**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

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**Form 10-K**
| x                                                                                                                                                                                                                                                             | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For the fiscal year ended DECEMBER 31, 2005**                                                                                                                                                                                                               |
| **OR**                                                                                                                                                                                                                                                        |
| o                                                                                                                                                                                                                                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the transition period  from                  to                  ** |

 

**Commissionfile number 0-24230**

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**FIBERSTARS, INC.**

(Exact name of registrant asspecified in its charter)

| **California**                  | **94-3021850**       |
|---------------------------------|----------------------|
| (State or other jurisdiction of | (I.R.S. Employer     |
| incorporation or organization)  | Identification  No.) |

 

**32000 Aurora Road, Solon,OH 44139**

(Address of principalexecutive offices) (Zip Code)

Registrant’s telephonenumber, including area code: **(440) 715-1300**

Securities registered undersection 12(b) of the Exchange Act: **None**

Securities registered underSection 12(g) of the Exchange Act:

Title of Each Class

**CommonStock, $0.0001 par value**

**Series AParticipating**

**PreferredStock**

**PurchaseRights**

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o  No x

Indicate by check mark whether the registrant (1) hasfiled all reports required by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendments to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

Large accelerated filer o            Acceleratedfiler o            Non-acceleratedfiler. x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act)  Yes o  No x

The aggregate market value of the voting and non-votingcommon equity held by non-affiliates of the registrant was approximately$71,896,000 as of June 30, 2005 (based upon the last trading price of theCommon Stock of registrant on the Nasdaq National Market as of that date).Shares of common stock held as of June 30, 2005 by each director andexecutive officer of the registrant, as well as shares held by each holder ofmore than 10% of the common stock known to the registrant, have been excludedfor purposes of the foregoing calculation. This calculation does not reflect adetermination that any person is an affiliate of the registrant for any otherpurpose.

As of March 22, 2006, there were11,310,910 shares of the registrant’s Common Stock outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Items 10 (as to directorsand Section 16 (a) Beneficial Ownership Reporting Compliance), 11, 12(as to Beneficial Ownership), 13 and 14 of Part III of this Report on Form 10-Kincorporates information by reference from registrant’s definitive ProxyStatement to be filed with the Securities and Exchange Commission in connectionwith the solicitation of proxies for registrant’s 2006 Annual Meeting ofShareholders to be held June 15, 2006.

 

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**FORWARD-LOOKING STATEMENTS**

*When used in thisReport, the words “expects,” “anticipates,” “estimates,” “plans,” “intends” andsimilar expressions are intended to identify forward-looking statements.These statements include, but are not limited to, statements as to our*competitiveposition, future operating results, net sales growth, expected operatingexpenses and capital expenditures, gross product margin improvement, sources ofrevenues, anticipated credits from government contracts, product development andenhancements, liquidity and cash reserves, our reliance upon a limited numberofcustomers,our accounting policies, the effect of recent accounting announcements, thedevelopment and marketing of new products, relationships with customers anddistributors, relationships with, dependence uponand the ability to obtaincomponents from suppliers, as well as our remarks concerning our ability tocompete in the fiber optic lighting market, the evolution and future size ofthe fiber optic lighting market, seasonal fluctuations, plans for and expectedbenefits of outsourcing and offshore manufacturing, trends in the price andperformance of fiber optic lighting products, the benefits and performance ofour lighting products, the adequacy of our current facilities, our strategywith regard to protecting our proprietary technology, our ability to retainqualified employees; and the risks set forth below under Item 1A, “Risk Factors”.These forward-looking statements speak only as of the date hereof. Weexpressly disclaim any obligation or undertaking to release publicly anyupdates or revisions to any forward-looking statements contained hereinto reflect any change in ourexpectations with regardthereto or any change in events, conditions or circumstances on which any suchstatement is based.

Fiberstars®, BritePak®, OptiCoreTM, Lightly Expressed®,Jazz LightTM, FX LightTM, FX Spa LightTM and Fiberstars EFO® are our registeredtrademarks. We also refer to trademarks of other corporations and organizationsin this document.

All references to “Fiberstars,”“we,” “us,” “our” or “the Company” means Fiberstars, Inc. and itssubsidiaries, except where it is made clear that the term means only the parentcompany.

**PART I**

**Item 1. Business**

**Overview**

Fiberstars designs, develops, manufactures and marketsfiber optic lighting systems for wide-ranging uses in both the generalcommercial and the pool and spa lighting markets. Our Efficient Fiber Optic, orEFO, system, introduced in 2004, offers greater energy savings, heatdissipation, and maintenance cost benefits over conventional lighting formultiple applications. Accordingly, we believe our EFO system will become aleading technology in accent lighting and numerous niche lighting markets.

We currentlyoperate in two principal markets, Commercial Lighting and Pool and SpaLighting, with several product lines:

·       *Commercial Lighting.*Within thismarket we sell both EFO lighting systems and traditional fiber optic lightingsystems used in commercial applications.

·        *Energy Efficient Accent Lighting.*Wemarket our EFO lighting systems primarily as an energy efficient alternative toMR-16 halogen lamps used for accent lighting in retail and commercialbuilding settings. We also target niche lighting markets such as generalillumination on naval ships, adjustable spot lights used on loading docks anddisplay and freezer case lighting.

·        *Specialty Decorative and Special EffectsLighting.*We market our traditional small diameter fiber opticsystems in specialty and special effects lighting applications including caselighting, decorative and neon alternative applications and signage.

·       *Pool and Spa Lighting.*We marketboth our traditional fiber optic lighting products, developed prior to theintroduction of EFO, and other energy efficient non-fiber optic systems forunderwater 

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lighting applications. Ourunderwater lighting systems are installed in pools and spas built by poolbuilders throughout the United States and Canada.

Our fiber optic lighting systems combine threecomponents—an illuminator, fiber and fixtures—that are used in configurationsdesigned for specific applications. The electrically powered illuminatorencases the lamp and serves to generate and efficiently focus light to thefiber. Currently our illuminators use HID or halogen lamps, but in the futuremay be adapted to use any energy efficient light sources, including LEDs. Ourproprietary large diameter fiber cables used in our EFO systems connect to theilluminator and are designed to emit light either at the end of the fiber as apoint of light, or along the length of the fiber, similar in effect to neonlighting. We currently market our EFO system with six or eight fiber cablesconnected to the illuminator.

Our EFO fiber optic lighting system consists of acentral source of illumination connected to multiple end-points via fibercables. The electrically powered illuminator lamp encases our patentedcollectors that have our proprietary nanotechnology coating layers enabling theefficient capture of over 90% of the light from the lamp. Our large diameterfiber cables, manufactured through a proprietary continuous extrusion process,connect to the illuminator and efficiently deliver 95% of the light from theilluminator to the fiber while virtually eliminating infrared and ultravioletlight that negatively affect perishable goods and works of art. Our proprietarycouplers attach the end-points of our fiber cables to the fixtures, enhancingcompatibility with new fixtures. The efficiency benefits provided by thesecomponents coupled with our proprietary fiber optic extrusion manufacturingprocess distinguish our EFO system from other fiber optic lighting systems andtraditional lighting technologies for numerous lighting applications. As aresult of these developments, we believe we are the first to market energy efficientfiber optic lighting systems for specific applications such as accent lightingused in retail and commercial settings.

The increasingly stringentregulatory environment, high energy prices, retail and commercial demand foraccent lighting and recent innovations in our fiber optic for lighting systemsposition our products to address a meaningful segment of the general lightingmarket.

**Industry Overview**

The worldwide market forelectric lamps, lighting fixtures and ballasts was approximately $79 billion in2001 and expected to grow to $100 billion by 2006, representing 5% annualgrowth, according to a 2003 report by The Freedonia Group, Inc., a marketresearch firm. We estimate that our current addressable market for EFOtechnology is currently greater than $5 billion. This addressable marketincludes halogen accent lighting, freezer case lighting in supermarkets, docklighting and display case lighting. The limitations of the lighting productscommonly used for these applications, combined with rising energy costs andincreasingly stringent energy regulations, present a compelling opportunity foralternative lighting solutions in these niche markets.

*Impact of EnergyRegulation in the Lighting Industry*

In the United States, electricity consumption is projectedto increase from 3.5 billion kilowatt hours in 2003 to 5.2 billion kilowatthours in 2025, according to the United States Department of Energy’sInternational Energy Outlook. According to the report, electricity consumptionin the commercial sector is the fastest growing segment at 2.5% annuallythrough 2025. The Department of Energy in a 2005 report estimated that lightingin the United States accounts for approximately 27% of total electricityconsumed by commercial end-users. The electric power industry faces thechallenge of satisfying increasing demand while being constrained by thelimited supply of fossil fuels as well as infrastructure limitations affectinggeneration, transmission and distribution, all of which may result in higherelectricity prices.

These challengeshave resulted in a variety of new government regulations and initiativesintended to curtail energy consumption. This growing global concern with energyutilization together with energy 

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conservationregulation has encouraged the development and implementation of more energyefficient lighting solutions. Some of the key regulations and initiativesaffecting the lighting industry include:

·       *ASHRAE-IESNA Standard 90.1.  *In July 2004, theDepartment of Energy adopted the 1999 version of ASHRAE-IESNA Standard 90.1,requiring all commercial and government buildings to reduce lighting powerdensity as measured by watts per square foot. For example, this standardgenerally mandated a reduction in power density to 1.9 watts per square footfor both new construction and renovations requiring building permits for retailbuildings in the United States. This standard was lowered for retail buildingsto 1.9 watts per square foot from the approximately 3.3 watts per square footunder the 1989 version adopted for retail buildings in some states.

·       *The Energy Policy Act of 2005.  *This recently enactedfederal legislation provides tax incentives to commercial and residentialelectricity consumers for making energy efficiency improvements well beyond presentstandards in their buildings and homes. The incentives are in place for a twoyear period beginning January 1, 2006.

·       *State Legislation.  *Certain states, such as California,have adopted standards that exceed the ASHRAE-IESNA 90.1 minimum requirements.California’s updated Title 24, which took effect in October 2005, requiresresidential and non-residential buildings to use energy efficient lighting thatmeets minimum lumens per watt.

·       *LEED—U.S. Green Building Council’s Leadership in Energy &Environmental Design.  *LEED is a self-assessing system designedfor energy efficiency rating of new and existing commercial, institutional andhigh-rise residential buildings. LEED evaluates the environmental performanceoftheentire building over its life cycle, providing a definitive standard for whatconstitutes a “green”building. To receive LEED certification, thebuilding must meet, among other things, ASHRAE-IESNA Standard 90.1lighting requirements. For each reduction of 10% beyond the 90.1requirements,the project receives an additional point toward achieving LEED certification.Incertainlocalities, a building must receive a LEED certificate in order to receive abuilding permit.

Recent legislation haslimited energy consumption available for lighting, which conflicts with thedesire of the user to maintain or even increase effectivelighting. For example, retailers valueeffective accent lighting as a critical element in showcasing merchandise andpromoting sales, but are constrained by thecurrentregulatory environment. Accent lighting is also essential in commercial andother buildings, including office buildings, schools, hospitals and casinos,which use lighting as a design element inhallways, entryways, conference rooms and to display artwork. To maintain or obtaineffective, high quality lighting, theseretailers and other commercial users need a lighting solution that meetsincreasingly stringent regulatory requirements.

*Overview ofLighting Technologies*

Multiple lighting technologies have evolved to addressa variety of lighting requirements. Each of these technologies hascharacteristics and limitations that affect its utility in a given application.

*Incandescent.**  *Due to its simplicity of use and low initial cost,the incandescent bulb is the dominant light source used in residential lightingin the United States. The basic technology for incandescent bulbs was createdin the 19th century and further developed in the mid 20th century with theintroduction of the Tungsten filament and gas fill. The MR-16 halogenlamp, one type of an incandescent lamp, has commonly been used in accentlighting. Incandescent bulbs including MR-16s have the following generalcharacteristics:

·       Producea high quality bright, white light;

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·       Emit significant heat,infrared and ultraviolet radiation that can damage perishable goods andincreases room temperature adding to coolingcosts; and

·       Requiresignificant electricity and frequent replacement due to short life.

*Fluorescent.**  *The fluorescent lamp is an energy efficientalternative to incandescent lamps commonly used in general illumination. Thefluorescent lamp was initially developed in the 1930s using mercury atoms in alow pressure discharge. The compact fluorescent lamp, developed in the 1980s,produces notably higher lumens per watt than an incandescent lamp. Fluorescentlamps have the following general characteristics:

·       Offerhigh energy efficiency with modern fluorescent lamps reaching efficiencies ofabout 80 lumens per watt;

·       Producea non-directional beam of light not ideal for accent lighting;

·       Emitlight with unfavorable color characteristics;

·       Containmercury, which leads to disposal issues; and

·       Exhibitlower light output and a shorter life in a cold environment.

*Solid State Lighting.**  *Invented in 1962, LEDs are only now beginning to showpromise as a light source. For example, LEDs are increasingly replacingincandescent lamps in traffic signals and as brake and high mount stop lightsfor new cars. As the technology develops further, some industry professionalspredict that LED’s, performance characteristics will equal or potentiallyexceed those of fluorescent lamps. Current LEDs have the following generalcharacteristics:

·       Offerenergy efficiency comparable to halogen sources;

·       Demonstrate long lifecycles; and

·       Emit low luminosity.

*High-Intensity Discharge.**  *The newest white light source, the metal halide HID lamp, was invented in1966 and is used extensively in outdoor applications, automotive headlamps andgeneral lighting sources in large indoor buildings such as warehouses. Metalhalide HID lamps with efficiencies exceeding incandescent and fluorescent lampsin lumens per watt are available commercially. Newer versions of HID lamps arebeing used as interior spotlights for commercial applications. Metal halide HIDlamps have the following general characteristics:

·       Emit high quality whitelight;

·       Offerenergy efficiency;

·       Provide cost effectivenessin larger light packages, but are too expensive when packaged in a smallerlight source partly due to their expensiveballasts; and

·       Radiate significant heat.

*Emergence of FiberOptic Lighting*

Given the limitations of traditional lightingtechnologies and the opportunity to develop an alternative lighting solutionfor particular applications, Fiberstars and other companies began to experimentin the 1980s with connecting optical fiber to MR-16 halogen lamps. Theprimary applications for early fiber optic technology had relatively low lightoutput and short lamp life, and were limited to color illumination in swimmingpools and commercial decorative markets. In the 1990s optical fiber was appliedin combination with metal halide light sources. This led to longer lamp lifeand higher light outputs. Additional 

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addressable markets wereunattainable with the early fiber optic lighting technology primarily due tothe inefficiency of the system, which in turn was a result of the size andgeometry of the light source, inefficiency of the collection optics and thesmall diameter fiber optic cables.

In the past several years,a number of patented technological advancements in our fiber optic lightingsystems have resulted in markedly better performance characteristics enablingpotential for broader use in a number of additional lighting applications. Webelieve our EFO fiber optic lighting systems are economically and aestheticallyappealing and well-suited for accent and other niche lighting applications.

**The Fiberstars Solution**

Our EFO systemoffers energy efficiency, lower life cycle costs and addresses the limitationsof traditional lighting systems in specific applications. Building uponsignificant recent breakthroughs in fiber optic lighting technology, the firstcommercial deployment of our EFO system to a major customer was in the firstquarter of 2004. Our patented EFO technology addresses the limitations ofcurrent fiber optic lighting technology and meets government regulations forenergy efficiency through a series of technological advances over the last 18months, including:

·       Improved light outputequivalent to MR-16s while being up to 80% more energy efficient;

·       Introduced a full spectrumlamp that closely simulates daylight color;

·       Improvedour patented large core fiber extrusion process enabling high volume productionand reducing manufacturing costs; and

·       Developedapplication-specific fixtures to meet a broad variety of customers’ needs,including light bars which replicate fluorescent tubes.

We believe the intensityand efficiency of our EFO system improves upon the lighting advantages oftraditional fiber optic lighting by enhancing customers’ lighting capabilities.EFO’s accent lighting capabilities allow a retailer to focus the attention ofshoppers to the areas and products that they want to highlight. Physicallyseparating the heat source from the fixture provides a non-heat radiatinglighting solution that lowers cooling costs associated with lighting andreduces food spoilage and melting. The benefits of our EFO system haveattracted customers such as Cinemark and Whole Foods Markets and have ledothers such as Albertson’s, Nordstrom, Publix, Costco and Pathmark to test ourproduct at select locations.

*Key Features of OurEFO System*

*Illuminator.**  *Most of our commercial illuminators today deploy ourspecially designed metal halide HID lamps due to the capacity of these lamps toprovide long life and maximum brightness. Our EFO technology can efficientlydistribute the light from higher wattage metal halide lamps to lower lightlevels. We may, however, in the future use other efficient lighting sources asthey become commercially viable.

*FiberCables.**  *Ourpatented large core fiber has outstanding clarity and consistency with lowattenuation for fiber optic lighting applications. By combining our compoundparabolic collector, or CPC, technology and our large core fiber, our systemdelivers light ranging from 30 to 60 lumens per watt, compared to approximatelyeight to 15 lumens per watt for a system using traditional MR-16 halogenlamps.

*Fixtures.**  *We produce a broad assortment of adjustable fixturesthat allow the customer to easily adjust the direction and beam spread of thelight for optimal light concentration.

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*Key Benefits of OurEFO System*

*Energy Efficiency.**  *Our EFO system can provide our customers with accentlighting that also satisfies government and other regulatory regulations forenergy efficient lighting. EFO technology enables customers to comply with ASHRAE-IESNAStandard 90.1 and Title 24, qualify for the tax incentives available under theEnergy Policy Act of 2005 and secure LEED certification without sacrificingintensity and light quality. The following table highlights the electricalsavings of one 70 watt EFO accent light compared to competing lightingtechnologies:

| **Light Source**                  | ** ** | ** ** | ** ** | **Number  equivalent  in 70 Watt  EFO** | ** ** | **Total Watts** | ** ** | **Estimated Energy  Savings %** | ** ** |
|----------------------------------------|------------|------------|------------|---------------------------------------------------|------------|----------------------|------------|--------------------------------------|------------|
| 70W EFO accent  light                  |       |       | 1          |                                              |       |                 | 70W        |                                 |       |   | — |   |   |
| 26W Compact  fluorescent down light    |       |       | 4          |                                              |       |                 | 104W       |                                 |       |   | 33 | % |   |
| 50W MR-16  halogen accent light        |       |       | 8          |                                              |       |                 | 400W       |                                 |       |   | 83 | % |   |
| 60W Incandescent  down light           |       |       | 7          |                                              |       |                 | 420W       |                                 |       |   | 83 | % |   |
| 3W Luxeon3 LED  accent light           |       |       | 60         |                                              |       |                 | 180W       |                                 |       |   | 61 | % |   |
| 25W Ceramic metal halide  accent light |       |       | 5          |                                              |       |                 | 125W       |                                 |       |   | 44 | % |   |

 

The EFO technologydelivers up to 80% energy savings over halogen or other incandescent lightingsystems commonly used in similar applications. For example, Cinemark reducedits energy consumption from 5,140 watts to 1,120 watts by installing our EFOsystem.

*Color.**  *Today our EFO system is available in warm white anddaylight colors. The warm white lamps have a color temperature that is suitablefor interior spaces. The daylight color temperature matches the colortemperature of the light entering spaces through windows. Because we controlthe design of the lamp, reflector and output fixture we can tune the system todeliver a balanced, full spectrum white light.

*Elimination of Virtuallyall Heat Radiation.**  *Our EFOsystem is designed to prevent the infrared and ultraviolet radiation emittedfrom the lamp from being funneled through the fiber. As a result, the lightoutput emits virtually no infrared or ultraviolet light, which produce heatwhen absorbed by the target, and the only heat generated is from light output itself,which is negligible. In contrast, halogen lamps produce approximately ninewatts of heat energy for every one watt of light.

*Cost Savings.**  *Our EFO system is able to significantly reducemaintenance and replacement costs that are normally attributed to traditionallighting systems. Our EFO systems contain lamps with a long life cycle and needfewer lamps to light a given area. For example, a customer would have toreplace 20-40 MR-16 halogen lamps for every one EFO lamp annuallybased on average retail usage. In addition, because the EFO lamp is physicallyseparated from the light fixture, when used in applications such as freezercases, the quality of light and life of the EFO lamp is not affected by thefreezing temperature. The EFO lamp does not radiate heat in the freezer and thefreezer does not need to be emptied to change the lamp as is the case withfluorescent lamps.

*Traditional Fiber Optic Lighting*

We also sell a line oftraditional fiber optic products that do not use our EFO technology. Theseproducts use an illuminator with HID or halogen light sources and a traditionalimaging optical method that focuses the light from the source into bundles ofstranded fiber. The system is used largely in decorative and display caselighting applications, where color changing and small points of light are keyfeatures.

In addition, we sell aline of fiber optic pool lighting products designed to add color and decorativelighting to water features for residential pools. We alsosell a variety of feature lighting systemsthat change color and includes an option to synchronize the color changes ofmultiple water features. The water feature

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lights are sold in kits that may be used to lightwaterfalls, one or more linear water streams, deck lights and landscape lights.

**Our Strategy**

Ourobjective is to become the leading provider of energy efficient lightingsystems. To achieve this objective, we intend to pursue the followingstrategies:

·       *Capitalize on the growing need for low cost, energy efficient lightingsystems.  *We intend to devote significant resources to ourproduct development efforts to maximize the energy efficiency and quality ofour lighting systems while reducing costs and enabling our customers to meetmore stringent government regulations. In addition, we plan to continue to hirepersonnel with technological expertise in the lighting industry, develop newproprietary technologies and integrate new and potentially more efficientlighting sources into our lighting systems.

·       *Focus on market niches where the benefits of our technology are mostcompelling.  *We intend to establish showcase installations todemonstrate the benefits of our EFO technology and build broader awarenessamong our target customer base. For example, we believe the benefits of our EFOtechnology will appeal to retailers and supermarket operators, who sharesimilar needs for highly efficient, flexible accent lighting solutions. Toreach our target markets, we also intend to continue to build a direct salesforce of experienced lighting salespeople.

·       *Develop and expand strategic relationships.  *To buildawareness of our EFO technology, we intend to market our systems to leadingarchitects, lighting designers, contractors and other entities that recommendor install lighting systems, as well as to fixture manufacturers and otherparticipants in the general lighting market. For example, we have an agreementwith Gensler Architecture, Design & Planning LLC or Gensler, a leadingarchitecture, design and planning firm, under which Gensler provides consultingservices and helps enhance our visibility and image within the design andconstruction communities. In addition, we plan to construct a FiberstarsLighting Academy in Solon, Ohio, where lighting specialists, designers andinstallers will attend courses on EFO lighting technology and installation. Webelieve these marketing efforts will help further adoption of our technology inthe general lighting market.

·       *Furtherdevelop and enhance pool lighting products.  *We intend todevelop new products that are complementary to traditional pool lights currentlysold by pool equipment suppliers. To maximize the sales of these new products,we plan to leverage our well-established presence in the pool and spa lightingmarket.

**Our Products**

We market a wide varietyof fiber optic lighting systems in two general markets: (1) commerciallighting and (2) pool and spa lighting. Within the commercial lightingmarket we sell EFO systems in energy efficient accent lighting and specialtydecorative and special effects lighting. All of our fiber optic lightingsystems are comprised of illuminators, fiber cables and fixtures. Othercustomized components for non-EFO systems include under water lenses, colorchanging electric pool lights, landscape lighting fixtures and a line oflighted water features including waterfalls and laminar flow water fountains.

*EFO System*

Our EFO system is a newtechnology capable of replacing halogen and compact fluorescent lamps in retailand commercial lighting settings while using only a fraction of the energy.This lighting system effectively distributes energy efficient light in auser-friendly manner. The EFO system is based upon a lighting system made up ofseveral components: a highly efficient light source, proprietary CPC optics,proprietary FiberJacks coupling technology and our large core fiber.

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The primary light sourcefor our EFO system is a unique metal halide HID lamp specifically developed incooperation with, and is produced exclusively for us by, Advanced LightingTechnologies, Inc. and its subsidiaries (“ADLT”) to maximize efficiency,output and life span. This source produces light with an efficiency of up to 90lumens per watt, five times the efficiency of the light source used in MR-16halogen lamps. We believe our metal halide HID lamp is the most energyefficient source of high quality light currently available and more closelymatches the daylight color spectrum than any other lamp available for fiberoptic applications. Furthermore, our standard metal halide HID lamp has acurrent life span of up to 10,000 hours, which is up to five times the typicallife of MR-16 halogen lamps. We also use alternative light sources suchas LEDs in certain applications, and in the future we anticipate utilizingthese light sources in more of our products as they become more energyefficient.

We surround our lightsource with a CPC and employ additional coupling optics. We hold eight UnitedStates patents and one corresponding patent in Australia, and two pendingpatent applications in the United States and 10 pending corresponding foreignpatent applications, for the CPC and those coupling optics. These collectorscapture more than 90% of the light generated by our light source. Traditionalimaging collectors are only about one half as efficient at delivering light totheir outputs. Our collectors have multiple coating layers each smaller than100 nanometers, which acting together form a reflective surface. Thesenanotechnology coatings were designed to act in conjunction with the othercomponents in our EFO system. The coatings are applied using a uniquelow-pressure chemical vapor deposition process. Together with the patentedshape of our collector, this non-imaging optical system delivers 93%reflectivity in the visible region. Furthermore, this optical system does notreflect infrared and ultraviolet radiation, minimizing the amount of infraredand ultraviolet light that leaves the collector.

Glass rods collect thelight output from our collector, piping it outside the housing. These rods actas thermal barriers and when coated, also become filters. These filters blockvirtually all remaining infrared and ultraviolet radiation that comes from thelight source directly or which is reflected by the collectors. The purity ofthe glass rods and the filters’ anti-reflective coatings allow for a transmissionof up to 95% of the light output from the collector. These rods are the pointof connection to the fiber optic cable. We house the lamp, solid state powersupply, collector and rods in a single package referred to as the illuminator.

Unlike most fiber opticlighting systems, which use bundles of thin strands of fiber, our fiber isproduced as a flexible large core polymer light pipe of varying diameters fromthree millimeters to 20 millimeters, depending on the customer’s applicationrequirements. Our large core fiber is manufactured using a new acrylic plasticcomposition and proprietary processing method that produces a fiber that canwithstand the heat and light conditions associated with EFO applications. Thismanufacturing process enables us to significantly reduce the cost of producinga continuous extruded large core fiber. We believe our large core fiber isapproximately twice as efficient as a comparable stranded fiber cable.

Our EFO system consists ofan illuminator, pre-cut lengths of our large core fiber with the FiberJackscouplers at either end, and application-specific fixtures. The FiberJackscouplers allow one end of the fiber to snap into the illuminator, similar tothe way a telephone line connects to a phone jack, and the other end into theapplication-specific fixtures. FiberJacks, a proprietary plug-and-play couplingsystem, has significantly changed the installation of fiber optic lightingsystems by eliminating the need for on-site fiber preparation, often anextremely precise process requiring highly skilled technicians. On-sitepreparation could result in errors in the alignment of the fibers, which inturn result in loss of light and variability of illumination at the fixture.With FiberJacks, all centering and alignment happens automatically, eliminatingthese types of losses and variability, and because all of our large core fibersare cut and finished with the FiberJacks couplers at the factory, the on-siteinstaller need only unpack the fiber and snap it into the illuminator and thefixture.

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*Application-Specific Fixtures*

Our EFO system can beadapted to any number of lighting applications, including those currently usingtraditional lighting systems. The primary concerns to commercial end-users,include quality of light, such as color, luminosity and directional lighting,and compliance with energy regulation. Our EFO system allows these customersgreater flexibility in meeting their lighting needs within these regulatoryconstraints while maintaining the desired effect. The key variable in each ofthese applications is the fixture. We have developed FiberJacks compatibleapplication-specific fixtures that allow the EFO system to be used, forexample, in supermarkets, commercial retail space, freezer cases, in-caselighting, casinos and commercial accent lighting where traditional lightingtechnology was not, or is no longer, capable of meeting the customer’s needs.In addition, our EFO system can provide greater energy efficiency thantraditional lighting systems with the advantages of directional lighting andfocusable beams that traditional lighting systems typically sacrifice to complywith energy regulation. Many of our output fixtures include optics that allowconsistent repetitive beam adjustment in both angle and beam spread. Inaddition, most of our fixtures are clean, simple and small in appearance, andinclude a wide range of trim and finishes.

These fixtures leveragethe strengths of fiber optics to deliver well-defined beams, in an attractivepackage, at a low cost.

**TraditionalFiber Optic Products and Other Products**

*Commercial Lighting*

The primary illuminator inthis product line is currently the 405 illuminator series, which uses a metalhalide HID light source. Other Fiberstars illuminators use a halogen lamp. Thislight source may be soldwith a colorwheel that causes the light output to rotate through a variety of colors fordecorative applications, or as a white light system for down lighting or star ceiling applications. When used in down lightingor star ceiling applications, the illuminator is coupled with a variety ofbundled fiber diameters and lengths that are encased in a plastic cladding. Wesell a variety of down light and accent light fixtures for this product line.When used in neon-like decorative applications, the illuminator is coupled witha variety of diameters and lengths of BritePak®, a woven stranded fiber cableencased in a clear plastic cladding.

*Pool and Spa Lighting Products*

Our pool lighting productsare designed to add color and decorative lighting to water features forresidential pools at night. The 6000 series illuminator is the primary fiber optic product line sold into theswimming pool market and also uses an HID-based illuminator with a traditionalimaging optical system. The illuminator is used with bundles of stranded fiberthat transfer the light from the illuminator under the pool decking and intothe pool where the end points are encased in a lens fixture. The illuminator isequipped with a color wheel that changes the color of the light output.

We sell a variety offeature lighting systems that also change color. These are sold with the 2000illuminator series, which includes an option for synchronizing the colorchanges of multiple water features and with outdoor spas. The water featurelights are sold in kits that may be used to light waterfalls, one or morelinear water streams, deck lights and landscape lights.

In addition, we sell theJazz Light, a pool light that changes color. This light fits into the wall ofthe pool and uses an HID lamp with a color wheel to provide pool color changes. We also sell portable spa lights that adddecorative color to portable spas.

*Other Products*

In our European operationswe sell small lines of other lighting products that use LEDs and smallincandescent light sources. These products are sold into the decorativelighting market.

