**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**FORM** **10-K**


þ
            
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


**For
      the fiscal year ended December 31, 2007**


o
            
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


**For
      the transition period from** **** **to** ****




**Commission
      file number 0-24230**


**ENERGY
      FOCUS, INC.**


(Exact
      name of registrant as specified in its charter)


**DELAWARE**
            
            **94-3021850**(State
                of incorporation)
            
            (I.R.S.
                Employer Identification No.)


**32000
      Aurora Road**


**Solon,
      Ohio 44139**


(Address
      of principal executive officers, including zip code)





Registrant’s
      telephone number, including area code: **440.715.1300**





Securities
      registered pursuant to Section 12(b) of the Act: None





Securities
      registered pursuant to Section 12(g) of the Exchange Act:





Title
      of Each Class


**Common
      Stock, Par Value $0.0001**


**Series
      A Participating Preferred Stock Purchase Rights**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      by
      Rule 405 of the Securities Act of 1933. Yes o No þ




Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or 15(d) of the Exchange Act. Yes o No þ




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act during the
      preceding 12 months (or for such shorter period that the registrant was
      required to file such reports), and (2) has been subject to such filing
      requirements for the past 90 days. Yes þ No o




Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this Form 10-K. þ




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting company.


Largeaccelerated filero
            
            Accelerated
                filerþNon-accelerated
                filero(Do not check if a smaller reporting company)
            
            Smaller
                reporting companyo




Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act).


Yes o No þ





Aggregate
      market value (on basis of closing bid price)
      of voting stock held by nonaffiliates as of June 29 ,
      2007:
      $ 72,640,030




Number
      of
      the registrant’s shares
      of
      common stock outstanding
      as of February 29 ,
      2008: 11,645,719





Documents
      Incorporated by Reference




Portions
      of the proxy statement for the 2008 Annual Meeting of Shareholders to be filed
      with the Securities and Exchange Commission are incorporated by reference into
      Part III of this report.







**TABLE
      OF CONTENTS**




**PART
                1****Page**Item
                1.
            Business
            3Item
                1A.
            Risk
                Factors
            9Item
                1B.
            Unresolved
                Staff Comment Letters
            10Item
                2.
            Properties
            10Item
                3.
            Legal
                Proceedings
            10Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            10**PART
                II**Item
                5.
            Market
                for the Registrant’s Common Equity, Related Stockholder Matter and Issuer
                Purchase of Equity Securities
            12Item
                6.
            Selected
                Financial Data
            13Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operation
            14Item
                8.
            Financial
                Statements and Supplementary Data
            23Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosures
            46Item
                9A.
            Control
                and Procedures
            46Item
                9B.
            Other
                Information
            48**PART
                III**Item
                10.
            Directors,
                Executive Officers, Promoters and Control Persons of the
                Registrant
            49Item
                11.
            Executive
                Compensation
            49Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management
            49Item
                13.
            Certain
                Relationship and Related Transactions
            49Item
                14.
            Principal
                Accounting Fees and Services
            49**PART
                IV**Item
                15.
            Exhibits
                and Financial Schedule
            50Exhibit
                Index
            
            51Signatures
            
            54




2




**PART I**




**Ite****m
      1. Business**




Energy
      Focus Inc. and subsidiaries (Energy Focus) design, develop, manufacture, and
      market lighting systems for wide-ranging use in both the general commercial
      market and the pool market. Energy Focus’s patented EFO system offers energy
      savings, heat dissipation and maintenance cost benefitsof
      significanceover
      conventional lighting for multiple applications





·
            **Overview**




We
      operate within a single industry segment. Our company is engaged in the
      manufacture, marketing and installation of lighting systems where it serves
      two principal markets; commercial/industrial lighting and pool lighting. Our
      business strategy revolves around our patented and proprietary technology called
      “EFO,” which first was introduced in 2004 and since then has been well accepted
      by the market. The EFO technology is an energy-efficient alternative to MR-16
      halogen lamps and fluorescent lights used for lighting in retail and commercial
      settings. The cost savings are in the range of 80% in electricity; in addition,
      the EFO lighting provides full-spectrum light closely simulating daylight
      colors.





Our
      proprietary, large-diameter fiber cables used in EFO technology are designed
      to
      emit light either at the end of the fiber as a point of light or along the
      length of the fiber. This feature has been well regarded by architectural and
      design firms and has resulted in the winning of several design awards in 2007.
      The fiber cables have been fashioned into unique hanging pendant lights or
      purely decorative products of myriad shapes, providing an opportunity to
      beautify interior space in a distinctive way. These lights have no glare,
      voltage, or heat, and they are very aesthetically pleasing. In May 2007, our
      company was named by an Ohio-based magazine as of one of the three top companies
      for “new product development and innovation” and received the Manny Award for
      manufacturing excellence. Additionally, our EFO lights emit neither ultraviolet
      rays nor infrared rays and therefore have numerous application possibilities
      in
      art museums, art galleries, and upscale homes where protection of objects of
      art
      is an important goal.





Our
      long-term strategy is to further penetrate the lighting market, which is
      estimated to be over $100 billion in size. We believe that the available EFO
      market is over $5 billion, and our goal is to transform Energy Focus into a
      profitable company with increased sales and well-established marketing channels
      both at home and abroad. Our greatest opportunity continues to be in the
      commercial and industrial segment. The passage of the Energy Independence and
      Security Act of 2007 by President Bush created a natural market for our
      energy-efficient products. Under this act, all incandescent light bulbs must
      use
      25% to 30% less energy than today’s products by the years 2012 - 2014. Since
      many of our EFO products already are 80% more efficient than incandescent bulbs,
      our focus is to increase the public’s knowledge of our technology and to
      establish comprehensive distribution channels so that demand can be fulfilled
      quickly.





We
      will
      continue to focus on market niches where the benefits of our technology are
      most
      compelling. These market niches include retailers, department stores,
      supermarkets, marine applications, and museums. A Lighting Academy is in the
      final phase of construction in Solon, Ohio, and is expected to be completed
      during the first quarter of 2008. At the Academy, lighting specialists,
      designers, and installers will attend courses
      on EFO technology and witness the technology in a variety of application
      settings, which will further help cement our relationship with our niche
      markets.





·
            **Products**





We
      produce and market a wide variety of fiber optic lighting systems in two general
      markets: (1) commercial lighting and (2) pool lighting. We are making
      in-roads in the government and military lighting area as well. Our products
      generally fall into two broad categories—fiber optic systems and LED lighting
      systems—and all of our fiber optic lighting systems are comprised of three
      components: illuminators, fiber cables, and fixtures. In addition, we also
      produce customized components such as underwater lenses, color-changing electric
      pool lights, landscape lighting fixtures, and a line of lighted water features,
      including waterfalls and laminar-flow water fountains.





The
      key
      features of our products are as follows:




·
            Many
                of our products meet the lighting efficiency standards mandated for
                the
                year 2020.


·
            Our
                products qualify for tax incentives for commercial and residential
                consumers in certain states.


·
            Our
                products make use of proprietary optical systems that enable high
                efficiencies.


·
            Certain
                utility companies have embraced our technology as an energy-efficient
                alternative and are promoting our EFO products to their
                customers.


·
            Our
                products are presently in use in U.S. Navy ships. Installation was
                completed in 2007 on one ship, and two others were completed in 2006.


·
            The
                heat source of the lighting fixtures usually is physically separated
                from
                the lamps, providing a “cool” light. This unique feature has special
                application in grocery stores, where reduction of food spoilage and
                melting due to heat is an important goal. In 2007, Southern California
                Edison confirmed that our patented product “EFO-Ice” used only 25% of the
                energy of comparable fluorescent lighting systems and 33% of the
                energy of
                comparable LED systems.


·
            Our
                products have been featured in magazines and trade journals, including
                LD+A, Architectural Lighting, Architectural Record, Display and Design
                Ideas, and Visual Merchandising and Store Design.




3




**Key
      Features of Our EFO Technology**




*Components
      of EFO Technology:*




*Illuminator.* Most
      of
      our commercial EFO illuminators deploy our specially designed metal halide
      HID
      lamps. These lamps provide long life and maximum brightness. Our EFO technology
      efficiently can separate the light from a single metal halide lamp into multiple
      lower light levels appropriate for a wide variety of applications.




*Fiber
      Cables.* Our
      patented, large-core fiber have outstanding clarity and consistency with low
      attenuation for fiber optic lighting applications. By combining our compound
      parabolic collector, or CPC, technology with our large-core fibers, our system
      delivers light ranging from 35 to 70 lumens per watt, compared to approximately
      eight to 15 lumens per watt for a system using traditional MR-16 halogen
      lamps.




*Fixtures.* We
      produce a broad assortment of aesthetic fixtures that allow the customer to
      easily adjust the direction and beam spread of the light for optimal light
      concentration.




*Key
      Benefits of Our EFO System*




*Energy
      Efficiency.* Our
      EFO
      system can provide our customers with accent lighting that also satisfies
      government and other regulatory regulations for energy-efficient lighting.
      EFO
      technology enables customers to comply with ASHRAE-IESNA Standard 90.1 and
      Title
      24, qualify for the tax incentives available under the Energy Policy Act of
      2005, and meet LEED certification requirements without sacrificing intensity
      and
      light quality. The following table highlights the electrical savings of one
      watt
      EFO accent light compared to competing lighting technologies:




**Light Source**
            
            
            **Number**
              **equivalent**
              **in 70-Watt**
              **EFO**
            
            
            **Total Watts**
            
            
            **Estimated Energy**
              **Savings
                %**70W
                EFO HID accent light
            
            
            1
            
            
            70W
            
            
            —26W
                compact fluorescent down light
            
            
            4
            
            
            104W
            
            
            33
            %25W
                ceramic metal halide accent light
            
            
            5
            
            
            125W
            
            
            44
            %50W
                MR-16 halogen accent light
            
            
            8
            
            
            400W
            
            
            83
            %60W
                incandescent down light
            
            
            7
            
            
            420W
            
            
            83
            %




The
      EFO
      technology delivers over 80% energy savings versus halogen or other incandescent
      lighting systems commonly used in similar applications. For example, Cinemark
      Theaters (a nationwide movie theater chain) reduced its energy consumption
      from
      5,140 watts to 1,120 watts by installing our EFO systems in selected
      facilities.




*Color.* Today,
      our EFO system is available in a range of color temperatures and renderings
      consistent with the lighting industry, which includes color temperatures of
      warm
      white (3,000k), neutral white (3,500k), cool white (4,100k), and daylight
      (5,500k). Both 70+ CRI and an 80+ CRI option is available. CRI is a measure
      of
      the degree of color shift that objects undergo when illuminated by the light
      source as compared with those objects when illuminated by a reference source
      of
      comparable correlated color temperature. The maximum CRI is 100. The warm white
      lamps have a color temperature that is suitable for interior space, while the
      daylight color temperature matches the color temperature of the light entering
      spaces through windows. Because we control the design of the lamp, reflector,
      and fixture, we can tune the system to deliver a balanced, full-spectrum white
      light.




*Elimination
      of Virtually all Heat Radiation.* Our
      EFO
      system is designed to prevent the infrared and ultraviolet radiation emitted
      by
      the lamp from being funneled through the fiber. As a result, the light output
      emits virtually no infrared or ultraviolet light, which produce heat when
      absorbed by the target, and the only heat generated is from light output itself,
      which is negligible. In contrast, halogen lamps produce approximately nine
      watts
      of heat energy for every one watt of light.




*Cost
      Savings.* Our
      EFO
      system significantly is able to reduce maintenance and replacement costs that
      normally are attributed to traditional lighting systems. Our EFO systems contain
      lamps with a long life cycle and need fewer lamps to light a given area. For
      example, a customer would have to replace 20-40 MR-16 halogen lamps for every
      one EFO lamp annually, based on average retail usage. In addition, because
      the
      EFO lamp is physically separated from the light fixture, when used in
      applications such as freezer cases, the quality of light and the life of the
      EFO
      lamp are not affected by the freezing temperature. The EFO lamp does not radiate
      heat in the freezer and the freezer does not need to be emptied to change the
      lamp, as is the case with fluorescent lamps.




**Strategy**




Our
      objective is to become the leading provider of energy-efficient lighting
      systems. To achieve this objective, we intend to pursue the following
      strategies:




·
            *Capitalize
                on the growing need for low-cost, energy-efficient lighting systems.*We
                intend to continue to devote significant resources to our product
                development efforts to maximize the energy efficiency and quality
                of our
                lighting systems while reducing costs and enabling our customers
                to meet
                more stringent government regulations. Further, we plan to continue
                to
                develop new proprietary technologies and integrate new and potentially
                more efficient lighting sources into our lighting
                systems.




·
            *Focus
                on increased market penetration where the benefits of our technology
                are
                most compelling.*We
                intend to broaden the penetration of our products within retail and
                supermarket operators, who share similar needs for highly efficient,
                flexible accent lighting solutions. To reach our target markets,
                we also
                intend to focus our direct sales force of experienced lighting salespeople
                on selected markets and niches.




4




·
            *Develop
                and expand strategic relationships.*To
                expedite the awareness of our EFO technology, we actively are pursuing
                strategic relationships with distributors, lighting designers, and
                contractors who distribute, recommend, and/or install lighting systems.
                We
                also are cultivating relationships with fixture manufacturers and
                other
                participants in the general lighting market. For example, we have
                entered
                into two strategic distribution relationships with TCP, Inc. and
                Eco
                Engineering to further enhance our penetration into certain broad-based
                lighting markets. Additionally, we are in the final stages of completing
                the Lighting Academy in Solon, Ohio, where lighting specialists,
                designers
                and installers will be able to attend courses on EFO lighting technology
                and installation as well as view our energy-efficient technology
                in a
                variety of applications and
                settings.




**Sales,
      Marketing, and Distribution of our Products**




Our
      products are sold through a combination of a direct sales force paid on
      commission, independent sales representatives, and various distributors in
      different geographic markets throughout the world. Our distributors’obligation
      to us is not contingent upon the resale of our product and as such does not
      prohibit revenue recognition.We have been successful in hiring
      experienced salespeople from leading firms in the industry. As of
      December 31, 2007, we had approximately 140 sales and independent sales
      representatives throughout the United States and Europe. In 2007, the position
      of vice president of sales and marketing (pool products) was filled by Steve
      Gasperson, an individual with eight years of experience with the company. He
      is
      a marketing expert with over twenty years of relevant experience, and in his
      new
      role, he will be overseeing the ongoing expansion of pool lighting
      products.





Within
      the commercial lighting business unit, we are focusing our efforts on large
      retailers, and our recent successes include the “W” Hotels, Wal-Mart (Mexico),
      Bath and Body Works, and significant expansions into Albertson’s Food Retailers
      and Whole Foods. Our typical sales process includes a testing phase, which
      starts with a demonstration of our products to key executives, followed by
      a
      prototype installation in one store and then to multiple stores. Finally, we
      install in all of the stores within the same chain.





Our
      ten
      largest customers accounted for 28% of our net sales. In 2007, there was no
      single customer who accounted for more than 10% of net sales.




**Manufacturing
      and Suppliers**




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





Some
      of
      our products are manufactured off shore, resulting in cost savings. Under a
      Production Share Agreement initiated in 2003 and renewed in August 2007, we
      conduct contract assembly in Mexico through North American Production Sharing
      Inc. and Industrias Unidas de BC, SA de CV, or North American. Under this
      agreement, North American provides administrative and manufacturing services,
      including labor services and the use of manufacturing facilities in Mexico,
      for
      the manufacturing and assembly of certain fiber optic systems and related
      equipment and components. Since 2004, we have been assembling products from
      ECDS, located in Cochin, India. These products are received on a purchase order
      basis, primarily by ocean shipment, and, in some cases, by air
      freight.





We
      manufacture our large core fiber products in our Solon, Ohio,
      facility, using
      either an extrusion process or a cast process.





Mitsubishi
      currently is the exclusive supplier of our small-diameter stranded fiber. In
      sales volume, our products that incorporate small-diameter stranded fiber
      historically have been the single largest fiber product that we sell and
      represent significant sales volume. We expect to maintain our relationship
      with
      Mitsubishi for the supply of small-diameter fiber.





Advanced
      Lighting Technologies, Inc. (ADLT), a leading supplier of metal halide light
      sources, has a collaborative relationship with Energy Focus. We rely on ADLT
      for
      furnishing of our lamps, reflectors, and power supplies. In April 2006, we
      entered into several new agreements with ADLT regarding mutual development
      collaboration for the continued improvement in our lamp technology and for
      support of our coating technologies. These agreements also provided for the
      purchase of certain coating equipment, the provision to us of certain other
      services, the continued supply to us of products manufactured by ADLT, and
      a
      cross-license of certain intellectual property.




**Research
      and Development**




Research
      and development has been a key focus of our company; accordingly, we have
      committed substantial resources to it. Our R&D team, located in Ohio, is
      dedicated to continuous improvement and innovation of EFO systems. We also
      have
      engineers based in California, focused on development of pool products.




We
      purchased the base technology of the EFO system in 2000 from Unison Fiber Optic
      Lighting Systems, LLC. Subsequently, we won government awards and contracts
      and
      now have proprietary and commercial rights on the technology developed from
      those government contracts.




Research
      and development expense for the years ended December 31, 2007, 2006, and 2005
      were $2,907,000, $2,341,000, and $2,190,000, respectively, net of credits from
      the government.




5




Our
      recent achievements include:




**2007:** In
      August
      2007, the VHESC Consortium (Very-High-Efficiency Solar Cells) reported a world
      record of 42.9% conversion efficiency on photovoltaic devices (PV). Energy
      Focus
      is a member of this consortium, and these solar cells make use of our
      proprietary optics technology. In November, we were awarded a $1-million
      contract with Dupont to develop advanced solar cell technologies. Additionally,
      we were awarded additional Phase II contracts for two Defense Advance Research
      Project Agency (DARPA) Small Business Innovation Research (SBIR) projects to
      research lamp coating technologies and an extruded, large-core fiber processing
      method. The two DOE Phase II contracts are for a total of $1,500,000. Lastly,
      we
      were awarded the prestigious DARPA Tech Award for Excellence in recognition
of
      our outstanding achievement for bridging the technology gap between inefficient
      traditional light sources and advanced high-efficiency light
      systems.




**2006:** We
      entered into a DARPA agreement with the Navy for supplying our lighting on
      three
      ships. Revenues from these ship installations totaled $1,979,000.




**2005:** We
      won a
      Phase II SBIR Award from the Department of Energy for an additional $1,500,000.
      These additional awards were for the continuation of work originally won in
      2004, incorporating additional R&D work on an instant version of EFO, and
      developing a fast cure for the fiber production process.




In
      October, we also won initial SBIR funding from the Department of Defense under
      DARPA totaling $200,000 to further explore improvements to lamp coatings and
      to
      further research materials and processing techniques for the company’s
      continuously extruded large-core fiber processing method.




In
      September, we entered into a third-party agreement with ADLT, where ADLT would
      provide consulting and other R&D services. This step augmented our internal
      research department efforts with several collaborations with suppliers and
      other
      third parties.




**2004:** In
      June,
      we won two Phase I SBIR Awards from the Department of Energy. One
      award
      was for work on an instant version of EFO, and the other was to develop a fast
      cure for the fiber production process. These
      awards were for an initial amount of $200,000 to cover two years of the project
      completion phase.




Also
      in
      June, we received $1,000,000 in funding from DARPA. This project had certain
      milestones that had to be achieved within a given timeframe for developing
      an
      LED version of the HED lighting for the EFO system. We achieved both milestones
      and received the full $1,000,000 at the end of 2005.




**Intellectual
      Property**




We
      believe that the success of our business depends primarily on our technical
      innovations, marketing abilities, and responsiveness to customer requirements,
      rather than on patents, trade secrets, trademarks, copyrights, and other
      intellectual property rights. Nevertheless, we have a policy of seeking to
      protect our intellectual property through patents, license agreements, trademark
      registrations, confidential disclosure agreements, and trade secrets. As of
      December 31,2007, our intellectual property portfolio consisted of 51 issued
      United States and foreign patents, various pending United States patent
      applications, and various pending Patent Cooperation Treaty, or PCT, patent
      applications filed with the World Intellectual Property Organization that serve
      as the basis of national patent filings in countries of interest. A total
      of 28 applications are pending. As of March 11, 2008, our intellectual
      property portfolio consisted of 58 issued United States and foreign patents,
      various pending United States patent applications, and various pending Patent
      Cooperation Treaty, or PCT, patent applications filed with the World
      Intellectual Property Organization that serve as the basis of national patent
      filings in countries of interest. A total of 51 applications are pending.
      Our issued patents expire at various times between August 2008 and June
      2025. Generally, the term of patent protection is 20 years from the
      earliest effective filing date of the patent application. There can be no
      assurance, however, that our issued patents are valid or that any patents
      applied for will be issued. There can be no assurance that our competitors
      or
      customers will not copy aspects of our fiber optic lighting systems or obtain
      information that we regard as proprietary. There also can be no assurance that
      others will not independently develop products similar to ours. The laws of
      some
      foreign countries in which we sell or may sell our products do not protect
      proprietary rights to products to the same extent as do the laws of the United
      States.





