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

Luna Innovations Incorporated

Consolidated Statements of Cash Flows

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

Luna Innovations Incorporated

Notes to Consolidated Financial Statements

Nature of Operations

Luna Innovations Incorporated (“Luna Innovations”) was incorporated in the Commonwealth of Virginia in 1990 and subsequently reincorporated in the State of Delaware in April 2003. We are engaged in the research, developmentdevelop and commercialization ofcommercialize innovative technologies in thetwo primary areas of molecular technology solutionsfocus: instrumentation and sensing solutions.test & measurement products and healthcare products. We have a disciplined and integrated business model that is designed to accelerate the process of bringing new and innovative products to market. We identify technologytechnologies that can fulfill identifiedunmet market needs and we then take these solutionstechnologies from the applied research stage through commercialization.

Unaudited Interim Financial Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP) and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by US GAAP for audited financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the annual financial statements and in the opinion of management reflect all adjustments, consisting of only normal recurring accruals, considered necessary to present fairly our financial position at SeptemberJune 30, 20062007 and results of operations and cash flows for the three and ninesix months ended SeptemberJune 30, 20062007 and 2005.2006. The results of the operations for the three and ninesix months ended SeptemberJune 30, 2006,2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

The year-end consolidated balance sheet data was derived from the audited December 31, 2005, balance sheet.2007.

The consolidated financial statements, including the Company’s significant accounting policies, should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto included in the Company’s Registration Statement on Form S-1 (No. 333-131764)10-K as amended and filed with the Securities and Exchange Commission on June 2, 2006.March 30, 2007. As used herein, the terms “Luna”, “Company”, “we”, “our” and “us” mean Luna Innovations Incorporated and its consolidated subsidiaries.

Certain reclassifications have been made to prior period amounts to conform with current year presentation.

Consolidation Policy

Our consolidated financial statements are prepared in accordance with US GAAP and include the accounts of the Company, its wholly owned subsidiaries and other entities in which the Company has a controlling financial interest. We eliminate from our financial results all significant intercompany transactions. The Company does not have any investments in entities it believes are variable interest entities for which the Company is the primary beneficiary.

Use of Estimates

The preparation of our consolidated financial statements in accordance with US GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements and accompanying notes. Although these estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may differ from such estimatesdiffer.

Inventory

Inventory consists of finished goods and assumptions.parts valued at the lower of cost (determined on the first-in, first-out basis) or market. We provide reserves for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions.

Net Loss Per Share

We compute net loss per share in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. Basic per share data is computed by dividing loss available to common shareholders by the weighted average number of shares outstanding during the period. Diluted per share data is computed by dividing loss available to common shareholders by the weighted average shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have been outstanding if potential common shares had been issued using the treasury stock method. Diluted per share data would also include the potential common share equivalents relating to convertible securities by application of the if-converted method.

Per share amounts for all periods presented in this report have been adjusted to reflect the 1-for-1.7691911 reverse stock split of our common stock effectedoccurring on May 23, 2006. All applicable share and per share amounts in the financial statements give pro forma effect to such split. The following information presents the pro forma effect of such split on basic and diluted net loss per share:

The effect of 3,800,5103,239,961 and 2,813,0974,084,989 common stock equivalents are ignored for the three months ended SeptemberJune 30, 2007 and 2006, and 2005, as they are antidilutive to earnings per share. The effect of 3,842,338 and 2,589,076 common stock equivalents are ignored for the nine months ended September 30, 2006 and 2005,respectively, as they are antidilutive to earnings per share. In addition, the conversion of the $5.0 million in senior convertible promissory notes would have been antidilutive for such periods.

Share Based Compensation

We have a stock-based compensation plan, which is described further in Note 9 to the Financial Statements in the Company’s Registration Statement on Form S-1 (No. 333-131764)10-K as amended and filed with the Securities and Exchange Commission on June 2, 2006.April 6, 2007. Effective January 1, 2006, we adopted SFAS No. 123R, Share-Based Payment (SFAS No. 123R) using the modified prospective transition method. Under this transition method, our financial statements for the periods prior to January 1, 2006 have not been restated. However, new awards and awards modified, repurchased or cancelled after January 1, 2006, result in compensation expense based on the fair value of the stock option as determined by the Black-Scholes option pricing model. We amortize share-based compensation for such awards on a straight-line basis over the related service period of the awards taking into account the effects of the employees’ expected exercise and post-vesting employment termination behavior.

The adoption of SFAS No. 123R has increased the net loss by approximately $440 thousand and $535 thousand for the three and nine months ended September 30, 2006, as compared to what our net loss would have been if we had continued toWe account for share-based compensation under Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees (APB No. 25).

For the periods prior to 2006, we accounted for share-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of APB No. 25, and related amendments and interpretations. We complied with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-based Compensation, as amended by SFAS No. 148, Accounting for Stock Based Compensation—Transition and Disclosure, which requires fair value recognition for employee stock-based compensation.123R. We account for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123123R and Emerging Issues Task Force (EITF) Issue No. 96-18.

Generally, we award options to employees and directors with exercise prices equal to or greater than the estimated fair value of our common stock on the date of grant. In September 2003, we entered into an option exchange with our employees that resulted in the new option grant being considered a re-pricing in accordance with FASB Interpretation No. (FIN) 44, Accounting for Certain Transactions Involving Stock Compensation (FIN 44). We apply variable plan accounting to outstanding options related to this award and measure compensation expense at each reporting period equal to an amount that reflects the change in the fair value of the underlying security.

Had compensation expense been measured under the fair value method prescribed by SFAS No. 123, our pro forma net loss, and pro forma net loss per share would have been as follows:

The fair value of each option granted is estimated as of the grant date using the Black-Scholes option pricing model with the following assumptions:

The risk-free interest rate is based on US Treasury interest rates, the terms of which are consistent with the expected life of the stock options. Expected volatility for the three months ended June 30, 2007 is based upon anthe volatility of our common stock price for the 12 month period beginning July 1, 2006 and ending June 30, 2007. Expected volatility for the six months ended June 30, 2006 was based on the average volatility of comparable public companies due to the limited timelack of historical market price data for our shares have been publicly traded.stock on such date. The expected life and estimated post employment termination behavior is based upon historical experience of homogeneous groups within our company.

A summary of the status of our 2003 Stock Plan and 2006 Equity Incentive Plan is presented below for the periods indicated:

At SeptemberJune 30, 2006,2007, our 5.05,093,318 million outstanding stock options (including fully vested options and options that are expected to vest) had a weighted average remaining contractual term of 8.48.1 years, and our 2.02,652,454 million outstanding and exercisable stock options had a weighted average remaining contractual term of 7.77.5 years.

For the three and nine months ended SeptemberJune 30, 2007 and 2006, we recognized $403,427$558,343 and $1,164,709$352,595 in share-based payment expense and for the six months ended June 30, 2007 and 2006, we recognized $1,096,555 and $761,282 in share-based payment expense. We will recognize approximately $5,616,000$6.5 million over the remaining requisite service period.period of approximately four years.

Income Taxes

Our effective quarterly tax rate is estimated based upon the effective tax to be applicable to the full fiscal year. A deferred tax asset of $600,000 was recorded at December 31, 2005,2006 and SeptemberJune 30, 2006,2007, based upon management’s assessment that more likely than not the benefit will be realized in future periods.

Effective January 1, 2007, we adopted FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes(FIN 48). FIN 48 prescribes a more-likely-than-not threshold of financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures. The cumulative effects of applying this interpretation did not have a significant impact on either our net deferred tax assets or valuation allowance.

We have made no adjustments to the classification of assets or liabilities, or recognition of any income tax related expenses, in connection with the adoption of FIN 48.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements. SFAS No. 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS No. 157 is effective for the fiscal year beginning January 1, 2007. The Company is currently evaluating the potential impact of theCompany’s adoption of SFAS No. 157 did not have a material impact on its future consolidated financial statements.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108,Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the fiscal year ending December 31, 2006.

In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, which is an interpretation of SFAS No. 109, Accounting for Income Taxes . FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109 by prescribing a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. FIN 48 will be effective for the Company beginning January 1, 2007. The Company is in the process of determining the effect, if any, the adoption of FIN 48 will have on its financial statements.

At the end of June 2007, the Company entered into a new line of credit agreement with First National Bank (FNB) for a 364 day term. The new line of credit increased the amount available to borrow from $2.5 million to $3.0 million. There were no outstanding balances on our $2.5 million line of credit with First National Bank (FNB) at SeptemberJune 30, 20062007 and at December 31, 2005,2006, and no borrowings during the ninesix month period ended SeptemberJune 30, 2006. In May 2006, we obtained a modification to allow2007. The agreement also includes a $1.0 million sub-limit under the line of credit for the issuance of letters of credit, and FNB issued a $719,500 letter of credit on our behalf to the Industrial Development Authority of Montgomery County, Virginia, in conjunction with the Company’s execution of an office lease.

The covenants under this line of credit agreement are reviewed annually at December 31. At December 31, 2005, we were not in compliance with the minimum interest coverage covenant. We requested and received a waiver from FNB for fiscal 2005.

On May 23, 2006, we effected a 1-for-1.7691911 reverse stock split of our common stock in anticipation of our initial public offering. In connection with our June 2, 2006 initial public offering, we sold 3,500,000 shares of common stock at $6.00 per share resulting in gross proceeds of $21.0 million. In connection with this offering, we paid $1.47 million in underwriting discounts and commissions and incurred estimated other offering expenses of approximately $1.66 million. The net proceeds from the offering were approximately $17.87$17.9 million.