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**AddressableMarkets and Applications**

Thefollowing table identifies our current addressable markets, potentialapplications and certain customers that have deployed or beta tested ourproducts:
| Market for EFO       | ** ** | **Potential Applications**                                                                                                                   | ** ** | **Customers**                                                                      |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|
| Supermarkets         |       | Accent lighting for  specialty product display sections such as seafood, meat, wine, freezer  cases, and any other specialty accent lighting |       | Whole Foods Markets,  Albertsons, Giant Eagle*, Heinens*                           |
| Specialty Retail     |       | Down lighting and accent  lighting applied to display items such as clothing racks and display windows                                       |       | Nordstrom, JCPenney,  Tiffany & Co.*, Kessler Jewelers, Ethan Allen*      |
| Ships                |       | Replacement of  fluorescent bulbs for general illumination                                                                                   |       | Department of Defense,  United States Navy                                         |
| Commercial Buildings |       | Accent and down lighting  used in entry ways, conference rooms, foyers, and art displays                                                     |       | Trammel Crow Company,  Department of Energy*, DARPA Headquarters, ING Headquarters |
| Dock Lighting        |       | Replacement of existing  hazardous and breakable dock lights used on loading docks                                                           |       | Giant Eagle, Heinens,  Pathmark, Publix, Wal-Mart                                  |
| Restaurants          |       | Down lighting and accent  lighting                                                                                                           |       | Cinemark                                                                           |
| Hospitals            |       | Down lighting for lobby,  waiting room, gift shop and floral cases                                                                           |       | Evergreen Medical Center,  Valley Childrens Medical Center                         |
| Signs                |       | Direct view end-point  stranded fiber                                                                                                        |       | Movado, Coach                                                                      |
| Museum Lighting      |       | Used for high quality  white light without damaging infrared or ultraviolet radiation                                                        |       | Museum of Jewish  Heritage, National Inventors Hall of Fame*                       |

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*                    Beta testinglocations.

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| Market for Specialty  Decorative and Special  Effect | ** ** | **Potential Applications**                                                                                                                                                        | ** ** | **Customers**                                                                                                                                              |
|------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Retail Case Lighting                                 |       | Used in glass display  cases for a low-heat emission and high quality bright white light                                                                                          |       | Tiffany & Co.,  Swarovski, GEMS, Lalique, Reeds Jewelers, Kessler Jewelers                                                                        |
| Museum Lighting                                      |       | Used for high quality  white light without damaging infrared or ultraviolet radiation                                                                                             |       | Smithsonian, National  Gallery of Art, Museum of Jewish Heritage, Newseum, American Folk Art Museum,  National Firearms Museum, Victoria and Albert Museum |
| Decorative                                           |       | Kiosk accent lighting,  wall wash accent, color light for added attention, direct view side-emitting  stripes, cove lighting, star fields, glass edge lighting                    |       | Niketown, DillonWorks,  Disney, Universal, McDonald’s, Sony Metreon, Chanel                                                                           |
| Neon Replacement                                     |       | Stripes of light going  around the façade, Interior decorative lighting                                                                                                      |       | Ethan Allen, Sonic, the  Ft. Lauderdale sea wall                                                                                                           |
| Signage                                              |       | Back light and halo  letters, side emitting outline or enhancing graphics. Direct view end point  with special effects color changing or animation                                |       | Whole Foods Markets,  Gable Signs, SignTech, Disney, Sherwin-Williams, Bally’s, Movado, Coach                                                         |
| Furniture                                            |       | Encased in furniture  such as cabinets                                                                                                                                            |       | Ethan Allan, IKEA                                                                                                                                          |
| Casinos                                              |       | Special effect single  color or white light only, accent down lighting on game tables, conference  rooms, same as commercial buildings.                                           |       | The Venetian, Harrah’s,  Swinomish Northern Lights, Bellagio, Caesars Palace, Mirage                                                                  |
| Hotels                                               |       | Hall way lighting, hotel  spas, saunas, workout rooms, conference rooms, display cases                                                                                            |       | Mandalay Bay, Bellagio                                                                                                                                     |
| Pool and Spa                                         |       | Safe and efficient  lighting solution that enables users to change color options in pools and  spas. Also has ability to light streams of water such as fountains and  waterfalls |       | Approximately 300,000  pools and spas since 1988                                                                                                           |

 

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**Sales, Marketing and Distribution**

Our products are soldthrough a combination of a direct sales force paid on commission, independentsales representatives and distributors into geographic markets throughout theworld. We also are building an internal sales force for the sale of our EFOsystems. We have been successful in hiring experienced salespeople fromindustry leading firms such as General Electric in order to facilitate oursales efforts. As of December 31, 2005, we had 32 sales and sales supportpeople throughout the United States and Europe. We believe the presence ofsalespeople with experience at industry-leading firms provides additionalcredibility to our marketing of our products, particularly our EFO systems,into markets historically dominated by a few large companies. In order tomaximize our sales opportunities, we have developed different sales andmarketing strategies to address various target markets of our products.

*Commercial Lighting*

*EFO Sales andMarketing*

Our initial strategy is to sell our EFO system toseveral large accounts. We then plan to leverage these successes intoadditional installations with these and new customers. We identify key accountsthrough marketing efforts combining advertising, articles in trade publicationand presentations at industry conferences and trade shows. The salespeoplefirst facilitate the testing of the EFO system with a customer and then workwith the customer for initial and follow-on sales. The typical test sequence isas follows: demonstrations to key executives within the store chain; smalltests of prototype installations in one store department; larger tests inmultiple departments; and finally, sales to store locations within chainregions. For example, a grocery store installation can include a variety ofdepartments including seafood, deli, bakery, meat, wine and produce. Thesedepartments often display their higher margin products around the store’sperimeter. In many cases the store chain derives most of its profit from thesesections of the store and is willing to spend more on highlighting theirmerchandise. Early multi-store sales have come from national supermarket chainsand other retailers such as Whole Foods Markets and Cinemark. For example, wehave begun rolling out our EFO system in three out of the eight Whole FoodsMarkets regions and our EFO system is installed in 13 stores within these threeregions. We began shipping products to a fourth region in the third quarter of2005. Similarly, we have outfitted seven Cinemark store locations. We also havetests underway at 10 additional grocery store chains. Our sales successes havecome as a result of our ability to demonstrate a reduction in energy costs,help the chain meet energy regulations and provide attractive lighting of thechain’s merchandise.

To increase adoption of our EFO technology, we alsointend to market our systems to leading architects, lighting designers,contractors and other entities that recommend or install lighting systems. Forexample, we have agreements with Gensler, a leading architecture, design andplanning firm, under which they assist in designing our EFO system in themarkets in which they do business. Gensler also provides strategic advice tohelp us enhance our visibility and image within the design and constructioncommunity as a manufacturer of preferred technology.

In addition, some utility companies have embraced ourtechnology as an energy efficient alternative to traditional lighting systemsand have begun to promote EFO to their customers.

We also sell our EFO systems through lightingrepresentatives who target specific lighting projects in local markets. Theserepresentatives will specify EFO systems as the lighting for projects where EFO’sefficiency and lighting intensity are important. The sales representative firmsare used in the United States, Canada, Europe and other international markets.We have more than 60 independent lighting representative organizationsthroughout the United States for our commercial lighting products, includingEFO and traditional lighting products. These organizations are paid on acommission basis. Approximately 20 of these representatives account for a largemajority of our commercial lighting product sales. We sell our products inEurope through two subsidiaries, Crescent Lighting Ltd. in the United Kingdomand 

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Lichtberatung Mann (LBM)in Germany. These two companies manage our sales operations in Europe, Russiaand the Middle East, which, as in the United States, include sales throughsub-distributors and sales representatives. In other international markets wesell through regional lighting representatives.

We regularly attendindustry conferences at which we give presentations on our products. Theseconferences include Lightfair, Food Marketing Institute and other United Statestrade shows targeted at our customers, as well as lighting industry trade showsin Europe, Australia, Japan, India and China. We have had articles on ourproducts written in LD+A, Architectural Lighting, Architectural Record, Displayand Design Ideas and Visual Merchandising and Store Design. We participate instudies conducted by independent third parties, including universities andother educational institutions, designed to evaluate the benefits of ourlighting systems. We also regularly give presentations to lighting designers onthe benefits of EFO systems. In addition to selling into national grocery storeand retail chains directly, our sales strategy for EFO is to convince lightingdesigners of EFO’s energy saving and accent lighting benefits. Lightingdesigners work with architects on larger building projects to ensure thatattractive and up-to-date lighting products are used.

*TraditionalCommercial Lighting Products*

Similar to our salesefforts for EFO systems, we sell our traditional fiber optic commerciallighting products through independent sales representatives. In addition, aswith our EFO systems, we sell our traditional commercial lighting products inEurope, Russia and the Middle East through our subsidiaries. We also sell our traditionalcommercial lighting products internationally in most industrialized countriesthrough distributors, including ADLT in Australia, Magic Lite in Canada,Verslite Hitech Lighting in India, Lighting Limited in China and Mitsubishi andKoto in Japan.

*Pool and SpaProducts*

Our sales and marketing strategy for our pool and spalighting products differs from our strategy for our commercial lightingproducts. Specifically, although the end-user for our pool and spa products isprimarily the residential market, we primarily focus on sales to pool buildersand pool product distributors by utilizing regional sales representativeorganizations that specialize in such sales. Accordingly, our marketing effortsfor swimming pool products depend in large part upon swimming pool buildersrecommending our products to their customers and adapting their swimming pooldesigns to include our lighting systems. Each representative organizationtypically has the exclusive right to sell our products within its territory, receivingcommissions on territory sales. In addition to using regional salesrepresentatives, we also market our products to regional and nationaldistributors in the swimming pool market. These distributors stock our productsto fill orders received from swimming pool builders. Some of these distributorsalso engage in limited marketing activities in support of our products. We alsomarket to certain large national pool builders under which they may purchasesystems directly from us and offer our products with their swimming pools. To alesser extent, we enter into incentive arrangements to encourage pool buildersto purchase our products. We provide pool builders and independent salesrepresentatives with marketing tools, including promotional videos, showroomdisplays and demonstration systems. We also use trade advertising and directmail in addition to an ongoing program of sales presentations to pool buildersand distributors.

SCP Pool Corporation, or SCP, the largest pooldistributor in the United States and our largest pool customer, accounted forapproximately 11%, 10% and 11% of our net sales in 2003, 2004 and 2005,respectively. We expect to maintain our business relationship with SCP;however, a cessation or substantial decrease in the volume of purchases by thiscustomer could reduce availability of our products to end users and have amaterial adverse effect on our net sales and results of operations. At December 31,2005, SCP accounted for 8% of accounts receivable and at December 31,2004, they accounted for 10% of accounts receivable.

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Sales of our swimming poolproducts follow a seasonal pattern. This typically results in higher sales inthe second and fourth quarters as pool distributors stock shelves for thespring and summer seasons. First quarter pool sales tend to be the lowest for agiven year. Consistent with industry practice, we provide extended terms todistributors for shipments in the fourth quarter of a given year whereby theyreceive products in November and December for which they pay in equalinstallments from March through June of the following year. We sellthe majority of our swimming pool lighting systems within the United States,Canada and Australia. Our pool lighting sales in Europe were not material in2003, 2004 or 2005.

**Backlog**

We typically ship standardproducts within a few days after receipt of an order and custom products within30 to 60 days of order receipt. Generally, there is not a significantbacklog of orders, except at year-end. Our backlog at the end of 2005 was $1,144,000compared to $1,454,000 at the end of 2004. We anticipate that all of ourbacklog as of December 31, 2005 will be filled in 2006.

**Competition**

Our products compete with conventional electriclighting systems and with a variety of lighting products, includingconventional light sources such as incandescent light bulbs as well as metalhalide lamps, LEDs, compact fluorescent lamps and decorative neon lighting. OurEFO systems compete with conventional electrical lighting systems, other fiberoptic lighting systems, and alternative energy efficient lighting products suchas compact fluorescent lighting. Our traditional commercial lighting productscompete with other lighting products primarily in the areas of down lighting,accent lighting and signage lighting. Our pool and spa lighting productscompete with other sources of pool and spa lighting in the areas of in-poollighting, including colored and color changing underwater lighting, and pooland spa accent lighting. Principal competitive factors include price,performance, ease of installation and maintenance requirements.

Our EFO systems compete with conventional electricallighting technologies and with other sources of accent and down lighting suchas ceramic metal halide, halogen and incandescent bulbs. Our EFO systemscompete with traditional electrical lighting systems and other fiber opticssystems in markets where energy efficiency, ease of installation and lowermaintenance costs are principal competitive factors. Our EFO systems also competewith manufacturers of lamps and fixtures who may sell their products toend-users as a system or as individual components.

We expect that our ability to compete effectively withconventional lighting technologies, other fiber optic lighting products and newlighting technologies that may emerge will depend substantially upon achievinggreater performance and reducing the cost of our EFO systems. Principalcompetitors in the EFO market include large lamp manufacturers and lightingfixture companies whose financial resources substantially exceed ours. Theseconventional lighting companies may introduce new or improved products that mayreduce or eliminate some of the competitive advantages of our products. Weanticipate the primary competition to our EFO systems will come from newtechnologies which offer increased energy efficiency, lower maintenance costsand/or lower heat radiation.

In traditional commercial lighting, we competeprimarily with local and regional neon lighting manufacturers that, in many cases,are more established in their local markets than we are. In traditionalcommercial lighting, fiber optic lighting products are offered by a number ofsmaller companies, some of which compete aggressively on price. Some of thesecompetitors offer products with performance characteristics similar to ourproducts. Additionally, some conventional lighting companies now manufacture orlicense fiber optic lighting systems that compete with our products. Schott, aGerman glass fiber company, markets fiber optic systems in the United States.Many companies compete with us in Asia, including Philips, Mitsubishi,Bridgestone and Toray. Mitsubishi also sells our BritePak fiber cables in 

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Japan. In addition, wecompete with Toray in the stranded small diameter optical fiber in the specialeffects lighting market.

In the pool and spa market, we face competition fromsuppliers and distributors who bundle lighting and non-lighting products andsell these packages to pool builders and installers. In addition, we face competitiondirectly from manufacturers who produce their own lighting systems andcomponents. For example, in the pool market, competitive products are offeredby Pentair’s American Products Division, a major manufacturer of pool equipmentand supplies, as well as Super Vision International. In the spa business, spamanufacturers install LED lighting systems during the manufacturing process. Weintend to develop new fiber optic lighting products that are complementary totraditional pool lights currently sold by pool equipment suppliers. To maximizethe sales of these new products, we plan to leverage our well-establishedpresence in the pool and spa lighting market.

While we cannot predictthe impact of competition on our business, we believe that an increase in therate of our market expansion may be accompanied by increased competition.Increased competition could result in price reductions, reduced profit marginsand loss of market share, developments which could adversely affect ouroperating results. There can be no assurance that we will be able to continueto compete successfully against current and future competitors.

**Manufacturing and Suppliers**

We produce our lighting systems through a combinationof internal and outsourced manufacturing and assembly. Our internal lightingsystem manufacturing consists primarily of fiber processing, final assembly,testing and quality control. We use independent contractors to manufacture somecomponents and sub-assemblies and have worked with a number of our vendors to designcustom components to meet our specific needs. We manage inventories ofdomestically produced component parts on a just-in-time basis when practicable.Our quality assurance program provides for testing of all sub-assemblies at keystages in the assembly process as well as testing of finished products.

In 2004, we initiated a program to manufacture more ofour products offshore, primarily in India and Mexico. As this processcontinues, we expect that more high volume products will be sourced offshore wherelabor and component cost savings may be achieved. Under a Production ShareAgreement initiated in 2003 and renewed in August 2005, we conductcontract assembly in Mexico through North American Production Sharing Inc. andIndustrias Unidas de BC, SA de CV, or North American. Under this agreementNorth American provides administrative and manufacturing services, includinglabor services and the use of manufacturing facilities in Mexico for themanufacture and assembly of certain of our fiber optic systems and relatedequipment and components. Also in 2004, we began obtaining assembled productsfrom ECDS, located in Cochain, India. These products are received on a purchaseorder basis, primarily by ocean shipment and in some cases by air freight.

We manufacture our large core fiber products in ourSolon, Ohio facility, using either anextrusion process or a cast process.

Under a supply agreement, which was last renewed in January 2000,Mitsubishi is the sole supplier of our small diameter stranded fiber. In salesvolume, our products that incorporate small diameter stranded fiber havehistorically been the single largest fiber product that we sell and representsignificant sales volume. We expect to maintain our relationship withMitsubishi for the supply of small diameter fiber.

ADLT and Fiberstars have had a strategic relationshipsince 1997 when ADLT acquired a substantial equity interest in Fiberstars,which was sold in 2004. Over the years ADLT and Fiberstars have maintained acollaborative relationship based on ADLT’s position as a leading supplier ofmetal halide light sources and Fiberstars need for “state of the art” lightsource technology. As a result, we rely on ADLT for our metal halide lamps,reflectors and power supplies. To further this relationship, in September, 2005we 

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entered into several newagreements with ADLT regarding mutual development collaboration for thecontinued improvement in our lamp technology. These agreements also provide forthe purchase of certain coating equipment, the provision to us of certain otherservices, the continued supply to us of products manufactured by ADLT, and across-license of certain intellectual property.

We also rely on other solesource suppliers for other lamps, reflectors, remote control devices and powersupplies. Although we cannot predict the effect that the loss of one or more ofsuch suppliers would have on our results of operations, such loss could resultin delays in the shipment of products and additional expenses associated withredesigning products and could have a material adverse effect on our operatingresults.

**Research and Development**

We believe that growth in fiber optic lighting will bedriven by improvements in technology to provide increased light output at lowercosts. Accordingly, we commit much of our research and development resources tothose challenges. We have a research and development team located in Ohioprimarily focused on developing new or improving our current EFO systems. Inaddition, we currently have engineers based in California and in India focusedon further developing our pool and spa products.

We purchased thebase technology underlying our EFO system in 2000 with the acquisition ofUnison Fiber Optic Lighting Systems LLC. Subsequent to this acquisition,we have been aided in our development of this technology, as well as thedevelopment of our traditional fiber optics products, by government awards andcontracts. We have commercial rights to all of the technology we develop aspart of these various government research and development contracts. A summaryof work under these contracts is as follows:

·       In2003, we successfully completed a three-year $2.0 million research anddevelopment project to develop a continuous extrusion process for large coreplastic optical fiber funded under a grant from the National Institute ofStandards and Technology, or NIST, of the United States Department of Commerce.

·       InFebruary 2003, the DARPA through the Army Aviation and Missile Command, orAMCOM, awarded to us and our partners a research and development contract forthe development of next-generation light sources, optics, luminaire andintegrated illuminated technologies for its high efficiency distributedlighting, or HEDLight, project. This contract provides for total payment of upto $7.8 million, including payments for subcontractors, over three years basedon the achievement of milestones in the development of fiber optic illuminatorsand fixtures for installation on ships and aircraft. We have received totalgross funding of $5.3 million under this contract through December 31,2004. For the year ending December 31, 2005, we qualified for receipt ofgross amounts, including amounts for subcontractors, of up to $2.5 million($2.0 million, net of subcontractor amounts), subject to attainment ofscheduled milestones. The contract term runs through February 2006.

·       InApril 2003, we announced, together with APL Engineered Materials, asubsidiary of ADLT, the award of a $2.7 million research and developmentcontract from DARPA for the development of a new arc discharge light source, aproject to be led by APL Engineered Materials. Of this amount, we expect toreceive $300,000, based on our achievement of certain milestones related to ourcontribution to this project. We anticipate that this new light source willexceed the performance of our existing EFO light source in efficiency,brightness and color rendering.

·       In June 2004, weannounced an additional $1.0 million in funding from DARPA, dependent on theachievement of certain milestones, to developan LED version of the HEDLight system. We achieved these milestones and earnedthe full $1.0 million by the end of 2005.

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·       Alsoin June 2004, we announced two Small Business Innovative Research, orSBIR, awards from the Department of Energy. One is to work on an instant-onversion of EFO, and the other is to develop a fast cure for the fiberproduction process, which would lower cost and improve throughput on the fiberproduction line. These awards were for an initial $100,000 for the firstfeasibility phase, and in September 2005 we received approval for anadditional funding of $750,000 for each project for the completion phase.

·       In addition, in October 2005,further SBIR awards from the Department of Defense under DARPA totaling$200,000 were obtained to further explore improvements to lamp coatings anddesign and to further research materials and processing techniques for theCompany’s Continuously Extruded Large Core Fiber processing method.

·       Netof payments to subcontractors, we received from DARPA aggregate payments of$2.0 million, in 2005, $2.5 million in 2004 and $1.5 million in 2003.

On September 19, 2005, we entered into agreementswith ADLT regarding development assistance to be provided to us by ADLT and byus to ADLT. Under these agreements, ADLT will provide us with consulting,research and development services, including the development of lamps to beused in our current and future EFO systems for projects.

In addition to our agreement with ADLT, we furtheraugmented our internal research and development efforts by collaborating withother component suppliers, independent consultants and third parties. We dependsubstantially on these parties to undertake research and development effortsnecessary to achieve improvements that would not otherwise be possible giventhe multiple and diverse technologies that must be integrated into our productsand our limited engineering, personnel and financial resources. These thirdparties have no material contractual commitments to participate in theseefforts, and there can be no assurance that they will continue to do so.

Research and developmentexpense for the years ended December 31, 2005, 2004 and 2003 were $2.2million, $1.2 million and $1.3 million, respectively, net of credits forresearch and development from the government.

**Intellectual Property**

We believe that the success of our business dependsprimarily on our technical innovations, marketing abilities and responsivenessto customer requirements, rather than on patents, trade secrets, trademarks,copyrights and other intellectual property rights. Nevertheless, we have apolicy of seeking to protect our intellectual property through patents, licenseagreements, trademark registrations, confidential disclosure agreements andtrade secrets. As of December 31, 2005, our intellectual propertyportfolio consisted of 41 issued United States and foreign patents, variouspending United States  patentapplications and various pending Patent Cooperation Treaty, or PCT, patentapplications filed with the World Intellectual Property Organization that serveas the basis of national patent filings in countries of interest. Our issuedpatents expire at various times between August 2008 and April 2023.Generally, the term of patent protection is 20 years from the earliesteffective filing date of the patent application. There can be no assurance,however, that our issued patents are valid or that any patents applied for willbe issued. There can be no assurance that our competitors or customers will notcopy aspects of our fiber optic lighting systems or obtain information that weregard as proprietary. There also can be no assurance that others will notindependently develop products similar to ours. The laws of some foreigncountries in which we sell or may sell our products do not protect proprietaryrights to products to the same extent as do the laws of the United States.

We are aware that a largenumber of patents and pending patent applications exist in the field of fiberoptic technology. We are also aware that certain of our competitors hold andhave applied for patents 

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relatedto fiber optic lighting. Although, to date, we have not been involved inlitigation challenging our intellectual property rights, we have in the pastreceived communications from third parties asserting rights in our patents orthat our technology infringes intellectual property held by such third parties.Based on information currently available to us, we do not believe that any suchclaims involving our technology or patents are meritorious. However, we may berequired to engage in litigation to protect our patent rights or to defendagainst the claims of others. There can be no assurance that third parties willnot assert claims that our products infringe third party patents or otherintellectual property rights or that, in case of a dispute, licenses to suchtechnology will be available, if at all, on reasonable terms. In addition, wemay need to take legal action to enforce our intellectual property rights in thefuture. In the event of litigation to determine the validity of any third-partyclaims or claims by us against third-parties, such litigation, whether ornot determined in our favor, could result in significant expense to us anddivert the efforts of our technical and management personnel from productivetasks. Also, in the event of an adverse ruling in such litigation, we might berequired to expend significant resources to develop non-infringing technologyor to obtain licenses to the infringing technology, which licenses may not beavailable on acceptable terms. In the event of a successful claim against usand our failure to develop or license a substitute technology, our operatingresults could be adversely affected.

**Employees**

As of December 31, 2005, we had 92 full timeemployees, of whom 32 were involved in sales, marketing and customer service,24 in research and product development, 17 in assembly and quality assurance,and 19 in finance and administration. From time to time, we employ part-time personnelin various capacities, primarily assembly and clerical support. In addition, wehave 35 contract employees in Mexico. We have never experienced a workstoppage. No employees are subject to any collective bargaining agreement, andwe believe our employee relations to be good.

We believe that our futuresuccess will depend to a large extent on the continued contributions of certainemployees, many of whom would be difficult to replace, and on our ability toattract and retain qualified technical, sales, marketing and managementpersonnel, for whom competition is intense. The loss of or failure to attractand retain any such persons could delay product development cycles, disrupt ouroperations or otherwise harm our business or results of operations.

**Available Information**

Our Web site is *http://www.fiberstars.com*. We make available free of charge,on or through our Web site, our annual, quarterly and current reports, and anyamendments to those reports, as soon as reasonably practicable after electronicallyfiling such reports with the SEC. Information contained on our Web site is notpart of this Report.

**Item 1A. Risk Factors**

**Wehave recently changed the focus of our business and may be unsuccessful orexperience difficulties in implementing this change. If this occurs, we may notbe able to achieve operating profitability.**

In connection with the reorganization andrestructuring of Fiberstars, we intend to shift the primary focus of ourbusiness from our pool and spa products to products using our EFO technology.While we intend to continue designing and manufacturing pool and spa products,we plan to allocate significant resources to the development, marketing anddistribution of our EFO system in the accent lighting market. We have a limitedoperating history in this market, and our shift in focus may affect our abilityto accurately forecast sales, establish adequate reserves, estimate amounts ofwarranty and returns and other similar expenses. Our ability to achieve andmaintain profitability depends on our ability to successfully implement our newbusiness strategy.

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**Ouroperating results are subject to fluctuations caused by many factors that couldresult in decreased revenue and a decline in the price of our common stock.**

Our quarterlyoperating results can vary significantly depending upon a number of factorsincluding:

·       thelighting market’s acceptance of, and demand for, our products;

·       thelevel and seasonality of orders and the delivery of new products;

·       thecontinued availability of our current manufacturing channels and raw materialsuppliers;

·       thecontinued availability of our distributors or the availability of replacementdistribution channels;

·       fluctuationsin our sales volumes and mix of low and high margin products;

·       productdevelopment and marketing expenditures, which are made well in advance of potentialresulting revenue;

·       increasedexpenses in research and development if we are not able to meet certainmilestones in our Defense Advanced Research Project Agency, or DARPA,contracts;

·       theseasonality of the construction industry, which results in a substantialportion of our historical quarterly sales in the last month of each of thesecond and fourth quarters of the year;

·       asignificant portion of our expenses are relatively fixed, and if sales fallbelow our expectations, we will not be able to make any significant adjustmentin our operating expenses; and

·       theimpact of natural disasters, terrorist acts and other unforeseeablecatastrophic events.

Although we attempt to control our expense levels,these levels are based, in part, on anticipated revenue. Therefore, we may notbe able to control spending in a timely manner to compensate for any unexpectedrevenue shortfall.

Youshould not rely on period-to-period comparisons of our operating results as anindication of future performance. The results may be below theexpectations of market analysts or investors, which would likely cause ourshare price to decline.

**Ourfuture success is highly dependent on the successful adoption of EFO systems bythe lighting market, which is traditionally slow in adopting new technologies.**

EFO is a relatively new and unproven type of lightingthat may not achieve acceptance by lighting designers or other consumers oflighting products. Our potential retail customers are widespread andindependent, and their decisions are influenced by a variety of factors whichare often unique to each customer. These customers have multiple choices inlighting designs and products, including incandescent and fluorescenttechnologies, and may be averse to adopting new technology or incurring thecosts of utilizing new technologies. In addition, these alternative lightingproducts are manufactured by large, established companies with significantlygreater resources than us for developing energy efficient lighting. As aresult, even if potential customers choose to adopt new lighting technologies,our products still may not be utilized. Even if some customers utilize ourproducts on a limited basis, there is no guarantee that they will expand theiruse of or continue to utilize our products.

One of our significant markets is large-scale newconstruction, including retail and grocery stores. Effective lighting by thesecustomers is a critical element in showcasing merchandise and promoting sales.As a result, these customers are reluctant to change current lighting productsfor fear of losing sales. In order to penetrate these markets, we must persuadethis customer base that the adoption of our EFO systems will not negativelyimpact their business. This process is slow, time-consuming and expensive. If 

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our EFO system is notadopted by this customer base, we may not generate sufficient revenue to offsetthe cost of bringing our EFO technology into these target markets.

Finally, successfulpenetration in certain markets or geographic regions does not guarantee that wewill be able to achieve successful penetration into the accent lighting marketor that our acceptance will be geographically widespread.

**Ourdaylight color spectrum lamp is untested by the retail market and may not beaccepted without technological changes, if at all.**

Our EFO system offers anew full spectrum lamp that closely simulates daylight for use in retail stores.If our new daylight color spectrum lamp isnot as effective as we anticipate or does not meet the specific needs ofthis target customer base, we may need to expend additional resources to maketechnological changes to the spectrum. If our new daylight color spectrum isnot accepted or if we are unable to make the changes necessary for customeracceptance, this could negatively impact sales of our EFO system.

**We plan on allocating a significant amount ofresources to the research and development of our EFO lighting technology. Ifour EFO lighting system is not accepted in our target market, we may not recoupthese expenses.**

We plan on devoting asubstantial portion of our research and development resources to developing newproducts using our EFO lighting technology and marketing it in our targetmarkets. Because our EFO lighting system is a relatively new product, we do notknow if we will be successful in penetrating our target markets. As a result,we may not generate a sufficient amount of revenue from the sales of our EFOlighting systems to offset the costs necessary to bring our EFO lightingsystems to market. Our gross margins and operating results will suffer if ourEFO lighting systems are not accepted in our target markets.

**Ourfiber manufacturing is centralized in a single facility, which may affect ourability to sufficiently meet product demand in a cost effective or timelymanner.**

We manufacture our largecore fiber through a unique proprietary process and currently have one machinethat manufactures this fiber, located at the facility we lease in Solon, Ohio.This large core fiber is used in a majority of our EFO systems. As a result, weare subject to manufacturing delays due to facility shutdown, power loss orlabor difficulties. If our facility were to experience temporary shutdown, orbe unable to function at predicted capacity, we may be unable to meet ourdemand in a cost efficient manner, if at all. Furthermore, our ability tomodify our production output for custom orders is limited by our having onemachine at a single facility. In addition, our alternative method is not costeffective. We recently entered into an agreement, with ADLT to purchase acoating machine and the supply of certain coatings which will be operated andmaintained by a third party. If this machine is not operated or maintainedproperly we may experience delays in our manufacturing process.

**Ifelectricity costs decline or regulatory requirements for energy efficientlighting are repealed, demand for our products may decline.**

The principal advantage ofour EFO technology over competing lighting technologies is energy efficiency.Factors compelling our target customers to utilize more energy efficientlighting technologies include increasing energy costs and federal and state government regulations requiring lowerwattage per square foot such as ASHRAE-IESNA Standard 90.1, which limitselectricity consumption for lighting per square foot to 1.9 watts forboth new construction and renovations requiring building permits for retailbuildings in the United States. If the need for increasingly energy efficientlighting technologies by our target customer base declines, the attractivenessof our technology would also decline.