We
      are
      aware that a large number of patents and pending patent applications exist
      in
      the field of fiber optic technology and LED lighting. We are also aware that
      certain competitors hold and have applied for patents related to fiber optic
      lighting and LED lighting. Although, to date, we have not been involved in
      litigation challenging our intellectual property rights, we have in the past
      received communications from third parties asserting rights over our patents
      or
      that our technology infringes intellectual property held by such third parties.
      Based on information currently available to us, we do not believe that any
      such
      claims involving our technology or patents are meritorious. However, we may
      be
      required to engage in litigation to protect our patent rights or to defend
      against the claims of others. There can be no assurance that third parties
      will
      not assert claims that our products infringe third-party patents or other
      intellectual property rights or that, in case of a dispute, licenses to such
      technology will be available, if at all, on reasonable terms. In addition,
      we
      may need to take legal action to enforce our intellectual property rights in
      the
      future. In the event of litigation to determine the validity of any third-party
      claims or claims by us against third parties, such litigation, whether or not
      determined in our favor could result in significant expense to us and divert
      the
      efforts of our technical and management personnel from productive tasks. Also,
      in the event of an adverse ruling in such litigation, we might be required
      to
      expend significant resources to develop non-infringing technology or to obtain
      licenses to the infringing technology, and the licenses may not be available
      on
      acceptable terms. In the event of a successful claim against us and our failure
      to develop or license a substitute technology, our operating results could
      be
      adversely affected.




**Backlog**




We
      typically ship standard products within a few days after receipt of order.
      Custom products are shipped within 30-60 days of receipt of order. Generally,
      there is not a significant backlog of orders except at year-end. Our backlog
      at
      the end of 2007 was $983,000, compared to $1,143,000 at the end of
      2006.




6




**Competition**




Our
      products compete with conventional electric lighting systems and with a variety
      of lighting products, including conventional light sources such as incandescent
      light bulbs as well as metal halide lamps, LEDs, compact fluorescent
      lamps , and
      decorative neon lighting. Our EFO systems compete with conventional electrical
      lighting systems, other fiber optic lighting systems, and alternative
      energy - efficient
      lighting products such as compact fluorescent lighting. Our traditional
      commercial lighting products compete with other lighting products primarily
      in
      the areas of down lighting, accent lighting , and
      signage lighting. Our pool lighting products compete with other sources of
      pool
      lighting in the areas of in-pool lighting, including colored and
      color - changing
      underwater lighting, and pool accent lighting. Principal competitive factors
      include price, performance, ease of installation , and
      maintenance requirements.




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




We
      expect
      that our ability to compete effectively with conventional lighting technologies,
      other fiber optic lighting products and new lighting technologies that may
      emerge will depend substantially upon achieving greater performance and reducing
      the cost of our EFO systems. Principal competitors in the EFO market include
      large lamp manufacturers and lighting fixture companies whose financial
      resources substantially exceed ours. These conventional lighting companies
      may
      introduce new or improved products that may reduce or eliminate some of the
      competitive advantages of our products. We anticipate that the
      primary competition to our EFO systems will come from new technologies that offer
      increased energy efficiency, lower maintenance costs and/or lower heat
      radiation. In certain applications we compete with LED systems produced by
      large
      lighting companies such as Phillips and General Electric.




In
      traditional commercial lighting, we compete primarily with local and regional
      lighting manufacturers that, in many cases, are more established in their local
      markets than we are. In traditional commercial lighting, fiber optic lighting
      products are offered by a number of smaller companies, some of which compete
      aggressively on price. Some of these competitors offer products with performance
      characteristics similar to those
      of our
      products. Additionally, some conventional lighting companies now manufacture
      or
      license fiber optic lighting systems that compete with our products. Schott,
      a
      German glass fiber company, markets fiber optic systems in the United States.
      Many companies compete with us in Asia, including Phi l lips,
      Mitsubishi, Bridgestone ,
      and
      Toray. Mitsubishi also sells our BritePak fiber cables in Japan. In addition,
      we
      compete with Toray in the stranded, small - diameter
      optical fiber in the special effects lighting market.




In
      the
      pool market, we face competition from suppliers and distributors who bundle
      lighting and non-lighting products and sell these packages to pool builders
      and
      installers. In addition, we face competition directly from manufacturers who
      produce their own lighting systems and components. For example, in the pool
      market, competitive products are offered by Pentair’s American Products
      Division, a major manufacturer of pool equipment and supplies, as well as Super
      Vision International. In the spa business, spa manufacturers install LED
      lighting systems during the manufacturing process. We intend to develop new
      fiber optic lighting products that are complementary to traditional pool lights
      currently sold by pool equipment suppliers. To maximize the sales of these
      new
      products, we plan to leverage our well-established presence in the pool lighting
      market.




**Employees**




As
      of
      December 31, 2007, we had 102 full-time employees, 19 of whom are located
      in the United Kingdom, 12 in Germany, and 71 in the U.S.A. We have 26 employees
      dedicated to developing technology, research, and product development. We also
      have 20 people involved with sales and sales support.





No
      employees are subject to any collective bargaining agreement, and we believe
      our
      employee relations to be good.





**Business
      Segment**




The
      company operates in a single industry segment where it serves two principal
      markets; commercial/industrial lighting and pool lighting. It markets its
      products for worldwide distribution primarily through independent sales
      representatives and distributors in North America, Europe, and the Far
      East.




**Available
      Information**




Our
      Web
      site is *http://www.energyfocusinc.com* .
      We make
      available free of charge, on or through our Web site, our annual, quarterly,
      and
      current reports, as well as any amendments to those reports, as soon as
      reasonably practicable after electronically filing such reports with the SEC.
      Information contained on our Web site is not part of this report.




7




**FORWARD-LOOKING
      STATEMENTS**





When
      used
      in this report, the words “expects,” “anticipates,” “estimates,” “plans,”
“intends,” and similar expressions are intended to identify forward-looking
      statements. These statements include, but are not limited to, statements as
      to
      our competitive position; future operating results; net sales growth; expected
      operating expenses and capital expenditures; gross product margin improvement;
      sources of revenues; anticipated credits from government contracts; product
      development and enhancements; liquidity and cash reserves; our reliance upon
      a
      limited number of customers; our accounting policies; the effect of recent
      accounting announcements; the development and marketing of new products;
      relationships with customers and distributors; relationships with, dependence
      upon, and the ability to obtain components from suppliers; as well as our
      remarks concerning our ability to compete in the fiber optic lighting market;
      the evolution and future size of the fiber optic lighting market; seasonal
      fluctuations; plans for and expected benefits of outsourcing and offshore
      manufacturing; trends in the price and performance of fiber optic lighting
      products; the benefits and performance of our lighting products; the adequacy
      of
      our current facilities; our strategy with regard to protecting our proprietary
      technology; our ability to retain qualified employees; and the risks set forth
      below under Item 1A, “Risk Factors.” These forward-looking statements speak only
      as of the date hereof. We expressly disclaim any obligation or undertaking
      to
      release publicly any updates or revisions to any forward-looking statements
      contained herein to reflect any change in our expectations with regard thereto
      or any change in events, conditions, or circumstances on which any such
      statement is based.


Fiberstars®,
      BritePak®, OptiCoreTM, Lightly Expressed®, Jazz LightTM, FX LightTM, FX Spa LightTM,
      Fiberstars EFO®, and E-enlightened Innovations TM, are our registered trademarks.
      We also refer to trademarks of other corporations and organizations in this
      document.




All
      references to “Energy Focus,” “we,” “us,” “our,” or “the company” means Energy
      Focus, Inc. and its subsidiaries, except where it is made clear that the
      term means only the parent company.




8


**Item
      1A. Risk Factors** ****




**Global
      Economic Risk** :
      The c ompany
      may be adversely impacted by weakness in general economic conditions including
      the onset of recession
      and increase in inflation. General recession may contribute towards our
      inability to increase sales, whereas inflation may cause the cost of material
      and labor to go up. Specifically, the downturn in housing construction may
      adversely affect the sale of pool products, whereas the consumer credit crunch
      may cause retail sales to decrease, thereby halting further construction of
      retail outlets—our primary commercial market.




We
      have
      significant international activities and customers and plan to continue these
      efforts. This subjects us to additional business risks, including logistical
      complexity, political instability, and the general economic conditions in those
      markets. Because the market for our products tends to be highly dependent upon
      general economic conditions, a decline in general economic condition likely
      would harm our operating results.




Risks
      we
      face in conducting business internationally include the following:




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




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




·
            difficulties
                and costs in recruiting and retaining individuals skilled in international
                business operations;




·
            increased
                costs associated with maintaining international marketing
                efforts;




·
            potentially
                adverse tax consequences; political and economic instability, including
                wars, acts of terrorism, political unrest, boycotts, curtailments
                of
                trade, and other business restrictions;
                and




·
            currency
                fluctuations.




In
      addition, we face additional risks in the Asia/Pacific region associated with
      disease, increased political tensions between countries
      in that region ,
      potentially reduced protection for intellectual property rights,
      government-fixed foreign exchange rates, relatively
      uncertain legal products, and developing telecommunications infrastructures.
      In
      addition, some countries in this region, such as
      China, have adopted laws, regulations, and policies that impose additional
      restrictions on the ability of foreign companies to conduct business in that
      country or otherwise place them at a competitive disadvantage in relation to
      domestic companies.




**Liquidity
        Risk:** The
        company has incurred net losses in each of the past five years. The $11,300,000
        loss in 2007 has been the largest loss in the company’s history. Throughout
        those years, the company has relied upon its cash reserves and current assets,
        provided by equity financing, along with bank credit to furnish funds for
        operations and development and make up for the absence of positive cash flow.
        In
        2007, management instituted several measures to reverse the trend of losses,
        including determined expense reduction and the hiring of a new chief financial
        officer, as well as the development and implementation of a strategic sales,
        marketing, and long-term growth strategy. Management is concerned, however,
        that
        despite continuing efforts to increase income and manage expenses, the company
        may not have sufficient cash and liquid assets to remain in business throughout
        2008 without obtaining additional external financing. Therefore, management
        intends to pursue the raising of additional financing in 2008. On March 14,
        2008, the company raised approximately $9,500,000 in equity financing, net
        of
        expenses, in a private placement of shares of common stock and warrants to
        existing shareholders. This additional financing will be used to fund working
        capital, pay debt and perform additional research and development. The
        company received the funds on March 17, 2008. Management believes that
        this additional financing, when combined with current cash reserves and current
        assets, will be sufficient to fund on-going operations for the next 12
        months.




**Competitive
      Risk** :
      Competition continues to increase in the commercial decorative, accent, and
      pool
      lighting markets, as well as in the energy-efficient lighting markets. A number
      of companies
      offer directly competitive products, including color halogen lighting for
      swimming pools and incandescent and fluorescent lighting
      for commercial decorative and accent lighting. We also compete with LED products
      in water lighting and other lighted signs. In addition, many of our competitors
      in the pool market bundle their lighting products with other pool- related
      products, which many customers find to be an attractive alternative. Our
      competitors include large and well-established companies such as General
      Electric, Sylvania, Philips, Schott, 3M, Bridgestone, Pentair, Mitsubishi,
      and
      OSRAM/Siemens.




Furthermore,
      many of our competitors have substantially greater financial, technical, and
      marketing resources than we do. We may not be able to adequately respond to
      technological developments or fluctuations in competitive pricing. We anticipate
      that any future growth in energy-efficient lighting will be accompanied by
      continuing increases in competition, which could adversely affect our operating
      results if we cannot compete effectively. To stay competitive, we must continue
      to allocate sufficient resources to research and development, which could
      negatively impact our gross margins. If we are unable to provide more efficient
      lighting technology than our competitors do, our operating results will be
      adversely affected.




**Technological
      Risk** :
      The EFO
      system offers a new full-spectrum lamp for use in retail stores. However, since
      the technology used is fairly untested we may need to incorporate certain design
      changes before it becomes widely applicable. Also, a substantial portion of
      our
      R&D resources have been devoted to the development of EFO technologies. If
      future revenue generation is not ramped up, we may not be able to off-set the
      cost involved in developing these technologies.




In
      the
      past, we have experienced design defects and product failure. Our EFO systems
      experienced defects related to the power supply in the illuminator, and our
      pool products experienced defects with our circuit sequencing color wheel.
      We
      cannot guarantee that we will not experience defects or compatibility issues
      in
      components or products in the future. Errors or defects in our products also
      could result in product liability claims. We estimate warranty and other returns
      and accrue reserves for such costs at the time of sale. Any estimates, reserves,
      or accruals may be insufficient to cover sharp increases in product returns,
      and
      such returns may harm our operating results.




**Supplier
      Risk:** The
      company currently buys all of its small diameter stranded fiber, the main
      component of its product, from one supplier. The company also relies on a sole
      supplier for certain lamps, reflectors, remote control devices, and power
      supplies. In the event of disruption in the supply chain, the company may incur
      losses due to delay or cancellation of orders.




9




**Facility
      Risk:** The
      large-core fiber manufacturing unit is housed in a single facility in Solon,
      Ohio. Moreover, only one machine is able to produce the patented fiber optics
      used in a majority of EFO products. In the event of physical damage or any
      other
      event leading to the temporary shut down of the unit, we may not be able to
      meet
      our pending production schedule. This, is turn, may adversely affect our revenue
      generation process, thereby negatively impacting net income.




**Third-Party
      Risk:** Three
      strategic pieces of equipment are operated by third parties. Failure to properly
      maintain the equipment and/or the creation of any delays or inabilities to
      meet
      our production requirements on the part of any of these suppliers will result
      in
      disruption of promised delivery to our clients.




**Credit
      Risk:** The
      company sells its products primarily through distributors and contractors in
      North America, Europe, and the Far East. While the company performs periodic
      credit evaluations of its customers, it generally does not require collateral.
      The company therefore faces credit risk in the event that its customers are
      unable to pay. The company maintains an allowance for potential credit loss
      as a
      buffer against this risk.




**Intellectual
      Property Risk** :
      As of
      December 31, 2007, our intellectual property portfolio consisted of 51 issued
      United States and foreign patents, various pending United States patent
      applications, and various pending Patent Cooperation Treaty, or PCT, patent
      applications filed with the World Intellectual Property Organization that serve
      as the basis of national patent filings in countries of interest. As of December
      31, 2007 a total of 28 applications were pending.





Our
      issued patents expire at various times between August 2008 and June 2025.
      Generally, the term of patent protection is 20 years from the earliest
      effective filing date of the patent application.





There
      can
      be no assurance, however, that our issued patents are valid or that any patents
      applied for will be issued. There can be no assurance that our competitors
      or
      customers will not copy aspects of our fiber optic lighting systems or obtain
      information that we regard as proprietary. There also can be no assurance that
      others will not independently develop products similar to ours. The laws of
      some
      foreign countries in which we sell or may sell our products do not protect
      proprietary rights to products to the same extent as do the laws of the United
      States .




**Key
      Employee Risk:** Our
      future success will depend to a large extent on the continued contributions
      of
      certain employees, such as our current chief executive officer, chief financial
      officer, chief operations officer, and chief technical officer. These and other
      key employees would be difficult to replace. Our future success also will depend
      on our ability to attract and retain qualified technical, sales, marketing
      and
      management personnel, for whom competition is very intense. The loss of—or
      failure to attract, hire, and retain— any such persons could delay product
      development cycles, disrupt our operations or otherwise harm our business or
      results of operations. In addition, we plan to restructure our internal sales
      force to generate more sales. However if this plan is not implemented well,
      then
      planned sales may not occur, and the anticipated revenues may not be
      realized.




**Risk
      of Losing Governmental Funding for Research:** Historically, approximately 54% of our EFO research and development efforts
      have
      been supported directly by government funding. In 2007, approximately 46% of
      our
      EFO research and development funding came from government sources and was
      contracted for short periods, usually one to two years. If government funding
      is
      reduced or eliminated, there is no guarantee that we would be able to continue
      to fund our research and development efforts in EFO technology and products
      at
      their current levels, if at all. If we are unable to support our EFO research
      and development efforts, there is no guarantee that we would be able to develop
      enhancements to our current products or develop new products.




**Litigation
      Risk:** At
      any
      given time, the company may be subject to litigation, the disposition of which
      may have a material adverse effect upon our business, financial condition,
      or
      results of operation. Information regarding the company’s current legal
      proceeding is presented in Part I, Item 3.





**Foreign
      Risk:** We use
      plants in Mexico, India, and Taiwan to manufacture and assemble many of our
      pool
      products. The supply of these finished goods may be impacted by local political
      or social conditions as well as the financial strength of the companies with
      which we do business.





**Item
      1B. Unresolved Staff Comment Letters**





None




**Item
      2. Property**




Our
      principal executive offices and commercial lighting manufacturing and assembly
      facilities are located in a 79,000 square foot facility in Solon, Ohio, under
      a
      lease agreement expiring in 2011. 10,000 square feet of this space is subleased
      to another tenant through June 2008. We also have leased sales facilities in
      Pleasanton, California, and Berkshire, United Kingdom. We also own a
      sales/assembly facility in Berching, Germany. In addition, we have a contract
      manufacturing facility near Tijuana, Mexico. We believe that our current
      facilities are adequate to support our current and anticipated
      operations.




**Item
      3. Legal Proceedings**




From
      time
      to time ,
      we
      occasionally become involved in ordinary routine litigation incidental to our
      business. We currently are not involved in any material litigation, and we
      do
      not anticipate becoming involved in any in the foreseeable
      future.




**Item
      4. Submission of Matters to a Vote of Security Holders**




During
      the fourth quarter of the year ended December 31, 2007, there
      were no matters submitted to a vote of security holders.




10




**Supplemental
      Item: Executive Officers of the Registrant**




Pursuant
      to Form 10-K, General Instructions G (3), the following information on Executive
      Officers is included as an additional item in Part I:




Name
            
            Age
            
            Current
                Position and Business Experience**John
                Davenport**
            
            62
            
            **Chief
                Executive Office and Director**-
                July 2005 to present. Chief Operating Officer - July 2003 to July
                2005.
                Vice President and Chief Technology Officer - November 1999 to July
                2003.
                Prior to joining Energy Focus, Mr. Davenport served as the president
                of
                Unison Fiber Optic Lighting Systems, LLC from 1998 to 1999. Before
                that,
                Mr. Davenport served at GE Lighting in various capacities for 25
                years.**Nicholas Berchtold**
            
            41
            
            **Chief
                Financial Officer and Vice President of Finance**-
                July 31, 2007, to present. Prior to joining Energy Focus, Mr. Berchtold
                was the division controller at Wellman Products Group, a division
                of Hawk
                Corporation, from 2000 to 2007, where he was responsible for global
                financial reporting and analysis. Additionally, he served as the
                corporate
                assistant controller at Olympic Steel, Inc. from 1997 to
                2000.**Roger
                Buelow**
            
            35
            
            **Chief
                Technology Officer, General Manager, and Vice President**-
                July 2005 to present. Vice President Engineering from February 2003
                to
                July 2005. Prior to joining Energy Focus, Mr. Buelow was the director
                of
                engineering at Unison Fiber Optic Lighting Systems, LLC from 1998
                to
                1999.**Eric
                Hilliard**
            
            40
            
            **Chief
                Operating Officer**-
                November 2006 to present. Business Manager at Saint Gobain - Flight
                Structures Business from 2002 to 2006. Additionally, he served at
                Goodrich
                Aerospace Company and HJ Heinz Company for 7 years from 1994 to
                2002




11




**PART II**




**Item
      5. Market for the Registrant’s Common Equity and Related Stockholder
      Matters**




Our
      common stock trades on the Nasdaq National Market under the symbol “EFOI.” The
      following table sets forth the high and low sales prices for our common stock
      from its consolidated transaction reporting system.





**High**
            
            **Low**First
                quarter 2006
            
            $
            9.33
            
            $
            7.61Second
                quarter 2006
            
            
            9.09
            
            
            6.91Third
                quarter 2006
            
            
            8.85
            
            
            6.75Fourth
                quarter 2006
            
            
            7.95
            
            
            5.42First
                quarter 2007
            
            $
            8.75
            
            $
            5.20Second
                quarter 2007
            
            
            7.52
            
            
            5.60Third
                quarter 2007
            
            
            7.85
            
            
            4.60Fourth
                quarter 2007
            
            
            9.95
            
            
            4.80




There
      were approximately 108 holders of record of our common stock as of February
      29,
      2008, and we estimate that at that date there were approximately 800 additional
      beneficial owners.





We
      have
      not declared or paid any cash dividends and do not anticipate paying cash
      dividends in the foreseeable future .




**Stockholder
      Matters**




There
      were no reportable transactions for equity securities that required stockholder
      approval during 2007 since there were no sales or purchases of stock during
      2007. Options and warrants exercised during 2007 were all issued prior to
      calendar year 2007.




12




**Item
      6. Selected Financial Data**




The
      Selected Operations and Balance Sheet Data set forth below have been derived
      from our Consolidated Financial Statements. It should be read in conjunction
      with the information appearing under the heading “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations” included in
      Item 7 of this report and the Consolidated Financial Statements and related
      notes found in Item 8 of this report.