Concurrent with the initial public offering, all outstanding shares of our Class A voting Common Stock, Class B non-voting Common Stock, and Class C voting Common Stock were converted to shares of common stock on a one-for-one basis. All outstanding shares of our Redeemable Class B Common Stock converted to common stock on a one-for-one basis as the successful initial public offering eliminated the redeemable feature of such shares. We also issued 96,724 shares of common stock to Carilion Health SystemClinic in accordance with the anti-dilution provisions of our previous amended and restated certificate of incorporation, which was adopted in connection with our Class C Common Stock financing in December 2005. Upon the closing of our initial public offering the total authorized shares of our capital stock increased to 100,000,000 shares of common stock and 5,000,000 shares of preferred stock.

For the ninesix months ended SeptemberJune 30, 2006,2007, our capital structure changed as follows:

Our operations are divided into two operating segments—Contract ResearchTechnology Development and Product and Licensing.

The Contract ResearchTechnology Development segment provides applied research to customers in our areas of focus. Our engineers and scientists collaborate with our network of government, academic and industry experts to identify technologies and ideas with promising market potential. We then compete to win fee-for-service contracts from government agencies and industrial customers who seek innovative solutions to practical problems that require new technology. The Contract ResearchTechnology Development segment derives its revenue primarily from services.

The Product and Licensing segment develops and sells products or licenses technologies based on commercially viable concepts developed, in whole or in part, by the Contract ResearchTechnology Development segment. The Product and Licensing segment derives its revenue from product sales, funded product development fees and technology licenses.

The Chief Executive Officer and his direct reports collectively represent our chief operating decision makers, and they evaluate segment performance based primarily on revenue and operating income or loss. The accounting policies of our segments are the same as those described in the summary of significant accounting policies (see Note 1 to our Financial Statements, “Organization and Summary of Significant Accounting Policies,” presented in the Registration Statement on Form S-110-K as amended and filed with the Securities and Exchange Commission on June 2, 2006)March 30, 2007).

The table below presents revenues and operating loss for reportable segments:

Additional segment information is as follows:

There are no material inter-segment revenues for any period presented.

The United States Government accounted for approximately 72%61% and 81%73% of total consolidated revenues for the three months ended SeptemberJune 30, 2007 and 2006, and 2005,62% and 74% and 64% of revenues for the ninesix months ended Septemberending June 30, 2007 and June 30, 2006, and 2005.respectively.

International revenues (customers outside of the United States) accounted for 4.0%0.0% and 2.8%4.6% of total revenues for the three months ended SeptemberJune 30, 2007 and 2006, and 2005,0.6% and 3.5% and 1.3%3.2% of total revenues for the ninesix months ended SeptemberJune 30, 20062007 and 2005.June 30, 2006.

The Company is from time to time involved in certain legal proceedings in the ordinary course of conducting its business. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on its financial position or results of operations. On June 22, 2007, Hansen Medical, Inc. (“Hansen”) filed a lawsuit against us in California State Court, Santa Clara County, alleging misappropriation of trade secrets, unfair competition, breach of contract, and breach of the implied covenant of good faith and fair dealing. The claims allegedly stem from our past relationship with Hansen and our past and future relationship with Intuitive Surgical, Inc. (“Intuitive”). The lawsuit makes an unspecified claim for damages, however Hansen has not indicated how it will substantiate such damages and we are unable to reasonably estimate the amount of damages, if any, that Hansen will seek. We cannot predict the ultimate outcome of this litigation and we are unable to estimate any potential liability we may incur.

The Company has an outstanding letter of credit at SeptemberJune 30, 2006,2007, of $719,500 to the Industrial Development Authority of Montgomery County, Virginia, to support a lease of office space. This letter of credit expires in 2011.

The Company has an agreement with a suppliertwo suppliers to purchase inventory and estimates its noncancellable obligation to approximate $959,400$1.5 million through October 2007.

The Company leases its facilities in Blacksburg, Charlottesville, Danville, Hampton and Roanoke, Virginia, under non-cancellable operating leases that expire between 2006 and 2013. Certain of the leases are subject to fixed escalations. Future minimum lease payments for the remainder of 2006 and for each of the subsequent four years from 2007 through 2010 approximate $286,000, $1,483,000, $1,350,000, $1,199,000, and $1,178,000, respectively.December 2008.

The Company has entered into indemnification agreements with its officers and directors, to the extent permitted by law, pursuant to which the Company has agreed to reimburse the officers and directors for legal expenses in the event of litigation and regulatory matters. The terms of these indemnification agreements provide for no limitation to the maximum potential future payments. The Company has a directors and officers insurance policy that may, in certain instances, mitigate the potential liability and payments.

ITEM 2.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this Quarterly Report on Form 10-Q.

report. In addition to historical financial information, this reportthe following discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks, uncertainties and assumptions. These statements include, among other things, statements concerning:

Our actual results and timing of selected events may relate to, but are not limited to, expectations of future operating results or financial performance, capital expenditures, introduction of new products, regulatory compliance, plans for growth and future operations, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. These risks and other factors include, but are not limited to,differ materially from those listed under the section entitled “Risk Factors”anticipated in Item 1A of Part II of this report. In some cases, you can identifythese forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential,” “continue,” “seek” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events and/or results may differ materially.

The forward-looking statements contained in this report are made pursuant to the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act of 1933, as amended. Except as required by applicable law, including the rules and regulations of the SEC, we do not plan to publicly update or revise any forward-looking statements, whether as a result of any new information, future events or otherwise,many factors, including those discussed under “Risk factors” and elsewhere in this report, as well as those discussed in other than through the filing of periodic reports in accordancedocuments we file with the Securities and Exchange Act of 1934, as amended.Commission. We take no obligation to revise or otherwise disclose any revision to these forward-looking statements.

Overview

We research, develop and commercialize innovative technologies in two primary areas: molecular technology solutionsareas of focus: instrumentation and sensing solutions.test & measurement products and healthcare products. We have a disciplined and integrated business model that is designed to accelerate the process of bringing new and innovative products to market. We identify technologies that can fulfill large and unmet market needs and then take these technologies from the applied research stage through commercialization incommercialization.

To manage a diverse set of products effectively across a range of development stages, we are organized into two main groups: our two areas of focus:

We have a successful track record in executing our market-driven business model. Since our inception, we have developed products serving various industries including energy, telecommunications, life sciences and defense.more diversified mix of products.

Our annual revenues were $16.5$7.9 million in 2005 and $15.5$4.9 million during the ninethree months ended SeptemberJune 30, 2006.2007 and 2006, respectively, and we had net losses of $2.2 million and $2.7 million for the same periods, respectively. We generate revenues through contract research,technology development services provided under contractual arrangements, product sales and license fees. We had net losses of $2.0 million and $6.8 million for the year ended December 31, 2005 and the nine months ended

September 30, 2006, respectively, and we expect to incur significant additional expenses as we expand our business. We also expect losses to continue for the foreseeable future primarily due to increased expenditures related to our nanomaterial and medical device product development efforts.

Historically, our contract researchtechnology development revenues have accounted for a large and growing proportion of our total revenues, and we expect that they will continue to grow and will represent a significant portion of our total revenues for the foreseeable future. Our contract research revenue was $15.4technology development revenues grew from $4.1 million in 2005. We generated contract research revenues of $4.9 million and $13.0to $5.9 million for the three and nine months ended SeptemberJune 30, 2006 and 2007, respectively. As of September 30, 2006, our Contract Research Group was working on 94 contracts. In addition to these contracts, weWe regularly have a backlog of contracts for which work has been scheduled, but for which a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. The approximate value of our backlog was $24.1$24.8 million as of SeptemberJune 30, 2006.2007.

Revenues from product sales currently represent a smallsmaller proportion of our total revenues, and, historically, we have derived most of these revenues from the sales of our sensing systemsinstrumentation and test and measurement products, including products that make use of light-transmitting optical fibers, or fiber optics. License revenues wereassociated with our proprietary technologies have been significant in 2004 primarily due to the Luna Energy transactions described in our Registration Statement on Form S-1.prior years. Although we have been successful in licensing certain technology, we do not expectcurrently earn significant license revenues to represent a significant portion of future revenues. However, over time we do intend to gradually increase such revenues. ForIn the full year,near term, we expect revenues from product sales to increase because of growth in our acquisitionexisting instrumentation and test and measurement products and because of Luna Technologies, Inc. (“Luna Technologies”) on September 30, 2005.growth in new product lines, particularly medial device products. We also expect to

increase our investments in product development and commercialization, which we anticipate will lead to increased product sales growth. In the future, we expect that revenues from product sales will represent a larger proportion of our total revenues and that as we develop and commercialize new products, these revenues will reflect a broader and more diversified mix of products.