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**We depend on a limited number of suppliers from whom wedo not have guarantees of adequate supplies, thus increasing the riskthat loss of or problems with a single supplier could result in impairedmargins, reduced production volumes, strained customer relations and loss ofbusiness.**

Mitsubishi is the solesupplier of our small diameter stranded fiber, which is used extensively in ourfiber pool and spa lighting products, and to a lesser extent, in our EFOsystems. We also rely on a sole source for some of our EFO lamps. The loss ofone or both of these suppliers could result in delays in the shipment ofproducts, additional expense associated with redesigning products, impaired margins, reduced productionvolumes, strained customer relations and loss of business or could otherwiseharm our results of operations.

**Wedepend on ADLT for a number of components used in our products as well asfuture development of new components and also rely on ADLT to operate andmaintain our coating machine and provide certain related services.**

ADLT supplies us with certain lamps, including our EFOlamps, reflectors and coatings used in our products, including our EFO systems.ADLT came out of bankruptcy proceedings in December 2003, and while it hasbeen financially viable since then, there can be no assurances that this willcontinue. In addition, ADLT can terminate for convenience its obligations tosupply us with components and related services for the coating machinepurchased from them upon nine months notice to us. As a result, we haveidentified alternative suppliers for these components, but there could be aninterruption of supply and increased costs if a transition to a new supplierwere required. We could lose current or prospective customers as a result ofsupply interruptions. Increased costs and delays would negatively impact ourgross margins and results of operations.

We recently signed adevelopment agreement with ADLT pursuant to which it agreed to provide us withcertain consulting, research and development services, including thedevelopment of lamps to be used in our current and potential EFO systemprojects. Our ability to make timely research improvements or develop newproducts may be negatively effected if ADLT fails to meet specified milestones under our agreement. Inaddition, ADLT’s obligations are subject to mutually agreed upon costlimitations, whichmay impair thelevel of service we receive. ADLT may also terminate these obligations forconvenience upon ninety days notice to us.

**Wehave experienced negative cash flow from operations and may continue to do soin the future. We may need to raise additional capital in the future, but ourability to do so may be limited.**

While we have historicallybeen able to fund cash needs from operations, bank lines of credit or fromcapital markets transactions, due to competitive, economic or other factorsthere can be no assurance that we will continue to be able to do so. If ourcapital resources are insufficient to satisfy our liquidity requirements andoverall business objectives we may seek to sell additional equity securities or obtain debt financing.Adverse business conditions due to a weak economic environment or a weak marketfor our products have led to and may lead to continued negative cashflow from operations, which may require us to raise additional financing,including equity financing. Any equity financing may be dilutive toshareholders, and debt financing, if available, will increase expenses and mayinvolve restrictive covenants. We may be required to raise additional capitalat times and in amount which are uncertain,especially under the current capital market conditions. Under thesecircumstances, if we are unable to acquire additional capital or arerequired to raise it on terms that are less satisfactory than desired, it mayharm our financial condition, which could require us to curtail our operationssignificantly, sell significant assets, seek arrangements with strategicpartners or other parties that may require us to relinquish significant rightsto products, technologies or markets, or explore other strategic alternativesincluding a merger or sale of our company.

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**Wemay be unable to attract and retain qualified accounting personnel and we maybe unable to maintain adequate disclosure controls and procedures in thefuture.**

In connection with ourrelocation, we need to hire additional accounting personnel that can provide uswith the depth of accounting experience necessary to maintain adequatedisclosure controls and procedures. We may not be able to attract the necessarypersonnel in a timely fashion or with the requisite experience. As a result, wemay not have the review and oversight capabilities necessary to maintainlegally required disclosure controls and procedures.

**We sell products into a marketplace where ourcompetitors often have lower initial product pricing. If we are unable to provide customers with long term cost savings, wemay not be able to successfully penetrate our target markets, which could harmour revenue and gross profits.**

Customers in our targetmarkets currently use conventional lighting technologies, includingincandescent, halogen and fluorescent lighting. The initial cost of using thesetraditional lighting technologies is relatively low. Historically, we have notbeen able to price our EFO lighting system to compete with these traditionallighting products. As a result, in order to gain market share, our EFO lightingsystem must provide our target customers with longer life cycles. This isachieved through reduced maintenance costs,reduced energy costs and providing customers with the desired lighting effectwithout resulting in damage to or loss of goods. Ifwe are not able to persuade potential customers ofthe long-term cost savings in using our EFO lighting system, we may not be ableto successfully compete in our target markets. Our financial resultswill suffer if we are not able to penetrate these target markets and gain market share. Additionally, MR-16halogen lamp pricing is declining, and in order to remain competitive andbroaden our market targets to include compact fluorescent lamps andother lamp types, we believe we must continue to reduce EFO costs and pricing.

**Weoperate in markets that are intensely and increasingly competitive. To besuccessful, we must provide energy saving solutions that offer compellingcompetitive advantages over conventional lighting technologies.**

Competition is increasing in the commercial decorativeand accent lighting and pool lighting markets, as well as in the energyefficient lighting markets. A number of companiesoffer directly competitive products, including color halogen lighting forswimming pools and incandescent and fluorescent lighting for commercialdecorative and accent lighting. We also compete with LED products in waterlighting and in neon and other lighted signs. In addition, many of ourcompetitors in the pool and spa market bundle their lighting products withother pool and spa related products, which many customers find to be anattractive alternative. Our competitors include large and well-establishedcompanies such as General Electric, Sylvania, Philips, Schott, 3M, Bridgestone,Pentair, Mitsubishi and OSRAM/Siemens.

Many of our competitorshave substantially greater financial, technical and marketing resources than wedo. We may not be able to adequately respond to technological developments orfluctuations in competitive pricing. We anticipate that any future growth infiber optic lighting will be accompanied by continuing increases incompetition, which could adversely affect our operating results if we cannotcompete effectively. To stay competitive we must continue to allocate ourresources to research and development, which could negatively impact our grossmargins. If we are unable to provide more efficient lighting technology thanour competitors, our operating results will be adversely affected.

**Werely on intellectual property and other proprietary information that may not beprotected and that may be expensive to protect.**

We currently hold 39patents in the United States, and three corresponding patents in Japan and onecorresponding patent in Australia. We also have 14 patents pending in theUnited States. There can be no assurance, however, that our issued patents arevalid or that any patents applied for will be issued. We have 

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a policyof seeking to protect our key intellectual property through, among otherthings, the prosecution of patents with respect to certain of our technologies.There are many issued patents and pending patent applications in the field offiber optic technology, and some of our competitors hold and have applied forpatents related to fiber optic and non-fiber optic lighting. We have in thepast received communications from third parties asserting rights in our patentsor that our technology infringes intellectual property rights held by suchthird parties. For example, we were recently involved in patent litigation withPentair with respect to our FX Pool Light product, which was subsequentlysettled. Litigation to determine the validity of any third-party claims orclaims by us against such third party, whether or not determined in our favor,could result in significant expense and divert the efforts of our technical andmanagement personnel, regardless of the outcome of such litigation. Inaddition, we do not know whether our competitors will in the future apply forand obtain patents that will prevent, limit or interfere with our ability tomake, use, sell or import our products. Although we may seek to resolve anypotential future claims or actions, we may not be able to do so on reasonableterms, or at all. If, following a successful third-party action forinfringement, we cannot obtain a license or redesign our products, we may haveto stop manufacturing and marketing our products and our business would sufferas a result.

**Salesof our EFO systems depend on acceptance by multiple decision makers, resultingin lengthy sales cycles. As a result, the flow of EFO revenue is notpredictable.**

One of our significantmarkets is large-scale new construction and the length of our sales cycle inthis market can be anywhere from nine months to as long as three years.Decisions about lighting products utilized in large-scale new construction are made at multiple levels by our current andpotential customers, including merchandising and purchasing personnel, thechief financialofficer and the chiefexecutive officer. These decisions are influenced by a number of factorsincluding cost, reliability of the product and reliability of itssource. In addition, some of these customers function autonomously anddecisions with respect to construction, including lighting, are made by eachstore, even if part of a large chain. As a result, with respect to suchcustomers, we often must meet with all the decision makers at each store wherewe want to install our EFO systems. Furthermore, such decisions are made significantly in advance of the utilization of theactual product. As a result, if we are unable to access the multiple decisionmakers or convince them to adopt our products and utilize them on awidespread basis, we may be unable to successfully penetrate these markets. Wemay also be required to invest significant time and resources into marketing tothese customers before we are able to determine if we will be able to sell suchcustomers our products.

**Wedepend on key employees in a competitive market for skilled personnel, and theloss of the services of any of our key employees could materially affect ourbusiness.**

Our future success willdepend to a large extent on the continued contributions of certain employees,such as our current chief executive officer, chief financial officer and chieftechnical officer. These and other key employees would be difficult to replace.Our future success will also depend on our ability to attract and retainqualified technical, sales, marketing and management personnel, for whomcompetition is intense. The loss of or failure to attract, hire and retain anysuch persons could delay product development cycles, disrupt our operations orotherwise harm our business or results of operations. In addition, we plan tobuild a new internal sales force, which may not generate the anticipated netsales and may incur unanticipated expenses.

**Weare becoming increasingly dependent on foreign sources of supply for many ofour components and in some cases complete assemblies, which due to distance orpolitical events, may result in untimely deliveries.**

In order to control costs,we are continually seeking offshore supply of components and assemblies. Wecurrently import supplies from, or have products assembled in, Mexico, India,China, Taiwan, Japan 

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and someEuropean countries. This results in longer lead times for deliveries, which canmean less responsiveness to sudden changes in market demand for the productsinvolved. Some of the countries where components are sourced may be less stablepolitically than the United States or may be subject to natural disasters ordiseases, and this could lead to an interruption in the delivery of keycomponents. Delays in the delivery of key componentscould result in delays in product shipments, additional expenses associatedwith locating alternative component sources orredesigning products, impaired margins, reduced production volumes,strained customer relations and loss of customers, any of which couldharm our results of operations. Furthermore, we bear the risk of theft ordamage to our products with certain of our offshore partners, particularly withregard to our assembly facilities in Mexico.

**If wefail to maintain an effective system of internal controls, we may not be ableto accurately report our financial results or prevent fraud. As a result,current and potential shareholders could lose confidence in our financialreporting, which could harm our business and the trading price of our commonstock.**

Effective internalcontrols are necessary for us to provide reliable financial reports andeffectively prevent fraud. We have in the past discovered, and may in thefuture discover, areas of our internal controls that need improvement. Forexample, in connection with the audit of our consolidated financial statementsfor 2004, our independent registered public accounting firm informed us that itbelieved that inadequate segregation of duties in our financial reportingprocess and our information technology governance controls, and a number ofadjustments to financial statements during the course of the audit process,constituted significant deficiencies that aggregated to form a materialweakness in our internal controls. In addition, Section 404 of theSarbanes-Oxley Act of 2002 requires us to evaluate and report on our internalcontrols over financial reporting and have our independent registered publicaccounting firm annually attest to our evaluation, as well as issue their ownopinion on our internal control over financial reporting, which we expect willbe required for the first time in connection with our Annual Report onForm 10-K for the fiscal year ending December 31, 2006. We arepreparing for compliance with Section 404 by strengthening, assessing andtesting our system of internal controls to provide the basis for our report.However, the continuous process of strengthening our internal controls andcomplying with Section 404 is expensive and time consuming, and requiressignificant management attention. We cannot be certain that these measures willensure that we will maintain adequate control over our financial processes andreporting. If we or our independent registered public accounting firm discovera material weakness, the disclosure of that fact, even if quickly remedied,could reduce the market’s confidence in our financial statements and harm ourstock price. In addition, future non-compliance with Section 404 couldsubject us to a variety of administrative sanctions, including the suspensionor delisting of our common stock from The NASDAQ National Market and the inabilityof registered broker-dealers to make a market in our common stock, which wouldfurther reduce our stock price. Estimates of our costs, independent ofadditional audit fees, required to comply with Section 404 are $600,000 orhigher. While we expect these costs to increase our operating expensessignificantly, we cannot predict or estimate the amount of future additionalcosts we may incur or the timing of such costs.

**Ourcomponents are difficult to manufacture and procure in large quantities andsupply may be limited in the short term.**

EFO system includes componentsthat are difficult to manufacture and procure in large quantities in the shortterm. These components include lamps and optical and electroniccomponents. Furthermore, if these components are in limited supply, oursuppliers may allocate their supply to larger customers. If an increase indemand outpaces the projected expansion of our manufacturing capabilities, orif larger quantities are needed in a shorter time frame than anticipated, wemay not be able to meet customers’ requirements and our ability to market ourEFO system may be adversely affected. Our inability to meet customers’requirements may also negatively affect our ability to gain market share andacceptance among lighting designers and other repeat customers of lightingproducts.

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**Wehave historically relied on government funding for our research anddevelopment.**

Historically,approximately 60% of our EFO research and development efforts have beensupported directly by government funding. In 2005, for example, approximately59% of our EFO research and development funding came from DARPA and all ourcurrent funding from DARPA is set to expire in February 2006 without anyguarantee of renewal or replenishment. If government funding were to be reducedor eliminated, there is no guarantee we would be able to continue to fund ourresearch and development efforts in EFO technology and products at theircurrent levels, if at all. If we are unable to support our EFO research anddevelopment efforts, there is no guarantee we would be able to developenhancements to our current products or develop new products.

**Changesto financial accounting standards may affect our results of operations andcause us to change our business practices.**

We prepare our financialstatements to conform with generally accepted accounting principles, or GAAP,in the United States. These accounting principles are subject to interpretationby the American Institute of Certified Public Accountants, the Securities andExchange Commission and various bodies formed to interpret and createappropriate accounting policies. A change in those policies can have asignificant effect on our reported results and may affect our reporting oftransactions completed before a change isannounced. Changes to those rules or the questioning of current practicesmay adversely affect our reported financial results or the way weconduct our business. For example, accounting policies affecting many aspectsof our business, including rules relating to employee stock option grants, have recently been revised or are underreview. The Financial Accounting Standards Board and other agencies havefinalized changes to GAAP that will require us, starting in our first quarterof 2006, to record a charge to earnings for employee stock option grants andother equity incentives. We may have significant and ongoing accounting chargesresulting from option grant and other equity incentive expensing that couldreduce our overall net income. In addition, because we historically have used equity-related compensation as a component ofour total employee compensation program, the accounting change could make theuse of equity-related compensation less attractive to us and therefore make itmore difficult to attract and retain employees.

**Wecurrently rely on lighting representatives for a significant portion of ourdecorative and special effects lighting systems sales and terms and conditionsof sales are subject to change with very little notice.**

Most of our decorative andspecial effects lighting systems are sold through lighting representatives, andwe do not have long-term contracts with our distributors. If these distributorssignificantly change their terms with us or change their historical pattern ofordering products from us, there could be a significant adverse impact on ournet sales and operating results.

**Recentchanges to our senior management could negatively effect our operations andrelationships with customers, suppliers and employees.**

In connection with therestructuring and reorganization, we also made changes to our seniormanagement, including the appointment of a new chief executive officer andchief technology officer. These changes could negatively affect our operationsand our relationships with our suppliers, customers, employees, distributors andstrategic partners. In addition, our senior management has limited experienceas officers of a publicly traded company. If the integration of new members toour senior management team does not go as smoothly as anticipated, it couldnegatively affect our ability to execute our business plan.

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**Oursales are dependent upon new construction levels and are subject to seasonaland general economic trends.**

Constructionlevels are affected by general economic conditions, real estate market,interest rates and the weather. Sales of commercial lighting productsdepend significantly upon the level of new building construction andrenovation. Sales of our pool and spa lighting products, which currently areavailable only with newly constructed pools and spas, depend substantially uponthe level of new construction of pools. Because of the seasonality ofconstruction, our sales of swimming pool and commercial lighting products, and thus our overall revenues and income, have tendedto be significantly lower in the first and the third quarters of eachyear. Various economic and other trends may alter these seasonal trends fromyear to year, and we cannot predict the extent to which these seasonal trendswill continue.

**If weare not able to timely and successfully develop, manufacture, market and sellour new products, our operating results will decline.**

We expect to introduce newproducts each year in the pool and spa lighting market and the commerciallighting market. We depend on various components and raw materials for use inthe manufacturing of our products from sole and foreign suppliers. We may notbe able to successfully manage price fluctuations due to market demand orshortages. Significant increases in the costs, or sustained interruptions in our receipt of adequate amounts, of necessarycomponents and raw materials could harm our margins, result inmanufacturing halts, harm our reputation and relationship with our customersand negatively impact our results of operations. In addition, we could havedifficulties manufacturing these new products as a result of our inexperiencewith them or the costs could be higher thanexpected and delivery of these products may cause us to incur additionalunexpected research and development expenses. Furthermore, in order tocompetitively price our products and achieve broader market acceptance, we mayneed to redesign our manufacturing processto produce our products in higher volume and at a reduced cost. Furthermore,any delays in the introduction of these new products could result inlost sales, loss of customer confidence and loss of market share. Also, it isdifficult to predict whether the market will accept these new products. If anyof these new products fails to meet expectations, our operating results will beadversely affected.

**Werely on the largest pool distributor in the United States for a significantportion of our pool and spa lighting products sales.**

We sell a significantportion of our pool and spa lighting products through SCP. SCP accounted forapproximately 11%, 10% and 11% of our net sales in 2003, 2004 and 2005,respectively. If SCP ceases to purchase or substantially decreases its volumeof purchases, this could significantly reduce the availability of our productsto end users, which could negatively impact our net sales and operatingresults. Furthermore, because SCP is the largest distributor in the UnitedStates, we may not be able to increase sales to our other distributorssufficiently to offset the loss resulting from SCP’s reduction or cessation insales.

**Theloss of a key sales representative could have a negative impact on our netsales and operating results.**

We rely on key salesrepresentatives and outside sales agents for a significant portion of oursales. These sales representatives and outside sales agents have uniquerelationships with our customers and would be difficult to replace. The loss ofa key sales representative or outside sales agent could interfere with ourability to maintain customer relationships and result in declines in our net salesand operating results. In addition, these sales representatives and salesagents carry multiple products lines, including those of our competitors.Generally, a sales representative or sales agent will primarily sell productsfrom one well-established company and supplement these sales with products fromsmaller companies, such as 

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Fiberstars.As a result, if we lost a key sales representative or sales agent, we may havedifficulty replacing the sales representative or sales agent, if at all, whichcould negatively impact our net sales.

**Weuse plants in Mexico and India to manufacture and assemble many of our pool andspa products. The supply of these finishedgoods may be impacted by local political or social conditions as well as thefinancial strength of the companies with which we do business.**

As we attempt to reducemanufacturing expenses, we are becoming increasingly dependent upon offshorecompanies for the manufacturing and final assembly of many of our pool and spaproducts. To do so, we must advance certain raw materials, inventory andproduction costs to these off-shore manufacturers. The supply of finished goodsfrom these companies, and the raw materials, inventory and funds that weadvance to them may be at risk depending upon the varying degrees of stabilityof the local political, economic and social environments in which they operate,and the financial strength of the manufacturing companies themselves.

**Becausewe depend on a limited number of significant customers for our net sales, theloss of a significant customer, reduction in order size or the effects ofvolume discounts granted to significant customers from time to time could harmour operating results.**

Our business is currentlydependent on a limited number of significant customers, and we anticipate thatwe will continue to rely on a limited number of customers. For example, in2005, SCP, our largest pool and spa customer, accounted for approximately 11% of our net sales. We expect these customers tocontinue to represent a significant portion of our net sales in the future. Theloss ofany of these significantcustomers would harm our net sales and operating results. Customer purchasedeferrals, cancellations, reduced order volumes or non-renewals from anyparticular customer could cause our quarterly operating results to fluctuate ordecline and harm our business. In addition, volume discounts granted tosignificant customers from time to time could lead to reduced profit margins,and negatively impact our operating results.

**Our components and products could have defects or designor compatibility issues, any of which could be costly to correct and couldresult in the rejection of our products and damage to our reputation, as wellas lost sales, diverted development resources and increased warranty reservesand manufacturing costs.**

In the past, we haveexperienced design defects and product failure. For example, in our EFOsystems, we experienced defects related to the power supply and theilluminator. In our pool and spa products, we experienced defects with ourcircuit sequencing color wheel. We cannotguarantee that we will not experience defects or compatibility issues incomponents or products in the future. Errors or defects in our productsmay arise in the future, and, if significant or perceived to be significant,could result in rejection of our products, product returns or recalls, damageto our reputation, lost revenue, diverted development resources and increasedcustomer service and support costs and warranty claims. Errors or defects inour products could also result in product liability claims. We estimatewarranty and other returns and accrue reserves for such costs at the time ofsale. Any estimates, reserves or accruals may be insufficient to cover sharpincreases in product returns, and such returns may harm our operating results.In addition, customers may require designchanges in our products in order to suit their needs. Losses, delays or damageto our reputation due to design or defect issues would likely harm ourbusiness, financial condition and results of operations.

**If weare unable to predict market demand for our products and focus our inventoriesand development efforts to meet market demand, we could lose salesopportunities and experience a decline in sales.**

In order to arrange forthe manufacture of sufficient quantities of products and avoid excess inventorywe need to accurately predict market demand for each of our products.Significant unanticipated 

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fluctuationsin demand could cause problems in our operations. We may not be able toaccurately predict market demand in order to properly allocate ourmanufacturing and distribution resources among our products, especially withrespect to the manufacturing of our large core fiber, as we use one machine tomanufacture this fiber. As a result, we may experience declines in sales andlose, or fail to gain, market share. Conversely, if we overbuild inventories werun the risk of having inventory write-offs due to obsolescence.

**Wedepend on collaboration with third parties, who are not subject to materialcontractual commitments, to augment our research and development efforts.**

Ourresearch and development efforts include collaboration with third parties. Manyof these third parties are not bound by any material contractualcommitment leaving them free to end their collaborative efforts at will. Lossof these collaborative efforts could adversely affect our research anddevelopment efforts and could have a negative effect on our competitiveposition in the market. In addition, arrangements for joint development effortsmay require us to make royalty payments on sales of resultant products or enter into licensing agreements forthe technology developed, which could increase our costs and negatively impactour results of operations.

**Thedemand for new construction is affected by general economic conditions.**

The United States andinternational economies are cyclical and therefore difficult to predict. Asustained economic recovery is uncertain. In particular, recent increases inthe cost of oil, increases in energy costs, terrorist acts and similar events,continued turmoil in the Middle East or warin general could contribute to a slowdown of the market demand for productsthat require significant initial capital expenditures, including newresidential and commercial buildings. In addition, increases in interest ratesmay increase financing costs to customers, which in turn may decrease buildingrates and associated demand for our products. If the economic recovery slows downas a result of the recent economic, political and social turmoil, or if thereare further terrorist attacks in the United States or elsewhere, we mayexperience decreases in the demand for our products, which may harm ouroperating results.

**Theimpact of recent hurricanes may continue to have a significant negative effecton our business, financial condition and results of operations.**

In late August 2005,Hurricane Katrina struck the coast of a number of states on the Gulf of Mexico,including Louisiana, Mississippi and Alabama. It is not possible at this timeto determine either the effects Hurricane Katrina will have on the generaleconomy and our business. We have, however, experienced delays in orders forour EFO system in Houston and Florida. We are unable to predict whether thesedelays will continue or what additional effects the recent hurricanes will haveon our business. Damages and higher prices caused by hurricanes such asHurricane Katrina could have an adverse effect on the financial condition of our current and potential customers located in theGulf Coast region and elsewhere in the United States, which could result inlower or delayed sales. It is also possible that we could experiencegreater costs related to disruptions to the supply chain which would negativelyimpact our results of operations.

**Weare subject to global economic or political conditions, which may disrupt thegeneral economy, reducing demand for our products.**

We have significant international activities andcustomers, and plan to continue these efforts, which subject us to additionalbusiness risks, including logistical complexity, political instability and thegeneral economic conditions in those markets. Sales outside the United Statesaccounted for approximately 30% of our net sales in 2003, 33% of our net salesin 2004 and 33% of our net sales in 2005. Because the market 

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for our products tends tobe highly dependent upon general economic conditions, a decline in generaleconomic conditions would likely harm our operating results.

Risks we face inconducting business internationally include:

·       multiple,conflicting and changing laws and regulations, export and import restrictions,employment laws, regulatory requirements and other government approvals,permits and licenses;

·       difficultiesand costs in staffing and managing foreign operations such as our offices inGermany and the United Kingdom;

·       difficultiesand costs in recruiting and retaining individuals skilled in internationalbusiness operations;

·       increasedcosts associated with maintaining international marketing efforts;

·       potentiallyadverse tax consequences; • political and economic instability, including wars,acts of terrorism, political unrest, boycotts, curtailments of trade and otherbusiness restrictions; and

·       currencyfluctuations.

In addition, in theAsia/Pacific region generally, we face risks associated with a recurrence ofSARS, spreading of Asian bird flu, tensions between countries in that region, such as political tensions between China andTaiwan, the ongoing discussions with North Korea regarding its nuclearweapons program, potentially reduced protection for intellectual propertyrights, government-fixed foreign exchange rates, relatively uncertain legal products and developing telecommunications infrastructures.In addition, some countries in this region, such as China, have adoptedlaws, regulations and policies which impose additional restrictions on theability of foreign companies to conduct business in that country or otherwiseplace them at a competitive disadvantage in relation to domestic companies.

**Item 2. Property**

Our principal executiveoffices and commercial lighting manufacturing and assembly facilities arelocated in a 59,000 square foot facility in Solon, Ohio, under a lease agreementexpiring in 2008. We have other local sales offices in the United States inPleasanton, California and New York and in Europe sales and operations officesin the United Kingdom in Thatcham, under lease. We also own a local office inBerching, Germany. We also have a contract manufacturing facility near Tijuana,Mexico. We believe that our current facilities are adequate to support ourcurrent and anticipated near-term operations and that we can obtain additionalspace we may need in the future at commercially reasonable terms.

**Item 3. Legal Proceedings**

On December 20, 2005, we entered into asettlement agreement with Sherwin-Williams Company (or Sherwin-Williams) andThe Wagner Electric Sign Company (or Wagner). We were a third-party defendantin a lawsuit filed in the Court of Common Pleas, Cuyahoga County, Ohio filed onSeptember 21, 2004, for alleged breach of warranty and breach of contractin connection with an allegedly defective sign manufactured and sold by Wagner.The settlement agreement calls for certain payments to be made toSherwin-Williams by the defendant parties and for certain repairs to be made.

On September 8, 2005, we entered into asettlement agreement with Pentair Water Pool and Spa, Inc. In a lawsuitfiled against us on April 5, 2005 in the United States District Court,Northern District of California, Pentair alleged that the manufacture, use andsale of our FX Pool Light infringed three United States patents that Pentairclaims to own relevant to certain synchronized light technology. On September 12,2005, we filed a dismissal, with prejudice, of our counterclaims and, inaccordance with the terms of the settlement agreement, Pentair filed adismissal, with prejudice, of its complaint.

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We may also from time to time become involved in legalproceedings in the ordinary course of business.

There were no matterssubmitted to a vote of security holders during the quarter ended December 31,2005.

**ExecutiveOfficers of the Registrant**

Ourexecutive officers and their ages as of December 31, 2005, are as follows:
| Name               | ** ** | ** ** | ** ** | ** ** | **Age** | ** **                                                | ** ** | **Position** | ** ** | ** ** |
|--------------------|------------|------------|------------|------------|---------|-----------------------------------------------------------|------------|--------------|------------|------------|
| John Davenport     |       |       | 60         |       |    | Chief Executive Officer  and Director                     |
| Roger Buelow       |       |       | 33         |       |    | Vice President,  Engineering and Chief Technology Officer |
| Robert A. Connors  |       |       | 57         |       |    | Vice President, Finance  and Chief Financial Officer      |
| Ted des Enfants.   |       |       | 34         |       |    | Vice President and  General Manager, Fiberstars EFO       |
| Barry R. Greenwald |       |       | 59         |       |    | President and General Manager, Pool Division              |
|                    |            |            |            |            |         |                                                           |            |              |            |            |  |  |

 

*Mr. Davenport*was appointed ourChief Executive Officer and a director in July 2005. Mr. Davenportjoined us in November 1999 as Vice President, Chief Technology Officer andwas appointed Chief Operating Officer in July 2003. Prior to joiningFiberstars, Mr. Davenport served as President of Unison Fiber OpticLighting Systems, LLC, or Unison, from 1998 to 1999. Mr. Davenport beganhis career at GE Lighting in 1972 as a research physicist and thereafter served25 years in various capacities including GE Lighting’s research and developmentmanager and as development manager for high performance LED projects. He is arecognized expert in light sources, lighting systems and lighting applications,with special emphasis in low wattage discharge lamps, electronic ballasttechnology and distributed lighting systems using fiber optics.

*Mr. Buelow***was appointed our Chief Technology Officer in July 2005. Mr. Buelowhas also served as our Vice President, Engineering since February 2003.Prior to joining Fiberstars in 1999, he served as Director of Engineering forUnison from 1998 to 1999. Prior to that he served four years as an engineer atGE Lighting working on several fiber optic lighting projects. Mr. Buelowis a Certified Quality Engineer with ten patents.

*Mr. Connors*joined the Company in July 1998 as VicePresident, Finance, and Chief Financial Officer. From 1984 to 1998, Mr. Connorsheld a variety of positions for Micro Focus Group Plc, a software companywith 1997 revenues of $165 million, including Chief Financial Officer andChief Operating Officer. Prior to working for Micro Focus Group Plc, heheld senior finance positions with Eagle Computer and W. R. Grace.

*Mr. desEnfants*joined the Company in January 2005 asVice President and General Manager, Fiberstars EFO. From 1994 to 2003, Mr. desEnfants held a variety of positions with the GE Lighting, most recently asDistrict Sales Manager in the eastern region. From 1998 to 2001, he wasNational Account Manager with GE Lighting and from 1994 to 1998 held variousSales and Sales Manager positions at GE Lighting.

*Mr. Greenwald*joined the Company in October 1989 as General Manager, Pool Division. Hebecame Vice President in September 1993, Senior Vice President in February 1997and President of the Pool Division in July 2005.  Prior to joining the Company, Mr. Greenwaldserved as National Sales Manager at Aquamatic, a swimming pool accessorycompany, from August 1987 to October 1989. From May 1982 to August 1987,Mr. Greenwald served as National Sales Manager at Jandy Inc., aswimming pool equipment company.