**SELECTED
      CONSOLIDATED FINANCIAL DATA**




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


**YEARS
                  ENDED DECEMBER 31,**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**OPERATING
                  SUMMARYNet
                  sales
              
              $
              22,898
              
              $
              27,036
              
              $
              28,337
              
              $
              29,731
              
              $
              27,238Gross
                  profit
              
              
              6,282
              
              
              7,785
              
              
              10,626
              
              
              11,511
              
              
              10,341As
                  a percentage of net sales
              
              
              27.4
              %
              
              28.8
              %
              
              37.5
              %
              
              38.7
              %
              
              38.0
              %Research
                  and development expenses
              
              
              2,907
              
              
              2,341
              
              
              2,190
              
              
              1,188
              
              
              1,279As
                  a percentage of net sales
              
              
              12.7
              %
              
              8.7
              %
              
              7.7
              %
              
              4.0
              %
              
              4.7
              %Sales
                  and marketing expenses
              
              
              9,789
              
              
              9,774
              
              
              9,595
              
              
              8,595
              
              
              7,188As
                  a percentage of net sales
              
              
              42.8
              %
              
              36.2
              %
              
              33.9
              %
              
              28.9
              %
              
              26.4
              %General
                  and administrative expenses
              
              
              4,651
              
              
              4,956
              
              
              3,135
              
              
              2,459
              
              
              2,435As
                  a percentage of net sales
              
              
              20.3
              %
              
              18.3
              %
              
              11.1
              %
              
              8.3
              %
              
              8.9
              %Restructure
                  expenses
              
              
              456
              
              
              734
              
              
              3,120
              
              
              —
              
              
              —As
                  a percentage of net sales
              
              
              2.0
              %
              
              2.7
              %
              
              11.0
              %
              
              —
              %
              
              —
              %Loss
                  before tax
              
              
              (11,127
              )
              
              (9,537
              )
              
              (7,314
              )
              
              (762
              )
              
              (594
              )As
                  a percentage of net sales
              
              
              (48.6
              )%
              
              (35.3
              )%
              
              (25.8
              )%
              
              (2.6
              )%
              
              (2.2
              )%Net
                  loss
              
              
              (11,317
              )
              
              (9,650
              )
              
              (7,423
              )
              
              (704
              )
              
              (608
              )As
                  a percentage of net sales
              
              
              (49.4
              )%
              
              (35.7
              )%
              
              (26.2
              )%
              
              (2.4
              )%
              
              (2.2
              )%Net
                  loss per shareBasic
              
              $
              (.98
              )
              $
              (0.85
              )
              $
              (0.90
              )
              $
              (0.10
              )
              $
              (0.10
              )Diluted
              
              $
              (.98
              )
              $
              (0.85
              )
              $
              (0.90
              )
              $
              (0.10
              )
              $
              (0.10
              )Shares
                  used in per-share calculation:Basic
              
              
              11,500
              
              
              11,385
              
              
              8,223
              
              
              7,269
              
              
              5,993Diluted
              
              
              11,500
              
              
              11,385
              
              
              8,223
              
              
              7,269
              
              
              5,993FINANCIAL
                  POSITION SUMMARYTotal
                  assets
              
              $
              28,869
              
              $
              40,592
              
              $
              46,209
              
              $
              27,018
              
              $
              24,119Cash,
                  cash equivalents, and short-terminvestments
              
              
              8,412
              
              
              15,968
              
              
              23,578
              
              
              3,609
              
              
              4,254Working
                  capital
              
              
              12,512
              
              
              22,410
              
              
              31,530
              
              
              14,541
              
              
              12,449Credit
                  line borrowings
              
              
              1,159
              
              
              1,124
              
              
              47
              
              
              —
              
              
              —Current
                  portion of Long-term borrowings
              
              
              1,726
              
              
              778
              
              
              342
              
              
              38
              
              
              30Long-term
                  borrowings
              
              
              314
              
              
              1,862
              
              
              1,089
              
              
              484
              
              
              521Shareholders’
                  equity
              
              
              21,618
              
              
              30,880
              
              
              38,184
              
              
              21,202
              
              
              18,950Common
                  shares outstanding
              
              
              11,623
              
              
              11,394
              
              
              11,270
              
              
              7,351
              
              
              6,317




13




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




**Overview**




We
      manufacture and sell fiber optic and LED lighting systems, and our business
      is
      involved in two specific markets: commercial lighting and pool lighting. Our
      patented system, used by both product lines, is called the “EFO” system. The EFO
      system delivers higher energy savings, heat dissipation, and lower maintenance
      cost. These features provide a distinct advantage over our competitors’
products, and we have been able to successfully cater to a niche market. Our
      products are a good fit for the lighting needs of supermarkets, retail stores,
      the U.S. Navy, museums, and other specialized markets, including but not limited
      to hotel chains, dock lighting, and casinos. Also, the lighted fiber optic
      cables, an integral part of the lighting system, are aesthetically pleasing
      and
      have been warmly welcomed by design firms.





Even
      though our net sales have been trending downward during the past years, the
      sales from our EFO systems, our patented product, have been progressively
      improving. The EFO-generated sales were $7,011,000 in 2007, $5,316,000 in 2006,
      and $3,645,000 in 2005. The EFO systems have been well received by architectural
      and design firms and are now marketed in Europe, Russia, and the Middle
      East.





In
      August
      2007, our company was awarded the prestigious Defense Advanced Research Project
      Agency (DARPA) Award for small business innovation. This award brings awareness
      in the marketplace about our technological contribution, which we hope will
      result in increased sales. In 2007 and 2006, a modified version of our EFO
      system was fitted to three Navy ships. This project was funded through a
      government grant from DARPA. During the first quarter of 2007, we became a
      subcontractor to the University of Delaware for conducting research on
      Very-High-Efficiency Solar Cells (VHESC). This is a prestigious assignment
      that
      we hope will bring awareness about our technological strengths.





**Trends
      and Uncertainties:** The
      following is a summary of trends and uncertainties that affected our financial
      performance in 2007:





**Economic
      Trends:** During
      the second half of 2007, the U.S. economy was adversely affected by continued
      deterioration in the housing market and extraordinary volatility in the
      fixed-income markets. These problems affected our 2007 results in varying
      degrees. Certain geographic regions were impacted more significantly than
      others, and this had some influence on the seasonal and regional business
      conducted by our pool business. Economic decline in the construction industry
      affected sales negatively in both the pool and commercial lighting markets.





**Management
      Team:** During
      2007, we experienced turnover in several senior management positions. We believe
      that we have a new management team focused on addressing the issues of declining
      sales and increasing revenue through improved marketing channels while reducing
      expenses. We expect our operations to benefit from the expertise of the new
      leaders who joined our organization in 2007.





**Sales
      Plans:** We
      introduced a new product category called “EFO LED” as part of our EFO systems.
      Initial feedback is that it has been well accepted by the market and is expected
      to contribute positively to future sales growth. In 2008, we constructed a
      new
      showroom at our headquarters in Solon, Ohio, to showcase our products to
      architects and designers. This effort too will help bolster sales in the future.
      We recently entered into partnership with TCP, Inc., of Aurora, Ohio, and Eco
      Engineering, LLC of Cincinnati, Ohio, to distribute a broad range of our
      products to their national customers. This is a significant step for increasing
      sales in the future and is in addition to the previously used marketing channels
      of commission-based sales representatives. We believe that this step will
      positively affect our sales in the near future.


**Liquidity:** Due to
        continued losses and sales declines in 2007, management intends to pursue
        the raising of additional equity financing in 2008. On March 14, 2008, the
        company raised
        approximately $9,500,000 in equity financing, net of expenses, in a private
        placement of shares of common stock and warrants to existing
        shareholders. This
        additional financing will be used to fund working capital, pay debt and perform
        additional research and development. The company received the funds on
        March 17, 2008. Management believes that this additional financing, when
        combined with current cash reserves and current assets, will be sufficient
        to
        fund on-going operations for the next 12 months.





**United
      States Bank Borrowings:** We
      currently have $2,645,000 in borrowings outstanding with Silicon Valley Bank
      which become due on February 29, 2008. On March 14, 2008, our company entered
      into a sixth amendment with Silicon Valley Bank which extends our
      due date to April 30, 2008.




14




**Results
      of Operations**




**Net
      Sales**




Our
      net
      sales decreased 15% to $22,898,000 in 2007, compared to $27,036,000 in 2006.
      Net
      sales were $28,337,000 in 2005.




In
      2007,
      sales of pool products, excluding EFO products, decreased by 25%, or $2,956,000,
      and commercial lighting products, excluding EFO products, decreased by 29%,
      or
      $2,877,000. This decrease was partially offset by improved sales of EFO
      products—an increase of 32%, or $1,695,000, compared to the year before. The
      decrease in pool lighting sales was due to a $2,533,000, or 23%, drop in sales
      of in-ground pool products and also a $423,000, or 46%, decrease in sales of
      Jazz lighting products. However, Jazz lighting products are no longer considered
      a core product for the future, and the decrease was anticipated.





Our
      sales
      breakdowns, by product lines, with EFO products as a separate line item, are
      as
      follows:





**Product
      Line Breakdown**


*(in
      thousands)*




**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**EFO
            
            $
            7,011
            
            $
            5,316
            
            $
            3,645Traditional
                Pool
            
            
            9,002
            
            
            11,958
            
            
            14,744Traditional
                Commercial Lighting
            
            
            6,885
            
            
            9,762
            
            
            9,948Total
            
            $
            22,898
            
            $
            27,036
            
            $
            28,337




EFO
      sales
      reported in 2006 and 2005 have been restated for comparability with EFO products
      included in 2007.




The
      increased sales of EFO products were a result of organic sales growth
      and  the
      introduction of certain new EFO products in 2007. These new products were an
      addition to the existing EFO fiber optic product and contributed $3,970,000,
      or
      57%, in sales out of the total EFO sales of $7,011,000.





In
      2006,
      net sales decreased by 5% to $27,036,000, compared to $28,337,000 in 2005.
      The
      2006 decrease was a result of lower sales of pool products, excluding EFO,
      of
      19%, or $2,786,000, and commercial lighting products of 2%, or $186,000, which
      partially was offset by increased sales of EFO products of 46%, or $1,671,000,
      including $1,478,000 of new EFO pool products. The decrease in traditional
      pool
      lighting sales was due primarily to decrease in sales from our in-ground and
      jazz lighting products. The decrease in traditional commercial lighting sales
      was due to lower sales in the U.S. and Germany.





During
      2007, $234,000 of revenue was recognized on a percentage-of-completion basis
      for
      milestones completed as a subcontractor  to
      the
      University of Delaware for continuing research on Very-High-Efficiency Solar
      Cells.





International
      sales accounted for approximately 35% of net sales in 2007, as compared to
      31%
      of net sales in 2006 and 33% in 2005. The falling exchange rate for U.S. dollars
      helped boost the international sales reported this year. The breakdown of our
      international sales is as follows:





**International
      Sales**


*(in
      thousands)*





**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**United
                States Domestic
            
            $
            14,949
            
            $
            18,776
            
            $
            19,123Germany
            
            
            3,136
            
            
            2,998
            
            
            3,399U.K.
            
            
            4,265
            
            
            4,817
            
            
            4,775Others
            
            
            548
            
            
            445
            
            
            1,040Total
                Sales
            
            $
            22,898
            
            $
            27,036
            
            $
            28,337







15




**Gross
      Profit**




We
      had
      gross profit of $6,282,000 in 2007, a decrease of 19%, compared to $7,785,000
      in
      2006. Total gross profit as a percentage of total net sales was 27% in 2007,
      compared to 29% in 2006.





In
      2006,
      we had gross profit of $7,785,000, compared to $10,626,000in 2005. As a
      percentage of sales, the gross profit for 2006, was 29% compared to 38% in
      2005.
      Lower margins from commercial lighting and pool sales contributed towards much
      of the decline in both 2007 and 2006.




**Operating
      Expenses**




*Research
          and Development* **




Research
      and development expenses were $2,907,000 in 2007, a 24% increase from $2,341,000
      in 2006.




Overall,
      we decreased gross spending in research and development expense on personnel
      and
      project costs related to partially subsidized government awards and on
      improvements for existing products. This spending continued to be offset by
      expense credits for funds received in 2007, under various government awards
      for
      which we are the sole beneficiary of such research. The gross research and
      development spending along with credits from government contracts is shown
      in
      the following table:




**Year ended December 31,****2007**
            
            **2006**
            
            **2005***(in thousands)****Gross
                R& D******E******xpense
                and******G******overnment******R******eimbursement:***GrossExpenses
                forR&D
            
            $
            3,424
            
            $
            3,556
            
            $
            4,485Deduct:Incurred
                andAccruedCredits
                fromGovernmentContracts
            
            (517
            )
            (1,215
            )
            (2,295
            )NetR&DExpenses
            
            $
            2,907
            
            $
            2,341
            
            $
            2,190***Total
                Credits******R******eceived
                ***and
                Revenue Recognized***on Government
                Projects:***Incurred
                and Accrued Credits from Government Contracts
            
            $
            517
            
            $
            1,215
            
            $
            2,295Revenue
                Recognized for Completed Deliveries
            
            
            542
            
            
            1,979
            
            
            —Net
                Credits Received and Revenue
                Recognized
            
            $
            1,059
            
            $
            3,194
            
            $
            2,295




Credits
      received from government contracts for research for which we are the beneficiary
      during the fiscal year are recorded as a reduction to research and development
      expense. The net of payments to subcontractors amounted to $517,000 in 2007,
      compared to $1,215,000 in 2006, and $2,295,000 in 2005. Gross expenses for
      research and development decreased by $132,000 in 2007, a 4% decrease compared
      to 2006. Net research and development expenses were 12.7% of sales in 2007,
      compared to 8.7% of sales in 2006, and 7.7% in 2005.




This
      decrease in credits from 2005 to 2006 was due to the completion of the AMCOM
      contract and associated credits in 2005. Gross expenses for research and
      development decreased by $929,000 from 2005 to 2006 due to the re-allocation
      of
      some research and development staff to building milestone deliverables under
      the
      Navy ship installation contract and their associated costs being included in
      cost of sales in 2006, whereas there was no such activity or re-classed expenses
      in 2005.




When
      the
      government contract is for the delivery of a product or service, we recognize
      revenue from those government projects according to percentage of completion
      method or actual deliveries made. Costs related to the completion of the sale
      are charged to cost of sales. In 2007, revenue recognized from completed
      deliveries was $542,000. The revenue recognized for completed deliveries of
      products or services was $1,979,000 in 2006 and none in 2005. For further
      information on our revenue recognition policy, please refer to “Critical
      Accounting Policies and Estimates” within this section of the
      report.




Net
      credits received from government reimbursement are the combination of revenue
      and credits against gross research and development costs. In 2007, our net
      credits were $1,059,000, compared to $3,194,000 in 2006 and $2,295,000 in
      2005.




16




*Sales
          and Marketing*




Sales
      and
      marketing expenses were $9,789,000 in 2007, compared to $9,774,000 in 2006.
      While the net dollar amounts are similar for both years, in terms of percentage
      of sales, it was 43% in 2007 and 36% in 2006. In
      2007,
      sales expenses for the pool product line amounted to $2,676,000, or 27% of
      total
      marketing cost, whereas the commercial lighting line was $7,113,000, or 73%
      of
      total marketing costs.





In
      2006,
      sales and marketing expenses were $9,774,000, a 2% increase compared to the
      $9,595,000 in 2005. Last year’s increase was due in part to an increase of
      $734,000 in EFO sales and marketing offset by lower commissions of $443,000,
      and
      lower pool sales and marketing of $120,000 in 2006.




*General
          and Administrative*




General
      and administrative expenses were 20% of sales in 2007, 18% of sales in 2006,
      and
      11% of sales in 2005. General and administrative expenses were $4,651,000 in
      2007, a $305,000 or 6% decrease as compared to $4,956,000 in 2006. This year’s
      lower general and administrative expense was largely a result of a $241,000
      decrease in stock-based compensation compared to 2006, as well as management’s
      efforts to reduce overall costs.




General
      and administrative cost reduction efforts during 2007 were offset by a one-time
      charge of $409,000 for severance, $172,000 of which was in the general and
      administrative expenses category. The rest of the severance expenses were
      related to other line items such as sales and marketing and restructuring
      expenses. In 2007, we also incurred a non-recurring general and administrative
      charge of $342,000 in the third quarter and for bad debts due to a change in
      policy for calculating the reserve.  Without
      these two non-recurring charges, the general and administrative expenses for
      2007 would have been $4,150,000, a decrease of 10% from 2006.




General
      and administrative expenses were $4,956,000 in 2006, a $1,821,000 increase
      as
      compared to $3,135,000 in 2005. The 2006 increase was due to higher costs
      associated with complying with the Sarbanes-Oxley Act of 2002, option expenses
      associated with implementing FAS 123 (R), accounting fees, investor relations
      costs, and legal fees. We became an accelerated filer with the SEC as a result
      of our market capitalization as of June 30, 2006. As a result, we were
      required to comply with Section 404 of the Sarbanes-Oxley Act of 2002
      beginning with our fiscal year ending December 31, 2006. Our outside costs
      to comply with Section 404 were approximately $500,000, independent of
      additional audit fees.




The
      restructuring expenses in 2007 were $456,000, compared to $734,000 in 2006,
      a
      decrease of 38 %. In 2005, our restructuring expenses were $3,120,000. The
      2007
      cost is associated with relocating the fiber production operation from Mexico
      to
      Solon, Ohio. The 2006 and 2005 restructuring costs were for the relocation
      from
      Fremont, California to Solon, Ohio.




In
      June 2005, we announced the relocation of our headquarters from Fremont,
      California, to Solon, Ohio. We had indicated that the cost of the restructure
      would be approximately $3,500,000 and would result in approximately $2,000,000
      in savings. In 2005, we spent approximately $3,100,000 on restructuring
      expenses.




**Other
          Income and Expenses**




We
      had
      interest income of $605,000 and interest expense of $321,000 in 2007. Interest
      income consists of interest earned on deposits and marketable securities and
      gains on securities sales. Interest expense is for bank interest on equipment
      loans and on a building loan in Germany for our corporate offices there. Our
      interest income was $760,000 in 2006, compared to $138,000 in 2005. Our interest
      expense was $277,000 in 2006, compared to $39,000 in 2005.





We
      have
      certain long-term leases. Payments due under these leases are disclosed below
      in
      Note 8 and in the Consolidated Financial Statements and related notes included
      elsewhere in this report.




**Income
      Taxes**




We
      have a
      full valuation allowance against our deferred tax assets in the United States
      and Germany. There was a tax expense of $13,000 for our U.K. operations in
      2007.
      There were no tax expenses or benefits for our United States or German
      operations. In 2007, all expected benefits were offset by an increase in our
      valuation allowance. We had a tax expense of $177,000 in the U.S., resulting
      from a tax liability associated with tax treatment for goodwill.





For
      2006,
      we had a full valuation allowance against our deferred tax assets in the United
      States and Germany. There was no operating statement tax expense or benefit
      for
      our German operation in 2006 as any expected benefit was offset by an increase
      in our valuation allowance. We had a tax expense of $75,000 in the U.S resulting
      from a tax liability associated with the tax treatment for goodwill. In addition
      we had a $38,000 tax expense shown for 2006 is a result of tax expense for
      our
      United Kingdom operations which experienced a profit of 2006.





For
      2005,
      we had a full valuation allowance against our deferred tax assets in the United
      States. There was no operating statement tax expense or benefit for our United
      States operations in 2005 as any expected benefit was offset by an increase
      in
      our valuation allowance. The $109,000 tax expense shown for 2005, is a result
      of
      tax expense for our United Kingdom and German operations which experienced
      a
      profit of 2005




**Net
      Loss**




The
      net
      loss was $11,317,000, an increase of 17% from our net loss of $9,650,000 in
      2006.





For
      2006,
      the net loss of $9,650,000, which was an increase of 30% compared to the net
      loss of $7,423,000 in 2005.




17




**Liquidity
      and Capital Resources**




*Cash
      and Cash Equivalents*




At
      December 31, 2007, our cash and cash equivalents were $8,412,000, compared
      to $3,705,000 at December 31, 2006. We had $314,000 in long-term borrowings
      and $2,885,000 in short-term borrowings as of December 31, 2007. We had
      $1,862,000 in long-term borrowings and $1,902,000 in short-term borrowings
      as of
      December 31, 2006. We did not have any short-term securities at December
      31, 2007. We had $12,263,000 in short-term securities at December 31,
      2006 *.*




*Operating
      Activities*




Net
      cash
      used by operating activities primarily consists of net loss adjusted by non-cash
      items, including depreciation, amortization, stock-based compensation, and
      the
      effect of changes in working capital. Cash decreased during 2007, by a net
      loss
      of $11,317,000, compared to net losses of $9,650,000 and $7,423,000 for 2006,
      and 2005 respectively. After adjustments, net cash used by operating activities
      was $7,502,000 in 2007, compared to $7,184,000 for 2006 and $3,472,000 in
      2005.




In
      2007,
      all short-term investments were converted to cash. Further, our efforts to
      reduce accounts receivable and inventory provided cash of $2,411,000 and
      $947,000, respectively during 2007. Cash was also used during 2007 to decrease
      accounts payable by $1,942,000. In 2006, cash decreased by $2,457,000 due to
      a
      reduction in accruals, largely due to paying off restructuring expenses accrued
      in 2005 and increased by $1,510,000 and $558,000 due to increases in accounts
      payables and a reduction in prepaids, respectively. During 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 cash in 2005 through
      an
      increase of $1,830,000 largely as a result of scheduled payments outstanding
      on
      restructuring expenses.




*Cash
      Provided by Investing Activities*




There
      was
      a net contribution of cash of $11,842,000 in 2007, largely due to net sales
      of
      short-term securities, totaling $12,351,000. In 2006, the contribution of cash
      was $2,058,000 in investing activities, also due to net sales of short-term
      investments totaling $5,761,000 and partially offset by the acquisition of
      fixed
      assets of $3,703,000. This compares to a net utilization of cash of $19,921,000
      in investing activities in 2005, primarily due to the investments made in
      short-term securities and the acquisition of fixed assets.




*Cash
      Provided by Financing Activities*




In
      2007,
      the net contribution to cash from financing activities was $407,000, compared
      to
      $2,908,000 in 2006 and $25,749,000 in 2005. Proceeds from stock issuances
      provided $964,000 in cash in 2007. Also in 2007, additional bank borrowings
      of
      $289,000 were reduced by debt payments of $908,000. During 2006, the net cash
      contribution primarily was due to our receipt of $2,686,000 in proceeds from
      bank borrowings, of which $1,609,000 was used to finance the purchase of
      manufacturing equipment. During 2005, the net cash contribution was primarily
      due to proceeds received from issuances of common stock.