In June 2005, prior to its acquisition by Luna Innovations, Luna Technologies entered into a Joint Cooperation Agreement with Luna Energy, an independent company which is no longer affiliated with us. Under this agreement, both parties have agreed to cooperate to develop a fiber optic sensing system product and have agreed to contribute materials, intellectual property, personnel and other resources to the development effort. Upon successful completion of product development, Luna Energy will receive a license to certain of Luna Technologies’ intellectual property and will be required beginning in 2007 and continuing through December 31, 2017 to make payments to Luna Technologies with respect to revenues derived from products sold that utilize this intellectual property. As of September 30, 2006, Luna Energy had not yet sold products that would entitle Luna Technologies to royalty payments under this joint cooperation agreement. Luna Technologies had received aggregate development milestone payments of $320 thousand as of that date under this agreement and is entitled to receive additional development milestone payments of up to $105 thousand in the aggregate, subject to the satisfaction of certain conditions. Luna Technologies also has the right to receive royalty payments from sales of products in the future. The license of certain of the intellectual property from Luna Technologies to Luna Energy shall be an exclusive license if Luna Energy makes certain minimum royalty payments of $420 thousand in the aggregate between 2007 and 2017, and shall be a non-exclusive license if Luna Energy fails to make these minimum royalty payments. Since December 2004, we have not held an ownership interest in Luna Energy. Luna Technologies continues to operate as part of our products group.

In connection with becoming a public company, in June 2006, we have incurred and will continue to incur significant additional expenses such as audit fees, professional fees, increased directors’ and officers’ insurance, premiums, advisory board and board of directors compensation, and expenses related to hiring additional personnel and expanding our administrative functions. Many of these expenses were not incurred by us in prior periods. We began to incur these expenses during the second half of 2005 and we expect that these expenses will continue to increase. In addition, usingupon receiving the net proceeds from our initial public offering, we have begun to implement ourimplemented a strategy for expansion that havehas significantly increased our operating expenses and will likely

create continue to result in substantial losses. We incurred consolidated net losses of approximately $2.0$4.9 million and $6.8$4.8 million for the yearsix month periods ended December 31, 2005June 30, 2007 and the nine months ended September 30, 2006, respectively. We expect to continue to incur significant additional expenses as we expand our business, including increased expenses for research and development, sales and marketing, manufacturing, finance and accounting personnel and expenses associated with being a public company. We may also grow our business in part through acquisitions of additional companies and complementary technologies which could cause us to incur greater than anticipated transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we expect that we will likely continue to incur losses for the foreseeable future,in 2007 and that these losses could be substantial.

Our operating expenses to date for fiscal year 2006 have also increased asAs a result of the adoption of the provisions of the Financial Accounting Standards Board’s revised Statement of Financial Accounting Standards No. 123 Share-Based Payment (SFAS No. 123R)., our operating expenses for 2006 and to date for fiscal year 2007 include stock-based compensation charges. We recorded stock-based compensation charges of $403 thousand and $1,165 thousand$0.6 million for the three and nine months ended SeptemberJune 30, 2006, respectively.2007. We also expect to record an aggregate stock-based compensation charge for stock options granted through SeptemberJune 30, 20062007 of $5.6$6.5 million to be recognized over years 20062007 through 2011.

Description of Our Revenues, Costs and Expenses

Revenues

We generate revenues from technology development (contract research), contract research, product salesdevelopment, and license payments.product sales. We derive contract researchtechnology development revenues from providing research and development services to third parties, including government entities, academic institutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we complete contracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred or upon the achievement of certain milestones specified inbuilt into the contracts.

Our product revenues reflect amounts that we receive from sales of our products andor development fees paid by third-parties to complete development or create customized applications of products that we anticipate will lead to product sales or licensing revenues. Such product revenuesfor third parties and currently represent a small but growing portionapproximately 25% of our total revenues. Revenues from product sales that require no ongoing obligations are recognized as revenues when the product has shipped to the customer, title has passed and collection is reasonably assured. In transactions where a right-of-return exists, revenues are deferred until acceptance has occurred and the period for the right-of-return has lapsed.

Our license revenues comprise up-front license fees paid to us in connection with licenses or sublicenses of certain patents and other intellectual property as well as royalties, which currently represent an insignificant portion of our license revenues. Amounts received from third parties for licenses to our intellectual property are recognized when earned under the terms of the agreements. Revenues are recognized upon transfer of the license unless we have continuing obligations for which fair value cannot be established, in which case the revenues are recognized over the period of the obligation. If there are extended payment terms, license fees are recognized as these payments become due and collectibility is probable. We consider all arrangements with payment terms beyond twelve months not to be fixed and determinable.

Certain of our agreements also involve research and development activities. We apply the guidance from the Emerging Taskforce Consensus on Issue 00-21, Revenue Arrangements with Multiple-Deliverables (EITF 00-21). Accordingly, we will allocate our arrangement fees to the various elements based upon objective reliable evidence of fair value, if available. For those arrangements in which evidence of fair value is not available, we will defer revenues from any upfront payments and recognize them over the service period in the arrangement. Certain of these arrangements also include the payment of performance bonuses based upon the achievement of specific milestones. Generally, there are no assurances at the onset of these arrangements that the milestones will

be achieved. As such, fees related to such milestones are excluded from the initial allocation of the arrangement fee in accordance with EITF 00-21 and are recognized upon achievement of the milestone provided that such fees are non-refundable and collection is probable.

Cost of Revenues

Cost of revenues associated with contract researchtechnology development revenues consists of costs associated with performing the related research contract costs,activities, including direct labor, amounts paid to subcontractors and overhead allocated to contract researchtechnology development activities.

Cost of revenues associated with product sales and license revenues consists of license fees for use of certain technologies; product manufacturing costs including all direct material and direct labor costs; amounts paid to our contract manufacturers; manufacturing, shipping and handling; provisions for product warranty; and inventory obsolescence, as well as overhead allocated to these activities. Product manufacturing activity has historically been and continues to be a relatively insignificant element of our cost of revenues due to our relatively low product sales activity in comparison with our other activities, however, we anticipate this element will grow over time as we expand our manufacturing capabilities.

Operating Expense

Operating expense consists of selling, general and administrative expenses, as well as expenses related to research and development, depreciation of fixed assets and amortization of intangible assets. These expenses also include: compensation for employees in executive and operational functions including certain non-cash charges related to expenses from option grants and other equity-based compensation;grants; facilities costs to the extent not allocable to cost of revenues;costs; professional fees; salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities; costs of marketing programs and promotional materials; salaries, bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Contract Research Group;Technology Development Division; product development activities not covered by contracted research;provided under contracts with third parties; and overhead costs related to these activities.

We anticipate our operating expenses will continue to increase over time due to dedication of resources to product development and increased administrative costs for insurance, professional fees, external reporting requirements, Sarbanes-Oxley compliance and investor relations activities associated with operating as a public company. These increases will also include the hiring of additional personnel.

Interest Income / Income/Expense Net

Interest expense historically related primarily to interest we paid under our senior secured revolving credit facility. As of SeptemberJune 30, 2006,2007, there was no amount outstanding on our credit facility, and we do not expect to draw on that facility in the near term. Beginning December 2005, interestfacility. Interest expense also includedincludes interest accrued on the outstanding aggregate principal of the senior convertible promissory notes issued to Carilion Health SystemClinic on December 30, 2005.

Interest income consists ofincludes amounts earned aton our cash deposits with financial institutions. During 2006 and the first two quarters of 2007, the company invested the proceeds of the Carilion financing transactions and the net proceeds from its initial public offering in a money market rates on our available cash balances.account and draws from that account as needed to fund ongoing operations.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP). The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the

accompanying notes. We base our estimates on historical experience and on various other assumptions that we

believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or judgments. Our significant accounting policies are described in the Management Discussion and Analysis section and the notes to our audited consolidated financial statements previously included in our Registration StatementAnnual Report on Form S-1 (No. 333-131764),10-K for the period ended December 31, 2006, as amended and filed with the Securities and Exchange Commission on June 2, 2006.March 30, 2007.

Results of Operations

Three Months Ended SeptemberJune 30, 20062007 Compared to Three Months Ended SeptemberJune 30, 20052006

Revenues

Total revenues increased 53%59% to $6.0$7.9 million for the three months ended SeptemberJune 30, 2006,2007, from $3.9$4.9 million for the three months ended SeptemberJune 30, 2005.2006. The increase was due in part to increased product sales related to our Luna Technologies Division, which was not acquired until September 30, 2005 and thus was not yet reflected in the results of our consolidated operations for the third quarter of 2005.Division. Our acquisition of Luna Technologies in September 2005 and the subsequent product sales by that division are key elements of our strategic transition towards our goal of increased product sales revenues. We generated approximately $1.2$2.0 million in product sales in the thirdsecond quarter of 20062007 as compared with no such product sales revenues$0.8 million in the thirdsecond quarter of 2005.2006.

Growth in our contract researchtechnology development revenues also contributed to our overall growth in revenues for the thirdsecond quarter of 20062007 as compared with the thirdsecond quarter of 2005. Contract research2006. Technology development revenues increased 24%40% to $4.9$5.9 million for the three months ended SeptemberJune 30, 20062007 from $3.9$4.2 million for the same period in 2005.corresponding 2006 period. This increase was primarily a result of a continued strong success in obtaining research contracts, an increase in the size of certain awards, and the addition of direct contract personnel. The increase was driven in part by application of proceeds from the Carilion financing activities in the second half of 2005, which enabled us to devote more resources to pursuing contract awards.