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**PART II**

**Item5. Market for the Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities**

Ourcommon stock trades on the Nasdaq National Market under the symbol FBST. Thefollowing table sets forth the high and low sales prices for our common stock,from its consolidated transaction reporting system.

| ** **           | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------|------------|----------|------------|---------|------------|
| First quarter  2004  |       | 10.75    |       | 6.15    |       |
| Second quarter  2004 |       | 10.95    |       | 7.01    |       |
| Third quarter  2004  |       | 10.50    |       | 6.70    |       |
| Fourth quarter  2004 |       | 10.49    |       | 6.40    |       |
| First quarter 2005   |       | 10.12    |       | 7.28    |       |
| Second quarter  2005 |       | 12.50    |       | 8.28    |       |
| Third quarter  2005  |       | 15.50    |       | 9.75    |       |
| Fourth quarter 2005  |       | 10.80    |       | 8.00    |       |

 

There were approximately 300 holders of record of ourcommon stock as of March 22, 2006, and we estimate that at that date therewere approximately 800 additional beneficial owners.

We have not declared orpaid any cash dividends and does not anticipate paying cash dividends in theforeseeable future.

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

Information regarding theSecurities Authorized for Issuance Under our Equity Compensation Plans can befound under Item 12 of this Annual Report on Form 10-K.

**Item 6. Selected Financial Data**

The Selected Operationsand Balance Sheet Data set forth below have been derived from our ConsolidatedFinancial Statements. It should be read in conjunction with the informationappearing under the heading “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included in Item 7 of this Report andthe Consolidated Financial Statements and related notes found in Item 15of this Report.

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**SELECTEDCONSOLIDATED FINANCIAL DATA(IN THOUSANDS, EXCEPT PER SHARE DATA)**

| **YEARS ENDED DECEMBER 31,**        | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| OPERATING SUMMARY                                  |       |       |       |     |       |     |       |     |       |     |       |
| Net sales                                          |       | $          | 28,337     |     | $          | 29,731   |       | $        | 27,238     |     | $          | 30,960   |       | $ | 29,053 |   |
| Gross profit                                       |       | 10,626     |       | 11,511   |       | 10,341   |       | 11,474   |       | 11,447   |       |
| As a percent of net sales                          |       | 37.5       | %          | 38.7     | %          | 38.0     | %          | 37.1     | %          | 39.4     | %          |
| Research and development expenses                  |       | 2,190      |       | 1,188    |       | 1,279    |       | 2,290    |       | 2,764    |       |
| As a percent of net sales                          |       | 7.7        | %          | 4.0      | %          | 4.7      | %          | 7.4      | %          | 9.5      | %          |
| Sales and marketing expenses                       |       | 9,595      |       | 8,595    |       | 7,188    |       | 7,907    |       | 8,371    |       |
| As a percent of net sales                          |       | 33.9       | %          | 28.9     | %          | 26.4     | %          | 25.5     | %          | 28.8     | %          |
| General and administrative expenses                |       | 3,135      |       | 2,459    |       | 2,435    |       | 2,709    |       | 3,627    |       |
| As a percent of net sales                          |       | 11.1       | %          | 8.3      | %          | 8.9      | %          | 8.8      | %          | 12.5     | %          |
| Restructure expense                                |       | 3,120      |       | —   |       | —   |       | —   |       | —   |       |
| As a percent of net sales                          |       | 11.0       | %          | —   | %          | —   | %          | —   | %          | —   | %          |
| Loss before tax                                    |       | (7,314     | )          | (762     | )          | (594     | )          | (1,441   | )          | (3,381   | )          |
| As a percent of net sales                          |       | (25.8      | )%         | (2.6     | )%         | (2.2     | )%         | (4.7     | )%         | (11.6    | )%         |
| Net loss                                           |       | (7,423     | )          | (704     | )          | (608     | )          | (3,519   | )          | (2,128   | )          |
| As a percent of net sales                          |       | (26.2      | )%         | (2.4     | )%         | (2.2     | )%         | (11.4    | )%         | (7.3     | )%         |
| Net loss per  share                                |       |       |       |     |       |     |       |     |       |     |       |
| Basic                                              |       | $          | (0.90      | )        | $          | (0.10    | )          | $        | (0.10      | )        | $          | (0.70    | )          | $ | (0.45 | ) |
| Diluted                                            |       | $          | (0.90      | )        | $          | (0.10    | )          | $        | (0.10      | )        | $          | (0.70    | )          | $ | (0.45 | ) |
| Shares  used in per share calculation:             |       |       |       |     |       |     |       |     |       |     |       |
| Basic                                              |       | 8,223      |       | 7,269    |       | 5,993    |       | 5,028    |       | 4,756    |       |
| Diluted                                            |       | 8,223      |       | 7,269    |       | 5,993    |       | 5,028    |       | 4,756    |       |
| FINANCIAL  POSITION SUMMARY                        |       |       |       |     |       |     |       |     |       |     |       |
| Total assets                                       |       | $          | 46,209     |     | $          | 27,018   |       | $        | 24,119     |     | $          | 20,101   |       | $ | 21,434 |   |
| Cash, cash equivalents and short-term  investments |       | 23,578     |       | 3,609    |       | 4,254    |       | 231      |       | 584      |       |
| Working capital                                    |       | 31,660     |       | 14,541   |       | 12,449   |       | 7,417    |       | 8,498    |       |
| Short-term borrowings                              |       | 389        |       | 38       |       | 30       |       | 593      |       | 101      |       |
| Long-term borrowings                               |       | 1,089      |       | 484      |       | 521      |       | 449      |       | 419      |       |
| Shareholders’ equity                          |       | 38,184     |       | 21,202   |       | 18,950   |       | 14,240   |       | 16,431   |       |
| Common shares  outstanding                         |       | 11,270     |       | 7,351    |       | 6,317    |       | 4,667    |       | 4,329    |       |

 

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**Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

*The following discussion of our financial conditionand results of operations should be read together with the consolidatedfinancial statements and the related notes incorporated by reference in thisAnnual Report on Form 10-K or referred to herein. This discussioncontains, in addition to historical information, forward- looking statementsthat involve risks and uncertainties. Our actual results could differ materiallyfrom the results discussed in the forward-looking statements. Factors thatcould cause or contribute to these differences include, but are not limited to,those discussed below as well as those discussed under “Risk Factors,” “SpecialNote Regarding Forward-Looking Statements” and elsewhere in this Report. Wedisclaim any obligation to update information contained in any forward-lookingstatement.*

**Overview**

Fiberstars designs,develops, manufactures and markets fiber optic lighting systems forwide-ranging uses in both the general commercial and the pool and spa lightingmarkets. Our EFO system introduced in 2004, offers greater energy savings, heatdissipation and maintenance cost benefits over conventional lighting formultiple applications. Accordingly, we believe our EFO system will become aleading technology in accent lighting and numerous niche lighting markets.

*Net Sales*

In 2005, 2004 and 2003, products generated net salesof $28.3 million, $29.7 million, and $27.2 million. Of these net sales, in2005, 2004 and 2003, sales of our EFO systems generated net sales of$1,527,000, $582,000 and $172,000, respectively, and sales of our traditionalcommercial lighting systems generated net sales of $12.0 million, $12.2 millionand $12.1 million, respectively. In addition, in 2005, 2004 and 2003, wegenerated net sales of $14.8 million, $16.9 million and $14.9 million fromsales of our pool and spa lighting products.

We sell our general commercial lighting systemsthrough direct sales personnel and independent lighting representatives.Specifically, we target large accounts and regional lighting representativeswho in turn target specific lighting projects in local markets. We also intendto work with architects, lighting designers, contractors, utilities and otherentities that recommend or install lighting systems to build awareness for ourEFO systems. For example, we have an agreement with Gensler, an architecture,design and planning firm, under which Gensler assists us in designing our EFO systemsin the markets in which they do business. We sell our traditional commerciallighting products through our national account sales personnel as well asindependent lighting representatives. We also sell both our EFO and traditionalcommercial lighting products in Europe, Russia and the Middle East through ourtwo subsidiaries who manage our sales operations in those regions. For our pooland spa lighting products, we utilize regional sales representatives thatspecialize in selling swimming pool systems to pool builders and pool productdistributors.

Our target markets and end customers for ourcommercial lighting products include national supermarket chains, specialtyretail stores, restaurants and hotels and other commercial entities seekingdown lighting and accent lighting solutions. The target customers for our pooland spa lighting markets are pool builders and pool product distributors who inturn sell our products into the residential market.

We sell the majority ofour commercial lighting systems and pool lighting products in the UnitedStates, Canada and Australia. Sales in the United States accounted forapproximately 67% of our net sales in 2005, 67% in 2004 and 70% in 2003.

*Cost of Sales*

Cost of sales consistsprimarily of costs associated with the manufacture of our products, includingpersonnel and occupancy costs associated with manufacturing support and qualityassurance.

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*Research andDevelopment*

Research and developmentexpense consists primarily of salaries, bonuses and benefits for engineeringpersonnel, depreciation of equipment, costs of third party subcontractors andconsultants and costs associated with various projects, including testing,developing prototypes and URL related expenses. Funds received under governmentcontracts are recorded as a credit to research and development expense.

*Sales and Marketing*

Sales and marketingexpense consists primarily of salaries, bonuses, benefits and related costs forsales and marketing personnel, sales commissions, and costs associated with tradeshows, literature and participation at industry conferences.

*General andAdministrative*

General and administrativeexpense consists primarily of salaries, bonuses, insurance, bank charges,benefits and related costs for finance and administrative personnel and foroutside service expenses, including legal, accounting and investor relations.

*Restructuring*

In June 2005 weannounced a restructuring which called for moving our headquarters and base ofoperations from Fremont, California to Solon, Ohio. We indicated at that timethat the cost of the restructure would be approximately $3,500,000 and wouldresult in approximately $2 million in savings. In 2005 we spent $3,120,000 onrestructuring expenses.

*Seasonality*

Sales of our productsfollow a seasonal pattern which typically results in higher sales in the secondand fourth quarters as pool distributors stock shelves for the spring andsummer seasons. First quarter sales for our products tend be lower in any givenyear. Consistent with industry practice, we provide extended terms todistributors for shipments in the fourth quarter of a given year whereby theyreceive products in November and December for which they pay in equalinstallments from April through June of the following year.

**CriticalAccounting Policies and Estimates**

The preparation offinancial statements requires that we make estimates and assumptions thataffect the reported amounts of assets and liabilities, the disclosure ofcontingencies and the reported amounts of revenue and expenses in the financialstatements. Material differences may result in the amount and timing of revenueand expenses if different judgments or different estimates were utilized.Critical accounting policies, judgments and estimates which we believe have themost significant impact on our financial statements are set forth below:

·       Revenuerecognition;

·       Allowancesfor doubtful accounts, returns and discounts;

·       Valuationof inventories; and

·       Accounting for incometaxes.

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*Revenue Recognition*

We recognize revenue when: (1) we have received apurchase order from the customer or completed of a sales agreement with thecustomer; (2) shipment of the product has occurred or services have beenprovided; and (3) the sales price is fixed or determinable andcollectibility is reasonably assured. Revenue from product sales is generallyrecognized upon shipment, and allowances are provided for estimated returns,discounts and warranties. Such allowances are adjusted periodically to reflectactual and anticipated returns, discounts and warranty expenses. Revenue onsales that include services such as design, integration and installation isgenerally recognized using the percentage-of-completion method. Under thepercentage-of-completion method, revenue recognized reflects the portion of theanticipated contract revenue that has been earned, equal to the ratio of laborcosts expended to date to anticipated final labor costs, based on currentestimates of labor costs to complete the project. Our products are generallysubject to warranties, and we provide for the estimated future costs of repair,replacement or customer accommodation in costs of sales. Fees for research anddevelopment services are determined on a cost-plus basis and are recognized asrevenue when ownership of the completed work-product passes to the customer.

We recognize shipments to pool lighting distributorsas revenue upon shipment. Estimated sales returns are recorded upon recognitionof revenues from distributors having rights of return, including exchangerights for unsold products. Historically, returns have been minimal. Shipmentsmade to commercial lighting representatives and distributors are alsorecognized as revenue upon shipment because in these instances therepresentative or distributor is acting as a pass-through agent to a specificlighting project for which we have an existing contract or purchase order.

Revenue recognition ineach period is dependent on our application of these accounting policies. Ourapplication of percentage-of-completion accounting is subject to our estimatesof labor costs to complete each project. In the event that actual resultsdiffer from these estimates or we adjust these estimates in future periods, ouroperating results for a particular period could be materially affected.

*Allowances forDoubtful Accounts, Returns and Discounts*

We establish allowancesfor doubtful accounts, returns and discounts for specifically identifieddoubtful accounts, returns and discounts based on credit profiles of ourcustomers, current economic trends, contractual terms and conditions andhistorical payment, return and discount experience. For each year ended December 31,the allowance for doubtful accounts, returns and discounts was $1.4 million for2005, $1.2 million for 2004 and $1.1 million for 2003. The amount charged toallowances for doubtful accounts and discounts was $1,168,000 in 2005, $873,000in 2004 and $792,000 in 2003. The amount charged to expenses for doubtfulaccounts was $76,000 in 2005, $47,000 in 2004 and $2,000 in 2003. In the eventthat actual returns, discounts and bad debts differ from these estimates or weadjust these estimates in future periods, our operating results and financialposition could be materially affected.

*Valuation ofInventories*

We state inventories atthe lower of standard cost (which approximates actual cost determined using thefirst-in-first-out method) or market. We establish provisions for excess andobsolete inventories after evaluation of historical sales, current economictrends, forecasted sales, product lifecycles and current inventory levels.During 2005, 2004 and 2003 we charged $196,000, $116,000 and $128,000 to costof sales for excess and obsolete inventories. Adjustments to our estimates,such as forecasted sales and expected product lifecycles, could harm ouroperating results and financial position.

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*Accounting forIncome Taxes*

As part of the process of preparing our consolidatedfinancial statements, we are required to estimate our income tax liability ineach of the jurisdictions in which we do business. This process involvesestimating our actual current tax expense together with assessing temporarydifferences resulting from differing treatment of items, such as deferredrevenues, for tax and accounting purposes. These differences result in deferredtax assets and assets and liabilities, which are included in our consolidatedbalance sheet. We must then assess the likelihood that these deferred taxassets will be recovered from future taxable income and, to the extent webelieve that recovery is not more likely than not or is unknown, we mustestablish a valuation allowance.

Significant managementjudgment is required in determining our provision for income taxes, ourdeferred tax assets and liabilities and any valuation allowance recorded againstour deferred tax assets. At December 31, 2005, we have recorded a fullvaluation allowance against our deferred tax assets, due to uncertaintiesrelated to our ability to utilize our deferred tax assets, primarily consistingof certain net operating losses carried forward. The valuation allowance isbased on our estimates of taxable income by jurisdiction and the period overwhich our deferred tax assets will be recoverable.

**Results of Operations**

*Net Sales*

Our net sales decreased 5% to $28,337,000 in 2005compared to $29,731,000 in 2004 and $27,238,000 in 2003. The 2005 decrease wasa result of lower sales of pool products of 13% or $2,134,000 which waspartially offset by increased sales of commercial lighting products of 5% or$698,000. This decrease in pool lighting sales was primarily due to a$2,414,000 decrease in sales from our spa lighting products. The increase incommercial lighting sales was due to $945,000 in increased sales of EFOproducts partially offset by a decline in traditional fiber optic sales fromour core legacy commercial lighting products of $247,000. We expect net salesto increase in 2006 due to an anticipated increase in demand for EFOTM systems in commercial lighting markets andpartially offset by an expected continued decline in demand of our traditionalfiber optic products and pool products. The market for our products is highlydependent upon general economic conditions.

Net sales increased 9% to $29,731,000 in 2004 comparedto $27,238,000 in 2003. The 2004 increase largely reflects an increase in salesof pool products of 13% or $1,997,000 combined with a smaller increase in salesof commercial lighting products of 4% or $496,000. This increase in poollighting sales was primarily due to $1,574,000 in increased sales from ourin-ground fiber pool lighting products and $1,094,000 in increased sales fromour Jazz electric light products, and was partially off-set by a decline insales of $662,000 from our spa light products. The increase in commerciallighting sales was due to $410,000 in increased sales of EFO products combinedwith relatively flat sales from our core legacy commercial lighting products.

International salesaccounted for approximately 33% of net sales in 2005 as compared to 33% of netsales in 2004 and 30% in 2003. The relative increase in international salesfrom 2003 to 2004 was due to growth in European sales compared to a decline indomestic sales. The increase in 2004 international sales was a result of highersales from our German operation.

*Gross Profit*

We had gross profit of $10,626,000 in 2005, a decreaseof 8% compared to $11,511,000 in 2004. Gross profit as a percent of salesdecreased to 38% in 2005 compared to 39% in 2004. This decrease was primarilydue to lower gross profit margins from commercial lighting sales (5 percentagepoints) combined with a smaller decrease in pool lighting margins (2 percentagepoints). Commercial lighting gross profit 

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margins declined due toincreased sales from EFO products which are selling at a lower margin thantraditional fiber optic products. We expect gross profit margins to improve dueto the restructuring, however this may be offset by lower gross profit marginson EFO sales, which may cause overall gross profit margins to remain flat, ordecline slightly in 2006. Gross profit margins are also dependent upon generaleconomic conditions.

Gross profit of$11,511,000 in 2004 increased by 11% compared to $10,341,000 in 2003. Grossprofit as a percent of sales increased to 39% in 2004 compared to 38% in 2003. Thisincrease was primarily due to improved gross profit margins from pool and spalighting sales (3 percentage points) partially offset by lower gross profitmargins from commercial lighting sales. Pool and spa lighting gross profitmargins improved as a result of lower direct costs obtained by manufacturingsome products off-shore. Commercial lighting gross profit margins declined dueto increased competition for the core legacy products in Europe and in theUnited States.

*Operating Expenses*

Researchand development expenses were $2,190,000 in 2005, an 84% increase from researchand development expenses of $1,188,000 in 2004. Although we increased spendingin research and development expense on personnel and project costs related togovernment contract work and on improvements for existing products, thisspending was offset by the increase in expense credits for funds received in2005 under certain Department of Energy, or DOE, contracts and under DefenseAdvanced Research Projects Agency, or DARPA, research and development contractsawarded in February and April of 2004. The gross research anddevelopment spending along with credits from government contracts is shown inthe following table:

| ** **                                      | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                    | ** ** |
| Gross expenses  for research and development    |       | $                                          | 4,485      |   | $ | 3,670 |   | $ | 3,325 |   |
| Deduct: credits  for NIST award                 |       | —                                     |       | — |   | (583 | ) |
| Deduct: credits  from DARPA & DOE contracts |       | (2,295                                     | )          | (2,482 | ) | (1,463 | ) |
| Net research and  development expense           |       | $                                          | 2,190      |   | $ | 1,188 |   | $ | 1,279 |   |

 

Funds received from DOE and DARPA for milestonesachieved during the fiscal year are recorded as a credit to research anddevelopment expense. Net of payments to subcontractors, this amounted to$2,295,000 in 2005 compared to $2,482,000 in 2004. This decrease in DOE andDARPA credits was a result of lower DARPA credits in the year as a result ofbeing in the final year of the 3 year contract. These lower credits werepartially offset by an increase in credits from DOE. Gross expenses forresearch and development increased by $815,000, which was made up of increasedpersonnel, consultants and project costs for government projects and forprototyping new products. Research and development expenses were 8.0% of salesin 2005 compared to 4% of sales in 2004. We expect research and developmentexpenses to increase in 2006 due to a decrease in anticipated DARPA credits.

Research and development expenses were $1,188,000 in2004, a 7% decrease from research and development expenses of $1,279,000 in2003. Although we increased spending in research and development expense onpersonnel and project costs related to government contract work and onimprovements for existing products, this spending was offset by the increase inexpense credits for funds received in 2004 under certain DOE contracts andunder DARPA research and development contracts awarded in February and April of2003. Funds received from DOE and DARPA for milestones achieved during thefiscal year are recorded as a credit to research and development expense. Netof payments to subcontractors, this amounted to $2,482,000 in 2004 compared to$1,463,000 in 2003. This increase in DOE and DARPA credits was partially offsetby an increase in research and development spending of $345,000, 

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which was made up ofincreased personnel and project costs for government projects, along with adecrease in other government research and development credits of $583,000.Research and development expenses were 4.0% of sales in 2004 compared to 4.7%of sales in 2003.

Sales and marketing expenses were $9,595,000 in 2005,a 12% increase compared to the $8,595,000 in sales and marketing expenses for2004. This increase was due in part to an increase of $730,000 in 2005 largelyfrom higher pool and spa sales and marketing as a result of settling thePentair lawsuit and additional selling costs with SCP. The balance of theincrease is due to higher spending on EFO sales and marketing in the UnitedStates and Europe. Sales and marketing expenses were 34% of sales in 2005 and29% of sales in 2004. The Company expects sales and marketing expenses toincrease in absolute dollars in 2006 compared to 2005.

Sales and marketing expenses were $8,595,000 in 2004,a 20% increase compared to the $7,188,000 in sales and marketing expenses for2003. This increase was due in part to increased commission expenses of$516,000 in 2004 compared to $239,000 in 2003. This largely reflects a changefrom our selling pool and spa products through salaried inside sales people in2003 to our using outside commissioned sales agents in 2004. The balance of the2004 increase in sales and marketing expenses was primarily due to an increasein personnel, promotional literature and advertising costs and stock optionexpenses associated with marketing our EFO products. Sales and marketingexpenses were 29% of sales in 2004 and 26% of sales in 2003.

General and administrative expenses were $3,135,000 in2005, a $676,000 increase as compared to $2,459,000 in 2004. General andadministrative expenses were 11% of sales in 2005 and 8% of sales in 2004 and9% of sales in 2003. The increase wasprimarily due to higher accounting, investor conferences and legal fees. Wecurrently do not qualify for accelerated filing status with the SEC as a resultof our market capitalization as of June 30, 2005. We will be required tocomply with Section 404 of the Sarbanes-Oxley Act of 2002 beginning fiscalyear ending December 31, 2006 if our non-affiliate market capitalizationis over $75 million on June 30, 2006. Costs required for a company of oursize to comply with Section 404 are estimated to be at least $600,000,independent of additional audit fees. Some of these additional expenses wereincurred in 2005. We expect general and administrative expense toincrease in absolute dollars in 2006 as compared to 2005 due to anticipatedhigher accounting fees and expense associated with the impact of the Sarbanes-Oxley Act of 2002 and anticipatedincreased legal fees.

General and administrative expenses were $2,459,000 in2004, a $24,000 increase as compared to $2,435,000 in 2003. General andadministrative expenses were 8% of sales in 2004 and 9% of sales in 2003.

In June 2005, weannounced our plans to close our Fremont office and consolidate most of ouroperations in Solon, Ohio, where we already had a local sales office and amanufacturing facility. The relocation resulted in a restructuring charge ofapproximately $3.5 million for severance payments, redundancy, lease andinventory write-offs. We recognized a $3,120,000 restructuring charge in theyear ended December 31, 2005. We expect the total restructuring charge tobe near expected levels, with the balance of the expense being incurred in2006.

*Other Income andExpenses*

We had interest income of $138,000 and interestexpense of $39,000 in 2005. Interest income consists of interest earned ondeposits and marketable securities in 2005, most of which was earned afterreceiving funds from the follow-on stock offering closed in November 2005.Interest expense is for bank interest on a building loan in Germany for ourcorporate offices there. Our interest expense, which consists of expense forbank interest, was $17,000 in 2004 as compared to $119,000 in 2003. Thedecrease in 2004 compared to 2003 was a result of reduced bank borrowings inthe United States in 2004.

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We have certain long-termleases. Payments due under these leases are disclosed below in Item 7 and inthe Consolidated Financial Statements and related Notes included elsewhere inthis Report.

*Income Taxes*

We have a full valuationallowance against our deferred tax assets in the United States. There was nooperating statement tax expense or benefit for our United States operations in2005 as any expected benefit was offset by an increase in our valuationallowance. The $109,000 tax expense shown for 2005 is a result of tax expensefor our United Kingdom and German operations which experienced a profit in2005.

*Net Income (Loss)*

Due to the increase inexpenses in 2005 combined with a decrease in gross profit as a result of thelower pool lighting sales, the amount of loss before income taxes was$7,314,000, an increase from the loss before taxes of $762,000 in 2004. Afterincluding taxes from international operations the loss was $7,423,000, anincrease of $6,719,000 over 2004. This compares to a 2003 loss of $608,000.

**Liquidity and Capital Resources**

*Cash and CashEquivalents*

At December 31, 2005,our cash and cash equivalents were $5,554,000 as compared to $3,609,000 at December 31,2004. We had $1,092,000 in borrowings against our $3.0 million equipment lineof credit as of December 31, 2005 and no borrowings against this line asof December 31, 2004. We also had $18,024,000 in short-term securities at December 31,2005 and no investments in short-term securities at December 31, 2004.

*OperatingActivities*

Net cash used by operating activities primarilyconsists of net loss adjusted by non-cash items, including depreciation,amortization, stock-based compensation, and the effect of changes in workingcapital. Cash decreased during 2005 by a net loss of $7,423,000 compared to netlosses of $704,000 and $608,000 for2004 and 2003, respectively. After adjustments for depreciation andamortization and non-cash stock-based compensation charge, net cash used byoperating activities was $5,933,000 in 2005 as compared to net cash provided byoperating activities of $431,000 for 2004.

There were several changes in working capital in 2005.Cash increased by $722,000 due to a reduction in accounts receivable and by$363,000 due to a reduction in inventories. Accrued liabilities added to cashin 2005 through an increase of $1,830,000 largely as a result of scheduledpayments outstanding on restructuring expenses.

After adjustments for allnon-cash items, including cash used for working capital, net cash used inoperating activities was $3,472,000 in 2005 compared to $2,469,000 used inoperating activities in 2004 and $929,000 provided by operating activities in2003.

*Cash Used inInvesting Activities*

There was a netutilization of cash of $19,921,000 in investing activities in 2005 primarilydue to the investments made in short-term securities and the acquisition offixed assets. This compares to $724,000 spent on fixed asset acquisitions in2004. In December 2005 we purchased $45,768,000 in short-term investmentsand sold $27,767,000 with varying maturities from three to fifteen months. Asof December 31, 2005 the value of these securities plus interest earnedincreased by $24,000.

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*Cash Provided byFinancing Activities*

There was a net contribution to cash from financingactivities of $25,749,000 in 2005 compared to net contributions of $2,511,000and $3,447,000 in 2004 and 2003, respectively. This net contribution wasprimarily due to our receipt of $22,174,000, net of expenses, from a stockoffering closed in November 2005, combined with cash receipts of$2,477,000 from the sale of our common stock upon the exercise of outstandingstock options and warrants.

As a result of the cash provided by operating andfinancing activities and the cash used in investing activities, there was a netincrease in cash in 2005 of $1,945,000 that resulted in an ending cash balanceof $5,554,000. This compares to a net decrease in cash of $645,000 in 2004resulting in an ending cash balance of $3,609,000 for 2004.

We had a Loan and Security Agreement (AccountsReceivable and Inventory) dated December 7, 2002, with Comerica Bank for$5 million through August 14, 2005. We agreed to a new bank line of creditagreement with Silicon Valley Bank on August 15, 2005. This creditfacility is for $5.0 million, bears interest equal to prime plus 1.75% perannum and is secured by accounts receivable. It has a minimum tangible networth covenant which we must meet going forward. On December 31, 2005 thisagreement was amended and restated to include an additional $3 millionterm-loan line of credit for equipment purchases. This agreement calls forrepayment of principle in equal amounts over 4 years from the date of purchaseof the equipment and has an interest rate of prime plus 0.5% if the quick ratiois greater than 1.5, and prime plus 1.5% if the quick ratio is at or below 1.5.Borrowings under the Silicon Valley Agreement are collateralized by our assetsand intellectual property. Specific borrowings under the revolver are tied toaccounts receivable and inventory balances, and we are required to comply withcertain covenants with respect to effective net worth and financial ratios,which we met as of December 31, 2005. We had total borrowings of$1,092,000 under the term-loan portion of the agreement as of December 31,2005, and had no borrowings under this portion as of December 31, 2004. Wepay an unused line fee of 0.25% against any unused daily balance during theyear.

Through our U.K. subsidiary, we maintain a bankoverdraft facility of $430,000 (in UK pounds sterling, based on the exchangerate at December 31, 2005) under an agreement with Lloyds Bank Plc. Therewere no borrowings against this facility as of December 31, 2005 and 2004,respectively. The facility is renewed annually on January 1.

Through our German subsidiary, we maintain a creditfacility under an agreement with Sparkasse Neumarkt Bank. This credit facilityis in place to finance our building of new offices in Berching, Germany whichis owned and occupied by our German subsidiary. As of December 31, 2005,we had borrowings of $331,000 (in Euros, based on the exchange rate at December 31,2005) against this credit facility, all of which comes due between 2006 and 2008.In addition, our German subsidiary has a revolving line of credit for $177,000(in Euros, based on the exchange rate at December 31, 2005) with SparkasseNeumarkt Bank. As of December 31, 2005, there were borrowings of $47,000against this facility and no borrowings against this facility at December 31,2004. The revolving facility is renewed annually on January 1.

In a March 2002 private placement, we sold328,633 shares of common stock for net proceeds of $972,000 (net of fees andexpenses). In addition, we issued to each purchaser a warrant to purchase anumber of shares of our common stock equal to 20% of the number of sharespurchased by such purchaser in the offering. The $3.00 per share offering pricewas based on an 8.8% discount on the 10-day average price as of March 14,2002. The purchase price of the common stock for insiders who participated inthe offering was $3.35, which was the higher of (1) the price on theclosing date or (2) the 10-day average price as of March 14,2002, plus a $.03 premium because of the issuances of the warrants. Thewarrants have an initial exercise price of $4.30 per share, with a life of5 years.