As
      a
      result of the cash used in operating activities and the cash provided by
      financing and investing activities, there was a net increase in cash in 2007
      of
      $4,707,000 that resulted in an ending cash balance of $8,412,000 as of December
      31, 2007. This compares to a net decrease in cash of $1,849,000 in 2006,
      resulting in an ending cash balance of $3,705,000 at the end of 2006, and a
      net
      increase in cash of $1,945,000 in 2005, resulting in an ending cash balance
      of
      $5,554,000 at the end of 2005.





We
      have a
      bank line of credit agreement with Silicon Valley Bank effective August 15,
      2005. It was further amended September 25, 2006, and extended through August
      15,
      2007,  and
      again
      on October 31, 2007, extending the agreement to December 31, 2007. This credit
      facility is for $5,000,000 and is secured by our assets and intellectual
      property. At December 31, 2007, the interest rate was 7.75%. It has a minimum
      tangible net worth covenant that we must meet going forward. On
      December 31, 2005, this agreement was amended and restated to include an
      additional $3,000,000 term-loan line of credit for equipment purchases. This
      agreement calls for repayment of principle in equal amounts over four years
      from
      the date of purchase of the equipment and has an interest rate of prime plus
      0.5% if the quick ratio is 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 assets and intellectual property. Specific borrowings
      under the revolver are tied to accounts receivable and inventory balances,
      and
      we are required to comply with certain covenants with respect to effective
      net
      worth and financial ratios. The company had borrowings of $973,000 under the
      revolving line of credit at December 31, 2007, $1,000,000 borrowings at December
      31, 2006, and no borrowings as of December 31, 2005. We had total borrowings
      under the term-loan portion of the agreement of $1,672,000 as of
      December 31, 2007, $2,261,000 as of December 31, 2006, and $1,092,000 as of
      December 31, 2005. We pay an unused line fee of 0.25% against any unused daily
      balance during the year.




On
      January 29, 2008, the company entered into a fifth amendment, retroactive to
      December 30, 2007. Under this new agreement, all advances become due on February
      29, 2008. On March 14, 2008, our company entered into a sixth amendment with
      Silicon Valley Bank which extends the due date to April 30, 2008.





Through
      our U.K. subsidiary, we maintain a bank overdraft facility of $496,000 (in
      U.K.
      pounds sterling, based on the exchange rate at December 31, 2007) under an
      agreement with Lloyds Bank Plc. There were no borrowings against this facility
      as of December 31, 2007 and 2006, respectively. The facility is renewed
      annually on January 1.





Through
      our German subsidiary, we maintain a credit facility under an agreement with
      Sparkasse Neumarkt Bank. This credit facility is in place to finance our
      building of new offices in Berching, Germany, owned and occupied by our German
      subsidiary. As of December 31, 2007, we had borrowings of $368,000 (in
      Euros, based on the exchange rate at December 31, 2007) against this credit
      facility. In addition, our German subsidiary has a revolving line of credit
      for
      $219,000 (in Euros, based on the exchange rate at December 31, 2007) with
      Sparkasse Neumarkt Bank. As of December 31, 2007, there were borrowings of
      $186,000 against this facility and borrowings of $124,000 against this facility
      at December 31, 2006. The revolving facility is renewed annually on
      January 1.




18


On
      November 8, 2005, the company closed a follow-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. On
      November 11, 2005, the company announced that the underwriters had
      exercised 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 from
      the selling of 2,952,497 new shares (before costs and expenses). The net amount
      received by the company after deducting 6% in underwriters’ fees and legal,
      accounting, and other costs was $22.2 million.





On
      March
      14, 2008, the company raised
      approximately $9,500,000 in equity financing, net of expenses, in a private
      placement of shares of common stock and warrants to existing shareholders.This additional financing will be used to fund working capital, pay
      debt
      and perform additional research and development. The company received 100%
      of the funds (net of fees) on March 17, 2008. Management believes that this
      additional financing, when combined with current cash reserves, will be
      sufficient to fund on-going operations for the next 12 months.




**Contractual
      Obligations**




The
      following summarizes our contractual obligations as of December 31, 2007,
      consisting of current and future payments for borrowings by our German
      subsidiary, borrowings under an equipment term loan in the United States, and
      minimum lease payments under operating leases, as well as the effect that these
      obligations are expected to have on our liquidity and cash flow in future
      periods ( *in
      thousands* ).




**Borrowings**
              **by German**
              **Subsidiary**
            
            
            **Borrowings**
              **under**
              **Equipment**
              **Term Loan**
            
            
            **Non-**
              **Cancelable**
              **Operating**
              **Leases**2008
            
            $
            240
            
            $
            1,672
            
            $
            9352009
            
            
            57
            
            
            —
            
            
            9452010
            
            
            60
            
            
            —
            
            
            7972011
            
            
            64
            
            
            —
            
            
            282Thereafter
            
            
            133
            
            
            —
            
            
            297$
            554
            
            $
            1,672
            
            $
            3,256




The
      company also has $973,000 for credit line borrowings, in the United States,
      recorded as a current liability at December 31, 2007.




**Off-Balance
      Sheet Arrangements**




We
      had no
      off-balance sheet arrangements as of December 31, 2007 or
      2006.




19






**Critical
      Accounting Policies and Estimates**




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





·
            Revenue
                recognition;


·
            Allowances
                for doubtful accounts, returns and
                discounts;


·
            Long-lived
                assets;


·
            Valuation
                of inventories;


·
            Accounting
                for income taxes; and


·
            Share-Based
                compensation




**Revenue
      Recognition**




Revenue
      is recognized when it is realized or realizable, has been earned, and when
      all
      of the following has occurred:




·
            Persuasive
                evidence or an arrangement exists, e.g., a sales order, a purchase
                order,
                or a sales agreement.




·
            Shipment
                has occurred (the standard shipping term is F.O.B. ship point) or
                services
                provided on a percentage-of-completion basis or installation have
                been
                completed.




·
            Price
                to the buyer is fixed or determinable.




·
            Collectibility
                is reasonably assured.




Revenue
      from **product
      sale** generally is recognized upon shipping because of the following:




·
            All
                sales made by the company to its customer base are non-contingent,
                meaning
                that they are not tied to that customer’s resale of
                products.




·
            Standard
                terms of sale contain shipping terms of F.O.B. ship point, meaning
                that
                title is transferred when shipping
                occurs.




·
            There
                are no automatic return provisions that allow the customer to return
                the
                product in the event that the product does not sell within a defined
                timeframe.




Revenue
      from **installation
      services** ,
      including design and integration services and other services (where product
      sales are not incorporated into the contract), is recognized upon the
      following:




·
            Percentage-of-completion
                method using the ratio of labor cost incurred to the total final
                estimated
                labor cost. Under this method, revenue recognized reflects the portion
                of
                anticipated revenue that has been earned.




Revenue
      from product sales that incorporate **specifically
      defined installation** services
      is recognized as follows:




·
            product
                sale at completion of installation
                and




·
            installation
                service at completion of
                installation




We
      warrant our products against defects or workmanship issues. We set up allowances
      for estimated returns, discounts, and warranties upon recognition of revenue
      and
      these allowances are adjusted periodically to reflect actual and anticipated
      returns, discounts, and warranty expenses. Our distributors’obligation
      to us is not contingent upon the resale of our product and as such does not
      prohibit revenue recognition.




**Allowances
      for Doubtful Accounts, Returns, and Discounts**




We
      establish allowance for doubtful accounts for probable losses, based on past
      history, current economic conditions, and contractual terms. The specific
      components are as follows:




·
            Allowance
                for doubtful accounts for accounts receivable,
                and




·
            Allowance
                for sales returns


20


In
      2007,
      the total allowance was $848,000, with $698,000 related to accounts receivable
      and $150,000 related to sales return. In 2006, the total allowance had a balance
      of $600,000 with $355,000 related to accounts receivable and $245,000 related
      to
      sales return.





The
      company reviews these allowance accounts periodically and adjusts them according
      to current conditions.


**Long-lived
        Assets**
 
 The
        company has $4,359,000 in goodwill in 2007, which represents 15% of total
        assets. We test goodwill for impairment annually, and at December 31, 2007,
        it
        was determined that no impairment occurred. The first test for impairment
        requires us to make an assessment of our book value versus our market
        capitalization value. Since our market value was greater than book value,
        no
        further impairment testing was required. If these values change in the future,
        additional analysis would be required, and we may incur non cash charges
        for
        impairment of goodwill.


**Valuation
      of Inventories**





We
      state
      inventories at the lower of standard cost (which approximates actual cost
      determined using the first-in-first-out method) or market. We establish
      provisions for excess and obsolete inventories after evaluation of historical
      sales, current economic trends, forecasted sales, product lifecycles, and
      current inventory levels. During 2007, 2006, and 2005, we charged $677,000,
      $868,000, and $196,000, respectively, to cost of sales for excess and obsolete
      inventories. Adjustments to our estimates, such as forecasted sales and expected
      product lifecycles, could harm our operating results and financial
      position.





**Accounting
      for Income Taxes**





As
      part
      of the process of preparing our consolidated financial statements, we are
      required to estimate our income tax liability in each of the jurisdictions
      in
      which we do business. This process involves estimating our actual current tax
      expense together with assessing temporary differences resulting from differing
      treatment of items, such as deferred revenues, for tax and accounting purposes.
      These differences result in deferred tax assets and liabilities, which are
      included in our consolidated balance sheet. We then must assess the likelihood
      that these deferred tax assets will be recovered from future taxable income
      and,
      to the extent that we believe that recovery is not certain or is unknown, we
      must establish a valuation allowance.





Significant
      management judgment is required in determining our provision for income taxes,
      our deferred tax assets and liabilities, and any valuation allowance recorded
      against our deferred tax assets. At December 31, 2007, we have recorded a
      full valuation allowance against our deferred tax assets in the United States
      and Germany, due to uncertainties related to our ability to utilize our deferred
      tax assets, primarily consisting of certain net operating losses carried
      forward. The valuation allowance is based upon our estimates of taxable income
      by jurisdiction and the period over which our deferred tax assets will be
      recoverable.





**Share-Based
      Payments**




In
      December 2004, the FASB issued FAS No. 123 (revised 2004) or FAS
      123(R), “Share-Based Payments.” FAS 123(R) requires all entities
      to recognize compensation expense in an amount equal to the fair value of
      share-based payments, such as stock options granted
      to employees. The company has applied FAS 123(R) using the modified prospective
      method. Under this method, the company is
      required to record compensation expense (as previous awards continue to vest)
      for the unvested portion of previously granted awards that remain outstanding
      at
      the date of adoption. The company could have elected to adopt FAS 123(R) by
      restating previously issued financial statements, basing the amounts on the
      expense previously calculated and reported in the pro forma disclosures that
      had
      been required by FAS 123. FAS 123(R) was first effective for the company for
      its
      year ending December 31, 2006. In March 2005, the SEC released Staff
      Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107), which
      provides interpretive guidance related to the interaction between FAS
      123(R) and certain SEC rules and regulations. It also provides the SEC
      staff’s views regarding valuation of share based payment arrangements. The
      application of FAS 123(R) with SAB 107 had the effect of increasing stock-based
      compensation expense and reducing earnings by $877,000 in 2007 and $1,118,000
      in
      2006.




We
      measure all employee stock-based awards as an expense based on the grant-date
      fair value of these awards. Effective January 1, 2006, we began to recognize
      expense for all stock-based awards granted on or after that date and for all
      previous unvested awards using the modified prospective method. The fair value
      of options is estimated using the Black-Scholes option pricing model. Weighted
      average assumptions used in the model include the expected life of the options,
      volatility, and risk-free interest rate. The volatility estimates are calculated
      using historical pricing experience.




21




**Recently
      Issued Accounting Pronouncements**




**Accounting
      Pronouncements Adopted in 2007**





***Accounting
      for uncertain tax positions.*** In
      July
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), an interpretation
      of Statement of Financial Accounting Standard No. 109, “Accounting for Income
      Taxes” (SFAS 109), regarding accounting for income tax uncertainties effective
      for fiscal years beginning after December 15, 2006 (effective January 1, 2007,
      for the company). FIN 48 applies to all tax positions related to income taxes
      subject to SFAS 109 on Accounting for Income Taxes. The impact of adopting
      the
      positions of this interpretation did not have a material impact on the company’s
      overall financial position or results of operations.





**Accounting
      Pronouncements Pending Adoption at December 31, 2007**





***Fair
      value measurements.*** In
      September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (FAS
      157), which defines fair value, establishes a framework for measuring fair
      value, and expands disclosures about fair value measurements. This guidance
      applies only when other guidance requires or permits assets or liabilities
      to be
      measured at fair value; it does not expand the use of fair value in any new
      circumstances. FAS 157 will be effective for fiscal years beginning after
      November 15, 2007 (effective January 1, 2008, for the company). In February
      2008, the FASB issued Staff Position FAS 157-1, which provides that FAS 157
      does
      not apply under FAS 13, “Accounting for Leases,” and other accounting
      pronouncements that address fair value measurements for leases. In February
      2008, the FASB also issued Staff Position FAS 157-2, which delays the effective
      date of FAS 157 for all nonfinancial assets and liabilities, except those
      recognized or disclosed at fair value in the financial statements on a recurring
      basis (at least annually). For items within the scope of Staff Position FAS
      157-2, the effective date will be for fiscal years beginning after November
      15,
      2008. Early adoption of FAS 157 for nonfinancial assets and liabilities within
      the scope of the new guidance is permitted. Management is evaluating the
      potential effect that this guidance may have on the company’s overall financial
      position or results of operations.





***Fair
      value option for financial assets and financial liabilities.*** In
      February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial
      Assets and Financial Liabilities” (FAS 159). This guidance provides an option to
      selectively report financial assets and liabilities at fair value and
      establishes presentation and disclosure requirements designed to facilitate
      comparisons between entities that choose different measurement attributes for
      similar types of assets and liabilities. FAS No. 159 will be effective for
      fiscal years beginning after November 15, 2007 (effective January 1, 2008,
      for
      the company). The company has elected not to apply this fair value option to
      any
      of its existing assets or liabilities. However, the company may adopt this
      guidance for assets or liabilities in the future as permitted under FAS No.
      159.





***Business
      Combinations.*** In
      December 2007, the FASB issued FAS No.
      141(R), “Business Combinations” (FAS
      141(R)). The new pronouncement requires the acquiring entity in a business
      combination to recognize only the assets acquired and liabilities assumed in
      a
      transaction (e.g., acquisition costs must be expensed when incurred),
      establishes the fair value at the date of acquisition as the initial measurement
      for all assets acquired and liabilities assumed, and requires expanded
      disclosures. FAS 141(R) will be effective for fiscal years beginning after
      December 15, 2008 (January 1, 2009, for the company). Early adoption is
      prohibited. Management is evaluating the potential effect that this guidance
      may
      have on the company’s overall financial position or results of
      operations.





***Noncontrolling
      Interests*** .
      In
      December 2007, the FASB issued FAS No .
      160,
“Noncontrolling Interests in Consolidated Financial Statements, an Amendment
      of
      ARB No. 51” (FAS 160). The new pronouncement requires all entities to report
      noncontrolling (minority) interests in subsidiaries as a component of
      shareholders’ equity. FAS No. 160 will be effective for fiscal years beginning
      after December 15, 2008 (January 1, 2009, for company). Early adoption is
      prohibited. Management is evaluating the potential effect that this guidance
      may
      have on the company’s overall financial position or results of
      operations.




**Item
      7A. Qualitative and Quantitative Disclosures About Market
      Risk**





As
      of
      December 31, 2007, we had $1,129,000 in cash held in foreign currencies based
      on
      the exchange rates at December 31, 2007. The balances for cash held overseas
      in
      foreign currencies are subject to exchange rate risk. We have a policy of
      maintaining cash balances in local currencies unless an amount of cash
      occasionally is transferred in order to repay inter-company debts.





As
      of
      December 31, 2007, we had borrowings of $186,000 (in Euros, based on the
      exchange rate at December 31, 2007) against a credit facility secured by real
      property owned by our German subsidiary. As of December 31, 2006, we had
      $124,000 (in Euros, based on the exchange rate at December 31, 2006,) borrowed
      against this credit facility.




22




**Item
      8. Financial Statements and Supplementary Data**




**TABLE
      OF CONTENTS**




PageReport
                of Independent Registered Public Accounting Firm
            24Consolidated
                Balance Sheets as of December 31, 2007 and 2006
            25Consolidated
                Statements Of Operations for the years ended December 31, 2007, 2006
                and
                2005
            26Consolidated
                Statements of Comprehensive Income (Loss) for the years ended December
                31,
                2007, 2006 and 2005
            27Consolidated
                Statements of Shareholders’ Equity for the years ended December 31, 2007,
                2006,and 2005
            28Consolidated
                Statements of Cash Flows for the Years Ended December 31, 2007, 2006
                and
                2005
            29Notes
                to Consolidated Financial Statements for December 31, 2007, 2006
                and
                2005
            30




23




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





Board
      of
      Directors and Shareholders


Energy
      Focus, Inc.





We
      have
      audited the accompanying consolidated balance sheets of Energy Focus, Inc (a
      Delaware corporation) and subsidiaries (collectively the “Company”) as of
      December 31, 2007 and 2006, 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, 2007. ** Our
      audit
      of the basic financial statements included the financial statement schedule
      listed in the index under Item 15(a)(2) *.* These
      financial statements and financial statement schedule are the responsibility
      of
      the Company’s management. ** Our
      responsibility is to express an opinion on these financial statements and
      financial statement schedule based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). ** Those
      standards require that we plan and perform the audit to obtain reasonable
      assurance about whether the financial statements are free of material
      misstatement. ** An
      audit
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the financial statements. ** An
      audit
      also includes assessing the accounting principles used and significant estimates
      made by management, as well as evaluating the overall financial statement
      presentation. ** We
      believe that our audits provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Energy Focus, Inc. and
      subsidiaries as of December 31, 2007 and 2006, and the results of their
      operations and their cash flows for each of the three years in the period ended
      December 31, 2007 in conformity with accounting principles generally accepted
      in
      the United States of America. Also, in our opinion, the related financial
      statement schedule, when considered in relation to the basic financial
      statements taken as a whole, present fairly, in all material respects, the
      information set forth therein.





As
      discussed in Note 2 to the consolidated financial statements, effective January
      1, 2006, the Company adopted SFAS 123(R) “Share-Based Payment” as
      revised.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), Energy Focus, Inc.’s internal control over
      financial reporting as of December 31, 2007, based on criteria established
      in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO *)* and
      our
      report dated March 17, 2008 expressed an unqualified opinion
      thereon.