Cost of Revenues

Cost of revenues increased 34%41% to $4.1$5.0 million for the three months ended SeptemberJune 30, 20062007 from $3.1$3.5 million for the three months ended September 30, 2005. This increase was consistent with our overall increase in revenues.corresponding 2006 period. The main component of this overall increase was the inclusionincreased costs of productlabor and materials related to increases in technology development revenue. New technology development cost of sales costs due to the operations of our Luna Technologies Division during the third quarter of 2006; these costs were not previously a component of our operations in the third quarter of 2005. New product sales costsincreases accounted for approximately $521 thousand,$0.9 million, or 65%, and product sales cost increases accounted for approximately half,$0.5 million, or 35%, respectively, of the overall increase in costs of revenues.

Contract researchTechnology development costs increased 17%30% to $3.6$4.0 million for the three months ended SeptemberJune 30, 20062007 from $3.1 million in the same period in 2005.2006. This increase was lower thanconsistent with the 40% increase in our contract researchtechnology development revenues, due in part to a higherand was comprised primarily of additional direct labor utilization.and the technology associated overhead related to research and development activities.

With the inclusion of product sales in the third quarter of 2006, ourOur overall gross margin improved significantly as compared with the thirdsecond quarter of 2005.2006. Our overall gross margin during the three months ended SeptemberJune 30, 20062007 was 32%37% compared to 22%29% during the same period in 2005.2006. During the three months ended SeptemberJune 30, 2006, contract research2007, technology development activity returned a gross margin of approximately 27%31% compared to 22%26% in the same period of 2005.2006. Product sales activity returned a higher gross margin of 55% for the three months ended SeptemberJune 30, 2007, compared to 46% for the same period in 2006. One of our objectives in seeking greater relative product sales is based on the goal of achieving higher margins to improve our overall profitability.

Operating Expense

Operating expense increased 295%22% to $4.1$5.2 million for the three months ended SeptemberJune 30, 20062007 from $1.0$4.3 million for the corresponding quarter in 2005.2006. Much of the increase in the thirdsecond quarter of 20062007 as compared to the same period in 20052006 was due to significant indirect expenses in connection with implementing our

business plan relating to commercializing new products and increasing our product sales capabilities, as well as the costs associated with becoming a public company. Consistent with our strategy of building a growing portfolio of businesses and products, we were and are actively hiring additional staff with related recruitment and relocation charges, incurring legal and professional fees and implementing various internal changes to prepare and to strengthen our existing infrastructure and management resources as a result of becoming a public company. With the completion of our second round financing with Carilion Health SystemClinic in December 2005, and the proceeds from our IPO in June 2006, we gained the necessary resources to begin implementing many of these important changes to our business. We expect that our operating expenses will remain at these increased levels in the coming months due to our continued growth and development as well as the indirect costs of our initial public offering and compliance with the various regulatory requirements associated with being a public company.

Another factor Our operating expenses of $5.1 million incurred in the increase insecond quarter of 2007 were consistent with our operating expense betweenof $5.2 million incurred in the third quarter of 2006 and the third quarter in 2005 was our adoption of SFAS No. 123R, which required us to record expense related to the fair value of unvested option grants. We recorded share-based compensation expense of approximately $403 thousand during the three months ended September 30, 2006.immediately preceding quarter.

Other Income (Expense)

Net interest income (expense) increased from a net expense during the three months ended Septemberabout $109,000 to $113,000 between June 30, 20052006 and 2007, respectively, which was attributable to net income during the same period in 2006.earnings on invested cash. Nearly all of the interest expense during the three months ended SeptemberJune 30, 2006,2007, was incurred on our senior convertible promissory notes issued to Carilion Health SystemClinic on December 30, 2005, which were not previously outstanding during the third quarter of 2005. These notes have an aggregate outstanding principal of approximately $5.0 million and accrue simple interest at a rate of 6.0% per year. During the three month period ended SeptemberJune 30, 2006,2007, interest expense on such notes was approximately $75 thousand. At the same time, the proceeds from the issuance of the senior convertible promissory notes and the proceeds from the sale of our Class C Common Stock received at the beginning of the first quarter in 2006 continued to provide a cash surplus for us. Additionally, the net proceeds of $17.87 million from the initial public offering were received in the first week of June 2006. The proceeds from these financing transactions resulted in our holding significantly greater interest-bearing balances in the three months ended September 30, 2006, than during the same period in 2005.$100,000. Interest income for the three months ended SeptemberJune 30, 2006,2007, totaled $318 thousand.$167,000. Finally, during the thirdsecond quarter of 2006,2007, we did not have an outstanding balance on our $2.5$3.0 million line of credit. As such, wecredit, and did not incur interest expense on that line of credit in 2006 compared to interest expense of $23 thousand incurred in the thirdsecond quarter of 2005. We do not anticipate a need to draw on that line of credit in the near term given the funds raised from our August and December 2005 financing with Carilion Health System and from our initial public offering in June 2006.2007.

Nine months ended SeptemberSix Months Ended June 30, 20062007 Compared to Nine months ended SeptemberSix Months Ended June 30, 20052006

Revenues

Total revenues increased 39%58% to $15.5$14.9 million for the ninesix months ended SeptemberJune 30, 20062007, from $11.1$9.4 million for the ninesix months ended SeptemberJune 30, 2005.2006. The increase was due in part to increased product sales related to our Luna Technologies Division, which was not acquired until September 30, 2005 and thus was not yet reflected in the results of our consolidated operations for the first, second and third quarters of 2005.Division. Our acquisition of Luna Technologies in September 2005 and the subsequent product sales by that division is aare key elementelements of our strategic transition towards our goal of increased product sales revenues. We generated approximately $2.5$3.8 million in product sales in the first nine monthsand second quarter of 20062007 as compared with no such product sales revenues$1.4 million in the same periodfirst and second quarter of 2005.2006.

Growth in our contract researchtechnology development revenues also contributed to our overall growth in revenues for the first nine monthsand second quarter of 20062007 as compared with the same periodfirst and second quarter of 2005. Contract research2006. Technology development revenues increased 17%38% to $13.0 million for the nine months ended September 30, 2006, from $11.1 million for the same period in 2005.six months ended June 30, 2007 from $8.1 million for the corresponding 2006 period. This

increase was primarily a result of a continued strong success rate in obtaining research contracts, an increase in the size of certain awards, and the addition of direct contract personnel. The increase in the success rate was driven in part by application of proceeds from the Carilion financings in the second half of 2005, which enabled us to devote more resources to pursuing new contracts.

Cost of Revenues

Cost of revenues increased 26%44% to $10.8$9.6 million for the ninesix months ended SeptemberJune 30, 20062007 from $8.5$6.7 million for the nine months ended September 30, 2005. This increase was consistent with our overall increase in revenues and our product mix.corresponding 2006 period. The main component of this overall increase was the inclusionincreased costs of productlabor and materials related to increases in technology development revenue. New technology development cost of sales costs due to the operations of our Luna Technologies Division during the first nine months of 2006 resulting from our acquisition of Luna Technologies in September, 2005. New product sales costsincreases accounted for approximately $1.2$1.9 million, or more than half,64%, and product sales cost increases accounted for approximately $1.0 million, or 36%, respectively, of the overall increase in costs of revenues.

Contract researchTechnology development costs increased 12%31% to $9.6$7.9 million for the ninesix months ended SeptemberJune 30, 20062007 from $8.5$6.0 million in the same period in 2005.2006. This increase was consistent with the overall58% increase in contractour technology development revenues, and was comprised primarily of additional direct labor and the technology associated overhead related to research revenues.and development activities.

With the inclusion of product sales in the first nine months of 2006, ourOur overall gross margin improved as compared with the first ninesix months of 2005.2006. Our overall gross margin during the ninesix months ended SeptemberJune 30, 20062007 was 30%36% compared to 23%29% during the same period in 2005.2006. During the ninesix months ended SeptemberJune 30, 2006, contract research2007, technology development activity returned a gross margin of approximately 26%29% compared to 23%25% in the first nine monthssame period of 2005.2006. Product sales activity returned a higher gross margin of 53% during55% for the ninesix months ended SeptemberJune 30, 2007, compared to 43% for the same period in 2006. Our objectiveOne of our objectives in seeking greater relative product sales is based on the goal of achieving higher margins to improve our overall profitability.

Operating Expense

Operating expense increased 300%35% to $11.8$10.4 million for the ninesix months ended SeptemberJune 30, 20062007 from $3.0$7.7 million for the corresponding period of 2005.in 2006. Much of the increase in the first ninesix months of 20062007 as compared to the same period in 20052006 was due to significant indirect expenses in connection with implementing our business plan relating to commercializing new products and increasing our product portfolio and product sales capabilities, as well as the costs associated with becoming a public company. Consistent with our strategy of building a growing portfolio of businesses and products, we were and are actively hiring additional staff with related recruitment and relocation charges, incurring legal and professional fees and implementing various internal changes to prepare and to strengthen our existing infrastructure and management resources during and after our transition to beingas a result of becoming a public company. With the completion of our second round financing with Carilion Health SystemClinic in December 2005, and the proceeds from our IPO in June 2006, we gained the necessary resources to begin implementing many of these important changes to our business. We expect that our operating expenses will remain at these increased levels in the coming months due to our continued growth and development as well as the costs ofand compliance with the various regulatory requirements ofassociated with being a public company.

Another factor in the increase in our operating expense for the nine months ended September 30, 2006 compared to the same period in 2005 was our adoption of SFAS No. 123R, which required us to record expense related to the fair value of unvested option grants. We recorded share-based compensation expense of approximately $1.2 million during the nine months ended September 30, 2006.