On June 17, 2003, we entered into a securitiespurchase agreement to sell up to 1,350,233 shares of common stock and warrantsto purchase 405,069 shares of common stock for an aggregate purchase price of$4,388,250 in a two-stage private placement. The first stage of the privateplacement, involving the sale of 923,078 shares of common stock and warrants topurchase 276,922 shares of common stock, closed on 

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June 17, 2003 withour receiving net proceeds of $2,769,000 (net of fees and expenses). The secondstage of the private placement, involving the sale of 427,155 shares of commonstock and warrants to purchase 128,147 shares of common stock, closed on August 18,2003 with our receiving net proceeds of $1,043,000 (net of fees and expenses). Asrequired by NASDAQ Marketplace Rules, the issuance and sale of the shares andwarrants in the second stage were subject to shareholder approval because theprice was less than the greater of book or market value per share and amountedto 20% or more of the our common stock. The shareholders approved the issuanceand sale of the shares and warrants in the second stage at a special meeting ofshareholders held on August 12, 2003. For both stages, the purchase priceof the common stock was $3.25 per share, which was a 12.5% discount on the 10-dayaverage price as of June 1, 2003. The warrants have an initial exercise priceof $4.50 per share and a life of 5 years. The warrants were valued at $641,000and $297,000 for the first and second stages, respectively, based on aBlack-Scholes calculation as of the June 17, 2003 and August 18, 2003closing dates and under EITF 00-19 were included at those values inlong-term liabilities at the time of each closing. The balance of the netproceeds was accounted for as additional paid in capital. Under EITF 00-19,we marked-to-market the value of the warrants at the end of each accountingperiod until the registration statement for the shares and warrants wasdeclared effective by the SEC on September 24, 2003. Once the registrationstatement for the shares and warrants was declared effective, the warrant valueon the effective date was reclassified to equity as additional paid in capital.As a result of the change in value of the warrants issued in the first stagefrom the closing date to the end of the second quarter on June 30, 2003,we realized a benefit of $8,000 that was included in other income in the secondquarter of 2003. As a result of the change in value of the first stage warrantsfrom June 30, 2003 and the second stage warrants from the second closingdate to September 30, 2003, we realized a benefit of $15,000 that was includedin other income in the third quarter of 2003. We are subject to certainindemnity provisions included in the stock purchase agreement entered into aspart of the financing. In  2003, we alsoissued warrants to purchase 81,104 shares of common stock to the firm MerrimanCurhan Ford & Co. as compensation as placement agent for the privateplacement. These warrants have the same terms as the warrants issued in theprivate placement.

On November 8, 2005 the Company closed afollow-on offering, selling 2,500,000 new shares of Common Stock at a price of$8.25. The purchase price of the Common Stock was set at $8.25 per share on November 2,2005, which was approximately a 5% discount on the closing price on that day. OnNovember 11, 2005 the Company announced that the underwriters hadexercised their option to sell an additional 452,497 shares of Common Stock for$8.25 as part of the offering. The gross amount raised was $24.4 million fromthe selling of 2,952,497 new shares, before costs and expenses. The net amountreceived by the company after deducting 6% in underwriter’s fees and legal,accounting and other costs was $22.2 million.

We believe that ourexisting cash balances, funds received from the financing described above andfunds available to us through our bank lines of credit together with funds thatwe anticipate generating from our operations, will be sufficient to finance ourcurrently anticipated working capital requirements and capital expenditurerequirements for at least the next 12 to 18 months months. However, a suddenincrease in product demand requiring a significant increase in manufacturingcapability, or unforeseen adverse competitive, economic or other factors mayimpact our cash position, and thereby affect operations. From time to time wemay be required to raise additional funds through public or private financing,strategic relationships or other arrangements. There can be no assurance thatsuch funding, if needed, will be available on terms acceptable to us, or atall. Furthermore, any additional equity financing may be dilutive toshareholders, and debt financing, if available, may involve restrictivecovenants. Strategic arrangements, if necessary to raise additional funds, mayrequire that we relinquish rights to certain of our technologies or products.Failure to generate sufficient revenues or to raise capital when needed couldhave an adverse impact on our business, operating results and financialcondition, as well as our ability to achieve intended business objectives.

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**Contractual Obligations**

Thefollowing summarizes our contractual obligations as of December 31, 2005,consisting of current and future payments for borrowings by our Germansubsidiary, borrowings under an equipment term loan in the United States andminimum lease payments under operating leases and the effect these obligationsare expected to have on our liquidity and cash flow in future periods.

| ** ** | ** ** | **Borrowings  By German  Subsidiary** | ** ** | **Borrowings  Under  Equipment  Term Loan** | ** ** | **Non-  Cancelable  Operating  Leases** | ** ** |
|------------|------------|--------------------------------------------|------------|--------------------------------------------------|------------|-----------------------------------------|------------|
| 2006       |       |                                       | $          | 108                                              |       |                                    |       | $ | 273 |   |   |   | $ | 1,275 |   |   |
| 2007       |       |                                       | —     |                                             |       |                                    | 273        |   |   |   | 654 |   |   |
| 2008       |       |                                       | 270        |                                             |       |                                    | 273        |   |   |   | 611 |   |   |
| 2009       |       |                                       | —     |                                             |       |                                    | 273        |   |   |   | 119 |   |   |
| 2010       |       |                                       | —     |                                             |       |                                    | —     |   |   |   | 122 |   |   |
| Thereafter |       |                                       | —     |                                             |       |                                    | —     |   |   |   | 20 |   |   |
|       |       |                                       | $          | 378                                              |       |                                    |       | $ | 1,092 |   |   |   | $ | 2,801 |   |   |

 

**Off-Balance Sheet Arrangements**

We had no off-balancesheet arrangements as of December 31, 2005 or 2004.

**RecentlyIssued Accounting Pronouncements**

In December 2004, the FASBissued SFAS No. 123 (revised 2004) or SFAS 123R, “Share-Based Payments.”SFAS 123R requires all entities to recognize compensation expense in anamount equal to the fair value of share-based payments, such as stock options granted to employees. The Company will apply SFAS123R using the modified prospective method. Under this method, the Companyis required to record compensation expense (as previous awards continue tovest) for the unvested portion of previously granted awards that remainoutstanding at the date of adoption. The Company could have elected to adoptSFAS 123R by restating previously issued financial statements, basing theamounts on the expense previously calculated and reported in the pro formadisclosures that had been required by SFAS 123. SFAS 123R is effective for thefirst fiscal year beginning after December 15, 2005. In March 2005,the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment”(“SAB 107”), which provides interpretive guidance related to the interactionbetween SFAS 123(R) and certain SEC rules and regulations. It alsoprovides the SEC staff’s views regarding valuation of share based paymentarrangements. When adopted SFAS 123R with SAB 107 will increase stock-basedcompensation expense and reduce earnings in a manner previously only presentedas pro forma disclosure, with no or little impact on the Company’s overallfinancial position.

In December 2004, theFASB issued SFAS No.151, “Inventory Costs,” which amends part of ARB 43, “InventoryPricing,” concerning the treatment of certain types of inventory costs. Theprovisions of ARB No. 43 provided that certain inventory-related costs, such as double freight, re-handling, mightbe “so abnormal” that they should be charged against current earnings ratherthan beincluded in the cost ofinventory and, that is capitalized to future periods. As amended by SFAS No. 151,the “so-abnormal” criterion has been eliminated. Thus, all such(abnormal) costs are required to be treated as current-period charges under allcircumstances. In addition, fixed production overhead should be allocated basedon the normal capacity of the production facilities, with unallocated overheadcharged to expense when incurred. SFAS 151 is required to be adopted for fiscalyears beginning after June 15, 2005. The Company is assessing the impactof adopting SFAS No.151, but does not believe its adoption will have a materialimpact on the overall financial position.

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**Item 7A. Qualitative and Quantitative DisclosuresAbout Market Risk**

At December 31, 2005, we had $625,000 in cashheld in foreign currencies based on the exchange rates at December 31,2005. It is our practice to maintain cash balances in local currencies subjectto periodic conversions prior to transfer to repay inter-company debts.

Through our Germansubsidiary, we maintain a credit facility under an agreement with SparkasseNeumarkt Bank. At December 31, 2005, we had total borrowings of $331,000against this facility which comes due between 2006 and 2008 and is secured byreal property owned by our German subsidiary. In addition, our Germansubsidiary has a revolving line of credit for $177,000 (in Euros, based on theexchange rate at December 31, 2005) with Sparkasse Neumarkt Bank. Therewere $47,000 and no borrowings against this facility at December 31, 2005and 2004, respectively. If funds from the credit facility are used to repayinter-company debts there is an exchange rate conversion risk.

**Item 8. Consolidated Financial Statements andSupplementary Data.**

Our consolidated financialstatements and related notes required by this item are listed and set forth inthis report at Item 15 beginning at page F-1. The accompanying notesare an integral part of our consolidated financial statements.

**SupplementaryFinancial Information**

The following table sets forth our selected unauditedfinancial information for the eight quarters in the period ended December 31,2005. This information has been prepared on the same basis as the auditedfinancial statements and, in the opinion of management, contains alladjustments necessary for a fair presentation thereof.

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**QUARTERLYFINANCIAL DATA(IN THOUSANDS, EXCEPT PER SHARE DATA)**

| **2005 QUARTERS ENDED** | ** ** | ** ** | ** ** | **DEC. 31** | ** ** | **SEP. 30** | ** ** | ** ** | **JUN. 30** | ** ** | ** ** | ** ** | **MAR. 31** | ** ** |
|-----------------------------------|------------|------------|------------|------------------|------------|------------------|------------|------------|------------------|------------|------------|------------|------------------|------------|
| Net sales                         |       | $          | 6,234      |             | $          | 7,638            |       |       | $                | 7,645      |       |       | $                | 6,820      |   |
| Gross profit                      |       | 2,203      |       | 2,958            |       |             | 2,922      |       |             | 2,543      |       |
| As a percent of net sales         |       | 35.3       | %          | 38.7             | %          |             | 38.2       | %          |             | 37.3       | %          |
| Net income (loss)                 |       | (3,535     | )          | (2,074           | )          |             | (763       | )          |             | (1,051     | )          |
| As a percent of net sales         |       | (56.7      | )%         | (27.2            | )%         |             | (10.0      | )%         |             | (15.4      | )%         |
| Net income (loss) per  share:     |       |       |       |             |       |             |       |       |             |       |       |
| Basic                             |       | $          | (0.37      | )                | $          | (0.25            | )          |       | $                | (0.10      | )          |       | $                | (0.14      | ) |
| Diluted                           |       | $          | (0.37      | )                | $          | (0.25            | )          |       | $                | (0.10      | )          |       | $                | (0.14      | ) |
|                                   |            |            |            |                  |            |                  |            |            |                  |            |            |            |                  |            |  |  |  |  |  |

 

| **2004 QUARTERS ENDED** | ** ** | ** ** | ** ** | **DEC. 31** | ** ** | ** ** | **SEP. 30** | ** ** | **JUN. 30** | ** ** | ** ** | **MAR. 31** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|------------------|------------|------------|------------------|------------|------------------|------------|------------|------------------|------------|------------|
| Net sales                         |       |       | $          | 7,840            |       |       | $                | 7,333      |             |       | $          | 8,550            |       |       |   | $ | 6,008 |   |   |
| Gross profit                      |       |       | 3,098      |             |       | 2,745      |             |       | 3,567            |       |       |             | 2,101      |       |   |
| As a percent of net sales         |       |       | 39.5       | %                |       | 37.4       | %                |       | 41.7             | %          |       |             | 35.0       | %          |   |
| Net income (loss)                 |       |       | (341       | )                |       | (60        | )                |       | 461              |       |       |             | (764       | )          |   |
| As a percent of net sales         |       |       | (4.3       | )%               |       | (0.8       | )%               |       | 5.4              | %          |       |             | (12.7      | )%         |   |
| Net income (loss) per  share:     |       |       |       |             |       |       |             |       |             |       |       |             |       |       |   |
| Basic                             |       |       | $          | (0.05            | )          |       | $                | (0.01      | )                |       | $          | 0.06             |       |       |   | $ | (0.11 | ) |   |
| Diluted                           |       |       | $          | (0.05            | )          |       | $                | (0.01      | )                |       | $          | 0.06             |       |       |   | $ | (0.11 | ) |   |
|                                   |            |            |            |                  |            |            |                  |            |                  |            |            |                  |            |            |  |  |  |  |  |  |  |  |

 

**Item 9. Changes In and Disagreements With Accountantson Accounting and Financial Disclosure**

None.

**Item 9A. Controls and Procedures**

(a)   *Evaluation of disclosure controls andprocedures.  *We maintain “disclosure controls and procedures,”as such term is defined in Rule 13a-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is recorded, processed, summarized, and reported withinthe time periods specified in Securities and Exchange Commission rules andforms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating our disclosure controls and procedures, managementrecognized that disclosure controls and procedures, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the disclosure controls and procedures are met. Ourdisclosure controls and procedures have been designed to meet, and managementbelieves that they meet, reasonable assurance standards, subject to thedeficiencies and weaknesses identified and discussed under the sub-heading “Changesin Internal Controls” at Item 9A(b) below. Additionally, in designingdisclosure controls and procedures, our management necessarily was required toapply its judgment in evaluating the cost-benefit relationship of possibledisclosure controls and procedures. The design of any disclosure controls andprocedures also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

Based on their evaluation as of the end of the period covered by thisAnnual Report on Form 10-K, our Chief Executive Officer and ChiefFinancial Officer have concluded that, subject to the limitations noted aboveour disclosure controls and procedures were effective to ensure that materialinformation 

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relating to us, including our consolidatedsubsidiaries, is made known to them by others within those entities,particularly during the period in which this Annual Report on Form 10-Kwas being prepared.

(b)   *Changes in internal controls.*   Therewas no change in our internal control over financial reporting (as defined in Rule 13a-15(f)under the Exchange Act) identified in connection with the evaluation describedin Item 9A(a) above that occurred during our last fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

Acontrol deficiency exists when the design or operation of a control does notallow management or employees, in the normal course of performing theirassigned functions, to prevent or detect misstatements on a timely basis. Asignificant deficiency is a control deficiency, or combination of controldeficiencies, that adversely affects a company’s ability to initiate,authorize, record, process, or report external financial data reliably inaccordance with accounting principles generally accepted in the United Statessuch that there is more than a remote likelihood that a misstatement of theentity’s annual or interim financial statements that is more thaninconsequential will not be prevented or detected. A material weakness is asignificant deficiency, or combination of significant deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected.

**Item 9B. Other Information**

Not applicable.

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**PART III**

**Item 10. Directors and Executive Officers of theRegistrant**

The information requiredby this Item regarding directors and nominees is incorporated herein byreference to the information under the caption “PROPOSAL NO. 1: ELECTION OFDIRECTORS” in our definitive Proxy Statement to be filed with the SEC inconnection with the solicitation of proxies for our 2006 Annual Meeting of Shareholders to be held on June 15, 2006(the “Proxy Statement”). Information on our executive officers may be found in Part I.

**Item 405 ofRegulation S-K calls for disclosure of any known late filings or failureby an insider to file a report required by Section 16 of theSecurities Exchange Act of 1934, as amended. This disclosure is contained inthe section entitled “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTINGCOMPLIANCE” in the Proxy Statement and is incorporated herein by reference.**

We have a separately designated standing AuditCommittee established in accordance with Section 3(a)(58)(A) of theSecurities Exchange Act of 1934, as amended. The members of the Audit Committeeare Ronald Casentini (Chairperson), Michael Kasper and John B. Stuppin. All ofsuch members meet the independence standards established by The NASDAQ StockMarket for serving on an audit committee. SEC regulations require that wedisclose whether a director qualifying as an “audit committee financial expert”serves on our Audit Committee. Our Board of Directors has determined that both Mr. Casentiniand Mr. Stuppin qualify as an “audit committee financial expert” withinthe meaning of such regulations.

Our Board of Directorsadopted a Code of Ethics and Business Conduct for all of its directors,officers and employees on February 25, 2004. To request a copy of the Codeof Ethics and Business Conduct, please send a written request to our Secretaryat Fiberstars Inc., 32000 Aurora Road, Solon, OH 44139. It is also availablefrom our corporate website http://www.fiberstars.com.

**Item 11. Executive Compensation**

The information regardingexecutive compensation required by Item 11 is incorporated herein by referencefrom the information in the Proxy Statement under the captions “EXECUTIVECOMPENSATION AND OTHER MATTERS,” “PROPOSAL NO. 1: ELECTION OF DIRECTORS—DirectorCompensation” and “PROPOSAL NO. 1: ELECTION OF DIRECTORS—CompensationCommittee Interlocks and Insider Participation.”

**Item12. Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters**

The information regardingsecurity ownership of certain beneficial owners and management required byItem 12 is incorporated herein by reference from the information in theProxy Statement under the caption “SECURITY OWNERSHIP OF PRINCIPAL SHAREHOLDERSAND MANAGEMENT.”

 

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**EquityCompensation Plan Information**

Thefollowing table sets forth certain information regarding our equitycompensation plans as of December 31, 2005: 

| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       |       | 1,075,000  |                                                                                                                                                  |       |                                                                                                             | $          | 6.67                                                                                                                                                                                                                  |       |   |   | 24,000 | (1)(2) |   |
| Equity  compensation plans not approved by security holders |       |       | 8,000      |                                                                                                                                                  |       |                                                                                                             | $          | 4.50                                                                                                                                                                                                                  |       |   |   | — |   |   |
| Total                                                       |       |       | 1,083,000  | (3)                                                                                                                                                   |       |                                                                                                             | $          | 6.04                                                                                                                                                                                                                  |       |   |   | 24,000 |   |   |

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(1)          Includes the number ofshares reserved for issuance under our 2004 Stock Incentive Plan.

(2)          Includes 10,000 sharesavailable for sale pursuant to our 1994 Employee Stock Purchase Plan. Shares ofcommon stock will be purchased at a price equal to 85% of the fair market valueper share of common stock on either the first day preceding the offering periodor the last date of the offering period, whichever is less.

(3)          Includes8,000 warrants held by employees or directors.

**Item 13. Certain Relationships and RelatedTransactions**

The information regardingcertain relationships and related transactions required by Item 13 isincorporated herein by reference to the information in the Proxy Statementunder the caption “CERTAIN TRANSACTIONS.”

**Item 14. Principal Accountant Fees and Services**

The information regardingprincipal accountant fees and services and the pre-approval policies andprocedures required by Item 14 is incorporated by reference from theinformation contained in the Proxy Statement under the caption “RATIFICATION OFAPPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS—Principal AccountantFees and Services” and “RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTANTS—Pre-Approval Policies and Procedures.”

 

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**PART IV**

**Item 15. Exhibits AND Financial Statement Schedule**

(a)   (1) FinancialStatements

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directorsand Shareholders ofFiberstars, Inc.

We have audited the accompanying consolidated balancesheets of Fiberstars, Inc. and subsidiaries as of December 31, 2005and 2004, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity,and cash flows for each of the three years in the period ended December 31,2005. These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Fiberstars, Inc.and subsidiaries as of December 31, 2005 and 2004, and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2005 in conformity with accountingprinciples generally accepted in the United States of America.

Our audits were conductedfor the purpose of forming an opinion on the basic financial statements takenas a whole. The financial statement schedule listed in Item 15(a)(2) ofthis Form 10-K is presented for purposes of additional analysis andis not a required part of the basic financial statements. This schedule hasbeen subjected to the auditing procedures applied in the audit of the basicfinancial statements and, in our opinion, is fairly stated in all materialrespects in relation to the basic financial statements taken as a whole.

/s/ Grant Thornton LLP

San Francisco, CaliforniaMarch 10, 2006

F-1

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**FIBERSTARS, INC.CONSOLIDATED BALANCE SHEETS, December 31,*(amounts in thousands except share and per shareamounts)***

| ** **                                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                     | ** ** |
| Current assets:                                                                                |       |     |       |     |       |
| Cash and cash equivalents                                                                      |       | $        | 5,554      |     | $          | 3,609 |   |
| Short-term investments                                                                         |       | 18,024   |       | —   |       |
| Accounts receivable, net of allowances for doubtful  accounts of $260 in 2005 and $239 in 2004 |       | 6,287    |       | 7,224    |       |
| Inventories, net                                                                               |       | 7,852    |       | 8,433    |       |
| Prepaids and other current assets                                                              |       | 879      |       | 607      |       |
| Total current assets                                                                           |       | 38,596   |       | 19,873   |       |
| Fixed assets, net                                                                              |       | 3,422    |       | 2,604    |       |
| Goodwill, net                                                                                  |       | 4,135    |       | 4,279    |       |
| Intangibles, net                                                                               |       | —   |       | 150      |       |
| Other assets                                                                                   |       | 56       |       | 112      |       |
| Total assets                                                                                   |       | $        | 46,209     |     | $          | 27,018 |   |
| **LIABILITIES**                                                                                | ** ** |
| Current liabilities:                                                                           |       |     |       |     |       |
| Accounts payable                                                                               |       | $        | 2,623      |     | $          | 2,920 |   |
| Accruals and other current liabilities                                                         |       | 3,924    |       | 2,374    |       |
| Short-term bank borrowings                                                                     |       | 389      |       | 38       |       |
| Total current liabilities                                                                      |       | 6,936    |       | 5,332    |       |
| Long-term  bank borrowings and liabilities                                                     |       | 1,089    |       | 484      |       |
| Total liabilities                                                                              |       | 8,025    |       | 5,816    |       |
| Commitments and  contingencies (Note 8).                                                  |       |     |       |     |       |
| **SHAREHOLDERS’ EQUITY**                                                                  |       |
| *Preferred stock, par value  $0.0001 per share:*                                               |       |     |       |     |       |
| Authorized:  2,000,000 shares in 2005 and 2004                                                 |       |     |       |     |       |
| Issued and  outstanding: no shares in 2005 and 2004                                            |       |     |       |     |       |
| *Common stock, par value $0.0001  per share:*                                                  |       |     |       |     |       |
| Authorized:  30,000,000 shares in 2005 and 2004                                                |       |     |       |     |       |
| Issued and outstanding: 11,270,000 shares in 2005  and 7,351,142 shares in 2004                |       | 1        |       | 1        |       |
| Additional paid-in  capital                                                                    |       | 52,452   |       | 27,520   |       |
| Unearned  stock-based compensation                                                             |       | (397     | )          | (490     | )          |
| Accumulated other  comprehensive income                                                        |       | 41       |       | 661      |       |
| Accumulated  deficit                                                                           |       | (13,913  | )          | (6,490   | )          |
| Total shareholders’ equity                                                                |       | 38,184   |       | 21,202   |       |
| Total liabilities  and shareholders’ equity                                               |       | $        | 46,209     |     | $          | 27,018 |   |

 

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

F-2

----

**FIBERSTARS, INC.CONSOLIDATED STATEMENTS OF OPERATIONSFor the years ended December 31,*(amounts in thousands except per share amounts)***

| ** **                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                                                    |       | $        | 28,337     |     | $          | 29,731   |       | $ | 27,238 |   |
| Cost of sales                                                |       | 17,711   |       | 18,220   |       | 16,897   |       |
| Gross profit                                                 |       | 10,626   |       | 11,511   |       | 10,341   |       |
| Operating  expenses:                                         |       |     |       |     |       |     |       |
| Gross research and development                               |       | 4,485    |       | 3,670    |       | 3,325    |       |
| Deduct credits from DARPA, DOE & NIST contracts          |       | (2,295   | )          | (2,482   | )          | (2,046   | )          |
| Net research and development expense                         |       | 2,190    |       | 1,188    |       | 1,279    |       |
| Sales and marketing                                          |       | 9,595    |       | 8,595    |       | 7,188    |       |
| General and administrative                                   |       | 3,135    |       | 2,459    |       | 2,435    |       |
| Restructuring expenses.                                      |       | 3,120    |       | —   |       | —   |       |
| Total operating expenses                                     |       | 18,040   |       | 12,242   |       | 10,902   |       |
| Loss from operations                                         |       | (7,414   | )          | (731     | )          | (561     | )          |
| Other income (expense):                                      |       |     |       |     |       |     |       |
| Other income (expense)                                       |       | 1        |       | (14      | )          | 86       |       |
| Interest Income                                              |       | 138      |       | —   |       | —   |       |
| Interest expense                                             |       | (39      | )          | (17      | )          | (119     | )          |
| Net loss before income taxes                                 |       | (7,314   | )          | (762     | )          | (594     | )          |
| Income tax  benefit (provision)                              |       | (109     | )          | 58       |       | (14      | )          |
| Net loss                                                     |       | $        | (7,423     | )        | $          | (704     | )          | $ | (608 | ) |
| Net loss per share—basic and diluted                    |       | $        | (0.90      | )        | $          | (0.10    | )          | $ | (0.10 | ) |
| Shares used in  per share calculation—basic and diluted |       | 8,223    |       | 7,269    |       | 5,993    |       |

 

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

F-3

----

**FIBERSTARS, INC.CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the years ended December 31,*(amounts in thousands)***

| ** **                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net loss                                 |       | $        | (7,423     | )        | $          | (704     | )          | $ | (608 | ) |
| Other comprehensive  income:             |       |     |       |     |       |     |       |
| Foreign currency translation adjustments |       | (636     | )          | 233      |       | 547      |       |
| Net unrealized gain on securities        |       | 16       |       | —   |       | —   |       |
| Comprehensive  loss                      |       | $        | (8,043     | )        | $          | (471     | )          | $ | (61 | ) |

 

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

F-4

----

**FIBERSTARS, INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITYFor the years ended December 31, 2005, 2004 and 2003*(amounts in thousands)***

| ** **                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **       | ** ** | **Notes**         | ** ** | **Accumulated**  | ** ** | **Retained** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|------------------|------------|-------------------|------------|------------------|------------|--------------|------------|------------|------------|
| ** **                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | **Unearned**     | ** ** | **Receivable**    | ** ** | **Other**        | ** ** | **Earnings** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Stock-Based** | ** ** | **From**         | ** ** | **Comprehensive** | ** ** | **(Accumulated** | ** ** | ** **   | ** ** |
| ** **                                                   | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Compensation** | ** ** | **Shareholder**   | ** ** | **Income**       | ** ** | **Deficit)** | ** ** | **Total**  | ** ** |
| Balances,  December 31, 2002                            |       | 4,667                 |       |        | $          | 1               |       |             |       | $                 | 19,611     |             |       |         | $          | —     |       |   |   | $ | (75 | ) |   |   | $ | (119 | ) |   |   | $ | (5,178 | ) |   | $ | 14,240 |   |
| Issuance of common  stock—private placement             |       | 1,350                 |       |        |       |            |       |             | 3,730      |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 3,730 |   |
| Non-employee  stock-based compensation                       |       |                  |       |        |       |            |       |             | 27         |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 27 |   |
| Issuance of common  stock under employee stock purchase plan |       | 8                     |       |        |       |            |       |             | 23         |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 23 |   |
| Issuance of common  stock under employee stock option plan   |       | 292                   |       |        |       |            |       |             | 1,140      |              |       |             |       |         |       |       | (224       | ) |   |   |   |   |   |   |   |   |   | 916 |   |
| Note receivable  from shareholder                       |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       | 75         |   |   |   |   |   |   |   |   |   |   | 75 |   |
| Foreign currency  translation adjustment                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   | 547 |   |   |   |   |   |   | 547 |   |
| Net loss                                                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   | (608 | ) |   | (608 | ) |
| Balances,  December 31, 2003                            |       | 6,317                 |       |        | 1          |            |       |             | 24,531     |              |       |             |       |         |       |       | (224       | ) |   |   | 428 |   |   |   | (5,786 | ) |   | 18,950 |   |
| Exercise of common  stock warrants                           |       | 553                   |       |        |       |            |       |             | 121        |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 121 |   |
| Issuance of common  stock under employee stock purchase plan |       | 4                     |       |        |       |            |       |             | 31         |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 31 |   |
| Exercise of common  stock options                            |       | 477                   |       |        |       |            |       |             | 2,201      |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 2,201 |   |
| Non-employee  stock-based compensation                       |       |                  |       |        |       |            |       |             | 123        |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 123 |   |
| Unearned  stock-based compensation                           |       |                  |       |        |       |            |       |             | 513        |              |       |             | (513       | )            |       |       |       |   |   |   |   |   |   |   |   |   |   | — |   |
| Amortization of  unearned stock-based compensation           |       |                  |       |        |       |            |       |             |       |              |       |             | 23         |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 23 |   |
| Note receivable  from shareholder                       |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       | 224        |   |   |   |   |   |   |   |   |   |   | 224 |   |
| Foreign currency  translation adjustment                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   | 233 |   |   |   |   |   |   | 233 |   |
| Net loss                                                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   | (704 | ) |   | (704 | ) |
| Balances,  December 31, 2004                            |       | 7,351                 |       |        | 1          |            |       |             | 27,520     |              |       |             | (490       | )            |       |       | —     |   |   |   | 661 |   |   |   | (6,490 | ) |   | 21,202 |   |
| Issuance of common  stock S-3 Filing                         |       | 2,952                 |       |        |       |            |       |             | 22,174     |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 22,174 |   |
| Exercise of common  stock warrants                           |       | 587                   |       |        |       |            |       |             | 408        |              |       |             |       |         |       |       | (62        | ) |   |   |   |   |   |   |   |   |   | 346 |   |
| Issuance of common  stock under employee stock purchase plan |       | 4                     |       |        |       |            |       |             | 31         |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 31 |   |
| Exercise of common  stock options                            |       | 376                   |       |        |       |            |       |             | 2,131      |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 2,131 |   |
| Unearned  stock-based compensation                           |       |                  |       |        |       |            |       |             | 53         |              |       |             | (53        | )            |       |       |       |   |   |   |   |   |   |   |   |   |   | — |   |
| Amortization of  unearned stock-based compensation           |       |                  |       |        |       |            |       |             | 197        |              |       |             | 146        |         |       |       |       |   |   |   |   |   |   |   |   |   |   | 343 |   |
| Net unrealized  gain on securities                           |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   | 16 |   |   |   |   |   |   | 16 |   |
| Foreign currency  translation adjustment                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   | (636 | ) |   |   |   |   |   | (636 | ) |
| Net loss                                                     |       |                  |       |        |       |            |       |             |       |              |       |             |       |         |       |       |       |   |   |   |   |   |   |   | (7,423 | ) |   | (7,423 | ) |
| Balances,  December 31, 2005                            |       | 11,270                |       |        | $          | 1               |       |             |       | $                 | 52,514     |             |       |         | $          | (397       | )          |   |   | $ | (62 | ) |   |   | $ | 41 |   |   |   | $ | (13,913 | ) |   | $ | 38,184 |   |

 

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

F-5

----

**FIBERSTARS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSFor the years ended December 31,*(amounts in thousands)***

| ** **                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Cash flows from operating  activities:**                                   |       |     |       |     |       |     |       |
| Net loss                                                                     |       | $        | (7,423     | )        | $          | (704     | )          | $ | (608 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |     |       |     |       |     |       |
| Depreciation and amortization                                                |       | 1,145    |       | 989      |       | 961      |       |
| Provision for doubtful accounts receivable                                   |       | 76       |       | (84      | )          | (22      | )          |
| Stock-based compensation                                                     |       | 345      |       | 146      |       | 27       |       |
| Unrealized income from marketable securities                                 |       | (16      | )          | —   |       | —   |       |
| Changes in assets  and liabilities:                                          |       |     |       |     |       |     |       |
| Accounts receivable, trade                                                   |       | 722      |       | (1,448   | )          | (238     | )          |
| Inventories                                                                  |       | 363      |       | (1,673   | )          | 398      |       |
| Prepaid and other current assets                                             |       | (313     | )          | (208     | )          | 219      |       |
| Other assets                                                                 |       | 56       |       | 70       |       | 52       |       |
| Accounts payable                                                             |       | (257     | )          | 694      |       | 168      |       |
| Accruals and other current liabilities                                       |       | 1,830    |       | (251     | )          | (28      | )          |
| Total adjustments                                                            |       | 3,951    |       | (1,765   | )          | 1,537    |       |
| Net cash provided by (used in) operating activities                          |       | (3,472   | )          | (2,469   | )          | 929      |       |
| **Cash  flows from investing activities:**                                   |       |     |       |     |       |     |       |
| Purchase of short-term investments                                           |       | (45,768  | )          | —   |       | —   |       |
| Sale of short-term investments                                               |       | 27,767   |       | —   |       | —   |       |
| Acquisition of fixed assets                                                  |       | (1,920   | )          | (724     | )          | (717     | )          |
| Net cash used in investing activities                                        |       | (19,921  | )          | (724     | )          | (717     | )          |
| **Cash  flows from financing activities:**                                   |       |     |       |     |       |     |       |
| Proceeds from issuances of common stock                                      |       | 24,680   |       | 2,354    |       | 4,920    |       |
| Repayment of loan made to shareholder                                        |       | —   |       | 224      |       | 75       |       |
| Loan made to shareholder                                                     |       | —   |       | —   |       | (224     | )          |
| Proceeds from (repayments of) long-term  liabilities                         |       | 1,069    |       | (67      | )          | (26      | )          |
| Net proceeds from short-term bank borrowings                                 |       | —   |       | —   |       | (607     | )          |
| Bank overdraft                                                               |       | —   |       | —   |       | (691     | )          |
| Net cash provided by financing activities                                    |       | 25,749   |       | 2,511    |       | 3,447    |       |
| ***Effect  of exchange rate changes on cash***                               |       | (411     | )          | 37       |       | 364      |       |
| **Net  increase (decrease) in cash and cash equivalents**                    |       | 1,945    |       | (645     | )          | 4,023    |       |
| **Cash  and cash equivalents, beginning of year**                            |       | 3,609    |       | 4,254    |       | 231      |       |
| **Cash  and cash equivalents, end of year**                                  |       | $        | 5,554      |     | $          | 3,609    |       | $ | 4,254 |   |
| **Supplemental  information:**                                               |       |     |       |     |       |     |       |
| Interest paid                                                                |       | $        | 39         |     | $          | 17       |       | $ | 119 |   |
| Fully depreciated  assets disposed of                                        |       | $        | 1,083      |     | $          | —   |       | $ | — |   |

 

The accompanying notes are an integral part of these financial statements

F-6

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005 and 2004**

**1.**   Natureof Operations:

Fiberstars, Inc.(the “Company”) develops and assembles lighting products using fiber optictechnology for commercial lighting and swimming pool and spa lightingapplications. The Company markets its products for worldwide distributionprimarily through independent sales representatives, distributors and swimmingpool builders.