/s/
      GRANT
      THORNTON LLP








Cleveland,
      Ohio


March
      17,
      2008




24




**ENERGY
      FOCUS, INC.**


**CONSOLIDATED
      BALANCE SHEETS, December 31,**


***(amounts
      in thousands except share and per-share amounts)***




**2007**
            
            **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            8,412
            
            $
            3,705Short-term
                investments
            
            
            —
            
            
            12,263Accounts
                receivable, net of allowances for doubtful accounts of $698 in 2007
                and
                $355 in 2006
            
            
            3,454
            
            
            6,185Inventories,
                net
            
            
            6,888
            
            
            7,708Prepaids
                and other current assets
            
            
            381
            
            
            324Total
                current assets
            
            
            19,135
            
            
            30,185Fixed
                assets, net
            
            
            5,316
            
            
            5,978Goodwill,
                net
            
            
            4,359
            
            
            4,247Other
                assets
            
            
            59
            
            
            182Total
                assets
            
            $
            28,
                869
            
            $
            40,592**LIABILITIES**Current
                liabilities:Accounts
                payable
            
            $
            2,265
            
            $
            4,202Accruals
                and other current liabilities
            
            
            1,473
            
            
            1,671Credit
                line borrowings
            
            
            1,159
            
            
            1,124Current
                portion of long-term bank borrowings
            
            
            1,726
            
            
            778Total
                current liabilities
            
            
            6,623
            
            
            7,775Other
                deferred liabilities
            
            
            62
            
            
            —Deferred
                tax liabilities
            
            
            252
            
            
            75Long-term
                bank borrowings
            
            
            314
            
            
            1,862Total
                liabilities
            
            
            7,251
            
            
            9,712Commitments
                and contingencies (Note 8).**SHAREHOLDERS’
                EQUITY***Preferred
                stock, par value $0.0001 per share:*Authorized:
                2,000,000 shares in 2007 and 2006Issued
                and outstanding: no shares in 2007and 2006*Common
                stock, par value $0.0001 per share:*Authorized:
                30,000,000 shares in 2007 and 2006Issued
                and outstanding: 11,623,000 shares in 2007 and 11,394,000 shares
                in
                2006
            
            
            1
            
            
            1Additional
                paid-in capital
            
            
            55,682
            
            
            53,841Accumulated
                other comprehensive income
            
            
            815
            
            
            601Accumulated
                deficit
            
            
            (34,880
            )
            
            (23,563
            )Total
                shareholders’ equity
            
            
            21,618
            
            
            30,880Total
                liabilities and shareholders’ equity
            
            $
            28,869
            
            $
            40,592




The
      accompanying notes are an integral part of these financial
      statements




25




**ENERGY
      FOCUS, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**For
      the years ended December 31,**


***(amounts
      in thousands except per-share amounts)***




**2007**
            
            
            **2006**
            
            
            **2005**Net
                sales
            
            $
            22,898
            
            $
            27,036
            
            $
            28,337Cost
                of sales
            
            
            16,616
            
            
            19,251
            
            
            17,711Gross
                profit
            
            
            6,282
            
            
            7,785
            
            
            10,626Operating
                expenses:Gross
                research and development
            
            
            3,424
            
            
            3,556
            
            
            4,485Deduct
                credits from government contracts
            
            
            (517
            )
            
            (1,215
            )
            
            (2,295
            )Net
                research and development expense
            
            
            2,907
            
            
            2,341
            
            
            2,190Sales
                and marketing
            
            
            9,789
            
            
            9,774
            
            
            9,595General
                and administrative
            
            
            4,651
            
            
            4,956
            
            
            3,135Restructuring
                expenses
            
            
            456
            
            
            734
            
            
            3,120Total
                operating expenses
            
            
            17,803
            
            
            17,805
            
            
            18,040Loss
                from operations
            
            
            (11,521
            )
            
            (10,020
            )
            
            (7,414
            )Other
                income (expense):Other
                income
            
            
            110
            
            
            —
            
            
            1Interest
                Income
            
            
            605
            
            
            760
            
            
            138Interest
                expense
            
            
            (321
            )
            
            (277
            )
            
            (39
            )Net
                loss before income taxes
            
            
            (11,127
            )
            
            (9,537
            )
            
            (7,314
            )Income
                tax provision
            
            
            (190
            )
            
            (113
            )
            
            (109
            )Net
                loss
            
            $
            (11,317
            )
            $
            (9,650
            )
            $
            (7,423
            )Net
                loss per share—basic and diluted
            
            $
            (0.98
            )
            $
            (0.85
            )
            $
            (0.90
            )Shares
                used in per share calculation—basic and diluted
            
            
            11,500
            
            
            11,385
            
            
            8,223




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




26




**ENERGY
      FOCUS, INC.**


**CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE INCOME (LOSS)**


**For
      the years ended December 31,**


***(amounts
      in thousands)***


**2007**
              
              **2006**
              
              **2005**Net
                  loss
              
              $
              (11,317
              )
              $
              (9,650
              )
              $
              (7,423
              )Other
                  comprehensive income:Foreign
                  currency translation adjustments
              
              
              283
              
              
              507
              
              
              (636
              )Net
                  unrealized (loss) gain on securities
              
              
              (69
              )
              
              53
              
              
              16Comprehensive
                  loss
              
              $
              (11,103
              )
              $
              (9,090
              )
              $
              (8,043
              )




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




27




**ENERGY
      FOCUS, INC.**


**CONSOLIDATED
      STATEMENTS OF SHAREHOLDERS’ EQUITY**


**For
      the years ended December 31, 2007, 2006, and 2005**


***(amounts
      in thousands)***




**Common
                  Stock**
              
              **Additional**
                  **Paid-In**
              
              **Unearned**
                  **Stock-Based**
              
              **Notes**
                    **Receivable**
                    **from**
              
              **Accumulated**
                    **Other**
                    **Comprehensive**
              
              **Retained**
                    **Earnings**
                    **(Accumulated****Shares**
              
              **Amount**
              
              **Capital**
              
              **Compensation**
              
              **Shareholder**
              
              **Income**
              
              **Deficit)**
              
              **Total**Balances,
                  December 31, 2004
              
              
              7,351
              
              $
              1
              
              $
              27,520
              
              $
              (490
              )
              $
              —
              
              $
              661
              
              $
              (6,490
              )
              $
              21,202Issuance
                    of common stock S-3 Filing
              
              
              2,952
              
              
              
              
              
              22,174
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              22,174Exercise
                    of common stock warrants
              
              
              587
              
              
              
              
              
              408
              
              
              
              
              
              (62
              )
              
              
              
              
              
              
              
              346Issuance
                    of common stock underemployee
                  stock purchase plan
              
              
              4
              
              
              
              
              
              31
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              31Exercise
                    of common stock options
              
              
              376
              
              
              
              
              
              2,131
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,131Unearned
                    stock-based compensation
              
              
              
              
              
              
              
              
              53
              
              
              (53
              )
              
              
              
              
              
              
              
              
              
              
              —Amortization
                    of unearned stock- based compensation
              
              
              
              
              
              
              
              
              197
              
              
              146
              
              
              
              
              
              
              
              
              
              
              
              343Net
                  unrealized gain on securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              16
              
              
              
              
              
              16Foreign
                    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
              )
              $
              38,184Reclassification
                  of unearnedStock-based
                  compensation uponFAS
                  123R adoption
              
              
              
              
              
              
              
              
              (397
              )
              
              397
              
              
              
              
              
              
              
              
              
              
              
              —Additional
                    Costs from 2005 S-3 Filing
              
              
              
              
              
              
              
              
              (45
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              (45
              )Exercise
                    of common stock warrants
              
              
              14
              
              
              
              
              
              62
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              62Exercise
                    of common stock options
              
              
              106
              
              
              
              
              
              563
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              563Issuance
                    of common stock under employee stock purchase plan
              
              
              4
              
              
              
              
              
              26
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              26Note
                    Receivable from shareholder
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              62
              
              
              
              
              
              
              
              
              62Stock-based
                  compensation
              
              
              
              
              
              
              
              
              1,118
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,118Net
                  unrealized gain on securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              53
              
              
              
              
              
              53Foreign
                    currency translation adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              507
              
              
              
              
              
              507Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (9,650
              )
              
              (9,650
              )Balances,
                  December 31, 2006
              
              
              11,394
              
              $
              1
              
              $
              53,841
              
              $
              —
              
              $
              —
              
              $
              601
              
              $
              (23,563
              )
              $$
              30,880Exercise
                  of common stock warrants
              
              
              86
              
              
              
              
              
              295
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              295Exercise
                    of common stock options
              
              
              140
              
              
              
              
              
              651
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              651Issuance
                      of common stock under employee stock purchase
                      plan
              
              
              3
              
              
              
              
              
              18
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              18Stock-based
                  compensation
              
              
              
              
              
              
              
              
              877
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              877Net
                  unrealized loss on securities
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (69
              )
              
              
              
              
              (69
              )Foreign
                    currency translation adjustment
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              283
              
              
              
              
              
              283Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (11,317
              )
              
              (11,317
              )Balances,
                  December 31, 2007
              
              
              11,623
              
              $
              1
              
              $
              55,682
              
              $
              —
              
              $
              —
              
              $
              815
              
              $
              (34,880
              )
              $
              21,618




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




28




**ENERGY
      FOCUS, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**For
      the years ended December 31,**


***(amounts
      in thousands)***




**2007**
            
            **2006**
            
            **2005****Cash
                flows from operating activities:**Net
                loss
            
            $
            (11,317
            )
            $
            (9,650
            )
            $
            (7,423
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            1,236
            
            
            1,197
            
            
            1,145Provision
                for doubtful accounts receivable
            
            
            387
            
            
            151
            
            
            76Stock-based
                compensation
            
            
            877
            
            
            1,118
            
            
            345Unrealized
                loss (gain) from marketable securities
            
            
            69
            
            
            (53
            )
            
            (16
            )Gain
                on sale of fixed asset
            
            
            (1
            )
            
            —
            
            
            —Deferred
                Taxes
            
            
            177
            
            
            63
            
            
            —Changes
                in assets and liabilities:Accounts
                receivable, trade
            
            
            2,411
            
            
            127
            
            
            722Inventories
            
            
            947
            
            
            351
            
            
            363Prepaid
                and other current assets
            
            
            (54
            )
            
            558
            
            
            (313
            )Other
                assets
            
            
            131
            
            
            (99
            )
            
            56Accounts
                payable
            
            
            (1,942
            )
            
            1,510
            
            
            (257
            )Accruals
                and other current liabilities
            
            
            (423
            )
            
            (2,457
            )
            
            1,830Total
            
            
            3,815
            
            
            2,466
            
            
            3,951Net
                cash used in operating activities
            
            
            (7,502
            )
            
            (7,184
            )
            
            (3,472
            )**Cash
                flows from investing activities:**Sale
                of short-term investments
            
            
            49,441
            
            
            114,595
            
            
            27,767Purchase
                of short-term investments
            
            
            (37,090
            )
            
            (108,834
            )
            
            (45,768
            )Proceeds
                from sale of fixed assets
            
            
            33
            
            
            —
            
            
            —Acquisition
                of fixed assets
            
            
            (542
            )
            
            (3,703
            )
            
            (1,920
            )Net
                cash provided by (used in) investing activities
            
            
            11,842
            
            
            2,058
            
            
            (19,921
            )**Cash
                flows from financing activities:**Proceeds
                from issuances of common stock
            
            
            964
            
            
            651
            
            
            24,680Repayment
                of loan made to shareholder
            
            
            —
            
            
            62
            
            
            —Proceeds
                from credit line borrowings
            
            
            129
            
            
            1,077
            
            
            —Proceeds
                from long-term borrowings
            
            
            160
            
            
            1,609
            
            
            1,069Payments
                of Line of Credit
            
            
            (107
            )
            
            —
            
            
            —Payments
                of long-term borrowings
            
            
            (801
            )
            
            (491
            )
            
            —Other
                Liabilities
            
            
            62
            
            
            —
            
            
            —Net
                cash provided by financing activities
            
            
            407
            
            
            2,908
            
            
            25,749***Effect
                of exchange rate changes on cash***
            
            
            (40
            )
            
            369
            
            
            (411
            )**Net
                increase (decrease) in cash and cash equivalents**
            
            
            4,707
            
            
            (1,849
            )
            
            1,945**Cash
                and cash equivalents, beginning of year**
            
            
            3,705
            
            
            5,554
            
            
            3,609**Cash
                and cash equivalents, end of year**
            
            $
            8,412
            
            $
            3,705
            
            $
            5,554**Supplemental
                Information**Interest
                Paid
            
            $
            334
            
            $
            248
            
            $
            39Non-cash
                investing activitiesFully
                depreciated assets disposed of
            
            $
            205
            
            $
            79
            
            $
            1,083




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




29


ENERGY
      FOCUS, INC.


NOTES
      TO CONSOLIDATED FINANCIAL
      STATEMENTS


December
      31, 2007, 2006, and
      2005




**1.**
            **Nature
                of Operations******




Energy
      Focus, Inc. (“the company”) develops and assembles lighting products using
      fiber optic technology for commercial lighting and swimming pool lighting
      applications. The company markets its products for worldwide distribution
      primarily through independent sales representatives, distributors, and swimming
      pool builders.




**2.**
            **Summary
                of Significant Accounting Policies******




**Basis
      of Presentation**




The
      consolidated financial statements (“financial statements”) include the accounts
      of the company and its subsidiaries. All significant inter-company balances
      and
      transactions have been eliminated.





**Liquidity**





Due
      to
      continued losses and sales declines in 2007, the company has actively pursued
      the raising of additional equity financing in 2008. On March 14, 2008, the
      company publicly announced that it received an additional $9,500,000 in equity
      financing net of expenses. This additional financing will be used to fund
      working capital, pay debt and perform additional research and development.
      The
      company received the funds on March 17, 2008. The company believes that this
      additional financing, when combined with current cash reserves and current
      assets, will be sufficient to fund on-going operations for the next 12
      months.




**Use
      of Estimates**




The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amount of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of revenues and expenses
      during the reported period. Estimates include, but are not limited to, the
      establishment of reserves for accounts receivable, sales returns, inventory
      obsolescence, and warranty claims; the useful lives for property, equipment,
      and
      intangible assets; and stock-based compensation. Actual results could differ
      from those estimates.




**Revenue
      Recognition**




Revenue
      is recognized when it is realized or realizable, has been earned, and when
      all
      of the following has occurred:




·
            Persuasive
                evidence or an arrangement exists, e.g., a sales order, a purchase
                order,
                or a sales agreement.




·
            Shipment
                has occurred (the standard shipping term is F.O.B. ship point) or
                services
                provided on a percentage-of-completion basis or installation has
                been
                completed.




·
            Price
                to the buyer is fixed or determinable.




·
            Collectibility
                is reasonably assured.




Revenue
      from **product
      sale** generally is recognized upon shipping because of the following:




·
            All
                sales made by the company to its customer base are non-contingent,
                meaning
                that they are not tied to that customer’s resale of
                products.




·
            Standard
                terms of sale contain shipping terms of F.O.B. ship point, meaning
                that
                the title is transferred when shipping
                occurs.




·
            There
                is no automatic return provision that allows the customer to return
                the
                product in the event the product does not sell within a defined
                timeframe.




Revenue
      from **installation
      services** ,
      including design and integration services and other services (where product
      sales are not incorporated into the contract), is recognized upon the
      following:




·
            Percentage-of-completion
                method using the ratio of labor cost incurred to the total final
                estimated
                labor cost. Under this method, revenue recognized reflects the portion
                of
                anticipated revenue that has been earned.




Revenue
      from product sales that incorporate **specifically
      defined installation** services
      is recognized as follows:




·
            product
                sale at completion of installation
                and




·
            installation
                service at completion of
                installation


Energy
        Focus warrants its products against defects or workmanship issues. We set
        up
        allowances for estimated returns, discounts, and warranties upon recognition
        of
        revenue, and these allowances are adjusted periodically to reflect actual
        and
        anticipated returns, discounts, and warranty expenses. The distributors’
obligation to us is not contingent upon the resale of the company’s product and
        as such does not prohibit revenue recognition.


30


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
          31, 2007, 2006, and
          2005


**Cash
      Equivalents**




The
      company considers all highly liquid investments purchased with original maturity
      of three months or fewer to be cash equivalent. The company has $7,283,000
      in
      cash on deposit with Silicon Valley Bank in the U.S.A. The remaining cash of
      the
      company is on deposit with European based banks in the U.K. and Germany. The
      cash in the U.S.A. is invested in money market funds that earned an annual
      interest of 2.5% per annum.




**Short-Term
      Investments**




At
      December 31, 2007, we had no short-term investments. All monies were invested
      in
      money market funds and therefore classified as cash or cash
      equivalents.





The
      company’s short-term investments are classified as available-for-sale, which are
      stated at estimated fair value. The company has determined that its short-term
      investments are available to support current operations and, accordingly, has
      classified such short-term investments as current assets without regard for
      contractual maturities. The unrealized gains or losses on these short-term
      investments are included in accumulated other comprehensive income as a separate
      component of shareholders’ equity until realized.




The
      change in net unrealized holding loss on securities available for sale in the
      amount of $69,000 has been charged to other comprehensive income for the year
      ended December 31, 2007. The cost of securities sold is based upon the
      specific identification method.




Proceeds
      from the sale of available securities during 2007 were $49,441,000. Gross gains
      of $241,000 were realized on the sales of available for sale securities during
      2007. Proceeds from the sale of available securities during 2006 were
      $108,800,000. Gross gains of $562,000 were realized on the sales of available
      for sale securities during 2006. Gross gains in both years are included as
      a
      component of Interest Income.




**Inventories**




The
      company states inventories at the lower of standard cost (which approximates
      actual cost determined using the first-in-first-out method) or market. The
      company establishes provisions for excess and obsolete inventories after
      evaluation of historical sales, current economic trends, forecasted sales,
      product lifecycles, and current inventory levels. Charges to cost of sales
      for
      excess and obsolete inventories amounted to $677,000, $868,000, and $196,000
      in
      2007, 2006, and 2005, respectively.




**Accounts
      Receivable**




The
      company’s customers currently are concentrated in the United States and Europe.
      In the normal course of business, the company extends unsecured credit to its
      customers related to the sale of its products. Typical credit terms require
      payment within 30 days from the date of delivery or service. The company
      evaluates and monitors the creditworthiness of each customer on a case-by-case
      basis. The company provides allowances for sales returns and doubtful accounts
      based on its continuing evaluation of its customers’ ongoing requirements and
      credit risk. The company writes off accounts receivable when they become
      uncollectible, and payments subsequently received on such receivables are
      credited to the allowance for doubtful accounts. The company does not require
      collateral from its customers.




**Income
      Taxes**




As
      part
      of the process of preparing its consolidated financial statements, the company
      estimates its income tax liability in each of the jurisdictions in which it
      does
      business. This process involves estimating the company’s actual current tax
      expense together with assessing temporary differences resulting from differing
      treatment of items, such as deferred revenues, for tax and accounting purposes.
      These differences result in deferred tax assets and liabilities, which are
      included in the consolidated balance sheet. The company then assesses the
      likelihood that these deferred tax assets will be recovered from future taxable
      income and, to the extent to which the company believes that recovery is more
      likely than not, or is unknown, the company establishes a valuation
      allowance.




Significant
      management judgment is required in determining the provision for income taxes,
      deferred tax assets and liabilities, and any valuation allowance recorded
      against such deferred tax assets. At December 31, 2007, the company
      recorded a full valuation allowance against deferred tax assets in the United
      States and Germany due to uncertainties related to its ability to utilize those
      deferred tax assets. The valuation allowance is based on estimates of taxable
      income by jurisdiction and the periods over which its deferred tax assets could
      be recoverable.




**Long-Lived
      Assets**




Goodwill
      represents the excess of acquisition cost over the fair value of tangible and
      identified intangible net assets of the businesses acquired. Goodwill is not
      amortized but is subjected to an annual impairment test. Fixed assets are stated
      at cost and are depreciated using the straight-line method over the estimated
      useful lives of the related assets (two to five years). Leasehold improvements
      are amortized on a straight-line basis over their estimated useful lives or
      the
      lease term, whichever is shorter, generally three to seven years. When
      events or changes in circumstances indicate that assets may be impaired, an
      evaluation is performed comparing the estimated future undiscounted cash flows
      associated with the asset to the asset’s carrying amount to determine whether a
      write-down to market value or discounted cash flow is required.




**Fair
      Value of Financial Instruments**




Carrying
      amounts of certain financial instruments including cash and cash equivalents,
      accounts receivable, and accounts payable approximate fair value due to their
      short maturities. Based on borrowing rates currently available to the company
      for loans with similar terms, the carrying value of long-term debt obligations
      also approximates fair value.




31


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
        31, 2007, 2006, and
        2005


**Certain
      Risks and Concentrations**




The
      company invests its excess cash in deposits and high-grade short-term securities
      with a major financial institution that is insured by the Federal Deposit
      Insurance Corporation (“FDIC”) up to $100,000 and the Securities Investor
      Protection Corporation (“SIPC”) up to $500,000 of primary net equity protection
      including $100,000 for claims for cash. At times, the cash balances exceed
      the
      amounts insured by the FDIC. As of December 31, 2007, the company does not
      have
      any short-term securities investments. The company has not experienced any
      losses in such accounts and believes that it is not exposed to significant
      risk
      of loss.





The
      company sells its products primarily to commercial lighting distributors and
      residential pool distributors and pool installation contractors in North
      America, Europe, and the Far East. The company performs ongoing credit
      evaluations of its customers and generally does not require collateral. Although
      the company maintains allowances for potential credit losses that it believes
      to
      be adequate, a payment default on a significant sale could materially and
      adversely affect its operating results and financial condition. At
      December 31, 2007 and 2006, one customer accounted for 8.1% and 6% of
      accounts receivable, respectively. One customer accounted for 7.1%, 11%, and
      11%
      of net sales in 2007, 2006, and 2005, respectively.





The
      company currently buys all of its small-diameter stranded fiber, the main
      component of most of its products, from one supplier. There is a limited number
      of fiber suppliers, and even if an alternative supplier were obtained, a change
      in suppliers could cause delays in manufacturing and a possible loss of sales,
      which would adversely affect operating results.





The
      company also relies on sole source suppliers for certain lamps, reflectors,
      remote control devices, and power supplies. Although the company cannot predict
      the effect that the loss of one or more of such suppliers would have on the
      company, such loss could result in delays in the shipment of products and
      additional expenses associated with redesigning products. It also could have
      a
      material adverse effect on the company’s operating results.




**Research
      and Development**




Research
      and development expenses include salaries, contractor and consulting fees,
      supplies and materials, as well as costs related to other overhead such as
      depreciation and facilities costs. Research and development costs are expensed
      as they are incurred.





The
      company treats government and other third-party funding for whom it is the
      primary beneficiary of such work conducted as a credit to research and
      development costs.





In
      addition, the company receives payments from government and other third parties
      for the completion of deliveries of product and/or services. These payments
      are
      recorded as revenue, and the corresponding costs associated with the production
      of the product or services are charged to the cost of sales in the same period
      in which the revenue is recognized.




**Earnings
      Per Share**




Basic
      loss per share is computed by dividing net loss available to common shareholders
      by the weighted average number of common shares outstanding for the period.
      Diluted loss per share is computed giving effect to all dilutive potential
      common shares that were outstanding during the period. Dilutive potential common
      shares consist of incremental shares upon exercise of stock
      options.




A
      reconciliation of the numerator and denominator of basic and diluted loss per
      share is provided as follows *(in
      thousands, except per* - *share
      amounts):*


**Years
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**Numerator—Basic
                  and Diluted loss per shareNet
                  loss
              
              $
              (11,317
              )
              $
              (9,650
              )
              $
              (7,423
              )Denominator—Basic
                  and Diluted loss per shareWeighted
                  average shares outstanding
              
              
              11,500
              
              
              11,385
              
              
              8,223Basic
                  and diluted loss per share
              
              $
              (0.98
              )
              $
              (0.85
              )
              $
              (0.90
              )




The
      shares outstanding used for calculating basic and diluted loss per share for
      a
      portion of the year 2005 included 156,375 shares of common stock, issuable
      for
      no cash consideration upon exercise of certain exchange provisions of warrants
      held by ADLT and two of its former employees. There were no warrants outstanding
      for ADLT during 2007 or 2006.