Other Income (Expense)

Net interest income (expense) increased from a net expense during$0.1 million to $0.2 million for the ninesix months ended SeptemberJune 30, 20052006 and 2007, respectively, which was attributable to net income during the same period in 2005.earnings on invested cash. Nearly all of the interest expense during the ninesix months ended SeptemberJune 30, 20062007, was incurred on our senior convertible promissory notes issued to Carilion Health

SystemClinic on December 30, 2005 which were not previously outstanding during the first nine months of 2005. These notes have an aggregate outstanding principal of approximately $5.0 million and accrue simple interest at a rate of 6.0% per year. During the ninesix month period ended SeptemberJune 30, 2006,2007, interest expense on such notes was approximately $225 thousand. At the same time, the$0.2 million. The proceeds from the issuance of the senior convertible promissory notes and the proceeds from the sale of our Class C Common Stock received at the beginning of the first quarter in 2006 continued to provide a cash surplus for us. Additionally, the proceeds of the initial public offering were received in the first week of June. The proceeds from these financing transactions2006 resulted in our holding significantly greater interest-bearing balances in the ninesix months ended SeptemberJune 30, 2006, compared to2007, than during the same period in 2005.2006. Interest income for the ninesix months ended SeptemberJune 30, 2006,2007, totaled $612 thousand.$0.2 million. Finally, during the first ninesix months of 2006,2007, we did not have an outstanding balance on our $2.5$3.0 million line of credit. As such, we did not incur interest expense on that line of credit in 2006 as compared to interest expensethe first six months of $67 thousand incurred in 2005. We do not anticipate the need to draw on that line of credit in the near term given the funds raised from our August and December 2005 financing rounds with Carilion Health System and our initial public offering.2007.

Liquidity and Capital Resources

Prior to August 2005, our primary source of liquidity had been cash provided by operations, financing from the revolving credit facility, and divestitures of certain assets and businesses. In August 2005, we completed our first outside equity financing and raised $7.0 million through an equity investment by Carilion Health System.Clinic. Carilion Health SystemClinic invested an additional $8.0 million in December 2005 in the form of $5.0 million in senior convertible promissory notes and $3.0 million in additional equity. Our principal uses of cash have been to fund our expansion, including facilities, personnel, working capital and other capital expenditures, and to fund our costs of transition to a public company.

We have a $2.5$3.0 million senior secured revolving credit facility with First National Bank that is collateralized by a security interest in substantially all of our assets. The interest rate on borrowings under our secured revolving credit facility is equal to the prime rate, limited to no less than 6.0% and no greater than 10.0% per annum, with interest payable monthly. This agreement was modified in May 2006, to allowalso provides a $1.0 million sub-limit for letters of credit and to extend the expiration date to Novembercurrently expires June 30, 2006. Under the terms of the senior secured revolving credit facility, the outstanding principal is payable in full on demand or at maturity on November 30, 2006.2008. The senior secured revolving credit facility contains covenants which require us to maintain $1.0 to $2.0 million in liquidity depending on our outstanding balance. Additionally, without First National Bank’s prior approval, we may not make a direct loan to an affiliate or subsidiary of ours exceeding $500 thousand$500,000 annually, guaranty the debt of our affiliate or subsidiary or incur debt in excess of $200 thousand with other than First National Bank debt annually.third parties. Finally, we are obligated to continue to provide First National Bank an assignment of life insurance in a minimum amount of $1.0 million on the life of Kent A. Murphy, covering all of our indebtedness to First National Bank. As of December 31, 2005, we had repaid theJune 30, 2007, there was no outstanding balanceborrowing on our secured revolvingthis credit facility, and we do not anticipate the need to draw on that line of credit in the near term given the funds raised from our August and December 2005 financing rounds with Carilion Health System as well as the proceeds from our initial public offering.line. With the exception of our obligations under the senior convertible promissory notes, the senior secured revolving credit facility and our capital lease, we have no other debt outstanding.

On June 2, 2006, the effective date of our initial public offering, we sold 3,500,000 shares of common stock at $6.00 per share resulting in gross proceeds of $21.0 million. In connection with this offering, we paid $1.47 million in underwriting discounts and commissions and incurred other offering expenses of approximately $1.66 million. The net proceeds from the offering were approximately $17.87 million.

Discussion of Cash Flows

Recent Activity

During the nine months ended September 30, 2006, weWe used approximately $6.3$2.6 million and $2.7 million of net cash from operations. This wasoperations during the six months ended June 30, 2007 and 2006, respectively. The decrease in cash used in operations resulted from an increase of $50,000 in net loss, offset by the $0.7 million impact of increased non-cash changes for depreciation, amortization, and share-based compensation. Additionally, changes in working capital accounts provided a substantialnet $0.3 million in cash from operating activities for the six months ended June 30, 2007 compared to $0.8 million for the six months ended June 30, 2006. The change overin working capital accounts for the activitysix months ended June 30, 2007 includes a $1.4 million increase in the corresponding nine months of 2005. Most of this change was due to the addition of operationsdeferred revenue arising from the Luna Technologies Division, which was not reflected

in thetiming difference between receipt of cash flows from operations in the first nine months of 2005, and the general increase in cash outflows that resulted from our expenditures increaserecognition of revenue for certain long-term development contracts to achieve a greater relative amountbe accounted for using the percentage of product sales, fund new product development activities, and our preparation to become a public company.completion method.

Cash used in investing activities for the ninesix months ended SeptemberJune 30, 2006,2007 related primarily to the purchase of property and equipment and legal fees associated with securing patent rights to certain technology. Our overall cash used in investing activities was $1.7 million representing an increase of $1.1$1.4 million in the first ninesix months ofended June 30, 2007, compared to $0.8 million in the corresponding June 30, 2006 as compared with the first nine months of 2005period. This increase was due primarily to capital expenditures to support our increase in personnel and test equipment requirements. In future months, we expect an increaseto maintain a lower rate of growth in net cash used in investing activities as we believe that we now have the necessary resources to begin and complete a number of longer-term investments in our growth.

Cash flows fromused by financing activities for the ninesix months ended SeptemberJune 30, 2007 was $13,000, representing a decrease in cash flow from cash generated by financing activities for the six months ended June 30, 2006. Cash generated by financing activities for the six months ended June 30, 2006 increased significantly comparedconsisted of proceeds from the issuance of common stock of $17.7 million, related to the first nine months of 2005 due to the net proceeds of $17.9 million from our initial public offering. As a result of our increased cash position through the initial public offering and our Carilion financing at the end of 2005, weLuna’s Initial Public Offering. Luna did not need to draw additional financing from our line of credit or other sources in the first ninesix months of 2006 as we had previously done in the first nine months of 2005.2007.

At SeptemberJune 30, 2006,2007, total cash and cash equivalents were approximately $22.4$13.9 million. We believe that our current cash on hand and cash available under our line of credit agreement will be sufficient to fund operations for the next 12 months.

Summary of Contractual Obligations

We lease our facilities in Blacksburg, Charlottesville, Danville, Hampton, McLean and Roanoke, Virginia under operating leases that expire on various dates through December 2013January 2014 or under a month-to-month arrangement. Upon expiration of the leases, we may exercise certain renewal options as specified in the leases.

We also lease certain computer equipment and software under capital lease agreements that expire through January 2010. The assets subject to these obligations are included in property and equipment on our consolidated balance sheet.

Our Luna Technologies Division has an agreement with a supplier to purchase tunable lasers and estimates its noncancellable obligation to be approximately $959 thousand$1.5 million through 2007.2008.

In March 2004, we received a grant of $900 thousand$0.9 million from the City of Danville, Virginia under a Grant Agreement to support the expansion of economic and commercial growth within the City. Under the Grant Agreement, we agreed to locate a nanomaterials manufacturing and research facility and maintain its operations in Danville until March 25, 2009. As of September 25, 2006, we had not fully met the capital expenditures and job milestones under this agreement, and, as a result, we may be obligated to repay the City of Danville a portion of the $900 thousand$0.9 million in funds based on a formula of the pro rata shortfall of such expenditures and jobs falling below such required levels. Because of the failure to meet these milestones and the continuing obligation to maintain our investment and employees at this location through March 25, 2009, we currently have classified the full amount of the grant as a liability on our balance sheet in anticipation of potentially returning the funds.

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements as defined in Regulation S-K 303(a)(4)(ii).

Interest Rate Risk

We do not use derivative financial instruments as a hedge against interest rate fluctuations, and, as a result, interest income earned on our cash and cash equivalents and short-term investments is subject to changes in interest rates. However, we believe that the impact of these fluctuations does not have a material effect on our financial position due to the immediate available liquidity or short-term nature of these financial instruments. As of SeptemberJune 30, 2006,2007, we had $22.3$13.1 million deposited in cash and cash equivalents bearing a weighted-average interest rate of 4.8%5.21%.

Foreign Currency Exchange Rate Risk

Our product sales to foreign customers are denominated in U.S. dollars and we do not receive payments in foreign currency. As such, we are not directly exposed to currency gains or losses resulting from fluctuations in foreign exchange rates.

Evaluation of Disclosure Controls and Procedures

Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report, have concluded that as of SeptemberJune 30, 2006,2007, our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

Within the past nine months, we have hired a new Chief Financial Officer, a Chief Accounting Officer as well as an additional senior accountant. These individuals have prior experience with external financial reporting in a public company environment and should improve our ability to prepare timely consolidated financial statements as well as to address more complex accounting matters, such as business combinations and share-based payments.