**2.**   Summaryof Significant Accounting Policies:

**Basis ofPresentation:**

The consolidated financialstatements include the accounts of Fiberstars, Inc. and its subsidiaries.All significant inter-company balances and transactions have been eliminated.

**Use of Estimates:**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amount of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportedperiod. Estimates include, but are not limited to, the establishment ofreserves for accounts receivable, sales returns, inventory obsolescence andwarranty claims; the useful lives for property, equipment, and intangibleassets, and stock-based compensation. Actual results could differfrom those estimates.

**Cash Equivalents:**

The Company considers allhighly liquid investments purchased with an original maturity of three monthsor less to be cash equivalents.

**Short-TermInvestments:**

The Company’s short-term investments are classified asavailable-for-sale, which are stated at estimated fair value. The Company hasdetermined its short-term investments are available to support currentoperations and, accordingly, has classified such short-term investments ascurrent assets without regard for contractual maturities. These short-terminvestments are invested through a major financial institution. The unrealizedgains or losses on these short-term investments are included in accumulatedother comprehensive income as a separate component of shareholder’s equityuntil realized.

Short-terminvestments at December 31, 2005 were as follows (*inthousands)*:

| ** **                             | ** ** | **Cost** | ** ** | **Net  unrealized gain** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------|------------|----------|------------|-------------------------------|------------|--------------------------------|------------|
| Money Market Fund                      |       | $        | 287        |                          |       | $                              | —     |   |   |   | $ | 287 |   |   |
| Federal National  Mortgage Association |       | 2,429    |       |                          | 4          |                           |       |   | 2,433 |   |   |
| Federal Home Loan                      |       | 12,069   |       |                          | 7          |                           |       |   | 12,076 |   |   |
| Federal Farm  Credit                   |       | 1,628    |       |                          | 4          |                           |       |   | 1,632 |   |   |
| Commercial Paper                       |       | 1,595    |       |                          | 1          |                           |       |   | 1,596 |   |   |
| Total                                  |       | $        | 18,008     |                          |       | $                              | 16         |   |   |   | $ | 18,024 |   |   |

 

F-7

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2.**   Summary of SignificantAccounting Policies: (Continued)

The short-term investments maturing in 2006 total$14,366. The remaining short-term investments have scheduled maturity dates in2007 and consist of the Federal Farm Credit and a portion of the Federal HomeLoan investments.

The change in net unrealized holding gains onsecurities available for sale in the amount of $16,000 has been charged toother comprehensive income for the year ended December 31, 2005. This ismade up of gross unrealized gains of $19,000 during 2005 included inaccumulated other comprehensive income, net of unrealized losses of $3,000during 2005 also included in accumulated other comprehensive income. The costof securities sold is based on the specific identification method.

Proceeds from the sale ofavailable securities during 2005 were $27,767,000. Gross gains of $8,000 wererealized on the sales of available for sale securities during 2005.

**Investments inJoint Ventures:**

The Company records itsinvestments in joint ventures under the equity method of accounting. These wereimmaterial in 2005.

**Fair Value ofFinancial Instruments:**

Carrying amounts ofcertain of the Company’s financial instruments including cash and cashequivalents, short-term investments, accounts receivable and accounts payableapproximate fair value due to their short maturities. Based on borrowing ratescurrently available to the Company for loans with similar terms, the carryingvalue of long-term debt obligations also approximates fair value.

**RevenueRecognition:**

The Company recognizes revenue upon: (1) receiptof a purchase order from the customer or completion of a sales agreement withthe customer; (2) shipment of the product has occurred or services havebeen provided; and (3) the sales price is fixed or determinable andcollectibility is reasonably assured. Revenue from product sales is generallyrecognized upon shipment, and allowances are provided for estimated returns,discounts and warranties. Such allowances are adjusted periodically to reflectactual and anticipated returns, discounts and warranty expenses. Revenue onsales that include services such as design, integration and installation isgenerally recognized using the percentage-of-completion method. Under thepercentage-of-completion method, revenue recognized reflects the portion of theanticipated contract revenue that has been earned, equal to the ratio of laborcosts expended to date to anticipated final labor costs, based on currentestimates of labor costs to complete the project. The Company’s products aregenerally subject to warranties, and the Company provides for the estimatedfuture costs of repair, replacement or customer accommodation in costs ofsales. Fees for research and development services are determined on a cost-plusbasis and are recognized as revenue when performed.

The Company recognizesshipments to pool lighting distributors as revenue upon shipment. Estimatedsales returns are recorded upon recognition of revenues from distributorshaving rights of return, including exchange rights for unsold products.Shipments made to commercial lighting representatives and distributors are alsorecognized as revenue upon shipment because in these instances therepresentative or 

F-8

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2.**   Summary of SignificantAccounting Policies: (Continued)

distributoris acting as a pass-through agent to a specific lighting project for which theCompany has an existing contract or purchase order.

**Inventories:**

The Company statesinventories at the lower of standard cost (which approximates actual costdetermined using the first-in-first-out method) or market. The Companyestablishes provisions for excess and obsolete inventories after evaluation ofhistorical sales, current economic trends, forecasted sales, product lifecyclesand current inventory levels. Charges to cost of sales for excess and obsoleteinventories amounted to $196,000, $116,000 and $128,000 in 2005, 2004 and 2003,respectively.

**AccountsReceivable:**

The Company’s customersare currently concentrated in the United States and Europe. In the normalcourse of business, the Company extends unsecured credit to its customersrelated to the sale of its products. Typical credit terms require paymentwithin 30 days from the date of delivery or service. The Company evaluates andmonitors the creditworthiness of each customer on a case-by-case basis. TheCompany provides allowances for sales returns and doubtful accounts based onits continuing evaluation of its customers’ ongoing requirements and creditrisk. The Company writes-off accounts receivable when they becomeuncollectible, and payments subsequently received on such receivables arecredited to the allowance for doubtful accounts. The Company does not requirecollateral from its customers.

**Income Taxes:**

As part of the process of preparing its consolidatedfinancial statements, the Company estimates its income tax liability in each ofthe jurisdictions in which it does business. This process involves estimatingthe Company’s actual current tax expense together with assessing temporarydifferences resulting from differing treatment of items, such as deferredrevenues, for tax and accounting purposes. These differences result in deferredtax assets and liabilities, which are included in the consolidated balancesheet. The Company then assesses the likelihood that these deferred tax assetswill be recovered from future taxable income and, to the extent the Companybelieves that recovery is not more likely than not, or is unknown, the Companyestablishes a valuation allowance.

Significant managementjudgment is required in determining the provision for income taxes, thedeferred tax assets and liabilities and any valuation allowance recordedagainst such deferred tax assets. At December 31, 2005, the Company’sdeferred tax assets primarily consist mainly of certain net operating lossescarried forward. The Company has recorded a full valuation allowance of$6,747,000 against these deferred tax assets, due to uncertainties related toits ability to utilize those deferred tax assets. The valuation allowance isbased on estimates of taxable income by jurisdiction and the periods over whichits deferred tax assets could be recoverable.

**Long-lived Assets:**

Goodwill represents theexcess of acquisition cost over the fair value of tangible and identifiedintangible net assets of the businesses acquired. Goodwill is not amortized,but is subjected to an annual 

F-9

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2.**   Summary of SignificantAccounting Policies: (Continued)

impairmenttest. Intangible assets from acquisitions are stated at cost and are amortizedon a straight-line basis over the estimated life of the assets acquired, but inno case for a period longer than 10 years. Fixed assets are stated at costand are depreciated using the straight-line method over the estimated usefullives of the related assets (two to five years). Leasehold improvements areamortized on a straight-line basis over their estimated useful lives or thelease term, whichever is shorter, generally 3 to 7 years. When events orchanges in circumstances indicate that assets may be impaired, an evaluation isperformed comparing the estimated future undiscounted cash flows associatedwith the asset to the asset’s carrying amount to determine if a write-down tomarket value or discounted cash flow is required.

**Certain Risks andConcentrations:**

The Company invests its excess cash in deposits andhigh-grade short-term securities with a major financial institution that isinsured by the Federal Deposit Insurance Corporation (“FDIC”) up to $100,000and the Securities Investor Protection Corporation (“SIPC”) up to $500,000 ofprimary net equity protection including $100,000 for claims for cash. At timesthe cash balances exceed the amounts insured by the FDIC. Currently the Companyhas approximately $18 million in short term securities invested with BearStearns Securities Corporation, under the management of Seneca Capital. TheCompany has not experienced any losses in such accounts and believes it is notexposed to significant risk of loss.

The Company sells its products primarily to commerciallighting distributors and residential pool distributors and pool installationcontractors in North America, Europe and the Far East. The Company performsongoing credit evaluations of its customers and generally does not requirecollateral. Although the Company maintains allowances for potential creditlosses that it believes to be adequate, a payment default on a significant salecould materially and adversely affect its operating results and financialcondition. At December 31, 2005, one customer accounted for 8% of accountsreceivable and at December 31, 2004, the one customer accounted for 10% ofaccounts receivable. One customer accounted for 11%, 10% and 11% of net salesin 2005, 2004 and 2003, respectively.

The Company currently buys all of its small diameterstranded fiber, the main component of most of its products, from one supplier.There is a limited number of fiber suppliers, and even if an alternativesupplier were obtained, a change in suppliers could cause delays inmanufacturing and a possible loss of sales which would adversely affectoperating results.

The Company also relies onsole source suppliers for certain lamps, reflectors, remote control devices andpower supplies. Although the Company cannot predict the affect that the loss ofone or more of such suppliers would have on the Company, such loss could resultin delays in the shipment of products and additional expenses associated with redesigningproducts and could have a material adverse affect on the Company’s operatingresults.

**Research andDevelopment:**

Research and development costs are charged tooperations as incurred. In 2000 the Company received a federal grant from theNational Institute of Standards and Technology (“NIST”) for $2,000,000 overthree years for research and development of solid core fiber for lightingpurposes. This award provided the Company with $566,000 in research anddevelopment credits for the fiscal year ended December 31, 2003.

F-10

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2.**   Summary of SignificantAccounting Policies: (Continued)

In February 2003, Defense Advanced Research Projects Agency, or DARPA, awarded theCompany and its partners a research and development contract for thedevelopment of next generation light sources, optics, luminaire and integratedilluminated technologies for its High Efficiency Distributed Lighting(HEDLight) project. The DARPA contract calls for gross payments of $7,824,000to the Company over three years based on achievement of various research anddevelopment milestones. On April 10, 2003 the Company announced that itand APL Engineered Materials, a subsidiary of Advanced Lighting TechnologiesInc. (ADLT), were awarded a further $2.7 million research and developmentcontract from DARPA to develop a new arc discharge light source. The contractsprovided the Company $1,966,000, $2,502,000 and $1,463,000 in research anddevelopment credits for the fiscal years ended December 31, 2005, 2004 and2003 respectively, net of subcontractor fees. The milestones are for workperformed in developing fiber optic illuminators and fixtures for installationon ships and aircraft. Funds for each year are subject to annual congressionalbudget approval.

During 2005, the Companyreceived a total of $1.5 million in awards from the Department of Energy underits Small Business Innovation Research “SBIR” program to improve its energysaving lighting technology, EFO. In addition, further SBIR awards from theDepartment of Defense under DARPA totaling $200,000 were obtained to furtherexplore improvements to lamp coatings and design and to further researchmaterials and processing techniques for the Company’s Continuously ExtrudedLarge Core Fiber processing method.

**Earnings Per Share:**

Basic earnings (loss) per share is computed bydividing income (loss) available to common shareholders by the weighted averagenumber of common shares outstanding for the period. Diluted earnings (loss) pershare is computed giving effect to all dilutive potential common shares thatwere outstanding during the period. Dilutive potential common shares consist ofincremental shares upon exercise of stock options.

Areconciliation of the numerator and denominator of basic and diluted earnings(loss) per share is provided as follows *(in thousands, except pershare amounts)*:

| ** **                                         | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator—Basic and  Diluted loss per share   |       |                                        |       |   |   |   |   |
| Net loss                                           |       | $                                           | (7,423     | ) | $ | (704 | ) | $ | (608 | ) |
| Denominator—Basic and  Diluted loss per share |       |                                        |       |   |   |   |   |
| Weighted average shares outstanding                |       | 8,223                                       |       | 7,269 |   | 5,993 |   |
| Basic and diluted loss  per share                  |       | $                                           | (0.90      | ) | $ | (0.10 | ) | $ | (0.10 | ) |

 

The shares outstanding used for calculating basic anddiluted earnings (loss) per share for a portion of the year 2005 included156,375 shares of common stock and 114,375 and 445,000 shares of common stockin 2004 and 2003 issuable for no cash consideration upon exercise of certainexchange provisions of warrants held by ADLT and two of its former employees.

F-11

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2. Summary of SignificantAccounting Policies: (Continued)**

Options and warrants topurchase 1,485,678 shares, 2,167,903 shares and 1,989,017 shares of commonstock were outstanding at December 31, 2005, 2004 and 2003, respectively,but were not included in the calculations of diluted earnings (loss) per sharebecause the Company had a loss for these years and their inclusion would beanti-dilutive.

**Stock-BasedCompensation:**

As of December 31,2005, the Company has two stock-based employee compensation plans, whichare described more fully in Note 9. The Company accounts for those plansunder the recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees,* and relatedInterpretations. Under these principles, employee stock options are valued atthe excess of the fair value of the underlying common stock over the exerciseprice of the options on the grant date. The Company accounts for equity instruments issued to non-employees inaccordance with the provisions of SFAS No. 123 and relatedinterpretations. Under these principles, the equity instruments are valued atthe fair value which is computed based on stock price on the date of grant orother measurement date, exercise price, estimated life, stock volatility andthe risk free rate of interest.

The following tableillustrates the effect on net income and earnings (loss) per share if theCompany had applied the fair value recognition provisions of FASB Statement No. 123,*Accounting for Stock-Based Compensation,*to stock-based employee compensation.

*(in thousands,except per share amounts):*

| ** **                                                                                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net Loss—as  reported                                                                                                                    |       | $                                           | (7,423     | ) | $ | (704 | ) | $ | (608 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss, net of related  tax effects                                    |       | 20                                          |       | 12 |   | — |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (530                                        | )          | (420 | ) | (527 | ) |
| Net Loss—Pro forma                                                                                                                       |       | $                                           | (7,933     | ) | $ | (1,112 | ) | $ | (1,135 | ) |
| Basic and Diluted Loss Per Share—As reported                                                                                             |       | $                                           | (0.90      | ) | $ | (0.10 | ) | $ | (0.10 | ) |
| Basic and Diluted  Loss Per Share—Pro forma                                                                                              |       | $                                           | (0.96      | ) | $ | (0.15 | ) | $ | (0.19 | ) |

 

F-12

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2. Summaryof Significant Accounting Policies: (Continued)**

The fair value of eachoption grant and stock purchase plan grant combined is estimated on the date ofgrant using the Black-Scholes option pricing model with the followingweighted-average assumptions used for grants in 2005, 2004 and 2003:

| ** **                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Fair value of  options issued |       | $          | 5.14       |       | $          | 3.77       |       | $ | 1.65 |   |
| Exercise price                |       | $          | 10.65      |       | $          | 7.50       |       | $ | 5.04 |   |
| Expected life of  option      |       | 5.02 years |       | 4.88 years |       | 3.93 years |       |
| Risk-free  interest rate      |       | 3.58       | %          | 3.00       | %          | 3.87       | %          |
| Expected volatility           |       | 49         | %          | 48         | %          | 48         | %          |

 

**Foreign CurrencyTranslation:**

The Company’sinternational subsidiaries use their local currencies as their functionalcurrencies. For those subsidiaries, assets and liabilities are translated atexchange rates in effect at the balance sheet date and income and expenseaccounts at average exchange rates during the year. Resulting translationadjustments are recorded directly to accumulated comprehensive income withinthe statement of shareholders equity. Foreign currency transaction gains and lossesare included as a component of interest income and other. Gains and losses fromforeign currency translation are included as a separate component ofcomprehensive income (expense) within the consolidated statement of operations.

**AdvertisingExpenses:**

The Company expenses thecosts of advertising, which consists of costs for the placement ofadvertisements in various media as incurred. Advertising expenses were$192,000, $206,000 and $119,000 for the years ended December 31, 2005,2004 and 2003, respectively.

**Product warranties:**

TheCompany warrants finished goods against defects in material and workmanshipunder normal use and service for periods of one to three years for illuminatorsand fiber. Settlement costs consist of actual amounts expensed for warrantyservices, which are largely a result of third party service calls, and costs ofreplacement products. A liability for the estimated future costs under productwarranties is maintained based on estimated future warranty expense forproducts outstanding under warranty *(in thousands)*:

| ** **                                             | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Balance at the  beginning of the year                  |       | $                                      | 430        |   | $ | 330 |   |
| Accruals for  warranties issued                        |       | 656                                    |       | 912 |   |
| Settlements made  during the year (in cash or in kind) |       | (693                                   | )          | (812 | ) |
| Balance at the end of  the year                        |       | $                                      | 393        |   | $ | 430 |   |

 

F-13

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**2. Summaryof Significant Accounting Policies: (Continued)**

**RecentPronouncements:**

In December 2004, the FASBissued SFAS No. 123 (revised 2004) or SFAS 123R, “Share-BasedPayments.” SFAS 123R requires all entities to recognize compensationexpense in an amount equal to the fair value of share-based payments, such asstock options granted to employees. TheCompany will apply SFAS 123R using the modified prospective method. Underthis method, the Company is required to record compensation expense (asprevious awards continue to vest) for the unvested portion of previouslygranted awards that remain outstanding at the date of adoption. The Companycould have elected to adopt SFAS 123R by restating previously issuedfinancial statements, basing the amounts on the expense previously calculatedand reported in the pro forma disclosures that had been required bySFAS 123. SFAS 123R is effective for the first fiscal year beginningafter December 15, 2005. In March 2005, the SEC released StaffAccounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”), whichprovides interpretive guidance related to the interaction between SFAS 123(R)and certain SEC rules and regulations. It also provides the SEC staff’sviews regarding valuation of share based payment arrangements. When adoptedSFAS 123R with SAB 107 will increase stock-based compensation expenseand reduce earnings in a manner previously only presented as pro formadisclosure, with no or little impact on the Company’s overall financialposition.

In December 2004,the FASB issued SFAS No. 151, “Inventory Costs,” which amends part ofARB 43, “Inventory Pricing,” concerning the treatment of certain types ofinventory costs. The provisions of ARB No. 43 provided that certaininventory-related costs, such as doublefreight, re-handling, might be “so abnormal” that they should be chargedagainst current earnings rather than beincluded in the cost of inventory and, that is capitalized to futureperiods. As amended by SFAS No. 151, the “so-abnormal” criterionhas been eliminated. Thus, all such (abnormal) costs are required to be treatedas current-period charges under all circumstances. In addition, fixedproduction overhead should be allocated based on the normal capacity of theproduction facilities, with unallocated overhead charged to expense whenincurred. SFAS 151 is required to be adopted for fiscal years beginningafter June 15, 2005. The Company is assessing the impact of adopting SFASNo. 151, but does not believe its adoption will have a material impact onthe overall financial position.

**3.Inventories***(inthousands)*:

| ** **        | ** ** | **December 31,** | ** ** |
|-------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Raw materials     |       | $                     | 6,431      |   | $ | 6,441 |   |
| Inventory reserve |       | (859                  | )          | (513 | ) |
| Finished goods    |       | 2,280                 |       | 2,505 |   |
|              |       | $                     | 7,852      |   | $ | 8,433 |   |

 

F-14

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**4.Fixed Assets***(inthousands)*:

| ** **                                                         | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Equipment (useful  life 5 years)                                   |       | $                     | 5,648      |   | $ | 4,188 |   |
| Tooling (useful  life 2 - 5 years)                                 |       | 1,998                 |       | 1,825 |   |
| Furniture and  fixtures (useful life 5 years)                 |       | 193                   |       | 239 |   |
| Computer software  (useful life 3 years)                      |       | 368                   |       | 269 |   |
| Leasehold  improvements (the shorter of useful life or lease life) |       | 839                   |       | 1,909 |   |
|                                                               |       | 9,046                 |       | 8,430 |   |
| Less accumulated  depreciation and amortization                    |       | (5,624                | )          | (5,826 | ) |
|                                                               |       | $                     | 3,422      |   | $ | 2,604 |   |

 

Fixed assets are stated atcost and are depreciated using the straight-line method over the estimateduseful lives of the related assets (two to five years). Leasehold improvementsare amortized on a straight-line basis over their estimated useful lives or thelease term, whichever is shorter, generally 3 to 7 years.

**5. Goodwill andIntangibles**

In accordance with SFAS 142, goodwill is subjectto an annual impairment test. The Company performs the test in the fourthquarter of every year. The tests showed no impairment of the Company’s goodwillasset.

Thechanges in the carrying amounts of goodwill and intangibles for the years endedDecember 31, 2005 and 2004 were as follows *(inthousands)*:

| ** **                            | ** ** | **Goodwill**              | ** ** | **Intangibles**             | ** ** |
|---------------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Balance as of  January 1, 2004   |       |                      | $          | 4,190                       |       |   |   | $ | 770 |   |   |   | $ | (464 | ) |   |   | $ | 306 |   |   |
| Amortization  expense                 |       |                      | —     |                        |       |   | — |   |   |   | (156 | ) |   |   | (156 | ) |   |
| Foreign currency  translation         |       |                      | 89         |                        |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Balance as of December 31, 2004  |       |                      | 4,279      |                        |       |   | 770 |   |   |   | (620 | ) |   |   | 150 |   |   |
| Amortization  expense                 |       |                      | —     |                        |       |   | — |   |   |   | (150 | ) |   |   | (150 | ) |   |
| Foreign currency  translation         |       |                      | (144       | )                           |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Balance as of  December 31, 2005 |       |                      | $          | 4,135                       |       |   |   | $ | 770 |   |   |   | $ | (770 | ) |   |   | $ | — |   |   |

 

Intangibles at December 31, 2005 includedeveloped and core technology and patents with a gross carrying amount of$399,000 and $371,000, respectively, and accumulated amortization of $399,000and $371,000, respectively. Intangibles at December 31, 2004 includedeveloped and core technology and patents with a gross carrying amount of$399,000 and $371,000, respectively, and accumulated amortization of $322,000and $298,000, respectively.

The estimated annualamortization expense for intangibles is zero for fiscal 2006 and thereafter.

F-15

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**6.Accruals and Other Current Liabilities***(in thousands): (Continued)*

| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Sales commissions  and incentives      |       | $                     | 1,089      |   | $ | 1,059 |   |
| Accrued warranty  expense              |       | 393                   |       | 430 |   |
| Accrued legal and  accounting fees     |       | 155                   |       | 15 |   |
| Accrued employee  benefits             |       | 304                   |       | 280 |   |
| Accrued  payables—related parties |       | 15                    |       | 188 |   |
| Accrued rent                           |       | 871                   |       | 149 |   |
| Accrued DARPA  payables                |       | 314                   |       | 154 |   |
| Accrued Severance                      |       | 455                   |       | — |   |
| Others                                 |       | 328                   |       | 99 |   |
|                                   |       | $                     | 3,924      |   | $ | 2,374 |   |

 

**7.Bank Borrowings:**

The Company had a Loan and Security Agreement(Accounts Receivable and Inventory) dated December 7, 2002, with ComericaBank for $5 million through August 14, 2005. The Company agreed to a newbank revolving  line of credit agreementwith Silicon Valley Bank on August 15, 2005. This credit facility is for$5.0 million, bears interest equal to prime plus 1.75% per annum and issecured by accounts receivable. It has a minimum tangible net worth covenantwhich the Company must meet going forward. On December 31, 2005 thisagreement was amended and restated to include an additional $3 millionterm-loan line of credit for equipment purchases. This agreement calls forrepayment of principal in equal amounts over 4 years from the date of purchaseof the equipment and has an interest rate of prime plus 0.5% if the quick ratiois greater than 1.5, and prime plus 1.5% if the quick ratio is at or below 1.5.Borrowings under the Silicon Valley Agreement are collateralized by the Company’sassets and intellectual property. Specific borrowings under the revolver aretied to accounts receivable and inventory balances, and the Company is requiredto comply with certain covenants with respect to effective net worth andfinancial ratios, which the Company met as of December 31, 2005. TheCompany had no borrowings under the revolving line of credit at December 31,2005 and at December 31, 2004. The Company had total borrowings of$1,092,000 under the term-loan portion of the agreement as of December 31,2005 under terms described above, and had no borrowings under this portion asof December 31, 2004. The Company pays an unused line fee of 0.25% againstany unused daily balance during the year.

Through its U.K. subsidiary, the Company maintains abank overdraft facility of $430,000 (in UK pounds sterling, based on theexchange rate at December 31, 2005) under an agreement with Lloyds BankPlc. There were no borrowings against this facility as of December 31,2005 and 2004, respectively. The facility is renewed annually on January 1.

Through its German subsidiary, the Company maintains acredit facility under an agreement with Sparkasse Neumarkt Bank. This creditfacility is in place to finance our building of new offices in Berching,Germany, which is owned and occupied by our German subsidiary. As of December 31,2005, the Company had borrowings of $331,000 (in Euros, based on the exchangerate at December 31, 2005) against this credit facility, all of whichcomes due between 2006 and 2008. In addition, our German subsidiary has arevolving line of credit for $177,000 (in Euros, based on the exchange rate at December 31,2005) with Sparkasse Neumarkt Bank. As of December 31, 2005, there wereborrowings of $47,000 against this facility and no borrowings against thisfacility at December 31, 2004. The revolving facility is renewed annuallyon January 1.

F-16

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**8.Commitments and Contingencies:**

TheCompany occupies manufacturing and office facilities under non-cancelableoperating leases expiring through 2011 under which it is responsible forrelated maintenance, taxes, and insurance. Minimum lease commitments under theleases are as follows *(inthousands):*

| **Year ending December 31,** | ** ** | ** ** | ** ** | **Minimum lease  commitments** | ** ** |
|---------------------------------------------|------------|------------|------------|-------------------------------------|------------|
| 2006                                        |       |       | $          | 1,275                               |       |   |
| 2007                                        |       |       | 654        |                                |       |
| 2008                                        |       |       | 611        |                                |       |
| 2009                                        |       |       | 119        |                                |       |
| 2010                                        |       |       | 122        |                                |       |
| 2011                                        |       |       | 20         |                                |       |
| Total minimum lease  payments               |       |       | $          | 2,801                               |       |   |

 

These leases includedcertain escalation clauses and thus rent expense was recorded on astraight-line basis. Rent expense approximated $1,026,000, $839,000 and$891,000 for the years ended December 31, 2005, 2004 and 2003,respectively.

At December 31, 2005,a letter of credit in the amount of $261,000 was held by the Company on behalfof Sparkasse Neumarkt Bank. The letter of credit would be drawn against theCompany’s line of credit facility with Silicon Valley Bank in the event of adefault by the Company’s German subsidiary, LBM, on its outstanding loan withSparkasse Neumarkt Bank.

On December 20, 2005,the Company entered into a settlement agreement with Sherwin-Williams Company(or Sherwin-Williams) and The Wagner Electric Sign Company (or Wagner). TheCompany was a third-party defendant in a lawsuit filed in the Court of CommonPleas, Cuyahoga County, Ohio filed on September 21, 2004, for allegedbreach of warranty and breach of contract in connection with an allegedlydefective sign manufactured and sold by Wagner. The settlement agreement callsfor certain payments to be made to Sherwin-Williams by the defendant partiesand for certain repairs to be made.

**9.Shareholders’ Equity:**

**Common Stock:**

The Company hadshareholder notes receivable outstanding of $62,000 for warrants exercised in2005 and paid for in 2006.