Options
      and warrants to purchase 1,459,716 shares, 1,690,430 shares, and 1,485,678
      shares of common stock were outstanding at December 31, 2007, 2006, and
      2005, respectively, but were not included in the calculations of diluted loss
      per share because the company had a loss for these years, and their inclusion
      would be anti-dilutive.




32


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


**Stock-Based
      Compensation**




In
      December 2004, the FASB issued FAS No. 123(R), Share-Based Payment (“FAS No.
      123(R)”). FAS No. 123(R) is a revision of FAS No. 123, Accounting for
      Stock-Based Compensation (“FAS No. 123”), and supersedes Accounting Principles
      Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”),
      and its related implementation guidance. On January 1, 2006, the company adopted
      the provisions of FAS No. 123(R) using the modified prospective method. FAS
      No.
      123(R) focuses primarily on accounting for transactions in which an entity
      obtains employee services in share-based payment transactions. The statement
      requires entities to recognize compensation expense for awards of equity
      instruments to employees based on grant-date fair value of those awards (with
      limited exceptions). FAS No. 123(R) also requires the benefits of tax deductions
      in excess of recognized compensation expense to be reported as a financing
      cash
      flow rather than as an operating cash flow as prescribed under the prior
      accounting rules. This requirement reduces net operating cash flows and
      increases net financing cash flows in periods after adoption. Total cash flow
      remains unchanged from what would have been reported under prior accounting
      rules. For the year ended December 31, 2007, the company recorded compensation
      expense of $877,000. For the year ended December 31, 2006, the company had
      compensation expenses of $1,118,000. At December 31, 2005, the company had
      unamortized compensation expense of $397,000. This amount is now part of total
      unearned compensation of $1,485,000 remaining at December 31, 2007. The
      remaining weighted average life is approximately 1.9 years. These costs will
      be
      charged to expense, amortized on a straight-line method, in future periods
      in
      accordance with FAS No. 123(R) accounting. Additional options were granted
      in
      2007 and have been valued in accordance with FAS No. 123(R). At December 31,
      2007, the intrinsic value of total options outstanding was
      $991,000.




The
      expenses for 2007 and 2006 include both the costs of awards granted in both
      years and those unvested at the beginning of 2006. Both the expense and future
      unearned compensation have been estimated using the Black-Scholes option pricing
      model. Estimates utilized in the calculation include the expected life of the
      option, risk-free interest rate, and volatility and are further comparatively
      detailed below. The volatility estimates are calculated using historical pricing
      experience.





As
      of
      December 31, 2007, the company has two stock-based employee compensation
      plans, which are described more fully in Note 9. Prior to January 1, 2006,
      the company accounted for those plans under the recognition and measurement
      principles of APB Opinion No. 25, Accounting for Stock Issued to Employees,
      and related interpretations. Under these principles, employee stock options
      are
      valued at the excess of the fair value of the underlying common stock over
      the
      exercise price of the options on the grant date. The company accounts for equity
      instruments issued to non-employees in accordance with the provisions of FAS
      No. 123(R) and related interpretations. Under these principles, the equity
      instruments are valued at the fair value, which is computed based on stock
      price
      on the date of grant or other measurement date, exercise price, estimated life,
      stock volatility, and the risk-free rate of interest.





The
      following table illustrates the effect on net income and loss per share if
      the
      company 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* )





**2005**Net
                Loss—as reported
            
            $
            (7,423
            )Add:
                Stock-based employee compensation expense included in reported net
                loss,
                net of related tax effects
            
            
            20Deduct:
                Total stock-based employee compensation expense determined under
                fair
                value based method for all awards, net of related tax
                effects
            
            
            (530
            )Net
                Loss—Pro Forma
            
            $
            (7,933
            )Basic
                and Diluted Loss Per Share—As Reported
            
            $
            (0.90
            )Basic
                and Diluted Loss Per Share—Pro Forma
            
            $
            (0.96
            )




The
      fair
      value of each option grant and stock purchase plan grant combined is estimated
      on the date of grant using the Black-Scholes option pricing model with the
      following weighted-average assumptions used for grants in 2007, 2006, and
      2005.




**2007**
            
            **2006**
            
            **2005**Fair
                value of options issued
            
            $
            3.00
            
            $
            3.52
            
            $
            5.14Exercise
                price
            
            $
            6.28
            
            $
            7.09
            
            $
            10.65Expected
                life of option
            
            
            4.0
                years
            
            
            4.0
                years
            
            
            5.02
                yearsRisk-free
                interest rate
            
            
            4.70
            %
            
            4.91
            %
            
            3.58
            %Expected
                volatility
            
            
            56
            %
            
            59
            %
            
            49
            %




**Foreign
      Currency Translation**




The
      company’s international subsidiaries use their local currencies as their
      functional currencies. For those subsidiaries, assets and liabilities are
      translated at exchange rates in effect at the balance sheet date and income
      and
      expense accounts at average exchange rates during the year. Resulting
      translation adjustments are recorded directly to accumulated comprehensive
      income within the statement of shareholders’ equity. Foreign currency
      transaction gains and losses are included as a component of interest income
      and
      other. Gains and losses from foreign currency translation are included as a
      separate component of comprehensive income (expense) within the consolidated
      statement of comprehensive income (loss).




33


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


**Advertising
      Expenses**





The
      company expenses the costs of advertising, which consists of costs for the
      placement of advertisements in various media. Advertising expenses were
      $464,000, $415,000, and $192,000 for the years ended December 31, 2007,
      2006, and 2005, respectively .




**Product
      Warranties**




The
      company warrants finished goods against defects in material and workmanship
      under normal use and service for periods of one to three years for illuminators
      and fiber. Settlement costs consist of actual amounts expensed for warranty
      services, which are largely a result of third-party service calls, and costs
      of
      replacement products. A liability for the estimated future costs under product
      warranties is maintained based on estimated future warranty expenses for
      products outstanding under warranty.





*(in
      thousands)*


**Year
                  Ended****December
                  31,****2007**
              
              **2006**Balance
                  at the beginning of the year
              
              $
              230
              
              $
              393Accruals
                  for warranties issued
              
              
              381
              
              
              219Settlements
                  made during the year (in cash or in kind)
              
              
              (399
              )
              
              (382
              )Balance
                  at the end of the year
              
              $
              212
              
              $
              230




34


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


**Accounting
      Pronouncements Pending Adoption at December 31, 2007**





***Fair
      value measurements.*** In
      September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (FAS
      157), which defines fair value, establishes a framework for measuring fair
      value, and expands disclosures about fair value measurements. This guidance
      applies only when other guidance requires or permits assets or liabilities
      to be
      measured at fair value; it does not expand the use of fair value in any new
      circumstances. FAS 157 will be effective for fiscal years beginning after
      November 15, 2007 (effective January 1, 2008, for the company). In February
      2008, the FASB issued Staff Position FAS 157-1, which provides that FAS 157
      does
      not apply under FAS 13, “Accounting for Leases,” and other accounting
      pronouncements that address fair value measurements for leases. In February
      2008, the FASB also issued Staff Position FAS 157-2, which delays the effective
      date of FAS 157 for all nonfinancial assets and liabilities, except those
      recognized or disclosed at fair value in the financial statements on a recurring
      basis (at least annually). For items within the scope of Staff Position FAS
      157-2, the effective date will be for fiscal years beginning after November
      15,
      2008. Early adoption of FAS 157 for nonfinancial assets and liabilities within
      the scope of the new guidance is permitted. Management is evaluating the
      potential effect that this guidance may have on the company’s overall financial
      position or results of operations.





***Fair
      value option for financial assets and financial liabilities.*** In
      February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial
      Assets and Financial Liabilities” (FAS 159). This guidance provides an option to
      selectively report financial assets and liabilities at fair value and
      establishes presentation and disclosure requirements designed to facilitate
      comparisons between entities that choose different measurement attributes for
      similar types of assets and liabilities. FAS No. 159 will be effective for
      fiscal years beginning after November 15, 2007 (effective January 1, 2008, for
      the company). The company has elected to not apply this fair value option to
      any
      of its existing assets or liabilities. However, the company may adopt this
      guidance for assets or liabilities in the future as permitted under FAS No.
      159.





***Business
      Combinations.*** In
      December 2007, the FASB issued FAS No.
      141(R), “Business Combinations” (FAS
      141(R)).The new pronouncement requires the acquiring entity in a business
      combination to recognize only the assets acquired and liabilities assumed in
      a
      transaction (e.g., acquisition costs must be expensed when incurred),
      establishes the fair value at the date of acquisition as the initial measurement
      for all assets acquired and liabilities assumed, and requires expanded
      disclosures. FAS 141(R) will be effective for fiscal years beginning after
      December 15, 2008 (January 1, 2009, for the company). Early adoption is
      prohibited. Management is evaluating the potential effect that this guidance
      may
      have on the company’s overall financial position or results of
      operations.





***Noncontrolling
      Interests*** .
      In
      December 2007, the FASB issued FAS No .
      160,
“Noncontrolling Interests in Consolidated Financial Statements, an Amendment
      of
      ARB No. 51” (FAS 160). The new pronouncement requires all entities to report
      noncontrolling (minority) interests in subsidiaries as a component of
      shareholders’ equity. FAS No. 160 will be effective for fiscal years beginning
      after December 15, 2008 (January 1, 2009, for company). Early adoption is
      prohibited. Management is evaluating the potential effect that this guidance
      may
      have on the company’s overall financial position or results of
      operations.





**Accounting
      Pronouncements Adopted in 2007**





***Accounting
      for uncertain tax positions.*** In
      July
      2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
      No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an
      interpretation of Statement of Financial Accounting Standard No. 109,
“Accounting for Income Taxes” (SFAS 109) regarding accounting for income tax
      uncertainties effective for fiscal years beginning after December 15, 2006
      (effective January 1, 2007, for the company). FIN 48 applies to all tax
      positions related to income taxes subject to FAS 109 on Accounting for Income
      Taxes. The impact of adopting the positions of this interpretation did not
      have
      a material impact on the company’s overall financial position or results of
      operations.




35


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


**3.**
            **Inventories***(in thousands)***:**




**December 31,****2007**
            
            **2006**Raw
                materials
            
            $
            5,965
            
            $
            6,354Inventory
                reserve
            
            
            (713
            )
            
            (899
            )Finished
                goods
            
            
            1,636
            
            
            2,253$
            6,888
            
            $
            7,708




**4.**
            **Fixed
                Assets***(in thousands)***:**




**December 31,****2007**
            
            **2006**Equipment
                (useful life 5 years)
            
            $
            8,654
            
            $
            8,411Tooling
                (useful life 2 - 5 years)
            
            
            2,751
            
            
            2,657Furniture
                and fixtures (useful life 5 years)
            
            
            225
            
            
            202Computer
                software (useful life 3 years)
            
            
            417
            
            
            395Leasehold
                improvements (the shorter of useful life or lease life)
            
            
            1,576
            
            
            1,47513,623
            
            
            13,140Less
                accumulated depreciation and amortization
            
            
            (8,307
            )
            
            (7,162
            )$
            5,316
            
            $
            5,978




Fixed
      assets are stated at cost and are depreciated using the straight-line method
      over the estimated useful lives of the related assets (two to five years).
      Leasehold improvements are amortized on a straight-line basis over their
      estimated useful lives or the lease term, whichever is shorter, generally three
      to seven years.




**5.**
            **Goodwill***(in thousands)***:**




In
      accordance with FAS No. 142, goodwill is subject to an annual impairment
      test. The company performs the test in the fourth quarter of every year. The
      tests showed no impairment of the company’s goodwill assets. At December 31,
      2007, the company did not have any intangible assets other than
      goodwill.





The
      changes in the carrying amounts of goodwill for the years ended
      December 31, 2007 and 2006 were as follows.




**Goodwill**
              **Net**
              **Carrying**
              **Amount**Balance
                as of December 31, 2005
            
            $
            4,135Amortization
                expense
            
            
            —Foreign
                currency translation
            
            
            112Balance
                as of December 31, 2006
            
            $
            4,247Amortization
                expense
            
            
            —Foreign
                currency translation
            
            
            112Balance
                as of December 31, 2007
            
            $
            4,359




36


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


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




**December 31,****2007**
            
            **2006**Sales
                commissions and incentives
            
            $
            445
            
            $
            445Accrued
                warranty expense
            
            
            212
            
            
            230Accrued
                and accounting fees
            
            
            302
            
            
            29Accrued
                employee benefits
            
            
            260
            
            
            418Accrued
                payables—related parties
            
            
            —
            
            
            81Accrued
                rent
            
            
            19
            
            
            57Accrued
                taxes
            
            
            116
            
            
            45Others
            
            
            119
            
            
            366$
            1,473
            
            $
            1,671




**7.**
            **Bank
                Borrowings**




The
      company’s bank line of credit in the United States is based on an agreement with
      Silicon Valley Bank dated August 15, 2005. It was amended on September 25,
      2006,
      August 15, 2007, and again on October 31, 2007. This most recent amendment
      is
      retroactive to September 30, 2007, and has extended the credit agreement through
      December 31, 2007. This credit facility is for $5,000,000. The interest rate
      was
      7.75% at December 31, 2007, and 8.75% at December 31, 2006. The rate is the
      same
      for both the term loan and line of credit in both periods.. On December 31,
      2005, this agreement was amended and restated to include an additional
      $3,000,000 term loan line of credit for equipment purchases. This agreement
      calls for repayment of principal in equal amounts over four years from the
      date
      of purchase of the equipment and has an interest rate of prime plus 0.5% if
      the
      quick ratio is 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’s assets and intellectual property. Specific borrowings under the
      revolver are tied to accounts receivable, and the company is required to comply
      with certain covenants with respect to effective net worth and financial ratios.
      The company had borrowings under the revolving line of credit of $973,000 at
      December 31, 2007, and $1,000,000 at December 31, 2006. The revolving line
      of
      credit is a current liability. The company had total borrowings of $1,672,000
      under the term loan portion of the agreement as of December 31, 2007, which,
      according to the most recent amendment, has been classified as a current
      liability. At December 31, 2006, the term loan amount was $2,261,000. The
      company pays an unused line fee of 0.25% against any unused daily balance during
      the year.




On
      October 15, 2007, it was determined that both Silicon Valley Bank and the
      company incorrectly had calculated the tangible net worth covenant for 2007.
      When recalculation of the tangible net worth covenant was accomplished, it
      was
      determined that the company had failed to satisfy the tangible net worth
      covenant for the months of April 2007 through September 2007. The company then
      entered into a fourth amendment to the agreement, which waived all
      non-compliance with the covenant, amended and restated the covenant, and
      extended the maturity date of the line of credit through December 31, 2007.
      On
      January 29, 2008, the company entered into a fifth amendment, retroactively
      effective for December 30, 2007. Under this new agreement, all advances became
      due on February 29, 2008. The maturity schedule for borrowings reflects this
      change. On March 14, 2008, our company entered into a sixth amendment with
      Silicon Valley Bank which extends the due date to April 30, 2008.




Through
      the company’s U.K. subsidiary, it maintains a bank overdraft facility of
      $496,000 (in U.K. pounds sterling, based on the exchange rate at December 31,
      2007) under an agreement with Lloyds Bank Plc. There were no borrowings against
      this facility as of December 31, 2007, or December 31, 2006. The facility is
      renewed annually on January 1. The rate on the facility was 7.75% at December
      31, 2007, and 7.25% at December 31, 2006.





Through
      the company’s German subsidiary, it maintains a credit facility under an
      agreement with Sparkasse Neumarkt Bank. This credit facility was put in place
      to
      finance the building of new offices in Berching, Germany, which are owned and
      occupied by the company’s German subsidiary. As of December 31, 2007, the
      company had borrowings of $368,000 (in Euros, based on the exchange rate at
      December 31, 2007) and $379,000 as of December 31, 2006 (in Euros, based on
      the
      exchange rate at December 31, 2006) against this credit facility. The interest
      rate was 5.49% at December 31, 2007, and 5.35% as of December 31, 2006. In
      addition, the company’s German subsidiary has a revolving line of credit for
      $219,000 (in Euros, based on the exchange rate at December 31, 2007) with
      Sparkasse Neumarkt Bank. As of December 31, 2007, there were borrowings against
      this facility of $186,000, compared to $124,000 at December 31, 2006. The
      revolving facility is renewed annually on January 1. Interest rates on this
      line
      of credit were 10.75% at December 31, 2007, and 9.75% at December 31, 2006.
      The
      $186,000 revolving line of credit is a current liability.




37


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


Future
      maturities of remaining borrowings are *(in
      thousands* ):




**U.S.A.**
            
            **Germany**
            
            **Total****Year Ending December 31,**2008
            
            $
            2,645
            
            $
            240
            
            $
            2,8852009
            
            
            —
            
            
            57
            
            
            572010
            
            
            —
            
            
            60
            
            
            602011
            
            
            —
            
            
            64
            
            
            642012
            
            
            —
            
            
            67
            
            
            672013
                and Thereafter
            
            
            —
            
            
            66
            
            
            66Total
                Commitment
            
            $
            2,645
            
            $
            554
            
            $
            3,199




**8.**
            **Commitments
                and Contingencies**




The
      company occupies manufacturing and office facilities under non-cancelable
      operating leases expiring through 2017 under which it is responsible for related
      maintenance, taxes, and insurance. Minimum lease commitments under the leases
      are as follows




*(in
      thousands* ):




**Gross
                Lease**
              **Commitments**
            
            **Sublease**
              **Payments**
            
            **Minimum Lease**
              **Commitments****Year Ending December 31,**2008
            
            $
            968
            
            $
            (33
            )
            $
            9352009
            
            
            945
            
            
            —
            
            
            9452010
            
            
            797
            
            
            —
            
            
            7972011
            
            
            282
            
            
            —
            
            
            2822012
                —
                2017
            
            
            297
            
            
            —
            
            
            297Total
                minimum lease payments
            
            $
            3,289
            
            $
            (33
            )
            $
            3,256




These
      leases included certain escalation clauses; thus, rent expense was recorded
      on a
      straight-line basis. Consolidated net rent expense approximated $998,000,
      $828,000, and $1,026,000 for the years ended December 31, 2007, 2006, and
      2005, respectively. Beginning in 2006, a portion of our Solon facility has
      been
      subleased. For 2007 and 2006, the gross rent was reduced by $75,000 and $67,000
      of sublease rentals, respectively.




At
      December 31, 2007, a letter of credit in the amount of $316,000 was held by
      the company on behalf of Sparkasse Neumarkt Bank. The letter of credit would
      be
      drawn against the company’s line of credit facility with Silicon Valley Bank in
      the event of a default by the company’s German subsidiary, LBM, on its
      outstanding loan with Sparkasse Neumarkt Bank.




**9.**
            **Shareholders’
                Equity**




**Common
      Stock**




The
      company did not have any notes receivable from shareholders in 2007. During
      2006, the company had a shareholder note receivable of $62,000 for warrants
      exercised in 2005 and paid for in 2006.




38


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
        31, 2007, 2006, and
        2005


**Warrants**




There
      have been no warrants issued by the company in 2007, 2006, and 2005. Warrants
      were issued in 2000 as part of acquisitions, and in 2002 and 2003 as part of
      stock-based financings. There have been no warrants issued to employees,
      directors, or consultants for compensation purposes. All warrants are fully
      vested and exercisable. All warrants will expire on June 17, 2008. The activity
      relating to previously issued warrant activity is as follows:


**Warrants**
              
              **Warrants****Outstanding**
              
              **Outstanding**
              
              **Warrants****Shares**
              
              **Exercise
                  Price**
              
              **Exercisable**
              
              **Amount****(***in
                  thousands***)**Balance,
                  December 31, 2004
              
              
              1,016,002
              
              $
              0.01
                  - $5.563
              
              
              586,002
              
              $
              2,535Warrants
                  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
              
              $
              1,837Warrants
                  exercised
              
              
              (13,800
              )
              $
              4.50
              
              
              (13,800
              )
              
              (62
              )Balance,
                  December 31, 2006
              
              
              396,951
              
              $
              4.30
                  - $4.50
              
              
              396,951
              
              $
              1,775Warrants
                  exercised
              
              
              (85,478
              )
              $
              0.01
                  - $5.563
              
              
              (85,478
              )
              
              (295
              )Warrants
                  cancelled
              
              
              (40,274
              )
              $
              0.01
                  - $5.563
              
              
              (40,274
              )
              
              (260
              )Balance,
                  December 31, 2007
              
              
              271,199
              
              $
              4.30
                  - $4.50
              
              
              271,199
              
              $
              1,220




**1988
      Stock Option Plan**




Upon
      adoption of the 1994 Stock Option Plan (see below), the company’s Board of
      Directors determined to make no further grants under the 1988 Stock Option
      Plan
      (the 1988 Plan). Upon cancellation or expiration of any options granted under
      the 1988 Plan, the related reserved shares of common stock became available
      instead for options granted under the 1994 Stock Option Plan, and, after
      May 19, 2004, under our 2004 Stock Incentive Plan.




**1994
      Directors’ Stock Option Plan**




At
      December 31, 2004, a total of 400,000 shares of common stock had been
      reserved for issuance under the 1994 Directors’ Stock Option Plan. The plan
      provided for the granting of nonstatutory stock options to non-employee
      directors of the company. This plan was terminated on May 19,
      2004.




**1994
      Stock Option Plan**




At
      December 31, 2004, an aggregate of 1,550,000 shares of the company’s common
      stock had been reserved for issuance and were issued under the 1994 Stock Option
      Plan to employees, officers, and consultants at prices not lower than the fair
      market value of the common stock of the company on the date of grant in the
      case
      of incentive stock options and not lower than 85% of the fair market value
      on
      the date of grant in the case of non-statutory stock options. Options granted
      may be either incentive stock options or nonstatutory stock options. The plan
      administrator (the Board of Directors or a committee of the Board) determines
      the terms of options granted under the plan, including the number of shares
      subject to the option, exercise price, term, and exercisability. This plan
      was
      terminated on May 19, 2004.