We also intend to continue to establish new and enhanced systems of internal control that we believe will be necessary to allow management to report on, and our independent auditors to attest to, our internal controls. To improve the timeliness of our financial reporting, we instituted a detailed closing schedule to enhance overall completeness and quality of our reporting. The closing schedule was first implemented in March 2006 and provides guidance on routine processes, such as procedures for handling key account reconciliations, month end cutoff procedures for accounts payable and accrued expenses as well as cutoff procedures for revenue and related receivables. The documentation will be expanded in later periods to provide detailed guidance of our entire closing process including preparation of interim and year-end consolidated financial statements and related notes.

We have also taken measures to improve our cutoff and accrual procedures. Specifically, during the past nine months we have implemented a process to improve our estimation of subcontractor expenses to ensure completeness of our direct costs and related revenue. We will continue to review this process to monitor the sufficiency of such policies and procedures.

We do not believe we have material weaknesses or significant deficiencies related to our policies and procedures, including those that pertain to maintenance of records, authorizations of receipts and expenditures, or prevention or timely detection of unauthorized acquisition, use, or disposition of our assets. However, we have not performed specific tests to determine the effectiveness of key controls within these policies and procedures. We intend to monitor those policies and procedures in connection with the establishment of a formally documented system of internal control. We are continuing documentation of our internal controls processes in order to identify additional areas for improvement as well as in anticipation of our futureneed to comply with the requirements underof the Sarbanes-Oxley Act of 2002.

PART II. OTHER INFORMATION

From time to time, we may become involved in litigation in relation to claims arising out of our operations in the normal course of business. While management currently believes the amount of ultimate liability, if any, with respect to these actions will not materially affect our financial position, results of operations, or liquidity, the ultimate outcome of any litigation is uncertain. Were an unfavorable outcome to occur, or if protracted litigation were to ensue, the impact could be material to us.

In July 2005, we received a letter from legal counsel retained by a former employee and consultant that such law firm is investigating whether such former employee has any claims against us, including breaches of contract, fiduciary duty, implied covenants of good faith and fair dealing as well as potential violations of minority stockholder rights that such former employee may have as a stockholder in one of our subsidiaries. On May 30, 2006, we were served process of a complaint filed by the former employee in the Circuit Court for the City of Roanoke, Virginia, alleging that we breached our consulting contract with the former employee, and that we are indebted to the former employee in an unspecified amount of at least $100 thousand.one hundred thousand dollars. We have answered the complaint and intend to defend the company vigorously in this matter. While we believe the former employee’s claims are without merit, counsel for such former employee has indicated that it may file additional claims against us. We cannot predict whether such former employee will file additional litigation against us or our subsidiaries or the ultimate outcome of any such litigation.

ITEM 1A.    RISK FACTORSOn June 22, 2007, Hansen Medical, Inc. (“Hansen”) filed a lawsuit against us in California State Court, Santa Clara County, alleging misappropriation of trade secrets, unfair competition, breach of contract, and breach of the implied covenant of good faith and fair dealing. The claims allegedly stem from our past relationship with Hansen and our past and future relationship with Intuitive Surgical, Inc. (“Intuitive”). The lawsuit makes an unspecified claim for damages, however Hansen

has not indicated how it will substantiate such damages and we are unable to reasonably estimate the amount of damages, if any, that Hansen will seek. In addition, Hansen may seek equitable relief, including, for example, an injunction to prevent us from misusing Hansen’s trade secrets or proprietary information or an injunction to prevent us from working with Intuitive. This litigation is in its early stages. No discovery has been exchanged yet, and no trial date has been set. We believe Hansen’s allegations are without merit and we intend to vigorously defend ourselves in this lawsuit. However, we cannot predict the ultimate outcome of this litigation and we are unable to estimate any potential liability we may incur.

You should carefully consider the risks described below before deciding whether to invest in our common stock. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations and financial results. If any of the following risks actually occurs, our business, financial condition or results of operations could be adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment. Our filings with Securities and Exchange Commission also contain forward-looking statements that involve risks or uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks we face described below.

Risks Related to Our Business and TechnologiesRISKS RELATING TO OUR BUSINESS

If we are unable to manage our growth effectively, our revenuesrevenue and profitsnet loss could be adversely affected.

While historically we have developed and commercialized only a few products at a time, we plan to grow by developing and commercializing multiple products concurrently across many industries, technologies and markets. Our ability to grow by developing and commercializing multiple products simultaneously requires that we manage a diverse range of projects, and expand our personnel resources. Our inability to do any of these could prevent us from successfully implementing our growth strategy, and our revenues and profits could be adversely affected.

To advance the development of multiple promising potential products concurrently, we need to manage effectively the logistics of maintaining the requisite corporate, operational, administrative and financing functions for each of these product opportunities. Potentially expanding our operations into new geographic areas and relying on multiple facilities to develop and manufacture different products concurrently pose additional challenges. We have little experience in managing these functions simultaneously for multiple projects in development or in building new infrastructure and integrating the operations of various facilities. If we cannot manage this process successfully, we may be subject to operating difficulties, additional expenditures and limited revenue growth.

We need to expand our personnel resources to grow our business effectively. We believe that sustained growth at a higher rate will place a strain on our management, as well as on our other human resources. To

manage this growth, we must continue to attract and retain qualified management, professional, scientific and technical and operating personnel. During the most recently completed calendar quarter, ended September 30, 2006, the labor market, particularly for highly-specialized scientists and engineers remained tight. If we are unable to recruit a sufficient number of qualified personnel, we may be unable to staff and manage projects adequately, which may slow the rate of growth of our contract researchtechnology development revenue or our product development efforts.

We have incurred recent losses, and because our strategy for expansion may be costly to implement, we may experience continuing losses which may be significant.

We incurred consolidated net losses of approximately $2.0 million and $6.8$9.4 million for the year ended December 31, 20052006, and $4.9 million for the ninesix months ended Septemberending June 30, 2006, respectively.2007. We expect to continue to incur significant additional expenses as we expand our business, including increased expenses for research and development, sales and marketing, manufacturing, finance and accounting personnel and expenses associated with being a public company. We may also grow our business in part through acquisitions of additional companies and complementary technologies which could cause us to incur greater than anticipated transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we expect that we may likely continue to incur losses for the foreseeable future, and these losses could be substantial.

Because of the numerous risks and uncertainties associated with our business and our expansion strategy, we are unable to predict when or if we will be able to achieve profitability again. If our revenues do not increase, or if our expenses increase at a greater rate than our revenues, we will continue to experience losses. Even if we do achieve profitability, we may not be able to sustain or increase our profitability on a quarterly or annual basis.

If we cannot successfully transition our revenue mix from technology development revenues to product sales and license revenues, we may not be able to fully execute our business model or grow our business.

Our business model and future growth depend on our ability to transition to a revenues mix that contains significantly larger product sales and license revenues components. Product sales and license revenues potentially offer greater scalability and higher gross margins than services-based technology development revenues. Our current plan is to increase our portfolio of commercial products and, accordingly, we expect that our future product sales and license revenues will represent a larger percentage of total revenues. However, if we are unable to develop and grow our product sales and license revenues to augment our technology development revenues, our ability to execute our business model or grow our business could suffer.

We may not be successful in identifying market needs for new technologies and developing new products to meet those needs.

The success of our business model depends on our ability to identify correctly market needs for new technologies. We intend to identify new market needs, but we may not always have success in doing so, in part, because our technology development largely centers on identification and development of unproven technologies, often for new or emerging markets. Furthermore, we must identify the most promising technologies from a sizable pool of projects. If our commercialization strategy process fails to identify projects with commercial potential or if management does not ensure that such projects advance to the commercialization stage, we may not successfully commercialize new products and grow our revenues.

Our growth strategy requires that we not only identify new technologies that meet market needs, but that we also develop successful commercial products that address those needs. We face several challenges in developing successful new products. Many of our existing products and those currently under development-including our Trimetasphere carbon nanomaterials, which are nanomaterials in the form of a carbon sphere with three metal atoms enclosed inside-are technologically innovative and require significant and lengthy product development efforts. These efforts include planning, designing, developing and testing at the technological, product and manufacturing-process levels. These activities require us to make significant investments. Although there are many potential applications for our technologies, our resource constraints require us to focus on a limited number of products and to forgo other opportunities. We expect that one or more of the potential products we choose to develop will not be technologically feasible or will not achieve commercial acceptance, and we cannot predict which, if any, of our products we will successfully develop or commercialize.

The technologies we research and develop are new and steadily changing and advancing. The products that are derived from these technologies may not be applicable or compatible with the state of technology or demands in existing markets. Our existing products and technologies may become uncompetitive or obsolete if our competitors adapt more quickly than we do to new technologies and changes in customers’ requirements. Furthermore, we may not be able to identify if and when new markets will open for our products given that future applications of any given product may not be readily determinable, and we cannot reasonably estimate the size of any markets that may develop. If we are not able to successfully develop new products, we may be unable to increase our product revenues.

Our failure to attract, train and retain skilled employees would adversely affect our business and operating results.