**Warrants:**

As part of the acquisition of Unison Fiber OpticLighting Systems, LLC in 2000, the Company provided ADLT with warrants to purchaseone million shares of the Company’s common stock exercisable at one penny pershare. 518,000 of these warrants were exercised in 2004 and 482,000 wereexercised in 2005.

As part of the acquisition in 2000 of LightlyExpressed, Ltd, or Lightly Expressed, the Company granted the Lightly Expressedshareholders warrants to purchase 100,000 shares which may be exercised inthree years if certain operating profits from sales of the products acquiredare met. There were no warrants for shares of common stock exercisable as of December 31, 2005.

F-17

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**9. Shareholders’ Equity:(Continued)**

On June 17, 2003, the Company entered into asecurities purchase agreement to sell up to 1,350,233 shares of Common Stock andwarrants to purchase 405,069 shares of Common Stock for an aggregate purchaseprice of $4,388,250 in a two-stage private placement. The first stage of theprivate placement, involving the sale of 923,078 shares of Common Stock andwarrants to purchase 276,922 shares of Common Stock, closed on June 17,2003 with the Company receiving net proceeds of $2,769,000 (net of fees andexpenses). The second stage of the private placement, involving the sale of427,155 shares of Common Stock and warrants to purchase 128,147 shares ofCommon Stock, closed on August 18, 2003 with the Company receiving netproceeds of $1,043,000 (net of fees and expenses). As required by Nasdaq Marketplace Rules,the issuance and sale of the shares and warrants in the second stage were subjectto shareholder approval because the price was less than the greater of book ormarket value per share and amounted to 20% or more of the Company’s CommonStock. The shareholders approved the issuance and sale of the shares andwarrants in the second stage at a special meeting of shareholders held on August 12,2003. For both stages, the purchase price of the Common Stock was $3.25per share, which was a 12.5% discount on the 10-day average price as of June 1,2003. The warrants have an initial exercise price of $4.50 per share and a lifeof 5 years. The warrants were valued at $641,000 and $297,000 for the first andsecond stages, respectively, based on a Black-Scholes calculation as of the June 17,2003 and August 18, 2003 closing dates and under EITF 00-19 wereincluded at those values in long-term liabilities at the time of each closing. Thebalance of the net proceeds was accounted for as additional paid in capital. UnderEITF 00-19, the Company marked-to-market the value of the warrantsat the end of each accounting period until the registration statement for theshares and warrants was declared effective by the Securities and ExchangeCommission (“SEC”) on September 24, 2003. Once the registration statementfor the shares and warrants was declared effective, the warrant value on theeffective date was reclassified to equity as additional paid in capital. As aresult of the change in value of the warrants from the first stage from theclosing date to the end of the second quarter on June 30, 2003, theCompany realized a benefit of $8,000 which was included in other income in thesecond quarter of 2003. As a result of the change in value of the first stagewarrants from June 30, 2003 and the second stage warrants from the secondclosing date to September 30, 2003, the Company realized a benefit of$15,000 which was included in other income in the third quarter of 2003. TheCompany is subject to certain indemnity provisions included in the stockpurchase agreement entered into as part of the financing. In December 2003,the Company also issued warrants to purchase 81,104 shares of common stock tothe firm Merriman Curhan Ford & Co. as compensation as placement agentfor the private placement. These warrants have the same terms as the warrantsissued in the private placement.

In a private placement in March 2002, the Companysold 328,633 shares of common stock for $972,000, net of fees and expenses of$28,000. In addition, each purchaser was issued a warrant to purchase a numberof shares of the Company’s common stock equal to 20% of the number of shares ofcommon stock purchased by such purchaser in the offering. The purchase price ofthe common stock was $3.00 per share, which was based on an 8.8% discount onthe 10-day average price as of March 14, 2002. The purchase price ofthe common stock for insiders who participated in the offering was $3.35, whichwas the higher of (1) the price on the closing date or (2) the 10-dayaverage price as of March 14, 2002, plus a $.03 premium because of theissuances of the warrants. The warrants have an initial exercise price of $4.30per share, with a life of 5 years.

F-18

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**9. Shareholders’ Equity: (Continued)**

Warrant activitycomprised:

| ** **                       | ** ** | **Warrants  Outstanding  Shares** | ** ** | **Warrants  Outstanding  Exercise Price** | ** ** | **Warrants  Exercisable** | ** **              | **Amount**              | ** ** |
|----------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|---------------------------|-------------------------|-------------------------|------------|
| ** **                       | ** ** | ** **                        | ** ** | ** **                                     | ** ** | ** **                | ** **              | **(in thousands)** | ** ** |
| Balance,  December 31, 2002 |       |                              | 1,165,726  |                                           |       | $                         | 0.01 - $6.00  |                    |       | 65,726 |   |   |   | $ | 3,283 |   |   |
| Warrants vested.                 |       |                              | —     |                                           |       | $4.50                     |                    |                    | 376,922    |   |   |   | — |   |   |
| Warrants granted                 |       |                              | 486,173    |                                           |       | $4.50                     |                    |                    | —     |   |   |   | 1,265 |   |   |
| Warrants  cancelled              |       |                              | (50,000    | )                                              |       | $6.00                     |                    |                    | (50,000    | ) |   |   | (300 | ) |   |
| Balance,  December 31, 2003 |       |                              | 1,601,899  |                                           |       | $                         | 0.01 - $6.00  |                    |       | 392,648 |   |   |   | 4,248 |   |   |
| Warrants vested.                 |       |                              | —     |                                           |       | $                         | 0.01 - $5.563 |                    |       | 779,251 |   |   |   | — |   |   |
| Warrants  exercised              |       |                              | (553,312   | )                                              |       | $                         | 0.01 - $5.563 |                    |       | (553,312 | ) |   |   | (1,532 | ) |   |
| Warrants  cancelled              |       |                              | (32,585    | )                                              |       | $5.563                    |                    |                    | (32,585    | ) |   |   | (181 | ) |   |
| Balance,  December 31, 2004 |       |                              | 1,016,002  |                                           |       | $                         | 0.01 - $5.563 |                    |       | 586,002 |   |   |   | 2,535 |   |   |
| Warrants vested.                 |       |                              | —     |                                           |       | $                         | 0.01 - $5.563 |                    |       | 427,269 |   |   |   | — |   |   |
| Warrants  exercised              |       |                              | (587,374   | )                                              |       | $                         | 0.01 - $5.563 |                    |       | (587,374 | ) |   |   | (625 | ) |   |
| Warrants  cancelled              |       |                              | (17,877    | )                                              |       | $5.563                    |                    |                    | (15,146    | ) |   |   | (73 | ) |   |
| Balance,  December 31, 2005 |       |                              | 410,751    |                                           |       | $                         | 4.30 - $4.50  |                    |       | 410,751 |   |   |   | $ | 1,837 |   |   |

 

**1988 Stock Option Plan:**

Upon adoption of the 1994 Stock Option Plan (seebelow), the Company’s Board of Directors determined to make no further grantsunder the 1988 Stock Option Plan (the 1988 Plan). Upon cancellation orexpiration of any options granted under the 1988 Plan, the related reservedshares of common stock became available instead for options granted under the1994 Stock Option Plan, and, after May 19, 2004, under our 2004 StockIncentive Plan.

**1994 Directors’ Stock Option Plan:**

At December 31, 2004, a total of 400,000 sharesof common stock had been reserved for issuance under the 1994 Directors’ StockOption Plan. The plan provided for the granting of nonstatutory stock optionsto non-employee directors of the Company. This plan was terminated on May 19,2004.

**1994 Stock Option Plan:**

At December 31, 2005, an aggregate of 1,550,000shares of the Company’s common stock had been reserved for issuance under the1994 Stock Option Plan to employees, officers, and consultants at prices notlower than the fair market value of the common stock of the Company on the dateof grant in the case of incentive stock options, and not lower than 85% of thefair market value on the date of grant in the case of non-statutory stockoptions. Options granted may be either incentive stock options or nonstatutorystock options. The plan administrator (the Board of Directors or a committee ofthe Board) determines the terms of options granted under the plan including thenumber of shares subject to the option, exercise price, term and exercisability.This plan was terminated on May 19, 2004.

F-19

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**9. Shareholders’ Equity:(Continued)**

**2004 StockIncentive Plan**

On May 19, 2004,the shareholders approved the 2004 Stock Incentive Plan (the “2004 Plan”). Thestated purpose of the 2004 Plan is to promote the long-term success of theCompany and the creation of stockholder value by (a) encouragingemployees, outside directors and consultants to focus on critical long-rangeobjectives, (b) encouraging the attraction and retention of employees,outside directors and consultants with exceptional qualifications and (c) linkingemployees, outside directors and consultants directly to stockholder intereststhrough increased stock ownership. The 2004 Plan seeks to achieve this purposeby providing for awards in the form of restricted shares, stock units, options(which may constitute incentive stock options or nonstatutory stock options) orstock appreciation rights. An aggregate of 500,000 shares of the Company’scommon stock was reserved for issuance under the 2004 Plan on May 19,2004.

Optionactivity under all plans comprised:

| ** **                       | ** ** | **Options  Available  For Grant** | ** ** | **Number of Shares  Outstanding** | ** ** | **Weighted  Average Exercise  Price Per Share** | ** ** |
|----------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                       | ** ** | **(in thousands)**                | ** ** | **(in thousands)**                     | ** ** | ** **                                                     | ** ** |
| Balance,  December 31, 2002 |       |                                   | 301        |                                        |       |                                                           | 1,432      |   |   |   | $ | 4.57 |   |   |
| Granted                          |       |                                   | (369       | )                                           |       |                                                           | 369        |   |   |   | $ | 4.41 |   |   |
| Cancelled                        |       |                                   | 123        |                                        |       |                                                           | (123       | ) |   |   | $ | 3.62 |   |   |
| Exercised                        |       |                                   | —     |                                        |       |                                                           | (291       | ) |   |   | $ | 3.91 |   |   |
| Balance,  December 31, 2003 |       |                                   | 55         |                                        |       |                                                           | 1,387      |   |   |   | $ | 4.18 |   |   |
| Granted                          |       |                                   | (273       | )                                           |       |                                                           | 273        |   |   |   | $ | 7.20 |   |   |
| Cancelled                        |       |                                   | 29         |                                        |       |                                                           | (29        | ) |   |   | $ | 5.11 |   |   |
| Exercised                        |       |                                   | —     |                                        |       |                                                           | (477       | ) |   |   | $ | 4.62 |   |   |
| Additional shares reserved       |       |                                   | 500        |                                        |       |                                                           | —     |   |   |   | — |   |   |
| Balance,  December 31, 2004 |       |                                   | 311        |                                        |       |                                                           | 1,154      |   |   |   | $ | 5.56 |   |   |
| Granted                          |       |                                   | (376       | )                                           |       |                                                           | 376        |   |   |   | $ | 9.88 |   |   |
| Cancelled                        |       |                                   | 79         |                                        |       |                                                           | (79        | ) |   |   | $ | 5.50 |   |   |
| Exercised                        |       |                                   | —     |                                        |       |                                                           | (376       | ) |   |   | $ | 8.95 |   |   |
| Balance,  December 31, 2005 |       |                                   | 14         |                                        |       |                                                           | 1,075      |   |   |   | $ | 6.48 |   |   |

 

F-20

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**9. Shareholders’Equity: (Continued)**

At December 31, 2005,2004 and 2003, options to purchase 539,000 shares, 703,404 shares and 1,005,466shares of common stock, respectively, were exercisable at weighted average fairvalues of $5.61, $5.36 and $4.86, respectively.

| **OPTIONS OUTSTANDING**            | ** ** | **OPTIONS CURRENTLY  EXERCISABLE** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  of Shares  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |   |
| ** **                              | ** ** | **(in thousands)**                 | ** ** | **(in years)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |   |
| $0.90 -  $4.00                          |       |                                    | 284        |   |   |   | 5.8 |   |   |   | $ | 3.71 |   |   |   | 232 |   |   |   | $ | 3.73 |   |   |   |
| $4.50 -  $5.50                          |       |                                    | 163        |   |   |   | 8.6 |   |   |   | $ | 5.03 |   |   |   | 123 |   |   |   | $ | 5.21 |   |   |   |
| $5.88 -  $7.87                          |       |                                    | 288        |   |   |   | 6.0 |   |   |   | $ | 7.07 |   |   |   | 133 |   |   |   | $ | 7.19 |   |   |   |
| $8.60 -  $12.00                         |       |                                    | 340        |   |   |   | 5.0 |   |   |   | $ | 9.91 |   |   |   | 51 |   |   |   | $ | 10.25 |   |   |   |
|                                    |       |                                    | 1,075      |   |   |   |   |   |   |   |   |   |   |   | 539 |   |   |   |   |   |   |   |
|                                         |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**1994 Employee StockPurchase Plan:**

A total of 100,000 sharesof common stock had been reserved for issuance under the 1994 Employee StockPurchase Plan. The plan permits eligible employees to purchase common stockthrough payroll deductions at a price equal to the lower of 85% of the fairmarket value of the Company’s common stock at the beginning or end of theoffering period. Employees may end their participation at any time during theoffering period, and participation ends automatically on termination ofemployment with the Company. At December 31, 2005, 90,306 shares had beenissued under this plan.

**Shareholder RightsPlan**

On September 12,2001, the Board of Directors of Fiberstars, Inc. declared a dividenddistribution of one “Right” for each outstanding share of common stock of theCompany to shareholders of record at the close of business on September 26,2002. One Right will also attach to each share of common stock issued by theCompany subsequent to such date and prior to the distribution date definedbelow. With certain exceptions, each Right, when exercisable, entitles theregistered holder to purchase from the Company one one-thousandth of ashare of a new series of preferred stock, designated as Series AParticipating Preferred Stock, at a price of $30.00 per one one-thousandthof a share, subject to adjustment. The Rights were distributed as a non-taxabledividend and expire ten years from the date of the Rights Plan. In general, theRights will become exercisable and trade independently from the common stock ona distribution date that will occur on the earlier of (i) the publicannouncement of the acquisition by a person or group of 15% or more of thecommon stock or (ii) ten days after commencement of a tender or exchangeoffer for the common stock that would result in the acquisition of 15% or moreof the common stock. Upon the occurrence of certain other events related tochanges in ownership of the common stock, each holder of a Right would beentitled to purchase shares of common stock, or an acquiring corporation’scommon stock, having a market value of twice the exercise price. Under certainconditions, the Rights may be redeemed at $0.001 per Right by the Board ofDirectors. The description and terms of 

F-21

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**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**9. Shareholders’Equity: (Continued)**

theRights are set forth in a Rights Agreement dated as of September 20, 2002between the Company and Mellon Investor Services LLC, as rights agent.

**Follow-On StockOffering**

On November 8, 2005the Company closed a follow-on offering, selling 2,500,000 new shares of CommonStock at a price of $8.25. The purchase price of the Common Stock was set at$8.25 per share on November 2, 2005, which was approximately a 5%discount on the closing price on that day. On November 11, 2005 theCompany announced that the underwriters had exercised their option to sell anadditional 452,497 shares of Common Stock for $8.25 as part of the offering. Thegross amount raised was $24.4 million from the selling of 2,952,497 new shares,before costs and expenses. The net amount received by the company afterdeducting 6% in underwriter’s fees and legal, accounting and other costs was$22.2 million.

**10. Income Taxes:**

Thecomponents of the benefit from (provision for) income taxes are as follows *(in thousands)*:

| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                                   |       |                                        |       |   |   |   |   |   |   |
| Federal                                    |       | $                                           | —     |   |   | $ | — |   |   | $ | — |   |
| Foreign                                    |       | (107                                        | )          |   | 58 |   |   | (14 | ) |
| State                                      |       | (2                                          | )          |   | — |   |   | — |   |
|                                       |       | (109                                        | )          |   | 58 |   |   | (14 | ) |
| Deferred:                                  |       |                                        |       |   |   |   |   |   |   |
| Federal                                    |       | —                                      |       |   | — |   |   | — |   |
| State                                      |       | —                                      |       |   | — |   |   | — |   |
|                                       |       | —                                      |       |   | — |   |   | — |   |
| Benefit from (provision  for) income taxes |       | $                                           | (109       | ) |   | $ | 58 |   |   | $ | (14 | ) |

 

Thefollowing table shows the geographic components of pretax income (loss) betweenUnited States and foreign subsidiaries *(in thousands)*:

| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States         |       | $                     | (7,714     | ) | $ | (813 | ) | $ | (788 | ) |
| Foreign  subsidiaries |       | 400                   |       | 51 |   | 194 |   |
|                  |       | $                     | (7,314     | ) | $ | (762 | ) | $ | (594 | ) |

 

 

F-22

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**10. Income Taxes:(Continued)**

The principal itemsaccounting for the difference between income taxes computed at the UnitedStates statutory rate and the benefit from (provision for) income taxesreflected in the statements of operations are as follows:

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States  statutory rate             |       | 34.0                  | %          | 34.0 | % | 34.0 | % |
| State Taxes (net  of federal tax benefit) |       | 5.5                   | %          | 5.5 | % | 5.5 | % |
| Valuation  allowance                      |       | (46.5                 | )%         | (28.3 | )% | (39.5 | )% |
| Other                                     |       | 5.5                   | %          | (3.6 | )% | (2.3 | )% |
|                                      |       | (1.5                  | )%         | 7.6 | % | (2.3 | )% |

 

Thetax effects of temporary differences that give rise to significant portions ofthe deferred tax assets are as follows *(in thousands)*:

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Allowance for  doubtful accounts     |       | $                     | 99         |   | $ | 84 |   | $ | 118 |   |
| Accrued expenses  and other reserves |       | 1,681                 |       | 1,227 |   | 571 |   |
| Tax credits                          |       | 194                   |       | 155 |   | 155 |   |
| Net operating  loss                  |       | 4,617                 |       | 1,699 |   | 1,519 |   |
| Deferred R&D                     |       | 158                   |       | 184 |   | 233 |   |
| Total deferred  tax asset            |       | 6,749                 |       | 3,349 |   | 2,596 |   |
| Valuation  allowance                 |       | (6,749                | )          | (3,349 | ) | (2,596 | ) |
| Net deferred tax asset               |       | $                     | —     |   | $ | — |   | $ | — |   |

 

The Company has a full valuation allowance against itsdeferred tax assets. There was a minimal tax expense for the United Statesoperations in 2005 as any expected benefit has been offset by and increase inthe valuation allowance. The $58,000 tax benefit shown for 2004 is a result ofdeferred tax for the German operations which experienced a loss in 2004 afterbeing profitable in prior years.

As of December 31, 2005, the Company has a netoperating loss carry-forward of approximately $11.9 million and$9.4 million for federal and state income tax purposes, respectively. Ifnot utilized, these carry-forwards will begin to expire in 2020 for federal and2008 for state purposes.

Under the Internal RevenueCode Section 382, the amounts of and benefits from net operating lossescarry-forwards may be impaired in certain circumstances. Events which causelimitations in the amount of net operating losses that the Company may utilizein any one year include, but are not limited to, a cumulative ownership changeof more than 50%, as defined, over a three year period.

**11. Segments andGeographic Information:**

The Company has two primary product lines: the pooland spa lighting product line and the commercial lighting product line, each ofwhich markets and sells fiber optic lighting products. The 

F-23

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**11. Segmentsand Geographic Information: (Continued)**

Company markets itsproducts for worldwide distribution primarily through independent sales representatives,distributors and swimming pool builders in North America, Europe and the FarEast.

Asummary of geographic sales is as follows *(in thousands)*:

| ** **              | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States  Domestic |       | $                                           | 19,123     |   | $ | 19,974 |   | $ | 19,171 |   |
| Other Countries         |       | 9,214                                       |       | 9,757 |   | 8,067 |   |
|                    |       | $                                           | 28,337     |   | $ | 29,731 |   | $ | 27,238 |   |

 

A summary of geographiclong-lived assets (fixed assets and goodwill) is as follows *(in thousands)*:

| ** **              | ** ** | **December 31,** | ** ** |
|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| United States  Domestic |       | $                     | 5,975      |   | $ | 4,973 |   |
| Germany                 |       | 1,506                 |       | 1,923 |   |
| Other Countries         |       | 76                    |       | 137 |   |
|                    |       | $                     | 7,557      |   | $ | 7,033 |   |

 

Asummary of sales by product line is as follows *(inthousands)*:

| ** **             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------|------------|---------------------------------------------|------------|
| ** **             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Pool and Spa  Lighting |       | $                                           | 14,744     |   | $ | 16,888 |   | $ | 14,888 |   |
| Commercial  Lighting   |       | 13,593                                      |       | 12,843 |   | 12,350 |   |
|                   |       | $                                           | 28,337     |   | $ | 29,731 |   | $ | 27,238 |   |

 

**12. Employee RetirementPlan:**

The Company maintains a401(k) profit sharing plan for its employees who meet certainqualifications. The Plan allows eligible employees to defer up to 15% of theirearnings, not to exceed the statutory amount per year on a pretax basis throughcontributions to the Plan. The Plan provides for employer contributions at thediscretion of the Board of Directors; however, no such contributions were madein 2005, 2004 or 2003.

**13. Reorganization**

In June 2005, theCompany announced its plans to close its Fremont office and consolidate most ofits operations in Solon, Ohio, where the Company already had a local salesoffice and a manufacturing facility. The relocation resulted in a restructuringcharge of approximately $3.5 million for severance payments, redundancy, leaseand inventory write-offs. The Company recognized a $3,120,000 restructuringcharge in the year ended December 31, 2005. The Company expects the totalrestructuring charge to be near expected levels, with the balance of theexpense being incurred in 2006. It is expected that the cost savings from therestructuring will be between $1.5 million and $2 million on an annual basis,with the 

F-24

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**13. Reorganization(Continued)**

savingsbeginning in Q3 of 2006. These savings will be reflected largely in reducedcost of sales with a lesser amount in operating expenses. These savings may beoffset by expense increases as a result of building production capacity andincreasing expenses for the development, sales and marketing of new products,primarily EFO.

**14. Related PartyTransactions**

The Company entered into a consulting agreement withJeffrey H. Brite, a member of its Board of Directors, effective date ofNovember 1, 2004. As a consultant under this agreement, Mr. Brite is to assistFiberstars, Inc.’s President and Vice President of Sales in identifying,contacting and making introductions to key building project personnel in aposition to facilitate the purchase of Fiberstars, Inc. products. In return,Fiberstars, Inc. is to compensate Mr. Brite with the award of an option for theacquisition of up to 40,000 shares of its common stock at a per share exerciseprice of $7.23 and with annual aggregate cash payments of $50,000 to be paid inquarterly installments during each of the years 2005, 2006 and 2007.

Gensler Architecture, Design & Planning, P.C., aNew York Professional Corporation (“Gensler”) provides contract services to theCompany in the areas of fixture design and marketing targeted at expanding themarket for the Company’s EFO® products. Mr. Jeffrey H. Brite, an employee ofGensler, is a member of the Company's Board of Directors. The Company enteredinto a three year consulting agreement with Gensler, effective December 15,2004. Gensler has agreed to assist Fiberstars’ marketing group with matters ofstructure, procedure and practices as they relate to the design, real estateand procurement communities, and to advise Fiberstars on strategies to enhanceits visibility and image within the design and construction community as amanufacturer of preferred technology. In return, Fiberstars has agreed tocompensate Gensler with a one-time cash payment of $60,750 for servicesdelivered in advance of the completion of the negotiation of the ConsultingAgreement, $50,000 annual cash payments to be paid in quarterly installments of$12,500 in arrears for each of the calendar years 2005, 2006 and 2007, and aone-time option award to acquire up to 75,000 shares of Fiberstars’ commonstock at a per share exercise price of $6.57. For the fiscal year endedDecember 31, 2005 and 2004, the Company paid Gensler $50,000 and $60,750 forservices performed.

On July 1, 2005, David Ruckert, the Company’s CEOresigned as CEO and served as President and Director through September 30, 2005afterwhich he served as director.  Mr.Ruckert signed a severance agreement with the Company which was effective July1, 2005, and which resulted in a payment of $332,076 upon his departure as anemployee, October 1, 2005.

On September 19, 2005, the Company entered into amaster services agreement and related ancillary agreements with AdvancedLighting Technologies, Inc. (“ADLT”). These agreements include developmentagreements governing the provision of research and development services by ADLTto the Company, and by the Company to ADLT, which agreements are subject topre-determined cost limitations and the ability of either party to terminatethese agreements for convenience and with proper notice, and under which theCompany expects ADLT to develop new lamps for the Company’s energy efficientlighting system known as EFO®, and ADLT expects the Company to adapt theCompany’s patented CPC optic technology to certain ADLT products; an equipmentpurchase and supply agreement governing the Company’s purchase of manufacturingequipment from ADLT and the supply of support and manufacturing services byADLT related to the purchased equipment; a mutual supply agreement 

F-25

----

**FIBERSTARS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005 and 2004**

**14. RelatedParty Transactions (Continued)**

governing the sale andpurchase of the Company’s products by ADLT and of ADLT’s products by theCompany; and a cross license agreement governing the mutual grant of rights andlicenses between the Company and ADLT for specified uses of intellectualproperty. These agreements became effective upon ADLT’s sale of certain sharesof the Company’s common stock in connection with the completion of the publicoffering of the shares of the Company’s Common Stock on November 8, 2005,as described in a registration statement on Form S-3 filed with theSecurities and Exchange Commission on September 19, 2005, in which ADLTparticipated as a selling shareholder. Purchases from ADLT were $1,478,000,$562,000 and $657,000 in 2005, 2004 and 2003. Purchases in 2005 include$1,092,000 in capital equipment. Sales to ADLT were $136,000, $280,000 and$156,000 in 2005, 2004 and 2003. Accounts receivable with ADLT were $132,000and $48,000 at December 31, 2005 and 2004 respectively. Accounts payablewere $33,000 and $114,000 at December 31, 2005 and 2004 respectively.

On September 26, 2005, the Company entered into asublease agreement with Venture Lighting International, Inc., a subsidiary ofADLT.  The sublease agreement initiallyleases 43,750 square feet of office and manufacturing space to Fiberstars inSolon, Ohio, with various options to increase the square footage to 79,625 overthe term of the lease, September 26, 2005 to December 31, 2008.  Lease payments for the initial leasedpremises are $50,116 per month and increase based on exercising options foradditional square feet and option clauses.

F-26

----

**Item 15 (continued)**

(a)          (continued)

(2)          Financial StatementSchedules

The following Financial Statement Schedule ofFiberstars, Inc. is filed as part of this Form 10-K included inItem 15(c) below:

Schedule II—Valuation and Qualifying Accounts.

All other schedulesare omitted either because they are not applicable or the required informationis shown in the financial statements or the notes thereto.

(3)     Exhibits

See Item 15 (b) below.

Each management contract or compensatory plan orarrangement required to be filed has been identified.