**2004
      Stock Incentive Plan**




A
      total
      of 1,000,000 shares of common stock had been reserved for issuance under the
      2004 Employee Stock Purchase Plan. On May 19, 2004, the shareholders
      approved the 2004 Stock Incentive Plan (the “2004 Plan”). The stated purpose of
      the 2004 Plan is to promote the long-term success of the Company and the
      creation of stockholder value by (a) encouraging employees, outside
      directors, and consultants to focus on critical long-range objectives;
      (b) encouraging the attraction and retention of employees, outside
      directors, and consultants with exceptional qualifications; and (c) linking
      employees, outside directors, and consultants directly to stockholder interests
      through increased stock ownership. The 2004 Plan seeks to achieve this purpose
      by providing for awards in the form of restricted shares, stock units, options
      (which may constitute incentive stock options or nonstatutory stock options),
      or
      stock appreciation rights. An aggregate of 500,000 shares of the company’s
      common stock was reserved for issuance under the 2004 Plan on May 19, 2004.
      On June 15, 2006, the shareholders reserved an additional 500,000 shares of
      the
      company’s common stock for issuance under the 2004 Plan.




39


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
        31, 2007, 2006, and
        2005


Option
      activity under all plans comprised:


**Options**
                  **Available**
              
              **Number
                    of Shares**
              
              **Weighted**
                    **Average
                      Exercise****for
                  Grant**
              
              **Outstanding**
              
              **Price
                  Per Share****(***in
                  thousands***)**
              
              **(***in
                  thousands***)**Balance,
                  December 31, 2004
              
              
              311
              
              
              1,154
              
              $
              5.56Granted
              
              
              (376
              )
              
              376
              
              $
              9.88Cancelled
              
              
              79
              
              
              (79
              )
              $
              5.50Exercised
              
              
              —
              
              
              (376
              )
              $
              8.95Balance,
                  December 31, 2005
              
              
              14
              
              
              1,075
              
              $
              6.48Granted
              
              
              (330
              )
              
              330
              
              $
              7.12Cancelled
              
              
              6
              
              
              (6
              )
              $
              5.52Exercised
              
              
              —
              
              
              (106
              )
              $
              5.36Additional
                  shares reserved
              
              
              500
              
              
              —
              
              $
              —Balance,
                  December 31, 2006
              
              
              190
              
              
              1,293
              
              $
              7.00Granted
              
              
              (189
              )
              
              189
              
              $
              6.24Cancelled
              
              
              153
              
              
              (153
              )
              $
              6.77Exercised
              
              
              —
              
              
              (140
              )
              $
              4.66Balance,
                  December 31, 2007
              
              
              154
              
              
              1,189
              
              $
              7.19




At
      December 31, 2007, options to purchase 784,000 shares of common stock were
      exercisable at a weighted-average fair value of $2.75, and a total intrinsic
      value of $764,000. At December 31, 2007, total outstanding shares were
      1,189,000, with a weighted-average fair value of $3.01, and a total intrinsic
      value of $991,000.


**OPTIONS
                  CURRENTLY****OPTIONS
                  OUTSTANDING**
              
              **EXERCISABLE****Weighted-**
              
              
              
              
              
              **Weighted-****Average**
              
              
              
              
              
              **Average**
              
              **Weighted-****Number**
              
              **Remaining**
              
              **Weighted**
              
              
              
              **Remaining**
              
              **Average****Range
                  of**
              
              **of
                  Shares**
              
              **Contractual**
              
              **Average**
              
              **Number**
              
              **Contractual**
              
              **Exercise****Exercise
                  Prices**
              
              **Outstanding**
              
              **Life**
              
              **Exercise
                  Price**
              
              **Exercisable**
              
              **Life**
              
              **Price***(in
                  thousands***)**
              
              **(***in
                  years***)**
              
              
              
              **(***in
                  thousands***)**
              
              **(***in
                  years***)**$2.95
                  - $4.80
              
              
              199
              
              
              3.6
              
              $
              3.88
              
              
              189
              
              
              3.6
              
              $
              3.85$5.25
                  - $7.19
              
              
              409
              
              
              7.9
              
              $
              6.47
              
              
              166
              
              
              6.0
              
              $
              6.52$7.23
                  - $9.50
              
              
              305
              
              
              7.1
              
              $
              7.68
              
              
              238
              
              
              6.8
              
              $
              7.77$9.60
                  - 12.00
              
              
              276
              
              
              7.5
              
              $
              10.09
              
              
              191
              
              
              7.5
              
              $
              10.251,189
              
              
              
              
              
              
              
              
              784




**1994
      Employee Stock Purchase Plan**




A
      total
      of 150,000 shares of common stock had been reserved for issuance under the
      1994
      Employee Stock Purchase Plan. The plan permits eligible employees to purchase
      common stock through payroll deductions at a price equal to the lower of 85%
      of
      the fair market value of the company’s common stock at the beginning or end of
      the offering period. Employees may end their participation at any time during
      the offering period, and participation ends automatically on termination of
      employment with the company. On June 15, 2006, the shareholders reserved an
      additional 50,000 shares of the company’s common stock for issuance under the
      1994 Employee Stock Purchase Plan. At December 31, 2007, 2006, and 2005,
      97,831 shares, 94,614 shares, and 90,306 shares had been issued under this
      plan,
      respectively.




40


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
        31, 2007, 2006, and
        2005


**Shareholder
      Rights Plan**




On
      September 12, 2001, the Board of Directors declared a dividend distribution
      of one “Right” for each outstanding share of common stock of the company to
      shareholders of record at the close of business on September 26, 2002. One
      Right also will attach to each share of common stock issued by the company
      subsequent to such date and prior to the distribution date defined below. With
      certain exceptions, each Right, when exercisable, entitles the registered holder
      to purchase from the company one one-thousandth of a share of a new series
      of
      preferred stock, designated as Series A Participating Preferred Stock, at a
      price of $30.00 per one one-thousandth of a share, subject to adjustment. The
      Rights were distributed as a non-taxable dividend and expire ten years from
      the
      date of the Rights Plan. In general, the Rights will become exercisable and
      trade independently from the common stock on a distribution date that will
      occur
      on the earlier of (i) the public announcement of the acquisition by a
      person or group of 15% or more of the common stock or (ii) 10 days after
      commencement of a tender or exchange offer for the common stock that would
      result in the acquisition of 15% or more of the common stock. Upon the
      occurrence of certain other events related to changes in ownership of the common
      stock, each holder of a Right would be entitled to purchase shares of common
      stock, or an acquiring corporation’s common stock, having a market value of
      twice the exercise price. Under certain conditions, the Rights may be redeemed
      at $0.001 per Right by the Board of Directors.




The
      description and terms of the Rights are set forth in a Rights Agreement dated
      as
      of September 20, 2002, between the company and Mellon Investor Services
      LLC, as rights agent. On
      March
      12, 2008, as part of a private placement of shares of common stock and
      warrants to a number of existing shareholders; with the largest portion being
      purchased by the Quercus Trust of Costa Mesa, California, the company and Mellon
      Investor Services, LLC amended the agreement to increase the 15% ceiling noted
      above to 20% for the Trust and persons who are beneficial owners through the
      Trust without triggering the rights under the agreement.




**Follow-On
      2005 Stock Offering**




On
      November 8, 2005, the company closed a follow-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. On
      November 11, 2005, the company announced that the underwriters had
      exercised 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 from
      the selling of 2,952,497 new shares before costs and expenses. The net amount
      received by the company after deducting 6% in underwriters’ fees and legal,
      accounting, and other costs was $22,174,000.




**10.**
            **Income
                Taxes**




The
      company adopted the provisions of FASB Interpretation 48, Accounting for
      Uncertainty in Income Taxes— an Interpretation of FASB Statement No. 109, on
      January 1, 2007. FIN 48 prescribes a recognition threshold and measurement
      attribute for the financial statement recognition and measurement of a tax
      position taken or expected to be taken in a tax return. Guidance also is
      provided on derecognition, classification, interest and penalties, accounting
      in
      interim periods, and disclosure and transition. Based on the company’s
      evaluation, there are no significant uncertain tax positions requiring
      recognition in the company’s financial statements. There was no effect on
      financial condition or results of operations as a result of implementing
      FIN 48 to all tax positions for which the statute of limitation remained
      open, and the company did not have any unrecognized tax benefits. At
      December 31, 2007, there have been no changes to the liability for
      uncertain tax positions, and there are no unrecognized tax
      benefits.





The
      company files income tax returns in the U.S. federal jurisdiction, as well
      as in various states and foreign jurisdictions. With few exceptions, the company
      is no longer subject to U.S. federal, state, and local, or
      non-U.S. income tax examinations by tax authorities for years before
      2004.





The
      company’s policy is to reflect interest expense related to uncertain income tax
      positions as part of income tax expense, when and if they become
      applicable.




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




**Years
                  Ended December 31,****2007**
              
              **2006**
              
              **2005**CurrentFederal
              
              $
              —
              
              $
              —
              
              $
              —Foreign
              
              
              (13
              )
              
              (50
              )
              
              (107
              )State
              
              
              —
              
              
              —
              
              
              (2
              )(13
              )
              
              (50
              )
              
              (109
              )DeferredFederal
              
              
              (162
              )
              
              (74
              )
              
              —Foreign
              
              
              —
              
              
              12
              
              
              —State
              
              
              (15
              )
              
              (1
              )
              
              —(177
              )
              
              (63
              )
              
              —Provision
                  for income taxes
              
              $
              (190
              )
              $
              (113
              )
              $
              (109
              )




41


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


The
      following table shows the geographic components of pretax income (loss) between
      United States and foreign subsidiaries *(in
      thousands)* :


**December
                  31,****2007**
              
              **2006**
              
              **2005**United
                  States
              
              $
              (10,593
              )
              $
              (9,510
              )
              $
              (7,714
              )Foreign
                  subsidiaries
              
              
              (534
              )
              
              (27
              )
              
              400$
              (11,127
              )
              $
              (9,537
              )
              $
              (7,314
              )




The
      principal items accounting for the difference between income taxes computed
      at
      the United States statutory rate and the benefit from (provision for) income
      taxes reflected in the statements of operations are as follows:




**December 31,****2007**
            
            **2006**
            
            **2005**United
                States statutory rate
            
            
            34.0
            %
            
            34.0
            %
            
            34.0
            %State
                Taxes (net of federal tax benefit)
            
            
            1.9
            %
            
            2.0
            %
            
            5.5
            %Valuation
                allowance
            
            
            (38.2
            )%
            
            (39.0
            )%
            
            (46.5
            )%Other
            
            
            0.6
            %
            
            1.8
            %
            
            5.5
            %(1.7
            )%
            
            (1.2
            )%
            
            (1.5
            )%




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




**December 31,****2007**
            
            **2006**
            
            **2005**Allowance
                for doubtful accounts
            
            $
            218
            
            $
            113
            
            $
            99Accrued
                expenses and other reserves
            
            
            1,233
            
            
            1,097
            
            
            1,681Tax
                credits, Deferred R&D, and other
            
            
            202
            
            
            154
            
            
            352Net
                operating loss
            
            
            12,413
            
            
            8,328
            
            
            4,617Valuation
                allowance
            
            
            (14,054
            )
            
            (9,680
            )
            
            (6,749
            )Total
                deferred tax asset
            
            
            12
            
            
            12
            
            
            —Deferred
                tax liabilities associated with indefinite-lived
                intangibles
            
            
            (252
            )
            
            (75
            )
            
            —Net
                total deferred taxes
            
            $
            (240
            )
            $
            (63
            )
            $
            —




The
      company has a full valuation allowance against its United States and German
      deferred tax assets. The net deferred tax assets for 2007 amounted to $12,000
      and were for the company’s United Kingdom subsidiary, which had a loss in 2007
      after being profitable for several years. The net deferred liabilities were
      $252,000 at December 31, 2007, compared to $75,000 at December 31, 2006. There
      were no tax expenses for the United States operations in 2007, as any expected
      benefits were offset by an increase in the valuation allowance. No tax benefits
      were recorded for the 2007 German operations loss. The deferred tax provision
      for 2007 and 2006 resulted from tax amortization of intangible assets with
      indefinite lives for book purposes. In 2007 and 2006, cumulative tax
      amortization exceeded book amortization that had been previously recorded
      resulting in the requirement to record a deferred tax liability of $252,000
      and
      $75,000 at December 31, 2007 and December 31, 2006 respectively.





As
      of
      December 31, 2007, the company has a net operating loss carry-forward of
      approximately $33,500,000 and $34,400,000 million for federal and
      state and local income tax purposes, respectively. If not utilized, these
      carry-forwards will begin to expire in 2020 for federal and 2008 for state
      purposes.





Under
      the
      Internal Revenue Code Section 382, the amounts of and benefits from net
      operating losses carry-forwards may be impaired in certain circumstances. Events
      that cause limitations in the amount of net operating losses that the company
      may utilize in any one year include, but are not limited to, a cumulative
      ownership change of more than 50%, as defined, over a three-year period. A
      valuation allowance is recognized if, based on the weight of available evidence,
      it is more likely than not that some portion or all of the deferred tax asset
      will not be realized. A valuation allowance has been provided because it is
      more
      likely than not that the deferred tax assets relating to certain of the federal
      and state loss carryforwards will not be realized.




42


ENERGY
        FOCUS, INC.
 NOTES
        TO CONSOLIDATED FINANCIAL
        STATEMENTS
 December
        31, 2007, 2006, and
        2005


**11.**
            **Segments
                and Geographic Information**





The
      company has two primary product lines: the pool lighting product line and the
      commercial lighting product line, each of which markets and sells fiber optic
      lighting products. The company markets its products for worldwide distribution
      primarily through independent sales representatives, distributors, and swimming
      pool builders in North America, Europe, and the Far East.




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




**Years Ended December 31,****2007**
            
            **2006**
            
            **2005**United
                States Domestic
            
            $
            14,949
            
            $
            18,776
            
            $
            19,123Other
                Countries
            
            
            7,949
            
            
            8,260
            
            
            9,214$
            22,898
            
            $
            27,036
            
            $
            28,337




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




**December 31,****2007**
            
            **2006**United
                States Domestic
            
            $
            7,791
            
            $
            8,406Germany
            
            
            1,773
            
            
            1,674Other
                Countries
            
            
            111
            
            
            145$
            9,675
            
            $
            10,225




A
      summary
      of sales by product line is as follows *(in
      thousands)* :




**Years Ended December 31,****2007**
            
            **2006**
            
            **2005**Pool
                Lighting
            
            $
            11,002
            
            $
            13,364
            
            $
            14,744Commercial
                Lighting
            
            
            11,896
            
            
            13,672
            
            
            13,593$
            22,898
            
            $
            27,036
            
            $
            28,337




**12.**
            **Employee
                Retirement Plan**




The
      company maintains a 401(k) profit-sharing plan for its employees who meet
      certain qualifications. The Plan allows eligible employees to defer up to 15%
      of
      their earnings, not to exceed the statutory amount per year on a pretax basis,
      through contributions to the Plan. The Plan provides for employer contributions
      at the discretion of the Board of Directors; however, no such contributions
      were
      made in 2007, 2006, or 2005.




**13.**
            **Reorganization
                and Restructuring**




On
      May 8,
      2007, Energy Focus, Inc., a wholly owned subsidiary of Fiberstars, Inc., was
      merged into Fiberstars, Inc. As a result of this merger, the name of Fiberstars,
      Inc. was changed to Energy Focus, Inc. Existing certificates for shares of
      the
      company, bearing the name Fiberstars, Inc., will continue to be valid
      certificates for Energy Focus, Inc., and no action is required by the
      shareholders as a result of the name change .




During
      2007, the company moved the fiber production operation from Mexico to Solon,
      Ohio. The cost associated with this move was $456,000.




During
      2006, the company charged to operations $734,000 for costs associated with
      moving its operations from Fremont, California to Solon, Ohio.




In
      2005,
      the company closed its offices in Fremont, California and consolidated its
      operations in Solon, Ohio, where the company already had a local sales office
      and manufacturing facility. The company recognized a $3,120,000 restructuring
      charge in 2005. The company did not have any liabilities for remaining
      restructuring costs at either December 31, 2007 or 2006,
      respectively.




43


ENERGY
          FOCUS, INC.
 NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS
 December
          31, 2007, 2006, and
          2005


**14.**
            **Related
                Party Transactions**




The
      company entered into a consulting agreement with Jeffrey H. Brite, a member
      of
      its Board of Directors, on November 1, 2004. This agreement ended on March
      7,
      2007, upon Jeffrey H. Brite’s resignation as a member of the Board of Directors.
      As a consultant under this agreement, Mr. Brite assisted the company in various
      capacities. In return, the company compensated Mr. Brite with the award of
      an
      option for the acquisition of up to 40,000 shares of its common stock at a
      per-share exercise price of $7.23, which was expensed during 2004, and with
      annual aggregate cash payments of $50,000 paid in quarterly installments during
      each of the years 2005, 2006, and part of 2007. Payments for the twelve months
      ending December 31, 2007, were $13,690, compared to $50,000 in 2006 and 2005,
      respectively.





Gensler
      Architecture, Design, and Planning, P.C., a New York professional corporation
      (“Gensler”), provided contract services to the company since December 15, 2004.
      Mr. Jeffrey Brite, an employee of Gensler, was a member of the company’s Board
      of Directors through March 7, 2007. Since his resignation, the contract with
      Gensler has been terminated as well. The company had entered into a three-year
      consulting agreement with Gensler for design- and marketing-related matters.
      In
      return, the company compensated Gensler with a one-time cash payment in 2005
      of
      $60,750 and a $50,000 annual cash payment paid in quarterly installments of
      $12,500 in arrears for each of the calendar years 2005, 2006, and part of 2007.
      Also, there was a one-time option award for acquiring up to 75,000 shares of
      the
      company’s common stock at a per-share exercise price of $6.57, which was
      expensed in 2006 under FAS 123(R). No payments were made in the fourth quarter
      of 2007 to Gensler, but the company accrued expenses of $12,500. Payments total
      $37,500 for the twelve months ending December 31, 2007, compared to $50,000
      in
      2006 and 2005, respectively.





On
      July
      1, 2005, David Ruckert, the company’s CEO, resigned as CEO and served as
      president and director through September 30, 2005, after which he served as
      director. Mr. Ruckert signed a severance agreement with the company that was
      effective July 1, 2005, and which resulted in a payment of $332,076 upon his
      departure as an employee on October 1, 2005.





On
      February 3, 2006, the company had entered into a consulting agreement with
      David
      Ruckert, a member of its Board of Directors. Additionally, Mr. Ruckert was
      granted options to purchase 32,000 shares of the company’s common stock. Stock
      expense incurred under FAS 123(R) related to these options was $30,000 during
      2007, compared to $15,000 during 2006.This agreement was terminated on June
      30,
      2007. Mr. Ruckert was paid $110,000 during 2006 and $76,000 during 2007 under
      this agreement.




On
        March
        14, 2008, the company received an additional $9,500,000 in equity financing,
        net
        of expenses. The investment was made by several current Energy Focus
        shareholders, including four members of the Board of Directors. These investors
        agreed to an at-market purchase of approximately 3.1 million units for $3.205
        per unit, based on the closing bid price of Energy Focus common shares on
        March
        13, 2008 of $3.08. Each unit comprises one share of the Company’s common stock,
        par value $0.0001 per share, and one warrant to purchase one share of the
        Company’s common stock at an exercise price of $3.08 per share. The warrants are
        immediately separable from the units and immediately exercisable, and will
        expire five years after the date of their issuance. This additional financing
        will be used to fund working capital, pay debt and perform additional research
        and development. The company received 100% of the funds from escrow on March
        17,
        2008. Among the investors were Ronald A. Casentini, John M.Davenport, John
        B.
        Stuppin and Philip Wolfson, all of whom are members of our Board of Directors
        and who invested approximately $100,000 in the aggregate.




**15.**
            **Subsequent
                Event: Supplemental Equity Financing**




On
      March
      14, 2008, the company received an additional $9,500,000 in equity
      financing, net of expenses. The investment was made by several
      current Energy Focus shareholders, including four members of the Board
      of Directors. These investors agreed to an at-market purchase of approximately
      3.1 million units for $3.205 per unit, based on the closing bid price of Energy
      Focus common shares on March 13, 2008 of $3.08. Each unit comprises one share
      of
      the Company's common stock, par value $0.0001 per share, and one warrant to
      purchase one share of the Company's common stock at an exercise price of $3.08
      per share. The warrants are immediately separable from the units and immediately
      exercisable, and will expire five years after the date of their issuance. This
      additional financing will be used to fund working capital, pay debt and perform
      additional research and development. The company received 100% of the
      funds from escrow on March 17, 2008.




44







**Supplementary
      Financial Information to Item 8**




The
      following table sets forth our selected unaudited financial information for
      the
      eight quarters in the period ended December 31, 2007. This information has
      been prepared on the same basis as the audited financial statements and, in
      the
      opinion of management, contains all adjustments necessary for a fair
      presentation thereof.




Any
      variations from year to date amounts reported in this report are a result of
      rounding.




