rate for the year and applies that rate to the year to date profit before tax to determine the quarterly and year to date tax expense. Certain loss entities are excluded from the calculation of annual estimated effective tax rate if the Company anticipates that it will not be able to recognize a benefit from those loss entities at year end. Certain expenses are accounted for as discrete to the quarter and excluded from the estimated annual effective tax rate.

     The effective tax rate after discrete items for the sixnine months ended JuneSeptember 30, 2010, was 17%153% of pretax income, compared to 10%2% of pretax loss for the same period in 2009. The tax rate for the third quarter of 2010 differed from the U.S. statutory rate primarily due to the tax effect of foreign earnings taxed at lower rates, losses not benefited of $5.7 million, nondeductible costs of $1.4 million related to the acquisition transaction with Battery Ventures announced September 20, 2010, dividend income of $2.5 million from a foreign subsidiary, and discrete true-up adjustments applicable to 2010.

     The effective tax rate is highly dependent upon the geographic distribution of the Company’s worldwide earnings or loss, tax regulations in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of its tax planning strategies. The Company regularly monitors the assumptions used in estimating its annual effective tax rate and adjusts its estimates accordingly. If actual results differ from its estimates, future income tax expense could be materially affected.

     During fiscal year 2008, the Company’s internal audit department identified certain payments and gifts made by certain personnel in the Company’s operations in the People’s Republic of China (“China”) that may have violated the United States Foreign Corrupt Practices Act (“FCPA”). Following this discovery, the Audit Committee of the Board of Directors initiated an independent investigation. The Company has made a voluntary disclosure to the United States Department of Justice (DOJ) and the United States Securities and Exchange Commission (SEC) regarding the results of its investigation. The Company has also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with violations. The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company booked an accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter. In June 2010, the Company met with officials from the Department of JusticeDOJ and the Securities and Exchange CommissionSEC to provide an update on the Company’s compliance with the FCPA. The management team expectsManagement is working diligently with both the DOJ and the SEC to haveobtain closure on this matter in the near future.matter.

     In December 2004, the Company moved into its current corporate headquarters in San Jose, California and abandoned a leased facility in Sunnyvale, California. During the second quarter of 2005, the Company accrued a restructuring reserve of approximately $2.0 million for the remaining lease term of the former headquarters in Sunnyvale. The discount rate used was 4.85% and the liability was not reduced for any anticipated future sublease income. In March 2007, due to improved conditions for office rentals, the Company revised the estimated loss on abandonment of the lease and reduced the operating expense by $595,000. During the second quarter of 2007, a sublease was executed with rental income commencing in June 2007. Both the master lease and the sublease expired in October 2009. Rent payments for the three months ended JuneSeptember 30, 2010 and 2009 were zero and $132,000, respectively, for the Sunnyvale building with sublease income of zero and $45,000$46,000 for the three months ended JuneSeptember 30, 2010 and 2009, respectively. Rent payments for the sixnine months ended JuneSeptember 30, 2010 and 2009 were zero and $263,000,$395,000, respectively, for the Sunnyvale building with sublease income of zero and $90,000$136,000 for the sixnine months ended JuneSeptember 30, 2010 and 2009, respectively.

     In December 2008, the Company invested approximately $1.2 million for land use rights in Shanghai, China to construct a new manufacturing, engineering and administrative facility. Construction began during the first quarter of 2010. The estimated cost to complete this project is approximately $5.3$4.4 million with the work scheduled to be completed during the first quarterhalf of 2011. Upon completion of construction, the Company intends to vacate its existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, the Company believes it will be able to terminate the lease without penalty. However, no assurance can be given at this time that the Company will not be subject to a lease termination penalty.

     During the three and sixnine months ended JuneSeptember 30, 2010, $23,000$33,000 and $51,000,$84,000, respectively, of interest expense was capitalized for construction of the Company’s new facility in Shanghai.

     The Company is permitted under Delaware law and required under RAE Systems’ Certificate of Incorporation and Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. To date the Company has not incurred any losses under these agreements.

     The Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

     The Company maintains credit facilities to support its operations in the United States and China.

     In the United States, the Company had a $10.0 million revolving credit agreement as of December 31, 2009. This credit facility is renewed annually and, on April 26, 2010, was renewed to expire on April 25, 2011. Available credit is based on a percentage of specific qualifying assets and the total facility is collateralized by a blanket security interest in the Company’s assets in the United States. The Company is required to comply with certain reporting and financial requirements in addition to the ongoing requirement to submit quarterly financial statements. Interest accrues at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. In addition, the Company pays 30 basis points annually of the average unused portion of the facility and is required to maintain a compensating balance of at least $2.0 million at all times. The compensating balance is included in Restricted cash on the Condensed Consolidated Balance Sheets. As of JuneSeptember 30, 2010 and December 31, 2009, $1.8 million was outstanding against the revolving credit agreement.

     Financial covenants under the revolving credit agreement: 1) require the Company to maintain specified trailing two-quarter minimum earnings before interest, depreciation, amortization and non-cash stock compensation expenses; and 2) limit the size of potential monetary penalties under the FCPA to $3.5 million. The Company was in compliance with these covenants as of JuneSeptember 30, 2010 and December 31, 2009.

     On November 9, 2009, RAE Fushun, the Company’s 70% owned subsidiary in Fushun, China, borrowed RMB 10.0 million, or approximately $1.5 million, to provide working capital for its operations. The loan is due on April 26, 2011 and bears interest at a fixed rate of 8.1% for 12 months. The interest rate will be reset once in November 2010 at 1.5 times the People’s Bank of China benchmark rate. Loan repayment is guaranteed by an unrelated third party, to whom RAE Fushun has granted a lien which includes the wholly owned plant and associated land rights. As a condition of the loan, the lending bank required a deposit of approximately $0.1 million from the guarantor. This deposit was funded by RAE Fushun from the loan proceeds and is included in Restricted Cash on the Condensed Consolidated Balance Sheets.

     The Company accounts for its 40% ownership in Renex Technologies Ltd. (“Renex”), a Hong Kong company following the equity method. The Company’s total investment in Renex at JuneSeptember 30, 2010 and December 31, 2009 was $242,000$225,000 and $339,000, respectively. The Company recorded losses of $45,000$17,000 and $66,000$46,000 on its equity interest in Renex for the three months ended JuneSeptember 30, 2010 and 2009, respectively, and losses of $96,000$114,000 and $133,000$180,000 in Renex for the sixnine months ended JuneSeptember 30, 2010 and 2009, respectively.

     The Company paid Renex zero and $95,000 for research work during the nine months ended September 30, 2010 and 2009, respectively.

     In conjunction with the investment in RAE Beijing, unsecured notes payable bearing interest at 6.48% were established for the previous RAE Beijing shareholders as part of the purchase price agreement in July 2006. As of JuneSeptember 30, 2010 and December 31, 2009, $386,000$365,000 and $370,000, respectively, was included in current notes payable to related parties in the Company’s Condensed Consolidated Balance Sheets and $356,000zero and $363,000, respectively, was included in non-current notes payable to related parties. The remaining scheduled annual paymentspayment of principal and accrued interest under these notes from 2010 throughat maturity in July 2011 are $386,000 and $356,000, respectively.

     In addition to its 40% ownership in Renex, the Company has investments in three distributors of RAE Systems products, RAE Australia, RAE Benelux and RAE Spain. The Company owns 19%, 10% and 19% of RAE Australia, RAE Benelux and RAE Spain, respectively. These investments are accounted for under the cost method.