(c)  Exhibits

| Exhibit   Number | ** ** | **Description of Documents**                                                                                                                                                                                                                                                                         |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3(i).1           |       | Amended and Restated Articles of Incorporation of  the Registrant (incorporated by reference to Exhibit 3.1 to the  Registrant’s Annual Report on Form 10-K for the year ended  December 31, 2000).                                                                              |
| 3(i).2           |       | Certificate of  Determination of Series A Participating Preferred Stock of the  Registrant (incorporated by reference to Exhibit 3(i) to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2001).                                   |
| 3(ii)            |       | Bylaws of the  Registrant, as amended (composite copy) (incorporated by reference to  Exhibit 3(ii) to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2004).                                                                                  |
| 3.2              |       | Bylaws of the Registrant  as amended effective September 13, 2005 (composite copy)                                                                                                                                                                                                              |
| 3.3              |       | Certificate of Amendment  of Bylaws dated April 27, 2005 (incorporated by reference to the  Registrant’s Current Report on Form 8-K filed on April 27,  2005).                                                                                                                   |
| 3.4              |       | Certificate of Amendment  of Bylaws dated September 13, 2005 (incorporated by reference from  Exhibit 3(ii) to the Registrant’s Current Report on Form 8-K  filed September 19, 2005).                                                                                 |
| 4.1              |       | Form of Warrant  issued to the Underwriters in the Company’s initial public offering  (incorporated by reference to Exhibit 1.1 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                           |
| 4.2              |       | Rights Agreement dated  as of September 20, 2001 between the Registrant and Mellon Investor  Services (incorporated by reference to Exhibit 4.1 to the Registrant’s  Form 8-A filed on September 21, 2001).                                                                 |
| 4.3              |       | Amendment No. 1 to  Rights Agreement dated as of March 26, 2002, between the Registrant and  Mellon Investor Services, LLC, as rights agent (incorporated by reference to  Exhibit 4.2 to the Registrant’s Amendment No. 1 to Form 8-A  filed on April 17, 2002). |
| 4.4              |       | Form of Warrant for  the purchase of shares of Common Stock (incorporated by reference to  Exhibit 4.1 to the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended March 31, 2002).                                                                            |

----

 

| 4.5        |   | Amendment  No. 2 to Rights Agreement dated as of June 17, 2003, between the  Registrant and Mellon Investor Services, LLC, as rights agent (incorporated  by reference to Exhibit 4.1 to the Registrant’s Current Report on  Form 8-K filed on June 19, 2003).                                                                                                                                                     |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.6        |   | Amendment No. 3 to  Rights Agreement dated as of December 8, 2003, between the Registrant  and Mellon Investor Services, LLC, as rights agent (incorporated by reference  to Exhibit 4.2 to the Registrant’s Current Report on Form 8-K  filed on February 10, 2004).                                                                                                                                              |
| 10.1† |   | Form of Indemnification Agreement for directors  and officers of the Registrant (incorporated by reference to  Exhibit 10.1 to the Registrant’s Registration Statement on Form SB-2  (Commission File No. 33-79116-LA)).                                                                                                                                                                                                |
| 10.2† |   | 1988 Stock Option Plan,  as amended, and forms of stock option agreement (incorporated by reference to  Exhibit 10.2 to the Registrant’s Registration Statement on Form SB-2  (Commission File No. 33-79116-LA)).                                                                                                                                                                                                            |
| 10.3† |   | 1994 Stock Option Plan,  amended as of May 24, 2000, (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-52042) filed on December 18, 2000).                                                                                                                                                                                              |
| 10.4† |   | 1994 Employee Stock  Purchase Plan, amended as of December 7, 2000, (incorporated by  reference to Exhibit 99.3 to the Registrant’s Registration Statement on  Form S-8 (Commission File No. 333-52042) filed on  December 18, 2000).                                                                                                                                                                              |
| 10.5† |   | 1994 Directors’ Stock  Option Plan, amended as of May 23, 2001, (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-68844) filed on August 31, 2001).                                                                                                                                                                                |
| 10.6       |   | Registration Rights  Agreement dated as of June 27, 1990, between the Registrant and certain  holders of the Registrant’s capital stock, as amended by Amendment No. 1  dated as of February 6, 1991 and Amendment No. 2 dated as of  April 30, 1994 (incorporated by reference to Exhibit 10.10 to the  Registrant’s Registration Statement on Form SB-2 (Commission File  No. 33-79116-LA)). |
| 10.7       |   | Amendment No. 3 to  Registration Rights Agreement to include Warrant shares as Registerable  Securities (incorporated by reference to Exhibit 1.2 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                          |
| 10.8† |   | Stock Purchase Agreement  and related Promissory Note between David N. Ruckert and the Registrant  dated as of December 9, 1987, as amended (incorporated by reference to  Exhibit 10.14 to the Registrant’s Registration Statement on Form SB-2  (Commission File No. 33-79116-LA)).                                                                                                                              |
| 10.9† |   | Common Stock Purchase  Warrant dated as of June 27, 1988 issued by the Registrant to Philip  Wolfson (incorporated by reference to Exhibit 10.15 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                           |
| 10.10      |   | Form of Agreement  between the Registrant and independent sales representatives (incorporated by  reference to Exhibit 10.20 to the Registrant’s Registration Statement on  Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                                               |
| 10.11*     |   | Distribution Agreement  dated March 21, 1995, between the Registrant and Mitsubishi  International Corporation (incorporated by reference to Exhibit 10.18 to  the Registrant’s Annual Report on Form 10-KSB for the year ended  December 31, 1994).                                                                                                                                                                    |

----

 

| 10.12       |   | Stock Purchase  Agreement dated March 21, 1995, among the Registrant, Mitsubishi  International Corporation and Mitsubishi Corporation (incorporated by  reference to Exhibit 10.20 to the Registrant’s Annual Report on  Form 10-KSB for the year ended December 31, 1994).                                                                                           |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13       |   | Asset Purchase Agreement  dated as of November 19, 1998, by and among the Registrant,  Hillgate (4) Limited, Crescent Lighting Limited, Michael Beverly  Morrison and Corinne Bertrand (incorporated by reference to Exhibit 2.1  to the Registrant’s Current Report on Form 8-K filed on December 4,  1998).                                                |
| 10.14*      |   | Purchase and Take-over  Agreement between Frau Claudia Mann, acting for LBM Lichtleit-Fasertechnik  and Fiberstars Deutschland GmbH, represented by its Managing Director Herr  Bernhard Mann (incorporated by reference to Exhibit 10.34 to the  Registrant’s Amended Annual Report on Form 10-KSB/A for the year  ended December 31, 1998).                          |
| 10.15       |   | Multi-tenant  Industrial Triple Net Lease last executed December 1, 1998, between the  Registrant and Catellus Development Corporation (incorporated by reference to  Exhibit 10.36 to the Registrant’s Amended Annual Report on Form 10-KSB/A  for the year ended December 31, 1998).                                                                                 |
| 10.16       |   | Asset Purchase Agreement  dated as of January 14, 2000, among the Registrant and Unison Fiber  Optic Lighting Systems, LLC (incorporated by reference to  Exhibit 7(c) to Advanced Lighting Technologies, Inc.’s  Amendment No. 3 to Schedule 13D filed on March 9, 2000).                                                                              |
| 10.17       |   | Agreement and Plan of  Reorganization dated April 18, 2000, between the Registrant and Lightly  Expressed, Ltd. (VA), Lightly Expressed, Ltd. (CA), William Leaman  and Michael Weber (incorporated by reference to Exhibit 2.1 to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2000).                                    |
| 10.18*      |   | Three (3) Year  Supply Agreement dated November 30, 2000, between the Registrant and  Mitsubishi International Corporation (incorporated by reference to  Exhibit 10.30 to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2000).                                                                                                    |
| 10.19       |   | Second Amended and  Restated Investor Agreement dated January 6, 2004, by and among the  Registrant, Advanced Lighting Technologies, Inc., ADLT Series 7  Liquidating Trust and Unison Fiber Optic Lighting Systems, LLC  (incorporated by reference to Exhibit 99.1 to ADLT Series 7  Liquidating Trust’s Schedule 13D filed on January 6, 2004). |
| 10.20† |   | Consulting Agreement  effective as of October 18, 2001, between the Company and John B.  Stuppin (incorporated by reference to Exhibit 10.37 to the Registrant’s  Annual Report on Form 10-K for the year ended December 31,  2001).                                                                                                                              |
| 10.21       |   | Loan and Security  Agreement (Accounts and Inventory) as dated December 7, 2001, between  Comerica Bank-California, a California banking corporation and the  Company (incorporated by reference to Exhibit 10.38 to the Registrant’s  Annual Report on Form 10-K for the year ended December 31,  2001).                                                              |
| 10.22       |   | Common Stock and Warrant  Purchase Agreement, dated March 29, 2002, by and among the Registrant  and the investors named therein (incorporated by reference to  Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended March 31, 2002).                                                                                                 |

----

 

| 10.23       |   | Securities  Purchase Agreement dated June 17, 2003, by and among the Registrants and  the investors named therein (incorporated by reference to Exhibit 99.2  to the Registrant’s Current Report on Form 8-K filed on  June 19, 2003).                                                                       |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24       |   | Form of  Warrant by and between the Registrants and each of the investors party to the  Securities Purchase Agreement dated June 17, 2003 (incorporated by  reference to Exhibit 99.3 to the Registrant’s Current Report on  Form 8-K filed on June 19, 2003).                                          |
| 10.25† |   | Form of  Indemnification Agreement for officers of the Registrant (incorporated by  reference to exhibit 10.42 to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2003).                                                                                                             |
| 10.26       |   | Form of Indemnification  Agreement for directors of the Registrant (incorporated by reference to  exhibit 10.44 to the Registrant’s Annual Report on Form 10-K for  the year ended December 31, 2003).                                                                                                            |
| 10.27       |   | Production Share  Agreement dated October 9, 2003, by and among the Registrant, North  American Production Sharing, Inc. and Industrias Unidas de B.C., S.A. de C.V  (incorporated by reference to exhibit 10.45 to the Registrant’s Annual  Report on Form 10-K for the year ended December 31, 2003). |
| 10.28       |   | Consulting Agreement  effective as of November 1, 2004, between the Registrant and Gensler  Architecture, Design & Planning, P.C. (Incorporated by reference to  exhibit 10.28 to the Registrant’s Annual Report on Form 10-K for the year  ended December 31, 2005)                                               |
| 10.29† |   | Consulting Agreement  effective as of November 1, 2004, between the Registrant and Jeffrey H.  Brite. (Incorporated by reference to exhibit 10.29 to the Registrant’s Annual  Report on Form 10-K for the year ended December 31, 2005)                                                                                |
| 10.30       |   | Fourth Amended to Loan  and Security Agreement (Accounts and Inventory) and Amended and Restated  Inventory Rider (Revolving Advances) dated April 27, 2005, by and  between the Registrant and Comerica Bank (incorporated by reference to the  Registrant’s Current Report on Form 8-K filed on May 10,  2005). |
| 10.31       |   | Loan and Security  Agreement between Silicon Valley Bank and the Registrant, dated  August 15, 2005 (incorporated by reference from Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K filed August 18,  2005).                                                                                    |
| 10.32† |   | Employment Agreement  between the Registrant and John N. Davenport, dated July 1, 2005  (incorporated by reference from Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                              |
| 10.33† |   | Severance Agreement  between the Registrant and David N. Ruckert, dated September 16, 2005  (incorporated by reference from Exhibit 10.3 to the Registrant’s  Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                          |
| 10.34       |   | Fiberstars Development  Agreement between the Registrant and Advanced Lighting  Technologies, Inc. dated September 19, 2005 (incorporated by  reference from Exhibit 10.4 to the Registrant’s Quarterly Report on  Form 10-Q (File No. 000-24230) filed on  November 14, 2005).                    |
| 10.35       |   | ADLT Development  Agreement between the Registrant and Advanced Lighting  Technologies, Inc. dated September 19, 2005 (incorporated by  reference from Exhibit 10.5 to the Registrant’s Quarterly Report on  Form 10-Q (File No. 000-24230) filed on  November 14, 2005).                          |

----

 

| 10.36  |   | Equipment Purchase and  Supply Agreement between the Registrant and Deposition Services, Inc.  dated September 19, 2005 (incorporated by reference from  Exhibit 10.6 to the Registrant’s Quarterly Report on Form 10-Q  (File No. 000-24230) filed on November 14, 2005).                                                                                                          |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.37  |   | Cross License Agreement  between the Registrant and Advanced Lighting Technologies, Inc. dated  September 19, 2005 (incorporated by reference from Exhibit 10.7 to  the Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                                                                               |
| 10.38  |   | Master Services  Agreement between the Registrant and Advanced Lighting  Technologies, Inc. dated September 19, 2005 (incorporated by  reference from Exhibit 10.8 to the Registrant’s Quarterly Report on  Form 10-Q (File No. 000-24230) filed on  November 14, 2005).                                                                                                            |
| 10.39  |   | First Amendment to  Production Share Agreement, effective as of August 17, 2005, by and  among the Registrant, North American Production Sharing, Inc. and  Industrias Unidas de B.C., S.A. de C.V. (incorporated by reference from  Exhibit 10.1 to the Registrant’s Current Report on Form 8-K  filed October 25, 2005).                                                               |
| 10.40  |   | Sublease between Venture  Lighting International, Inc. and the Registrant dated as of  November 11, 2005 (incorporated by reference from Exhibit 10.1 to  the Registrant’s Current Report on Form 8-K (File No. 000-24230)  filed on November 17, 2005).                                                                                                                            |
| 10.41  |   | Amended and Restated  Loan and Security Agreement (together with Schedule to Amended and Restated  Loan and Security Agreement and Compliance Certificate) between  Fiberstars, Inc. and Silicon Valley Bank dated December 30, 2005  (incorporated by reference from Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K (File No. 000-24230) filed on  January 6, 2006). |
| 21.1   |   | Significant subsidiaries  of the Registrant.                                                                                                                                                                                                                                                                                                                                                                           |
| 23.1   |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                                                                                             |
| 31.1   |   | Rule 13a-14(a) Certification  by Chief Executive Officer.                                                                                                                                                                                                                                                                                                                                                    |
| 31.2   |   | Rule 13a-14(a) Certification  by Chief Financial Officer.                                                                                                                                                                                                                                                                                                                                                    |
| 32.1** |   | Statement of Chief  Executive Officer under 18 United States Code § 1350.                                                                                                                                                                                                                                                                                                                               |
| 32.2** |   | Statement of Chief  Financial Officer under 18 United States Code § 1350.                                                                                                                                                                                                                                                                                                                               |

----

*                    Confidentialtreatment has been granted with respect to certain portions of this agreement.

**             In accordance withitem 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8338and 34-47986, Final Rule: Management’s Reports on Internal Control OverFinancial Report and Certification of Disclosure in Exchange Act PeriodicReports, the certifications furnished in Exhibits 32.1 and 32.2 hereto aredeemed to accompany this form 10-K and will not be deemed “filed” forpurposes of Section 18 of the Exchange Act. Such certifications will notbe deemed incorporated by reference into any filing under the Securities Act orthe Exchange Act, except to the extent that the Registrant specificallyincorporates it by reference.

†                    Indicatesmanagement contracts or compensatory plan or arrangement.

(d)         Financial StatementSchedules

----

**SCHEDULE II**

**FIBERSTARS, INC.SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS**

| ** **                                   | ** ** | ** **                           | ** ** | ** **                                   | ** ** | ** **                   | ** ** | ** **                    | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|------------------------------|------------|-------------------------------|------------|----------------|------------|
| **Description**                              | ** ** | ** **                           | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charges  To Revenue** | ** ** | **Charges  To Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
| ** **                                   | ** ** | **(Amounts in thousands)** | ** ** |
| Year Ended  December 31, 2005           |       |                                 |       |                                         |       |                         |       |                          |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts and returns |       |                                 | $          | 381                                          |       |                         |       | $                             | —     |           |       |   | $ | 106 |   |   |   | $ | 39 |   |   |   | $ | 448 |   |   |
| Valuation  allowance for deferred tax assets |       |                                 | 3,349      |                                         |       |                         | —     |                          |       |           | 3,400      |   |   |   | — |   |   |   | 6,749 |   |   |
| Year Ended  December 31, 2004           |       |                                 |       |                                         |       |                         |       |                          |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts and returns |       |                                 | 465        |                                         |       |                         | —     |                          |       |           | 47         |   |   |   | 131 |   |   |   | 381 |   |   |
| Valuation  allowance for deferred tax Assets |       |                                 | 2,596      |                                         |       |                         | —     |                          |       |           | 753        |   |   |   | — |   |   |   | 3,349 |   |   |
| Year Ended  December 31, 2003           |       |                                 |       |                                         |       |                         |       |                          |       |           |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts and returns |       |                                 | 604        |                                         |       |                         | —     |                          |       |           | 1          |   |   |   | 141 |   |   |   | 465 |   |   |
| Valuation allowance for  deferred tax Assets |       |                                 | 2,035      |                                         |       |                         | —     |                          |       |           | 561        |   |   |   | — |   |   |   | 2,596 |   |   |
|                                              |            |                                      |            |                                              |            |                              |            |                               |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this Report to be signed on itsbehalf by the undersigned, thereto duly authorized.

|                            |   | FIBERSTARS, INC. |
|----------------------------|--------|-----------------------|
| Date: March 31,  2006 |   | By:                   |   | /s/  JOHN M. DAVENPORT |
|                       |   | * *              |   | John M. Davenport |
|                       |   | * *              |   | *Chief  Executive Officer  (Principal Executive Officer)* |

 

Inaccordance with the Securities Exchange Act of 1934, this Report has beensigned by the following persons in the capacities and on the dates indicated.

|                           | **Signature** | ** **                                     | ** ** |                     | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|---------------------------|---------------|------------------------------------------------|------------|---------------------|-----------|------------|------------|--|----------|------------|
| /s/ JOHN M.  DAVENPORT    |          | Chief Executive  Officer and Director          |       | March 31, 2006 |
| John  M. Davenport        | * *      | *(Principal Executive Officer)*                |       |                |
| /s/ ROBERT A.  CONNORS    |          | Chief Financial  Officer                       |       | March 31, 2006 |
| Robert  A. Connors        | * *      | *(Principal Financial and Accounting Officer)* |       |                |
| /s/ JOHN B.  STUPPIN      |          | Director                                       |       | March 31, 2006 |
| John  B. Stuppin          |          |                                           |       |                |
| /s/ RONALD  CASENTINI     |          | Director                                       |       | March 31, 2006 |
| Ronald  Casentini         |          |                                           |       |                |
| /s/ JEFFREY  BRITE        |          | Director                                       |       | March 31, 2006 |
| Jeffrey  Brite            |          |                                           |       |                |
| /s/ MICHAEL  KASPER       |          | Director                                       |       | March 31, 2006 |
| Michael  Kasper           |          |                                           |       |                |
| /s/ PAUL VON  PAUMGARTTEN |          | Director                                       |       | March 31, 2006 |
| Paul  Von Paumgartten     |          |                                           |       |                |
| /s/ PHILIP  WOLFSON       |          | Director                                       |       | March 31, 2006 |
| Philip Wolfson            |          |                                           |       |                |
| /s/  DAVID N. RUCKERT     |          | Director                                       |       | March  31, 2006     |
| David N. Ruckert          |          |                                           |       |                |

 

 

----

| Exhibit   Number | ** ** | **Description of Documents**                                                                                                                                                                                                                                                                         |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3(i).1           |       | Amended and Restated Articles of Incorporation of  the Registrant (incorporated by reference to Exhibit 3.1 to the  Registrant’s Annual Report on Form 10-K for the year ended  December 31, 2000).                                                                              |
| 3(i).2           |       | Certificate of  Determination of Series A Participating Preferred Stock of the  Registrant (incorporated by reference to Exhibit 3(i) to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2001).                                   |
| 3(ii)            |       | Bylaws of the  Registrant, as amended (composite copy) (incorporated by reference to  Exhibit 3(ii) to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2004).                                                                                  |
| 3.2              |       | Bylaws of the Registrant  as amended effective September 13, 2005 (composite copy)                                                                                                                                                                                                              |
| 3.3              |       | Certificate of Amendment  of Bylaws dated April 27, 2005 (incorporated by reference to the  Registrant’s Current Report on Form 8-K filed on April 27,  2005).                                                                                                                   |
| 3.4              |       | Certificate of Amendment  of Bylaws dated September 13, 2005 (incorporated by reference from  Exhibit 3(ii) to the Registrant’s Current Report on Form 8-K  filed September 19, 2005).                                                                                 |
| 4.1              |       | Form of Warrant  issued to the Underwriters in the Company’s initial public offering  (incorporated by reference to Exhibit 1.1 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                           |
| 4.2              |       | Rights Agreement dated  as of September 20, 2001 between the Registrant and Mellon Investor  Services (incorporated by reference to Exhibit 4.1 to the Registrant’s  Form 8-A filed on September 21, 2001).                                                                 |
| 4.3              |       | Amendment No. 1 to  Rights Agreement dated as of March 26, 2002, between the Registrant and  Mellon Investor Services, LLC, as rights agent (incorporated by reference to  Exhibit 4.2 to the Registrant’s Amendment No. 1 to Form 8-A  filed on April 17, 2002). |
| 4.4              |       | Form of Warrant for  the purchase of shares of Common Stock (incorporated by reference to  Exhibit 4.1 to the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended March 31, 2002).                                                                            |
| 4.5              |       | Amendment No. 2 to  Rights Agreement dated as of June 17, 2003, between the Registrant and  Mellon Investor Services, LLC, as rights agent (incorporated by reference to  Exhibit 4.1 to the Registrant’s Current Report on Form 8-K  filed on June 19, 2003).         |
| 4.6              |       | Amendment No. 3 to  Rights Agreement dated as of December 8, 2003, between the Registrant  and Mellon Investor Services, LLC, as rights agent (incorporated by reference  to Exhibit 4.2 to the Registrant’s Current Report on Form 8-K  filed on February 10, 2004).  |
| 10.1†       |       | Form of  Indemnification Agreement for directors and officers of the Registrant  (incorporated by reference to Exhibit 10.1 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                                    |
| 10.2†       |       | 1988 Stock Option Plan, as  amended, and forms of stock option agreement (incorporated by reference to  Exhibit 10.2 to the Registrant’s Registration Statement on Form SB-2  (Commission File No. 33-79116-LA)).                                                                |
| 10.3†       |       | 1994 Stock Option Plan,  amended as of May 24, 2000, (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-52042) filed on December 18, 2000).                                                  |
| 10.4†       |       | 1994 Employee Stock  Purchase Plan, amended as of December 7, 2000, (incorporated by  reference to Exhibit 99.3 to the Registrant’s Registration Statement on  Form S-8 (Commission File No. 333-52042) filed on  December 18, 2000).                                  |

----

 
| 10.5† |   | 1994 Directors’ Stock  Option Plan, amended as of May 23, 2001, (incorporated by reference to  Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8  (Commission File No. 333-68844) filed on August 31, 2001).                                                                                                                                                                                |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6       |   | Registration  Rights Agreement dated as of June 27, 1990, between the Registrant and  certain holders of the Registrant’s capital stock, as amended by Amendment  No. 1 dated as of February 6, 1991 and Amendment No. 2 dated  as of April 30, 1994 (incorporated by reference to Exhibit 10.10 to  the Registrant’s Registration Statement on Form SB-2 (Commission  File No. 33-79116-LA)). |
| 10.7       |   | Amendment No. 3 to  Registration Rights Agreement to include Warrant shares as Registerable  Securities (incorporated by reference to Exhibit 1.2 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                          |
| 10.8† |   | Stock Purchase Agreement  and related Promissory Note between David N. Ruckert and the Registrant  dated as of December 9, 1987, as amended (incorporated by reference to  Exhibit 10.14 to the Registrant’s Registration Statement on Form SB-2  (Commission File No. 33-79116-LA)).                                                                                                                              |
| 10.9† |   | Common Stock Purchase  Warrant dated as of June 27, 1988 issued by the Registrant to Philip  Wolfson (incorporated by reference to Exhibit 10.15 to the Registrant’s  Registration Statement on Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                           |
| 10.10      |   | Form of Agreement  between the Registrant and independent sales representatives (incorporated by  reference to Exhibit 10.20 to the Registrant’s Registration Statement on  Form SB-2 (Commission File No. 33-79116-LA)).                                                                                                                                                                                               |
| 10.11*     |   | Distribution Agreement  dated March 21, 1995, between the Registrant and Mitsubishi  International Corporation (incorporated by reference to Exhibit 10.18 to  the Registrant’s Annual Report on Form 10-KSB for the year ended  December 31, 1994).                                                                                                                                                                    |
| 10.12      |   | Stock Purchase Agreement  dated March 21, 1995, among the Registrant, Mitsubishi International  Corporation and Mitsubishi Corporation (incorporated by reference to  Exhibit 10.20 to the Registrant’s Annual Report on Form 10-KSB  for the year ended December 31, 1994).                                                                                                                                            |
| 10.13      |   | Asset Purchase Agreement  dated as of November 19, 1998, by and among the Registrant,  Hillgate (4) Limited, Crescent Lighting Limited, Michael Beverly  Morrison and Corinne Bertrand (incorporated by reference to Exhibit 2.1  to the Registrant’s Current Report on Form 8-K filed on  December 4, 1998).                                                                                                 |
| 10.14*     |   | Purchase and Take-over  Agreement between Frau Claudia Mann, acting for LBM Lichtleit-Fasertechnik  and Fiberstars Deutschland GmbH, represented by its Managing Director Herr  Bernhard Mann (incorporated by reference to Exhibit 10.34 to the  Registrant’s Amended Annual Report on Form 10-KSB/A for the year  ended December 31, 1998).                                                                           |
| 10.15      |   | Multi-tenant  Industrial Triple Net Lease last executed December 1, 1998, between the  Registrant and Catellus Development Corporation (incorporated by reference to  Exhibit 10.36 to the Registrant’s Amended Annual Report on Form 10-KSB/A  for the year ended December 31, 1998).                                                                                                                                  |
| 10.16      |   | Asset Purchase Agreement  dated as of January 14, 2000, among the Registrant and Unison Fiber  Optic Lighting Systems, LLC (incorporated by reference to  Exhibit 7(c) to Advanced Lighting Technologies, Inc.’s  Amendment No. 3 to Schedule 13D filed on March 9, 2000).                                                                                                                               |

----

 
| 10.17       |   | Agreement and Plan of  Reorganization dated April 18, 2000, between the Registrant and Lightly  Expressed, Ltd. (VA), Lightly Expressed, Ltd. (CA), William Leaman  and Michael Weber (incorporated by reference to Exhibit 2.1 to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2000).                                    |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18*      |   | Three (3) Year  Supply Agreement dated November 30, 2000, between the Registrant and  Mitsubishi International Corporation (incorporated by reference to  Exhibit 10.30 to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2000).                                                                                                    |
| 10.19       |   | Second Amended and  Restated Investor Agreement dated January 6, 2004, by and among the  Registrant, Advanced Lighting Technologies, Inc., ADLT Series 7  Liquidating Trust and Unison Fiber Optic Lighting Systems, LLC  (incorporated by reference to Exhibit 99.1 to ADLT Series 7  Liquidating Trust’s Schedule 13D filed on January 6, 2004). |
| 10.20† |   | Consulting Agreement  effective as of October 18, 2001, between the Company and John B.  Stuppin (incorporated by reference to Exhibit 10.37 to the Registrant’s  Annual Report on Form 10-K for the year ended December 31,  2001).                                                                                                                              |
| 10.21       |   | Loan and Security  Agreement (Accounts and Inventory) as dated December 7, 2001, between  Comerica Bank-California, a California banking corporation and the  Company (incorporated by reference to Exhibit 10.38 to the Registrant’s  Annual Report on Form 10-K for the year ended December 31,  2001).                                                              |
| 10.22       |   | Common Stock and Warrant  Purchase Agreement, dated March 29, 2002, by and among the Registrant  and the investors named therein (incorporated by reference to  Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q  for the quarter ended March 31, 2002).                                                                                                 |
| 10.23       |   | Securities Purchase  Agreement dated June 17, 2003, by and among the Registrants and the  investors named therein (incorporated by reference to Exhibit 99.2 to  the Registrant’s Current Report on Form 8-K filed on June 19,  2003).                                                                                                                                 |
| 10.24       |   | Form of Warrant by  and between the Registrants and each of the investors party to the Securities  Purchase Agreement dated June 17, 2003 (incorporated by reference to  Exhibit 99.3 to the Registrant’s Current Report on Form 8-K  filed on June 19, 2003).                                                                                                    |
| 10.25† |   | Form of  Indemnification Agreement for officers of the Registrant (incorporated by  reference to exhibit 10.42 to the Registrant’s Annual Report on Form 10-K  for the year ended December 31, 2003).                                                                                                                                                                       |
| 10.26       |   | Form of Indemnification  Agreement for directors of the Registrant (incorporated by reference to  exhibit 10.44 to the Registrant’sAnnual Report on Form 10-K for  the year ended December 31, 2003).                                                                                                                                                                       |
| 10.27       |   | Production Share  Agreement dated October 9, 2003, by and among the Registrant, North  American Production Sharing, Inc. and Industrias Unidas de B.C., S.A. de  C.V (incorporated by reference to exhibit 10.45 to the Registrant’s Annual  Report on Form 10-K for the year ended December 31, 2003).                                                                |
| 10.28       |   | Consulting Agreement effective  as of November 1, 2004, between the Registrant and Gensler Architecture,  Design & Planning, P.C. (Incorporated by reference to exhibit 10.28  to the Registrant’s Annual Report on Form 10-K for the year ended December  31, 2005)                                                                                                         |
| 10.29† |   | Consulting Agreement  effective as of November 1, 2004, between the Registrant and Jeffrey H.  Brite. (Incorporated by reference to exhibit 10.29 to the Registrant’s Annual  Report on Form 10-K for the year ended December 31, 2005)                                                                                                                                          |

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| 10.30       |   | Fourth Amended to Loan  and Security Agreement (Accounts and Inventory) and Amended and Restated  Inventory Rider (Revolving Advances) dated April 27, 2005, by and  between the Registrant and Comerica Bank (incorporated by reference to the  Registrant’s Current Report on Form 8-K filed on May 10,  2005).                                                                                  |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.31       |   | Loan and Security  Agreement between Silicon Valley Bank and the Registrant, dated  August 15, 2005 (incorporated by reference from Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K filed August 18,  2005).                                                                                                                                                                     |
| 10.32† |   | Employment Agreement  between the Registrant and John N. Davenport, dated July 1, 2005  (incorporated by reference from Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                                                                                                               |
| 10.33† |   | Severance Agreement  between the Registrant and David N. Ruckert, dated September 16, 2005  (incorporated by reference from Exhibit 10.3 to the Registrant’s  Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                                                                                                           |
| 10.34       |   | Fiberstars Development  Agreement between the Registrant and Advanced Lighting  Technologies, Inc. dated September 19, 2005 (incorporated by  reference from Exhibit 10.4 to the Registrant’s Quarterly Report on  Form 10-Q (File No. 000-24230) filed on  November 14, 2005).                                                                                                     |
| 10.35       |   | ADLT Development Agreement  between the Registrant and Advanced Lighting Technologies, Inc. dated  September 19, 2005 (incorporated by reference from Exhibit 10.5 to  the Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                                                                            |
| 10.36       |   | Equipment  Purchase and Supply Agreement between the Registrant and Deposition  Services, Inc. dated September 19, 2005 (incorporated by reference  from Exhibit 10.6 to the Registrant’s Quarterly Report on Form 10-Q  (File No. 000-24230) filed on November 14, 2005).                                                                                                          |
| 10.37       |   | Cross License Agreement  between the Registrant and Advanced Lighting Technologies, Inc. dated  September 19, 2005 (incorporated by reference from Exhibit 10.7 to  the Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)  filed on November 14, 2005).                                                                                                               |
| 10.38       |   | Master Services  Agreement between the Registrant and Advanced Lighting  Technologies, Inc. dated September 19, 2005 (incorporated by  reference from Exhibit 10.8 to the Registrant’s Quarterly Report on  Form 10-Q (File No. 000-24230) filed on November 14,  2005).                                                                                                            |
| 10.39       |   | First Amendment to  Production Share Agreement, effective as of August 17, 2005, by and  among the Registrant, North American Production Sharing, Inc. and  Industrias Unidas de B.C., S.A. de C.V. (incorporated by reference from Exhibit 10.1  to the Registrant’s Current Report on Form 8-K filed  October 25, 2005).                                                               |
| 10.40       |   | Sublease between  Venture Lighting International, Inc. and the Registrant dated as of  November 11, 2005 (incorporated by reference from Exhibit 10.1 to  the Registrant’s Current Report on Form 8-K (File No. 000-24230)  filed on November 17, 2005).                                                                                                                            |
| 10.41       |   | Amended and Restated  Loan and Security Agreement (together with Schedule to Amended and Restated  Loan and Security Agreement and Compliance Certificate) between Fiberstars, Inc.  and Silicon Valley Bank dated December 30, 2005 (incorporated by  reference from Exhibit 10.1 to the Registrant’s Current Report on  Form 8-K (File No. 000-24230) filed on January 6,  2006). |
| 21.1        |   | Significant subsidiaries  of the Registrant.                                                                                                                                                                                                                                                                                                                                                                           |
| 23.1        |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                                                                                             |
| 31.1        |   | Rule 13a-14(a) Certification  by Chief Executive Officer.                                                                                                                                                                                                                                                                                                                                                    |
| 31.2        |   | Rule 13a-14(a) Certification  by Chief Financial Officer.                                                                                                                                                                                                                                                                                                                                                    |

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| 32.1** |   | Statement of Chief  Executive Officer under 18 United States Code § 1350. |
|--------|--------|------------------------------------------------------------------------------------------|
| 32.2** |   | Statement of Chief  Financial Officer under 18 United States Code § 1350. |

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*                    Confidentialtreatment has been granted with respect to certain portions of this agreement.

**             In accordance withitem 601(b)(32)(ii) of Regulation S-K and SEC Release Nos. 33-8338and 34-47986, Final Rule: Management’s Reports on Internal Control OverFinancial Report and Certification of Disclosure in Exchange Act PeriodicReports, the certifications furnished in Exhibits 32.1 and 32.2 hereto aredeemed to accompany this form 10-K and will not be deemed “filed” forpurposes of Section 18 of the Exchange Act. Such certifications will notbe deemed incorporated by reference into any filing under the Securities Act orthe Exchange Act, except to the extent that the Registrant specificallyincorporates it by reference.

†                    Indicatesmanagement contracts or compensatory plan or arrangement.

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