**QUARTERLY
      FINANCIAL DATA (UNAUDITED)**


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




**2007 QUARTERS ENDED**
            
            
            **DEC. 31**
            
            
            **SEP. 30**
            
            
            **JUN. 30**
            
            
            **MAR. 31**Net
                sales
            
            $
            5,440
            
            $
            5,745
            
            $
            6,704
            
            $
            5,009Gross
                profit
            
            
            543
            
            
            1,988
            
            
            2,280
            
            
            1,470As
                a percent of net sales
            
            
            10.0
            %
            
            34.6
            %
            
            34.0
            %
            
            29.4
            %Net
                income (loss)
            
            
            (3,665
            )
            
            (3,175
            )
            
            (1,870
            )
            
            (2,606
            )As
                a of net sales
            
            
            (67.4
            )%
            
            (55.3
            )%
            
            (27.9
            )%
            
            (52.0
            )%Net
                income (loss) per share:Basic
            
            $
            (0.31
            )
            $
            (0.28
            )
            $
            (016
            )
            $
            (0.23
            )Diluted
            
            $
            (0.31
            )
            $
            (0.28
            )
            $
            (0.16
            )
            $
            (0.23
            )




**2006 QUARTERS ENDED**
            
            
            **DEC. 31**
            
            
            **SEP. 30**
            
            
            **JUN. 30**
            
            
            **MAR. 31**Net
                sales
            
            $
            7,191
            
            $
            6,808
            
            $
            7,709
            
            $
            5,327Gross
                profit
            
            
            1,819
            
            
            2,036
            
            
            2,328
            
            
            1,602As
                a percent of net sales
            
            
            25.3
            %
            
            29.9
            %
            
            30.2
            %
            
            30.0
            %Net
                income (loss)
            
            
            (2,784
            )
            
            (2,125
            )
            
            (2,299
            )
            
            (2,441
            )As
                a percent of net sales
            
            
            (38.7
            )%
            
            (31.2
            )%
            
            (29.8
            )%
            
            (45.8
            )%Net
                income (loss) per share:Basic
            
            $
            (0.24
            )
            $
            (0.19
            )
            $
            (0.20
            )
            $
            (0.22
            )Diluted
            
            $
            (0.24
            )
            $
            (0.19
            )
            $
            (0.20
            )
            $
            0.22
            )







45




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




None




**Item
      9A. Controls and Procedures**





(a)
            Evaluation
                of disclosure controls and procedures.





We
      maintain “disclosure controls and procedures,” as such term is defined in Rule
      13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that
      are designed to ensure that information required to be disclosed by us in
      reports that we file or submit under the Exchange Act is recorded, processed,
      summarized, and reported within the time periods specified in Securities and
      Exchange Commission rules and forms and that such information is accumulated
      and
      communicated to our management, including our Chief Executive Officer and Chief
      Financial Officer, as appropriate, to allow timely decisions regarding required
      disclosure. In designing and evaluating our disclosure controls and procedures,
      management recognized that disclosure controls and procedures, no matter how
      well conceived and operated, can provide only reasonable, not absolute,
      assurance that the objectives of the disclosure controls and procedures are
      met.
      Our disclosure controls and procedures have been designed to meet, and
      management believes that they meet, reasonable assurance standards.
      Additionally, in designing disclosure controls and procedures, our management
      necessarily was required to apply its judgment in evaluating the cost-benefit
      relationship of possible disclosure controls and procedures. Any design of
      disclosure controls and procedures also is based in part upon certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions.




Based
      on
      their evaluation as of the end of the period covered by this Report on Form
      10-K, our Chief Executive Officer and Chief Financial Officer have concluded
      that, subject to the limitations noted above, our disclosure controls and
      procedures were effective to ensure that material information relating to us,
      including our consolidated subsidiaries, is made known to them by others within
      those entities, particularly during the period in which this report on Form
      10-K
      was being prepared.




(b)
      Changes in internal control over financial reporting.





There
      were significant changes made to the financial organization during the third
      quarter with the consolidation of the Chief Financial Officer and controller
      positions into one position held by the current Chief Financial Officer. Even
      though internal controls have not been affected materially by this
      consolidation, we reviewed and tested our internal control environment as a
      result of this change and other changes within the organization. While nominal
      issues were identified within the segregation of duties arena, we experienced
      no
      material deficiencies in our internal control environment over financial
      reporting (as defined in Rule 13a-15(f) under the Exchange Act).




**Management’s
          Report on** **Internal
          Controls over Financial Reporting**





The
      management of Energy Focus, Inc. is responsible for establishing and maintaining
      adequate internal control over financial reporting, as such a term is defined
      in
      Exchange Act Rules 13a-15(f). Under the supervision and with the participation
      of management, including our principal executive officer and principal financial
      officer, we conducted an evaluation of the effectiveness of internal control
      over financial reporting based upon criteria set forth by the Committee of
      Sponsoring Organizations of the Treadway Commission in Internal
      Control—Integrated Framework (COSO framework).





An
      effective internal control system, no matter how well designed, has inherent
      limitations, including the possibility of human error and circumvention or
      overriding of controls; therefore, it can provide only reasonable assurance
      with
      respect to reliable financial reporting. Furthermore, effectiveness of an
      internal control system in future periods can not be guaranteed, because the
      design of any system of internal controls is based in part upon assumptions
      about the likelihood of future events. There can be no assurance that any
      control design will succeed in achieving its stated goals under all potential
      future conditions. Over time, certain controls may become inadequate because
      of
      changes in business conditions, or the degree of compliance with policies and
      procedures may deteriorate. As such, misstatements due to error or fraud may
      occur and not be detected.





Based
      upon our evaluation under the COSO framework, management concluded that internal
      control over financial reporting was effective as of December 31, 2007.
      Grant Thornton LLP, an independent registered public accounting firm, has issued
      an attestation report dated March 17, 2008, on the effectiveness of Energy
      Focus, Inc.’s internal control over financial reporting, which is included
      herein.




46




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




Board
      of
      Directors and Shareholders


Energy
      Focus, Inc.




We
      have
      audited Energy Focus, Inc.’s (a Delaware Corporation) and subsidiaries
      (collectively the “Company”) internal control over financial reporting as of
      December 31, 2007, based on criteria established in *Internal
      Control—Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      The Company’s management is responsible for maintaining effective internal
      control over financial reporting and for its assessment of the effectiveness
      of
      internal control over financial reporting, included in the
      accompanying **** Management’s
      Report on Internal Controls Over Financial Reporting **.** Our
      responsibility is to express an opinion on the Company’s internal control over
      financial reporting based on our audit.




We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, assessing the risk that a material weakness exists, testing
      and evaluating the design and operating effectiveness of internal control based
      on the assessed risk, and performing such other procedures as we considered
      necessary in the circumstances. We believe that our audit provides a reasonable
      basis for our opinion.




A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company’s
      assets that could have a material effect on the financial
      statements.




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.




In
      our
      opinion, Energy Focus, Inc. maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2007, based on
      criteria established in *Internal
      Control—Integrated Framework* issued
      by COSO *.*




We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of the Company
      and its subsidiaries as of December 31, 2007 and 2006, 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, 2007 and our report dated March 17, 2008 expressed an
      unqualified opinion thereon.




/s/
      GRANT
      THORNTON LLP




Cleveland,
      Ohio


March
      17,
      2008




47




**Item
      9B. Other Information**




On
      May 8,
      2007, Energy Focus, Inc., a wholly owned subsidiary of Fiberstars, Inc., was
      merged into Fiberstars, Inc. As a result of this merger, the name of Fiberstars,
      Inc. was changed to Energy Focus, Inc. Existing certificates for shares of
      the
      company bearing the name Fiberstars, Inc. will continue to be valid certificates
      for Energy Focus, Inc., and no action is required by the shareholders as a
      result of the name change.


On
        March
        14, 2008, the company received an additional $9,500,000 million in equity
        financing, net of expenses. The investment was made by several current Energy
        Focus shareholders, including four members of the Board of Directors. These
        investors agreed to an at-market purchase of approximately 3.1 million units
        for
        $3.205 per unit, based on the closing bid price of Energy Focus common shares
        on
        March 13, 2008 of $3.08. Each unit comprises one share of the Company’s
        common stock, par value $0.0001 per share, and one warrant to purchase one
        share
        of the Company’s common stock at an exercise price of $3.08 per share. The
        warrants are immediately separable from the units and immediately exercisable,
        and will expire five years after the date of their issuance. This additional
        financing will be used to fund working capital, pay debt and perform additional
        research and development. The company received 100% of the funds from escrow
        on
        march 17, 2008.




48




**PART III**
  **Item
        10. Directors and Executive Officers of the Registrant**
  **Directors**
  The
        information regarding our directors is set forth under the caption entitled
        “Election of Directors” in our Proxy Statement for our 2008 Annual Meeting of
        Stockholders and is incorporated by reference.
 
 There
        were no material changes to the procedures by which security holders may
        recommend nominees to our Board of Directors during 2007.
  **Executive
        Officers**
  The
        information regarding our executive officers is set forth under the caption
        entitled “Executive Officers of the Registrant” in Part I, Item 4, of this
        report and is incorporated by reference.
  **Section
        16(a) Beneficial Ownership Reporting Compliance**
  The
        information regarding compliance with Section 16 of the Securities Exchange
        Act of 1934 is set forth under the caption entitled “Section 16(a)
        Beneficial Ownership Reporting Compliance” in our Proxy Statement and is
        incorporated by reference.
  **Audit
        Committee**
  The
        information regarding the Audit Committee of our Board of Directors and the
        information regarding “Audit Committee Financial Experts” are set forth under
        the caption entitled “Committees of the Board” in our Proxy Statement and is
        incorporated by reference.
  **Code
        of Ethics**
  We
        have
        adopted a Code of Ethics and Business Conduct, which applies to all of our
        directors, officers, and employees. Our Code of Ethics and Business Conduct
        is
        on our website at www.efoi.com. Any person may receive a copy without charge
        by
        writing to us at Energy Focus, Inc., 32000 Aurora Road, Solon, Ohio 44139,
        Attention: Secretary.
  We
        intend
        to disclose on our website any amendment to, or waiver from, a provision
        of our
        Business Ethics Policy that applies to our directors and executive officers,
        including our principal executive officer, principal financial officer,
        principal accounting officer or controller, or any persons performing similar
        functions, and that is required to be publicly disclosed pursuant to the
        rules
        of the Securities and Exchange Commission.
  **Item
        11. Executive Compensation**
  The
        information required by this item is incorporated by reference herein from
        the
        information provided in the sections captioned “Executive Compensation and Other
        Information” in our Proxy Statement.
  **Item
        12. Security Ownership of Certain Beneficial Owners and Management and Related
        Stockholder Matters**
  The
        information about security ownership of certain beneficial owners and management
        required by this item is incorporated by reference herein from the information
        provided in the sections captioned “ **Security
        Ownership of Principal Shareholders and**  **Management”** and
“ **Equity
        Compensation Plan Information** ”
in
        our
        Proxy Statement.
 
 The
        information regarding securities authorized for issuance under our equity
        compensation plans required by this item is incorporated by reference herein
        from the information provided in the section captioned “Equity Compensation Plan
        Information” in our Proxy Statement.
  **Item
        13. Certain Relationships and Related Transactions and Director
        Independence**
  The
        information regarding certain relationships and related transactions required
        by
        this item is incorporated herein by reference to the information in our
        Proxy Statement under the caption “Certain Transactions” and “Director
        Independence.”
  **Item
        14. Principal Accountant Fees and Services**
  The
        information regarding principal accountant fees and services and the
        pre-approval policies and procedures required by this item is incorporated
        herein by reference from the information contained in our Proxy Statement
        under
        the captions “Ratification of Appointment of Independent Registered Public
        Accountants—Principal Accountant Fees and Services” and “Pre-Approval Policies
        and Procedures.”
  49
  **PART IV**
  **Item
        15. Exhibits and Financial Statement Schedule**
  **(a)**
              (1)**Financial
                  Statements**
  ·
              Consolidated
                  Balance Sheets December 31, 2007 and
                  2006
  ·
              Consolidated
                  Statements of Operations for the Years Ended December 31, 2007,
                  2006, and
                  2005
  ·
              Consolidated
                  Statements of Shareholders’ Equity for the Years ended December 21, 2007,
                  2006, and 2005
  ·
              Consolidated
                  Statements of Cash Flows for the Years ended December 31, 2007,
                  2006, and
                  2005
  ·
              Notes
                  to Consolidated Financial Statements for the Years ended December
                  31,
                  2007, 2006, and 2005
  ·
              Report
                  of Independent Registered Public Accounting
                  Firm
  (2) **Financial
        Statements Schedules**
  Schedule II—Valuation
        and Qualifying Accounts is set forth below. All other schedules are omitted
        either because they are not applicable or the required information is shown
        in
        the financial statements or the notes.
  **SCHEDULE
        II**
 **ENERGY
        FOCUS, INC.**
 **SCHEDULE
        OF VALUATION AND QUALIFYING ACCOUNTS**
 **Balance
                    at****Beginning
                    of**
                
                **Charges**
                
                **Charges**
                
                
                
                **Balance
                      at****Description**
                
                **Year**
                
                **to
                    Revenue**
                
                **to
                    Expenses**
                
                **Deductions**
                
                **End
                      of
                      Year****(***amounts
                    in thousands***)**Year
                    Ended December 31, 2007Allowance
                    for doubtful accounts and returns
                
                $
                600
                
                $
                —
                
                $
                338
                
                $
                90
                
                $
                848Valuation
                    allowance for deferred tax assets
                
                
                9,680
                
                
                —
                
                
                4,374
                
                
                —
                
                
                14,054Year
                    Ended December 31, 2006Allowance
                    for doubtful accounts and returns
                
                
                448
                
                
                —
                
                
                220
                
                
                68
                
                
                600Valuation
                    allowance for deferred tax Assets
                
                
                6,749
                
                
                —
                
                
                2,931
                
                
                —
                
                
                9,680Year
                    Ended December 31, 2005Allowance
                    for doubtful accounts and returns
                
                
                381
                
                
                —
                
                
                106
                
                
                39
                
                
                448Valuation
                    allowance for deferred tax Assets
                
                
                3,349
                
                
                —
                
                
                3,400
                
                
                —
                
                
                6,749
  50
  (3) **Exhibits**
  **Exhibit**
                **Number**
              
              **Description
                  of Documents**2.1
              
              Agreement
                  and Plan of Merger between Fiberstars, Inc., a California corporation,
                  and
                  Fiberstars, Inc., a Delaware corporation (incorporated by reference
                  to
                  Appendix C to the Registrant’s Definitive Proxy Statement on Schedule 14A
                  filed on May 1, 2006).3.1
              
              Certificate
                  of Incorporation of the Registrant (incorporated by reference to
                  Appendix
                  A to the Registrant’s Definitive Proxy Statement on Schedule 14A filed May
                  1, 2006).3.2
              
              Certificate
                  of Designation of Series A Participating Preferred Stock of the
                  Registrant (incorporated by reference to Exhibit 3.2 to the Registrant’s
                  current report on Form 8K filed on November 27, 2006)3.3
              
              Bylaws
                  of the Registrant, (incorporated by reference to Appendix C to
                  the
                  Registrant’s Current Report on Form 8-K filed November 27,
                  2006).4.1
              
              Form of
                  Common Stock Certificate (incorporated by reference to Exhibit 4.1 to
                  the Registrant’s Current Report on Form 8-K filed November 27,
                  2006)4.2
              
              Rights
                  Agreement dated as of October 25, 2006, between the Registrant
                  and Mellon
                  Investor Services, as rights agent (incorporated by reference to
                  Exhibit 4.2 to the Registrant’s Current Report on Form 8-K filed
                  November 27, 2006).4.3
              
              Form of
                  Warrant for the purchase of shares of Common Stock (incorporated
                  by
                  reference to Exhibit 4.2 to the Registrant’s Current Report on Form
                  8-K filed November 27, 2006).
 
 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†
              
              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).10.3
              
              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)).10.4
              
              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))10.5†
              
              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))10.6†
              
              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))10.7
              
              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))10.8*
              
              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)
 
 10.9
              
              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).10.10
              
              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)10.11*
              
              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)
  51
  10.12
              
              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)10.13*
              
              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)10.14†
              
              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)10.15
              
              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)
 
 10.16
              
              Securities
                  Purchase Agreement dated June 17, 2003, by and among the Registrant
                  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)10.17
              
              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)10.18†
              
              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)10.19
              
              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)10.20
              
              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)10.21
              
              Consulting
                  Agreement effective as of November 1, 2004, between the Registrant
                  and Gensler Architecture, Design, and 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)10.22†
              
              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)10.23
              
              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)10.24
              
              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)10.25
              
              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)10.26
              
              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)10.27
              
              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)
  10.28
              
              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)10.29
              
              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)
  52


10.30
            
            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)10.31
            
            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)10.32
            
            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)10.33
            
            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)10.34
            
            Consulting
                Agreement by and between Registrant and David N. Ruckert dated as
                of
                February 3, 2006 (incorporated by reference from Exhibit 10.1 to the
                Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)
                filed on May 15, 2006)10.35
            
            Equipment
                and Supply Agreement entered into May 25, 2006, between Fiberstars,
                Inc.
                and Deposition Sciences, Inc. (incorporated by reference from
                Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q
                (File No. 000-24230) filed on August 11, 2006)10.36
            
            Modification
                to sublease between Fiberstars, Inc. and Keystone Ruby,
                LLC. (incorporated by reference from Exhibit 10.2 to the
                Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)
                filed on August 11, 2006)10.37
            
            Amendment
                No. 1 To Amended And Restated Loan And Security Agreement between
                Fiberstars, Inc. and Silicon Valley Bank dated September 25,
                2006. (incorporated by reference from Exhibit 10.1 to the
                Registrant’s Quarterly Report on Form 10-Q (File No. 000-24230)
                filed on November 14, 2006)10.38
            
            First
                Amendment to Consulting Agreement by and between Registrant and David
                N.
                Ruckert dated as of February 3, 2006 (incorporated by reference from
                Exhibit 10.32 to the Registrant’s Annual Report on Form 10-K filed on
                March 16, 2007)10.39
            
            Amendment
                No. 4 to Amended and Restated Loan and Security Agreement between
                Silicon
                Valley Bank and Registrant dated as of October 1, 2007.10.40
            
            Amendment
                  No. 5 to Amended and Restated Loan and Security Agreement between
                  Silicon
                  Valley bank and Registrant dated as of January 29, 2008.10.41
            
            Management
                Agreement between Barry R. Greenwald and Registrant dated as of October
                19, 2007.21.1
            
            Significant
                subsidiaries of the Registrant.23.1
            
            Consent
                of Independent Registered Public Accounting Firm.24.1
            
            Power
                of Attorney filed in conjunction with this Report31.1
            
            Rule 13a-14(a) Certification
                by Chief Executive Officer31.2
            
            Rule 13a-14(a) Certification
                by Chief Financial Officer32.1
            
            Section
                1350 Certification of Chief Executive Officer32.2
            
            Section
                1350 Certification of Chief Financial
                Officer




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




†
            Indicates
                management contracts or compensatory plan or
                arrangement.




53




**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange
      Act of 1934, the Registrant has duly caused this Report to be signed on its
      behalf by the undersigned, thereto duly authorized.




ENERGY
                FOCUS, INC.Date:
                March 17, 2008
            By:
            /s/
                JOHN M. DAVENPORTJohn
              M. Davenport
              President
                  and Chief Executive Officer
                  (Principal
                    Executive Officer)




In
      accordance with the Securities Exchange Act of 1934, this Report has been signed
      by the following persons on behalf of the Registrant and in the capacities
      indicated on March 17, 2008.




**Signature**
            
            **Title**/s/
                JOHN M. DAVENPORT
            
            President,
                Chief Executive Officer and DirectorJohn
                M. Davenport
            
            *(Principal
                Executive Officer)*/s/
                NICHOLAS
                G. BERCHTOLD
            
            Vice
                President Finance and Chief Financial OfficerNicholas
                G. Berchtold
            
            *(Principal
                Financial and Accounting Officer*)* JOHN
                B. STUPPIN
            
            DirectorJohn
                B. Stuppin* RONALD
                CASENTINI
            
            DirectorRonald
                Casentini* MICHAEL
                KASPER
            
            DirectorMichael
                Kasper* PAUL
                VON PAUMGARTTEN
            
            DirectorPaul
                Von Paumgartten* DAVID
                  N. RUCKERT
            
            DirectorDavid
                N. Ruckert*
                  PHILIP WOLFSON
            
            DirectorPhilip
                  Wolfson




The
      undersigned, by signing his name, signs this Report on March 17, 2008 on behalf
      of the above officers and directors pursuant to a Power of Attorney executed
      by
      them and filed as an exhibit to this Report.




By:/s/
      JOHN M. DAVENPORT




John
      M. Davenport, Attorney-in-Fact.




54





**EXHIBIT
      INDEX**


**EXHIBITS**
              
              **DESCRIPTION**10.39
              
              Amendment
                  No. 4 to Amended and Restated Loan and Security Agreement between
                  Silicon
                  Valley Bank and Registrant dated as of October 1, 2007.10.40
              
              Amendment
                    No. 5 to Amended and Restated Loan and Security Agreement between
                    Silicon
                    Valley bank and Registrant dated as of January 29, 2008.10.41
              
              Management
                  Agreement between Barry R. Greenwald and Registrant dated as of
                  October
                  19, 2007.21.1
              
              Significant
                  subsidiaries of the Registrant.23.1
              
              Consent
                  of Independent Registered Public Accounting Firm.24.1
              
              Power
                  of Attorney filed in conjunction with this Report31.1
              
              Rule 13a-14(a) Certification
                  by Chief Executive Officer31.2
              
              Rule 13a-14(a) Certification
                  by Chief Financial Officer32.1
              
              Section
                  1350 Certification of Chief Executive Officer32.2
              
              Section
                  1350 Certification of Chief Financial
                  Officer


55