The availability of highly trained and skilled technical and professional personnel is critical to our future growth and profitability. Competition for scientists, engineers, technicians and professional personnel is intense and competitors aggressively recruit key employees. WeIn the past, we have recently experienced difficulties in recruiting and hiring these personnel as a result of the tight labor market in certain fields. This fact, combined with our growth strategy and future needs for additional experienced personnel, particularly in highly specialized areas such as nanomaterial manufacturing and innovative ultrasound technologies, may make it more difficult to meet all of our needs for these employees in a timely manner. Although we intend to continue to devote significant resources to recruit, train and retain qualified employees, we may not be able to attract and retain these employees, especially in technical fields where the supply of experienced qualified candidates is limited. Any failure to do so would have an adverse effect on our business.

In addition, our future success depends in a large part upon the continued service of key members of our senior management team. In particular, our Chairman, CEO and founder, Kent A. Murphy, Ph.D., is essential to our overall management as well as the development of our technologies, our culture and our strategic direction. All of our executive officers and key employees are at-will employees, and, except with respect to Kent A. Murphy, Ph.D., we do not maintain any key-person life insurance policies. The loss of any of our management or key personnel could seriously harm our business.

We may not be successful in identifying market needs for new technologies and developing new products to meet those needs.

The success of our business model depends on our ability to identify correctly market needs for new technologies. We intend to identify new market needs, but we may not always have success in doing so, in part, because our contract research largely centers on identification and development of unproven technologies, often for new or emerging markets. Furthermore, we must identify the most promising technologies from a sizable

pool of projects. If our commercialization strategy process fails to identify projects with commercial potential or if management does not ensure that such projects advance to the commercialization stage, we may not successfully commercialize new products and grow our revenues.

Our growth strategy requires that we not only identify new technologies that meet market needs, but that we also develop successful commercial products that address those needs. We face several challenges in developing successful new products. Many of our existing products and those currently under development—including our Trimetasphere™ carbon nanomaterials, which are nanomaterials in the form of a carbon sphere with three metal atoms enclosed inside—are technologically innovative and require significant and lengthy product development efforts. These efforts include planning, designing, developing and testing at the technological, product and manufacturing-process levels. These activities require us to make significant investments. Although there are many potential applications for our technologies, our resource constraints require us to focus on specific products and to forgo other opportunities. We expect that one or more of the potential products we choose to develop will not be technologically feasible or will not achieve commercial acceptance, and we cannot predict which, if any, of our products we will successfully develop or commercialize. The technologies we research and develop are new and steadily changing and advancing. The products that are derived from these technologies may not be applicable or compatible with the state of technology or demands in existing markets. Our existing products and technologies may become uncompetitive or obsolete if our competitors adapt more quickly than we do to new technologies and changes in customers’ requirements. Furthermore, we may not be able to identify if and when new markets will open for our products given that future applications of any given product may not be readily determinable, and we cannot reasonably estimate the size of any markets that may develop. If we are not able to successfully develop new products, we may be unable to increase our product revenues.

We rely and will continue to rely on contract research, including government-funded research contracts, for a significant portion of our revenues. Any decreaseA decline in these revenues,government funding of existing or future government research contracts, including Small Business Innovation Research or SBIR,(or SBIR) revenues, could adversely affect our business.revenues and cash flows and our ability to fund our growth.

We derive a significant portionTechnology development revenue, which consists primarily of our revenues from contract research that we perform for third parties. Contractgovernment-funded research, accounted for approximately 93.5%74% and 83.7%85% of our consolidated total revenues for the year ended December 31, 2005 and the ninethree months ended SeptemberJune 30, 2007 and 2006, respectively. As a result, we are vulnerable to adverse changes in our revenues and cash flows if a significant number of our research contracts and subcontracts are simultaneously delayed or canceled for budgetary, performance or other reasons. The U.S. government, for example, may cancel these contracts at any time without cause and without penalty or may change its requirements, programs or contract budget, any of which could reduce our revenues and cash flows from U.S. government research contracts. Our revenues and cash flows from U.S. government research contracts and subcontracts could also be reduced by declines or other changes in U.S. defense, homeland security and other federal agency budgets. In addition, we compete as a small business for some of these contracts, and in order to maintain our eligibility to compete as a small business, we (together with any affiliates) must continue to meet size and revenue limitations established by the U.S. government.

In addition to contract cancellations and changes in agency budgets, our future financial results may be adversely affected by curtailment of the U.S. government’s use of contract research providers, including curtailment due to government budget reductions and related fiscal matters. These or other factors could cause U.S. defense and other federal agencies to conduct research internally rather than through commercial research organizations, to reduce their overall contract research requirements or to exercise their rights to terminate contracts. Any of these actions could limit our ability to obtain new contract awards and adversely affect our revenues and cash flows and our ability to fund our growth.

We also derive a significant portion of our technology development revenues from SBIR contracts. SBIR revenues accounted for approximately 59.8%61% and 65.2%67% of our consolidated total revenues for the year ended December 31, 2005 and the ninethree months ended SeptemberJune 30, 2007 and 2006, respectively, and 52.8% of our pro forma consolidated total revenues, which include the operations of Luna Technologies for the year ended December 31, 2005.respectively. Contract research, including SBIR, will remain a significant portion of our consolidated total revenues for the foreseeable future. Our strategy for developing innovative technologies and products depends in large part on our ability to continue to enter into and generate revenues from non-SBIR contract research, including in the near term SBIR contracts, for which we must comply with certain eligibility criteria. research.

Our contract research customer base includes government agencies, corporations and academic institutions. Our customers are not obligated to extend their agreements with us. In addition, our contracts with government agencies, which accounted for approximately 93.3% and 88.6% of our contract research revenues for the year ended December 31, 2005 and the nine months ended September 30, 2006, respectively, provide that the U.S. government may terminate funding prior to the expiration of these contracts, regardless of whether we have demonstrated technological feasibility or have met specified milestones. In addition, we may not be successful in securing future contracts. Our customers’ priorities regarding funding for certain projects may change and funding resources may no longer be available at previous levels.

We rely and will continue to rely on contracts and grants awarded under the SBIR program for a significant portion of our revenues. A finding by the Small Business Administration, or SBA, that we no longer qualify to receive SBIR funding could adversely affect our business.

We may not qualify to participate in the Small Business Administration’s, or SBA’s, SBIR program or receive new SBIR awards from federal agencies in the future. In order to qualify for SBIR contracts and grants,

at least 51% of our equity must be owned and controlled by U.S. citizens or permanent resident aliens, or by another entity that is at least 51% owned or controlled by U.S. citizens or permanent resident aliens, and we must have 500 or fewer employees. These eligibility criteria are applied as of the time of the award of a contract or grant. In determining whether we satisfy the 51% equity ownership requirement, agreements to merge, stock options, convertible debt and other similar instruments are given “present effect” by the SBA, as though the underlying securities were actually issued unless the exercisability or conversion of such securities is speculative, remote or beyond the control of the security holder. We therefore believe our outstanding options and warrants held by eligible individuals may be counted as, and our convertible debt may be excluded from, outstanding equity for purposes of meeting the 51% equity ownership requirement.

We believe that we are currently in compliance with the SBIR eligibility criteria but we cannot provide assurance that the SBA will interpret its regulations in our favor. As of December 31, 2006, giving present effect to our outstanding options, we estimate that at least approximately 58% of our equity is owned by U.S. citizens or permanent residents. We must be able to certify that we meet the SBIR ownership and size requirements as of the time we enter into each SBIR contract or grant, and SBA may review our size status in connection with each SBIR contract or grant. As we grow our business, it is foreseeable that we will eventually exceed the SBIR eligibility limitations and we may need to find other sources to fund our research and development efforts. If we are unsuccessful in obtaining additional contracts or funding grants because we cannot meet the eligibility requirements or if our customers decide to reduce or discontinue support of our products, we may be required to seek alternative sources of revenues or capital.

The SBA could determine that, as a result of Carilion Health System’sClinic’s equity ownership, the number of our employees exceeds the size limitation placed on SBA contract and SBIR grant recipients, and therefore we will not be eligible to receive future SBA contracts and SBIR grants.

In addition to the U.S. ownership eligibility criteria discussed above, to be eligible for SBA contracts and SBIR grants, the number of our employees including those of any entities that are considered to be affiliated with us, cannot exceed 500.

As of SeptemberJune 30, 2006,2007, we, including all of our divisions, had 184 full-timeapproximately 222 full and 17 part-timepart time employees. However, in determining whether we are affiliated with any other entity, the SBA analyzes whether another entity controls or has the power to control us. If the SBA determines that another entity controls or has the power to control us, it will aggregate that entity’s employees (and the employees of its subsidiaries and affiliates) with our own for purposes of applying the 500 employee test.

The SBA may make an affiliation determination based on stock ownership. For example, the SBA may presume that two or more entities have the power to control a company if the entities each own, control or has the power to control, less than 50 percent of the company’s stock, such minority holdings are equal or approximately equal in size, and the aggregate of the minority holdings is large as compared to any other stock holding. However, this presumption may be rebutted by showing that such control or power to control does not in fact exist. As of SeptemberJune 30, 2006,2007, Carilion Health SystemClinic held approximately 22.6%22.2% of our outstanding common stock, and Dr. Kent Murphy held approximately 26.7%26.8% of our outstanding common stock. Thus, applying the criteria stated above, the SBA could find that both Carilion Health SystemClinic and Dr. Murphy own less than 50% of the stock, their percentages are roughly equal, and their respective percentages are large compared to any other stock holding. We believe that the relative beneficial ownership of our individual stockholders rebuts the presumption of control by Carilion Health SystemClinic because the shares held by our executive officers and directors constitute the controlling interest in us. However, if the SBA were to make a determination that we are affiliated with Carilion Health System,Clinic, we would exceed the size limitations as Carilion Health SystemClinic has over 500 employees, and we therefore would lose eligibility for new SBA contracts, public contracts, grants and other awards that are set aside for small businesses, including SBIR grants.

We depend on government-funded research contracts for most of our contract research revenues, and a decline in government funding of existing or future government research contracts could adversely affect our revenues and cash flows and our ability to fund our growth.

Government-funded research accounted for approximately 93.3% and 88.6% of our contract research revenues and 87.2% and 74.2% of our consolidated total revenues for the year ended December 31, 2005 and the

nine months ended September 30, 2006, respectively. On a pro forma consolidated basis, which includes the results of operations of Luna Technologies as if acquired on January 1, 2005, government-funded research accounted for 76.9% of our pro forma consolidated total revenues for the year ended December 31, 2005. As a result, we are vulnerable to adverse changes in our revenues and cash flows if a significant number of our government research contracts and subcontracts are simultaneously delayed or canceled for budgetary, performance or other reasons. The U.S. government may cancel these contracts at any time without cause and without penalty or may change its requirements, programs or contract budget, any of which could reduce our revenues and cash flows from U.S. government research contracts. Our revenues and cash flows from U.S. government research contracts could also be reduced by declines or other changes in U.S. defense, homeland security and other federal agency budgets. In addition, we compete as a small business for some of these contracts, and in order to maintain our eligibility to compete as a small business, we (together with any affiliates) must continue to meet size and revenue limitations established by the U.S. government.

In addition to contract cancellations and changes in agency budgets, our future financial results may be adversely affected by curtailment of the U.S. government’s use of contract research providers, including curtailment due to government budget reductions and related fiscal matters. These or other factors could cause U.S. defense and other federal agencies to conduct research internally rather than through commercial research organizations, to reduce their overall contract research requirements or to exercise their rights to terminate contracts. Any of these actions could limit our ability to obtain new contract awards and adversely affect our revenues and cash flows and our ability to fund our growth.

If we cannot successfully transition our revenues mix from contract research revenues to product sales and license revenues, we may not be able to fully execute our business model or grow our business.

Our business model and future growth depend on our ability to transition to a revenues mix that contains significantly larger product sales and license revenues components. Product sales and license revenues potentially offer greater scalability than services-based contract research revenues. Our current plan is to increase our portfolio of commercial products and, accordingly, we expect that our future product sales and license revenues will represent a larger percentage of total revenues. However, if we are unable to develop and grow our product sales and license revenues to augment our contract research revenues, our ability to execute our business model or grow our business could suffer.

We might require additional capital to support business growth, and this capital might not be available.

We intend to continue to make investments to support our business growth and may require additional funds to respond to business challenges, including the need to develop new products or enhance our existing products, enhance our operating infrastructure, complete our development activities, build our commercial scale manufacturing facilities and acquire complementary businesses and technologies. In 2006, we had a net loss of $9.4 million and used $9.1 million in cash for operations in addition to $3.4 million cash used for investing activities. For the second quarter ended June 30, 2007, we had a net loss of $2.2 million, and generated $0.3 million in cash for operations in addition to $0.4 million used for investing activities. Our balance of cash and cash equivalents as of June 30, 2007, was $13.9 million. Accordingly, in the future we may need to engage in equity or debt financings to secure additional funds for these investments. In addition, we were contacted during the third quarter 2006 by counsel representing two former investorsto support our operations and investments in our Luna Technologies subsidiary who assert that they have a contractual right to put a portion of their stock in Luna Innovations back to us. Such investors have stated that they intend to file litigation against us unless we recognize their alleged claim. Based on the advice of counsel, we believe that such right was extinguished in connection with our initial public offering and that such claim is without legal basis. We cannot, however, predict whether such former investors will file litigation against us or the ultimate outcome of such litigation. Any repurchase of outstanding shares of our common stock would result in a reduction in our cash position and could accelerate our need to engage in equity or debt financings.new products.

If we raise additional funds through issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock, including shares of common stock sold in our initial public offering. Furthermore, such financings may jeopardize our ability to apply for SBIR grants or qualify for SBIR contracts or grants, and our dependence on SBIR grants may restrict our ability to

raise additional outside capital. In addition, we may not be able to obtain continued SBIR funding, or other additional financing on terms favorable to us, if at all. In order to retain SBIR eligibility, we may be restricted in our ability to raise certain forms of equity capital from institutional investors. For example, in connection with the closing of our financing with Carilion Health SystemClinic on December 30, 2005, we were not able to raise all proceeds through the issuance of equity without potentially jeopardizing our SBIR eligibility. We therefore elected to issue debt in the amount of $5.0 million of the total $8.0 million raised in such financing to maintain SBIR eligibility. Under the terms of these notes, we agreed that we will not draw down any amount under our existing senior secured credit facility with First National Bank or incur additional indebtedness other than under certain limited conditions. In addition, if we lose eligibility or elect to no longer compete for SBIR contracts prior to December 30, 2009, the holder of our $5.0 million senior convertible promissory notes has the right, at its discretion, to convert some or all of the principal and interest amounts into shares of our common stock, which would result in further dilution to our existing stockholders.

If we are unable to obtain adequate financing or financing on terms satisfactory to us, when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

If we are unable to secure third-party reimbursement for our healthcare products, including our EDAC QUANTIFIER and EN-TACT medical devices, our revenue and net loss could be adversely affected.

In both the United States and foreign markets where we intend to sell our medical products, third-party payors such as the government and health insurance companies are generally responsible for hospital and doctor reimbursement for medical products and services. Governments and insurance companies carefully review and increasingly challenge the prices charged for medical products and services. Reimbursement rates from private insurance companies vary depending on the procedure performed, the third party involved, the insurance plan involved, and other factors. In the United States, reimbursement for medical procedures under the Medicare and Medicaid programs is administered by Centers for Medicare & Medicaid Services. Medicare reimburses both hospitals and physicians a pre-determined, fixed amount based on the procedure

performed. This fixed amount is paid regardless of the actual costs incurred by the hospital or physician in furnishing the care and is often unrelated to the specific devices used in that procedure. Thus, any reimbursements that hospitals or physicians obtain for using our medical products will generally have to cover any additional costs that hospitals incur in purchasing such products.

Hospitals and medical centers to which we intend to sell our EDAC QUANTIFIER product typically bill the services performed with our products to various third-party payors, such as Medicare, Medicaid and other government programs and private insurance plans. If hospitals do not obtain sufficient reimbursement from third-party payors for procedures performed with our products, or if governmental and private payors’ policies do not permit reimbursement for services performed using our products, demand for our product may be negatively impacted.

In countries outside the United States, reimbursement is obtained from various sources, including governmental authorities, private health insurance plans and labor unions. To sell our product in foreign markets, we may need to seek international reimbursement approvals. We cannot be certain whether such required approvals will be obtained in a timely manner or at all.

Furthermore, any regulatory or legislative developments in domestic or foreign markets that eliminate or reduce reimbursement rates for procedures performed with our products could harm our ability to sell our products or cause downward pressure on the prices of our products, either of which would have a negative effect on our product revenue and net loss.

We face and will face substantial competition in several different markets that may adversely affect our results of operations.

We face or will face substantial competition from a variety of companies in several different markets. Our competitors in contract research include, but are not limited to, companies such as General Dynamics Corporation, Lockheed Martin Corporation, SAIC, Inc. and SRA International, Inc. In the molecular technology solutions products market, our competitors include, but are not limited to, large public manufacturers such as The Dow Chemical Company, E.I. du Pont de Nemoursinstrumentation and Company, Rohmtest and Haas Company and 3M Company, as well as emerging companies. In addition, in the MRI contrast agent market our competitors include Amersham Plc, Berlex Laboratories, Inc., Bracco Diagnostics, Inc., and Mallinckrodt Inc. In the sensor solutionsmeasurement products market, our competitors include, but are not limited to, large companies such as Agilent Technologies, Inc., Analog Devices, Inc., Freescale Semiconductor, Inc., JDS Uniphase Corp., Robert Bosch GmbH and Silicon Sensing, as well as emerging companies. In addition, in the MRI contrast agent market our competitors include Amersham Plc, Berlex Laboratories, Inc., Bracco Diagnostics, Inc., and Mallinckrodt Inc.

The products that we have developed or are currently developing will compete with other technologically innovative products as well as products incorporating conventional materials and technologies. We expect that our products will compete with companiesface competition in a wide range of industries, including semiconductors, electronics, biotechnology, textiles, alternative energy, military, defense, healthcare, telecommunications, industrial measurement,instrumentation, healthcare, military and security applications and consumer electronics.applications.

Many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. These competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. In addition, current and potential competitors have established or may establish financial or strategic relationships among themselves or with existing or potential customers or other third parties. Accordingly, new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We cannot assure you that we will be able to compete successfully against current or new competitors, in which case our net revenues may fail to increase or may decline.

A substantial portionWe may be obligated to repay part of our technology is subjectthe proceeds received in connection with a grant from the City of Danville, Virginia, for failing make certain agreed upon expenditures and failing to retained rights of our licensors, andmeet certain employment obligations.